The history of mergers and acquisitions in the United States is comprised of a series of five distinct waves of activity. Each wave occurred at a different time, and each exhibited some unique characteristics related to the nature of the activity, the sources of funding for the activity, and to some extent, differing levels of success from wave to wave. When the volume, nature, mechanisms, and outcomes of these transactions are viewed in an objective historical context, important lessons emerge.
The First Wave
The first substantial wave of merger and acquisition activity in the United States occurred between 1898 and 1904. The normal level of about 70 mergers per year leaped to 303 in 1898, and crested at 1,208 in 1899. It remained at more than 300 every year until 1903, when it dropped to 142, and dropped back again into what had been a range of normalcy for the period, with 79 mergers, in 1904. Industries comprising the bulk of activity during this first wave of acquisition and merger activity included primary metals, fabricated metal products, transportation equipment, machinery, petroleum products, bituminous coal, chemicals, and food products. By far, the greatest motivation for these actions was the expansion of the business into adjacent markets. In fact, 78% of the mergers and acquisitions occurring during this period resulted in horizontal expansion, and another 9.7% involved both horizontal and vertical integration.
During this era in American history, the business environment related to mergers and acquisitions was much less regulated and much more dynamic than it is today. There was very little by way of antitrust impediments, with few laws and even less enforcement.
The Second Wave
The second wave of merger and acquisition activity in American businesses occurred between 1916 and 1929. Having become more concerned about the rampant growth of mergers and acquisitions during the first wave, the United States Congress was much more wary about such activities by the time the second wave rolled around. Business monopolies resulting from the first wave produced some market abuses, and a set of business practices that were viewed as unfair by the American public. Even the Sherman Act proved to be relatively ineffective as a deterrent of monopolistic practices, and so Congress passed another piece of legislation entitled the Clayton Act to reinforce the Sherman Act in 1914. The Clayton Act was somewhat more effective, and proved to be particularly useful to the Federal Government in the late 1900s. However, during this second wave of activity in the years spanning 1926 to 1930, a total of 4,600 mergers and acquisitions occurred. The industries with greatest concentrations of these activities included primary metals, petroleum products, chemicals, transportation equipment, and food products. The upshot of all of these consolidations was that 12,000 companies disappeared, and more than $13 billion in assets were acquired (17.5% of the country’s total manufacturing assets).
The nature of the businesses formed was somewhat different in the second wave; there was a higher incidence of mergers and acquisitions to achieve vertical integration in the second wave, and a much higher percentage of the resulting businesses resulted in conglomerates that included previously unrelated businesses. The second wave of acquisition and merger activity in the United States ended in the stock market crash on October 29, 1929, and this altered – perhaps forever – the perspective of investment bankers related to funding these transactions. Companies that grew to prominence through the second wave of mergers and acquisitions in the United States, and that still operate in this country today, include General Motors, IBM, John Deere (now Deere & Company), and Union Carbide.
The Third Wave
The American economy during the last half of the 1960s (1965 through 1970) was booming, and the growth of corporate mergers and acquisitions, especially related to conglomeration, was unprecedented. It was this economic boom that painted the backdrop for the third wave of mergers and acquisitions in American history. A peculiar feature of this period was the relatively common practice of companies targeting acquisitions that were larger than themselves. This period is sometimes referred to as the conglomerate merger period, owing in large measure to the fact that acquisitions of companies with over $100 million in assets spiked so dramatically. Compared to the years preceding the third wave, mergers and acquisitions of companies this size occurred far less frequently. Between 1948 and 1960, for example, they averaged 1.3 per year. Between 1967 and 1969, however, there were 75 of them – averaging 25 per year. During the third wave, the FTC reports, 80% of the mergers that occurred were conglomerate transactions.
Although the most recognized conglomerate names from this period were huge corporations such as Litton Industries, ITT and LTV, many small and medium size companies attempted to pursue an avenue of diversification. The diversification involved here included not only product lines, but also the industries in which these companies chose to participate. As a result, most of the companies involved in these activities moved substantially outside of what had been regarded as their core businesses, very often with deleterious results.
