Longer-Odds Strategies for Creating Value from Acquisitions  599 Novartis shifted its strategic focus to innovation in its life sciences busi- ness (pharmaceuticals, nutrition, and agricultural) and spun off the $7 billion Ciba Specialty Chemicals business in 1997. Organizational changes included reorganizing research and development worldwide by therapeutic rather than geographic area, enabling Novartis to build up a world-leading oncology franchise. Across all departments and management layers, Novartis created a strong performance-oriented culture, supported by a change from a seniority- based to a performance-based compensation system for its managers. Buy Cheap The final way to create value from an acquisition is to buy cheap—in other words, at a price below the target’s intrinsic value. In our experience, how- ever, opportunities to create value in this way are rare and relatively small. Although market values revert to intrinsic values over longer periods, there can be brief moments when the two fall out of alignment. Markets sometimes overreact to negative news, such as the criminal investigation of an executive or the failure of a single product in a portfolio of many strong products. Such moments are less rare in cyclical industries, where assets are often undervalued at the bottom of the cycle. Comparing actual market valua- tions with intrinsic values based on a “perfect foresight” model, we found that companies in cyclical industries could more than double shareholder returns (relative to actual returns) if they acquired assets at the bottom of a cycle and sold at the top.19 However, while markets do provide occasional opportunities for compa- nies to buy below intrinsic value, we haven’t seen many cases. To gain control of the target, the acquirer must pay the target’s shareholders a premium over the current market value. Although premiums can vary widely, the average premiums for corporate control have been fairly stable, near 30 percent of the preannouncement price of the target’s equity. For targets pursued by multiple acquirers, the premium rises dramatically, creating the so-called winner’s curse. If several companies evaluate a given target and all identify roughly the same synergies, the one who overestimates potential synergies the most will offer the highest price. Since the offer price is based on an overestimate of value to be created, the supposed winner over- pays—and is ultimately a loser.20 A related problem is hubris, or the tendency of the acquirer’s management to overstate its ability to capture performance improvements from the acquisition.21 Since market values can sometimes deviate from intrinsic values, manage- ment must also be wary of the possibility that markets may be overvaluing a 19 T. Koller and M. de Heer, “Valuing Cyclical Companies,” McKinsey Quarterly, no. 2 (2000): 62–69. 20 K. Rock, “Why New Issues Are Underpriced,” Journal of Financial Economics 15 (1986): 187–212. 21 R. Roll, “The Hubris Hypothesis of Corporate Takeovers,” Journal of Business 59 (1986): 197–216. 600  Mergers and Acquisitions potential acquisition. Consider the stock market bubble during the late 1990s. Companies that merged with or acquired technology, media, and telecom- munications companies saw their share prices plummet when the market re- verted to earlier levels. Overpaying when the market is inflated is a serious concern, because M&A activity seems to rise following periods of strong mar- ket performance. If (and when) prices are artificially high, large improvements are necessary to justify an acquisition, even when the target can be purchased at no premium to market value. Estimating Operating Improvements As we’ve been discussing, the main sources of value created through M&A are the cost, capital, and revenue improvements, often referred to as synergies, that the combined company makes. Rarely does a cheap purchase price make the same sort of difference. So estimating the potential improvements is one of the most important success factors for M&A—along with executing on those improvements once the deal is completed. Before getting into the estimation, it’s worth emphasizing that estimat- ing improvements from combining corporate entities is not a one-time event. It’s done multiple times: first, before negotiations even begin; second, during negotiations, as the acquirer gets more information; and finally, after the deal closes. Some companies give short shrift to the last step, but it is critical. Some of our colleagues found that almost 50 percent of the time, pre-closing esti- mates failed to provide an adequate road map for fully identifying improve- ment opportunities.22 We find that companies do a much better job of realizing cost savings than revenue improvements. McKinsey’s Merger Management Practice analyzed 90 acquisitions and found that 86 percent of the acquirers were able to capture at least 70 percent of the estimated cost savings.23 In contrast, almost half of the acquirers realized less than 70 percent of the targeted revenue improve- ments, and in almost one-quarter of the observed acquisitions, the acquirer realized less than 30 percent of the targeted revenue improvements. Estimating Cost and Capital Savings Too often, managers estimate cost savings simply by calculating the differ- ence in financial performance between the bidder and the target. Having an earnings before interest, taxes, and amortization (EBITA) margin 200 basis 22 O. Engert and R. Rosiello, “Opening the Aperture 1: A McKinsey Perspective on Value Creation and Synergies” (working paper, McKinsey & Company, June 2010), www.mckinsey.com. 23 S. A. Christofferson, R. S. McNish, and D. L. Sias, “Where Mergers Go Wrong,” McKinsey Quarterly, no. 2 (2004): 93–99.