In corporate finance, a ‘divorce’ is sometimes the best decision

By Michael R. Malone

In corporate finance, a ‘divorce’ is sometimes the best decision

By Michael R. Malone
A newly released study, by Miami Herbert Business School experts on mergers and acquisitions, uses a social-finance lens to understand what doomed these partnerships.

In a recent study, Henrik Cronqvist, professor of finance at the University of Miami Patti and Allan Herbert Business School, and Désirée-Jessica Pély, who was a visiting scholar at the school in 2016, tracked a total of 1,365 mergers and acquisitions deals—high-stakes partnerships involving S&P 500 firms—over 27 years, from 1983 to 2010.

“Corporate Divorces: An Economic Analysis of Divested Acquisitions,” published in late July, determined that unforeseen “shocks’’ within the industry and cultural dissimilarities were primarily to blame for many breakups. 

“While there’s a bit of truth to both, we found that the evidence favors the second explanation—pre-M&A information asymmetries, e.g., regarding corporate culture,” said Cronqvist, who also serves as Bank of America Scholar and vice dean for Graduate Business Programs and Executive Education. 

“‘Shocks,’ however,” he explained, “have to do with disruptions in the industry or the economic landscape that neither company could have foreseen and that cause even a well-conceived strategy to go south.” The current COVID-19 scenario, though not studied, is an extreme example of a shock, he pointed out. 

Cronqvist explained that the study centered on two facets: descriptive—tracking the trends in the data relating to divestments—and analytical—exploring why companies would enter a partnership, then divest of some or all of the assets over time. 

“It was relatively easy to obtain the data about the deals themselves,” he said, “but the work to painstakingly track down the performances of the units and go through, deal by deal, to dissect what happened and why—that’s what took time and added such value to the research.” 

Yet after launching their study in 2016, a new question emerged. 

“We became very curious almost immediately to know if these were really failures—just because you broke up doesn’t mean it was a failure,” Cronqvist said. 

“When you buy something for $500 million and then sell it for $200 million, that’s a clear failure,” he said. “But if you’re a big company, like GE, and you buy a company that you make into one of your divisions, then sell it years later bundled together with other assets and sell it off, is that a failure? How do we know?” 

Firms may hide deteriorated assets to avoid revealing poor management decisions, he explained. 

Co-researcher Pély echoed the challenges of assessing failure and highlighted the parallels between the emerging field of social finance and the behaviors of individuals as it relates to partnerships. 

“There really are similarities between corporate and personal partnerships—that’s why we used the analogy to divorces,” explained Pély, who, after studying at the University, returned to her native Germany. She recently completed her Ph.D. in social and behavioral finance and now teaches at the Ludwig Maximilian University of Munich. 

“Not all corporate divorces are bad, some are necessary,” she said. “That’s mainly the case when you realize the industry is going down; it’s not a good fit anymore. And there are divorces because maybe it was a bad decision to get married in the first place—you didn’t do enough due diligence to investigate.” 

With corporate divorces, a thorough due diligence is recommended to reduce such information asymmetries. While industry and location knowledge are important, corporate culture is a crucial factor that needs to be assessed before entering a merger. 

Most previous studies regarding corporate culture have focused on cross-border partnerships, Pély pointed out. Because this study focused mainly on U.S.-based S&P 500 firms, a new measure was needed. And, lacking the means to effectively analyze the cultures of the firms, she explained that they introduced their own proxy—one that looks at cultural values and asymmetries on a regional level. 

Both researchers suggested that the study opened the door to learn more about how human behavior—the biases and tendencies of company leaders—impacts large decisions that potentially need to be corrected. 

They pointed to the not infrequent scenario where a CEO has made the decision to make an acquisition but then begins to see that it’s not working well. To protect the fact that the decision was not a good one, that same CEO maintains the assets—essentially to protect their reputation and to avoid revealing they made a flawed decision. A new CEO would simply divest of the asset, and the company would move on and be better off.

“Some CEOs are smarter than the rest—smarter in the sense that they don’t have reputational concerns or suffer from sunk cost fallacy [trying to recover a cost already incurred],” Pély said.   

“Hanging on to losers in order to protect your own career is a psychological phenomenon that we see on a pretty big scale,” Cronqvist added.