By GRETCHEN MORGENSON
Published: June 5, 2005
The Dark Side of the Deal
To most investors, mergers are the stock market's equivalent of catnip. Takeover bids typically provide a nice boost to investors' portfolios and confirm their stock-picking smarts. And to hear the executives orchestrating them tell it, they always produce greater profits at the combined company down the road. Business publications and newspapers, including The Times, celebrate the deals with breathless tales of how they came together, complete with photographs of smiling executives shaking hands in front of a crowd
This year, with the stock market moving sideways, buyouts and the gains they generate are prized all the more. There have been a lot of them, too. This year, according to Thomson Financial, the first quarter's combinations were valued at $308.2 billion, up 17 percent from the value of deals announced in the same period in 2004. If this activity continues, 2005 will be the fourth-largest year in deal size.
And yet, for all the profit and promise that mergers seem to hold, the truth about companies combining their operations is a darker one. Academic research suggests that few mergers add up to significantly more prosperous or successful companies and also that acquisitions during buyout booms, like the one we are in now, are more likely to fail than those made in other periods. And when one company acquires another using its own stock as currency, as commonly happens today, shareholders' stakes in the acquiring firm typically decline.
What's worse, there is a disturbing trend among some of the most aggressive corporate acquirers to use deals to mask deteriorating financial results at their companies and to reap outsize executive pay. The complexity of folding companies into one another makes it more difficult, whether by accident or by design, for investors to fathom what's really going on. Because mergers require the extensive use of estimates on matters like job cuts and asset write-offs, for example, deals represent an opportunity for management to throw everyday expenses into the merger cost bucket and make operating results look better than they actually are. It's probably no coincidence that some of the biggest frauds in recent years have involved serial deal makers like Tyco International, Waste Management and WorldCom. (Long before a jury found him guilty of securities fraud in federal court in March, Bernard J. Ebbers, the chief executive of WorldCom, entertained himself and his friends aboard his 118-foot yacht called the Aquasition.)
Perhaps the biggest downside to mergers, however, is their human toll. Deals that combine companies are becoming a bigger factor behind large-scale layoffs across the nation.
Some Bad Unions of the Recent Past
Robert F. Bruner, professor of business administration at the Darden School of Business at the University of Virginia, has compiled a list of colossal merger failures in a new book, ''Deals From Hell.'' High up on his roster is the Sony-Columbia Pictures merger in 1989, which cost $4.8 billion initially but ultimately resulted in a $2.7 billion write-off in 1994. Also on the list is the 1991 deal in which AT&T bought National Cash Register for $7.5 billion. Five years later, AT&T spun off NCR for $3.4 billion, for a loss of $4.1 billion. Another entry is the December 1994 purchase of Snapple Beverage by Quaker Oats for $1.7 billion, a deal that eventually produced a $1.5 billion loss. In late 1998 Mattel acquired the Learning Company, an educational software firm, for $3.8 billion in stock. Just over a year later, Mattel sold it for a loss.
But the champion of all failed mergers, even years later, remains the AOL-Time Warner combination, announced in January 2000 just as the technology stock bubble was about to burst. Time Warner's chief executive, Jerry Levin, called the deal a ''transforming transaction'' -- an accurate assessment, as it would turn out, if not precisely in the way he hoped. The deal resulted in a $200 billion loss in stock-market value and a $54 billion write-down in the worth of the combined company's assets.
What's more, in merging with AOL, Time Warner inherited accounting irregularities that attracted the attention of the Justice Department and the Securities and Exchange Commission. In December, the company agreed to pay $510 million to settle with the S.E.C. (neither admitting nor denying wrongdoing) and also to enter into a deferred-prosecution agreement with the Justice Department. Prosecutors said they would put off bringing criminal securities-fraud charges against the America Online unit as long as Time Warner adopted measures to correct past problems and engaged an independent monitor to oversee AOL's financial operations for two years.
