April 18, 2022

When Two Plus Two Equals Two

This week we explore the current craze in the mergers and acquisitions going on just now. And asking, do they actually create additional value? Or is it the case that two plus two does equal two? (Repeat)

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This week we explore the current craze in the mergers and acquisitions going on just now. And asking, do they actually create additional value? Or is it the case that two plus two does equal two? (Repeat)


BT12 When Two Plus Two Equals Two

Will Page: Welcome back to Bubble Trouble, with myself, Will Page, and independent analyst, Richard Kramer. So, management consultants are known for drawing two by two matrixes, being able to frame things that are very simple two by two format.

We're gonna play on that with our title this week. We're gonna knock out two by two, and it's gonna be two plus two. Which, if I went to school back in the time of Henry the Eighth, was equal to four.

But this week's podcast is called Two Plus Two Equals Two. And we're gonna be exploring the current craze in the mergers and acquisitions going on just now. And asking, do they actually create additional value? Or is it the case that two plus two does equal two? Back in a moment.

 Welcome back to Bubble Trouble, with myself, Will Page, and independent analyst, Richard Kramer. Richard, welcome along.

Richard Kramer: Good to be back, Will!

Will Page: Let's get into this one here. It- it does seem like we're going through another feeding frenzy in mergers and acquisitions, in corporate development teams and companies, we're working every hour of the day, every day of the week. You know? Licking it, shopping up companies like they're Pacman.

I wanna hear from you in terms of, what's the driving force of this huge splurge in mergers and acquisitions that's going on right now?

Richard Kramer: Well, there's a- a range of forces there. And I'd say the starting point is that the grass is really always gonna be greener on the outside. Whenever a company is missing a feature, a product, feels that what it has to offer is incomplete in some way, they face a make-or-buy decision.

They can either roll up their sleeves, spend more on product development or RND or what have you and- and pull together the solution. Or they can go buy a competitor or something off the shelf or even a small company that has some talent that might be able to build it for them. And that's where the seduction of M&A comes in.

Now, if you look at some of the research around M&A, it's very conclusive. There was one meta study that was done looking at 50,000 transactions and hundreds of academic studies. And guess what? It turned out that in over 80% of the cases, you didn't have a positive result on the performance of the two merged companies, that the two plus two didn't equal four, it equaled less than four.

Will Page: [laughs] so, what we're saying here is we're spending an awful lot of money, presumably on lawyers and analysts, et cetera. But we're not actually generating any new money for that money that goes out?

Richard Kramer: Yeah. And that- part of the reason for that is simply that thew new money that comes back in has to be judged on a very long timescale. And all those investment bankers and lawyers and people who take the fees out of the transaction, they take them right away. And so, a lot of times, the proof of the value of M&A is a negative one. Is, "My goodness, if we didn't do this, we'd really be in trouble. We'd be sub-scale." [crosstalk 00:03:03]

Will Page: Right. [crosstalk 00:03:03]

Richard Kramer: We have followed [crosstalk 00:03:05] by the wayside. And therefore, we get encouraged to do it. But one of the key reasons that all of those transactions on balance tend to destroy value, is the tendency to overpay.

And we can talk about the conflicts of interest in the incentives for both the- the company that's making the purchase and the company that's getting bought, and the people in the middle, as to why those transactions tend to take place at prices that are just eye-popping.

Will Page: So I'm feeling that and this incentive structure is something we keep on coming back to when we're trying to explain the causes and consequences of Bubble Trouble. But let's stick with what you're talking about there, in terms of how people think. Not so much on the spreadsheets, essentially, but what's in their minds.

It sounds to me there is a psychological aspect to all of this. And we hear a lot about FOMO, fear of missing out, and I think this is, you know, we're doing a podcast here, for irony's sake. In the podcast market, there's a fear of missing out. "What? You've got a big company? You don't have a podcast strategy? You've gotta go acquire one!"

Richard Kramer: As I said, the grass is always gonna be greener on the outside. And the companies that you're looking to buy have one tendency that I've observed dozens and dozens of times in my 20+ years as an analyst, which is, from the outside, you see an unstoppable Juggernaut. A company that has everything going for it that is every bit as good as its own marketing.

