Desperately SEEKING SYNERGY.

Mergers and acquisitions are happening at a frenetic pace. But do all these corporate meldings work happily ever after?

The new millennium had barely begun when news of the AOL Time Warner deal broke and merger mania quickly replaced the Y2K bug as the obsession du jour. Analysts greeted the deal with unreserved praise. "Combined, the synergy potential of AOL Time Warner Inc. will be stunning, in our opinion," wrote Paul L. Merenbloom and Katherine Styponias of Prudential Securities. The stock market echoed that sentiment like a hallelujah chorus, rocketing up on the day the deal was announced.

The next day, though, stock prices fell again as investors shook off the initial euphoria for a belated reality check. Talk of potential synergies had been heard before, but experience shows the potential is rarely realized. A 1997 book by a New York University professor, Mark Sirower -- The Synergy Trap -- explains in meticulously researched detail why synergy is little more than a dangerous, value-destroying myth. Research to that time had consistently demonstrated that 60 percent to 70 percent of mergers failed. In the years since Sirower's work was published, the failure rate has escalated. A research report by KPMG released in November 1999, just two months before the AOL Time Warner deal, finds 83 percent of mergers produce no benefit whatsoever to shareholders.

Why? Says Jack Prouty, partner in charge of KPMG's business integration practice, "People are doing things now that create greater complexity." Deals are getting bigger, and the rationale for merging has changed. In the early 1990s, companies merged to reduce costs. Now, Prouty says, companies are trying to buy their way to strategic growth with bigger acquisition premiums and more cross-border deals.

An acquisition premium is the amount an acquiring company pays above the current market price to buy a target company's stock. Investors put a lot of effort into the job of calculating the economic value of a company's expected future cash flows, and experience shows that the market price of a stock reasonably reflects that value.

So when executives of acquiring firms pay more than market value to buy a target company, they effectively agree to pay more for the target company's stock than anyone else in the market thinks it's worth. Russ Ray, a professor of finance at the University of Louisville, says even when these deals do create value, most of that value goes to shareholders of the target company, not shareholders of the acquirer. (This may explain the broad smiles with which option-laden Time Warner executives greeted their acquisition by AOL.)

Acquisitive managers typically justify paying a premium with claims that "synergy" will somehow make two plus two equal five. In practice, though, two plus two equals four, and the merged company never creates enough value to allow the acquirer's shareholders to recover the premium. So most acquisition premiums are a gift that managers of the acquiring firm give to shareholders of the target. But the managers don't pay for the gift themselves - it comes out of their own shareholders' pockets.

YOU ALWAYS HURT THE ONE YOU LOVE 

But why would managers of an acquiring company, who in theory work for shareholders, undertake the cost and effort of a major acquisition that will probably hurt those shareholders? Academics who've wrestled with that perplexing question conclude most deals are driven by factors that have nothing to do with shareholder value. "Executive salaries are highly correlated with company size, so acquirers know they'll likely make more money after the merger. Also, senior executives like power, and there's more power and prestige involved in running a bigger corporation," says Ray.

Interestingly, the KPMG report, "Unlocking Shareholder Value: The Keys to Success," lends some support to this view. When researchers asked a survey group about the business aims behind their merger or acquisition, only a fifth of the respondents cited "maximizing shareholder value" as a key consideration. Perhaps that's why 53 percent of the mergers examined actually destroyed value, and 30 percent of the deals left shareholders no better off than they'd have been without the acquisition.

Gabor Garai, managing partner of the Boston law office Epstein, Becker & Green, says he and his colleagues have worked on about 100 M&A deals in the past year. But he's at a loss to explain why so many executives ignore the undeniable fact that most mergers fail to deliver promised returns. So why aren't shareholders signing up for class-action lawsuits against managers who drag their companies into value-destroying mergers? Garai says managers have been protected to date by the "business judgment" rule, a legal doctrine that gives them wide latitude to run their shareholders' business as they see fit. But novel legal strategies could find a way around that rule.

"In the next downturn, when the economy takes a dive and you see that some of these things are disasters, I wouldn't be surprised if somebody brings a lawsuit. And I wouldn't be surprised if in a particularly egregious case where a huge premium was paid for a company, a jury would say management did not use reasonable judgement," he opines. But Garai compares mergers to gambling: The upside potential is so enormous when deals do work that executives may figure they're worth betting on even though the odds are against success.

