Financial troubles? Have you considered an acquisition?
While it is true that mergers and acquisitions have seen a moderate decline in the wake of the financial crisis, they continue to be important ways in which to grow or restructure businesses. Even though in the past it were primarily financially sound companies that took advantage of these techniques, nowadays an increasing number of acquisitions involve firms in financial troubles. Thorough academic analysis of such transactions is lacking, however. The research carried out by Evy Bruyland for her doctorate sets about filling this gap.
Bankruptcy doesn’t tend to appear out of thin air. Before getting to that stage, a company has usually undergone varying degrees of financial problems. For instance, it may have started by underperforming in comparison with its competitors and subsequently falling into financial distress before becoming insolvent. Evy has researched, on the basis of three studies, acquisitions of distressed targets as well as acquisitions by bidders performing badly or in financial difficulties themselves.
It seems to be the general consensus that acquisitions of distressed targets are riskier than those of companies in good financial health. But why is that so? “With distressed businesses, future turnover and return are uncertain. There can be hidden risks and liabilities. In addition, due diligence is often carried out quickly and under great time constraints because the going-concern value of such businesses gets lower the longer the acquisition process takes. Finally, the ‘reps & warranties’ of businesses in financial difficulties offer less of a safeguard,” explains Evy. “You can therefore also expect the acquirer’s default risk to increase”.
Evy researched more than 1,000 acquisitions of listed US companies in the period between 1990 to 2011 - of which almost 200 were acquisitions of distressed targets - and investigated the impact that these acquisitions had on the risk profiles of the acquirers.
She discovered that the default risk, measured using the distance-to-default model, did indeed increase for the acquirers. “Such an increase can also be observed for acquirers of companies with sound financials. This can be explained by the fact that after such an acquisition, management tends to exhibit risk-taking behaviour, driven by self-interest or overconfidence. Our research showed, however, that acquirers of distressed companies tend to be very prudent and to work sensibly towards achieving more financial flexibility. They usually limit their acquisitions to their own sector, often acquiring a business they are already familiar with because they already hold an interest in it”.
According to Evy, the fact that the default risk nevertheless increases, and more so than for acquirers of businesses in good financial health, can be explained by the fact that risk from the acquired company transfers to the acquirer, especially if the acquirer fails to restructure and integrate the acquired firm and accomplish the expected synergies.
Better performance through acquisition?
Can an acquisition be a solution for companies that are performing worse than their competitors? To answer this question, Evy analysed abnormal stock returns, both after acquisition announcements, and over the longer term, post-acquisition. She also researched the operational performance using accounting data.
She established the following:
Such companies tend to acquire firms in other sectors, perhaps for the purpose of diversification, and mostly firms that generate lower profits.
They generate positive and significantly higher announcement returns, suggesting that the market expects these bidders to do better and regain their financial strength.
However, their post-bid long-term stock returns are negative and significantly lower than healthy bidders. This can largely be explained by the fact that these acquirers, who already have a lower interest coverage ratio, fail to quickly reduce their heavy use of leverage after the acquisition and are not perceived to be in a position to significantly improve their operational efficiency.
Nevertheless, since long-run stock returns are related to only operating efficiency and leverage in the post-acquisition period, the market does not discount bidders’ past performance and investment history, but focuses more on whether the new acquisition can produce the necessary synergy gains.
Can we conclude from this that such acquisitions are by definition bad? “Not necessarily. The operational performance of acquirers does improve. It just stays behind that of their peers. The success of such acquisitions also hinges on being able to accomplish synergies and hence successful post-acquisition integration”, concludes Evy.
More than acquisitions
To what extent do businesses that find themselves in financial difficulties resort to other forms of restructuring? At what stage do companies turn to acquisitions and what is the impact of these different forms of restructuring and their timing on financial recuperation?
Evy’s third and final study uncovered the following:
Only half of the firms in financial difficulties researched managed to pull through.
Businesses that pulled through paid comparatively more attention to operational restructurings, disposal of assets and all manner of cost-reductions, before turning to an acquisition.
“This is because such restructuring measures improve operational efficiency and cash-flow, and restore the confidence of the various stakeholders”, explains Evy. “We can also see that in companies that succeeded in turning the tide, such an acquisition tended to be the first in a number of acquisitions that formed part of a wider refocusing and growth strategy”.
Look before you leap
The conclusions from these three studies are clear and unequivocal. Evy sums them up as follows: “Acquisitions by and of businesses in financial difficulties are riskier than others. The businesses that are successful are those which use acquisitions as part of a well-thought-out strategy, and which succeed in integrating the acquired business. Only then can an acquisition deliver added value”.
Source: ‘Distressed M&A and the role of M&A in corporate restructuring’. Doctoral dissertation in Applied Economic Sciences. Author: Evy Bruyland, researcher at Vlerick Business School. Promoter: Professor Wouter De Maeseneire (Vlerick Business School).