Is a Company doing Righteous Acquisition?

As a shareholder, you do well to place more emphasis on risk than on reward. Corporate management usually does the opposite, and this is why most large acquisitions fail.

Infact, I assume from the start that an acquisition will fail — or at least will turn out not nearly as profitable as the picture management paints.

For starters, a buyer typically pays too much. An old Wall Street saying comes to mind: “Price is what you pay; value is what you get.” It all starts with a control premium. When we purchase shares of a stock, we pay a price that is within pennies of the latest trade. When a company is acquired, though, the purchase price is negotiated during long dinners at fine restaurants and comes with a control premium that is higher than the latest stock quotation.

How much higher? Acquisitions have the elements of a zero-sum game. Both buyer and seller need to feel that they are getting a good deal. The seller has to convince the company’ s board and its shareholders that the sale price is high (unfairly good). The buyer in turn needs to convince his constituents that they are getting a bargain. Remember, both are talking about the same asset.

This is where a magic word — which must have been invented by Wall Street banks’ research labs — comes into play: “synergy.” The only way this acquisitions dance can work is if the buyer convinces his constituents that combining the two companies will create additional revenues otherwise not available, and/or it will eliminate redundant costs. Thus, the sum of synergies will turn the purchase price into a bargain.

If you examine why General Electric Co., for example, has been a subpar investment over the last two decades, you’ll find that it’s because of poor capital allocation. The company lost a lot of value in making destructive acquisitions — buying businesses at high prices, relying on false or unfulfilled synergies, and selling (divesting) at reasonable (or low) prices.

There are also a lot of “dis-synergies” (a term you’ll never see in an acquisition press release). The two corporate cultures may simply be incompatible. One company may have a strong founder-led culture, while in the other company decisions are made by consensus. Cultural incompatibilities only get worse when the buyer and seller are not engaged in the same business.

A case in point: Silicon Valley pioneer HP Inc. has been substantially gutted by large acquisitions. When the company acquired Compaq in 2002, HP’s unique engineering culture did not mix well with Compaq’s manufacturing culture. The same happened with EDS (acquired in 2008), which had a service culture, and again with Autonomy (in 2011) — a software company that ended up being a bag of bad goods (it used questionable accounting and overstated its sales). Each of these acquisitions severely damaged HP’s unique culture, and all were reversed through various spinoffs in recent years.