It is important to understand the difference between a diversified company, which is a company with some subsidiaries in other industries, but a majority of its production or services within one industry category, and a conglomerate, which conducts its business in multiple industries, without any real adherence to a single primary industry base. Boeing, which primarily produces aircraft and missiles, has diversified by moving into areas such as Exostar, an online exchange for Aerospace & Defense companies. However, ITT has conglomerated, with industry leadership positions in electronic components, defense electronics & services, fluid technology, and motion & flow control. While the bulk of companies merged or acquired in the long string of activity resulting in the current Boeing Company were almost all aerospace & defense companies, the acquisitions of ITT were far more diverse. In fact, just since becoming an independent company in 1995, ITT has acquired Goulds Pumps, Kaman Sciences, Stanford Telecom and C&K Components, among other companies.
Since the ascension of the third wave of mergers and acquisitions in the 1960s, there has been a great deal of pressure from stockholders for company growth. With the only comparatively easy path to that growth being the path of conglomeration, a lot of companies pursued it. That pursuit was funded differently in this third wave of activity, however. It was not financed by the investment bankers that had sponsored the two previous events. With the economy in expansion, interest rates were comparatively high and the criteria for obtaining credit also became more demanding. This wave of merger and acquisition activity, then, was executed by the issuance of stock. Financing the activities through the use of stock avoided tax liability in some cases, and the resulting acquisition pushed up earnings per share even though the acquiring company was paying a premium for the stock of the acquired firm, using its own stock as the currency.
The use of this mechanism to boost EPS, however, becomes unsustainable as larger and larger companies are involved, because the underlying assumption in the application of this mechanism is that the P/E ratio of the (larger) acquiring company will transfer to the entire base of stock of the newly combined enterprise. Larger acquisitions represent larger percentages of the combined enterprise, and the market is generally less willing to give the new enterprise the benefit of that doubt. Eventually, when a large number of merger and acquisition activities occur that are founded on this mechanism, the pool of suitable acquisition candidates is depleted, and the activity declines. That decline is largely responsible for the end of the third wave of merger and acquisition activity.
One other mechanism that was used in a similar way, and with a similar result, in the third wave or merger and acquisition activity was the issue of convertible debentures (debt securities that are convertible into common stock), in order to gather in the earnings of the acquired firm without being required to reflect an increase in the number of shares of common stock outstanding. The resulting bump in visible EPS was known as the bootstrap effect. Over the course of my own career, I have often heard of similar tactics referred to as “creative accounting”.
Almost certainly, the most conclusive evidence that the bulk of conglomeration activity achieved through mergers and acquisitions is harmful to overall company value is the fact that so many of them are later sold or divested. For example, more than 60% of cross-industry acquisitions that occurred between 1970 and 1982 were sold or divested in some other manner by 1989. The widespread failure of most conglomerations has certainly been partly the result of overpaying for acquired companies, but the fact is that overpaying is the unfortunate practice of many companies. In one recent interview I conducted with an extremely successful CEO in the healthcare industry, I asked him what actions he would most strongly recommend that others avoid when entering into a merger or acquisition. His response was immediate and emphatic: “Don’t become enamored with the acquisition target”, he replied. “Otherwise you will overpay. The acquisition has to make sense on several levels, including price.”
The failure of conglomeration, then, springs largely from another root cause. Based on my own experience and the research I have conducted, I am reasonably certain that the most fundamental cause is the nature of conglomeration management. Implicit in the management of conglomerates is the notion that management can be done well in the absence of specialized industry knowledge, and that just isn’t usually the case. Regardless of the “professional management” business curricula offered by many institutions of higher learning these days, in most cases there is just no substitute for industry-specific experience.
