The market for corporate control is facing a downturn. Thanks to tough borrowing conditions, depressed stock values and the slumping global economy, the value of merger and acquisitions transactions cancelled since the beginning of October almost equals the value of deals that have been completed, according to data compiled by Thomson Reuters. Those figures do not, however, include withdrawn deals for which values were never publicly disclosed. Notable withdrawn deals include the $147bn bid for Rio Tinto, the Anglo-Brazilian mining group, by BHP Billiton, the Australian mining giant; and the failed $48.5bn buy-out of Canada’s BCE telecoms by a consortium of private equity groups. The total volume of worldwide M&A deals globally fell 29 per cent in 2008 compared with 2007, with the US (down 32 per cent) and Japan (down 45 per cent) particularly hard hit.

The reduced activity in the market of corporate control, along with the collapse of iconic companies in the advisory community (investment banks, rating agencies, commercial lenders, consultants, lawyers, accountants) could be perceived as a big blow to many companies for whom acquisitions have been the preferred growth strategy in past decades. When carefully chosen, priced and executed, M&As help companies create value by providing access to new technological or human resources, exploiting learning opportunities, meeting customers’ needs, exploiting economies of scale or restructuring industry capacity.

However, the current slowdown in M&A activity, notably for large transactions, could provide an opportunity for companies to think more carefully about their M&A strategy and the process they have been using to buy companies. Indeed, M&As in past decades have, on average, destroyed value for the acquirer’s shareholders. It is therefore timely to step back and better understand the functioning of the market for corporate control in which companies operate.

Failures in the market for corporate control

Whereas acquisitions have been touted as a value-creating tool, most companies have failed to add value through acquisitions, at least in terms of shareholder value. Beyond the oft-cited reasons (failure to deliver on synergy potential, paying too high a price and integration issues), the root cause of most failures is the incentive system that encourages managers to ask the wrong questions.

Managers should ask how a potential acquisition might improve their company’s ability to meet customer needs in ways that cannot be easily matched by its competitors. They should value this using expected future cash flows to ensure that the purchase price does not exceed this future value. However, most managers ask very different questions, such as: how will this impact on our earnings per share?; how will this impact on our growth rate?; how will this help us to reach market share targets?; and how will this impact on our share price and my options pay-offs?

All targets on such indicators can be achieved by one of two methods: creating value or destroying value. The difference hinges on the expected value of the benefit realised relative to the price paid to obtain it. Whenever a manager delivers on an indicator, the question should be: “What is the value of delivering on the target and what will I have to pay to do so?”

It is important to distinguish between the overriding objective for companies, which is value creation, and the indicators that measure how well they are delivering on this objective which include, share price, EPS, market share, growth in any given indicator, customer satisfaction, etc. Most managers pursue incentives based on these indicators. The result is that managers knowingly destroy value in the pursuit of promotions/bonuses/option scheme pay-offs.

One symptom of these incentive compensation schemes is an undue focus on company size rather than value creation, due in part to the practice of benchmarking CEO compensation across companies of similar size – bigger being better. The result is that managements are willing to overpay for acquisitions and are encouraged to do so by advisers whose primary interest is often ensuring that the transaction takes place rather than ensuring that the acquirer creates value in the process.

Misaligned incentives and the current crisis

This combination of misaligned incentives and a focus on indicators rather than value contributed to the decisions made by bankers and mortgage brokers, among others, that led to the current financial crisis.

Finance and strategy scholars have found evidence of incentives misalignment between investment banks and their clients that arise when banks put their own fees and brokerage commissions ahead of client interests. Within the M&A context, powerful incentives within M&A advisory banking – such as the advisory teams’ bonus pool and the bank’s desire to advance in the M&A league tables by increasing deal numbers and volumes – may conflict with the interests shareholders.

The M&A advisory community has played a significant role in the failures in the market for corporate control. This community, from investment bankers to corporate lawyers, uses incentive systems that push for aggressive transaction execution. Certification agencies have failed to provide reliable estimation of company quality and viability. This violation of shareholder trust has seriously damaged the M&A advisory community’s credibility and this is likely to impact on the role in future. We believe that reliable advisers with the skills to assess and advise on the value impact of M&A opportunities will gain in importance.

Navigating the current M&A market

In the current situation, companies will need to be resourceful and creative to navigate through frictions in the M&A market. Solutions include using internally generated cash, more aggressive use of shares as acquisition currency, delayed payment schemes or other forms of vendor financing, or even using non-equity securities as acquisition currency, which essentially turns the selling company’s shareholders into lenders of acquisition debt financing. These sources will be more difficult for financial buyers to access than for strategic buyers. For this reason, private equity-led acquisitions will need to be more creative still, with recent trends towards higher equity percentages, aggressive vendor financing, and “growth-equity” investments where the returns will be driven by growth of the acquired business rather than cheap leverage.

In every case, it will remain critical that in addition to simply tapping creative financing schemes, the acquirer provides compelling arguments for value creation. Another important skill will be persistence. There will be even fewer “quick and easy” acquisition opportunities than in the past.

This additional pressure will further reinforce the focus on the right questions, such as how could this opportunity enhance our competitive advantage or its sustainability? It will also drive development of internal skills for better identifying, screening, valuing, negotiating, structuring and integrating the right targets at the right price. All of this will help companies to get through what will be a difficult short term, and simultaneously position them to be among the first to capture the opportunities that will arise as economies rebound.

In summary, while the crisis will impose many hurdles to financing and closing transactions in the market for corporate control, it will drive home the critical need to identify and capture value from any and all opportunities. This should strengthen the skills, internally and externally, that are required to deliver on this value-creation imperative as well as the corporate governance terms between shareholders, management and advisers. More than ever, it will be crucial for managers not to manage the short-term cash positions of their companies to ensure their survival, but also prepare for and build long-term value-creating strategies for their companies.

Laurence Capron is professor of strategy at Insead and research director of the Insead-Wharton alliance.
laurence.capron@insead.edu

Kevin Kaiser is affiliate professor of finance and director of the International Executive Programme at Insead.
kevin.kaiser@insead.edu