Will Page: Which could be talking your own book, it could be the shroud of the unused [inaudible 00:04:35] it could be all of those factors that we've already- [crosstalk 00:04:37]

Richard Kramer: Absolutely. But on the inside, as we all know, in every organization, you see the dysfunctionalities. The incompetencies. The living on past, uh, promise, as opposed to the future stuff that you're going to create. You see the missed deadlines and- and the internal politics. And that dirty laundry is rarely on public view.

There is always a tendency to ascribe magical properties or thinking to someone on the outside. And to quote the Wizard of Oz, "If I only had a brain, if I only had something else that would make me complete." And that, oftentimes, is what people look for in those acquisitions.

It's going to be the thing that I buy and it solves the problem. If I only had this, everything would be fine. And it's always faster and easier to buy that than to go through the painstaking process of building what you don't have. [laughs]

Will Page: It's almost as simple as keeping up with the Joneses. Your next door neighbor's got that new household feature or that new feature in their garden, you gotta have it too. So it's that fear of missing out drive to kind of keep pace with the competition through the acquisition strategy.

So, let's turn to the value of these deals. You've got a willing buyer, you've got a willing seller, and you've got a transaction. What do you see happening with the transactional value of deals that we're seeing happening right now? This crazy period, you're in lockdown where, you know, stock prices have rallied, markets seem to be overheating, risks of inflation. What do you see happening there?

Richard Kramer: Well, the one thing that's clear in almost all of these cases is that someone in the middle, typically the bankers and the advisors, have an incentive to increase the overall value. Because they're being paid as a percentage of the deal. They're not getting a flat fee.

"Hey, if company A buys company B for 100 or 200, we're gonna get paid the same. They might be getting three or seven percent of the deal or two percent of the deal. But the larger the deal is, the more they get paid. So, they have an incentive to increase the deal price.

The seller, obviously, wants to get the largest price possible and try to secure the largest portion of that in- in hard assets, in cash, as opposed to getting equity and the merged entity. The buyer is going to feel very insecure, especially if they think that there's someone else that's bidding against them for the very same asset.

And that's oftentimes the situation where companies, not only overpay, but manage to overlook all these flaws or issues that should be surfaced in due diligence, but just kept swept under the carpet in the rush to buy this magic thing that's going to transform their business or help them maintain their competitive position.

Will Page: To- you do remind me of, in auction theory, you have the winner's curse, which is if you win an auction, you're a real sucker. 'Cause nobody is willing to pay as much for that item as yourself. [crosstalk 00:07:39]

Richard Kramer: Absolutely. The- the other thing that's absolutely critical here is like a marriage, like any transaction, you're always gonna underestimate the challenge of integration. How many people get a pet home, and they realize, "Oh, geez. We didn't get a litter box for the cat! We didn't realize how often we'd have to take the dog out for a walk!"

And whether it's integrating in terms of company cultures, and I think you mentioned it very interestingly with bringing up two different companies that were suggested that they ought to get together and you said, "Well, geez, I couldn't think of two companies that have more different or distinct corporate cultures. Or the methods of the business, whether it's they're using different sorts of accounting software, whether they run their businesses in a different way.

Merging all those together, I liken it to imagine two toothbrushes and having to put them together and marry up all the bristles. But oftentimes, it's not a- a few dozens of bristles on your toothbrush, but thousands and tens of thousands of- of employees that need to be brought together and work in the same way. And that's always underestimated.

Will Page: Interesting. So, let's just recap here. So, we've got the- the point you make at the very start there about underestimating the challenge of integrating companies. And that, you know, is clearly staring you in the face. But sometimes you don't see that because you've got this fear of missing out. And this fear of missing out often leads you to overpaying, and then back to this overarching point for me, what happens going forward?

What happens when the deal is done? The invest analysts are all paid off, the lawyers are all paid off, and you have these two entities, bed-fellows, as it were, trying to work out how to get along. And I- I can see the irony of the situation of after the merges, spending gazillions of dollars on outsourcing projects to take what you've essentially merged and rip it out of the company and stick it- [crosstalk 00:09:32]

Richard Kramer: Well, this is where one of the big promises of M&A is that the two companies will find synergies. You bring two companies together, they both have HR departments and finance departments and accounting and legal departments.

And you might be able to run both the companies with one of those departments. But what typically kicks off is that six to 12 month bun fight as to whose department and whose staff from whose department actually still has their job.