The Fourth Wave
The first indications that a fourth wave of merger and acquisition activity was imminent appeared in 1981, with a near doubling of the value of these transactions from the prior year. However, the surge receded a bit, and really regained serious momentum again in 1984. According to Mergerstat Review (2001), just over $44 billion was paid in merger and acquisition transactions in 1980 (representing 1,889 transactions), compared to more than $82 billion (representing 2,395 transactions) in 1981. While activity fell back to between $50 billion and $75 billion in the ensuing two years, the 1984 activity represented over $122 billion and 2,543 transactions. In terms of peaks, the number of transactions peaked in 1986 at 3,336 transactions, and the dollar volume peaked in 1988 at more than $246 billion. The entire wave of activity, then, is regarded by analysts to have occurred between 1981 and 1990.
There are a number of aspects of this fourth wave that distinguish it from prior activities. The first of those characteristics is the advent of the hostile takeover. While hostile takeovers have been around since the early 1900s, they truly proliferated (more in terms of dollars than in terms of percent of transactions) during this fourth wave of merger and acquisition activity. In 1989, for example, more than three times as many dollars were transacted as a result of contested tender offers than the dollars associated with uncontested offers. Some of this phenomenon was closely tied to another characteristic of the fourth wave of activity; the sheer size and industry prominence of acquisition targets during that period. Referring again to Mergerstat Review‘s numbers published in 2001, the average purchase price paid in merger and acquisition transactions in 1970, for example, was $9.8 million. By 1975, it had grown to $13.9 million, and by 1980 it was $49.8 million. At its peak in 1988, the average purchase price paid in mergers and acquisitions was $215.1 million. Exacerbating the situation was the volume of large transactions. The number of transactions valued at more than $100 million increased by more than 23 times between 1974 and 1986, which was a stark contrast to the typically small-to-medium size company based activities of the 1960s.
Another factor that impacted this fourth wave of merger and acquisition activity in the United States was the advent of deregulation. Industries such as banking and petroleum were directly affected, as was the airline industry. Between 1981 and 1989, five of the ten largest acquisitions involved a company in the petroleum industry – as an acquirer, an acquisition, or both. These included the 1984 acquisition of Gulf Oil by Chevron ($13.3 billion), the acquisition in that same year of Getty Oil by Texaco ($10.1 billion), the acquisition of Standard Oil of Ohio by British Petroleum in 1987 ($7.8 billion), and the acquisition of Marathon Oil by US Steel in 1981 ($6.6 billion). Increased competition in the airline industry resulted in a severe deterioration in the financial performance of some carriers, as the airline industry became deregulated and air fares became exposed to competitive pricing.
An additional look at the ontology of the ten largest acquisitions between 1981 and 1989 reflects that relatively few of them were acquisitions that extended the acquiring company’s business into other industries than their core business. For example, among the five oil-related acquisitions, only two of them (DuPont’s acquisition of Conoco and US Steel’s acquisition of Marathon Oil) were out-of-industry expansions. Even in these cases, one might argue that they are “adjacent industry” expansions. Other acquisitions among the top ten were Bristol Meyers’ $12.5 billion acquisition of Squibb (same industry – Pharmaceuticals), and Campeau’s $6.5 billion acquisition of Federated Stores (same industry – Retail).
The final noteworthy aspect of the “top 10” list from our fourth wave of acquisitions is the characteristic that is exemplified by the actions of Kohlberg Kravis. Kohlberg Kravis performed two of these ten acquisitions (both the largest – RJR Nabisco for $5.1 billion, and Beatrice for $6.2 billion). Kohlberg Kravis was representative of what came to be known during the fourth wave as the “corporate raider”. Corporate raiders such as Paul Bilzerian, who eventually acquired the Singer Corporation in 1988 after participating in numerous previous “raids”, made fortunes for themselves by attempting corporate takeovers. Oddly, the takeovers did not have to be ultimately successful for the raider to profit from it; they merely had to drive up the price of shares they acquired as a part of the takeover attempt. In many cases, the raiders were actually paid off (this was called “greenmail”) with corporate assets in exchange for the stock they had acquired in the attempted takeover.
