Why Make An Acquisition?
“It is not the answer to all issues!”
Acquisition as a Strategy
Before you make an acquisition, management needs to be clear on the company’s business plans and strategy so that an acquisition complements the strategic plans. Clarification of why investments in organic growth would not be as successful as acquisition and what an acquisition should bring to the table are very important to ensure there is laser focus on the M&A strategy and selection to ensure management’s time is not unduly diverted and resources are properly allocated.
There is no magic formula to make acquisitions successful. Each transaction must have its own strategic logic. Less successful acquisition strategies tend to occur where there are vague strategic rationales. Also, stated strategies may not even be the real one; acquirers typically talk up several strategic benefits from acquisitions that are really only about cost cutting. When evaluating acquisitions, you need to ask yourself “what value are you creating?”. Even if you have the perfect rationale for acquiring a company, you will not create value if you over pay for the acquisition.
Rationales for Acquisitions
Buyers typically buy businesses for the following strategic reasons:
Improve The Targets’ And Acquirers Performance
Improving the performance (e.g., by increasing margins or cash flow or introducing revenue enhancinginitiatives) of the company is one of the most common value-creating acquisition strategies which is typically used by private equity firms. It is generally easier to improve the performance of a low rather than high performing business but there are considerable risks involved in buying a distressed or significantly non-performing business.
There is further scope in generating synergies and enhancing revenue by building on the strengths of each business unit be it from strengthened market position, better management and infrastructure, technologies or enhanced scale especially if you are merging businesses of sub scale. Size per se is not what creates a successful roll-up; what matters is the right kind of size. For example, a company with multiple shops in a few states may be a better acquisition target than a company with individual shops in multiple states.
New Customer Base
An acquisition can bring access to a new customer base for the acquirer and the acquiree and thus allow a business to (cross) sell its products or services to a larger customer base more quickly and effectively than could be developed organically. For example, relatively small companies with innovative new products (e.g., pharmaceutical companies) have difficulty reaching certain customers; an acquisition by a larger mature company operating in the same market may be able to easily rectify this problem.
However, it can be very difficult to evaluate how “sticky” the customer base is and how open the customer base is to new products and services especially from new companies that have not been part of the same group until recently.
New Skills Or Technologies
Acquisitions can be used to close gaps in skills, service offerings and technologies; this strategy was used very successfully by Cisco Systems and thus allowing it to assemble a broad line of networking products. Facebook has acquired more than 40 companies with its largest acquisition being the purchase of WhatsApp at a cost of $19 billion. Facebook also purchased the defunct company ConnectU in a court settlement and acquired intellectual property formerly held by rival Friendster. Most of Facebook’s acquisitions have been ‘talent acquisitions’ and acquired products are often shut-down. Facebook CEO Mark Zuckerberg has stated that “We have not once bought a company for the company. We buy companies to get excellent people… In order to have a really entrepreneurial culture one of the key things is to make sure we’re recruiting the best people. One of the ways to do this is to focus on acquiring great companies with great founders.”
Consolidate To Remove Excess Capacity From Industry
As industries mature, they typically develop excess capacity. In the chemical industry, for example, companies are constantly looking for ways to get more production out of their plants, while new competitors continue to enter the industry. Management often finds it easier to shut plants across the larger combined entity resulting from an acquisition than to shut their least productive plants and end up with a smaller company. Reducing excess in an industry is not just about production capacity; it is also about less tangible forms of capacity like (i) sales force as the combined product portfolios of merged companies change and they rethink how to interact with their customers doctors; or (ii) R&D capacity as acquired companies utilize more productive ways to conduct research and prune their portfolios of development projects.
While there is substantial value to be created from removing excess capacity, the buyer must be careful that the value created by this strategy is not earned more by the sellers especially as the risk is borne by the buyers.
Defensive And Build And Buy Strategy
Acquirers often make opportunistic acquisitions to prevent a present or new competitor gaining a competitive advantage and/or enhanced scale. By increasing scale, the acquirer makes it more difficult for a new competitor to enter the market at a later date as the acquirer becomes more dominant in the market place and has more resources to look after its customer base.
Acquirers sometimes believe that a consolidation will lead to competitors focusing less on price competition and result in improved performance; however, unless the industry consolidates to just three or four companies and can keep out new entrants, pricing behavior does not generally change.
Management also implements a build and buy strategy in the hope that a larger business will have a higher Price Earnings ratio which will lead to enhanced returns for its shareholders.
Acquires also look to acquisitions to diversify products, revenue streams and risks. For example, Cadbury, who sold chocolates mostly around the holidays and Easter periods, acquired Schweppes, who sold fizzing drinks which were much more popular in the hot summer months when it was more difficult to sell chocolate. In turn, Government contractors look to buy other similar businesses so that they have a less concentrated customer base.
While the acquirer has to be careful it is not acquiring a business which management does not understand (e.g., GEC acquisition of Marconi), this strategy of diversification can reduce the Beta risk of a company and increase the valuation in the new group. Correspondingly, a diversified portfolio of companies also leads to internal competition for resources, investment and financing with examples of well performing businesses being required to fund the operations of a growing and less profitable business; this scenario may lead to value destruction.
Early Stage Companies
Another strategy, which is very difficult to successfully implement, involves making acquisitions early in the life cycle of a new industry or product line, long before most others recognize that it will grow significantly. Johnson & Johnson pursued this strategy successfully in its early acquisitions of medicaldevice businesses, but one need only look at returns of Venture Capitalists to see how difficult it is to be successful at picking start-ups especially if you are only doing a couple of acquisitions and you are not prepared to help in the development of the growing business.
Buying Cheap Or Distressed Acquisitions
Some acquirers look to buy companies without a formal auction process (“under the radar screen” or “not in play” situations) being undertaken at a price below the company’s intrinsic value. Such opportunities are rare and relatively small but there are also instances in businesses which operate in cyclical industries where the companies are often undervalued at the bottom of a cycle (e.g., the housing market and banks during the financial crisis). Also, some markets overreact to negative news, such as a criminal investigation of an executive or the failure of a single product in a portfolio with many strong ones; this can lead to good opportunities to buy companies cost effectively.
While markets do throw up occasional opportunities for companies to buy targets at levels below their intrinsic value, acquirers need to be very patient and disciplined if they are pursing this strategy; it is very easy to get bored waiting for a suitable opportunity.
Transformational mergers are rare where both the target’s and acquirer’s performance is collectively improved and the acquisition is used as a catalyst for change. To achieve this scenario, management must be highly focused in not just identifying the right target but also in the post-merger activities and with a work force which is adaptable to change to achieve the right level of synergies and new culture.
When looking at acquisitions, management need to understand the upfront costs in terms of management time and the knock on impact on its business, due diligence and financing and to the appreciate not all acquisition strategies are consummated first time. It takes time to find the right target.
It is also important to seek approval for your acquisition strategy from not just the Board of Directors but also from other stakeholders like management, key shareholders and financers in advance, while still maintaining confidentiality, as without the buy in of all key stakeholders, then your acquisition strategy is unlikely to add to shareholder value and be completed efficiently.
A well-thought through acquisition strategy, with very specific criteria, needs to be clearly set to that management are focused on the right acquisition in terms of size, sectors, geographies, profitability and other skills and resources that the a business needs to bring to the table.