And which one is the most [crosstalk 00:10:03] effective at managing accounting or HR or which one is the buyer and which one is the seller and it's the buyer, the one who gets to make all those decisions.

Will Page: And that's not rational decision making, that's political in-fighting, and political in-fighting doesn't produce the conclusion that you- [crosstalk 00:10:19]

Richard Kramer: Absolutely. And you cannot underestimate, in large companies, the influence of political bureaucracy and culture, and saying, you know what? My department, we have 1100 people working for us. And so if I'm the head of that department, I feel pretty big and important. And if someone comes along and says, "Well, you know, we've bought your company and we wanna keep a few of your star performers but the rest of you can go." Well, I'm gonna do everything I can to fight that. Because I'm out of a job if I don't fight my corner there.

And so, the incentives for each individual are oftentimes very different than the incentives from the two merged entities getting together. And they're all chasing these ephemeral concept called 'synergies'. The idea that two plus two will equal five, but the cost space of two plus two is going to equal three or two or even one.

Will Page: That gets us to the end of part one where we've understood, you know, the reason why we have this activity, essentially, a fear of missing out. And the reason why a lot of this mergers and acquisitions often go wrong, because you underestimate the challenges. And also reasons why they overpay, because there's an incentive structure.

Again, an Achilles heel of Bubble Trouble and incentive structure where people are getting paid upfront on the value of the deal. Uh, it's like buying and selling a house. Do you want an agent on the buy side and then the agent on the sell side, therefore paid twice the fee structure.

In part two, I wanna look at the good, bad, and ugly of mergers and acquisitions. And then, as we always do on Bubble Trouble, exposing smoke signals to help you, the listener, spot when these deals could be going sour. Back in a moment.

 Back again with part two of Bubble Trouble. This time, we're confusing the mathematics. We're gonna call this one Two Plus Two Equals Two. Not four, but two. That is, when two companies merge, no value is created. In fact, some values potentially destroyed.

But let's wheel back on the mess for a second. You could have a good merger acquisition, where two plus two equals five. You could have a bad one, where two plus two equals four. You could have a- an ugly one, where two plus two does equal two. I don't- you can't generalize, let's explore each three lanes here independently.

Richard, can you give us the example where things have worked out really well? So, textbook example of "this is how to perform a merger" or "this is how to conclude an acquisition".

Richard Kramer: Sure. I think one of the best scenarios for M&A is when a large company that is already a well-run entity buys a smaller one in a promising evolving area. And let's go back to, I think it was 2006, somewhere around then, where Google paid a billion dollars for this little company called YouTube.

Now, over the ensuing 15 years or so, Google was able to provide tremendous support in terms of technical expertise and infrastructure and data centers and so forth, and to allow YouTube to flourish into the two billion plus daily user property it is today, or monthly active user property it is today.

So, you had a large company that knew it wanted to get into a new emerging area. You had a small company that was really a handful of people. The same when Facebook bought Instagram and could take those assets and give them the backing and support to allow them to absolutely fulfill their promise.

And, when you're buying a small company and bringing it into a larger one, you're not bringing all those other overheads and all those toes that are going to be stepped on if that company you've bought has its HR, its accounting, its finance departments that all need to be unwound.

Will Page: That's a great example of- of what could, like, it's the good old YouTube deal, which, you mentioned there, just happened in 2006. Interestingly, at the same time, Microsoft got fined half a billion dollars by the European Commission for abusing their dominance with Windows Media Player. And I just love that story of European Commissions thought that Windows Media Player was a dominant entity in internet at the same time that YouTube took off. A case of 'the horse has already bolted', perhaps.

Richard Kramer: Mmm.

Will Page: That's good. So we now have good. Let's- let's go to number two, which is bad. Give us the example that two plus two failed to equal four, uh [crosstalk 00:14:54] or the deal went sour.

Richard Kramer: There are many, many, many examples of that. Too many, really, to mention. But you have those that are verging on the- well, it's either bad or ugly, whether it's buyer, when they bought Monsanto and inherited a massive liability for the weed-killer product that [laughing] turned out to be cancerous, not just for the users, but for buyers' balance sheet.