''The AOL/Time Warner transaction dwarfs other deals from hell in almost all respects,'' Bruner writes. ''It leads the field in meltdown in value. The executive firings and resignations, the civil litigation, criminal investigation and the erasure of AOL from the corporation's name reveal a remarkable wipeout of the vision of the deal's architects.''
What Does It Profit a C.E.O.?
Given all the forces that seem to be lined up in opposition to mergers, it may be a bit surprising that the deals keep on coming. But there are people for whom they make perfect sense: the executives and the Wall Street bankers behind them. There are several reasons for this -- for example, acquisitions enable companies to show earnings growth that rising stock prices, and therefore investors, require -- but the most compelling case for mergers may simply be the immense wealth that they generate.
Executives began reaping big rewards from deals during the 1980's, when so-called golden parachutes were introduced. (Today those payouts look positively quaint.) Back then, shareholders viewed large payouts to managers at a company subject to takeover as a way to induce entrenched executives to consider a change in control there. Those inducements then became embedded in every executive's employment contract, growing to the gargantuan levels of today.
The actual numbers associated with some of the bigger deals can be staggering. James Kilts, the chief executive of Gillette Company, stands to make $165 million from merging that venerable Boston company with the Cincinnati-based Procter & Gamble. That payout was so large that Joseph F. Turley, the company's former president, and Joseph E. Mullaney, a former vice chairman of Gillette's board, deplored the merger in an open letter to Gillette's directors. ''Thousands of Gillette's employees will soon receive pink slips,'' they wrote. ''Their 'leader' will receive $170 million.''
While the Gillette pay stands out, it is by no means a singular occurrence. In April, Toys ''R'' Us disclosed that 21 current and former officers and directors could receive more than $170 million for selling the toy retailer to an investment group that includes Kohlberg Kravis Roberts & Company and Bain Capital, two buyout firms, and Vornado Realty Trust, a real-estate investment trust. The $6.6 billion deal will result in a $63 million payout to John H. Eyler Jr., the toy retailer's chairman and chief executive officer who has been with the company since 2000. That includes some $30 million in stock options, $7.1 million in restricted stock, an $11 million cash severance if he leaves after the deal closes, $7 million in deferred compensation and $7.5 million to pay taxes generated by the payout.
Last year, AXA, the French insurer, bid $1.5 billion for the MONY Group, a United States financial services company. In that deal, top MONY executives were set to receive $90 million in severance and other payments, but enraged MONY shareholders threatened to vote against the merger. Only then did the executives agree to forego about $7 million.
''Shareholders have to ask sometimes, Was this executive team motivated to do this deal only because they knew this pot of gold was waiting for them at the end of the rainbow?'' Pat McGurn, special counsel at Institutional Shareholder Services, an investor advisory firm in Rockville, Md., says. ''In some cases, it does border on what could be considered corporate waste.''
Unfortunately, shareholders find out how much of a merger's costs will wind up in the pockets of one or both company's executives only after the deals are announced. And because uncovering the payouts requires digging through complex corporate filings, some shareholders never learn about them at all. Michael S. Kesner, principal in charge of the executive compensation practice at Deloitte Consulting, says it is not uncommon for payouts to management to reach 8 percent of a merger's total cost.
How to Justify a Merger: It's All About the Growth -- Really
''I speak with senior executives in the course of my research,'' Robert Bruner, the Darden business school professor, told me. ''They all tell stories about how they are charged with maintaining earnings growth. They can only get 5 to 6 percent growth organically, yet the C.E.O. has set a target that is much more ambitious, and they must make up the difference by acquisitions.'' Bruner is critical of this process, which he calls financial cosmetics. ''It invites the creation of growth for appearance rather than growth that creates wealth for investors and society,'' he says.
Indeed, shareholders who own stock in companies that make a lot of acquisitions -- serial acquirers -- should consider whether the deals are being cooked up by executives concerned about a slowdown in growth inside their operations. (Of course, shareholders who expect rising stock prices are not without guilt themselves. As James A. Fanto, a professor at Brooklyn Law School, wrote in a study of mergers he conducted in 2000, ''It is not too strong an expression to say that investors have become addicted to these transactions.'')
