M&A strategies in the European IT services sector
How to create value through acquisitions?
University of Groningen
Faculty of Management and Organization Technology Management; Information Technology Author: Mark Bakker, August 2005
Thesis supervision
Dr. W. Westerman University of Groningen Prof. Dr. Ir. J.L. Simons University of Groningen Drs. F.P.U. Haffmans ABN AMRO Bank N.V.
B.J. de Vries MBA ABN AMRO Bank N.V.
© The author is responsible for the content of this thesis; the copyright belongs to the author.
Executive summary
Assignment
This study has been conducted upon request of ABN AMRO Bank N.V. in Amsterdam. The ABN AMRO technology team is the principal of this research. M&A advisory to companies in the European IT services industry is one of the main products that the ABN AMRO technology team offers to its clients. In order to be able to provide M&A advisory at a competitive level, it is of essential importance to know how M&A can create value for the companies that are advised by ABN AMRO. The research goal and question that address this issue are the following:
Research goal
Provide a report that the ABN AMRO technology team can use to improve its ability to advice companies in the European IT services sector on M&A strategies.
Research question
What are the determinants to create value from M&A strategies for companies operating in the European IT services sector?
The research has been a combination of a quantitative survey and a case study. Both research methods have been used to provide an answer to the research question which has sufficient depth and is generally applicable.
Buy often and constant
This study showed that the most acquisitive companies by far outperformed the least acquisitive companies in terms of annualized total shareholder return over the period 1997 - 2004. However, a more detailed look revealed that not all companies that conducted many acquisitions were successful. The timing of acquisitions appeared to be the most important determinant for acquisition success. Companies that bought after the stock market boom significantly outperformed companies that bought during the stock market boom. However, additional analysis revealed that among the highly acquisitive companies, the real outperformers appeared to be the companies that acquired companies both during and after the bubble. Apparently, frequent acquirers have learned to undertake value creating acquisitions during good and bad times.
Further, this study showed that more determinants exist that make companies successful buyers.
These determinants can be classified in four categories: strategy characteristics, structure characteristics, process characteristics and target characteristics.
Strategy
Companies need to derive their M&A strategy from their corporate strategy. A M&A strategy can only be successful when it is an integral part of and supports the company’s overall strategy.
Structure
The most successful acquirers have structures in place that allow them to find acquisition opportunities and help distinguish good targets from bad ones. It starts with a dedicated M&A team which is in the lead of the total acquisition process, from finding and screening targets up to the execution and integration of the target. Moreover, top and line management need to be continuously involved in the acquisitions process.
Process
Successful acquires are able to learn form acquisitions to improve acquisition success after each acquisition. In addition, they use an active approach to acquisitions, so they can respond immediately when an opportunity arises.
Target characteristics
A target has to meet several criteria in order to be value creating for the acquirer. A strong strategic and cultural fit should exist between the acquirer and the target. Also, the target should enhance the competitive advantage of the acquirer. Shared management vision between the merging companies, low integration impact and healthy financials of the target are further determinants for success. Finally, a company should make a thorough valuation of the target in an early stage in order to pay the right price.
A strong focus on the mentioned determinants allow companies to buy in good and bad times and to pursue the acquisitions that create value for the company. Moreover, frequent acquirers have institutionalized the mentioned determinants, since they could use their experience with acquisitions to further improve their already established strategy, structure, processes and ability to find good targets.
Preface
This thesis has been written as a final assignment of the study Technology Management, specialization Information Technology, at the University of Groningen. The thesis has been written during a seven-month internship at the global clients technology team of ABN AMRO Bank N.V. in Amsterdam.
I am very grateful that I got the opportunity to do my internship and write my thesis at the ABN AMRO Bank. The past seven months have been a very interesting and enjoyable time. During my internship I had the opportunity to experience the work at one of Europe’s leading investment banks. Moreover, I got the opportunity to write my thesis and use ABN AMRO’s excellent knowledge, information sources and facilities for this research. Therefore, I owe many thanks to the people of ABN AMRO who made this possible. Frank Haffmans, Ilja de Wit and especially Bart de Vries are the ones that made my internship possible, fruitful and enjoyable, both in a formal and social way.
Moreover, I would like to thank my supervisors from the University of Groningen, Mr.
Westerman and Mr. Simons, for assisting me in writing this thesis. Especially Mr. Westerman was always willing to read the several parts of my thesis and provide valuable feedback, hereby helping me to improve the research and finish the thesis without delay.
Finally, I would like to thank all other persons who assisted me in writing this thesis either by giving interviews or providing assistance and support in any other way.
