Fortune fails to favour the brave

It’s a measure of just how thin market activity has been this year that our league tables of M&A advisers for the first six months of 2002 have been knocked sideways by one big deal. When major deals are so few and far between, one transaction can make a huge difference to where the various institutions rank.

Pfizer’s bid for Pharmacia, announced on July 15, represents $59.4 billion-worth of league table boost for Bear Stearns and Lazard Frères which are advising Pfizer, and for Goldman Sachs in the Pharmacia camp – assuming that nothing gets in the way of completion. No doubt those banks will be delighted to take the credit for arranging what is by far the biggest deal of 2002 so far.

Welcome back to mega-merger territory. For at almost six times the size of the second largest transaction this year, that is where the Pfizer Pharmacia marriage lies. Closest behind is China Mobile’s spending spree in May when it splashed out $10.2 billion to buy eight regional mobile telecom companies. The previous month, UK power company National Grid launched a $9.3 billion bid for infrastructure technology group Lattice. In the US, meanwhile, no significant transaction has been announced since February when Northrop Grumman bid $7.6 billion for fellow defence firm TRW. A mixture of accounting scandals and the fear of being penalized by investors has left corporate America in a state of near paralysis.

But while the bankers and lawyers involved welcomed Pfizer’s bold move in such a desert-like fee environment, it’s not so obvious that investors felt the same way. Pfizer’s stock fell 11% to $28.78 in the immediate aftermath of the announcement and has continued south since. That it was hit so heavily suggests that some owners would rather throw in the towel now than risk being party to yet another value-destroying acquisition. Witness the huge sums of goodwill payments that have been written off by over-ambitious corporates lately, not to mention the fate of Tyco, the highly acquisitive US conglomerate whose stock price was recently savaged by panicky investors.

“I’m not really surprised at how the market reacted,” says Joe Anderson, head of global healthcare and biotechnology at First State Investments in London, who holds a large position in Pfizer. “Any bold moves or acquisitive strategies are being treated with suspicion and it’s hard to know whether that’s ill founded or not.”

So it seems that Pfizer’s share price suffered simply because CEO Hank McKinnell was prepared to put his head above the parapet when none of his peers would. That type of forthright attitude just doesn’t seem welcome in today’s environment. Essentially, there’s not really much wrong with the merger. It will result in a more diversified range of products and a stronger pipeline and should yield important synergies. “The Pfizer-Pharmacia deal is a good move. They had to do it if they wanted to be a credible company going forward,” says Pascal France, a senior buy-side analyst at Pictet et Cie.

According to analysts the deal will immediately add value. As a stand-alone company, Pfizer had forecast that it would generate a 16% growth in earnings for 2002 to 2004. With the addition of Pharmacia that goes up to 19%. The new Pfizer will be a global giant in the pharmaceuticals industry, setting standards in terms of sales and marketing – with a sales force of 13,000 compared with 8,000 at UK company GlaxoSmithKline, its closest rival – as well as research and development. It will also boast an 11% market share compared with 6% at GSK.

Big is not necessarily better

So why are investors so wary? “The market reaction was a little overdone,” admits Thomas Bucher, head of healthcare buy-side research at Deutsche Asset Management. “But maybe people are afraid that Pfizer is now too big to show top-line growth going forward.”

Or maybe just too big. Many investors and observers are sceptical of the rationale for some of the mergers that have been completed in recent years and point the finger at ambitious CEOs hungry for glory. Erik Stern, managing director Europe of consultancy Stern Stewart, is among those who feel that the drive to be big can be damaging. “The widespread use of indexing – an essentially passive activity – means that CEOs don’t come under pressure from investors to consider reducing the size of the company,” he says. “Performance tests are not what they should be,” he argues. “A CEO should be held accountable for producing the synergies he promises and if these don’t come about then he shouldn’t get a bonus.”

Though it’s easy for consultants such as Stern, investors and, in particular, corporate governance activists to spout about what they don’t like to see, it’s not quite so easy to determine what they are actually looking for. Judging by the market reaction to merger and acquisition deals that appear to have a strong industrial logic it seems they’ll balk at anything.

Checks on over-optimism

It’s not clear what any “performance tests” would entail, for example. Whether or not a merger has been successful can only really be seen in retrospect, so by the time it is established that a deal has not lived up to its promises the management team responsible might have moved on or even retired, given increasingly rapid CEO turnover. A recent survey by DBM, a human resources consultancy that is part of the Thomson Financial group, found that the average tenure of a CEO in 2001 was 2.75 years and only 28% served for five years or more, compared with 37% in 1999.

