Wit, Wisdom, Warren (Issue #13): Spoiled Princess, Toads, and Acquisitions

“All of humanity’s problems stem from man’s inability to sit quietly in a room alone.” ~ Blaise Pascal

You must have heard the fairy tale where a spoiled princess reluctantly befriends a toad, who magically transforms into a handsome prince triggered by the princess kissing it.

Well, those were the older times.

Today’s capitalistic society has been witness to a large number of spoiled princesses trying the same trick on a large number of toads, only to realize that the tale of them turning into princes they had heard of was just that…a fairy tale.

If you are confused why I am writing today about the tale of the toad and princess, let me get straight to the point now.

As the title of today’s post says, I will cover Warren Buffett’s thoughts on corporate acquisitions. In this case, the spoiled princess is the company that is looking to acquire another company, and the toad is that other company that’s waiting to be acquired.

Of such acquirers, here is what Warren Buffett wrote in 1981…

Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad’s body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss will do wonders for the profitability of Company T(arget).

He added…

Such optimism is essential. Absent that rosy view, why else should the shareholders of Company A(cquisitor) want to own an interest in T at the 2X takeover cost rather than at the X market price they would pay if they made direct purchases on their own? In other words, investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses had better pack some real dynamite.

We’ve observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses – even after their corporate backyards are knee‐deep in unresponsive toads.

How I wish the CEOs of Indian companies making or looking to make acquisitions bigger or worse than they can digest, read what Buffett has to say about the success of acquisitions…especially the over-priced ones.

Risking Cash and Reputation on a Coin Toss
Would you risk your life savings on a coin toss? Of course you wouldn’t. But over the past few years, CEOs of many Indian companies – large, mid, or small – have risked their business with the same odds – by making disastrous acquisitions.

So whether it was…

• Tata Steel’s acquisition of Corus
• Hindalco’s acquisition of Novelis
• Dr Reddy’s acquisition of Betapharm
• Biocon’s acquisition of Axicorp
• Suzlon’s acquisition of Hansen and Repower
• 3i Infotech’s many acquisitions
• Indian Hotels’s acquisition of Orient Hotels
• Opto Circuits’s acquisition of Cardiac Science

…CEOs after CEOs in India have shown what thrill for action when combined with cheap money can destroy shareholder wealth in such huge scales.

Apart from the hope that toads will turn into princes, Buffett gives two reasons so many companies get overenthusiastic about acquisitions.

The first reason was, as I mentioned above, the excitement of being in action. He wrote this in 1981…

Leaders, business or otherwise, seldom are deficient in animal spirits and often relish increased activity and challenge.

Then, in 1982, he wrote…

…in many of these acquisitions, managerial intellect wilted in competition with managerial adrenaline. The thrill of the chase blinded the pursuers to the consequences of the catch.

Pascal’s observation seems apt: “It has struck me that all men’s misfortunes spring from the single cause that they are unable to stay quietly in one room.”

The second reason Buffett gave was a CEO’s urgency to bring up his company to a large size before retiring, so as to justify a huge exist bonus.

He wrote this in 1981…

Most organizations, business or otherwise, measure themselves, are measured by others, and compensate their managers far more by the yardstick of size than by any other yardstick.

(Ask a Fortune 500 manager where his corporation stands on that famous list and, invariably, the number responded will be from the list ranked by size of sales; he may well not even know where his corporation places on the list Fortune just as faithfully compiles ranking the same 500 corporations by profitability.)

Then, here is what he wrote in 1994…

The sad fact is that most major acquisitions display an egregious imbalance: They are a bonanza for the shareholders of the acquiree; they increase the income and status of the acquirer’s management; and they are a honey pot for the investment bankers and other professionals on both sides. But, alas, they usually reduce the wealth of the acquirer’s shareholders, often to a substantial extent. That happens because the acquirer typically gives up more intrinsic value than it receives.

For all silly words you hear when a company is about to make an acquisition – like strategic fit, synergies, cost advantages etc. – know that in a large number of cases, the real keyword is “size” or “scale”.

Like, here is what Mr. Tulsi Tanti of Suzlon said while acquiring Hansen Transmission in March 2006…

The acquisition of Hansen gives us technological leadership and will make Suzlon a leading integrated wind turbine manufacturer in the world.

