The inefficient acquisition
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The cloud computing technology company 3 Par was a money-loser for its first 11 years in business, but Dell and Hewlett-Packard still went to war over its acquisition in 2010, a bidding battle that more than tripled the firm’s stock price in a month.
Why would two companies fight so fiercely for a company that never made money? A new study by University of Iowa law professor Robert Miller says the acquisition may be an example of inefficient overpricing in the mergers and acquisition market, which, he argues, can actually be perfectly rational from the point of view of the company that’s overpaying.
“In the M&A market, allocating resources to the highest bidder will often not produce an efficient result,” Miller says. “Because of unusual forces of the corporate control market, the party willing to pay the highest price to acquire the target and the party that would derive the greatest economic benefit by acquiring the target often will not be the same party.”
The reason, he says, is that, in many cases, one firm may want to acquire another not just to improve its own business, but to keep the target firm out of the hands of a competitor. If a competitor acquires the target, the company may see that competitor gaining a possible advantage that will cause the company to pay more for the target itself, maybe even more than it is worth in the form of increased future profits.
“The highest bidder will thus not necessarily be the highest-value user,” Miller says.
While culture differences and poor management often get blamed for failed mergers, Miller suggests that many are also hampered by this inefficient bidding process.
“This is a completely new explanation for the well-known empirical findings that acquirers tend to overpay in corporate acquisitions,” Miller says. “It shows that classical auction theory, which assumes that bidders set their bids without regard to the identity of other bidders, does not apply to the market for corporate control.”
Such was the case in the HP-Dell battle. 3 Par was not profitable, but it represented an entrée into a line of business—cloud computing—where both HP and Dell wanted a presence. Neither firm had a cloud technology that was as strong as 3 Par’s, so acquiring 3 Par would provide two advantages to the winning firm: a ready-made technology to strengthen its own position in the cloud computing market, and keeping that technology out of the hands of a direct competitor.
With that strategy, each company upped the ante during the month-long bidding war. An initial $18 per share bid by Dell was quickly matched by HP, and by the time the smoke cleared $15 per share later, HP had the company for $33 dollars per share or $2.35 billion, well above any reasonable valuation for 3 Par. The $33 per share price was more than three times 3 Par’s share price before the bidding started.
What can be done to reduce these inefficient takeovers, which may not always be in society’s best interests? Not much, Miller says. Not all M&A activity is driven by considerations that lead to inefficiency, and detecting corporate control transactions that misallocate resources because of these distortions is extremely difficult.
“In particular, any attempt to do so by a government agency seeking to prevent such misallocations would be subject to a very high error rate, and the costs of errors would generally also be very high, so the costs are likely greater than the benefits that could be captured by attempting to block suboptimal transactions,” he says. “From a social point of view, the best solution may be to suffer the costs of such misallocations.”
Miller’s study, “Inefficient Results in the Market for Corporate Control,” will be published in a forthcoming issues of the Journal of Corporation Law. It’s available online.