Mark Bakker
Amsterdam, August 2005
Table of Contents
Executive summary...2
Preface ...4
1 Introduction and methodology ...7
1.1 ABN AMRO ... 7
1.1.1 ABN AMRO bank ... 7
1.1.2 Wholesale Clients ... 8
1.1.3 Technology team... 9
1.2 Methodology ... 10
1.2.1 Introduction to the problem ... 10
1.2.2 Research design ... 10
1.2.3 Research strategy ... 14
2 Fundamental or behavioral? Drivers for M&A activity...18
2.1 Historical developments of M&A activity... 18
2.2 Developments of M&A activity in the European IT services sector ... 21
2.2.1 M&A activity 1995-2004... 21
2.2.2 Drivers for M&A activity in the bubble ... 21
2.2.3 Future M&A activity... 26
2.3 Conclusions... 31
3 M&A strategy as a competitive advantage, what makes an acquirer successful? ...32
3.1 The aspects for value creation of M&A strategies, a quantitative study ... 33
3.1.1 Introduction... 33
3.1.2 Methodology ... 35
3.1.3 Results... 38
3.1.4 Summary of results ... 45
3.2 The aspects for value creation of M&A strategies, an additional literature study.. 46
3.2.1 Introduction... 46
3.2.2 Strategy ... 46
3.2.3 Structure... 46
3.2.4 Process ... 48
3.2.5 Target ... 50
3.3 Conclusions... 54
4 The PinkRoccade case...56
4.1 Introduction... 56
4.2 Methodology ... 57
4.3 PinkRoccade ... 59
4.3.1 Overview, history and strategy ... 59
4.3.2 The ASZ acquisition ... 62
4.3.3 The TAS acquisition ... 67
4.3.4 Intermezzo: The downturn ... 70
4.3.5 Sale to Getronics ... 73
4.5 Conclusions... 81
5 Conclusions and recommendations ...82
5.1 Conclusions... 82
5.2 Recommendations... 85
5.2.1 Recommendations to ABN AMRO ... 85
5.2.2 Recommendations for further research ... 85
References...87
List of figures...92
Appendices...Error! Bookmark not defined.
Appendix I: Data for quantitative analysis ...Error! Bookmark not defined.
Appendix II: Regression analysis and t-Tests...Error! Bookmark not defined.
Appendix III: Questionnaire ...Error! Bookmark not defined.
Appendix IV: Interview with Aart Klompe ...Error! Bookmark not defined.
Appendix V: Interview with Mark Zuidema ...Error! Bookmark not defined.
1 Introduction and methodology
In this chapter, the methodology of the research will be described. The chapter will start with a description of ABN AMRO, the principal of this research. This will be followed by the introduction to the problem. Next, the research design will be described which consists of the problem definition and the sub questions. The chapter ends with a discussion of the research strategy that is used in this study.
1.1 ABN AMRO
1.1.1 ABN AMRO bank
ABN AMRO1 is a prominent international bank, its history going back to 1824. ABN AMRO ranks 11th in Europe and 20th in the world based on tier 1 capital, with over 3,000 branches in more than 60 countries, a staff of more than 97,000 full-time equivalents and total assets of EUR 742.9 billion (as at 31 March 2005).
Although ABN AMRO serves a broad range of clients, its strategic focus is on the mid-market segment. This is the client area where ABN AMRO has a strong and distinctive competitive advantage and where it believes it can be most profitable in the future.
ABN AMRO implements its strategy through a number of Strategic Business Units (SBU’s).
Each of these units is responsible for managing a distinct client segment or product segment, while also sharing expertise and operational excellence across the Group. The three most important SBU’s are:
• Consumer & Commercial Clients (CCC). CCC serves almost 20 million consumer clients and clients in the small and medium-sized enterprises sector worldwide. ABN AMRO is among the leading players in these segments in its three home markets (the Netherlands, the US Midwest and Brazil), while targeting other high-growth regions through its Business Unit New Growth Markets.
1 The information in the section is mainly based on ABN AMRO’s website and its intranet. For more information on ABN AMRO, see www.abnamro.com.
• Wholesale Clients (WCS). WCS provides integrated corporate and investment banking solutions to more than 10,000 corporate, institutional and public sector clients in nearly 50 countries.
• Private Clients & Asset Management. Private Clients provides private banking services to wealthy individuals and families and has EUR 115 billion assets under administration as of year-end 2004. Asset Management, which is one of the world's leading asset managers, operates from over 20 locations worldwide and manages EUR 161 billion worth of assets (as at 31 December 2004) for private investors and institutional clients.
The other three SBU’s are Transaction Banking Group, Group Shared Services and Group Functions. These three SBU’s focus on non-core activities.
1.1.2 Wholesale Clients
Wholesale Clients represents one of the largest European-based wholesale banking businesses, with currently more than EUR 5 billion in revenues, 10,000 clients, about 17,000 staff and operations in over 50 countries.
Wholesale Clients aims to be a leader in cross-border wholesale banking for selected clients. It delivers a full range of tailored advisory, financing and operational services to its chosen client group, with the intention to maintain top positions in selected sectors and products.
Wholesale Clients can be further divided in six value centres: global markets, structured derivatives, global clients, network, commercial banking and North America.
For this research, global clients is the most important value centre. Global clients focuses on a number of important multinational clients. These clients are mostly listed companies often with annual revenues of more than EUR 1bn. ABN AMRO global clients provides its clients with state of the art investment banking products and relevant sector expertise. To be able to optimally serve its clients, the global clients value centre can be further divided in six departments: technology, media & telecom (TMT), global industries, financial institutions/public sector (FIPS), energy &
resources, mergers & acquisitions/equity capital markets (M&A/ECM) and fixed income/capital markets. The first four departments are relationship focused. They consist of sector focused teams that maintain in-depth relationships with a small number of large clients. These teams generate ideas with their clients and act as originator for investment banking products. The product
specialists are part of the latter two departments. M&A/ECM assist clients in all aspects of mergers & acquisitions and equity (e.g. rights issues, IPO’s). Fixed income/capital markets deliver debt capital raising and capital management products to ABN AMRO’s global clients.
