Poor odds on the takeover lottery

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Second hand firms have something important in common with second hand cars. This explains why takeovers have tended to disappoint.

There have been four great merger booms in Britain this century. The first followed the development of mass production techniques which increased the efficient size of manufacturing plants and firms. Many of Britain’s leading companies today, like ICI and Unilever, are products of the wave of mergers which followed. The next was in the 1960s, when concentration at home was seen as a response to growing competition overseas. It rarely was, and few of the firms created then – like British Leyland or ICL – enjoyed the success their promoters had looked for.

The aftermath of those years itself developed to the theme of the 1980s’ merger boom. The issue was no longer size and scale, or the development of national champions; it was releasing value. A different management team could make more of the same assets, whether through acquisition or buyout. Hostile bids, unknown before the 1960s and rare even then, became routine – Burtons bought Debenhams, Guinness won Distillers, Sir James Goldsmith failed to take BAT.

But for the mergers and acquisitions of the 1990s, the argument is different yet again. The emphasis is on partnerships and alliances, integration and related diversifications, on industry restructuring. Strategic logic is the key buzz word.

The reasons for mergers may vary, but the response remains the same. And you need only look at the grin on Gerry Robinson’s face to see why. For the modern manager, only acquisition reproduces the thrill of the chase, the adventures of military strategy. There is the buzz that comes from the late-night meetings in merchant banks, the morning conference calls with advisers to plan strategy. Nothing else puts your picture and your pronouncements on the front page of the Financial Times, nothing else offers so easy a way to expand your empire and emphasise your role.

But does this have much to do with business? The intellectual case for this type of merger and acquisition activity was developed by American lawyers and finance economists in the mid-1960s, who created the concept of “the market for corporate control”. In this market, the right to manage corporations was a commodity for sale to the highest bidder, and as in any other market this process led resources to be deployed in the most efficient of all possible ways.

Yet there are at least two reasons why the analogy between the market for corporate control and the market for other goods and services does not really apply. One of the attractions of competitive markets is the pressure they create for gradual improvement and gradual correction. If your product is good, you gain market share, and that stimulates others to follow; if it is not, you lose market share and there is an immediate, and growing, need to respond.

The market for corporate control is not like that at all. Control, unlike market share, is an all or nothing business. So Distillers could wallow in complacency for thirty years until, in 1986, everything changed. There is no chance as there is in the detergent market to buy a bit more of Gerry, a little less of Rocco, and see how it works out; suddenly, and abruptly, Rocco is out and Gerry is in. The evolutionary process of the competitive market is replaced by the cataclysmic upheavals of the take-over process.

And that leads to the second important difference. Markets work best when there is symmetric information – when buyers and sellers are more or less equally well-informed about what it is they trade. The markets for used cars and life insurance never seem to work as well as they should – they are archetypes of asymmetric information. And so is the market for corporate control. Incumbent management always knows more about what is for sale than the potential purchaser. Even the worst of managers is better informed about his business than someone who has never been inside it.

And that is why, like used car trading, the market in second-hand companies is rarely efficient. Successful bidders are often only the people who were willing to pay too much – that is the reason why their bid succeeds. And at the same time, good buys may be ignored because there is no way the potential purchaser can be confident that he really is making a good buy. So companies get taken over that should stay independent, and companies stay independent that should be acquired. The largely random incidence of the take-over process means that it is very far from being the source of corporate accountability and effective discipline on management behaviour that the textbook model of the market for corporate control suggests.

And that is why the success record of acquisition activity, taken as a whole, is such a disappointing one. There are several ways in which the results can be assessed. Stock market studies show that, while take-overs certainly benefit owners of the acquired company, they do little for the acquirer. Analyses of pre- and post-merger profitability fail to come up with net gains. Corporate histories show that companies divest a high proportion of what they buy. And the simple subjective test of asking firms whether they thought their purchases had or had not been successful comes up with no more than a 50/50 response.

There are certainly particular acquisitions which have yielded indisputable benefits – like the transformation of Distillers, or some of the under-managed companies bought by Hanson. An activity can be unprofitable on average and yet produce many individual successes. The national lottery is built on just such a principle. As Camelot remind us each week, it could be you. But mostly it isn’t.

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