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Published under exclusive licence from The Economist by Profile Books Ltd 3 Holford Yard Bevin Way London wc1x 9hd www.profilebooks.com Copyright © Anna Faelten, Michel Driessen and Scott Moeller, 2016 All rights reserved. Without limiting the rights under copyright reserved above, no part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording or otherwise), without the prior written permission of both the copyright owner and the publisher of this book. The greatest care has been taken in compiling this book. However, no responsibility can be accepted by the publishers or compilers for the accuracy of the information presented. Where opinion is expressed it is that of the author and does not necessarily coincide with the editorial views of The Economist Newspaper. While every effort has been made to contact copyright-holders of material produced or cited in this book, in the case of those it has not been possible to contact successfully, the author and publishers will be glad to make amendments in further editions. Typeset in Milo by MacGuru Ltd Printed and bound in Great Britain by Clays, St Ives plc A CIP catalogue record for this book is available from the British Library isbn 978 1 78125 453 0 eisbn 978 1 78283 160 0

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Contents

List of figures and tablesxi Prefacexiii Introduction: The three big mistakes of dealmaking

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PART 1: PRE-DEAL13 1 Think before you buy15 What’s your Facebook relationship status? 16 Staying single 18 It’s complicated 23 Open relationship 26 Divorced30 In a relationship 31 Think before you buy: dos and don’ts 32 2 Avoid tunnel vision33 Deal strategy 34 Target selection 39 Diageo says saúde to Ypióca 41 ABN AMRO: it’s hard to see what’s in it 42 . Patience is the watchword: Diageo says s¸erefe to Mey Içki44 Has the bloom gone at Diageo? 45 Avoid tunnel vision: dos and don’ts 48 3 Knowledge is power49 Where is diligence most due? 50

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Due diligence in cross-border M&A How long should due diligence take? A. G. Barr’s Irn Bru and Britvic’s Indian Tonic Water taste very different, don’t they? Successful due diligence has solid foundations Getting it right the Cheung Kong Way Knowledge is power: dos and don’ts

54 55 57 60 61 63

4 Why the price isn’t always right65 Valuation versus pricing 66 Overpaying isn’t the end of the world 72 Pricing in risk 74 Valuing intangibles 77 IP due diligence 81 Deals leak 83 How to pay 84 Why the price isn’t always right: dos and don’ts 87 PART 2: THE DEAL89 5 Negotiating tactics91 Friend or foe? 92 Auctions: does the highest bidder always win? 92 Hard or soft? 94 “Bid ‘em up” Bruce 95 A football master class 96 Microsoft’s search engine bid 99 Keep your friends close and your enemies closer 100 Opening gambits: your place or mine? 103 Trade relations 104 Fast or slow? 105 The Baxalta bear hug 105 Still leaking? 107 Negotiating tactics: dos and don’ts 108 6 The engagement111 Spinning tales 112

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Institutional investors: a CEO’s best allies? Rise of the activists Prudential’s imprudence The engagement: dos and don’ts

115 117 120 123

7 Beware the regulator125 The “Danone law” 127 Kraft’s takeover of Cadbury hits a sour note 127 Deutsche Börse: you can’t always rely on the Germans 131 DP World: stuck in port 134 Beware the regulator: dos and don’ts 137 PART 3: POST-DEAL139 8 Doing the deal right141 Phase 1: Giving diligence its due 145 Off the rails: stopping runaway trains 146 Holding hands across the Atlantic 147 Other obstacles on the tracks 149 Hitting the political sidings 151 Phase 2: Day 1 of the 100-day plan 153 Getting it right: the Centrica way 155 Getting it wrong: the Zain way 158 Doing the deal right: dos and don’ts 161 9 A most amicable divorce163 Why split up? 164 HP: the 15-year road to divorce 166 The spin-off dumping ground 167 Getting divestment decisions right 168 Mergermarket Group: from start-up to global player 170 The investor’s view 173 A most amicable divorce: dos and don’ts 176 Conclusion: Hunting the corporate yeti177 Acknowledgements181 Further reading183 Index187

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Introduction: The three big mistakes of dealmaking

WHEN SILICON VALLEY heavyweight Hewlett-Packard (HP) sealed a takeover of the UK’s Autonomy in 2011, no one predicted the corporate car crash that would follow. There had been few significant deals since the 2008 global financial collapse and economic slowdown, which helped HP’s chief executive, Léo Apotheker, secure a reasonably upbeat reception when he made his bold statement to transform the sleepy information technology (IT) company into “a leader in the evolving information economy”. But just 12 months later, HP had lost its reputation and its chief executive and was facing write-downs of $8.8 billion, nearly 80% of the $11 billion it paid for Autonomy. Worse, in 2012, HP alleged that it had been the victim of fraud by Autonomy’s management and its auditors, blaming the losses on “serious accounting improprieties, disclosure failures, and outright misrepresentations”. Autonomy and its founders have, as you would expect, publicly and categorically rejected such claims. HP, however, has agreed to pay one of its shareholders, PGGM Vermogensbeheer, a Dutch pension fund, $100 million in damages, without admitting any liability. The company was and is facing years of legal battles. Irrespective of their outcome, the takeover will go down in history as a spectacular failure.

