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THERE’S BEEN DRAMA recently in a normally quiet corner of the market.
This story got its start back in 2015, when Warren Buffett helped to merge food makers Kraft and Heinz. At first, it looked like a smart idea. Through cost-cutting, the combined company was expected to save more than $1 billion in annual operating expenses.
“This is my kind of transaction,” Buffett said at the time, “uniting two world-class organizations and delivering shareholder value. I’m excited by the opportunities for what this new combined organization will achieve.”
The excitement was short-lived, and many observers were skeptical from the start, mainly because Buffett had teamed up with a private equity firm called 3G to make the purchase. 3G had a reputation for being overly zealous when it came to cost-cutting.
Initially, Buffett defended 3G. They “could not be better partners,” he wrote in his 2015 annual letter. But within a few years, it became clear that the skeptics had been right. Sales at the combined company began falling, and in 2018, Buffett’s Berkshire Hathaway recorded a $15 billion write-down on the value of its Kraft Heinz holdings.
The following year, Buffett publicly acknowledged that the merger had been a mistake and that Berkshire had overpaid for its stake. “The business does not earn more because you pay more for it,” he said.
In the years since, Kraft Heinz has continued to struggle with declining sales. To address the problem, in January of this year, the company brought in a new CEO, Steve Cahillane, and tasked him with splitting the company back up again.
By that point, though, Buffett had changed his mind again. His view was that it was now better to leave the combined company intact rather than going through the costly exercise of trying to break it back up. A breakup, he said, wouldn’t create value. “It doesn’t do a thing, you know, for what the ketchup tastes like.” Despite his influence, though, the break-up plan appeared to be moving forward, and Cahillane took the helm on January 1 with that mandate.
Within weeks, Cahillane came around to Buffett’s point of view. The company’s woes were more fundamental, he told the board, and breaking it up wouldn’t address those core issues. Where things go next is an open question.
This story is notable because of Warren Buffett’s involvement, but it turns out not to be so unusual. Studies over the years have found that corporate mergers and acquisitions, on average, do not create value. According to a study by KPMG of more than 3,000 acquisitions, 57% of deals were found to detract from shareholder value rather than increase it. Other research puts the failure rate in the neighborhood of 70%. Aswath Damodaran, a finance professor at NYU, sums it up this way: “More value is destroyed by acquisitions than by any other action that companies take.”
Why do so many transactions detract from shareholder value? Economist Richard Thaler attributes it to what he calls the “winner’s curse.” This phenomenon was first identified in the petroleum industry, where competitive auctions are held for oil leases. Research found that the winners of these competitive auctions often ended up disappointed—not because they didn’t find any oil, but simply because they had overpaid.
Thaler explains that auctions—especially when there are large numbers of bidders—can cause some participants to become emotional, to the point that they become undisciplined and end up bidding too much. The winners in these situations are thus “cursed” because they’re the ones who were willing to overpay the most and thus tend to be most disappointed.
Thaler found that the winner’s curse dynamic appears across industries, and that is what explains the poor track record of corporate acquisitions. Competitive situations, whether it was in the Kraft-Heinz case, or in the one that recently played out in the competition for Paramount, can cause prices to go too high. That’s great for sellers but a key reason why acquirers often end up regretting their decisions and why a large number of corporate takeovers end up being reversed.
So why, despite all this data, do corporate managers—including even Warren Buffett—pursue these transactions? There are three key reasons.
The first is that they’re an easy way for companies to combat stagnant growth—much easier than the hard work of developing new products. This helps explain the Kraft-Heinz tie-up. According to a write-up in 2015, when the merger was first announced, many of Kraft’s businesses had been stalled out, delivering zero or even negative growth.
Another reason mergers and acquisitions are popular despite the odds: Corporate managers tend to overestimate the economic benefits—so-called synergies—that will result from a transaction. Consider companies like Kraft and Heinz. It was easy to make the argument that two companies in the same industry would be able to gain significant efficiencies by combining operations and realizing economies of scale. And since some number of transactions do succeed, even if it’s only a minority, it’s natural for corporate managers to believe that their transaction will be the one to beat the odds.
In a 1986 paper, economist Richard Roll identified a related phenomenon, which he dubbed “the hubris hypothesis.” The logic is as follows: Corporate managers who find themselves in a position to be making acquisitions are, by definition, probably doing well. Their stock prices are up, and they likely have cash in the bank. Because their businesses are strong, they’re more likely to feel self-confident in their ability to succeed with a merger or an acquisition even when the data suggests the odds are against them.
The lesson for individual investors? Companies will probably always pursue transactions like this that end up subtracting from shareholder value. But since there’s no way to predict when this will happen, I see this as yet another reason to choose broadly-diversified index funds, where any one company’s mistake generally won’t have too much of a negative impact.
Also, to the extent that the company being acquired is also in the index, passive fund investors can enjoy the benefits that accrue to that company’s shareholders.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
Thank you once again for a thoughtful article.
The discussion about whether mergers and acquisitions create or destroy value reminded me of the mid-1980s when I worked as a reporter at Mergers & Acquisitions Magazine in Philadelphia. The editor, a brilliant and eccentric journalist who also taught a course on M&A at the Wharton School, started a newsletter called Corporate Restructuring, and we tracked what companies were doing. Using the company’s huge M&A database, we collaborated with a professor at Wharton on event studies to track what happened to the stock price of companies in the days leading up to and after the announcement of a merger or acquisition.
