Winning the Merger Game


A new wave of consolidation is coming. To succeed, a company must understand where its strengths are.

Fortnightly Magazine - March 2006

The U.S. power industry is poised for consolidation. Regulatory barriers to mergers and acquisitions (M&A) are lessening, many companies now have the resources to finance acquisitions, and the industry is highly fragmented. Yet common wisdom says that M&A frequently destroys value. Several studies have concluded that most deals fail to generate the anticipated synergies.

There is no question that M&A is challenging, but we believe that these negative assessments are misleading. Analysts often account only for fluctuations in total shareholder return (TSR) that occur in the days or weeks following an acquisition or merger. This is an insufficient amount of time to determine success or failure, and most executives know it. Most senior leaders are concerned with companies’ longer-term prospects, not with short-term fluctuations in their stock prices.

Our analysis of the long-term performance of companies that have M&A-intensive strategies suggests that M&A can generate tremendous value. We found that companies that relied heavily on M&A generated more than half of the value1 in the power industry during the 10 years ending in September 2005.

Furthermore, we found that more than half that value was generated by a handful of companies (four of the 58 we examined). This was no coincidence. These companies had the ability to assess their own skills and select the opportunities that would allow them to make M&A a success.

How did they do it? We identified five key capabilities that enabled these companies to excel in M&A:

Operational excellence;
Superior regulatory management;
Commercial excellence;
Superior capital management; and
Research excellence.

To succeed, a company must understand where its strengths are relative to these five capabilities. This knowledge will enable it to determine whether it is in a position to acquire, to identify appropriate targets, and to select one of four key strategies for success in M&A:

Utility roll-up;
Merchant asset rationalization;
T&D roll-up; or
Fuel diversification.

We estimate more than $400 billion of present value savings (for shareholders as well as ratepayers to share) in the industry. M&A is the key to unlocking this value.

The Time Is Right

Not only is the power industry recovering from the crisis it suffered between 2000 and 2002, but it began to outperform the S&P 500 for the first time since the beginning of the century. But while this high performance suggests that many companies may have the resources to invest in growth, prospects for organic growth are somewhat limited.

Sales, measured in megawatts per hour, have grown at a meager compound annual growth rate of about 1.8 percent since 1990, which is expected to remain flat for the foreseeable future. Retail deregulation, an organic growth vehicle for some companies, has stalled and is not expected to progress much over the next few years.

Efforts to diversify into other areas, such as telecom, proved unsuccessful in the 1990s. Since the overall pie is growing very slowly, M&A is one of the few viable options for value-creating growth. At the same time, the environment is becoming increasingly favorable for consolidation. Regulatory barriers to M&A are lessening. Recent repeal of the Public Utility Holding Company Act (PUHCA) enables power companies to own operations in non-contiguous regions.2

The Federal Energy Regulatory Commission also is attempting to make market rules somewhat more homogeneous. Regional transmission organizations (RTOs) have established common standards for interconnection among plants and standard protocols for wholesale trading. By making it easier for companies that operate in different regions to interact and share practices, the initiative will also make it easier for companies to capture scale and synergy benefits through M&A.

There is good reason to believe that many states’ public utility commissions will look more kindly on M&A activity if the value proposition for ratepayers is well conceived. To the extent that consolidation will put control in the hands of the natural owners of the industry’s assets—those that manage them best—consolidation will serve a public good. Reliability, service, and customer satisfaction could improve as a result.

Finally, the fragmented structure of the U.S. power industry indicates the potential for M&A. The top four power companies receive only 17 percent of industry revenues, compared with more than 50 percent or more for other basic industries, such as petroleum or chemicals. History shows that when barriers are removed, fragmented industries consolidate. This proved to be the case in Germany and the Netherlands, where the top four power companies now generate 90 percent and 65 percent of industry revenues, respectively.