And, indeed, there are some real success stories.

Cisco: RETENTION AND RETURNS

Cisco Systems has aggressively pursued a strategy of growth through acquisition while delivering some of the most impressive shareholder returns in Silicon Valley. "Cisco started out selling routers to enterprise customers about 15 years ago," says Ammar Hanafi, director of business development at Cisco. "But in 1993 we expanded our focus to include other technologies and services. For us, acquisition was a key strategy to make sure we have the products and solutions our customers look to us to provide."

Before joining Cisco, Hanafi worked on Wall Street with Morgan Stanley and Donaldson, Lufkin & Jenrerte. "On Wall Street, a lot of the thinking about M&A is about the numbers," he says. "You ask does the deal work, and how can we cut costs? When I came to Cisco, the focus on people was an eye-opener for me. I've gone to meetings where we asked whether the people working at a potential acquisition candidate had a similar vision to the Cisco team's, whether the fit was right, whether we had a meeting of the minds." Hanafi boasts that three quarters of the CEOs of companies Cisco has acquired have opted to remain with the company. "Our retention rate on acquired employees is as good as our

retention rate on hired employees," he says. "I'm very proud of that because it means we've done a good job keeping people excited about staying here. Lots of leadership opportunities and a culture that wants to succeed in a rapidly growing market - and of course money is also a factor. Cisco stock has been a very strong performer, so from a financial point of view people are excited to stay at Cisco."

Cisco has used its stock as the acquisition currency in 95 percent of its merger deals, Hanafi estimates, and doesn't shy away from paying steep premiums for companies it acquires. The market has driven valuations of Internet companies - including Cisco - to stratospheric levels, and Cisco has to compete with those valuations when it moves to acquire firms. "A lot of companies are private, and their alternative is to go public," he says. "Fundamentally, we consider what their technologies can be worth to us as we go out to fulfill our ambition to be the leading communications-equipment company of the 21st century."

GOLDMINE: COMPLEMENTARY DIFFERENCES

Half a continent and orders of magnitude away, tiny GoldMine Software Corporation had just completed a merger of equals when John Hillyard joined as CFO in November. The rationale for the merger: strategic growth through acquisition. "The newly merged company had been two companies doing about $25 million in sales each," Hillyard says. "The old GoldMine had been based on front-end, sales force automation. The old Bendata, the other side of the merger, was focused on help-desk applications. It was a natural fit to have a fully integrated customer relationship management product." Not only were the products complementary, but so were the marketing channels. The old GoldMine marketed its software through middlemen - "value-added resellers" in the jargon of the software trade. The old Bendata sold directly to end users and had an extensive customer training and support infrastructure. It looked as if each company could supply what the other lacked, and turn the combination into a powerful team. But those complementary differences could also have led to disaster.

Hillyard had been through a dozen mergers before joining GoldMine. He knew what doomed most combinations. "You have to make sure you work through the cultural issues so everyone understands where they fit in the organization," he warns. "You have to eliminate the 'we' vs. 'them' mentality. It's important to be honest and direct with people. We're not doing an acquisition to consolidate and eliminate costs. We have plenty of opportunity for all the good people we've acquired."

In the high-tech industry, where the demand for skilled people exceeds the supply, holding talent is the challenge. Golden handcuffs seem to be the best tool for that job. "We've created plenty of value, and all key players in the company have stock options," Hillyard says. The two companies merged in April. In December, a large, public company in the same industry space decided to take a 10-percent strategic stake in the combination -- at a price that gave the still-privately-held Gold-Mine an implied market capitalization of $800 million, a multiple of approximately 13 times sales.

THE PEOPLE FACTOR

Herb Marchand was a 10-year veteran of the M&A scene before he joined Toshiba International Corporation, where he's now vice president and CFO. He says when deals fail, it's usually because managers don't recognize that the most important factor in a merger isn't numbers -- it's people.

"They forget the most important part of the equation!" he exclaims. "One guy, as soon as we closed the deal, said, 'This is the first time in 35 years I've had a boss.' Quite frankly, he was not ready to give up any power, wasn't ready to work for anybody else, and it became a problem."

