Acquisition Rewards for the Dedicated Acquirer (Part II)

Experienced acquirers like Pfizer Inc., Cisco Systems Inc., and Newell Rubbermaid Inc. have developed world-class m&a capabilities. For these companies, m&a expertise has become a competitive advantage in its own right. But what about a company that does not have deep experience in m&a or that is trying to do a kind of acquisition that it’s never done before? How does a company become a successful acquirer? Companies that want to pursue acquisitive growth need to develop three key capabilities. * Embedding of m&a strategy in a comprehensive growth strategy; * Development of a far more rigorous approach to the valuation and pricing of potential targets than typically takes place in most companies today; and * Learning how to break the compromise between speed and thoroughness in postmerger integration. It is striking how frequently executives take what is largely a reactive approach to m&a. A macroeconomic turn, a surprise auction, or an accelerated consolidation by competitors or customers catches management off guard. The board demands action, or a bidding deadline looms. Then, like a clocked chess match, moves – and mistakes – rapidly unfold. Executives focus on the deal at hand rather than on the total universe of options. They make decisions without fully considering their impact. Often, it is not until after the deal is done that a strategic rationale is made up to justify the acquisition to the stock market. As a result, opportunities and shareholder value are squandered. For all these reasons, the first step toward becoming a successful acquirer is to define a growth strategy and determine the role of m&a in achieving it – in advance of bidding on any particular deal. It’s important to dedicate resources and time to fully understand the options well ahead of the emergency board meeting, the offering memorandum, or the lead story in the Financial Times or The Wall Street Journal. Company executives need to ask these questions: * What are the prospects for organic growth in our core business? * Are there more attractive growth paths than reinvesting in the core? If so, how far afield should we look? * What are the best means of entry? * If the answer is acquisition, how can we make sure that we have the necessary capabilities? Only when they have detailed answers to such questions will a company’s executives know whether an acquisitive growth strategy makes sense for them. Consider the dilemma of one U.S. packaged foods producer. The company had a dominant share in the U.S. market in its legacy product line, but economic trends in the industry seriously threatened long-term competitive advantage. For one thing, the continuing globalization of the company’s big retailing customers was transforming its category into a global business. Dominance in a single market was simply no longer good enough. In addition, there were significant scale-based cost advantages in manufacturing and distribution that favored larger players. Most important, only a full assortment of products in its category would enable the company to gain and maintain a position as “category captain” with the retailers – a status that would pay handsome dividends in the form of preferential positioning of the company’s products in stores. All these trends were driving a rapid concentration in the industry, as it shifted from relatively small, local, focused players to large, multi-product, global giants (see Exhibit 1). Unless the company rapidly followed suit, it would be unable to compete. This put acquisition squarely on the company’s strategic agenda. Getting a company’s growth strategy right also can shed light on precisely what kind of acquisitions make the most sense. The factors a company needs to look at include the basis for competition in its industry, its own organizational competencies, and the availability of attractive merger candidates. For example, one durable goods manufacturer, observing a mix of broadly diversified and narrowly focused players in its category, wanted to know if it needed to diversify in order to survive. A detailed analysis revealed that the shareholder return of diversified players in the industry was no better than that of focused ones (see Exhibit 2). Furthermore, the manufacturer could realize few synergies across broad categories along the value chain because the categories had dissimilar gains from scale. Distribution advantages also differed depending on the point of fabrication and major customers did not place great value on working with a more diversified supplier. But although broad-based diversification did not make competitive sense for the company, expansion into a narrower set of related categories where the manufacturer had brand relevance and an advantage in materials science did. The company is now profitably following that strategy and using it to create value for its shareholders. Only when a company has a clear sense of its strategy and the proper role of m&a can it narrow the field of available properties. By quickly eliminating all the possible deals that don’t make strategic sense, executives can devote their time to preparing detailed dossiers on the most likely candidates and developing a source book and game plan for active or reactive m&a moves downstream. One of the main reasons that so many acquisitions destroy value is the willingness of senior executives to overpay for seemingly attractive targets in the pursuit of synergies that either don’t exist or cannot be achieved. “Deal fever” can infect even the most experienced senior executives, causing them to talk themselves into overly optimistic estimates of synergies and the potential upside in an attempt to justify the price they think they have to pay to win the bidding. What’s more, they often underestimate the likely disruption to their core business from the cost and effort of doing the deal and carrying out integration. Deciding on a reasonable price for the acquisition – and avoiding overpayment – requires careful valuation of the combined entity’s potential upside. We advocate a far more rigorous approach to valuation than most companies take. The typical approach goes something like this: The would-be buyer analyzes comparable transactions and industry multiples, builds a discounted cash flow model based on the stand-alone value and likely earnings trajectory of the target, then adds overlays for projected cost and revenue synergies. To estimate cost synergies, executives typically use scale-economy rules of thumb. Revenue synergies emerge through consensus. Finally, the acquirer mines the seller’s data room, conducts site visits, and revises the valuation based on what it finds. Such an approach falls short because a lot of information that materially impacts value lies outside of its scope. The greatest information shortfall comes when new management teams tackle their first