3. Merger and Acquisition Premiums
The premium in a merger or acquisition is defined as the difference between the offer price and the market price of the target before the announcement of the transaction. A substantial body of evidence indicates that M&A premiums average 20 to 30 percent above a target’s preacquisition share price. For example, Kengelbach and Roos (2011) found that the average premium was 36 percent during the period 1990–2010. As conventional wisdom suggests, acquirers perform better when they pay a premium that is below average rather than above average. As mentioned earlier, a high premium is a sure path to overpaying and reducing the likelihood of making the acquisition a success.
M&A premiums are sometimes referred to as control premiums. In general, the target’s shareholders demand them as compensation for transferring controlling interest in the target to the acquirer. Majority control in a company conveys many valuable rights and benefits, including control over all operating policies and decisions, the selection of management and the board of directors, and the distribution of cash to shareholders.
M&A premiums can also represent compensation for other economic benefits, such as the expected synergies associated with the transaction. They can reflect capital market pricing inefficiencies as well, wherein a target is undervalued because the company or its industry is out of favor with investors.
If M&As yield these valuable economic rights and benefits, why do so many of them destroy value? The reasons are many, but the five principal explanations for value destruction appear to be the following:
- Overestimation of the target’s value, primarily caused by an overestimation of the growth and/or market potential (a forecasting error problem).
- Overestimation of the expected synergies (another forecasting error problem).
- Overbidding and overpayment, which is often a consequence of management’s hubris. The risk of overbidding and overpayment increases when several bidders are competing for the target because this heightened competition gives the target more bargaining power to negotiate a higher offer price and, thus, premium.
- Failure to undertake a thorough due diligence of the target.
- Failure to successfully integrate the target after the merger or the acquisition.
In essence, in about every other transaction, the acquirer’s management commits some type of critical error—in the due diligence investigation, in the bidding process, or in the postacquisition integration of the target. How to avoid each of these pitfalls is beyond the scope of this book; instead, we focus on the process of assessing the target’s value—namely, the specific accounting, finance, and taxation issues that the analyst must successfully deal with to estimate the value associated with a merger or acquisition.9