High expectations Founded in a garage in Palo Alto in 1939, HP was one of the original core Silicon Valley start-ups and later the world’s largest manufacturer of computers. But as the industry developed, the company found itself

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FIGURE INTRO.1 HP’s share price February 2009–December 2013 60 50

Nov-20-2012 HP announces a write-down of $8.8bn related to the acquisition of Autonomy

Aug-18-2011 Announcement of the acquisition of Autonomy

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Sources: Authors; S&P CapIQ data

stuck in the low-margin business of computer hardware production, and despite its hefty $95 billion market capitalisation, its share price was suffering (see Figure Intro.1). Under pressure from investors to improve its strategic positioning, the company brought in Apotheker as CEO in November 2010, with the strong expectation of immediate acquisitions. Apotheker was an experienced executive in the computer industry, having spent more than 20 years at SAP, a multinational German software company, and serving as co-CEO just before his appointment at HP. A tie-up with Autonomy, a British entrepreneurial success story, looked like the solution to faster and more innovative future growth. The company, a Cambridge University spin-off, was founded in 1996. By the time of HP’s bid, Autonomy was one of the FTSE 100. On August 18th 2011, HP announced a formal offer of £25.50 ($42.11) per share, a 64% premium on the previous day’s closing price. 2001 2003 2005 2007 Headed by Mike Lynch, a Cambridge University engineer who started out building the technology behind music synthesisers, Autonomy was one of the fastest-growing and most dynamic software businesses in the world. Its main product, the IDOL (Intelligent Data

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Operating Layer) platform, was ground-breaking and is still marketed by HP as a highly intelligent tool for indexing unstructured data. In the year of the deal, Autonomy posted record quarterly revenues of $256 million. However, some analysts questioned not only the value of Autonomy’s technology but also its accounting methods. Richard Windsor, formerly at Nomura Securities, commented on HP’s challenges to Autonomy’s accounting practices: Autonomy’s detractors have been writing about this for years and there has been the occasional obvious sign that things were not quite right. The most common red flag was that cash flow in some quarters often did not match profit. This is quite unusual in a software company. It is certainly noteworthy that HP acquired Autonomy at a record price tag, only to write down most of the price paid less than two years later, blaming the huge write off on the very accounting practices which industry experts and analysts had been questioning for years. Whatever the legitimacy of these accounting practices, any such issues should have been dealt with at the all-important due diligence stages – both pre-announcement and pre-completion – which are covered in Chapters 3 and 8.

The transaction and its aftermath On the day of the announcement Apotheker proudly told investors: HP is taking bold, transformative steps to position the company as a leader in the evolving information economy. Today’s announced plan will allow HP to drive creation of long-term shareholder value.

2011

2013

The decision to buy your way onto a new strategic path is common practice, but there are a number of alternatives to outright M&A – outlined in detail in Chapter 1 – which perhaps would have been better and less risky for HP. Deciding on the right target company to acquire to reach your strategic aim is also tricky. Chapter 2 highlights the need to have a “live” target list where you track your most desired assets closely. Sealing a deal means finding a company that is both the right strategic fit and potentially “in play” – that is, where a deal with the

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existing shareholders is possible. It is possible that HP suffered from a fixation on its target (Autonomy), a common error for buyers, which means it had already lost a significant amount of bargaining power when negotiating the final price paid. Although HP’s share price rose by 15% in the wake of the announcement, reflecting an initially positive reaction by the investment community, it closed the day as the US market’s worst performer. The new strategy, as laid out by management, was apparently not credible to HP’s shareholders when they analysed it. Analysts and investors challenged the ability of HP to integrate the combined business – perhaps remembering HP’s problems with its 2001 merger with Compaq – and the company faced an uphill battle to convince its various stakeholders that this large bet was a good one. As demonstrated in Chapter 6, effective communication on the day of the deal’s announcement is crucial, as it is management’s chance to position the strategy and value behind the deal and to align the views of internal stakeholders (who have known about the deal perhaps for several months) and external stakeholders (who only find out about the deal from the public announcement). Things quickly went from bad to worse for HP. Just weeks later, Apotheker was fired and replaced by Meg Whitman, previously CEO of eBay. Then in May 2012, after a mere eight months at HP, Lynch – who was a crucial part of the Autonomy takeover – left, taking much of Autonomy’s remaining management team with him. Many cited a culture clash between the corporate bureaucracy of HP and the more entrepreneurial, flat-structured Autonomy. As discussed throughout this book, a failure to recognise cultural differences between the buyer and the target – effectively choosing to ignore the human component of any deal – is one of the most cited reasons for M&A failure. These days – but also at the time of the HP/Autonomy deal – the due diligence process done properly includes a comprehensive segment on culture. The importance of that cultural fit is highlighted in Chapter 3, demonstrating that cultural compatibility or potential differences must be raised early in the deal conception phase, ideally well before any public announcements and especially if people are a key component of profitability, as was the case with Autonomy.

