Shareholders are getting something of a better deal in the current M&A boom than they did the last time around. Indeed, our research suggests that 2006 came close to a ten-year high as measured by the value (as a percentage of deal activity) that takeovers created for shareholders. But with no end in sight to the spending frenzy, boards and managers will need to demonstrate steady nerves if their newfound discipline is to hold. Signs that it’s being tested are already evident.

To gauge trends in the value being created through M&A, we reviewed nearly 1,000 global mergers and acquisitions, valued at more than $500 million, that occurred from 1997 to 2006. By examining stock price movements shortly before and after each deal was announced, we were able to assess how financial markets viewed its worth. While such “announcement effects” are by no means a perfect measure, academic research has shown them to be a good indicator of long-term value creation.¹

Our analysis shows that the value created by deals in the current M&A boom (2003 to 2006), for the buyer and the seller combined, averaged some 6 percent of the transaction value. This figure contrasts starkly with the boom of 1997 to 2000, when it averaged less than 2 percent. In addition, while an alarmingly high 58 percent of all acquiring companies still appear to be overpaying for acquisitions, that figure is an improvement on the more than 70 percent that were doing so at the peak of the previous boom.

Why are shareholders getting a better deal? Lower acquisition premiums are one explanation. In the previous boom, the price premium was around 30 percent of the pre-deal price, on average, compared with slightly more than 20 percent now. A second factor is the greater proportion of cash deals—acquirers paid cash for nearly half of the deals from 2003 to 2006, compared with 20 to 30 percent in the previous boom. Markets like cash deals for tax reasons and because such acquisitions signal management’s confidence in future earnings potential, especially if companies raise cash through debt.

A third factor is the greater number of hostile deals. In 2006 unsolicited bids totaling more than $500 billion were announced—almost four times the previous record, set in 2004. Markets believe that unsolicited bids create more value than friendly ones. The unsolicited deals in our sample created an average value of 11 percent, compared with 2 percent for friendly deals. The gap is significant, even adjusting for the fact that hostile deals are more often made in cash.

What might explain this greater degree of value creation? For one thing, boards anticipating a possible takeover fight typically scrutinize a bid’s details more closely before they approve it. Hostile bidders are also less likely than a friendly bidder to compromise on governance, restructuring, and other postmerger issues, and this gives them a freer hand to create value.

That said, unsolicited deals are not easy to pull off and so come with a health warning. In 2006 only around half of the announced unsolicited bids were eventually successful. What’s more, going hostile may damage the acquiring company’s reputation, and failed attempts sometimes leave the bidder itself vulnerable to a takeover.

The apparent improvement in the discipline of boards and management teams is particularly impressive given the increasing competition from private-equity firms, which now represent more than 20 percent of all global merger activity. But the resolve of boards and management teams will be tested further, as private-equity firms, which in the past managed to pay a lower premium for acquisitions than public companies did, are now paying more to win deals in a crowded market: the median premium for a private-equity acquirer increased from 11 percent in 2004 to 22 percent in 2006 and is now near the average premium for corporate acquirers—around 25 percent. Will public corporations soon be tempted to pay more just to stay in the game?

Our research already shows discipline slipping somewhat in recent months: for example, the average value created by deals in the second half of 2006 was about 7 percent, down from more than 10 percent in the first half. The proportion of acquirers overpaying is also on the rise. It would be wrong to set too much store by these half-year comparisons, given the limited number of transactions per period. But now is a good time for executives and boards to remind themselves of how to create value through M&A.

Any deal’s value creation depends on the potential synergies (cost, capital, revenue, and growth) it produces and the extent to which the premium paid cancels out those gains. Synergies, of course, must be rigorously quantified. The likelihood of actually realizing forecast synergies also needs to be assessed, along with such offsetting factors as lost revenue. The projected value created must then be weighed against any premium paid over the target’s intrinsic value rather than against the current share price, which often reflects takeover speculation and too often becomes the reference point in an M&A boom. The management of a business after a merger naturally plays a role in longer-term value creation, but unless the price is right even the best postmerger efforts will be wasted.

To stand a good chance of reaping postmerger rewards, companies must exert discipline in negotiating deals. Amid the excitement of an M&A fest to which all sectors in all parts of the world have been invited, CEOs and boards need steady nerves. Sometimes, walking away from a deal or becoming a seller can prove to be the best way to secure value for shareholders.