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By Pat Dorsey, CFA | 08-27-2010 10:44 AM

Big M&A: Better for Investment Bankers than the Market

If smart capital allocation is good for the market, most big mergers probably aren't, argues Morningstar's Pat Dorsey.

Pat Dorsey: Hi, I am Pat Dorsey, director of equity research at Morningstar.

As I'm sure you know, there is only three things a company can do with its excess cash. It can basically reinvest that cash back into the business. It can pay you a dividend or repurchase shares, basically return it to the shareholder. Or it can go out and buy another company--and that is what we're seeing quite a lot of lately with the bidding war out there for 3Par between Dell and HP, and a $7 billion deal for McAfee from Intel, one which could turn out that Intel is crazy like a fox, but we were frankly scratching our heads a little bit over that one. And then of course the Big Kahuna: $40 billion proposed takeout of Potash Corp. of Saskatchewan by BHP Billiton.

Now, the popular media likes to portray M&A as kind of good for the market. It's certainly good for investment bankers' pockets; there is no question about that. So it's probably good for the high-end jewelry market in Lower Manhattan.

I am not quite so sure that it's good for the market if you think about the market being a place where capital gets allocated efficiently, because of course the historical stats show that most mergers frankly stink. Most mergers do not create shareholder value. And generally, if you think about mergers being sort of two axes: size and its relationship to the existing business, the bigger the merger and the less well-related it is to the company's core business, the less likely it is to succeed. AOL/Time Warner, of course, being the poster child, but we can look at Tyco and CIT and tons and tons of examples like that. But in contrast, small deals by experienced acquirers in their area of core competency--you might think of a company like Illinois Tool Works, or ITW, that has lots and lots of deals every year and does very well at them, creates a lot of value from them--those tend to succeed.

But of course, if you're the CEO, and you're looking to go out and deploy lots of cash that's been piling up on your balance sheet, you are not looking for lots and lots of little deals. You're looking for the big score. You are looking for the transformative deal, which frankly I think the shareholders of the acquiring firm should be looking at with some skepticism. Shareholders of the acquired firms, of course, should be jumping up and down and selling as soon as possible. That's a whole separate ball of wax.

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