Geoff Meeks is Emeritus Professor of Financial Accounting at University of Cambridge Judge Business School. J Gay Meeks is a Senior Research Associate at the University of Cambridge Centre of Development Studies
It’s an often-quoted statistic that roughly 70 per cent of mergers fail. McKinsey’s 2010 report, from which that estimate is taken, echoes the consistent conclusion of four decades of academic research: most mergers fail to deliver any improvement in operating profit.
Yet despite the weight of evidence, vast and ever-increasing sums are spent on mergers and acquisitions — around $5tn globally in 2021 — and on some measures the number of deals has seen a forty-fold increase in forty years.
Should we expect merger rates to continue rising, accompanied by very high failure rates? Absent changes in the present framework, undoubtedly. The M&A market’s many talented, hard-working, highly skilled, law-abiding, income-maximising participants will continue to promote destructive mergers. It would be surprising if they did not.
There are three interwoven strands in this argument. First, contracts (explicit and implicit) often reward key players in the M&A market — executives and advisers — for deals that result in zero or negative operating gains.
Second, legal and taxation arrangements often enable acquirer executives, as well as shareholders in these cases, to extract economic rent from other stakeholders in deals that yield no operating gains.
Third, accounting rules and practice often offer rich opportunities for acquirers to mislead the market about the prospective operating gains from merger, and to flatter performance measures following merger.
Contracts and incentives
“Show me the incentive and I will show you the outcome”, said Berkshire Hathaway vice-chair Charlie Munger. Incentives for bidder CEOs were the subject of a 2007 analysis by Jarrad Harford and Kai Li, which concluded that “even in mergers where bidding shareholders are worse off, bidding CEOs are better off three-quarters of the time.” One factor in this is the strong link between CEO salary and firm size. Acquisition of another company is one of the easiest ways to grow.
For example, the $27bn purchase of Refinitiv by London Stock Exchange Group in 2021 immediately tripled the acquirer’s revenue. LSE boss David Schwimmer was “rewarded with a 25 per cent increase in base salary . . . to reflect the LSE’s increased size following the Refinitiv purchase”. Yet in the same month, LSE shares fell 25 per cent on concerns about its ability to extract synergies from the acquisition.
In an attempt to align the interests of executives with shareholders, the last three decades have of course seen increasing use of bonuses linked to measures of performance such as earnings per share. But there are particularly rich opportunities afforded by mergers to game performance-related pay, through morally hazardous borrowing and by tax avoidance and creative accounting, procedures that deliver improved pay and perks for no genuine improvement in the underlying operating performance that matters most for the wider economy.
Rewards to the CEO for increasing firm size are sometimes defended on the general grounds that a bigger organisation is harder to manage. But growing by the particular means of acquiring rivals can often bring the CEO a quieter life. In The Curse of Bigness, author Tim Wu describes how Facebook swallowed up Instagram and WhatsApp when their innovative products presented a challenge.
But don’t the non-executive directors constrain self-serving deals by executives? That’s not how it worked at General Electric, which in the two-decade tenure of Jack Welch was buying businesses at a rate of one a week. A recent book by Thomas Gryta and Tedd Mann gives a flavour of life in the GE boardroom:
One newcomer to the board under Welch was surprised by the CEO’s command of the board room and the sparse debate among the group. Confused by how the meeting transpired, the new director asked a more senior colleague afterward, “What is the role of a GE board member?”
“Applause,” the older director answered.
What about the investment bankers, lawyers, accountants and consultants hired by the acquirer? In practice it is not reasonable to expect professional advisers to caution against a deal they doubt will enhance operating profits, when the executives who hire them (and may hire them again) express no such doubts and are backing it to the hilt. After all, the advisers’ impressive fees are related to closing the deal, not to post-merger operating gains — fees of around $1.5bn in the case of AB InBev’s merger with SABMiller, one which was followed by unimpressive financial performance.
In some cases, mergers that lead to operating losses can still advantage the acquirer’s shareholders. Here, it is other stakeholders who bear the cost, thanks to legal, taxation and central banking arrangements favouring shareholders and executives at the expense of many others: the taxpaying public, creditors, pensioners . . .
Debt-financed acquisitions can magnify the equity-holders’ earnings even where operating profits fall. Of course, more debt means a higher risk of failure. But due to limited liability provisions much of the downside risk associated with slender equity cushions is borne by others — moral hazard in action.
An illustration is provided by Carillion, the former UK construction company. It had been built via a string of acquisitions and relied heavily on debt finance. When it failed, it owed around £2bn to 30,000 suppliers, who would receive little from the liquidators, and some of whom were themselves bankrupted as a result. Fellow casualties included members of Carillion’s systematically underfunded pension fund.
This incentive to make acquisitions unwarranted by operating gains is reinforced by the tax system. In most jurisdictions, corporation taxes are not levied on the portion of profits paid as interest to lenders. This privileged treatment makes it even easier to transform poor operating profits into enhanced surpluses for investors via a debt-financed merger. And the benefit can be particularly valuable in cross-border transactions.
Former tax inspector Richard Brooks writes in The Great Tax Robbery that “a cross-border takeover is to Britain’s tax lawyers and accountants what a well-fed wildebeest with a limp is to a pride of lions.” His examples include Spire Healthcare, acquirer of Bupa hospitals, “wiping out its taxable profits by paying interest offshore at 10 per cent.”
The incentives for unprofitable mergers offered by morally hazardous borrowing and tax subsidies have been yet further reinforced in recent years by the central banks’ manipulation of the debt market, forcing down interest rates. Cheap debt has been described by McKinsey partner Bryce Klempner as the “lifeblood of private equity”. And private equity has of course in recent years been a major force in the M&A market with its business model of buying firms, loading them with debt, and selling them a few years later. The model benefits then not only from imposing downside risk on other stakeholders, but also both from the generous tax treatment of debt finance, and from interest rates being held down by central banks.
To complete the package of benefits, the heads of these private equity firms have in the US and UK enjoyed privileged rates of tax on their personal profits from M&A, known as “carry”. In the words of an FT leader: “The result has been to foster a generation of buyout billionaires who have paid lower tax rates than their cleaners.”
Acquiring firms enjoy rich (but perfectly legal) opportunities to deploy creative accounting around mergers — flattering and smoothing reported and forecast profit, securing funding on unduly favourable terms, and masking subsequent declines in underlying performance.
A famous illustration is provided by GE’s spending spree — some 1700 acquisitions between 1980 and 2017 — followed by its decline and dismemberment. Critics have recounted creative accounting devices GE employed such as tweaking the expected future costs of multi-period contracts, fudging the value of inventory, writing down the ‘fair value’ of acquired assets and channel stuffing (bringing forward sales).
Governments, regulators and non-executive directors could install a series of measures to eliminate or mitigate these problems in the M&A market. It isn’t as if all this is inevitable — there is much that could be done to make this dysfunctional market much more efficient than it currently is. But under the present framework, there is every reason to suppose the disappointing outcomes of the M&A market will continue unabated.
Once the clues are followed on incentives, rent extraction and creative accounting opportunities, frequent pursuit of unproductive merger turns out not to be mysterious. And key participants in mergers are unlikely to seek to alter the status quo themselves. On the contrary, as Neil Collins writes:
Think of the impact of a “transformational” deal, the thrill of the chase, the media spotlight, the boasting rights, and — of course — the massive pay rises. You will be number one! By the time it all ends in tears, the executives who have laid waste to the shareholders are long departed with their winnings . . .
The authors’ book, The Merger Mystery, is free to download