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Note to CEOs: Most mergers don't pay

May 2, 2012: 5:00 AM ET

Nuff said?

A NBER study finds that most corporate deals turn out badly.

FORTUNE -- Beware of Wall Streeters bearing mergers and acquisition advice. That's the takeaway of a new study, and investors should take note as well.

The study by professors at the University of California, Berkeley, concludes that acquisitions, while nearly always initially cheered by investors, end up hurting a company, and in particular its share price, in the end. Winning by Losing, which was released this week by the National Bureau of Economic Research, found that following an acquisition the stock of that company tends to underperform shares of similar companies by 50% for the next three years. Another finding of the study: Deals done in cash, which is often considered a more conservative way to pay for acquisitions, tend to do worse than deals done for stock. If an acquiring company doesn't want its new owners' shares, you shouldn't either.

There are tons of examples of deals that have gone south - the one done by Fortune's parent company Time Warner at the height of the dot.com frenzy was a particular doozy. But despite the many bad deals, economists have generally thought mergers are beneficial for companies. Afterall, why would so many of them get done. Most deals, at least from the acquirers' perspective generally get a good reception in the market. What's more, proving otherwise is a hard thing to do. How do you know how a company would have performed without the deal?

To get around that problem, the two Berkeley professors, Ulrike Malmendier and Enrico Moretti, and a professor from the University of Amsterdam Florian Peters looked at situations where there were hotly contested acquisitions. They then compared the winners of the acquisition bidding war to a similar company that had lost out. What they found is that while the shares of the pairs of companies had tended to perform rather similarly before the acquisition, after the deal the prospects of the two companies diverged, with the company that had made the acquisition performing much more poorly than the company that did not.

You could argue that in contested bids acquirers tend to be pushed to pay more, and therefore end up with a worse deal than usual. But the professors compared what was paid in the contested deals they looked at and acquisitions where there hadn't been multiple bidders and found that the valuations put on the acquired companies were about the same. So an acquisition may fail because the acquiring company overpays, but if that's the case, that's a problem with all deals, not just when there is a bidding war.

What does this mean for Wall Street? I-banks have been criticized for many of the things they did during the financial crisis. Some have questioned whether the dicing up of mortgages added any value to the economy. Perhaps on the first go around with mortgage bonds. But once Wall Street got to creating credit default swaps on synthetic tranches of mortgage collaterlized debt obligations, no way. If anything, the economy and the 99% ended up worse off because of all those Wall Street deals. Here, too, it's not clear the I-banks' M&A business is adding any real value to the economy. The good news is that there is no evidence that bankers are pushing companies to do these deals. CEOs are more than happy to launch into ill-fated combinations all on their own. Nonetheless, Wall Street is complicit in the game, and makes plenty of money off it.

All this comes at a time when M&A deals have slowed considerably. According to Dealogic, this year has had one of the slowest starts for corporate combinations in recent history. The first few months of 2009 were slightly worse, but only slightly ($777 billion then vs. $800 billion today) and that was during the height of the credit crunch. So is there a hope that CEOs have finally learn that the urge to merge doesn't pay? Not likely.

"Executives always think this time will be different," says co-author Malmendier. "Yes, others have failed in the past, but I can do better." The real problem it seems is overconfidence. Unfortunately, that's a quality that is in high supply among CEOs.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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