You won’t be surprised to learn that the stock price of the acquiring companies fell and the stock of the target companies generally went up.
At the time–during the Reagan free market era–the SEC’s chief economist was Greg Jarrell, who later taught at the University of Rochester, and was a proponent of M&A activity–and a founding member of the “Shadow SEC” along with Merton Miller and some other economists whom I forget.
It became clear by the 1990s that companies were better off focusing on their core business and divesting unrelated businesses and we saw a lot of tax-free spinoffs, where a company was spun-off as a tax-free dividend, split-offs, where a company did a partial IPO of an unrelated business, and straight-up divestitures.
I believe ITT Corporation, under Harold Geneen, was the archetype example in the 1960s of companies becoming diversified conglomerates.
That backfired. The stock market rewarded those companies that returned to their core businesses.
Warren Buffett is brilliant, but not always right. Companies should stick to their knitting.
Appears that this could have been a successful merger if not for the initial overpayment (a bid if I admit). It made a lot of sense, not two completely different companies. A lot of back-office savings. But of course, all the bidders knew this. The smart ones bowed out when the price when too high. The “winner” not realizing they doomed what was a good idea.
So sad on the human level. I worked at Maxwell House (general Foods) which got taken over by Philip Morris and then Kraft. I then decided Pharm was better and I went to work for Ciba Geigy which ended up “merging” with Sandoz to become Novartis. I decided food was better and escaped to Nabisco-which then got taken over by PM/Kraft. After being independent for a while I joined Organon which then got taken over by Schering Plough and ultimately Merck. I am now getting a tiny pension from Heinz.
I was so very lucky and thrived and with the help of a number of voluntary severance packages, able to retire early with retiree medical. Yes, I know, very lucky.
I worked with so many wonder people who were not so lucky and whose lives were turned upside down and in some cases, destroyed. And the business side of things did not pan out in almost all these M&A.
Oh no. What a shame that all the companies you worked for were acquired. You were very lucky to get severance and retiree medical. Not many people were that lucky. The unluckiest ones were those whose companies were acquired in leveraged buyouts–now euphemistically called private equity–and who lost their jobs and benefits and the companies ended up in bankruptcy court.
If executive comp is tied to increased sales then mergers are more likely. Incentives matter a lot.
Wondering if this is a principal/agent problem. A large company with stagnating revenue/profit growth usually means trouble for CEO. An acquisition gives shareholders something to “chew” on instead of contemplating CEO replacement. The downsides, that manifest themselves a few years later, are borne largely by shareholders, not management.
A similar play does not usually happen for a private investor because she is the principal and would take the brunt of any potential downside of a big, risky bet.
Bigger is not always better. I learned this in my career and personally had more success with smaller. Thanks Adam for these interesting and meaningful articles.
I worked at a rather large bank, JPM, which was built up by acquisitions. Chemical Bank bought Manufacturer’s Hanover and Texas Commerce Bank, and then bought Chase. The combined company bought J P Morgan.
But…..we didn’t get any cost savings because we never actually integrated all the parts. We had seven different general ledgers connected by kludge bridges which were difficult to understand. Each unit had different products that were reported in different ways. Texas Commerce Bank was the worst – they operated as an independent fiefdom.
Then Bank One bought JPM and Jamie Dimon came along. His take was that this won’t do – no wonder nobody understands what’s going on. It took nearly 15 years to actually integrate and consolidate at the operational level, but eventually it happened. It was somewhat interrupted by the forced acquisition of Bear Sterns and Washington Mutual, but eventually, just about when I retired, we got things figured out.
I agree with the author’s observations regarding the detrimental effects of corporate mergers and acquisitions. Another thing the executive decision makers fail to recognize is how disruptive the “blending” process will be, in terms of time and money wasted, distractions, and decreased morale. Many years ago I witnessed this on three separate occasions, and they all had the same outcome:
Can’t name names, but most of the companies are well-known.
As an aside, the current corporate and governmental FOMO “jump-on-the-bandwagon” approach with regard to the acquisition and deployment of AI/LLM technology seems to be following a similar path. Time will tell….
Jmo.
Thanks Adam.
In my 31 years of benefits experience in Human Resources, I worked on over 50 different acquisition and divestiture transactions. Too many times, us benefits weenies were not included in the analysis, discussion and offer process until long after momentum for a deal had metasticized. we took a bath in red ink.
Here is an example. During the due diligence phase, after having only a day to look at the material, I was discussing the transaction with my ERISA legal counsel, on my way back from a visit to a field office. As I wound my way through the Appalacian hills/mountains on Interstate 64, I lost cell phone service once. After telling counsel I would stop and complete the discussion from a pay phone if I lost cell phone service, I lost it again. Five minutes later, I pulled into a stop for gas and another 5 minutes later I called from a pay phone. My legal counsel told me to forget it, because during the break he had called the deal makers and they had caved on every one of the seller’s benefits demand – most of which was expensive, unnecessary and injurious crap (a separate payroll cycle, an early retirement window, a unique severance and retention program, etc.)
My little part of the world was comparatively small potatoes in the M&A space. But, too often, years later, we had to resolve stupid promises and commitments that were obviously affected by the “winner’s curse” and/or “the hubris hypothesis.” only to become a drag on post-transaction financial results.
Interesting story, and a good example that even the smartest folks can sometimes be fooled, or carried away by their emotions.