Or when HP bought Autonomy and ended up, uh, realizing that a lot of the revenue that Autonomy had booked was fictitious and you're still now, a decade later, working on an extradition case for the former CEO of Autonomy- [crosstalk 00:15:34]

Will Page: Still?

Richard Kramer: Whether he goes back to the US to face charges there. And so, in those cases, you see that the company's fear of missing out, the company's eagerness to do a deal, blinded it to the potential liabilities and they didn't do the kind of due diligence that you would've expected.

And I think, in many cases, you'd be able to see that scenario where a chief executive is so eager to be just striding the markets like a colossus and doing the deal that's changing everybody's perception of their company, and they overlook the most basic, glaring problems that they could be inheriting.

Will Page: So, that's bad. And now I want to rev up the Richard Kramer rant machine, hear what ugly is. When have you seen a merger and acquisition which simply just didn't make sense? A complete facepalm where we just kinda walk on the block and say, "What on earth are these two corporate entities doing trying to perform this deal?"

Richard Kramer: So, one that I can mention, because it has now been, well, not finalized but unwound, is AT&T buying Time Warner. Now.

Will Page: [laughs]

Richard Kramer: There is a long and story tradition of Telcos, which, at their heart, are fundamentally utility businesses.

Will Page: They are. They are. They're nothing more.

Richard Kramer: Well, let us not... denigrate the humble utility, because we rely on them every day for our electricity and water and gas and phone service. And Broadband, and so forth. But when these companies make acquisitions to try to be something that they have no cultural background in delivering, namely entertainment services. Or, on a much smaller scale, Verizon having bought AOL and then Yahoo, putting them together, and then finally selling them a few years later to a private equity buyer.

It's the realization that, hey, we should never have done these deals in the first place. But of course, it's very difficult for the architects of those deals, often the same management that's defenestrating them, to admit that. And to admit that they made a mistake. They overpaid, or they got into an area where it was really outside of their core expertise to manage.

Will Page: I remember a colleague and an expert in Telco Space One refer to one of the biggest Telcos in the world as, "Please don't confuse these businesses as organized companies. They're all just separate entities buying in their own little entities and just headless chickens inside a corporate brand, as it were."

So, good, bad and ugly. And I can see what we discussed in part one resonating there. The fear of missing out, underestimating the complexity, and the tendency to overpay, almost like a carousel happening, causing some of these deals to go sour.

I think we've gotta bring this podcast to conclusion by doing what we always do, which is give our listeners those smoke signals. Like countless smoke signals of how to spot when a big merger and acquisition being announced in the media has got the potential to turn sour.

And I think media is important here, because often these deals are kept secret, right up until the last minute. There's a very carefully-planned PR strategy to signal to the market there's a deal about to be concluded. Perhaps like, you know, a game of playing fast [inaudible 00:18:49] can we get the deal done before there's an investigation?

So, we're seeing a lot of this happening now. How can listeners spot the words to be careful of when we're reading about mergers and acquisitions.

Richard Kramer: So, I think the first thing to be skeptical of is when companies talk about M&A being 'transformative'. When you have all of these examples of which there are a legion of large companies buying a small company with very promising technology, bringing it in-house and nurturing it that's a terrific example of M&A.

I think you have lots and lots of- of- of small companies that have been advanced because they got the resources of a large company behind them. But when a company is making a purchase to transform themselves, to become something they are not, that's always really dangerous.

It's like, a couple that's squabbling all the time saying, "Well, if we just bought the house down the block and moved there, we'll be happier."

Will Page: So, 'transformative' is smoke signal number one. What's- what else should we be looking out for in the- in the language being used to describe this very, very active market?

Richard Kramer: Given all the accounting issues we've talked about before and- and all the way in which the cards are held in the hands of the companies themselves, you have to be very cautious about discounting "synergies". The idea that you put two companies together and then be able to take out whole layers of costs in both those companies. And down the road, you'll be able to run the same business with half the number of people in accounting and finance and resources and all the other functional areas of the business.

Will Page: And this, being the latest, is just one spreadsheet that you're not allowed to interrogate with one assumption about what their values of synergies could be. That's gonna have a huge impact on how the knowledge of the acquisition is gonna be perceived from the outside.

Richard Kramer: Well, there are cost synergies, which are very rational. You could say, "Hey, we've got two headquarters and we can sell one or we can get out of our lease over time for one of them. And we can sit, have some cost savings." That's fine.

