Mergers and acquisitions have been a mainstay of Corporate America for more than a decade, first as sky-high stock prices and then a flood of private equity gave companies oodles of purchasing power to do deals—the bigger, the better.

No more.

Numerous forces have converged on the M&A world in the last 12 months to put the brakes on corporate buying sprees. Private equity cash is scarce. New accounting rules will force companies to disclose more details about a merger earlier in the process, which will give some businesses pause. And in the face of angry activist shareholders, boards are asking CEOs exactly why the mergers they want are such a good idea.

“Companies still have a lot of cash, so the smaller strategic deals where companies are buying technical expertise they don’t have, or smaller private equity deals, will continue,” says Ian Cookson, corporate finance director at Grant Thornton. “But you’ll see less of those big private equity deals.”

Already the numbers point in that direction. According to Dealogic, the number of M&A deals announced in the United States dropped from 2,096 in the second quarter of 2007 to only 1,887 in the fourth quarter—but the total value of those deals plunged 52 percent, from $565.6 billion to $270.8 billion. (By comparison, the first quarter of 2005 saw 2,047 deals worth $297.8 billion.)

Savor

Pavel Savor, finance professor at the Wharton School of Business, agrees: “These mega-buyouts, at least for the short- to medium-term future, are over.” He notes that mid-market deals—those in the $500 million to $5 billion range—remain active but could decline, too, if the economy and the debt markets continue to worsen.

The shrinking pool of private equity is the primary cause of fewer M&A deals, certainly. But the rise of shareholder activism—specifically, shareholders demanding better prices for their companies—is also prodding boards to examine proposed deals more carefully.

Paul Schulman, executive managing director of the Altman Group, anticipates that “a fair number of deals” will face opposition from hedge funds and other shareholders taking their cues from several deals last year, where mergers were opposed and the companies were forced to wrangle more value from the bidder. In 2007, for instance, hedge funds, institutions, and proxy advisory firm RiskMetrics all second-guessed Eli Lilly & Co.'s plan to buy ICOS, the pharmaceutical firm that created erectile-dysfunction drug Cialis. Eli Lilly ultimately raised the offer nearly 10 percent to $2.3 billion. Last fall, BEA Systems rejected one takeover bid from Oracle Corp., and then accepted a second offer in January when Oracle threw in another $2.7 billion.

Even though shareholder activism is on the rise, rarely does it result in a deal getting nixed, says Jim Mallea, product manager at FactSet MergerMetrics. He notes that only 6.2 percent of 2007 deals that had concluded by mid-January were withdrawn once a definitive agreement had been reached (the figures were 6.3 percent and 5.7 percent in 2006 and 2005, respectively). And of those failed deals, only 12 percent were withdrawn because of a lack of shareholder approval, according to Mallea.

What’s more, today’s deals are also taking place amid greater skepticism. Research has shown that many mergers fail to realize their intended increases in shareholder value. In hindsight, many of the deals look downright foolhardy. (Remember eBay, the online auctioneer, acquiring Skype, the online phone service, in 2005? eBay swallowed a $900 million write-down on the deal in October.)

DEAL BREAKDOWN

Recent trends in the pace and value of mergers and acquisitions in the United States.

Year

No. of Deals

Total Value (Billions)

2003

7,319

$571.4

2004

8,113

$850.6

2005

8,046

$1,179.5

2006

7,420

$1,531.5

2007

7,426

$1,591.1

2008 YTD

547

$57.9

2007 YTD

500

$85.9

Source

Dealogic (2008).

The motives behind deals are also being questioned. It’s widely known, Savor says, that the larger the business is, the larger the CEO’s salary is. So CEOs “have tended to increase the size of the firm because their pay will go up,” he says.

In some sense, the debate over whether boards are doing their due diligence depends on one’s opinion of corporate governance in general, because boards perform their analyses behind closed doors. Only in rare instances, such as when Walter Hewlett vehemently opposed the merger of Hewlett-Packard and Compaq in 2002, does a director openly criticize a deal, Savor says. In most cases, observers are left to construe what happened from other evidence.

Bruce Foerster, president of South Beach Capital Markets Advisory, a corporate finance and governance-consulting firm, believes that overly generous change-of-control packages are evidence that executives don’t necessarily place shareholders’ interests first and foremost when they make deals. “Why does the CEO of ABC Widget deserve a golden parachute package because the business is sold?” he asks. “A board’s first obligation is to the shareholders, not to existing management. Most boards, in my opinion, don’t even get that.”

And some deals present greater risks than others. Cookson notes that “big transformational deals have a history of not working out terribly well.” He calls the time Time Warner-AOL merger of 2001, a $182 billion behemoth that was the largest M&A deal in U.S. history, “the poster child” for transformational deals gone awry. Time Warner eventually wrote off nearly $100 billion and dropped the “AOL” from its name.

Adel Aslani-Far, a partner in the mergers and acquisition group at the law firm Latham & Watkins, says transformational deals are not nearly so risky if they’re the product of an ongoing discussion about strategy and the company’s long-range plans. What you don’t want, he says, “is a CEO who’s detached from the rest of the board and gets down the road on a transformational transaction that the board doesn’t hear about until it’s very far along.”

Asking Tough Questions

Aslani-Far

On the other hand, Aslani-Far observes that it’s far too easy to pick apart unsuccessful deals after the fact. One role of directors evaluating a merger is to “test management’s assumptions,” says Aslani-Far. “It’s not a hostile exchange. It’s part of carrying out their duties.”

Foerster urges directors to engage in a very frank exchange with the chief executive. “Look the CEO in the eye and say, ‘Why are we doing this? Are we doing this because you’re bored running the company as is? Are we doing this because you have investment banks pitching deals every day and this one caught your fancy?’” he says. Were those sorts of conversations regularly taking place, Foerster is convinced that the number of mergers being approved would fall, given the deals’ poor track records.

Savor emphasizes that the directors evaluating a deal should be independent of management so they can freely discuss the pros and cons of the situation. That being said, frank conversation can only take the board so far. He also urges directors to secure the appropriate outside expertise.

Making sure independent directors assess the deal and even getting third-party advice can help inoculate the board from legal challenges, Savor says. Cookson notes that board members are “increasingly aware of risks and are making sure they’re covered.” In the case of targeted companies, he says, this usually means getting a fairness opinion—essentially, an investment bank’s confirmation that, yes, some price offered for the company is a reasonable bid.

“[CEOs] have tended to increase the size of the firm because their pay will go up.”

— Pavel Savor,

Finance Professor,

Wharton School of Business

Beyond that independent opinion, Cookson says, “Your best defense is that you pursued a robust process and considered the alternatives before you.” For target companies, evaluating bids from a number of potential buyers shows that directors did a thorough job.

Savor encourages directors to consider the strategic advantages being promised very carefully. He also urges directors to press for specifics on what the acquiring company will do to ensure that the anticipated benefits are realized.

Finally, Savor believes that it’s best for directors to have a “significant financial stake in the firm,” enough to motivate them “to come up with the right decision.” This can be anything from restricted stock or stock options to bonus payments tied to overall performance.

In the end, almost everyone agrees that boards need a healthy dose of common sense when it comes to evaluating proposed mergers. Although it’s easy to advocate all sorts of precautions from the sidelines, directors know that a protracted decision-making process may mean that another bidder walks away with the prize. “You can be very careful and spend a year looking at a deal but then you won’t get any deals passed,” Savor says. “That might not be optimal for the company or for shareholders either.”