When Big Deals Go Bad— and Why

When Big Deals Go Bad— and Why
Amid A Flurry Of Bad News For Big Deals, It Bears Remembering That Successful Mergers Heed The Basic Rules Of Business

By Steve Rosenbush, Business Week | 7 October 2007

AOL Chairman and CEO Steve Case (left) and Time Warner Chairman and CEO Gerald Levin at the New York news conference announcing the AOL Time Warner deal on Jan. 10, 2000. Rick Maiman/Bloomberg News

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The greatest business successes are often engineered by bold visionaries who altered industries: Think Microsoft (MSFT), Berkshire Hathaway (BRKB), and Southwest Airlines (LUV). Unfortunately, when that type of grand thinking is applied to the mergers-and-acquisitions arena, disaster often ensues. Multibillion-dollar deals are based on personal relationships and egos, grandiose plans for so-called transformational changes to an industry, and a sense that the new sum will be far greater than all the previous parts. And, of course, the path for much of the wheeling and dealing is well lubricated by fee-hunting bankers and lawyers.

The wreckage of deals gone bad litters the business landscape these days. On Oct. 4, shareholders of German automaker DaimlerChrysler (DAI) are expected to approve renaming the company Daimler, jettisoning the last vestiges of the disastrous 1998 acquisition of Chrysler, for which it paid some $40 billion. While retaining a 19.9% stake in the Michigan company, Daimler's shareholders will be more than happy to forget the whole episode, which saw litigation over the deal, a dearth of hit models, cultural and operational snags between U.S. and German managers, and heavy financial losses. In May, Daimler agreed to sell the bulk of the company to private equity firm Cerberus Capital Management for a mere $6 billion.

On Oct. 1, online auction house eBay (EBAY) conceded that it had overpaid in its $2.6 billion acquisition of Internet telephone service Skype Technologies in 2005. EBay took a writedown of $1.4 billion, and Skype founders Niklas Zennström and Janus Friis departed from their former suitor.

And years after the catastrophic merger of Time Warner and AOL, Time Warner (TWX) is still trying to make the deal work. Time Warner's latest move: Focus AOL on the advertising market and move AOL headquarters from Virginia to Manhattan. "AOL is for keeps," Time Warner Chief Executive Richard Parsons has said, arguing that it wouldn't make sense to part with the Internet property just as advertising dollars are shifting online.

"Game-Changing" ROI and Disasters

How is it that such deals come together in the first place? In each case, managers were clearly swinging for the fences, pouring huge sums into the bet like a Vegas gambler desperate to score a big win as he sees his chips dwindle. And bad deals often are born of fear or desperation. A rival— or potential rival— is forging a new market or making inroads into the existing one and the incumbents feel compelled to respond. Sometimes there's a surfeit of confidence about what the future will hold and management's ability to stitch the various pieces together nicely. In many other cases, the deal may make some strategic sense, but is priced at a figure that makes no economic sense.

No doubt, some large deals yield rich rewards. One of the richest was the 1965 deal that merged Pepsi-Cola and Frito-Lay to form PepsiCo (PEP). In the decades since, the Purchase (N.Y.) company has become a global juggernaut, with more than 15 brands that each tout annual sales of over $100 million. And in July, 2005, many people questioned the wisdom when Rupert Murdoch's News Corp. (NWS) paid $580 million for the social networking site MySpace. Analysts now figure the popular property could be worth $10 billion, just as rival site Facebook is reportedly mulling selling a 5% stake that would also value it at around $10 billion. Two years on, Murdoch appears to have gotten an extraordinary bargain.

In many cases, the deals that end in disaster often come with descriptions like "game-changing" and "transformational," and hype attains currency. In every major disaster, the acquirer was a major player run by professional management and overseen by a board of directors. The target companies were scrutinized by analysts, vetted by advisers, and ultimately approved by shareholders, including sophisticated institutional investors. Yet those safeguards weren't adequate to prevent disaster at Time Warner, eBay, or Daimler. So why do they still happen so regularly?

Bad Decisions Lead to Understanding

M&A tends to go awry when well-run orderly deal machines are thrown off kilter by volatility or emotion. The tech and telecom sectors are rife with bad deals because revolutionary technological and regulatory change provoked fear and uncertainty, leading executives into bad decisions. That helped produce debacles such as AOL Time Warner. Arrogance, envy, and untamed ambition often lead to poor decisions as well. "Psychology is a big part of M&A. It's not all of it, but it's a big part," says veteran banker Hal Ritch, co-chief executive of M&A adviser Sagent Advisors and a former co-head of M&A at Citigroup (C), Credit Suisse in the U.S., and Donaldson Lufkin & Jenrette, which was acquired by Credit Suisse (CS).

To put such failures in perspective, it's helpful to understand what makes a good deal work. Companies with solid track records in M&A, such as Internet-equipment maker Cisco Systems (CSCO), tend to buy on a regular basis. They have methodical processes for selecting targets and integrating businesses postdeal. And they don't buy companies to prop up earnings or to enter dramatically new lines of business.

"We don't favor large, transformational deals," says Ned Hooper, senior vice-president of corporate business development at Cisco. "We think M&A works best when it is part of a regular and stable business process. The best deals tend to bolster existing lines of business, or open new lines of business in adjacent markets. And we don't do deals to boost near-term earnings. We do deals to acquire promising new technology and to capture market transitions to open up new areas of growth." It may not hurt that buyers such as Cisco tend to work on their own, without much outside influence from investment bankers. Hooper runs Cisco's M&A group as part of its overall business development unit, vetting ideas for acquisitions with his team.

M&A: Not a Cure-All

Many of the worst deals have come about because management tried to use M&A to fix a fundamental business problem, such as a market that faces a terminal regulatory or technological threat. Companies such as AT&T (T) and the former drugstore chain Revco sought acquisitions to steer their businesses out of troubled markets and move into new opportunities.

In AT&T's case, it tried to move from the traditional landline phone business— which was dying— into the newer and more promising broadband Internet and cable businesses. M&A proved to be a poor route for that transition. Years later, Verizon had more success by expanding from telecom into cable and broadband via large capital investments and relying on organic growth. Revco tried to move out of the pharmacy business with its 1983 acquisition of discounter Odd Lots, sealing the company's demise the next decade.

Just like AT&T, toymaker Mattel (MAT) nearly went bankrupt using M&A as a way to keep pace with technology. The company spent billions to buy software and game publisher The Learning Co. That, and a string of disappointing profit results, led to the ouster of former Chief Executive Jill Barad.

Market and Cultural Landscapes

Managers tend to make the biggest M&A blunders when they convince themselves that times have changed and that basic business rules no longer apply. "The best acquirers make a habit of constantly scouring the landscape for acquisition opportunities that make fundamental sense, and don't depend solely on whether the market is up or down at the moment," Ritch says. If that sounds like the description of a certain legendary billionaire businessman from Omaha, it's hardly a coincidence. That doesn't necessarily mean that all M&A targets must be profitable. Cisco often buys startups that have never turned a profit, as long as they possess a solid business plan.

Good acquirers also pay close attention to a potential deal's cultural fit and the odds that the two organizations can be integrated successfully. To this day, huge cultural divides remain between the staffs at the AOL and Time Warner units, making it difficult to construct a successful operation, industry insiders say.

As a general rule, the larger and more ambitious the deal, the more "landscape-shifting" it appears, the higher the risk. Time after time, deals heralded as transformational have merely transformed a troubled business into a terminal case headed for bankruptcy.


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