Other seasoned merger hands agree. Rod Jacobs, who retired from the CFO post in January after helping pilot Wells Fargo through a widely praised merger with Norwest, says, "I don't think there are any easy mergers. What makes them difficult is the people issues." Jacobs says when Norwest and Wells Fargo announced their merger in the spring of 1999, the market was skeptical. "Analysts thought the companies were too different culturally because Wells Fargo had more of a focus on line business, and Norwest focused more on geography," he adds. "But they didn't recognize that our similarities were stronger than our differences. We both thought about how to generate value for shareholders, and the right way to do this from a people standpoint. Now the market is talking about what a great cultural fit the merger was.

Mergers may be driven by economics and justified by analysis, but it takes people to make them work. Timothy J. Gilpin, author of The Complete Guide to Mergers and Acquisitions, says merger announcements raise troubling questions. "From executives down to front-line employees, people are concerned about pay, jobs, locations, who they will work for," he explains. "If they don't get answers to those questions in a timely and credible way, their focus drifts away from the business. You get a lot of infighting, and things start to unravel. So we recommend that management keep people informed along the way, even if they don't have the answers. At least keep people updated, because otherwise the gap will be filled with rumors of doom and gloom."

Ironically, while merger-bound executives concentrate on crunching numbers with their investment bankers, the market probably will be watching people for its own early clues to whether the merger is likely to deliver promised synergies. The merger of NationsBank and Bank of America had been touted as a merger of equals -- but within six months, key executives of Bank of America were bailing out. "When that happens, it's evident from the outside that things are off track," Galpin says.

Sometimes, though, the original plan to merge was so poorly thought through that no matter what's done on the people side, failure is almost assured. Mark Davis, vice president for research with the BancStock Group in New York, keeps a handy list of absurd bank mer-gers near at hand. "First Union's acquisition of Core State Financial happened at a price 600 percent above book value," he says. "When that deal took place, I was astounded. It happened just after NationsBank acquired Barnett Banks, which had a dominant franchise in Florida, a high-growth state with prospects of continuing growth that probably justified a premium price, and NationsBank only paid around 400 percent of book value. Core States is headquartered in Philadelphia and has offices in eastern Pennsylvania and New Jersey, a market area that doesn't have the growth potential of Florida. Plus, Core States was a great institution with excellent return on assets and equity. How do you promise the market that a price of six times book is justified? This was incredible." First Union is, he says, a competent organization -- but he doubts its shareholders will ever recover the premium it paid for Core States. "I do see mergers that work but it's mergers that are sensibly priced, where the institution being acquired is not a top grade performer, so you can see how costs can be cut or revenues increased," he explains.

Acquisition fever may abate somewhat this year, thanks to the elimination of pooling of interest accounting. Davis says, "I see a whole bunch of small institutions selling out for that reason." Purchase accounting defines any premium above book value as an intangible asset that must be amortized over time. Thus, Davis adds, "Purchase accounting results in a goodwill hit to the acquirer's income statements, so it will drive valuations down as acquirers attempt to minimize the impact, and acquisitions may have a hiccup along the way." But Cisco doesn't plan to back away from its acquisition strategy; in fact, it announced two more deals in January.

With the annual value of M&A transactions running near $2.5 trillion globally, there'll be no shortage of headline-making deals. But few will succeed. And if history is any guide, this period of combination and consolidation will be followed soon by a movement toward divestiture, spin-off and focus, as the forgotten lessons of the past are rediscovered as new wisdom. Who, after all, remembers walking past a Dean Witter counter on the way from the hardware to the sporting-goods department at Sears?

Gregory 1. Millman is a frequent contributor to Financial Executive.

Safety Tips & SURVIVAL STRATEGIES

Mergers are decidedly big business. But most deals fail because of predictable and avoidable blunders. Here's a quick checklist to help you skip the main stumbling blocks.

BUY RIGHT

"The most important consideration in any merger is the financial terms," says Robert LaRose, mergers and acquisitions partner with Thompson Coburn in St. Louis. Be skeptical about performance projections from the target company - they'll usually be optimistic, since the target's goal is to get the highest possible price. And don't pay for synergy - it won't be there until you make it happen.

IDENTIFY THE VALUE DRIVERS

Insist on knowing exactly how a merger will add value to your firm. If the value is to come from cost savings, find out whether the savings are achievable without damaging the business, If the value is to come from revenue synergies, look closely to see whether the two companies complement each other or merely duplicate each other. "Too often we see that due diligence is done, perhaps not quite on the back of an envelope, but certainly not rigorously," says Timothy J. Galpin, global practice leader for mergers and acquisitions with Watson Wyatt Worldwide, and co-author of The Complete Guide to Mergers and Acquisitions.