1.1.3 Technology team
The technology team is part of TMT, its position within the ABN AMRO organization is shown in figure 1.1. As a sector team it maintains in-depth relationships with its clients. It focuses on clients who are active in the European software and IT services industry. Examples of main clients are Getronics, Atos Origin, Exact and LogicaCMG. The role of the technology team is twofold. On the one hand it acts as a strategic, financial advisor to its clients. It provides strategic advice on a number of investment banking products related to debt capital and equity. The most important service, however, is M&A advisory. The team helps its clients to formulate and execute a sound M&A strategy. Important aspects of this strategy are the timing of acquisitions, the identification and selection of potential targets and the financing of acquisitions. The technology team can act as an advisor to both the selling and buying parties.
When a client decides to do an acquisition, the second role of the technology team comes into play. The team then acts as an advisor during the execution of an acquisition. Important aspects of the execution of an acquisition are the valuation of a target and due diligence about the target.
This work is conducted in conjunction with specialists from M&A/ECM, who are in the lead in the execution phase.
The technology team is the principal of this research.
Figure 1.1: Position of the technology team within the ABN AMRO organization
CCC Asset mgmt/private clients Wholesale
Structured
derivatives Global markets network commercial
banking
North America
Global clients
FI/CM Global
industries Energy FIPS M&A/ECM TMT
Media Telecom Technology
1.2 Methodology
1.2.1 Introduction to the problem
Over de past years, the ABN AMRO technology team has been on top of the league tables of acquisitions in the European IT services and software sector (see figure 1.2).
Figure 1.2: M&A league tables, source: Dealogic & Bloomberg (2004)
However, competition between investment banks is fierce and the team has to continue to improve to be able to stay ahead of the competition. In order to improve, a thorough understanding of mergers & acquisitions (M&A) is critical. Especially important is to know how M&A can create value for companies. Since ABN AMRO advices its clients on M&A, a thorough understanding of how M&A can create value can significantly enhance ABN AMRO’s ability to provide advice to its clients. In this research I will study how M&A can create value for companies. Hereby, I will specifically focus on companies in the European IT services sector.
1.2.2 Research design
Extensive research about value creation of M&A has already been conducted. Recent examples include Gao and Sudarsanam (2003) and Moeller, Schlingemann and Stulz (2005), but already in the 1980’s value creation of M&A drew a lot of attention (for an overview of studies see Agrawal and Jaffe, 2000). However, most of these studies focus on performance around acquisition announcements. These studies thus focus on individual acquisitions and not on acquisition strategies of companies. Several recent studies conducted by consulting firms argue that firms that actively pursue an acquisition strategy create more value than firms that made no or few acquisitions (Cools, King, Noonan and Tsusaka, 2004 and Frick and Torres, 2002). However, numerous issues concerning an acquisition strategy can be discussed. For example, important aspects of an acquisition strategy are the strategic rationale of acquisitions, the selection of targets
M&A, European software and IT services, announced and completed deals 2004
Rank EUR mln Deals
1 Morgan Stanley 4,341 4
2 ABN AMRO 3,937 8
3 BNP Paribas 3,626 2
4 SG Corporate & Investment Banking 3,093 3
5 HSBC 3,084 1
6 Credit Suisse First Boston 1,097 6
7 JP Morgan 1,019 3
8 UBS 1,016 7
9 Jefferies & Co Inc 766 6
10 Steinvender 603 1
M&A, European software and IT services, closed deals 2003
Rank USD mln Deals
1 ABN AMRO 765 7
2 Morgan Stanley 675 3
3 Merril Lynch 496 1
4 Goldman Sachs 317 1
5 Credit Suisse First Boston 234 3
6 JP Morgan 154 2
7 Davy Corporate Finance 140 1
8 Goodbody Corporate Finance 140 1
9 Close Brothers 124 5
10 Societe General 118 4
and the timing of acquisitions. In this study, I will focus on acquisition strategies and all aspects that are part of an acquisition strategy. The acquisition strategy can be seen as a part of the total M&A process. ABN AMRO identifies four steps in the M&A process. These steps are shown in figure 1.3.
Figure 1.3: Steps in the M&A process
In the first step, companies formulate their corporate & business strategy. Critical for the success of any acquisition is that M&A is an integral part of this strategy. In the second step companies should identify which acquisition targets fit in its corporate strategy. When a company decides to buy a target, it enters the third step in which the execution of an acquisition is conducted.
Important tasks in this step are an in-depth valuation of a target, due diligence of the target and negotiation of the purchase price and conditions. Although these tasks are primarily performed in the third step, a rough analysis of valuation, purchase price and financing should already be made in step two. The operational integration of the target is the fourth step of the M&A process.
ABN AMRO Bank advises a client in the first three steps of the process, although it focuses on steps two and three. In this research, I will primarily focus on the first two steps, which I will call M&A strategy. The reason for this focus is twofold. First, the primary role of the technology team is to advice clients on its M&A strategy (the first two steps), since the execution phase is more the work of the specialists from M&A. Second, the first two steps can be seen as a distinct phase from the third and fourth step. Sirower (2004) notes that most major transactions that ultimately fail are dead on arrival, no matter how they are managed after the deal is done. So, although execution and integration could be perfect, when the first two stages fail, an acquisition will be
1. Formulating corporate & business strategy
2. Screening and selection of targets
3. Execution
4. Integration
value destroying in any case. Of course, on the other hand, bad integration can destroy a good acquisition, but that is beyond the scope of the technology team and beyond the scope of this study.
Based upon the discussion above, I formulated a research goal and research question of this study. The research goal explains why the study is conducted. The research question is the central question to which the study should provide an answer (Braster, 2000).
Research goal
Provide a report that the ABN AMRO technology team can use to improve its ability to advice companies in the European IT services sector on M&A strategies.