acquisition or when experienced acquirers weigh a massive or game-changing transaction. In such instances, we recommend an approach that we call high-definition valuation. An acquirer needs to take an all-encompassing view of the value that might be created or lost in a prospective transaction, including all the external aspects of a transaction and its indirect consequences. Take the example of resource diversion. In theory, any project with a positive net present value justifies incremental investment. In practice, however, time and resources are constrained, and acquisitions rob other initiatives. For this reason, it’s important to review the impact of a potential acquisition on internal projects. For a given estimate of required acquisition and integration resources, what internal projects will be eliminated, discounted, or delayed? How much should the transaction upside be discounted as a result? Answering such questions helps ensure that the company pays only for unique, incremental transaction value and it doesn’t credit the deal with false synergy. It’s also important to quantify the costs of inaction. Forfeiting a property to a competing bidder not only closes off the potential upside but also exposes the company’s existing plans to a strengthened competitor. Where and how is a competing bidder likely to attack if it acquires the target company? What markets would the combined footprint of the two companies put at risk? What product launches might this new competitor preempt with strengthened R&D? How would its new cost position pressure prices? Answering such questions can help a company anticipate and minimize future damage. It also reveals the true value of acquiring the target. When it comes to estimating the stand-alone value of a target, it often pays to do original customer research rather than base projections on historical or average performance. For example, an acquirer can research the target’s most recent product performance; interview subjects with knowledge of the target’s business, including blind interviews of important suppliers and customers; and conduct an in-depth study of heavy-user segments and their consumption trends. There are also a number of things a company can do to test an acquisition’s upside. An acquirer can interview potential customers on the benefits of the merger in order to substantiate the estimated revenue; identify opportunities for rationalization by assessing plants and facilities; and map the overlap of acquirer and target patents, as well as tear down recent product launches, to estimate combined innovation potential. Finally, acquirers shouldn’t wait to think about postmerger integration until after the deal closes. Premerger integration exercises can simulate the integration process well before a deal is imminent. Because it’s impossible to fully understand a deal’s synergy potential without evaluating the integration risks, companies should develop a set of cost and revenue upsides with qualified probability by function, along with an implementation plan for the resource commitments required to achieve those benefits. If managers are made accountable for their analyses, this exercise builds realism into the valuation. It also provides a detailed roadmap for the eventual postmerger integration. Of course, even the most painstaking evaluation is meaningless if the upside is squandered in the bidding. A structured approach to setting opening and walk-away price points can ensure that identified value is brought back to shareholders. And it can inoculate management against deal fever. It is important to establish opening bids on the basis of precedent transactions, a conservative estimate of value creation, and an understanding of the transaction upside and the funding constraints of competing bidders. It is no less vital to set and stick to walk-away price points based on an aggressive but achievable estimate of the upside and of critical thresholds for funding, dilution, and earnings-per-share accretion. Finally, it’s essential to develop a clear-eyed view of possible competing bidders and their bidding potential. When an acquirer’s estimated upside is based on a unique advantage, competitors should be unable to match its bid. The real power of high-definition valuation is in the timing. Every aspect of the analysis can be accomplished well ahead of the bidding, across a number of worthy properties, without an offering memorandum and without a data room. This type of early valuation provides a commanding view of options for expansive growth. It enables a potential acquirer to move swiftly, value accurately, and bid intelligently when the time is right. In the end, it’s not the acquisition itself that creates value but rather the postmerger integration. This is where the synergies that will pay for the acquisition are actually realized. The integration process can make or break a merger, and it often differentiates experienced, successful acquirers from the less successful ones. Effective postmerger integration is a complicated balancing act. On the one hand, speed is of the essence. Potential synergies must be realized quickly – in the first 12 to 18 months after the deal – in order to communicate to the market that the merger is on track. What’s more, the longer senior executives are preoccupied with the internal details of the integration, the more likely they are to lose focus. On the other hand, an integration has to be thorough. In far too many cases, speed comes at the expense of comprehensiveness. Because executing a postmerger integration is such a high-pressure activity, there is a great temptation to declare victory too early. Executives often settle for suboptimal decisions. Interim organizations that are more the product of organizational politics than business logic have a way of becoming permanent. Potential synergies are identified but never completely captured because the organization loses its concentration. Good ideas are never thoroughly pursued. In many cases, substantial money is left on the table as a result. It takes courage and persistence to challenge such compromises and see things through to the end. It’s critical, of course, to have a structured integration process with clear objectives and accountabilities, well-defined phases and timetables, and ambitious targets with strong incentives to achieve them. But process alone is not enough. It’s more important to have the right mindset – an animating vision that makes the process robust and results-oriented as opposed to simply mechanistic. Senior executives can achieve these goals by focusing on three specific objectives. The first is to minimize the integration’s disruptive effect on the core business. Pulling off postmerger integration is too important to do in magic time or to assign to executives who already have important line responsibilities. Tasks need to be segregated from the core business, and