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Introduction: The three big mistakes of dealmaking



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The departure of Lynch and his team was the opening sequence of a long blame game leading, as mentioned earlier, to the now infamous $8.8 billion write-down announcement in November 2012. Responding to allegations of fraud, Lynch replied in an open letter: As we have said before, we believe the problem with the Autonomy acquisition by HP lies in the mismanagement of that business by HP under its ownership, making it impossible for Autonomy to deliver on HP’s expectations. Autonomy’s accounts were fully audited by Deloitte throughout the period in question and Deloitte has confirmed that it conducted its audit work in full compliance with regulation and professional standards. We refuse to be a scapegoat for HP’s own failings. Sadly, the HP and Autonomy story is far from unique. RBS’s acquisition, together with Fortis and Banco Santander, of ABN AMRO also crosses the line between the merely misguided and downright disastrous. In this book, these and many other examples of famous global companies and smaller, less well-known firms will demonstrate how much value has been destroyed by ill-considered or poorly executed M&A deals – and how this could have been avoided. There are a number of errors – or a common and recurring set of mistakes – which dealmakers appear to make consistently. Throughout the chapters of this book, these are summarised in a list of tips and guidelines, intended to help buyers and sellers avoid the usual pitfalls and therefore preserve value throughout the deal process. Our assessment of these deals is, by necessity, an analysis of their impact only in the broad period following the deals. For example, following the UK government’s inevitable re-flotation of RBS, the bank it bailed out during the 2008 financial crisis, it is conceivable – if unlikely – that events as yet unknown could propel RBS to the top of global banking’s profitability league in, say, 15–20 years’ time after the deal with ABN AMRO. But should that happen, none of the credit would belong to the men and women who executed the deal in 2007.

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Introducing the big three There were several manifest failures in the HP/Autonomy deal, as there are in many of the deals discussed in this book. These have been distilled to three overarching issues: failure of planning, failure of communication, and failure to properly consider the impact of people. These, we believe, are the three big mistakes of dealmaking:

1 Planning The supposedly transformational acquisition of Autonomy was by its nature inherently risky, even for HP, a company valued at nearly $100 billion. The cost of Autonomy was sizeable at $11 billion. Its importance for HP was magnified because the company was pinning its future on the transaction to deliver strategic wins in terms of culture change in the core business as well as cross-selling and its own market position. If you do not have a clear, detailed, well-thought-out and articulated deal strategy, no planning for its integration will be sufficient, as the two are inherently linked. As shown in Chapter 7, planning also entails being prepared for any pushback from the regulators, an increasingly important issue for corporate dealmakers because of the rise in crossborder acquisitions globally, among other factors. Although large, transformational deals are not automatically destined for failure, perhaps a more gradual shift towards high-end software products, buying smaller, more easily digestible targets, would have worked better for HP. As discussed in Chapter 1, hubris is one of the most common M&A pitfalls for business leaders who are prone either to overestimate their own ability or to underestimate the scale of the task.

2 Communication HP’s failure to communicate convincingly the benefits of the deal to its shareholders, as demonstrated by the significant fall in share price on the day of the announcement, was the start of the transaction’s downfall. Effective communication is often a reflection of a well-prepared and well-aligned combined management team. The case for synergies

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should be clearly articulated in the due diligence phase, and the 100-day integration plan should be written by the time the deal is announced. Knowing that in any deal there are significant risks, it was certainly appropriate for investors and analysts, for example, to ask questions about the price HP paid for Autonomy. The deal did, as stated, represent a significant premium on Autonomy’s share price, implying that HP expected to generate synergies from the deal worth, as suggested by several analysts at the time, a minimum of $2.9 billion on a net present value basis. Add to that the fact that HP was paying 24 times the trailing earnings before interest, tax and depreciation (EBITDA), and most analysts would say that the price was a stretch. And this figure did not include costs associated with the transaction such as adviser fees and integration costs, which were likely to be at least another 15–20% of the deal’s price. HP saw the transaction as the facilitator of a significant strategic shift towards high-end software and, indeed, as a tool to change the culture of its traditional core business. But when a buyer is attracted to a target because of its culture, an understanding of the specific components that make this culture unique is pivotal to making the deal work. HP might have admired Autonomy’s culture, but it did not truly understand it or know how, or even whether, it could be adopted by HP’s other divisions.