As discussed, in order to be able to provide advice on M&A strategies it is essential to understand how M&A strategies can create value for companies. The research question therefore is the following:
Research question
What are the determinants to create value from M&A strategies for companies operating in the European IT services sector?
Definitions
The research question consists of three elements (value creating, M&A strategy and European IT services sector) that need to be further defined, since these elements illustrate the focus of the study.
- Value creation: Throughout this study, value is defined as total shareholder return. Of course, value can be defined and measured in a number of ways, but I choose total shareholder return, since this is the most widely accepted and most easy way to measure value.
- M&A strategy: In this study, the term M&A strategy refers to the strategy of growing through mergers and acquisitions in a certain period of time. For this study, the difference between mergers and acquisitions is not relevant. However, I use the term M&A, because this is the common term used at ABN AMRO when referring to all forms of takeover
activity. Thus, in this study, the term M&A strategy is similar to acquisitions strategy or takeover strategy. Comparably, when I use the term acquisition or deal I refer to all types of takeovers.
- European IT services sector: A company is considered active in the European IT services sector when it earns all or part of its revenues in one or more European countries from the application of business and technical expertise to enable organizations in the creation, management, optimization or access to information and business processes (Gartner, 2005)
Sub questions
The research question will be given further meaning by formulating several sub questions. The sub questions deal with several issues that are all related to the research question. Together, the sub questions will help providing an answer to the central research question.
1. What are the drivers for past and present M&A activity?
Before acquisition strategies can be discussed, an understanding of M&A activity is needed.
Therefore, the first sub question focuses on historic and present M&A activity. It will be discussed when the most M&A activity occurred and what the drivers for this activity were. Also, present and future M&A activity drivers in the European IT services sector will be discussed.
2. How do different aspects of M&A strategies relate to shareholder value for companies in the European IT services sector?
The second sub question discusses the relation between several aspects of M&A strategies and shareholder value. The sub question helps to get a preliminary understanding which factors of M&A strategies can be directly related to shareholder value.
3. What are the aspects that make an acquisition strategy successful?
However, not all aspects of an M&A strategy can be directly related to shareholder value.
Therefore, the third sub question discusses aspects that couldn’t be related to shareholder value in the previous sub question. This sub question provides further insight in which factors a company has to take into account to become a successful acquirer.
4. How do the aspects for a successful acquisition strategy relate to the success factors for PinkRoccade’s M&A strategy?
The last sub question relates the factors that are discussed in the previous sub question to the success factors for PinkRoccade’s M&A strategy. PinkRoccade is a large company in the European IT services sector. The sub question helps to get a further understanding of the success factors for M&A strategies of a European IT services company.
Limitations to the research
- The research was conducted from February 2005 till August 2005.
- The research was conducted as a master thesis of the study Technology Management at the University of Groningen and therefore is subject to all requirements for a master thesis.
1.2.3 Research strategy
The research question is an example of an explanatory question, since it describes the determinants (or ‘explanations’) to create value from M&A strategies. A research questions determines the choice for a specific type of research. Braster (2000) identifies three different types of research strategies: experiment, survey and case study. From these three types are both the case study and survey useful for this study. Both strategies have their advantages and disadvantages.
In general, the survey is characterized as a research strategy which analyses many units at one time on a few characteristics. This analysis is done in a quantitative way. Statistical methods are used to yield significant and representative results, which can be applied to a larger population (Braster, 2000). A survey is useful for this research, since for a large group of companies the relation between several aspects of M&A strategies and value can be measured and statistically tested to obtain general applicable results. However, it would be too time consuming to make a quantitative analysis of all aspects of M&A strategies, because some aspects of M&A strategies are easy to obtain (e.g. the number of acquisitions), but other are much harder to obtain (e.g. the structure of a company). A quantitative survey therefore yields interesting results about a few determinants to create value from M&A strategies, but is certainly not complete. In order to find more determinants, an additional literature study is conducted after the quantitative survey. Based upon this literature study and the quantitative study a conceptual model has been developed that shows the determinants to create value from M&A strategies. However, this model can be too theoretical and might not be complete, since it is for a large part based on a literature study. This is the point were the case study becomes useful for this research.
The case study is almost the opposite of the survey. It analyses one or few units on many characteristics (Braster, 2000). Usually, but not always, a case study is done in a qualitative way.
This makes the case study a good technique to make an in-depth analysis. Therefore, for this study, the case study is a good strategy to analyze the determinants that could not be captured in the quantitative study and to test the conceptual model. The case study thus has two purposes.
First, the case study will test the insights obtained in the quantitative analysis and literature study.
Second, the case study will develop new theory which couldn’t have been obtained from the literature study or the quantitative survey. Therefore, the case study should be regarded as a theory testing case study and as a theory developing case study (Braster, 2000).
This research can be seen as a combination between a quantitative survey and a case study. It should be noted that individually both the quantitative survey and case study are not sufficient to answer the central question. However, when the two techniques combined, a sound answer is provided to the central question. Therefore, the two parts of the research should always be regarded together and not separately.
The structure of the research is shown in figure 1.4.
Figure 1.4: Research model
The research model shows the different chapters. The chapters match with the sub questions. In each chapter, a sub question will be discussed.