the integration process needs its own organization, responsible executives, and faster-than-normal governance and decision-making processes. That’s why experienced acquirers such as Pfizer, Cisco, and Newell appoint dedicated executives and explicitly carve out management-team time to lead their integration efforts. Second, any serious integration process needs to have a plan in place to ensure the smooth functioning of the core business. Companies need to be extremely vigilant about any fall-off in revenue and be ready for rapid intervention should it occur. Typical mechanisms for doing so include early-warning tracking systems to monitor emerging revenue trends, special temporary incentives to ensure continuity of performance on the part of salespeople and other key staff, and strategies to make sure that soon-to-expire contracts aren’t poached by competitors. Once a company has detailed plans in place for running both the integration and the ongoing business, it will find that there are many opportunities for cross-fertilization between the two. Take the example of a global industrial goods conglomerate that had recently purchased a smaller rival. As might be expected in this highly capital-intensive business, the initial focus of the integration was mainly on taking costs out of the combined manufacturing operation of the two companies. But the global integration effort uncovered an unanticipated opportunity on the revenue side in marketing and pricing. One of the integration teams, based in Asia, discovered that there were no explicit rules for pricing to customers in the same segment that bought the same or similar products. When the team plotted its findings, the result was a cloud of dots showing no discernible rhyme or reason to the prices charged to similar customers. When the company’s executives learned of the Asian team’s discovery, they made it the focus of a major effort: the development of a framework for segmenting customers and setting prices that could be applied across all the 46 countries where the company operated. The work identified opportunities for improving the company’s net margin by one to two percentage points – an enormous increase in a business where a half-point reduction in cost is significant. In effect, postmerger integration became the catalyst for a major shift in the company’s pricing strategy. A third way to break the compromise between speed and thoroughness is to routinely revisit synergy targets and results in the years after the formal integration is completed. Often during postmerger integration, a company has to make decisions for pragmatic or political reasons, as opposed to purely business reasons. They may make sense at the time, but unless they are revisited later, they can build uncompetitive costs into the business. Executives at one newly merged global food company, for example, knew that their firm’s international business was sub-scale. The logical move would have been to create a global unit combining the new company’s two chief segments. But this new organizational design faced a major obstacle: the opposition of the two powerful senior executives who headed the separate units and believed that integrating them involved too much business risk. The senior management team agreed to keep the two organizations separate for the time being. But they also made an explicit decision to revisit the move in two years. When the time was right, the company created an integrated global unit and achieved the cost savings that came with increased scale. As important as it is to hit a company’s synergy targets, it is also important to remember that integration is not just a numbers game. It is a complex change process that re-knits the human fabric of the organization. Executive careers are on the line. Integration leaders have to identify and retain key talent and persuade the two organizations that they have a better future together than apart. What’s more, all this must be done in an environment that will inevitably be colored – and, to a degree, distorted – by uncertainty and anxiety. In postmerger integration, this “soft stuff” is often the hardest to get right. One company, for example, had an acquisition disrupted by the unanticipated loss of some key individuals from the target company on the very first day of the integration. A few years later, when the company was in the process of acquiring a second target in what was the largest acquisition in the history of its industry, senior executives were determined not to make the same mistake again. A team incorporating human resources people developed a sophisticated tracking tool that captured key information about tens of thousands of employees at the acquired company. The system linked every employee to the most appropriate division or department of the acquiring company. It also included the employee evaluations conducted as part of the integration process, which identified “high-talent” personnel. The system tracked the positions in the newly combined company for which each individual had been interviewed. It also noted any offers extended to them, whether they had accepted, their willingness to relocate, and other pertinent information. As a result, management had a way of tracking and retaining high-talent employees. Just as important, from the very first day of the integration process, all the employees had a clear understanding of where they stood and to whom they reported. Among other things, they were already included on the relevant e-mail distribution lists. Practices like these help to make a company’s approach to integration disciplined, rapid, and thorough. When combined with a well thought-out strategy and rigorous valuation and pricing, they allow a company to capture the full value of a potential acquisition. Developing such capabilities puts a company in a strong position to take full advantage of future opportunities for acquisitive growth. Despite negative studies and headlines, mergers and acquisitions will continue to be an important component in building successful strategies for growth. Whether fueled organically, through acquisitions, or by a mixture of both, growth is growth, and any kind of growth has the potential to create shareholder value when it achieves consistent levels of operating returns above the cost of capital. The winners will be companies with a clear strategy for growth and an understanding of the conditions in which acquisitive or organic growth makes sense. Kees Cools, based in Amsterdam, is Global Leader of The Boston Consulting Group’s Corporate Finance and Strategy Practice; Kermit King is a Vice President in BCG’s Chicago office; Miki Tsusaka, based in New York, is Senior Vice President and Global Leader of BCG’s Postmerger Integration Practice; and Chris Neenan is a former Vice President in New York. Copyright 2004 Thomson Media Inc. 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