A possible solution for CEOs close to retirement age might be to base pension payments on the success or failure of transactions undertaken during their tenure. It’s an unpopular step, perhaps, but it would discourage all but the most clearly logical M&A deals. “People are just too optimistic about what acquisitions will do,” complains Tony Watson, chief executive of Hermes Pension Management, which is known for its activism on corporate governance issues.

What Hermes and other active shareholders look for as a basic starting point is that the deal is in the interests of shareholders. It must be obvious that the investment will produce a surplus over the capital outlay involved, for example.

Investors are also demanding fast and free-flowing information – assuming that an M&A move makes sense in the first place that is. “There’s a need for communication and justification of any deal. A good communication strategy should allow shareholders of the bidder firm to form an opinion on whether the strategy makes sense,” says Watson. He adds that what he is looking for is a precise, succinct account of why he should buy into a particular acquisition, rather than 28 pages of irrelevant marketing spiel. If a deal makes sense it should be possible to write down the rationale in a direct way and state clearly why it would give a company a competitive edge.

Surprisingly, some firms struggle to be convincing on this point. Marian Collins, head of corporate governance at Barclays Global Investors, says: “We’ve had situations where we’ve been unhappy and so we’ve hauled the company in and said to them: ‘Look, we’re trying to understand what you’re doing here because it looks very poor on paper.’ We were much happier after they’d explained it to us.”

Much to the chagrin of chief executives – who tend to accuse shareholders of short-termism – the sooner a company can show it is reaping the benefits of a deal the better. As Julian Franks, a professor of finance at London Business School, explains: “Investors want to be convinced that management has a viable plan and if they don’t see results quickly they’re going to get worried that it doesn’t have one.”

How quickly that evidence should be produced depends on the nature of the acquisition and the motivation behind it. If cost savings are the primary raison d’être and these aren’t seen within a year or two, says Franks, investors will conclude that it’s unlikely they’ll come through at all.

Other motivating factors, such as gaining entry into a new market – the reasoning behind Vodafone CEO Chris Gent’s interest in SFR, the French mobile phone assets of Vivendi – or because a CEO feels he can do a better job of managing a rival (which is why Royal Bank of Scotland bought NatWest), may reasonably take longer to bear fruit. “Results don’t necessarily have to be within a year but we would expect to see them in two or three years’ time. With any deal, we would have to look at the rationale,” says Collins.

Franks takes issue with investors and academics who believe that M&A necessarily destroys value. Historically some types of deals have produced results, he says, such as those in the oil and pharmaceuticals sectors, while others have failed to do so. Included in the second category are mergers in financial services and investment banking where increasing size has often turned out to be counterproductive.

Ultimately what investors really want is to be convinced that when a company makes a major strategic move it has been thoroughly debated by a board comprising a significant proportion of non-executive independent directors. “All I want to see when a company engages in M&A is that it has been approved by a board that is sufficiently distanced from management and sufficiently aligned with shareholder interests for the decision to be a reasonable one,” says Charles Elson, director of the centre for corporate governance at the University of Delaware.

In other words, the central tenet of good corporate governance – an active board – must be in place before investors can feel confident about any transaction. Collins at Barclays Global Investors agrees that the boardroom is the place to start when trying to determine the viability of a deal. “You have to look at the board,” she says. “If there’s a weak board and the CEO is over-dominant then the merger might be the CEO’s idea which he is then able to push through.”

The problem with relying on this type of evidence to form an opinion is that it’s in practice extremely difficult to determine the power structure of a board from the outside. Board meetings necessarily go on behind closed doors so who’s to know if a CEO chooses to withhold information from his non-executive directors or if the directors themselves fail to fulfil their duties? Although examples of one or both of these occurring come so readily to mind – WorldCom, Enron, Swissair – it’s hard to blame investors for being a little wary of Pfizer’s plans.

Whether more companies will follow now that Pfizer has broken the ice is anyone’s guess. Most M&A bankers are bearish on the prospects of a recovery in the market before the middle of next year. However, what is certain is that those CEOs who do choose to pursue a deal will have to work much harder to convince investors that they’re doing it for the right reasons.