Global M&A activity reached an all-time high of over $4.3 trillion in 2015. Cheap debt, tax inversions and market pressure to generate earnings growth drove companies' decisions to buy rather than build. This was particularly true in pharmaceuticals, where R&D productivity remained at an all-time low. But it was not all about drugs.
While Pfizer’s $160 billion takeover of Allergan was the biggest merger by value in 2015, Anheuser-Busch InBev’s $110 billion takeover of SABMiller created a dominant force in brewing and Dell’s $67 billion offer for EMC was the biggest tech deal ever.
Leaving aside the powerful incentive of cheap debt, why do CEOs find M&A so attractive, and what determines an accretive deal?
Three archetypes of CEO emerge:
- Strategists with war chests who love deals and who find themselves pressured to deliver growth during the inevitable earnings dip after a major change in corporate strategy.
- Consolidators whose growth fuelled by stock price appreciation and need deals to keep the ball rolling.
- Tacticians who opportunistically see value in undeveloped pipelines or unique distribution channels.
Acquiring footholds in new markets, acquiring products/intellectual property and gaining economies of scale are therefore the most obvious motivations for M&A.
But there are also powerful industry-specific drivers. In the technology, media and telecommunications world, for example, the strategic marriage of content and distribution has been a touchstone for M&A bankers for more than a decade – with sometimes disastrous results – for those who remember the $164 billion AOL/Time Warner merger of 2001.
Given these motiviations, what makes a deal work? One hypothesis that I have been nurturing for some time now is that intellectual property plays a big role in determining the successful medium to long-term outcome of an M&A transaction. Not intellectual property per se, but the proximity of intellectual property to product. Simply put, the closer the intellectual property that you acquire is to a product line or customer base, the more accretive the merger. If correct, I would expect to see earnings enhancement in pharmaceutical, media, publishing and fast-moving consumer goods deals, where patent/copyright is closely mapped to a specific product or a powerful brand. In contrast, where industries have extensive royalty stacking and mapping intellectual property directly to a product is a challenge (eg, mobile telephony or networks), I would expect to see choppy outcomes, with fewer deals generating real shareholder value. From this perspective, conducting an IP analysis before M&A would be an invaluable risk management tool in assessing outcomes and building sensitivity analyses. My own work in this area is compelling but anecdotal, and so I have been seeking a more systematic approach to prove my thesis. As such, I was happy to find some support recently for at least some elements of this idea.
In February 2014 McKinsey published an article entitled "Why Pharmaceutical Megamergers work", based on a study of 17 large deals that occurred between 1995 and 2011.
The definition of a 'megamerger' in the study was a deal larger than $10 billion in which the target boasted at least 10% of the acquirer's sales and 20% of the acquirer's market capitalisation. The metrics of success used were:
- excess total shareholder returns above the industry index of the acquiring company in the period two to five years after the merger was announced;
- post-deal revenue and margin growth;
- new product introductions;
- product pipeline for the combined company; and
- relative contribution from the acquired company.
The study's analysis led to three conclusions.
Megamergers created shareholder value
Median excess returns for megamergers in pharmaceuticals were 5% above the industry index two years after a deal's announcement. Interestingly, this was in contrast to large deals in other industries, which had marginal returns relative to industry indexes or, in the case of deals in the technology sector, sharply negative returns. While the study did not isolate intellectual property as a factor in these observations, they are consistent with my hypothesis that acquisitions where intellectual property maps directly to product (drugs) perform better than acquisitions where in general they do not (technology).
Consolidation deals generated greater near-term economic profit
Megamergers were classified into two broad types:
- those that consolidated existing players with significant overlaps; and
- growth-oriented deals that created new companies or expanded into new markets.
Consolidation deals historically generated the greatest near-term economic profit for acquirers (more than 60% growth) as cost cutting and revenue boosted share value. In contrast, growth-platform deals on average generated negative economic-profit growth. This is consistent with the reality that it takes time for IP-enhancing acquisitions to generate revenues as pipeline assets or technology platforms are integrated and activated.
Growth-oriented deals changed longer-term expectations
While consolidation deals generated superior near-term gains in economic profit, they ultimately did not address or solve longer-term issues with business models.
In contrast, growth-platform deals increased trading multiples by more than 60%, or 20% relative to top 20 peers, often from a low multiple for the acquirer before the deal.
One possible explanation for this difference in long-term expectations is the growth contribution that acquired companies made in launching new products supported by unique intellectual property. For growth-platform deals, the acquired company contributed around 24% of the combined company's new product revenue five years post deal, compared with just 10% in consolidation deals.
The strategic decision to acquire another company is one of the biggest calls a CEO can make and many factors fuel such a decision. In most industries the relative importance of intellectual property to long-term value creation in the merged company is unobserved and understated. However, for CEOs considering M&A, a better understanding of the value of the intellectual property that they are acquiring and its likely impact on short and long-term value creation could pay significant dividends, literally.
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