Warren Buffett's annual letter to Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) shareholders never disappoints. Longtime Buffett readers know that he pulls no punches when he unloads on what he perceives to be irrational behavior, and this year he took direct aim at the rationale around mergers and acquisitions.
It's not surprising that he picked M&A as worthy of some commentary -- it's Berkshire's best opportunity for growth in the coming years. 2017 was also the largest year on record for M&A more broadly throughout the economy, with over 50,000 deals made that were valued at some $3.5 trillion, according to Thomson Reuters data.
Debt is a mistake
Our aversion to leverage has dampened our returns over the years. But Charlie [Munger] and I sleep well. Both of us believe it is insane to risk what you have and need in order to obtain what you don't need.
Think about that for a minute. 2017 was the biggest year in history for M&A. This despite the stock market hitting all kinds of all-time highs and the Shiller P/E ratio -- a measure of stocks' valuation -- climbing over 30 (a valuation not seen since the dot-com days of the early 2000s).
How did would-be acquirers make those deals work in a way that might generate profits? Through debt, of course, as they took advantage of historically low interest rates to gobble up competitors. As Buffett notes: "The ample availability of extraordinarily cheap debt in 2017 further fueled purchase activity. After all, even a high-priced deal will usually boost per-share earnings if it is debt-financed."
Using debt means acquirers seemingly get the best of both worlds: more revenue- and profit-producing assets (the companies they buy) without reducing their cash position or diluting shareholder value. And since they used debt, return on equity (ROE) still looks good too. Think about it this way: You're considering buying a business that generates $50,000 per year in profit. The owner wants to sell it to you for $1 million. That 5% return on the money you put in -- that million dollars, your equity -- doesn't look so great. But what if a bank will lend you 80% of the money at a dirt cheap interest rate? Suddenly you're putting down $200,000 in cash to acquire a business generating $50,000 per year -- a 25% annual return on your initial investment (minus some debt service) makes the deal look a lot more attractive.
By levering up, companies are able to accept increasingly -- dare I say, irrationally -- inflated prices for their acquisitions and still hit ROE targets that will make Wall Street happy. But that debt increases risk for the acquirer, particularly when favorable macro factors (decreasing unemployment, expanding economy) inevitably shift, spoiling the party.
Don't expect synergies
Buffett also had a few choice words about so-called synergies, or the idea that two companies will benefit from combining elements of their organizations -- such as streamlining back-office functions like billing and HR, or merging their marketing and sales teams.
His comments were simple and left no room for doubt:
We also never factor in, nor do we often find, synergies.
Talk about turning conventional wisdom on its head. Wall Street loves hearing about synergies, and it shows in how companies explain their decision-making process.
In announcing CVS' $77 billion bid to buy health insurer Aetna, for instance, CFO David Denton claimed, "This transaction has the potential to deliver $750 million in near-term synergies in the second full year after close." (This and other quotes courtesy of S&P Global Market Intelligence.) Another case in point: AT&T's $85 billion bid for Time Warner in part hinges on, according to their press release, "$1 billion in annual run rate cost synergies within 3 years of the deal closing." The DowDuPont merger, which was recently completed, is "expected to result in run-rate cost synergies of approximately $3 billion." Offhand, I can't think of a major acquisition (say, more than $15 billion) in the last five years that didn't claim the potential for major cost synergies of some kind.
The data shows Buffett is right. A McKinsey study of 160 mergers found that about 40% failed to achieve at least 90% of the expected cost synergies -- and many created so-called revenue "dis-synergies" by driving once-loyal customers into the arms of competitors. That study also generated this priceless tidbit: "When companies merge, most of the shareholder value created is likely to go not to the buyer but to the seller. Indeed, on average, the buyer pays the seller all of the value generated by a merger."
With all of this in mind, last year's merger bonanza takes on a less celebratory hue. Companies saw their share prices spike as they heeded Wall Street's siren song and bought up competitors, but the jury's still out on whether that $3.5 trillion was money well spent.
Indeed, Buffett's final word on the philosophy of acquisitions in this year's letter was reminiscent of his famous "be fearful when others are greedy" aphorism: "The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own."
That feels a lot like a warning that the good times will end, and I believe we'd all be wise to heed it.