But the revenue synergies of adding two distinct products together, and selling more of both of them, is always very difficult to realize.

Will Page: Right. [crosstalk 00:20:57]

Richard Kramer: And you see that with product companies of all sorts where they say, "If we just add another arrow to our quiver, add another product to our lineup, that will unlock the potential of all of our products and we'll be able to do all this cross-selling."

But I think, as you know, bundling stuff isn't always better for the consumer. Sometimes they want to pick and choose what choices they have to make with all of these different areas.

Will Page: So now I'm getting to feel that you can overestimate the revenue synergies, but underestimate the complexity of the cost synergies. And those two variables, as it were, can move you in a wrong direction.

One last one I want to throw at you there, and it's one that we've discussed in the past, is this weird and wacky concept of goodwill.

Richard Kramer: Mmm.

Will Page: Where does that feature in immersion acquisition? Is that something that's getting traded as well?

Richard Kramer: Absolutely. And goodwill, typically, will be the price you pay over the assets of a company that you're buying. So if the company has a lot of land and buildings or has a lot of intellectual property and- and assets, whether tangible or intangible, you can value those fairly clearly.

But, if the company also relies on the regular custom of their users or the value of the brand that they've built up over time, that's not necessarily something you can take to the bank. And, more importantly, they value the goodwill of their employees. And that is always underestimated.

And any time you put two companies together, and you might have six or 12 months of delay while all the Ts get crossed and Is get dotted on all the legal documents bringing these companies together, it creates tremendous uncertainty for the staff of both of those companies that have to do the work and keep the plates spinning while the business is going.

And you lose the goodwill of your staff. And, by doing that, a lot of times, these people are gonna be fearful. "Am I one of those cost synergies?" Or, "Do I have to come up with a clever idea how to sell this other guy's product which he couldn't do himself or herself?"

Will Page: So, again, you can overestimate the value of goodwill, often to justify that fear of missing out price tag that you put together, but underestimate how quickly that good can turn bad as the political in-fighting happens through the complexity of costs and integrations of operating systems and company cultures.

Last thing is just to kind of start from a blank sheet of paper. Let's assume we're in Bubble Trouble, I don't think anyone's gonna disagree there. Let's assume that bubble bursts with the next coming months or years. Let's assume there's a big shakeout and people are thinking, "My God! Why did we try that merger? Why did we even attempt that acquisition?" How would you do things differently? What- what simple steps would you apply to say there's a more rational way to approach mergers and acquisitions, there's a better way to make two plus two actually equal five. Not four, not three, not two, but five, to extract value of a deal.

Richard Kramer: Again, I would say, almost always the successful deals are where large companies buy very small companies and nurture and incubate them. And where you have very large companies merging with other very large companies, they both bring all of their politics and baggage and history and processes to the table.

And it makes it very difficult to integrate them. And you have to contend with the cultures. And we haven't even explore the notion of cross-cultural mergers and- and, you know, the companies, as you know from your former employer, will have very different cultures in one office in one country, than in another office in another country.

And bringing those cultures of companies together across borders is fiendishly difficult.

Will Page: Well, maybe just to wrap this week's podcast up. Uh, my first week working for a Swedish firm, HR told me that, in Sweden, maybe there's three people in a meeting, so let's assume it's myself, Richard Kramer, and our wonderful producer Eric Nuzum. And there's a disagreement which myself and Eric Nuzum get our way, but Richard Kramer is left out in the cold.

You have to have a second meeting to ensure that Richard Kramer is still on board and part of the team.

Richard Kramer: [laughs]

Will Page: And I just don't think that's gonna be working out on Wall Street in New York. My gain is your pain. So, it's an example of cultures. Richard, this has been a joy to listen to on this one. And you couldn't get a more pivotal topic to explore. It's- this one's gonna run in long.

Uh, this has been Bubble Trouble and Will Page with Richard Kramer, independent analyst. And remember, this week's bubble, is next week's trouble.

 If you're new to Bubble Trouble, we'd encourage you to follow the podcast wherever you listen. Bubble Trouble is produced by Eric Nuzum, Jesse Baker and Magnificent Noise. You can learn more at BubbleTroublePodcast.com. See you next time!