Another term that came into the lexicon of the business community during this fourth wave of acquisition and merger activity is the leveraged buy-out, or LBO. Kohlberg Kravis helped develop and popularize the LBO concept by creating a series of limited partnerships to acquire various corporations, which they deemed to be underperforming. In most cases, Kohlberg Kravis financed up to ten percent of the acquisition price with its own capital and borrowed the remainder through bank loans and by issuing high-yield bonds. Usually, the target company’s management was allowed to retain an equity interest, in order to provide a financial incentive for them to approve of the takeover.
The bank loans and bonds used the tangible and intangible assets of the target company as collateral. Because the bondholders only received their interest and principal payments after the banks were repaid, these bonds were riskier than investment grade bonds in the event of default or bankruptcy. As a result, these instruments became known as “junk bonds.” Investment banks such as Drexel Burnham Lambert, led by Michael Milken, helped raise money for leveraged buyouts. Following the acquisition, Kohlberg Kravis would help restructure the company, sell off underperforming assets, and implement cost-cutting measures. After achieving these efficiencies, the company was usually then resold at a significant profit.
Increasingly, as one reviews the waves of acquisition and merger activity that have occurred in the United States, this much seems clear: While it is possible to profit from the creative use of financial instruments and from the clever buying and selling of companies managed as an investment portfolio, the real and sustainable growth in company value that is available through acquisitions and mergers comes from improving the newly formed enterprise’s overall operating efficiency. Sustainable growth results from leveraging enterprise-wide assets after the merger or acquisition has occurred. That improvement in asset efficiency and leverage is most frequently achieved when management has a fundamental commitment to the ultimate success of the business, and is not motivated purely by a quick, temporary escalation in stock price. This is related, in my view, to the earlier observation that some industry-specific knowledge improves the likelihood of success as a new business is acquired. People who are committed to the long-term success of a company tend to pay more attention to the details of their business, and to broader scope of technologies and trends within their industry.
There were a few other characteristics of the fourth wave of merger and acquisition activity that should be mentioned before moving on. First of all, the fourth wave saw the first significant effort by investment bankers and management consultants of various types to provide advice to acquisition and merger candidates, in order to earn professional fees. In the case of the investment bankers, there was an additional opportunity around financing these transactions. This opportunity gave rise, in large measure, to the junk bond market that raised capital for acquisitions and raids. Secondly, the nature of the acquisition – and especially the nature of takeovers – became more intricate and strategic in nature. Both the takeover mechanisms and paths and the defensive, anti-takeover methods and tools (eg: the “poison pill”) became increasingly sophisticated during the fourth wave.
The third characteristic in this category of “other unique characteristics” in the fourth wave was the increased reliance on the part of acquiring companies on debt, and perhaps even more importantly, on large amounts of debt, to finance the acquisition. A significant rise in management team acquisition of their own firms using comparatively large quantities of debt gave rise to a new term – the leveraged buy-out (or LBO) – in the lexicon of the Wall Street analyst.
The fourth characteristic was the advent of the international acquisition. Certainly, the acquisition of Standard Oil by British Petroleum for $7.8 billion in 1987 marked a change in the American business landscape, signaling a widening of the merger and acquisition landscape to encompass foreign buyers and foreign acquisition targets. This deal is significant not only because it involved foreign ownership of what had been considered a bedrock American company, but also because of the sheer dollar volume involved. A number of factors were involved in this event, such as the fall of the US dollar against foreign currencies (making US investments more attractive), and the evolution of the global marketplace where goods and services had become increasingly multinational in scope.