LOOK AT THE WHOLE CHESS BOARD

If synergies benefit you, they'll hurt your competitors. So your competitors obviously will try to prevent you from getting them. Failure to consider this point has doomed some high-profile mergers. In his 1997 book, The Synergy Trap, Mark Sirower, a professor at NYU, tells how Lockheed Martin was blind-sided after buying a majority interest in Loral, an electronics supplier. One of Loral's biggest customers was a competitor of Lockheed, and decided to take its business elsewhere. Similarly, when Anheuser-Busch decided to exploit potential distribution synergies and enter the snack-food business through a major acquisition, competitor Frito-Lay countered by cutting its prices and launching a campaign to increase market share. And Frito-Lay succeeded in raking in the chips - it drove Anheuser-Busch out of the snack-food business.

BE PERSONALLY INVOLVED, BUT PLAN FOR CONFLICT

"In some merger negotiations, the bankers keep the business people out of the room to prevent conflicts over who's going to run what, where headquarters will be, how power will be distributed, etc.," says Danny Ertel, director of Vantage Partners, a negotiation consulting firm based in Cambridge. "But the merger negotiation is the first best precedent for how they will solve problems later. There will be a lot of conflict during merger integration, and you want the new management team to send the right signals about how problems should be solved in the new entity. Conflict can create value as long as it's handled well."

TELL PEOPLE WHAT'S HAPPENING AND WHY

"Promptly define financial metrics so it will be clear how you are going to collect information and report on financial performance," advises Alberto Ruocco, vice president of The Revere Group. "The top executives generally focus on high-level legal or entity-creation issues, not on what various groups need to know and when." If you create an information vacuum, rumors will till it. Misunderstandings and uncertainty can cost you valuable people. *

BIG FISH, Little Fish

Mergers and acquisitions? "I'd like to see the field called acquisition and divestiture instead, because there are no true mergers of equals," says Andrew Tripoli, CFO of Wellpartner, Inc., an e-commerce solution provider to health care companies in Portland, Ore. "A classic example is Viacom and CBS. The CBS chairman and CEO had to take a back seat to Viacom's chairman. The latest example, of course, is AOL and Time Warner." And Tripoli, who works with two extremes of the capital market, advising the downtrodden (health care) and the inflated (technology), ought to know.

"Overvaluation is driving a lot of M&A activity today," he says. "Acquiring companies have too much stock that's overvalued to pay for these acquisitions. It's like Monopoly money, it's so far beyond stratospheric. Acquirers are paying with grossly inflated stock. Sellers are getting giddy over the valuations of the shares they're receiving. This hubris is distorting judgment all the way around, and is manifest in financial reporting as well as the capital markets. We saw this happen with health care in the mid-'90s. One company was making acquisitions with stock valued at $42, and analysts expected its shares to hit $70. Instead, the shares hit $1.50. The reality was harsh, especially for the sellers."

Tripoli thinks if deals depended on cash, the picture would be different. "There will be an abrupt decrease in M&A activity when the markets come back down to earth," he predicts. "It can trigger a general liquidity crisis; there won't be enough cash or stock of value available to pay for acquisitions."

Further, he adds, "The merger concept is flawed from an accounting and a financial concept standpoint. It's not a bringing together of equals. The FASB and SEC have signaled a clear intention to end pooling accounting. Once pooling goes, accounting for business combinations will reflect reality; that is, acquisition and divestiture, not so-called merger."

He does think, though, that acquisitions will pick up among for-profit health care plans, but for different reasons. "They need to combine to survive, but don't have the market capitalization of a technology company to pay for the acquisitions," he explains. "Valuations of the acquisitions, therefore, will be fair."

If your company is bound and determined to combine, he suggests you "look for undervaluation -- someone whose shares can be acquired relatively cheaply. The acquirer needs a strong valuation; its shares have to convey something of both immediate and sustainable value. I like to see the target company demand part of its proceeds in cash, then watch the valuations change on both sides of the transaction."

Then, too, there are operational factors to consider. "If both companies are similarly valued, there must be synergy: compatible management teams and the ability to provide different lines within the industry," Tripoli concludes.