What is in Question Now at Governance on Overseas M&A: Optimizing the decentralization and centralization of management as the key

MIYAJIMA Hideaki Faculty Fellow, RIETI

There have been notable cases of overseas mergers and acquisitions (M&A) having a significant impact on corporate management. Toshiba Corporation has posted considerable losses due to a downturn in the business performance of Westinghouse Electric Company of the United States. Japan Post Holdings had a massive amount of goodwill generated in relation to its logistics subsidiary Toll Holdings of Australia, and ended up with impairment. Overseas M&A resulting in the posting of large losses, impairment, and withdrawals are not anything new. This article will examine why there are such notable losses, and possible solutions for this, from the perspective of corporate governance.

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The first boom in overseas M&A took place in the second half of the 1980s, the period which is often referred to as the bubble economy. Against the backdrop of fund surpluses within Japan, there were a series of acquisitions centering on real estate and distribution firms that had become comparatively inexpensive due to the strong yen. Nevertheless, there were many cases of withdrawals resulting in large losses.

The second boom progressed in parallel with the first domestic M&A boom since World War II, which started in the early 2000s and peaked in 2006-2008. Factors behind this include technological innovation and the maturation of domestic demand and organizational changes related to holding companies, which enabled expeditious M&A.

The third boom started in 2011, and while domestic M&A stagnated, there was a sharp increase in large overseas M&A against the backdrop of the strong yen. With domestic markets shrinking, overseas M&A were viewed as the only option for maintaining growth. Furthermore, starting from Abenomics in 2013 when domestic conditions for funding took a favorable turn, there were increases not only in the areas of communications, pharmaceuticals, and the wholesale business—in which there is much M&A activity—but also finance, insurance, and machinery.

Meanwhile, in M&A, it is well recognized that the acquirer earns a profit about half of the time. In an analysis of overseas M&A by the auditing and consulting firm Deloitte Tohmatsu Group (2008, 2010, 2013), it was estimated that, on average, 30% of cases are successful (meaning that the objective of the acquisition was achieved) and 21% of cases are unsuccessful (meaning that the objective was not achieved). Thus, it appears that overseas M&A are high-risk ventures.

The reasons that the risks are high include the fact that since information is insufficient overseas, scenarios for creating value after acquisitions would be imprecise, and more importantly the fact that excessive premiums are often paid for acquisitions. The Figure below shows the representative examples of 34 companies involved in recent major overseas M&A where the premium is reported and their averages of premium, etc. The highest premium relative to the stock price before the acquisition was 123%, which was in the case of Sumitomo Dainippon Pharma's acquisition of a Canadian company, and the average was slightly below 50%.

The sources of the premiums lie in time-buying effects, acquisition of human resources, know-how, technologies that one's own company is lacking, and post-acquisition synergies, and the hope is that such effects will boost the company's value by an amount higher than the premium. Nevertheless, there is a strong tendency for the premium to exceed the value of the anticipated synergies.

First of all, in overseas M&A, competition with other companies in the same business often occur. Also, companies aiming for overseas development accept rising acquisition prices due to their hope of realizing the acquisition. Furthermore, there are also many cases in which companies faced with limited domestic growth opportunities have sufficient internal funds and a high capacity for borrowing, and this makes the presentation of high premiums a possibility.

Figure: Examples of Large Overseas M&A and Acquisition Premiums
Figure: Examples of Large Overseas M&A and Acquisition Premiums
Source: RECOF Corporation, etc.; Among overseas M&A of 50 billion yen or above in 2005 through 2016, 34 cases in which the premium is known.

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As such, with M&A, there is the potential for excessive payments, and, in order to curb this, effective corporate governance is essential. Nevertheless, when there is an overseas M&A whereby extensive preparations have been made under the leadership of the chief executive officer, internally making a decision to courageously withdraw right before the conclusion of the deal is not easy. Under such situations, external governance is important.