…over a period of time we will work with them in developing supply chain synergies.

And this is what the Investment Banking head of Yes Bank – who must have earned a fat fee – then said…

With this acquisition, Suzlon has truly emerged as a global player with significant market presence, manufacturing base and R&D centres…

…we see Suzlon becoming further cost competitive and providing an efficient and robust wind energy solution to its customers.

Here is Mr. Tanti again while selling Hansen in October 2011…

Today marks an important step towards deleveraging our balance sheet.

Now, let’s move from Suzlon to a much more “respected” company, i.e., Tata Steel, which acquired Corus in October 2006. This is what the company’s spokesman, surely fed by the management, had to say on the acquisition…

It is a big moment for Tata, this is a proud moment for the whole nation. This is the biggest foreign takeover ever by any Indian company.

On the other side of the table and happy at the expensive price he got from Tata Steel, the Chairman of Corus said…

This offer from Tata Steel reflects the substantial value created for Corus shareholders…

Then, the Investment Banker from ABN Amro, who was also the lender to Tata Steel for the acquisition expressed how good he felt that 2007 was going to be another bumper year for the steel industry and thus the acquisition was quite strategic for Tata Steel.

You see, like a “large-empire-but-poor-citizens” has been the aim of so many monarchs in history who gobbled up kingdoms after kingdoms, the secret wish of most acquirers and their investment bankers in the capitalist world isn’t any different.

Most research indicates that mergers and acquisitions (M&A) activity has an overall success rate of about 50% – basically a coin toss. But CEOs and their bankers avoid keeping those odds in mind, and for obvious reasons.

Buffett wrote this in 1997…

In some mergers there truly are major synergies – though oftentimes the acquirer pays too much to obtain them — but at other times the cost and revenue benefits that are projected prove illusory.

Of one thing, however, be certain: If a CEO is enthused about a particularly foolish acquisition, both his internal staff and his outside advisors will come up with whatever projections are needed to justify his stance.

Of Limping Horses and Foolish Valuations
Here is a story CEOs eyeing acquisitions – while assuming the target company to hold tremendous value for them, thanks to their own rosy projections and those prepared by the sellers and investment bankers – must read.

This is what Buffett had written in his 1995 letter…

…why potential buyers even look at projections prepared by sellers baffles me. Charlie and I never give them a glance, but instead keep in mind the story of the man with an ailing horse.

Visiting the vet, he said: “Can you help me? Sometimes my horse walks just fine and sometimes he limps.”

The vet’s reply was pointed: “No problem – when he’s walking fine, sell him.”

This is in fact what a selling company often does – whether it is selling shares in an IPO or selling to a company – it sell out when there’s madness all around that would justify a super-normal price for its troubled business.

Buffett wrote in 1995…

At Berkshire, we have all the difficulties in perceiving the future that other acquisition-minded companies do. Like they also, we face the inherent problem that the seller of a business practically always knows far more about it than the buyer and also picks the time of sale – a time when the business is likely to be walking “just fine.”

Even so, we do have a few advantages, perhaps the greatest being that we don’t have a strategic plan. Thus we feel no need to proceed in an ordained direction (a course leading almost invariably to silly purchase prices) but can instead simply decide what makes sense for our owners.

In doing that, we always mentally compare any move we are contemplating with dozens of other opportunities open to us, including the purchase of small pieces of the best businesses in the world via the stock market.

Our practice of making this comparison – acquisitions against passive investments – is a discipline that managers focused simply on expansion seldom use.

He then cites Peter Druker…

Talking to Time Magazine a few years back, Peter Drucker got to the heart of things: “I will tell you a secret: Dealmaking beats working. Dealmaking is exciting and fun, and working is grubby. Running anything is primarily an enormous amount of grubby detail work…dealmaking is romantic, sexy. That’s why you have deals that make no sense.”

Anyways, by making rosy predictions about the target company, managers also try to rationalize any price for the acquisition.

That’s like getting into the “commitment and consistency” bias.

First you commit to something, then you remain consistent with the original decision by justifying it using any argument and any amount of money.

In Corporate Finance, it’s called the “sunk cost fallacy”.

In the wise businessman’s lingo, it’s called ‘throwing good money after bad’.