Chapter 2, Fundamental or behavioural? Drivers for M&A activity
In chapter 2, sub question one will be discussed. The drivers for past, present and future M&A activity in the European IT Services sector will be discussed. This is done by a literature study in
Chapter 2 Chapter 3.1 Chapter 5
Drivers for M&A activity
The aspects for value creation of M&A
strategies
Literature study Quantitative survey
Determinants for a superior M&A
strategy
Chapter 3.2 Chapter 4
The aspects for value creation of M&A
strategies
PinkRoccade's M&A strategy
Literature study Case study
which ABN AMRO’s research reports, external data vendor’s research (Gartner, PAC2) and academic literature are used. Most academic literature that is used are articles from financial journals (e.g. Journal of Finance, Journal of Economic Perspectives).
Section 3.1, The aspects for value creation of M&A strategies, a quantitative study
In the first part of chapter three, sub question two will be discussed. This is done by a quantitative survey. A quantitative study has been conducted in which issues as the number of acquisitions, timing of acquisitions and the method of payment have been related to shareholder value. The methodology of this study will be discussed in detail in chapter three.
Section 3.2, The aspects for value creation of M&A strategies, an additional literature study In the second part of chapter three, sub question three will be discussed. The section provides further insight in which factors a company has to take into account to become a successful acquirer. This is done by a literature study in which existing academic and professional M&A literature is used. Examples are financial journals and reports from consultancy firms. Moreover, additional information has been gathered by holding interviews with M&A experts within ABN AMRO Bank. Hereby, the focus was on experts of M&A in the technology sector. In the two sections of chapter three, a conceptual model is created based upon the quantitative survey and the literature study. The model shows the determinants to create value from M&A strategies for companies in the European IT services sector and therefore helps answering the central question.
Chapter 4, How does the conceptual model relate to the success factors for PinkRoccade?
In chapter four, sub question four will be discussed. A case study about the M&A strategy of PinkRoccade for the period 1999 – 2004 has been conducted. The conceptual model that is developed in chapter is applied to the case. In the case study, the conceptual model is both tested and improved by the insights that are obtained from the case study. The methodology of the case study will be discussed in chapter four.
Chapter 5, Conclusions and recommendations
In chapter five, the conclusions and recommendations are discussed. In this chapter, an answer is provided to the central research question.
2 PAC is an abbreviation of Pierre Audion consultants. PAC offers a leading online information and analysis service for and about the European and US software and IT services industry (SITSI).
Besides all sources mentioned above, I talked informally to several investment banking professionals and IT services experts at ABN AMRO during the whole period of my study.
Particularly Bart de Vries (vice president, global clients, technology), Frank Haffmans (executive director, global clients, technology) and Rogier van Merkestein (associate, corporate finance) provided me with much valuable information about M&A in the European IT services sector that I used in all parts of this study.
2 Fundamental or behavioral? Drivers for M&A activity
This chapter will focus on the drivers for M&A activity. It starts with a description of the historical development of M&A activity. It will give a general overview when M&A activity occurred and why it occurred. Next, recent M&A activity in the IT services sector will be discussed. The chapter will end with future drivers for M&A activity and a conclusion.
2.1 Historical developments of M&A activity
It is well documented that M&A activity occurred in waves in the 20th century. Among others, Golbe and White (1988) and Andrade, Mitchell and Stafford (2001) show different waves in US merger activity. Roughly, five different waves can be identified. These waves occurred in the United States. The data of European M&A activity is not as clear as those for the US, however, the evidence is clear that M&A activity in Europe in recent decades showed the same patterns as M&A activity in the US (Weston, Mitchell, Mulherin, 2004).
The first wave occurred in the beginning of the 20th century and consisted mainly of horizontal mergers, which created high concentration in many industries. The main drivers behind the merger wave were major changes in economic infrastructure and production technologies.
Examples of such changes are the completion of a transcontinental railway system and the increased use of electricity. The improved infrastructure and utilities resulted in the development of a national economic market. This triggered the merger wave which transformed regional companies into national companies. The wave ended around 1903 when the economy went into a recession (Weston, Mitchell, Mulherin, 2004).
The second wave occurred in the 1920’s and, like the first wave, was triggered by major infrastructure and technological developments and increased business activity. In particular, the development of motor vehicles was a main driver behind the merger wave. In addition, improvements in communication methods (e.g. radio) made advertising on a nation wide scale possible, which called for larger enterprises. As was the case around 1903, the merger wave ended with an economic slowdown in 1929 (Weston, Mitchell, Mulherin, 2004).
The third merger wave occurred at the end of the 1960’s. This wave seemed to coincide with a booming economy and a change in governmental regulation. New regulation prohibited companies to engage in mergers that increased concentration, thus horizontal and vertical mergers (which occurred in the first two waves) were no longer possible. Therefore, in the 1960’s mergers typically involved firms from different industries and thus large conglomerates were formed (Shleifer and Vishny, 2003). The wave ended in 1969 due to regulations against conglomerate firms and a slowdown of the economy.
The fourth wave started at the beginning of the 1980’s and lasted almost the entire decade.
Several reasons for this wave can be identified. Bhagat, Shleifer and Vishny (1990) mention the relaxation of the antitrust regulations which made horizontal mergers once again possible. In addition they argue that the creation of high yield junk bonds was an important driver for the rise of financial buyers. Financed with high yield junk bonds, financial buyers bought segments of the conglomerates established in the 1960’s, because the conglomerate organization was no longer efficient. Furthermore, Mitchell and Mulherin (1996) add energy volatility and increased foreign competition as drivers for M&A activity in the fourth merger wave. The wave ended in 1989 due to an economic recession, a declining junk bond market and increased antitakeover regulation.
