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Tuesday, March 29, 2016

Senseless acquisitions

In my last blog I wrote of the mismatch between the investment community's expectations for Twitter and the apparently inherent limitations on Twitter's ability to grow and to monetize its user base. Today I want to address a similar perverse behavior of the investment community: overpaying for acquistions. It's a topic I know something about, having glimpsed the inside.

How many times have we seen Company A acquire Company B with great fanfare, only for Company A to quietly sell Company B several years later for less than the original value? Yesterday Dell announced that they're selling Perot Systems for $3.06 billion. They purchased it in 2009 for $3.9 billion. More examples? DaimlerBenz buys and sells Chrysler. Cisco buys and sells both Scientific Atlanta and Linksys (two mistakes by the over-rated John Chambers). eBay buys and sells Skype… and on and on.

Most of the time, Company B allows itself to be bought easily. The board of directors of Company B has a legal duty to get the highest price they can. As long as they don't lie about their company, they aren't to blame for a transaction gone wrong. I can't think of an instance when when the buyer of a company sued the seller for fraud or misrepresentation. I suppose it could happen, but caveat emptor is a good rule and the courts are reluctant to make amends for a buyer's misjudgment. Besides, when a buyer screws up, they'd rather put the matter behind them as quickly and quietly as possible. Even if the purchased company lied, critics will correctly say that the buyer should have discovered the lies during due diligence.

No, the blame for paying too much in an acquisition falls on the buyer —  and more directly on the buyer's investment banker. Of course, the investment banker is often compensated in proportion to the size of the deal, and they don't get paid in full if a deal doesn't close. It's no surprise, then, that investment bankers are often wildly optimistic about the numeric value of the transaction to the buyer.

When eBay was acquiring Skype in 2005, I happened to see the valuation package from eBay's investment banker. (How did I come to see such a tightly guarded document? Don't ask, don't tell.) The valuation was complete nonsense, but it was wrapped in impressive financial bling, it had a big name on the cover, and it purported to use the very best methodology from the Harvard, Wharton, Chicago, and Stanford business schools. If I include the earn-out provisions of the deal, eBay paid over $4 billion for Skype — an astounding figure. Not long after, having finally grasped the reality of what they'd bought, eBay sold most of Skype to outside investors at a valuation of less than $3 billion. Microsoft eventually stepped in and bailed out eBay, but eBay's executives and board of directors in 2005 should have been sacked and required to get brain MRIs before working in corporate America again. By the way, eBay has had a lackluster record ever since.

During my years at Nortel I saw acquisitions whose financials would make you laugh, cry, or vomit. Some of those purchases were paid in hard cash, not in the momentarily inflated Nortel common stock. Of course, Nortel eventually went bankrupt. Given the astute senior leadership as evidenced by those deals, the death of the company could have been predicted (and was, by a few people).

Sometimes an acquisition fails not because the buyer paid too much but because the buyer could not effectively assimilate the purchase. I saw that happen at Nortel too. But when a buyer overpays, the fish rots from the head.