M&A: The Price of Overpaying for Past Performance

As we approach the end of the major league baseball season, it’s still uncertain (at this writing) who will end up in the World Series. But one tradition that seems to hold up, year after year, is “buyers’ remorse” of general managers who pay astronomical sums to sign or extend the contract of superstars whose subsequent performance doesn’t nearly justify their 9-figure contracts.

Here are two examples:

In March 2019, 27-year old former Los Angeles Dodgers infielder Manny Machado signed a 10-year, $300 million deal with San Diego. And how has this deal paid off for the Padres? Well, other than marquee value, not much. So far, Machado’s batting average, runs batted in and home run count are well below his 2018 stats, while his strikeout count is higher. His wonky sabermetrics stats like Offensive Wins Above Replacement are down as well. Heck, he didn’t even make the All-Star team this year. On the other side of the country, we have the horrible $145 million contract extension the Boston Red Sox coughed up this year for left-handed starter Chris Sale. The former ace had his best year in 2017 but struggled during the second half of the 2018 season before redeeming himself by fanning three Los Angeles Dodgers (including Marchado) in the ninth inning of game 5 to win the World Series for the Sox. So, how did Sale fail to earn his keep in 2019? By starting his season 0 for 4 and ending with a career low 6-11 record before the chronic inflammation that has plagued his tenure with the Sox finally ended his season. I could go on and on about other similar contract-signing disasters (just where is $95 million Pablo Sandoval these days?). So what’s the lesson here? It’s dangerous to overpay for past performance. Mutual fund investors see this warning on every prospectus, brochure and ad. But it’s also one that asset managers who are looking for acquisition candidates need to take seriously as well. It’s all too tempting to speculate about what buying a top-rated asset manager could do for your reputation, let alone your AUM-boosting potential. But there’s a huge risk in paying far too much for a fund’s track record that may be more the result of luck rather than skill. Or one that, for reasons known or unknown, might not continue once the firm and its personnel come into the fold. Before you jump into any big deal, there are some key things you need to consider first.

Is performance for realor a fluke?

Sometimes all it takes is a few shrewd big trades for a middling fund to scale to the top of the performance charts. Or the addition of one or more all-star analysts. Or a change in their investment process or research and trading technology. Or a sudden influx of assets that gives them greater flexibility to make big trades. As a buyer, you need to dig behind the impressive numbers to figure out what really is driving their success. And whether it’s sustainable in an environment where the market might not be as accommodating.

Does the company have its marketing in order?

There are plenty of smaller “hot funds” that relegate marketing and sales to the back burner, counting on word-of-mouth and media buzz to drive inflows. If their web site, marketing collateral and sales decks make a bad impression, you’ll have to devote time, money and resources to get them up to your firm’s standards.

Would an acquisition dispel the “magic’?

The best smaller fund companies tend to have a positive “clubhouse mentality” where investment professionals generally share similar values, personalities and workflows. But would acquiring them potentially disrupt this balance? Would employees resent losing their independence? Could a clash in corporate and cultural values drive the firm’s best thinkers to jump ship? Could a potentially lengthy acquisition and integration process disrupt the investment routines that drove their success? Would there be a risk of investors bailing out?

Pay for potential, rather than past performance

An asset manager with a great track record will certainly want to get the best price from any potential buyer. But if you go head first into a blockbuster deal without fully considering the risks of such a venture, or specifying certain conditions (like requiring the firm’s best people to commit to staying with you for at least 3 years and/or signing non-compete agreements), you could end up with a money-losing, reputation-damaging albatross on your hands. Related: The Yellow Brick Road Towards Thought Leadership