''The only thing people get paid for these days is growth, not running a company well,'' Jack Ciesielski, editor of The Analyst's Accounting Observer in Baltimore, says. ''The cult of growth will always encourage companies to buy other companies to paper over the valleys in their earnings patterns.''
Perhaps the best -- or worst -- examples of acquisitions performed for earnings expediency were those made by Tyco International, a conglomerate, during the years it was run by L. Dennis Kozlowski. Founded in 1960 as a technology company, Tyco soon became a manufacturer of industrial products. By the late 1990's, however, it had begun promising investors that it would produce reliable earnings growth in excess of 20 percent a year. Kozlowski, who became chief executive in 1992, wanted to pattern his company after General Electric, which had produced remarkably steady earnings gains for years. Today Tyco has operations in fire and security services, health-care products and electronic components.
In 2002, Kozlowski and an associate were accused of stock fraud and of looting the company of $600 million (a figure later reduced to $150 million). After an earlier mistrial, he is currently on trial for the second time in New York State Supreme Court in Manhattan.
Whether or not Kozlowski is found guilty of fraud -- at the time this article went to press, the trial was winding down -- his acquisition record certainly turned out to be flawed. Since he left Tyco, the company has registered $9 billion in losses and impaired assets.
Kozlowski, however, received more than $330 million in stock sales and other compensation in his last three years running Tyco. A good bit of his compensation was based on achieving certain financial results. Tyco cleared most, if not all, of these hurdles, at least in part because of its many acquisitions. For example, in 2001, according to Tyco's regulatory filings, Kozlowski received a cash bonus of $4 million, based on the company's 39 percent increase in net income, before nonrecurring items, and on its 31.3 percent increase in operating cash flow. That year, the company made more than 10 acquisitions that contributed to both net income and cash flow.
The Bigger the Company, the More the C.E.O. Gets (Never Mind How the Company's Doing)
An academic study from 2000 examined the relationship between chief-executive compensation and mergers in the banking world. Richard T. Bliss, a professor at Babson College in Massachusetts, and Richard J. Rosen, then a professor at the Kelley School of Business at Indiana University, studied bank mergers that occurred from 1986 to 1995. They found that these deals had a positive effect on the size of executive compensation and that even when an acquiring bank's stock declined following a merger, the compensation paid to the chiefs running the institutions grew significantly enough to offset any losses to their stockholdings.
''The net result is that even mergers which reduce shareholder value can be in a manager's private interest,'' Bliss and Rosen concluded.
Their study found that more than three-quarters of the mergers in the sample led to a 10 percent or greater boost in executive compensation. The median change in compensation following a merger, the study showed, was an increase of between 20 and 30 percent of a chief executive's premerger pay.
Bliss and Rosen also compared increases in chief executive compensation at banks where assets grew organically with those at institutions that grew, more quickly, by acquisition. For every $1 million in new assets a bank acquires through a merger, the study found, its chief executive received an increase in total compensation of $54, on average. For every $1 million in assets grown organically at a bank, its chief executive received an average $30 rise in compensation.
But those are numbers from the mid-1990's and are probably a fraction of the riches that executives receive in mergers today. Exhibit A is James Kilts's $165 million in the Gillette-Procter & Gamble deal. Eric Kraus, a spokesman for Gillette, says that the merger is a ''historic opportunity'' for both shareholders and employees, and he adds that Kilts ''has taken a chronically underperforming company to an industry leader. . . . If the company didn't do well during his tenure as chairman, then he also wouldn't have done well, because his compensation is tied directly to performance.'' After the merger, according to Kraus, Kilts has agreed to keep the combined company's stock for at least 18 months.
