The Costly Myth of Growth Through Acquisition

In the banking world, M&A fever is in the air again. Stock prices are up, so buyers have a rich currency with which to close deals. And the yield curve is shifting: At least a few banks will thus come under earnings pressure soonu00e2u20ac”and look to be acquired as a way out of their problems. Perfect!

Perfect, that is, for everyone but the shareholders of the acquirers. Despite all the time, money, and brainpower that will go into deal-chasing in coming months, the sad fact is acquisitions hardly ever create shareholder valueu00e2u20ac”and very often destroy it. One study after another from consultants such as McKinsey and Marakon Associates shows this to be overwhelmingly true. So the next time your CEO brings you a wonder deal, think long and hard and ask some tough questions. You might start with these four:

1. How much due diligence was done? Alas, probably not enough. Too often, buyers rush through due diligence to get the deal done before word of it leaks out to employees and investors. That’s badu00e2u20ac”especially in this business. Banks, in particular, tend to have complex technological infrastructures and granular, heterogeneous asset portfolios. It’s simply impossible to analyze and understand all that stuff quickly.

Yet due diligence is routinely given short shrift. Earlier this year, Bain & Company quizzed merger and acquisition executives at large companies in and out of the financial services business and came away with some disturbing findings:
– 50% of M&A execs said their due-diligence efforts failed to uncover major problems at the acquired institution.
– 50% said the acquirees had been “dressed up” for sale.
– 67% said they routinely overestimated the synergies available.
– 30% said they were satisfied with the rigor of their due diligence process.

And these are people who do this stuff for a living! Moral of the story: insist that management has done the work to know the details of the business it’s buying.

2. Are you realistically calculating any economies of scale to be achieved? My guess is the answer to this will be “no”u00e2u20ac”no matter what your CEO says. The notion that economies of scale flow from big-bank mergers, so widely held by bank executives and their investment bankers, is simply a myth. Our research shows that once a bank gets past a relatively low level of assets, there is no, repeat no, correlation between its size and its efficiency, growth rate, or profitability. A study of economies of scale in banking organizations in other industrialized nations, published earlier this year by the Federal Reserve of Atlanta, came to the same conclusion. So if one of the rationales for a proposed deal is the economies of scale it can achieve, apply some discount factors to the initial projection.

3. What are you looking for in the way of revenue synergies? Hopefully, nothing. It’s no secret mergers often bring inefficiencies in the near term, by disruptions in customer, challenges with back-office systems integration, and the reallocation of marketing resources. Quickie spending cuts can be shortsighted and hurt the top line. This doesn’t mean acquirers tend to bad integratorsu00e2u20ac”it’s just the way the world works. Yet too often, acquirers assume they can improve the revenue growth rates at their acquirees. They can’t. So if your CEO says he’s going to make his deal work with revenue synergies, ask him how the numbers would look if the acquiree’s top line went down rather than up.

4. How do you know you’re not paying too much? Given the litany of mistakes described aboveu00e2u20ac”a chronic lack of due diligence and overly optimistic estimates of cost savings and revenue enhancementsu00e2u20ac”it shouldn’t be surprising that the acquirer usually overpays. The result is severe and permanent dilution of existing shareholders, which will become apparent in ensuing years. Too often, this unfortunately leads to that dreaded Wall Street malady: serial-acquirer-osis. That happens when an acquirer does another, bigger deal that’s designed to fix the earnings shortfall caused by the first one. But then that deal turns out to be dilutive, too, for all the same reasons the earlier one was. Then there’s another dealu00e2u20ac”and then another. All along the way, shareholders get shellacked.

Does all this mean that all deals are bad? Not a bit! Some of the best-run banks in the country have become experts at buying smart and integrating well. Fifth Third, M&T Bancorp., and Umpqua Holdings come to mind.
But the vast majority of companies that have grown through acquisition have not built shareholder value over the long term. Often, they’ve destroyed it. That’s something to keep in mind the next time a “perfect deal” comes your institution’s way.

My watchwords to live by: Take your time analyzing a potential acquisition and be realisticu00e2u20ac”even hardheadedu00e2u20ac”in your assumptions.