How good are we at predicting the future more than five years out?

Generally speaking, not too good. How many of us saw the 2008 Credit Crunch coming? How about the stock market recovery of the last four years?

I can think of some particularly silly sounding statements I made during my career that demonstrated just how little I knew about the direction of the future (let alone it's magnitude). Here are a few choice predictions:

We'll always have a Highway Bill in the U.S., it's one of the few things that both parties can agree on because it benefits every state and congressional district. (prior to July of 2012, the last Highway Bill was signed in 2005, leaving a three year funding gap).
If corn prices would just get to $2.50 a bushel, we'll sell so much our only problem would be how to make it all. (Corn last year was at $7.50 per bushel. The part about the problem being making enough product was probably true).
All this talk about Weapons of Mass Destruction is just saber rattling. We're not going to invade Iraq. (Duh. That prediction was wrong in just a matter of months.)

Acquisitions

Sam Goldwyn once said: "It is difficult to make forecasts, especially about the future."

Nowhere have I seen this statement be more accurate than with acquisitions. The forecasts have usually barely been worth the paper they're written on, including the ones I've bought for myself.

The problem is, putting a forecast together to justify an acquisition is basically a fool's errand.

Think about components of the typical acquisition analysis. In most of these financial models, the "answer" is a "fair value" for the business which is arrived at by estimating the cash generated by the business in the future, and discounting those back using an expected rate of return.

Expected rates of return are a bit problematic, as they change over time. A 5% return from 2009 - 2010 would have been pretty good by most people's standards, although it might still not cover a firm's theoretical "cost of capital." Even coming up with this relatively simple estimate is like hitting a moving target.

A bigger problem, however is forecasting the projected cash flows. These are built based mostly on history (remember those prospectus warnings: past performance is no guarantee of future results), a few prognostications about the future of the economy, the industry, and/or the company, and a handful of rules of thumb. If you examine the accuracy of forecasts for your own business five years into the future (which you should, arguably, know more about than any acquisition candidate), the results would not inspire confidence.

In most models, somewhere around half of the value comes from cash flows out beyond year five -- the so-called perpetuity calculation This is particularly worrisome because small changes in assumptions there can impact the results dramatically.

In aggregate the financial model for an acquisition is a house of cards built on assumption piled on top of assumption. All it takes is for one assumption to be wrong and the entire model crumbles.

Fun Fact: I recently completed the second draft of SYNERGY, a novel dealing with the some of the problems with Acquisition Integration. I hope to have the book released in 2015.

Holding people responsible for Performance.

There is intense clamoring in the investment community and among senior management to hold people's feet to the fire, insisting they take "ownership" for "their" performance.

Yet where acquisitions occur, how reasonable is this?

I've seen many a senior executive's career wrecked by being shackled to an inaccurate acquisition forecast. The problem almost always comes from one of three areas:

The world changes in an unpredictable manner (a deep recession, for example), and senior management and/or the board of directors stubbornly demand delivery of the original forecast despite its present irrelevance.
Something big was missed in the original analysis. I've seen instances where some key assumption (receivables as a percent of sales, gross margins of a new product, competitive response) was just plain wrong. In these instances the typical senior management response is to lean on those responsible for implementation to compensate for the error and still deliver the original plan.
Something goes wrong in implementation. A key person is lost, a synergy doesn't end up working, some aspect of integration takes much longer than expected. While in these cases it is probably reasonable to apply pressure to the post-acquisition team to compensate for the problem, this is still often as much a problem with the original forecasting as it is with implementing.

The Scapegoat

One of the critical problems with being involved in acquisitions is the CEO and Board's fingerprints are usually all over these deals. I've witnessed many instances when the post-acquisition implementation was going sour, and senior executives heaped pressure and blame on an underling in an attempt to distance themselves from the impending disaster.

In most corporate environments, the implementation, not the strategy or forecast, will be where the blame falls.

How do you navigate through all these risks?

My advice here has to fall more in the category of "do what I say, not what I did." I loved doing acquisitions, and was rarely in doubt about my ability to deliver on the forecasts, no matter how wild they might have seemed in the cold, hard, light of day. Following that path, however, got me in plenty of trouble along the way.

Express your doubts and concerns early and vocally. This can be tricky because you don't want to develop a reputation as a "nay-sayer." Better that, however, than being overly optimistic. Look for vulnerabilities and ways to work around or offset them. As a rule, I'd recommend you spend twice as much time exploring the downside risks as you do the upside opportunities.
Make the project some else's. The biggest risks with any acquisition are on the implementation end. Avoid being responsible for leading the implementation, if at all possible.
Point out errors in the forecast as they develop. There will undoubtedly be plenty of unforeseen things that happen. Pointing these out may not get you off the hook, but it will help to put things in perspective.

My worst acquisition

Hands down, my worst deal experience was handling the post-acquisition integration of a company supplying highway components on the east coast. Before the time of my involvement and a few days after the deal closed, the company apparently received notification from another party that they were in violation of certain design patents. My predecessor wisely decided to avoid selling the product in question, and the matter was quickly settled with the third party.

Unfortunately, that didn't stop one of the States in the east from bringing debarment proceedings against the company when I was running it. To settle the issue, we ended up with a multi-million dollar remediation program (which was totally unnecessary), a terminated general manager, extremely high employee turnover, a punitive state-led quality control process, millions more in losses, and the ultimate closure of the business.

Yeah, I had more than a few sleepless nights over that entire episode. For the many, many hours spent dealing with these issues, I received nothing positive in return. In fact, I'm sure my stock with CEO and Board dropped, because I wasn't anywhere close to the original acquisition forecast.

While in principle, everyone acknowledged that the acquisition forecast for the business was completely irrelevant under the circumstances, that forecast was still occasionally trotted out for self-flagellation purposes. It became a ball and chain I just couldn't take off.

Conclusion:

Acquisitions are a high risk aspect of corporate life, one that can make -- but more often break -- a career. To the degree you can avoid them, you probably should. Where you must be involved, there is far less downside to conservatism than to optimism. When you're stuck with implementation of a forecast, hold on and prepare for a wild ride. 23.2

A House of Cards

Tom Spears

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