There is an extensive list of reasons why companies and their management engage in Mergers and Acquisitions (M&A). For the acquiring entity (buy-side), M&A is a popular tool for expanding business operations or stimulating growth by increasing market share, entering new markets, shaping supply chains, acquiring new technologies and capabilities, etc. No matter the shape or structure of the transaction, the allure of buy-side M&A transactions lies in its potential to create value for shareholders in the medium- to long-term.

For entities selling their business in whole or in part (sell-side), the rationale could range from exiting a business, segment or market that no longer aligns with the strategic focus of the larger company, selling a part of a business to raise capital needed to sustain or salvage the remaining parts of the company, all the way to accepting an offer that is simply too good to refuse (as was the case with Twitter’s shareholders forcing Twitter into Mr. Musk’s arms for €40 billion). Another popular driver of sell-side M&A deals, increasingly in Germany, is the case of the retiring owner(s) of a family business making an exit either for the lack of interested or “competent” successors within the family to continue the business, or to reduce exposure / wealth concentration in a single company (diversification).

Despite the promise of increased revenue (or reduced unit cost), higher market share and ultimately, increase in shareholder value, it is well documented that most M&A transactions, specifically buy-side transactions, do not only fail to generate any value for shareholders, but in fact, destroy value and cost shareholders billions of Euros.

Most studies put the failure rate for M&A transactions at between 70% and 90%, according to a 2020 Harvard Business Review piece. This means that even before accounting for investments in startups and other venture capitalesque initiatives with expectedly low success rates, at least seven out of every 10 acquisitions fail, and the shareholders of these buy-side companies would have been better off selling their shares or receiving cash dividends, and setting some of the cash dividends on fire.

Aswath Damodaran, one of the world’s leading authorities on valuation, aptly referred to as the “Dean of Valuation”, was quoted referring to acquisitions as “the most value destructive action a company can take”. With such well documented and extensively disseminated evidence confirming the low rate of success, why do so many companies even bother with M&A (once again, specifically on the buy-side)? What sets the 10% to 30% of M&A activities that create shareholder value apart from those that destroy shareholder value? In exploring these questions, let us first review why most M&A transactions fail in the first place.

In February 2019, Paul McCaffrey – Editor of the CFA Institute’s Enterprising Investor blog succinctly wrote about Damodaran’s view on M&A, noting that most acquisitions fail “… because acquiring companies tend to overpay. By a lot”. Having reflected on this in the context of my nine years working as an M&A practitioner, I realize that it could not have been phrased any better. Most M&A activities indeed fail as a result of a huge disconnect between the intrinsic value of the target and the acquirer’s implied estimate of value (final purchase price paid).

One of the oldest principles of commerce, predating our use of cowrie shells and precious materials as a proxy for money, is “do not offer up more value than you expect to receive”. A violation of this fundamental principle is made worse with the agency problem (potential conflict of interest between a company’s management and its shareholders), irrespective of how the violation is justified – difficulty in realizing expected synergies from the acquisition, “unforeseen” market or industry forces, ego and empire-building motives by Management (potentially to justify higher compensation packages due to now-bigger company), etc.

Another important reason why many M&A transactions fail to deliver value for the acquirer is the difficulty in integrating two companies with different cultures, values, processes, and systems, as well as improper integration planning and execution. Even when the two companies operate in the same industry, and valuations are reasonable, these factors may make the integration process cumbersome, leading to operational inefficiencies and decreased productivity. This in turn, wipes out the expected gains from synergies and destroys value created by the deal.

Why then do companies still bother with M&A?

This requires a seemingly straight-forward answer. Despite the high failure rate, M&A can indeed provide access to new markets, technologies, or products, and can generate long-term growth and profitability, if managed correctly. Also, a typical M&A process is lined with industry professionals and veterans (including a highly experienced and successful management team at the acquirer) who, in many cases, have a good understanding of the business they are acquiring, and are supported by M&A practitioners and advisors across the entire M&A transaction cycle.

With such knowledge and experience, it is possible to identify targets with the potential to deliver deal value, and to put in place processes, systems and people needed to execute and realize identified deal value, including a careful and expediated post-merger integration process.

Given this wealth of experience, technical know-how and other resources, why then do 70% or more of all acquisitions still fail? At this point it must feel like we have come full circle, with the odds clearly stacked against companies making acquisitions.

What sets successful acquisitions apart from unsuccessful ones?

What then separates the 10% to 30% of acquisitions that turn out to be successful from unsuccessful deals? Are these investors better at estimating the assumptions (discount rates, growth rates, cash flows, etc.) required to properly value a target? Are they simply better at integrating acquired businesses? Are successful acquisitions conducted by the same group of investors or are success and failure distributed across most or all investors? Perhaps a look at the two major types of investors in M&A deals would provide some insight.

M&A deals involving financial investors such as Private Equity (PE) firms have a higher success rate than those carried out by strategic investors. This difference in success rates is often attributed to the business model of PE firms, which I would describe crudely as “buy for as low a valuation as possible; with as much inexpensive capital (a combination of debt and equity) as is practical, given the target’s cash flow situation; attempt to improve operational efficiency aggressively while reducing costs as much as possible; and finally, sell for as high as possible”. This model partly explains why, until recently, PE investors have been known to bid less than strategic investors on most acquisitions.

Although more PE firms are starting to give a higher priority to synergies, especially as they venture into the “buy-and-build” or “conglomerate” model of business and with often longer investment horizons, this focus on potential synergies has always been and remains a key focus for strategic investors when evaluating a target and justifying it to shareholders. This increases the risk overvaluation since some of these deals assign values to perceived synergies that are either simply not there or would be too costly or impractical to realize successfully.

In addition, PE firms are generally more active on the sell-side than strategic investors (with very few exceptions), since their business model often requires them to sell the companies that they acquire. This puts them in a position to benefit from the tendency for “acquires to overvalue / overpay for acquisitions”. Hence, even when a PE firm overpays for an acquisition, they are more likely, than strategic investors, to pass it on successfully (at least before the cracks begin to show) to another acquirer who would, in turn, overpay for the company. On the other hand, when strategic investors undo “unsuccessful mergers”, they often do them at a significant discount to initial acquisition price.

Fortunately, the type of investor is not the sole determinant of success in acquisitions. Some of the most successful acquisitions in history were made by strategic investors, for example, Disney’s acquisition of Pixar and Marvel, Google’s acquisition of Android, DoubleClick and YouTube, Meta’s acquisition of Instagram, Apple’s acquisition of NeXT, etc. However, these companies, often under the same management, have also had an endless list of failed acquisitions. This confirms that success in M&A isn’t restricted to the same groups of investors.

It then follows that, more than anything else, overvaluing a target (overestimating either synergies or stand-alone cash flows) is the biggest cause of failure in M&A. How much attention should strategic investors give to synergies, including how they are incorporated in the combined valuation and what is required to successfully realize the benefits from these synergies?

With appropriate valuation methodology, careful due diligence, effective integration planning, alignment of strategic goals, and dare I say, a little bit of luck (given market uncertainty and unpredictability of outcomes), strategic investors should be able to find success in M&A, despite the odds. Companies that approach M&A deals with a clear understanding of the risks and opportunities involved, and a well-defined integration plan are more likely to succeed regardless of the type of investor involved.