M&A is on the rise, but companies should proceed with caution

Executives must approach mergers and acquisitions objectively. (iStockPhoto)

Mergers and acquisitions are moving at a record clip, but without considering the “social side of strategy,” the deals could be at risk from the get-go, a study found.

Biases can distort outcomes when making big decisions, especially when those decisions are infrequent and under the microscope, according to McKinsey findings. What’s more, executives could get mired in tweaking their arguments by excluding underperforming business segments and asking for more resources then they can get. That’s why businesses need an external benchmark to measure against these social factors.

First, it’s important to recognize that market forces are efficient, making it tough for companies to generate returns, let alone acquire other businesses. Additionally, companies in the top quintile have nearly 90% of the economic profit created and average about 30 times as much economic profit as those in the middle three quintiles, while the bottom 20% has seen deep economic losses, the report found.

Another factor is industry performance. “There are 12 tobacco companies in our research, and nine are in the top quintile,” according to McKinsey. “Yet there are 20 paper companies, and none is in the top quintile. The role of industry in a company’s position on the power curve is so substantial that it’s better to be an average company in a great industry than a great company in an average industry.”

Lastly, it’s rare for companies to go from the middle quintiles to the top one—only 1 in 12 achieves this, the report found.

The five moves most likely to bring success are:

  • Programmatic M&A, a steady stream of deals every year amounting to no more than 30% of market cap.
  • Dynamic reallocation of resources, with the goal of moving 50% of capital expenditure among businesses every 10 years.
  • Strong capital expenditure, or spending 1.7 times the industry median.
  • Strength of productivity, which means improving productivity enough to land the company in the top 30% of its industry.
  • Improvements in differentiation, such as innovating to meet modern consumer demands.

A high rate of M&A is not necessarily the sign of a healthy marketplace, according to a MoneyWeek article.

“The value of merger and acquisition deals already done so far this year amounts to $1.7 trillion, says the Financial Times. That’s now running ahead of the prefinancial crisis highs,” the article states. “That’s a bad sign, in that you pretty much always get a lot of M&A activity near the top of the market, rather than near the bottom.”

What’s more, companies are more expensive today than they were in, say, 2009, which means the cost of borrowing will rise. It’s logical, the article says: During the financial crisis, companies held onto their money waiting for the next hit, but with recovery comes optimism. The risk to the upswing of the current cycle is the creation of a bubble that will inevitably pop, the article adds.