Lucien Bebchuk, a professor of law, economics and finance and director of the program on corporate governance at Harvard Law School, recently wrote a book with Jesse Fried on executive compensation titled ''Pay Without Performance.'' In it, he argues that when acquisitions enter the mix, top executives often get away with larger amounts of ''gratuitous payments'' than might otherwise be possible. One reason for this, he says, is that the gains typically made by the shareholders of a target company may lull them into complacency about outsize payments to top executives. In other words, since everyone is getting a little richer in the transaction, the fact that a couple of executives are getting a lot richer is less bothersome.
In addition, Bebchuk claims, after a firm is acquired, its directors often step down. As a result, they have less reason to be worried about confronting angry shareholders.
Why More Critics Don't Ask About the Payoffs for the Execs
It does seem odd that few large shareholders have objected to the skyrocketing payouts to top executives in these deals. One that did was the California-based CalPERS, the nation's largest public pension fund, which last year took exception to the $16.5 billion merger of two health insurance companies, Anthem, based in Indianapolis, and WellPoint Health Networks, in California.
Because the merger triggered certain changes in the employment contracts of the top executives at both companies, they received bonuses, severance payments and vested stock options totaling some $200 million. Leonard D. Schaeffer, WellPoint's chief executive, was entitled to $47 million in severance, stock options and enhanced retirement benefits.
CalPERS criticized the payments. ''All this is doing is putting more money in the pockets of management, not putting money back into the company to assure the long-term value shareowners require,'' Rob Feckner, head of CalPERS Investment Committee, said last June. CalPERS voted against the merger, but to no avail. The deal closed in November, creating the largest health insurer in the United States, now known as WellPoint Inc.
Such sweet deals for executives are exceedingly common. Last summer, for example, when Harrah's announced that it would acquire Caesars Entertainment for $5.2 billion, one of those who hit the jackpot in the deal was Wallace R. Barr, Caesars' chief executive. Under change-in-control provisions of his contract, Barr received almost $20 million. And if he resigned from Caesars ''for good reason'' after the two companies merged, the contract stated, he would be entitled to an additional $6.6 million. The merger is expected to close by the end of June. (Barr declined to comment.)
Another combination from last summer involved two banks, Wachovia and SouthTrust. Under the terms of the $14.7 billion deal, Wallace D. Malone Jr., the chief executive of SouthTrust, stood to receive $59 million in stock, options and termination awards over the next five years if he left the bank. His annual pension was approximately $3.8 million. He remains vice chairman at Wachovia. A spokeswoman for the bank and Malone declined to comment.
The single biggest factor behind these eye-popping numbers are stock options, which typically vest over a period of years but in a merger can be cashed in immediately. The 21 former officers and directors at Toys ''R'' Us, for example, are sharing $65 million in proceeds from the vesting of their options. (A spokeswoman for Toys ''R'' Us notes that Eyler has never sold a share of the company's stock since he took over as C.E.O. five years ago and that most of the directors have taken their pay in company stock. Thus, she says, the interests of the executives and directors are aligned with those of shareholders.)
But executives also receive other goodies in one lump sum following a merger. First they get a hefty multiple of their average base pay -- usually 2.99 times the amount. (Any more than that and a federal tax kicks in.) Corporate executives involved in a merger may also receive enhanced retirement benefits, like a crediting of their service to age 65, even if they are nowhere near that. Another common merger perquisite for top executives is the continuation of medical and life insurance benefits and allowances for financial counseling and outplacement counseling. Reimbursement of all legal fees can also be a part of a contract.
One apparent drawback to these enormous payments is the enormous tax bill they generate for executives. Happily for them, however, their contracts almost always require the companies to pay those bills. Enter the so-called excise tax gross-up provisions, which can be so colossal that, according to one pay expert, a major merger was scuttled not long ago because the cost of covering executives' tax bills generated by the deal exceeded $100 million. And while most companies claim that executive compensation is based on performance, supposedly aligning managers' goals with shareholders' interests, many of these huge payouts are triggered regardless of whether the executives performed well or not in the years before the deal.
