June 10, 2015, by John Colley
Strategy briefing – Advisors: Value Adding or Expensive Self Interest?
When Fred Goodwin spent £71bn of Royal Bank of Scotland’s money on ABN-AMRO in 2007 this was quite possibly the worst acquisition ever made. Although many would argue that the competition is particularly high in this respect!
The acquisition effectively bust the bank, requiring the British Government to rescue it. Before doing the deal, Fred discussed the price with his advisors. What advice did they give? How many counselled against the deal? How many were remunerated only on a successful deal?
Stockbrokers, financial advisors, management consultants, and agents are often on substantial fees only payable if the transaction runs. The fees can run to many millions. Is it possible this could cloud their judgment when offering advice?
As Warren Buffett famously noted in the Economist (2 Sept, 1995), ‘Whilst deals often fail in practice, they never fail in projections.’
Mergers and acquisitions
The majority of acquisitions (between 60 and 80%) destroy value and not far off half of all acquisitions are sold off within 5 years (Sirower, 1997). Mergers and acquisitions do not improve the stock market or financial performance of buying companies (Schweiger et al, 1993).
When a potential acquirer makes a bid, the shares in the target almost invariably rise and the acquirer’s shares frequently fall. This results in a transfer in value to the shareholders of the target.
These findings are robust and have been replicated in numerous academic studies. So why do highly intelligent CEOs destroy so much value and continue to pursue substantial acquisitions?
There are many factors which influence this issue; however advisors are an important and expensive element.
The major western financial markets are highly regulated, with associated extensive and complex technical requirements to raise money or complete any form of corporate transaction.
All businesses need specialised advisors to negotiate their path through the requirements. Consequently even a relatively simple deal will need financial advisors, lawyers,accountants, property agents, management consultants; and for listed companies stockbrokers.
The cost can be disproportionate in relation to the value of the deal, particularly if relatively low amounts of capital are being raised.
In small share placings total costs can be 12% of that raised, whilst even in management buy outs (MBOs) funded by private equity (PE) costs can be 20% of the money raised from PE. PE does like extensive reassurance from advisors as their knowledge of the business being acquired is often very limited.
These costs are normally ‘dumped ‘ in the company acquired.
I have known activist investors who dislike the use of advisors. In my experience they avoid using them where possible, due to the extraction of so much value from a business. However I have also known the same investors make major costly errors, which may have been avoided by using advisors.
When using advisors it is important to distinguish between technical advice in relation to law, tax and compliance with regulation; from commercial advice. It is best to treat the latter with great caution if they are on a success based deal. It will almost invariably be angled at persuasion to run the deal.
Indeed it is probably best to listen more closely to those on fixed fees or hourly rates who are not success incentivised. It is more likely the advice will be impartial if incentives are structured this way.
It is important to be very clear on expectation from advisors when they are hired. CEOs often think that advisors may be willing to take a significant role in negotiations.
Apart from technical, legal and tax advice they normally do not want to be part of the main negotiation which you will usually be doing yourself.
Again I have known plenty of exceptions to this but be clear on the precise expectations when hiring.
In MBOs the main problem for management is that they have not been through the process before. The negotiation with their financial backers to determine terms is often more extensive, complex, and difficult than the negotiation with the business sellers.
The advisors, PE, and the sellers are likely to have been through the process many times so the MBO team are hugely dependent on advisors for advice and to understand the norms. There is a temptation for them to be taken as ‘stooges’ by the other parties due to their naivety in this financial arena.
Advisors usually recommend their business contacts to take on the various needed roles and hence their loyalty to each other may rather exceed that to the MBO team.
Impartial advice may be hard to find, and management must be careful in deciding who is really advising in their own best interests.
Advisors will carefully try and build relationships with the CEO to increase and maximise their own influence. That relationship will not only influence the current deal but also the prospect of future work which the advisor will no doubt propose at some stage.
Advisors are keen to increase their political leverage within a business and for a CEO that can be a very slippery slope to losing some control and diminishing the authority of other executives within the business.
Whilst the ego of CEOs may be flattered by the attention of so many senior advisors they must guard against the inevitable politics and respect the internal governance and executive process. They should also choose and remunerate advisors and consultants very carefully.
Advisors will always argue that they need to show integrity and professionalism in a transaction to be considered for future work. They will also be quick to point out that the final decision on any failed project was not theirs, and retrospectively minimise the prominence of their role in such projects.
Clearly there are many advisors around with high integrity who give dispassionate advice. My experience is most are on fixed fees. However even those on fixed fees or hourly rates can attempt to widen their brief to sell additional services.
A business announcing a major acquisition may well bring smiles to the faces of advisors whilst the shareholders outlook is rather less certain.
Select your advisors carefully, avoid remunerating based on success, and be aware of remit and fee stretch.
Dr John Colley is Director of MBA Programmes at Nottingham University Business School. He was previously Group Managing Director of a FTSE 100 business, and Executive Managing Director of a French CAC 40 business. He currently chairs a listed Plc and is non-executive director of several private equity businesses. John is an ESRC/FME Senior Fellow.