Why M&A Is Underused

Recent large deal announcements involving Duke and Cinergy, Exelon and PSEG, Mid-American and PacificCorp, and FPL Group and Constellation suggest that M&A activity is on the rise. However, many companies still shy away from M&A. This stance is backed by commentators, academics, and industry experts who have found that the odds are stacked against successful value creation in M&A. A number of studies have shown that stock prices actually drop in the period leading up to a merger or acquisition or in the days following a majority of deals.

In a 1999 article published in the Harvard Business Review, Alfred Rappaport and Mark L. Sirower show that acquirers’ stock prices after a deal is announced decline immediately in about two-thirds of all acquisitions. They argue that this reflects investors’ beliefs that the acquirer is not likely to maintain the original value of the combined assets or achieve the synergies and other benefits required to justify the premium it paid to the owners of the target.

In their 2004 book, Mastering the Merger, David Harding and Sam Rovit cite a study of 790 deals made by U.S.-based companies from 1995 to 2001. They conclude that the study “corroborates the findings of the academic research,” which “demonstrate that something on the order of 70 percent of all deals fail to create meaningful shareholder value.” Thomas J. Flaherty, another industry expert, has said that utility mergers typically generate rather moderate synergies relative to the price paid for the target.

Indeed, previous McKinsey research came to a similar conclusion. An analysis of 193 deals that took place between January 1996 and September 1998 showed that 58 percent of acquiring companies destroy value. This conclusion was based on an analysis of the beta-adjusted change in stock price, relative to an index, from one week prior to the announcement of each deal to one week after the announcement was made.

Value Created Over Long Term

However, much of this analysis is misleading because it focuses exclusively on the short-term impact of M&A on share price. Our new research refutes the notion that M&A fails to generate value. While we agree that acquisitions in the power industry generally have destroyed short-term value for acquirers, our analysis shows that companies that pursue M&A-intensive strategies generate a majority of the industry’s value over the long-term.

We analyzed short- and long-term outcomes between September 1995 and September 2005, focusing on 22 acquirers that announced corporate deals during this period. For the short-term analysis we determined the change in their stock prices relative to the S&P 500 over a 10-day period that began five days before their announcements and ended five days after them. We then multiplied this figure by the acquirer’s starting equity capitalization. We found that acquirers destroyed almost $1 billion in market value in the short term.

However, our analysis of market value-added for these companies over the full 10-year period showed that together they generated about $102 billion in industry value.3

We then looked at the value created in the industry as a whole over this period (see Figure 1). We found that companies that pursued M&A strategies generated 55 percent ($102 billion) of the total value generated in the industry ($185 billion).4 Moreover, just four companies generated $64 billion of that $102 billion: Dominion, Energy East, Exelon, and FirstEnergy. We call these companies “M&A winners” because they not only pursued M&A-intensive strategies5 but also enjoyed an annual TSR of 10 percent or more during this period.

Companies that pursued organic growth opportunities and not M&A generated 45 percent of the value in the industry as a whole. However, most of this organic growth was generated by companies (e.g., Entergy, Kinder Morgan) occupying privileged positions that could not be occupied by other companies or replicated in other regions.

How the Winners Prevailed

Companies that profited from M&A in the 10 years we examined had an ability to understand their strengths and use them to their advantage when conducting mergers and acquisitions. These winners leveraged one or more of five distinctive competencies that are key to unlocking hundreds of billions of dollars industry-wide (see Figure 2).

Operational excellence is the ability to run efficiently at low cost. Companies that excel in this area continuously cut variable and fixed costs while increasing the flexibility of their resources to capitalize on new opportunities. M&A is an opportunity for these types of players to extend their best practices into companies that don’t operate as efficiently, and to capture scale benefits.

Superior regulatory management involves creating and maintaining a collaborative relationship with key regulatory bodies. Those that do this well are better able to appropriately influence policy decisions and create favorable regulatory conditions for themselves. In particular, those that develop collaborative relationships are more likely to be able to persuade regulators to let them keep a larger percentage of the cost savings they generate through acquisition (e.g., via synergies or scale benefits).