3 People Poor communication and a lack of understanding of the culture of Autonomy led to the third failure: to appreciate, evaluate and consider the value of people. Autonomy’s culture was what HP said it wanted, yet it failed to lock in and learn from its expensively acquired new management team and its different, more entrepreneurial culture. In summary, HP failed in all three areas, even though a failure in just one of the big three could have been sufficient to make the deal fail overall. Generally speaking it is necessary to be successful in all three, but certain deals may require a focus in one area more than another. The significant difference between valuation and pricing in M&A is discussed in Chapter 4, but the high price paid in this case implied

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that HP knowingly paid a premium over Autonomy’s pre-deal market valuation. HP must have seen real strategic business value in Autonomy as well as in its culture and management team, aspects that are difficult to assign a financial value to. It would have also assumed significant post-deal synergies, helping to justify the price paid. In hindsight, it is clear that those synergies were overstated or the estimated risk of delivering the same was understated. As Autonomy’s management team pointed out following HP’s court filing disclosures in September 2014, HP’s own estimated revenue synergies of $7.4 billion as a result of the two businesses operating as a combined entity was certainly a hefty target and, they claimed, the real reason behind the significant write-down. In its own court filings, HP pushed the argument of misstated underlying revenues which had led it to believe Autonomy had more potential – and value to HP – than was actually the case. The correct valuation is the result of sound and achievable financial forecasts based on accurate and well-researched due diligence data, none of which appeared to have been present in this particular deal. Although price and value are referred to here, they are not categorised as being among the big three mistakes. Pricing is a significant potential concern, but we do not believe that mispricing is generally terminal. First, there is no such thing as “one right price” in an M&A context. What the buyer ultimately pays for the target is based on its own views regarding the financial future value of the target, including the potential synergies as a result of the two businesses combining and any changes that the buyer may make post-deal. Clearly, the inputs into a financial model to determine the value will be different from bidder to bidder, and these are ultimately different from the view of the seller, who sees its company on a standalone basis. The difference here is what creates the opportunity to transact a deal, so the price paid will be incorrect for anyone but the buyer that closes the deal. The highest bidder will usually – but not always – prevail, and even though a full price was paid, it can be deemed a success if the underlying predictions are correct. Second, determining whether the price paid was “right” can only be done with the benefit of hindsight. There are a plethora of other factors that can destroy value for the acquirer. We have seen many deals where

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the pricing was certainly considered as full and the buyer was able to achieve its aims despite this. Mispricing in this context – where a price is paid well above market expectations – is the one major error that companies can recover from. However, appropriate pricing, meaning not overpaying, does make success easier to achieve. Few M&A transactions collapse as dramatically as HP’s takeover of Autonomy, but a far greater proportion fall far short of their promise to deliver on the expected value creation. Numerous studies from the 1980s and 1990s show a failure rate as high as 70–80%. But it is getting better. The best-case scenario in more recent studies is a success rate of just under 50%. Given the opportunities for value destruction of such a significant corporate event, a 50/50 hit rate is hardly satisfactory. The broader implications are highly significant. Mergers and acquisitions are part of the fabric of economic life. They help drive a sizeable proportion of corporate growth, whether in large, mature companies or recent start-ups. Globally, somewhere between 25,000 and 35,000 M&A deals are completed annually. They are not a rare phenomenon. According to a 2012 study by Sanford C. Bernstein, an equity research firm, the chance of a Fortune 1000 company being involved in a merger or acquisition in any given year is close to 30%. Of all the companies that have been listed on the UK stock exchange since 1995, our own research indicated that 25% announced an acquisition within 12 months of listing; by the second year the number rises to 41% and by the third year more than 50%. M&A deals are here to stay. M&A is one of the most fascinating activities in the business world. However, corporations more often than not get it wrong. We have purposely avoided a bias towards coverage of only private or only public deals – although Chapter 5 on negotiations and Chapter 7 on regulation are more skewed towards the latter – as the mistakes that are often made are the same for both types of deal. For reasons of data availability and familiarity, the case studies in this book are often of larger deals involving well-known companies. But the lessons learnt from these transactions are applicable to smaller deals between mid-sized or small businesses. Deals between smaller, private companies are often less process-driven and are likely to have

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