The fifth and most recent completed wave started with economic recovery in 1992. But apart from this recovery, Weston, Mitchell and Mulherin, (2004) mention technology, globalization, deregulation and financial aspects as major forces behind increased M&A activity. Like all other waves, the fifth wave ended with an economic recession and the ‘burst of the bubble’ at the beginning of the 20th century.
When comparing the different merger waves, two different conclusions can be derived. First, all merger waves started with changes in economical, technological and/or regulatory conditions.
Changes vary from relatively major technological changes like the development of railroads and motor vehicles, to political and financial changes as anti-trust regulations and the establishment of a high yield bond market. Although the types of changes differ for each wave, each wave followed major or minor changes. However, and that is the second conclusion, those changes are not the sole driver behind increased M&A activity. The changes have to coincide with an economic upturn and rising stock markets in order to trigger M&A activity. This view is supported by the finding that all waves started with an improving stock market and all waves ended with an economic recession and thus declining stock markets. This interpretation is also
consistent with the view of Shleifer and Vishny (2003) that acquisitions are driven by stock markets valuation. They argue that rational managers of firms with high stock price valuations take benefit of this high valuation to buy companies which stocks are lower valued. Dong et. al (2003) find empirical evidence that support Shleifer and Vishny’s view. Bouwman et. al (2003) provide a number of additional behavioral arguments that relate M&A activity to stock market booms. They argue that managers are more likely to suffer from managerial hubris, herding and investor sentiment in bullish markets. In bullish markets, managers are more encouraged to undertake acquisitions, because they see that other companies are doing acquisitions and they feel that the market expects acquisitions. Further in this chapter, these behavioral explanations will be discussed in more detail.
Figure 2.1 further supports the view that M&A activity is triggered by increasing stock markets.
It shows the dollar amount of United States M&A activity versus the S&P 500 index. The S&P 500 index is a capitalization-weighted index of 500 US stocks representing all major industries.
Therefore it is a good indication for overall US stock market performance. The graph shows that high stock market valuation coincides with high M&A activity.
0 200 400 600 800 1000 1200 1400 1600
1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
S&P 500 M&A activity in USD bn
Figure 2.1: S&P 5003 versus United States M&A activity, sources: Bloomberg (2005) and Weston, Mitchell, Mulherin (2004)
Especially at the end of the 90’s, large structural changes (globalization, the rise of the Internet) coincided with skyrocketing stock markets. The IT services sector was one of the industries that was affected most by those changes. Moreover, stocks of IT services companies were among the best performing in the market. Therefore, it can be expected that the IT services sector
3 The graph shows the position of the index at the end of each year.
experienced much takeover activity at the end of the 90’s. In the next section, I will describe takeover activity in this sector in more detail.
2.2 Developments of M&A activity in the European IT services sector
2.2.1 M&A activity 1995-2004
For the technology sector, the most recent wave is of course the most important one. Figure 2.2 shows M&A activity in the European IT services sector during the period 1995-2004. It clearly shows the bubble in 2000, the decline in the beginning of the 21st century and the recovery since 2003.
- 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 90,000
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 0 200 400 600 800 1000 1200 1400 1600 1800 2000
Amount in EURm
# of deals
Figure 2.2: M&A activity in the European IT services sector 1995-20044, source: Dealogic (2005)
2.2.2 Drivers for M&A activity in the bubble
In section 2.1, I briefly mentioned technology, globalization, deregulation, financial aspects and an increasing stock market as drivers for M&A activity in the 90’s. In this section, these drivers will be discussed in more detail. I will discuss which of those drivers were the most important forces behind the steep increase in M&A activity in the European IT services sector.
Real drivers
Technological innovation, globalization and deregulation can all be defined as real drivers. These drivers change the environment and companies are forced to adept to these drivers in order to
4 M&A activity is measured as the value of mergers & acquisitions in which the target company is active in the European IT services sector.
survive. Therefore, it is evident that these drivers influence the behavior of companies. However, it is doubtful whether those changes were the main drivers for M&A activity. Of course the rise of the Internet made the world a global marketplace and thus triggered globalization. Then, it can be argued that companies merged in order to become multinational companies. But against this background it seems strange that M&A activity suddenly dropped in 2001. Certainly, globalization and technological innovations didn’t stop, but continued to be a factor of importance. Also, deregulation does not seem to have played an important role in the IT services sector so far. However, two other important issues did play an important role in the IT services industry: the millennium problem (Y2k) and the introduction of the euro. Mainly in 1999 and 2001, companies spent a lot of money to make their systems Y2k and euro-proof. However, according to Mr. de Vries, vice president at ABN AMRO’s technology team, this did not very much increase the IT spending of companies. Mr. de Vries believes that companies determine their budgets for IT spending each year. These budgets are based more upon economic conditions than incidental events as Y2k and the Euro. The expenses for Y2k and the Euro determine which part of the budget can be spent on Y2k and the Euro and which part can be spend on other issues, but don’t increase the overall budget. Therefore, the increase in revenues of IT services companies at the end of the nineties, which was caused by increased IT budgets of companies, was primarily driven by economic conditions and not by Y2k and the Euro. Hence, it is unlikely that Y2k and the Euro caused M&A activity.
