Smart Investor: taking a sober approach to M&A

Mergers & acquisitions, or M&A, are back in the headlines on both sides of the pond. A key motive for the deals is the potential for cost-saving synergies.

The M&A activity is not a great surprise. Low interest rates, piles of cash sitting in company bank accounts and a general fear of where inflation may be going means companies want to find ways to invest surplus cash. Acquiring another company or even buying back your own shares have been in fashion before and are now back on the catwalks of Wall Street and the City.

So, what does this M&A activity mean for the economy, the companies involved and most importantly, for investors?

In terms of the economy, M&A activity may not be a great help given the current climate. This is because it will inevitably lead to job losses which, like it or not, will reduce tax receipts for income tax, VAT, taxes on savings etc. Job losses also mean government will have a larger unemployment benefit bill to pay.

The companies involved in the M&A activity may argue that job losses will be kept to a minimum, but if you look at any merger or acquisition there are almost always redundancies in departments such as finance, administration and other centralised departments.

This leads to the argument that government should perhaps consider stepping in to block the activity, as it would be in their own interest and in the interest of competition. However as the previous government showed with the Lloyds/HBOS takeover, job losses can be acceptable if a deal has the potential to create synergies. In other words the potential for more profit and higher tax receipts in the long run make up for higher unemployment in the short run.

Of course synergies are a known unknown. Before two companies merge, it is impossible to quantify to what extent synergies can be achieved and predict how the merged entity will perform in future. Furthermore we will never know if the companies would have performed better or worse in future if they had stayed apart.

Senior managers will argue that there will be a great deal of synergies and that they will boost profitability, offsetting the effect of any job losses on the economy. Indeed Senior Managers are almost always keen on M&A due to the bigger pay packet and prestige they normally enjoy as a result.

As for shareholders and investors, it is sometimes difficult to remain level-headed during takeovers, with all the talk of synergies and the excitement that naturally surrounds them. Ultimately though, the intelligent investor must accept that he has no means of working out how the merged company will perform. It could generate higher profits, lower profits or the same amount of profits in future.

A sensible suggestion may be for the smart investor to conduct his own due diligence of the financial position of the acquirer/acquiree in order to gain an idea of whether the merger is good value. Ultimately though, even if it is good value, it will still mean taking a risk on the future performance of the merged entity with no historical figures to back it up.

Whilst synergies may not exactly be gold at the end of a rainbow, they certainly are a known unknown. The intelligent investor, as always, will base his decisions on the current market value of the two companies relative to what he believes to be their intrinsic values, even if others are convinced there is a pot of gold waiting to be found somewhere, someday.