The Art of the Megadeal

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During slow economic growth, CEOs and boards often look to big M&A transactions to jump-start earnings. In 2011 so-called megadeals—transactions of $5 billion or more—grew five times as fast as the overall M&A market. But many boards remain skeptical about whether these deals deliver long-term value—a view fueled by the growing roster of failed mergers.

To see if this skepticism is valid, we analyzed 215 large mergers that took place across the globe from 2000 to 2010. We found that buyers were moderately successful, on average, with their stock outperforming the market by about 6% over two years. But behind this average was a huge dispersion: Half the deals led to long-term performance of at least 25% above or below the market.

Deals executed in down cycles actually perform better than other deals.

What distinguished the highly successful deals from the rest? Some factors are not surprising: Deals done within the buyer’s main business beat those done for diversification, and accretive deals (those projected to immediately increase the buyer’s earnings per share) outperformed dilutive deals (which lower EPS at the outset). Five findings, though, run contrary to beliefs commonly held by boards, and companies contemplating large acquisitions should keep them in mind. Our research shows that they can help differentiate transformative deals from the ones managers and investors live to regret.

Focus on the EPS Payback Time

Boards usually think about the immediate impact on EPS, but it’s also important to consider how long it takes for an initially dilutive deal to become accretive. Deals that boosted EPS within two years delivered long-term excess returns of 13%, while those that took longer underperformed the market by 17%—a swing of 30 percentage points.

Look Beyond the “Comps”

Boards considering mergers often look at “precedent deals” to learn the prices of similar acquisitions and to avoid overpaying. However, firms paying higher premiums than those in precedent deals outperformed the market by 12%, on average, whereas other acquiring firms slightly underperformed. Mergers are about benefits as well as costs, suggesting the need to supplement precedent analysis with a more fundamental assessment.

Don’t Protect Credit Ratings at All Costs

Although deals financed entirely by cash outperformed all-stock deals by 26%, they accounted for only a fifth of the deals we studied. Why so few? Boards are reluctant to jeopardize their companies’ credit ratings, but their caution is sometimes overblown: Firms that executed cash-financed deals, even at the cost of a credit downgrade, saw long-term excess returns of 15%, on average. Sacrificing a credit rating for the right deal can enhance value if it’s done prudently and with a clear plan for recovering financial strength within a reasonable period of time.

Understand Cross-Border Risks

Global mergers are popular. They can help companies expand into new markets and realign production and distribution strategies. We found that they perform as well as domestic mergers, with an important exception—global deals outside the buyer’s core sector perform very poorly.

Buck the Trend

Companies tend to pursue deals when business is good; 70% of the mergers we studied occurred during peak periods of the sector in question. Although it’s natural to be more confident when things are going well, deals executed in down cycles actually perform better, partly because lower stock valuations reduce the risk of overpaying.

A version of this article appeared in the April 2013 issue of Harvard Business Review.

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