''While much attention is focused on the failure of many mergers and acquisitions to create lasting shareholder value, less attention is paid to company performance leading up to the transaction,'' Tim Ranzetta, president of Equilar, a compensation analysis firm in San Mateo, Calif., says. ''It is not uncommon to see opportunistic transactions take place following a large drop in the target company's stock price or periods of chronic underperformance. It would seem illogical in situations like this that target executives would be 'rewarded' with a severance payout that can often approach three times their annual salary and bonus.''
One reason that shareholder outrage about these payments has been muted may be that few people, beyond the executives themselves and maybe the company's compensation committee, know how costly these pay deals are. Even with all the scrutiny of corporate governance in recent years, a full tally of what executives will earn under a change of control is undisclosed until the deal is struck.
Experts say that many compensation committees do not even understand the size of these pay packages because they do not routinely ask their consultants for detailed lists of the various pay components.
''Sometimes I think the boards themselves are shocked at what they've done, the astronomical dollar levels they've paid out,'' Pat McGurn of Institutional Shareholder Services says. ''That's why we encourage companies to do exactly this scenario -- what would happen tomorrow if you triggered the C.E.O. payout? Shareholders should force directors to sit down and have that 'holy cow' conversation.''
Does the Urge to Merge Ever Cease?
What may be most troubling about the lavish benefits and perquisites paid to executives is that they are doled out even as lower-level employees at the merging companies lose their jobs. ''One of the sine qua nons of a merger is that there is going to be some condensing of the operations,'' John Challenger, C.E.O. of Challenger, Gray & Christmas, an outplacement firm in Chicago, told me. ''So job cuts are automatic.''
For most executives that do deals, it is necessary to eliminate jobs after combining the companies' operations in order to clear the performance hurdles that investors demand. For example, the promise of the Hewlett-Packard and Compaq merger in 2002 was annual savings of $2.5 billion in operating costs; the company says it wound up saving more than $3 billion (ahead of schedule too). But those savings resulted ultimately in the loss of 17,900 jobs.
According to Challenger's firm, merger activity accounted for the elimination of almost 77,000 jobs in the first quarter of 2005, or 27 percent of the total cuts that were announced. Merger-related cuts in the first quarter were 17 percent higher than they were in all of 2004. Industries registering the largest job losses so far this year are telecommunications, defense and consumer goods.
The disparity between the way top managers and their lower-level colleagues are treated in a merger has the potential to create a backlash. ''I worry about merger-related job cuts,'' Robert Bruner says. But he adds that workers who have lost their jobs because of mergers have so far been able to find other jobs.
Merger manias do, of course, fizzle out. As is true of so many parts of the economy, they are cyclical. ''Merger waves seem to come up every 20 or 30 years or so,'' Richard Sylla, professor of business history at the Stern School of Business at N.Y.U., says. ''The great merger wave from 1898 to 1902 was when U.S. Steel was created. In the 1920's there were a lot of public utilities merging, and then we had another wave in the 1960's, which was the conglomerate merger wave.'' The current one, which began in the early 1980's, is the fourth such American fever of the last century or so.
In the 1960's, a combination of rising interest rates and investors' realizing that conglomerates were not necessarily the recipe for business success undermined that mania. The junk-bond-fed boom in the late 1980's ended when Michael Milken, at Drexel Burnham Lambert, drew prosecutorial scrutiny to his control of that part of the bond market. And sometimes government puts a stop to mergers: in the early 1900's, the government cracked down on a big railroad merger, Sylla notes, and in the 1930's regulations curtailed the mergers of public-utility holding companies.
What might end today's fever? ''Rising interest rates and falling stock markets'' could curb mergers, Bruner says. ''And either self-regulatory systems of accounting and industry watchdogs as well as government regulators may challenge practices that have grown aggressive during the height of the boom.''
Till then, however, we can count on more mergers, more money paid to executives
and fewer jobs for everyone else.
Gretchen Morgenson is a reporter and business columnist for The Times.