Kohers and Kohers (2001) mention that in 1999, technology stocks drove the NASDAQ to record gains of over 85%, which represented the best performance of any US market in history. In European IT services, the performance was even better with a gain of 113% during 1999, while the overall European market ‘only’ gained 37% during 19995. Moreover, this impressive performance was followed by an enormous level of M&A activity (see figure 2.3). The most likely driver for M&A activity therefore seems the high stock market valuation. However, it is not impossible that the overvaluation6 of the stock market, and especially the stocks of IT services companies, has been driven by the expected increase in growth and profitability caused by the
5 The performance of the overall European market is based on the Bloomberg European 500 Index which is capitalization-weighted index of the 500 most highly capitalized companies. The performance of the IT services companies is based on the capitalization-weighted performance of the IT services companies in the index.
6 I use both the terms high valuation and overvaluation of the stock market. I recognize that they are not necessarily the same and that some people may argue that the stock market was not overvalued at the end of the 90’s. However, such a discussion is beyond the scope of this study. I assume that stock market was both highly valued and overvalued at the end of the 90’s.
new technological developments. Jensen (2005) notes that society often seems to overvalue what’s new. Railroads, canals, automobiles and telephones all are historical examples.
Concluding, it seems likely that the expectations caused by new technological innovations in the 1990’s have led to overvaluation of the stock market which in turn has led to increased levels of M&A activity. Therefore, M&A activity was not in the first place driven by real factors, but primarily by factors related to stock market overvaluation. These factors I will discuss in the next section.
0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 45,000 50,000
1996 1997 1998 1999 2000 2001 2002 2003 2004
0 100 200 300 400 500 600
M&A in EU Rm (bidder) Bloomberg comp sv cs index
Figure 2.3: M&A in Europe7 and IT services stock market index8, sources: Dealogic and Bloomberg (2005)
Behavioral drivers
In a previous section I already mentioned managerial hubris, herding and investor sentiment as possible drivers for merger waves. These behavioral phenomenons’s can all be caused by high stock market valuations and therefore are likely drivers for increased M&A activity in the European IT services. In turn, I will discuss these and other behavioral factors to explain the recent merger wave in the European IT services sector.
Rational managers and overvalued stock
Shleifer and Vishny (2003) developed a model of merger and acquisitions based on stock market misvaluation of firms. Key of this model is that financial markets are inefficient9, so firms can be
7 M&A activity is measured as the value of mergers & acquisitions in which the bidder company is active in the European IT services sector.
8 The graph shows the position of the index at the end of each year.
valued incorrectly. Managers, however, are rational, understand stock market inefficiencies and take advantage of them in part through M&A decisions. Managers of highly valued firms know that their stock is overvalued and use their stock as a relatively cheap way of financing acquisitions. An important implication following from this theory is that acquisitions during the stock market boom in the 90’s (when the stocks of most companies were highly valued) should be financed with stock rather than cash. This is indeed supported by Andrade et al. (2001) who show that in the 1990’s stock is used in 71% of the cases compared to 45% in the 1970’s and 1980’s.
Another implication is that most acquisitions are conducted by the most overvalued firms.
Rhodes-Kropf, et. al (2004) indeed find empirical evidence for this implication. In addition, Dong et al. (2003) find that more overvalued bidders are more likely to use stock instead of cash to finance their acquisitions. This also provides support for Shleifer and Vishny’s theory.
Agency costs of overvalued stock
In Shleifer & Vishny’s theory managers are rational and act in the best interest of shareholders.
Jensen (2005) however, sees large agency costs of overvalued stock. By definition, overvalued equity means that a company will not be able to deliver the performance to justify the value, otherwise the equity had not been overvalued. Managers who know that the stock of their firm is overvalued also know that in time their stock price will decline unless performance will justify the stock price. Jensen argues that firms then will use their overvalued equity to make acquisitions in order to try to reach growth levels which can justify the overvalued stock price.
However, those acquisitions are likely to be value destroying in the long run, since they are not driven by synergy motives. Although from different points of view, both Shleifer & Vishny’s as well as Jensen’s theory explains why overvalued stock markets trigger M&A activity.
Managerial Hubris
Roll (1986) is the first to mention managerial hubris related to corporate takeovers. Managerial hubris in corporate takeovers is the phenomenon that a manager overestimates his ability to value a takeover target. A manager suffering from managerial hubris is confident that he makes the right valuation, while the market does not reflect the full economic value of a target. This leads a manager to pay a premium which is higher than the value that an acquisition can generate and thus leads to the destruction of shareholder value. Bouwman et. al (2003) argue that during stock market booms, managers are more likely to suffer from managerial hubris. In good times,
9 Throughout this study, I assume that markets can be inefficient and therefore firms can be valued incorrectly.
managers tend to be more optimistic and thus see more synergies than in reality exist. Therefore, more acquisitions will be undertaken during stock market booms. And because part of these acquisitions are driven by managerial hubris, on average, acquisitions undertaken in these periods are more likely to destroy value in the long run than acquisitions undertaken during periods of low market valuation. Bouwman et. al (2003) indeed find support for this hypothesis.
The same argument can be made for individual companies with high market valuations. A high valuation is an indicator of good past performance. Because of this good past performance, managers of those companies have become more self confident and are more likely to overestimate their own abilities to manage an acquisition, in other words are more likely to be infected by managerial hubris, which can drive more acquistions. An implication of this theory is that part of the acquisitions of highly valued companies is driven by managerial hubris and thus, on average, acquisitions undertaken by highly valued firms are more likely to destroy value than acquisitions undertaken by firms with low valuations, since these acquisitions are not backed by a rational decision. Rau and Vermaelen (1998) find support for this hypothesis. They show that
‘glamour’ firms (firms with a high valuation) significantly underperform ‘value’ firms (firms with a low valuation) in the three years following an acquisition. Moreover, they find that ‘glamour’
firms pay higher acquisition premiums than ‘value’ firms, which implicates that managers of
‘glamour’ firms see more synergies than managers of ‘value’ firms, which is likely to be caused by managerial hubris. Malmendier and Tate (2003) provide further evidence that overconfident, hubris exposed CEO’s make more acquisitions than their rational colleagues.
