The true cost of mergers and acquisitions

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“Statistics show that 70% of the time you acquire an asset, you’ve overpaid for it,” said John Williams, CEO of Domtar Corporation. “After an acquisition, the performance of the asset starts to decline. People tell you, “We’re underinvested. So go ahead and try putting in an extra billion or two in the hopes that it will fix the performance issue you just bought for a billion dollars. It happens every day in the industry.

We fully agree with this observation. In our twenty-five years spent in the trenches alongside our clients’ teams, we find that the vast majority of the time teams underestimate the total capital costs required when making a new acquisition.

Worse still, some companies don’t even try to account for future capex needs. They only go on site EBITDA multiples, another one of those irrelevant metrics. Too many times we have seen first hand the disastrous results of this line of thinking. EBITDA multiples do not take capex needs into account at all. It’s like buying a car for its market price and completely ignoring the fact that it needs a new engine. As if that weren’t worrying enough, EBITDA multiples tend to overvalue older assets and undervalue newer ones; since these are usually older plants for sale, you can imagine the outcome.

Above all, management views a potential M&A through an analytical lens, asking the black or white question: “Is this a good buy?” In our work with our clients, we have proven that it is impossible to assess whether a strategic decision is good or bad in isolation. It is only through a systems thinking lens that an individual site’s true contribution to the portfolio can be uncovered.

The question is, “What is the quality of our company’s accumulated discounted cash flows without the acquisition?” How good can our company’s accumulated discounted cash flows be with the acquisition? The answer to this question will not be the discounted cash flow of the acquisition target. The exception would be if the acquisition target is a completely separate business from what you have today, but why would you buy such a business?

The average success of acquisitions can be debated, and different companies have very different track records of success in their acquisition strategies. There is a large literature on the rationale for acquisitions and the potential risks from an intent perspective. There are, however, a few common pitfalls that are rarely discussed or understood at all.

The underestimation of future capex needs comes from underestimating the replacement costs of new assets by focusing too much on the later years of capex levels, depreciation and book value. Investment levels of recent years rarely give a real indication of the real investment needs in the future to keep assets running. Sellers often “dress the bride” or “put lipstick on the pig” by underinvesting. In addition, depreciation levels give no information about future investment needs. In fact, the correlation may even be negative. Low levels of depreciation often indicate aging assets and significant short-term reinvestment and/or consolidation needs. Then there are buyers who sometimes believe that the necessary capital expenditure does not matter since the investments that will be made will have a positive NPV. Since capital expenditures “will bear themselves”, they don’t think they should be included in the acquisition analysis at all. This is a terribly costly misunderstanding.

Since EBITDA does not reflect future capex needs and the remaining life of the site’s assets, it does not provide any linear information on the enterprise value. Using multiple industry standards, even taking into account the accepted spread between attractive and unattractive targets, tends to undervalue new assets and perhaps more dangerously overvalue aging ones – and again, the ones that get old are usually the ones for sale.

All capital-intensive industries are expected to assume a continued deterioration in the terms of trade, i.e. the cost of incoming goods will have higher cost increases relative to finished goods sold; this deterioration must continually be combated through process, quality and functionality improvements. This means that a significant portion of the investment amounts supposed to improve the business are actually only used to defend its current ability to generate cash flow.

Generally, acquisitions accelerate the optimal rate of consolidation of production capacities. At the extreme, a company with one machine doesn’t need to be able to make as many tough decisions about shutdowns and technology changes as a company that operates ten sites with interchangeability. So, at least from an investment strategy perspective, larger companies need to be more nimble and faster than their smaller competitors when maximizing the value of investment allocation.


Written by Fredrik Weissenrieder and Daniel Lindén authors of REDESIGN OF THE CAPEX STRATEGY.
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