Commercial excellence is the ability to exploit opportunities in the commercial and competitive areas of the business, including wholesale trading, marketing, merchant generation, and retail.

Superior capital management involves efficient prudent capital expenditures relative to profit. The most effective means of achieving this goal include establishing best-in-class capital allocation and capital project portfolio optimization skills. Project execution is also critical. In most cases, the asset base of an acquired company will be well established at the time of purchase, but the acquirer can still use its capital management skills to make more efficient the target’s expected capital expenditure requirements.

Research excellence is the ability to develop superior understanding of the key drivers of the market microeconomics, particularly from a micro-market perspective. Companies that develop robust proprietary perspectives often are able to take advantage of sudden changes and emerging trends. Those that understand where the market is headed can position themselves to capitalize on developments as they unfold.

Remember that M&A is more than just a path to growth. It can be a significant “unfreezing event” for the target company, bringing needed change throughout the organization and helping to unlock latent opportunities. Such events are particularly important in the power industry, since target companies often lack critical capabilities and are not given adequate incentives by regulators.

Capabilities Dictate Strategy

Companies must start with a thorough self-assessment that enables them to identify their strengths and weaknesses (see Figure 3). Based on this assessment, they should determine their goals and develop a plan to meet them. This process will involve taking inventory of current assets, identifying a universe of potential deals, determining compatibility with potential targets, and identifying likely competitors for specific deals.

These analyses are likely to lead most companies to adopt one of four main strategies for success in M&A.

Utility roll-up. Utilities that possess superior regulatory management and operational skills can seek to acquire or merge with other integrated utilities to develop geographic diversity and to capture synergies that result from sharing best practices.

Merchant asset rationalization. Those that excel at commercial activities and possess superior market insight could acquire merchant players that don’t have the skills to compete in the market.

T&D roll-up. Companies that have excellent operational and regulatory skills but lack commercial capabilities could acquire transmission and distribution assets and focus on the wires segment. Transmission and distribution are considered the natural monopoly segments of the business, and they will not experience deregulation. As a result, regulators usually provide attractive rates of return on T&D operations.

Fuel diversification. Those that possess superior operational and risk-management capabilities might acquire assets that enable them to meet regulations on CO2 and mercury, as well as other environmental restrictions. They also might acquire assets that reduce their reliance on gas or other fuels that are subject to significant price volatility.

The U.S. power industry will become increasingly dynamic. The universe of possible asset configurations will change, and the opportunity to participate will shrink rapidly as companies begin to strike deals. Companies that have not played a major role in the past might now enter the industry and compete for acquisitions, complicating the picture.

As more buyers compete for a limited number of assets, the price of these assets is likely to increase, which is sure to have a negative impact on acquirers’ returns. To survive and thrive in this new environment, companies should act resolutely to shape the industry, rather than letting the industry shape them.



1. Our research used market value-added (MVA) to determine the amount of value companies created in the power industry. We define MVA as the difference between the market value of equity and the book value of equity at the end of a period, divided by the market value of equity less the book value of equity at the beginning of a period.

2. Under PUHCA, it was virtually impossible for companies to conduct M&A across regions unless the operations of the companies involved in the deal were “physically interconnected or capable of physical interconnection.” This was a significant impediment for utilities that wanted to acquire regulated assets located outside their area of operations.

3. Our analysis shows that acquirers did generate a majority of the MVA in the industry, even over a three-, five-, and ten-year period.

4. To quantify the total value created in the industry, we calculated the value added to the market by the 57 companies included in the S&P utility index between September 1995 and September 2005.

5. We define “M&A intensity” as the company’s total investment in M&A divided by its average enterprise value. “M&A-intensive” companies have quotients that are equal to 30% or more. Companies were counted as pursuing M&A during this period if their quotient was 10% or more.