Herding and investor sentiment
Two other behavioral explanations for increased M&A activity during stock market booms are herding and investor sentiment. Herding and investor sentiment are related to each other.
Scharfstein and Stein (1990) define herding as managers who simply mimic the decisions of other managers. In case of a stock market boom, managers see that more acquisitions are conducted.
Then, managers may be inclined to do acquisitions, because everybody is doing acquisitions.
Managers may engage in this kind of behavior since the reputational damage from following a herd is smaller than from an isolated decision. Schenk (1999) elaborates on herding. Schenk argues that managers engage in a minimax-regret game in which managers of companies regret inaction more than action. Suppose that company A acquires another company. At that moment, company B, a competitor of company A, does not know whether the acquisitions will be successful or unsuccessful. Company B then has the choice to acquire too or to refrain from
acquisitions. The decision of company B depends on the amount of regret the company has.
Company B can (1) regret that it didn’t act and the acquisition of A appears successful or (2) regret that it did act and the acquisition of A appears unsuccessful. According to Schenk, the regret attached to situation (1) is higher than the regret attached to situation (2). This explains how one merger triggers other mergers and how a merger wave can be developed. Apart from the minimax-regret game, Schenk mentions another bandwagon effect. In an M&A wave, larger firms are created. Then, for small companies the likelihood of becoming a target increases. In order to prevent being taken over, small companies engage in M&A activity and help continuing the merger wave.
Investor sentiment is related to herding and the agency costs that Jensen (2005) mentions. When the market is bullish, managers may want to undertake acquisitions, because the market sentiment expects firms to take growth-enhancing initiatives. Similarly, managers avoid acquisitions during bear markets, because they believe that the market doesn’t expect acquisitions. Thus, during high market valuations M&A activity will be higher than during low market valuations.
The arguments I mentioned above are all related to behavioral factors. Although most studies that focus on behavioural factors do not differentiate between industries, it is reasonable to assume that these studies are applicable to the European IT services industry. Since the stocks of European IT services companies outperformed the market in the late nineties and the stocks subsequently became highly valued, it is likely that the behavioural factors were at least as prominent at the European IT services companies as at the average company in the market.
In the next section, I will focus on the future drivers for M&A activity. Because the stock markets nowadays are significantly lower than at the end of the nineties, the drivers for future M&A activity are likely to be real factors rather than behavioral factors.
2.2.3 Future M&A activity
Figure 2.4 shows that after the glamour days at the end of the nineties and the following downturn of the industry at the beginning of this century, the sector seems to be growing moderately since 2002. In this mature phase the sector seems to be ready for consolidation which will likely have a significant impact on future M&A activity.
1997 1998 1999 2000 2001 2002 2003 2004 2005
Revenue
Figure 2.4: Trend of total revenues in the European IT services industry 1997-2005, source: ABN AMRO sector research (2005)
2.2.4 Drivers for further M&A activity
Currently, several drivers for further M&A activity exist. These drivers will de described in this section.
Strong balance sheet
After the decline in the sector in the beginning of the 21st century, IT services companies have deployed significant restructuring programs. As a result of these programs and the recovery of the economy, IT services companies now have more cash than they have had in the last five years.
The companies can use this cash to fund new acquisitions.
Sector fragmentation
The IT services sector is still very fragmented. Figure 2.5 shows the leading players in the market. Together, the companies serve only 40% of the total European IT services market.
Rank Company Nat. 2003 Market share
1 IBM US 12,000 9.9%
2 EDS US 5,840 4.8%
3 HP (incl. Compaq) US 5,700 4.7%
4 T-Systems DE 5,390 4.5%
5 Siemens Business Services DE 4,090 3.4%
6 Accenture US 3,840 3.2%
7 Capgemini FR 3,480 2.9%
8 CSC US 2,940 2.4%
9 Atos Origin FR 2,643 2.2%
10 Fujitsu JP 2,620 2.2%
Western Europe - Leading Suppliers by IT services revenues* (EUR mln)
Figure 2.5: Leading suppliers by European IT services revenues, source: SITSI (2004)
Furthermore, many small local players co-exist in each European market, without achieving critical mass or being successful in moving upmarket. Therefore, room for consolidation in the market continue to exist, which triggers M&A activity.
Need for critical mass
Critical mass is needed for three main reasons. First, it helps to create bigger margins. Sub-critical operations hardly generate EBIT margins above 5%, while large operations can reach double digit margins. This is because overhead costs are better amortised in larger operations. ABN AMRO estimates that a company needs at least EUR 1bn in revenues to secure larger margins. Figure 2.6 shows that large companies indeed have greater margins than small companies. Second, critical mass is needed to serve global clients and secure large IT service contracts. Global clients demand an IT services supplier that is able to fulfil their needs on a global scale. This is only possible when a supplier operates on an international scale. Third, critical mass is increasingly necessary in the European context to compete with the US global companies like Accenture, IBM, and HP which are operating on a global scale and dominate the Western European market (see also figure 2.5). M&A is a way for European companies to become larger and obtain the critical mass.
