Companies spend more on mergers and acquisitions (M&A) than any other alternative for capital allocation. For many companies, M&A is the most significant and costliest course to redistribute corporate resources and pursue strategic goals. Since 1995, M&A volume has averaged 8 percent of the equity market capitalization in the U.S. and the world. As a result, nearly all companies and investment portfolios will feel the effect of M&A at some point. Exhibit 1 shows the dollar amount of M&A, as well as M&A as a percentage of market capitalization, from 1980 to 2016. M&A tends to follow the stock market closely, with more activity when the stock market is up. Volume in 2016 was down 17 percent versus that of 2015, but remained strong in a historical context. The outlook for 2017 is also robust.
Companies that act early in an M&A cycle tend to generate higher returns than those that act later. The first movers enjoy the benefits of a larger pool of targets and cheaper valuations than companies that buy later in the cycle. Cheap and accessible financing prompts action by buyers at the end of the cycle. So do bandwagon effects, or what Warren Buffett, chairman and chief executive officer of Berkshire Hathaway, calls the “institutional imperative.”
Empirical analysis shows that M&A creates value in the aggregate, but that the seller tends to realize most of that value. Exhibit 2 shows a measure that McKinsey & Company, a consulting firm, calls “deal value added.” Deal value added is the percentage change in the combined market capitalizations of the buyer and seller from
two days before to two days after the deal is announced. This has averaged about 6 percent over the past 20 years. Deal value added was 8 percent in 2016 and has averaged near 12 percent since the financial crisis. That the sellers realize most of the deal value added suggests that the buyers generally pay a full price for the
companies they acquire.
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