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COLUMN-Pity the owners of M&A bidding companies: James Saft

(The opinions expressed here are those of the author, a columnist for Reuters)

By James Saft

Sept 19 Shareholders in acquiring companies should be thankful: mergers and acquisitions are down sharply this year.

Despite oceans of happy talk after nearly every merger about new synergies, efficiencies and growth, the actual outcomes facing owners of the bidding companies are far less rosy.

Performance among Russell 3000 stocks which closed a merger between 2001 and 2013 lagged the broader market by more than 16 percentage points in the three years after the deal, according to an August study by S&P Global Market Intelligence. And if you think that's merely a reflection of companies in hard-hit sectors merging to manage decline, buyers also underperformed their industry by 12 percentage points over the same period.

After deals close, profit margins, earnings growth and return on capital all fall, due in substantial part to heavier debt loads, interest expense and the tendency of buyers to suddenly present investors with "special charges".

"When it comes to M&A - management promises to the contrary - the whole is often less than the sum of the parts," analysts at S&P Global led by Richard Tortoriello wrote.

"The larger the deal size relative to the acquirer and the more stock consideration paid, the greater the subsequent underperformance." (here)

This accords reasonably well with earlier work by Sandra Mortal of the University of Memphis and Michael Schill of the University of Virginia who found a connection in stock deals between poor performance and higher rates of asset growth. (here)

Firms, it would seem, wishing to expand their balance sheets often use stock over cash to fund expansion but find it difficult to pull off that growth profitably.

In the S&P Global sample acquirers with the highest pre-acquisition asset growth lag the market by 5.8 percent one year after the deal and by 13.3 percent over three years.

Earlier studies have also, on the whole, found evidence that mergers don't create value for owners.

U.S. M&A volume is down 27 percent year-to-date, according to Dealogic data, though it has passed $1 trillion for the third straight year, the first time that has happened since the bubble years of 1998-2000.

BURNING A HOLE IN YOUR POCKET

While it is indeed a good thing to be an investor in a company which gets a bid, the general picture of the results is of a giant exercise in value destruction, despite deals being universally praised by their own authors and generally lauded by analysts in the investment banking industry.

Besides deal size, which presumably is a marker for unwise aggression and optimism by management, it is notable that cash deals tend to outperform those funded more highly with stock.

This is not hard to explain. If you look back to the dotcom bubble, or even at some tech deals recently, there can be a tendency for managers to feel less constrained in paying up for target companies when the market is placing a rich valuation on their own stock. The post-merger underperformance may reflect a lack of price discipline by executives in bubble-type industries, or more simply the tendency of their stocks to eventually return to earth.

It is easier to spend money using a credit card as opposed to paying cash.

Ironically, a surfeit of cash can tempt a company into making unwise or badly priced acquisitions as well. Companies in the acquisition sample showing the most cash on balance sheet prior to the deals underperformed substantially afterwards; by 8.6 percent over one year and 10.1 percent over three years.

Again, it is hard to disentangle what exactly may be happening with cash-rich companies. Certainly the "cash burns a hole in your pocket" effect may be in play, as may be valuation effects, as companies which are doing well and piling up cash could see the buying power increased by expanding price/earnings multiples.

As ever, it probably makes sense to look at the inevitable conflicts between what is in the best interests of managers and shareholders. Buying companies is fun, and empire building brings with it the potential for an expanded compensation package to go along with expanded assets to manage. That this usually doesn't work so well over three or five years is a hard message for your typical over-confident CEO to hear and accept.

As for shareholders, the best strategy may be if it is not your company getting bought it should be you selling anyway. (Editing by James Dalgleish)

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