The Fifth Wave
The fifth wave of acquisition and merger activity began immediately following the American economic recession of 1991 and 1992. The fifth wave is viewed by some observers as still ongoing, with the obvious interruption surrounding the tragic events September 11, 2001, and the recovery period immediately following those events. Others would say that it ended there, and after the couple of years ensuing, we are seeing the imminent rise of a sixth wave. Having no strong bias toward either view, for purposes of our discussion here I will adopt the first position. Based on the value of transactions announced over the course of the respective calendar years, the dollar volume of total mergers and acquisitions in the US in 1993 was $347.7 billion (an increase from $216.9 billion in 2002), continued to grow steadily to $734.6 billion in 1995, and expanded still further to $2,073.2 billion by 2000.
This group of deals differed from the previous waves in several respects, but arguably the most important difference was that the acquisitions and mergers of the 1990s were more thoughtfully orchestrated than in any previous foray. They were more strategic in nature, and better aligned with what appeared to be relatively sophisticated strategic planning on the part of the acquiring company. This characteristic seems to have solidified as a primary feature of major merger and acquisition activity, at least in the US, which is encouraging for shareholders looking for sustainable growth rather than a quick – but temporary – bump in share price.
A second characteristic of the fifth wave of acquisitions and mergers is that they were typically more equity-based than debt-based in terms of their funding. In many cases, this worked out well because it relied less on leverage that required near-term repayment, enabling the new enterprise to be more careful and deliberate about the sell-off of assets in order to service debt created by the acquisition.
Even in cases where both of these features were prominent aspects of the deal, however, not all have been successful. In fact, some of the biggest acquisitions have been the biggest disappointments over recent years. For example, just before the announcement of the acquisition of Time Warner by AOL, a share of AOL common stock traded for about $94. In January of 2005, that share of stock was worth about $17.50. In the Spring of 2003, the average share price was more like $11.50. The AOL Time Warner merger was financed with AOL stock, and when the expected synergies did not materialize, market capitalization and shareholder value both tanked. What was not foreseen was the devaluation of the AOL shares used to finance the purchase. As analyst Frank Pellegrini reported in Time’s on-line edition on April 25, 2002: “Sticking out of AOL Time Warner’s rather humdrum earnings report Wednesday was a very gaudy number: A one-time loss of $54 billion. It’s the largest spill of red ink, dollar for dollar, in U.S. corporate history and nearly two-thirds of the company’s current stock-market value.”
The fifth wave has also become known as the wave of the “roll-up”. A roll-up is a process that consolidates a fragmented industry through a series of acquisitions by comparatively large companies (typically already within that industry) called consolidators. While the most widely recognized of these roll-ups occurred in the funeral industry, office products retailers, and floral products, there were roll-ups of significant magnitude in other industries such as discrete segments of the aerospace & defense community.
Finally, the fifth wave of acquisitions and mergers was the first one in which a very large percentage of the total global activity occurred outside of the United States. In 1990, the volume of transactions in the US was $301.3 billion, while the UK had $99.3 billion, Canada had $25.3 billion, and Japan represented $14.2 billion. By the year 2000, the tide was shifting. While the US still led with $2,073 billion, the UK had escalated to $473.7 billion, Canada had grown to $230.2 billion, and Japan had reached $108.8 billion. By 2005, it was clear that participation in global merger and acquisition activity was now anyone’s turf. According to barternews.com: “There was incredible growth globally in the M&A arena last year, with record-setting volume of $474.3 billion coming from the Asian-Pacific region, up 46% from $324.5 billion in 2004. In the U.S., M&A volume rose 30% from $886.2 billion in 2004. In Europe the figure was 49% higher than the $729.5 billion in 2004. Activity in Eastern Europe nearly doubled to a record $117.4 billion.”
The Lessons of History
Many studies have been conducted that focus on historical mergers and acquisitions, and a great deal has been published on this topic. Most of the focus of these studies has been on more contemporary transactions, probably owing to factors such as the availability of detailed information, and a presumed increase in the relevance of more recent activity. However, before sifting through the collective wisdom of the legion of more contemporary studies, I think it’s important to look at least briefly to the patterns of history that are reflected earlier in this article.
