Like the Trojan horse of Homerâs Iliad, HPâs acquisition of Autonomy was the âgiftâ that kept on giving negative consequences.
To start, HPâs stock price fell 25 percent in the two days following the announcement on August 18, 2011. Though it was difficult to pinpoint all the causes of this drastic decline, the general message was clear: the market did not believe that HPâs direction was a promising one.
Then, as Autonomyâs results faltered in the two quarters after the deal, HP took a harder look at its operating results and, in the spring of 2012, began raising serious questions about the financial records and revenue recognition practices of Autonomy. On November 20, 2012, HP announced that it was writing off $8.8 billion of its original $11 billion investment.
Normally, this would have been the end of the story as far as the press and public were concerned. But the deal made the headlines again when HP filed a lawsuit in the U.K., accusing former Autonomy CEO Mike Lynch and former CFO Sushovan Hussain of engaging in âimproper transactions and accounting practices that artificially inflated and accelerated Autonomyâs reported revenues,â which had the effect of making Autonomy appear more profitable and growing faster than it actually was. Specifically, HP alleged (among other things) that Autonomy engaged in numerous âcontrived transactionsâ that were devised to book revenue improperly. In some cases, HP said, Autonomy used third parties known as value-added resellers (VARs) to âfabricate or accelerateâ sales that were reported as revenue.1
Where Were the External Advisers?
Even if the charges are without merit, the fact that they appear to be credible begs the question: Why did none of the external advisers raise any red flags about these issues? For a transaction of this size, companies usually rely on a variety of advisersâfrom accounting firms and auditors to law firms and investment banksâto perform the due diligence, to provide strategic guidance, legal advice, and financing, and, most important, to uncover potential fraud and any legal and environmental liabilities. This deal was no exception to the rule. Between them, HP and Autonomy retained the services of 15 âbrand nameâ institutions.2
Among HPs external advisers was the accounting firm Deloitte, which was tasked with vetting Autonomyâs financials. (The company subsequently retained KPMG to audit Deloitte.) In addition, HP hired the boutique investment bank Perella Weinberg Partners to serve as lead adviser, along with Barclays. Banking advisers on both sides of the deal were paid a total of $68.8 million. On Autonomyâs side was Qatalyst Partners, which specializes in tech deals and earned $11.6 million. Autonomyâs investment bankers included UBS, Goldman Sachs, Citigroup, JPMorgan Chase, and Bank of America, which were each paid $5.4 million.3
Ultimately, HP management was responsible for the dealâs failure. It wasnât the first time (nor will it be the last time) that an M&A fiasco could be traced to poor decision-making by corporate leaders. But as Forbes pointed out in a November 2012 analysis, the external advisers also deserve some of the blame for having not unearthed the negative information during due diligence. And this last failure highlights a fundamental flaw in the M&A process: investment banks (and sometimes other advisers) have a perverse incentive to ensure that each and every transaction is completed, and they have few tangible incentives to slow down or kill a deal.
To quote the Forbes post-mortem, âMost [advisers] are paid by the hour or through a success fee, giving them a monetary incentive to originate and consummate mergers and acquisitionsâŠ. [N]o single adviser wants to be seen as the one putting up roadblocks. Once a corporate client decides to go ahead with a transaction, its advisers are basically there to fulfill its wishes, not to question the wisdom of the decision. As momentum for the deal snowballs, and pressure to finalize it under tight deadlines builds, it is very difficult for any adviser to put a stop to it.â4
Casper Kirketerp-Moeller, CEO of Clever A/S, noted that because investment banks are ranked and rated based on past successes, itâs important for them that deals go through. âThereâs a great deal of pressure to conclude deals or find ways to conclude them.â
Winners and Losers
Regardless of the merits of a particular M&A, investment bankers and CEOs are almost always happy when the deal closes. It is the buyerâs shareholders who bear the burden if the deal turns out to be a lemon. So the usual winners are the investment banks, the lawyers, the accountants, the auditors, and the seller (otherwise, it would not close the deal), as well as the CEOs of both companies (including the target, as she/he usually receives a very nice check). The losers, again, are the buyerâs shareholdersâand itâs these losses that Iâm referencing when I say that, on average, mergers destroy value.
This is not to suggest that investment banks arenât key stakeholders in many M&A deals. They are. What they are not, however, is key risk-takers after the transaction closes. Mergers and acquisitions represent one of the most important sources of fee-based income for investment banks, and banks typically risk most of their income by agreeing to work on a contingency basis (for the âsuccess feeâ). The average success fee ranges from 1 to 3 percent of the deal value, and even at these apparently small percentages, the payouts for successful closings can be enormous. For example, the fees earned by the three investment banks that participated in Royal Dutch Shellâs $70 billion takeover of British energy firm BG were estimated at $182.6 million. But that figure pales in comparison to the largest-ever fee that banks have earned from an M&A transaction. That âhonorâ belongs to the banks involved in the 1999 Vodafone acquisition of Mannesmann AG, who collected a staggering $530.7 million in combined fees.
The downside of the âsuccess feeâ is that a bankâs considerable investment of time, money, and human resources will generate next to nothing if the transaction isnât finalized. Therefore, itâs in the bankâs interest to ensure that every deal does close. Bankers do risk tarnishing their reputations if they close too many failed deals or appear to have pushed clients into making unwise decisions, but as long as most deals donât rise to the level of the HP-Autonomy disaster, the reputation of an established bank will usually survive the negative publicity.
