M&A Brokers & Adverse Incentives

You don’t have to search too long to find opinions alleging that M&A destroys value. NYU Professor Aswath Damodaran goes as far as to say that asking an investment bank to fairly value an acquisition target is akin to “asking a plastic surgeon to tell you your face is perfect.” When the so-called father of modern valuations is so vehemently against the practice, one might wonder why the volume of M&A transactions continues its upward trajectory.

Context is required here.

Firstly, most academic studies on M&A use event studies to measure the success of transactions. That is, when news of the transaction is publicly released, we assume the stock market’s response to be a gauge of the success or otherwise of the deal (success, as always with the stock market, being a translation for “future earnings”). There’s at least one major flaw in this, which even academics will admit to — it assumes that the stock market makes the right call all the time.

Secondly, to give some context to Damodaran’s remark, he’s not arguing against the logic of M&A transactions as much as this may appear to be the case. His argument is based on the problem inherent in deals: generally, a portion of the brokerage fees is based on transaction size. Even we at Morgan & Westfield, as M&A advisors, agree that this has the potential to lead to adverse outcomes. But again, it’s far too simplistic to assume that a process that may lead to bias does and will lead to bias.

The economy at large is full of situations where adverse incentives exist. Think of doctors who earn by the number of procedures carried out or who make the same money for riskier operations as they do for straightforward ones. Lawyers who bill by the hour are another notorious example. Thankfully, there are thousands of decent professionals in each discipline with whom you can build a relationship based on trust and confidence. Your M&A broker is no different.

Transactions can be carried out without brokers — there’s no question of that. In fact, many of the largest industrial companies (GE, as an example) often have their own in-house M&A units, which carry out all the functions of a brokerage. There’s a learning curve to each transaction, which means that if you’re planning on a series of transactions, your ability to extract value from a transaction increases incrementally with each one.

Therein lies one of the benefits of hiring a good broker. Your company is effectively paying for the knowledge gained over hundreds of similar transactions that the broker has viewed from the buy-side and the sell-side. That experience brings with it knowledge of small details that tend to re-occur in certain situations (and M&A transactions are all about details), best practices for negotiation (approaching a direct competitor without a brokerage is far more difficult), and as a stable of relevant contacts built up over the years.

There is no question that many M&A transactions destroy value. They’re a financial transaction: there’s an inherent risk in spending money on another company. Being aware of this, why wouldn’t you at least consult experts in the field? Establish a clear set of parameters for the M&A broker before beginning the process so that you minimize the problems mentioned above. With time, you’ll see that a good brokerage, far from being just an agent, can be an intrinsic part of value-creating.