Casting a view backward over this long history of mergers and acquisitions then, observing the relative successes and failures, and the distinctive characteristics of each wave of activity, what lessons can be learned that could improve the chances of success in future M&A activity? Here are ten of my own observations:
- Silver bullets and statistics. The successes and failures that we have reviewed through the course of this chapter reveal that virtually any type of merger or acquisition is subject to incompetence of execution, and to ultimate failure. There is no combination of market segments, management approaches, financial backing, or environmental factors that can guarantee success. While there is no “silver bullet” that can guarantee success, there are approaches, tools, and circumstances that serve to heighten or diminish the statistical probability of achieving sustainable long-term growth through an acquisition or merger.
- The ACL Life Cycle is fundamental. The companies who achieve sustainable growth using acquisitions and mergers as a mainstay of their business strategy are those that move deliberately through the Acquisition / Commonization / Leverage (ACL) Life Cycle. We saw evidence of that activity in the case of US Steel, Allied Chemical, and others over the course of this review.
- Integration failure often spells disaster. Failure to achieve enterprise-wide leverage through the commonization of fundamental business processes and their supporting systems can leave even the largest and most established companies vulnerable to defeat in the marketplace over time. We saw a number of examples of this situation, with the American Sugar Refining Company perhaps the most representative of the group.
- Environmental factors are critical. As we saw in our review of the first wave, factors such as the emergence of a robust transportation system and strong, resilient manufacturing processes enabled the success of many industrial mergers and acquisitions. So it was more recently with the advent of information systems and the Internet. Effective strategic planning in general, and effective due diligence specifically, should always include a thorough understanding of the business environment and market trends. Often times, acquiring executives become enamored with the acquisition target (as mentioned in our review of third wave activity), and ignore contextual issues as well as fundamental business issues that should be warning signs.
- Conglomeration is challenging. There were repeated examples of the challenges associated with conglomeration in our review of the history of mergers and acquisitions in the United States. While it is possible to survive – and even thrive – as a conglomerate, the odds are substantially against it. Those acquisitions and mergers that most often succeed in achieving sustainable long-term growth are the ones involving management with significant industry-specific and process-specific expertise. Remember the observation, during the course of our review of fourth wave activity, that “the most conclusive evidence that the bulk of conglomeration activity achieved through mergers and acquisitions is harmful to overall company value is the fact that so many of them are later sold or divested.”
- Commonality holds value. Achieving significant commonality in fundamental business processes and the information systems that support them offers an opportunity for genuine synergy, and erects a substantive barrier against competitive forces in the marketplace. We saw this a number of times; Allied Chemical is especially illustrative.
- Objectivity is important. As we saw in our review of the influence of investment bankers vetoing questionable deals during second wave activities, there is considerable value in the counsel of objective outsiders. A well-suited advisor will not only bring a clear head and fresh eyes to the table, but will often introduce important evaluative expertise as a result of experience with other similar transactions, both inside and outside of the industry involved.
- Clarity is critical. We saw the importance of clarity around the expected impacts of business decisions in our review of the application of the DuPont Model and similar tools that enabled the ascension of General Motors. Applying similar methods and tools can provide valuable insights about what financial results may be expected as the result of proposed acquisition or merger transactions.
- Creative accounting is a mirage. The kind of creative accounting described by another author as “finance gimmickry” in our review of third wave activity does not generate sustainable value in the enterprise, and in fact, can prove devastating to companies who use it as a basis for their merger or acquisition activity.
- Prudence is important when selecting financial instruments to fund M&A transactions. We observed a number of cases where inflated stock values, high-interest debt instruments, and other questionable choices resulted in tremendous devaluation in the resulting enterprise. Perhaps the most illustrative example was the recent AOL Time Warner merger described in the review of fifth wave activity.
Many of these lessons from history are closely related, and tend to reinforce one another. Together, they provide an important framework of understanding about what types of acquisitions and mergers are most likely to succeed, what methods and tools are likely to be most useful, and what actions are most likely to diminish the company’s capability for sustainable growth following the M&A transaction.