The first candidate to encourage a reexamination of the transaction should be the fund provider. Nonetheless, as mentioned earlier, in recent years, many overseas M&A have been financed with internal funds, and as they are excellent revenue opportunities for financial institutions, it is unlikely that such candidate will become a constraining factor. The next candidate should be the institutional investor. In many cases, stock price response to an acquisition with a high premium is negative. In the United States and the United Kingdom, institutional investors put the brakes on M&A with excessive premiums. Nevertheless, in Japan where block shareholding of institutional investors is not common, there are limited cases in which investors overturn decisions to carry out M&A via dialogues and the exercising of voting rights.

Going forward, the role of curtailing M&A will likely be fulfilled by independent directors invited from outside the company, etc. Important M&A are matters decided on by the board of directors, and accountability for inappropriate M&A approvals lies with the directors. When Olympus Corporation acquired a company from the United Kingdom in 2008, it recorded a large premium and compensation for relevant parties in order to dispose of massive off-the-book debts. This acquisition was approved by the board of directors without any significant objections, and this became a scandal after the misconduct was discovered.

In the recent introduction of the Corporate Governance Code, one expected function of independent directors is the appropriate monitoring of M&A. On the company side, the rationality of M&A, including their premium levels, is explained to independent directors, and the independent directors proactively express their opinions. As such, for companies that view overseas M&A as central to their growth strategy, appointing human resources that possess experience and expertise related to overseas business as independent directors is essential, and independent directors can be expected to fulfill the two roles of giving appropriate advice regarding M&A and putting on the brakes with regard to excessive cases.

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A large part of whether M&A succeed or fail depends on how the acquired company is reorganized after the merger (post-merger integration; PMI). In the case of overseas M&A in particular, the management and labor practices of the acquired company will greatly differ from those of the buyer, and there will be geographical constraints related to guidance and management, so compared with domestic M&A, the difficulty of governance is amplified.

Generally, there is a strong tradeoff between centralization in which the acquiring company strengthens its control of the acquired company, and decentralization in which the independence of top-level management is maintained. If centralization is carried out by securing majority at board of director meetings, etc., this will not only increase overhead and reduce the acquired company's decision-making speed, but also spur excellent human resources to leave. If independence is excessively preserved in order to avoid this, it will not be possible to fully prevent the loss of control over the top-level management of the acquired company, and to realize enough synergies for the group as a whole.

It seems that in order to resolve this tradeoff, an urgent and continuous task for companies carrying out overseas development based on M&A is finding the optimal combination of centralization and decentralization. Companies that have achieved globalization through a series of overseas M&A, such as Japan Tobacco Inc., have built unique systems for delegating authority. Currently, at companies that have started carrying out overseas M&A and are faced with related management problems, there is a general tendency for the management of overseas subsidiaries to be overly decentralized, and there are remarkable cases of companies being purchased and then left uncontrolled.

Going forward, in order to realize synergies, companies that have carried out M&A will need to strengthen centralization, and the primary key to this will be human resources. Domestic demand-based companies in particular are looking to overseas M&A as a growth strategy, and in the case of running overseas business with domestic business in an integrated manner, such companies will run into bottlenecks, such as failing to cultivate human resources that can handle the management of overseas subsidiaries. Thus, there is a need for the appropriate designing of control that combines the diversification of human resources including foreigners in management departments and the dispatching of outstanding human resources who have gained management experience at domestic group companies.

The second key is to clarify numerical targets and evaluation indices for monitoring in order to appropriately carry out the appointment/dismissal and decide on management remuneration that is at the core of the governance of subsidiaries. In many overseas M&A—in which there are difficulties regarding reorganization after the acquisition—there are notable cases of limiting evaluation indices to net profit such as return on assets (ROA), and thus synergies are not fully realized. Hereafter, it will be necessary to clarify objectives and indices related to synergies with group firms through introducing products and technologies transfer, and to give overseas subsidiaries the authority to make decisions regarding policies for realizing this.

>> Original text in Japanese

* Translated by RIETI.

June 6, 2017 Nihon Keizai Shimbun

September 5, 2017