Monday, January 23, 2017

Review of The Synergy Trap by Mark L. Sirower

We have an entire category of Credit Bubble Stocks posts about the principal agent problem at companies. One major principal-agent problem that occurs is when managements decide to grow through acquisitions. The problem is that managers of larger enterprises get paid more - in fact, management pay is in some sense a function of asset size or of equity size. (Also, status is a function of size.)

So, management can buy themselves a larger company by making an acquisition. Unless the managers are significant shareholders, the increased compensation they can expect will outweigh any effects on them from overpaying for another company. From the M&A academic research, we see that,

"Mergers are the quickest and surest way to grow, and thus may be undertaken by managers even if they do not promise profit and shareholder wealth increases."
One of the concepts that these managers use to justify, or "sell", a desired acquisition is the concept of "synergy": the idea that the combined companies will have higher revenue and/or lower costs, resulting in higher combined earnings than as separate companies.

Sirower's book, The Synergy Trap, explores a hypothesis that these synergies rarely materialize. Acquirers will universally claim that an acquisition will result in benefits from synergy, yet they will often make a purchase before putting together any sort of detailed plan for integrating the two companies' operations.

Every time there is an M&A boom, tons of shareholder value of acquiring firms is destroyed. One example in the book happened exactly 20 years ago. Did you know Snapple was once owned by Quaker Oats? 
"Closing one of the worst flops in corporate-merger history, Quaker Oats Co. agreed Thursday to sell Snapple Beverage Corp. to Triarc Cos. for $300 million, only 27 months after Quaker spent $1.7 billion to buy the maker of trendy drinks. (March 28, 1997)"
Triarc sold it to Cadbury Schweppes for $1.45 billion in September 2000, and then in 2008 it was spun-off and continues as a stand alone entity. Meanwhile, in 2001 Quaker was bought by Pepsi, which wanted to get its hands on Gatorade!

And as I've mentioned in the past, the mining and oil industries went on a debt-fueled acquisition boom during the peak of the "commodity supercycle" in 2011. Most of these companies had to restructure during the past two years, meaning that the acquisitions were not just harmful to shareholders but wiped them out entirely.

One very interesting point by Sirower is that the U.S. legal system encourages acquirers to overpay. As a shareholder of a company that makes a stupid acquisition, you have no recourse. The managers are protected by the business judgement rule. But the shareholders of the target have much more protection against their corporation being sold "too cheaply". The equilibrium result is that acquisition prices are too high and transfer value from acquiring firm shareholders to target shareholders.

Speaking of the unintended consequences of U.S. law on corporate governance, a Mises reviewer of Sirower's book makes a great point as well,
The key question that the author fails to ask here is, why is the company willing to pay top dollar on every share when it could buy so many shares at much lower prices on the stock market, and thus preserve a great deal of its own shareholder’s value? Regulation causes this anomaly because it prevents companies from acquiring large blocks of stock in companies, without registering their intentions with the government and alerting the market to their intentions. The government protects these “target firms” from “hostile takeovers.” [...]

Ultimately, the author is led to an explanation of mergers based on economic irrationality. Company executives make “value-destroying acquisitions” as a form of gambling that has their own self-aggrandizement as its goal.
I've made the point about takeover defenses in my review of Dear Chairman. These are state laws or bylaw provisions that make it difficult, slow, and expensive for an investor who purchases shares to translate that ownership into control. These mechanisms stand for the idea that if corporate mismanagement attracts an investor who thinks he can do a better job, he faces serious obstacles in simply buying shares from beleaguered owners and implementing a new plan.

Finally, the whole subject of acquisitions makes me think of a recent discussion of Sitestar on COBF:
"Roll ups of HVAC have been tried a number of times and nobody has cracked the code.  The problem is that they are largely mom and pops who's success is tied to an owner/manager who lives the business.  The customer relationships and employee loyalties are tied largely to that owner.  Once they sell out and move on, those relationships slowly dissipate and die - especially when employees are now reporting to an Area Manager and have to focus on budgeting and targets and other 'corporate' metrics.  There are very few synergies with the exception of some systems and purchasing but those tend to take more effort to integrate than they achieve in savings."
It is really stunning how often an acquisitive strategy will impress investors before flaming out. Bill Ackman alone has had two just in the past couple years: VRX and PAH.



CP said...

Quaker Oats:
Starting in 1902, the company's oatmeal boxes came with a coupon redeemable for the legal deed to a tiny lot in Milford, Connecticut. The lots, sometimes as small as 10 feet by 10 feet, were carved out of a 15-acre, never-built subdivision called "Liberty Park". A small number of children (or their parents), often residents living near Milford, redeemed their coupons for the free deeds and started paying the extremely small property taxes on the "oatmeal lots". The developer of the prospective subdivision hoped the landowners would hire him to build homes on the lots, although several tracts would need to be combined before building could start. The legal deeds created a large amount of paperwork for town tax collectors, who frequently couldn't find the property owners and received almost no tax revenue from them. In the mid-1970s, the town put an end to the oatmeal lots with a "general foreclosure" condemning nearly all of the property

Anonymous said...

So, over time, I’ve shifted much more to a high quality investing style. I want to find good to great businesses that the market isn’t pricing like good or great businesses. And finding those generally requires one of two situations:

Some shift in business conditions that have dramatically changed a company’s (or even an entire industry’s!) structure / outlook but that the market hasn’t picked up on yet.

The classic example of this would be a truly transformational merger. To take this back to Charter, if you listened to them when they bought Time Warner and ran the math on just how large the synergy / cost cutting / growth opportunity was, you’d realize the merger would create massive value for shareholders and the market hadn’t come close to adjusting for that.