Is the mega-merger falling out of fashion?

One key characteristic of economic and financial booms seems to be a rising enthusiasm for giant mergers and takeovers. We saw this in the Dot.com boom of 2000 (which ended with the ‘Worst Deal in History’ - the merger that created AOL Time Warner). The more recent boom that came to a crashing halt in 2008 featured more record-breaking takeovers, many of which were associated with the boom in private equity finance and nearly all of which were justified in the name of economies of scale.

So the collapse of the Prudential’s attempt to buy AIA of Asia for more than £24bn is an important event. Is big no longer beautiful?

Who blocked the merger? Not the management, who were enthusiastically up for the deal. They saw big strategic gains and yes – economies of scale to be captured. It probably felt quite exciting too.

No – the rebels were from ‘institutional’ shareholders - groups like pension funds, who own a big slice of the Prudential. They dared to take on the management, and seem to have won the day. Some commentators think this is a momentous turnaround in the way big PLCs will run in the future.

In a nutshell, these institutional shareholders thought the AIA purchase price was too high. The implications are significant. Robert Peston thinks that the Pru’s chief executive and chairman may have to resign, having wasted hundreds of millions of pounds of shareholders’ money on a deal that won’t happen.

And more importantly, it shows that investors have become much less supportive than they were of companies that want to become global giants through takeovers - since gigantism has often led to monstrous blunders.

After the woes of those enormous banks - from Citigroup to Royal Bank of Scotland - and the current humiliation of bid-bloated BP, it’s not surprising that shareholders now see big not as beautiful but as grotesquely, dangerously ugly.

What investors have learned is that there are limits to the benefits of geographic and product diversification. When a company becomes bigger and less reliant on a limited number of products, services or customers, there is reduction in the risk of serious setbacks – but only to a point where diseconomies of scale set in: the whole business becomes too complex to handle (see below). A number of massive global businesses - especially but not exclusively in the banking sector - grew well beyond the limits of management sophistication. All kinds of disasters have followed.

None of this is really new or surprising: back in November 2007 we asked why Mergers and takeovers rarely work out. The Today programme on BBC radio carry an interview with a representative of the rebellious shareholders who agree that the move was strategically exciting but the asking price was just too high. Economists refer to this as the Winners’ Curse - and there are plenty of examples of ambitious takeover bids where the purchaser eventually pays a price way above true value - leaving a trail of destroyed shareholder value in its wake.

Extra evaluation point: It’s worth rembering that in some industries, size really does matter. Back in September 2009 a blog highlighted those industries in which big is best. Check it out at Back And Bigger Than Ever.