Speaking of reputation, one of the most important factors that helps banks secure future business is their ranking in the league tables. Here, the worldâs biggest banks are ranked for M&A advisory work based on the value of the deals in which theyâve been involved, as an adviser of either the target or the acquirer. A bankâs position in the league tables is considered a measure of their experience and reputation. (For individual bankers, compensation is usually tied to the fees they help generate, as well as the number/quality of the relationships they cultivate.) Investment banks use league tables to promote themselves, but note that the tables highlight the monetary values of the completed dealsânot the value creation produced by those deals!
Although investment banks are a necessary part of transactions, companies should not solely rely on them to provide a final valuation and to negotiate the deal, thanks to the inherent conflict of interest stemming from their fee structure.
Most M&As are driven by international investment banks that are not going to be engaged in the operational realities of the deal or become responsible for the implementation or achievement of the promised synergies. Managers who simply outsource the valuation to an investment bank may be risking their companyâs money and jeopardizing potential opportunities for significant value creation for their shareholders.
This does not mean that companies should not hire investment banks. On the contrary, M&A participants must use them in most cases that involve publicly traded companies. But management should always be sure to also seek advice from additionalâand more objectiveâexperts to mitigate the banksâ conflict of interest.
Moreover, CEOs, CFOs, and other top executives need to be involved at the earliest possible stage of any merger and should understand how valuations are made, so they can maximize value creation for shareholders and steer their organizations toward identifying and assessing opportunities and risks.
Alternatives to the Success Fee
âOur industry is one in which the services of the leading investment bankers are all pretty much the same. So ⊠reputation is what matters,â said former Goldman Sachs Chairman John Whitehead. At the end of the day, investment bankers are peopleâpeople whose business is maximizing profits from the sale of their servicesâand advising against deals is a poor way to maximize profits. That said, most bankers do adhere to a set of ethical standards and are keen to enhance and maintain their personal reputations and those of the banks. For those reasons, said most of the executives and former bankers interviewed for this book, while some individual bankers are always on the side of the deal, most bankers look out for their clientsâ interests (up to a point). âIndividuals differ within banks: there are the people who really care about, and develop, a relationship with a selling and a buying company, and there are people purely driven by fees. And those people are known,â said Anastasia Kovaleva, a consultant with Bain & Company (and a former investment banker), who has worked on numerous deals.
Liana Logiurato, Global Head of M&A for Syngenta International, agreed. âMy simple view is that it all comes down to individuals â their personal ethics and whether they want to act in the best interest of their clients.â
Given the perverse incentive built into the success fee, you might think that acquiring companies (especially) would be eager to embrace the alternativesâhourly rates, higher retainer fees, or some combination of higher retainers and lower success fees. (Note: Retainers are typically non-refundable, paid in milestone-based installments or as an upfront lump sum, and are not contingent on the dealâs outcome.) But, said many of the experts interviewed, you would be mistaken if you thought so.
The vast majority of companies balk at the idea of raising the retainer or having bankers work for hourly rates. Why? Because lowering the success fee (which is a contingency fee) would transfer certain risks from the bank to the buyer and seller. In short, most acquirers and targets donât want to pay hefty upfront fees for deals that may never close.
Halbart Völker, Managing Director and Head of Industries Corporate Banking for NIBC Bank NV, neatly summarized this attitude,
to make higher upfront costs more acceptable to executives and shareholders.[T]he argument we always get from the client is that they do not want to have a huge cost upfront, particularly in case the deal doesnât go through. So itâs usually the client that skews much more towards the success-based fee, and therefore automatically accepts the inherent issues that come with that. I would say 99 out of 100 clients ⊠do not want to have huge expenses if the deal doesnât go through. And if the deal goes through, then [they pay] only a percentage of the dealâs cost, which is anything up to (say) five percent.⊠But if you have to explain to shareholders that you incurred an upfront cost to avoid a bad deal, thatâs still not accepted. So that is probably something that you would need to change.
For sellers and their investment banks, the incentives can align differently. There, success fees can serve as a âhealthy incentiveâ for the bankers, said Kirketerp-Moeller. âIf youâre successful in selling the company at a higher price than expected, then you get rewarded. But it also has its downsides. In companies where people are measured and paid based only on specific goals, then they tend to focus only on those goals and forget the rest.â
However, the fact remains that it is still better for the investment bank to close a deal (perhaps selling the company at a discount) than risking that the transaction wonât close by asking for too high a price. Similar incentives are found in other industriesâfor example, real estate brokers. So while alternatives to the success fee may look good in theory, in practice, the fee structure is very appealing to most corporations because they would rather not pay anything to their banks for a deal that isnât consummated.
The Benefits of In-House Valuations
Without question, investment banks can provide invaluable services, including intelligence, information, financial modeling, and sheer manpower (which can be critical for smaller clients). On the sellerâs side, âthe big value of an investment bank is having access to potential buyers,â said Stefan Wanjek, Head of M&A Economics at OMV AG. He opined that âThey often know the potential buyersâ universe better than we do here. They also may add value in terms of maximizing competition and optimizing the outcomes of negotiations.â
In addition, bankers can help immunize clients against legal challenges if the deal falls apart, if the transaction later âgoes south,â or if the price is questioned. âIf you hire a bank, youâll definitely get a faster M&A process because they are professionals at deal logistics and processing,â said Ken Sasaki, Partner at TNT Capital LLC (Japan). He further pointed that âInternal M&A team is often understaffed with other responsibilities. Thus, itâs helpful to be able to outsource the cumbersome due-...