In corporate mergers and acquisitions, the same bias forces managements to keep on allocating more capital into a recent merger in an attempt to revive it.

For example, take a look at Tata Steel’s expensive acquisition of the European steelmaker Corus.

In October 2006, Tata Steel proposed to buy Corus by paying 455 pence per share to the latter’s shareholders. While Corus’s management approved the acquisition, in November 2006, the Brazilian steel company CSN launched a counter offer for Corus at 475 pence per share. Tata then offered 500 pence, then CSN raised it to 515 and then to 603 pence per share.

In January 2007, Tata Steel finally announced that it was buying Corus at 608 pence per share, or 33% higher than its original bid of 455 pence!

As it stands now, after writing billions from its balance sheet towards losses at Corus, Tata Steel is looking to sell off some of the former’s assets in order to deleverage its balance sheet, apart from cutting jobs and closing manufacturing sites.

The company is in a fire-fighting mode and is trying to do everything under the sun to remain consistent with its original decision of buying Corus.

Not just Tata Steel and Corus, most acquisitions fail over the long run due to the commitment and consistency bias of the buyers. First, buyers pay expensive price for acquisitions and then when the expected benefits are not seen, they throw more good money after bad to remain consistent to their original actions instead of looking like fools.

As Buffett wrote in 1982…

While deals often fail in practice, they never fail in projections – if the CEO is visibly panting over a prospective acquisition, subordinates and consultants will supply the requisite projections to rationalize any price.

As an investor – existing or potential – in a company making an acquisition, it is important for you to beware of the projections from managers, sellers, and brokers…basically the entire acquisition process.

Here is what Buffett wrote in his 1995 letter…

…most deals do damage to the shareholders of the acquiring company. Too often, the words from HMS Pinafore apply: “Things are seldom what they seem, skim milk masquerades as cream.” Specifically, sellers and their representatives invariably present financial projections having more entertainment value than educational value.

And here’s some humour from Buffett on investment bankers, in his 1989 letter…

When they make these offerings, investment bankers display their humorous side: They dispense income and balance sheet projections extending five or more years into the future for companies they barely had heard of a few months earlier.

If you are shown such schedules, I suggest that you join in the fun: Ask the investment banker for the one-year budgets that his own firm prepared as the last few years began and then compare these with what actually happened.

Watch Out for the Spoiled Princess
Buffett wrote this in his 2000 letter…

We find it meaningful when an owner cares about whom he sells to. We like to do business with someone who loves his company, not just the money that a sale will bring him (though we certainly understand why he likes that as well). When this emotional attachment exists, it signals that important qualities will likely be found within the business: honest accounting, pride of product, respect for customers, and a loyal group of associates having a strong sense of direction.

The reverse is apt to be true, also. When an owner auctions off his business, exhibiting a total lack of interest in what follows, you will frequently find that it has been dressed up for sale, particularly when the seller is a “financial owner.”

And if owners behave with little regard for their business and its people, their conduct will often contaminate attitudes and practices throughout the company.

This is what he wrote of the sellers of businesses. We have already discussed enough about Buffett’s thoughts on the acquirers and how they rationalize stupid decisions and over-the-top valuations, duly helped by their investment bankers.

Buffett wrote in 1982…

If, however, the thirst for size and action is strong enough, the acquirer’s manager will find ample rationalizations for such a value‐destroying issuance of stock. Friendly investment bankers will reassure him as to the soundness of his actions. (Don’t ask the barber whether you need a haircut.)

As an investor, it’s important for you to be very careful of such managers – both buyers and sellers – and what you hear the investment bankers speak in media, again justifying such irrational decisions.

Of course, the upside of successful acquisitions can be substantial, but it’s also important for you to consider the base rate of success of acquisitions, which is very low…simply for the reason that most acquisitions lack business sense and are made at unjustified valuations.

Remember that acquisitions are often misused as the universal, over-simple growth formula, or just as a quick fix. As buying companies also boosts egos of managers making acquisitions, the essential questions can end up being dismissed as irrelevant, boring, or too mundane to be answered properly.

In all, be careful when you see the spoiled princess trying to kiss the ugly toad expecting it to turn into a beautiful prince.

That was a fairy tale. Yours could turn out to be a sorry tale.