The Economy

Deals Made During Downturns Create More Value

While companies are naturally conservative with cash when the economy goes bad, it may be a good time to consider making acquisitions, research sug...
David McCannSeptember 27, 2019
Deals Made During Downturns Create More Value

If there indeed is an economic downturn ahead, what should companies do during it?

Perhaps they should acquire another company. At least, that’s what research by Boston Consulting Group seems to suggest. In short, the research found that deals made in a weaker economy are associated with greater shareholder return than are those made in a strong economy.

BCG studied 51,600 acquisitions by publicly traded buyers, with a value of at least $250 million, from 1980 through 2018. It compared (1) acquiring companies’ cumulative abnormal stock returns (CARs) from three days before deal announcements to three days after (i.e., “announcement returns”), against (2) acquirers’ “relative total shareholder return” (RTSR) one year and two years after acquisitions.

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In an index where the average RSTR value was set at 100, the average RSTR one year after deals made in strong economies registered 99.7 . But the average RSTR a year following deals made in weak economies was almost seven percentage points higher, at 106.4. That gap widened to nine percentage points two years after acquisitions.

To determine whether the economy was strong or weak in each year, BCG looked at the inflation-adjusted global GDP growth rate. It defined the top third of all growth rates in the observation period as an indicator of a strong economy and the bottom third as an indicator of a weak economy.

Abnormal returns are the difference between actual stock returns and those predicted by a capital markets model. RTSR is total shareholder returns compared with a set of comparable companies, which BCG derived using an industry classification from the Refinitiv database.

Interestingly, in a weak economy, acquisitions of businesses outside the buyer’s industry (that is, “noncore” deals) created more value — 3.9 percentage points higher one-year RTSR — than those within the buyer’s industry, according to BCG’s research.

Conversely, in a strong economy noncore deals destroyed value for the buyer (one-year RTSR of -1%), while core deals preserved value (one-year RTSR of 0.0%).

The research also found that “experienced buyers” particularly excelled in weak economies. BCG defined those as having completed at least four acquisitions in the data sample, while “occasional buyers” were those that completed one to three transactions.

Experienced buyers produced two-year RTSR of 1.1% in strong economies and a remarkable 7.3% in weak economies.

Occasional buyers delivered two-year RTSR of 1.4% in weak economies, but a horrific -13.8% in strong ones. Such buyers were “obviously responsible for the value destruction observed in the overall sample,” BCG wrote.

“Occasional buyers should regard a weak economy as an opportunity to gain experience, because depressed asset prices (as reflected in the lower deal multiples observed during the last recession) increase the margin for error in deal-making,” BCG counseled.

Otherwise, the consulting firm offered little explanation for the outperformance of deals made in weak economies.

Despite the research findings, BCG suggested that the prospect of an upcoming economic slowdown has steered companies away from deals since early 2018. After strong deal activity in the first quarter of last year, the pace has plummeted since.

“With concerns mounting that a downturn may be near, shareholders are losing their appetite for risk and are scrutinizing more carefully an acquisition’s potential to create value,” said BCG.

Traditionally, the firm noted, investors have reacted to the announcement of public-to-public deals by pricing targets’ shares somewhere near the bid price, while acquirers’ stock fell on concerns of earnings dilution, poor fit, and excessive diversification, among others.

From 2012 through 2017, however, CARs centered around deal announcement dates were positive for both targets and acquirers, indicating that investors were placing their bets on deal-makers.

That trend reversed for acquirers in 2018, with such CARs falling to an average of -0.4%, although that was still better than the average since 1990 of -1.1%.

BCG offered the following advice:

During downturns, “have the courage to stay the course. A company that has a well-considered transformation strategy should not alter its plans when it faces the prospect of a negative short-term reaction by capital markets. Although core segment deals are greeted more favorably by markets around the announcement dates, medium-term value creation is higher for companies that make bold moves to acquire attractive targets beyond their core industry.”

During a strong economy, “resist the temptation to go on a buying spree or to follow the crowd in acquiring the most sought-after assets…. Corporate decision-makers who simply follow the herd, without a clear strategic rationale for their acquisitions, will eventually destroy shareholder value.”