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M&A Value Creation: Combating the "Winner's Curse"

Significant value waits to be unlocked through consolidation, but conventional approaches have been inadequate.

Fortnightly Magazine - October 2006

The basic fundamentals for utility industry consolidation are strong. The industry is fragmented, notably in North America, but also in the UK, Australia, and Brazil, and cost pressures are escalating. These factors, coupled with limited alternative growth options, are increasing merger and acquisition (M&A) activity as an important industry top-line growth driver. However, significant uncertainties remain. Can consolidation, no matter how intuitively attractive, create sustainable long-term value? Or will it prove seductive but, ultimately, disappointing to shareholders, employees, customers, and management alike?

Value creation from an acquisition is not a given. The “first wave” of whole company mergers (1997-2004) produced mixed to disappointing results. In the majority of major acquisitions, positive value was not created in the first two years and was seen only after an average of four years. Systematic overestimation of strategic and operational synergies, particularly in the heat of “bidding wars,” led to excessive price premiums and elongated payback periods. To some extent, an acquisition entailed a “winner’s curse.”

As consolidation continues, and the target pool decreases, this will prove increasingly problematic for acquirers. Significant constraints ( e.g., regulation, weak scale, labor, etc.) reduce an acquirer’s degrees of freedom and ability to actually drop value to the bottom-line. In particular, natural scale opportunities are limited, and most consolidated companies remain sub-scale post-merger.

This failure to realize estimated synergies is not simply a utility industry phenomenon. Globally, across all industries, 70 percent of mergers fail to achieve projected revenue synergies, with one quarter of deals falling more than 75 percent short. Performance on the operational side is better, but yet, one quarter of companies overestimate cost synergies by at least 25 percent. Failing to achieve revenue and cost synergies can lead, conservatively, to a 5 to 20 percent error in valuation. For example, in a deal like Exelon-PSEG, this error could translate into $0.6 to $2.4 billion in additional premium paid.

Our view is that significant value waits to be unlocked through the consolidation of the utility industry. However, conventional industry approaches to valuing and capturing merger benefits have been inadequate in our experience. In particular, utilities have been slow to move to single operating platforms and, outside of nuclear consolidation, to proactively establish and target specific performance advantages. In addition, cross-industry trends and competitors are raising the performance bar.

These trends are creating the impetus for new business/operating and cost/service level models. Operational excellence—powered by innovative operating models—will become the “price of entry” for successful consolidators. Leaders will be characterized by simplified, standardized, and extendable operating models and capabilities. They will possess improved operating performance, scale, differentiated leadership, governance, and performance management competencies, as well as a focused M&A team. They will leverage these capabilities to improve targeting and valuation and,

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