Warming Up to Alliances: Today’s alliances, long evolved from the partnerships of 10 years ago, are gaining in popularity as a vehicle for pursuing external opportunities.

Does anemic deal flow have you down? Is difficulty in lining up financing slowing down the few deals you have in the pipeline? Is the renewed emphasis on organic growth making your acquisition pitches more balls than strikes? Despair not, dealmakers, help is on the horizon. Just as the character portrayed by Dustin Hoffman in “The Graduate” was tipped off by a family friend that the future was in “plastics,” a cadre of your fellow dealmaking experts wants to clue you in on the one word that just might revitalize your career, grow your company, and make your m&a activities more successful. The word is “alliances.” “Alliances are the biggest thing since the advent of strategic planning in the 70s,” says Peter Pekar, a managing director at Houlihan Lokey Howard & Zukin. He says that alliances represent a relatively new field, and one that has exploded in the last five or six years. But he adds that investment bankers and other deal professionals haven’t wanted to, or haven’t been flexible enough, to see them for the vital strategic option that they are. Dealmaking experts emphasize that partnerships provide business leaders with a third arrow in their quiver of strategic options. “You used to have only two options – buy a business or build one. Now you have a viable third option, which is to bond with a partner,” Pekar says. Alliances are a great way for companies to gain access to new products, technology, expertise, and customers – all while spreading the risk by partnering with another firm. They are generally less costly than buying a company, and they can provide increased cash flow, reduced overhead, and improved access to capital. They are also a good tool for diversifying into new markets, bolstering weaker areas of the company, and strengthening relationships with existing customers and suppliers, dealmaking experts say. In today’s markets, alliance gurus note, business leaders increasingly are opting for joint ventures, strategic alliances, and other partnerships over costly acquisitions and internal development in order to pursue new growth opportunities. Yet even the most enthusiastic alliance boosters don’t expect partnerships to replace m&a. While mergers and acquisitions won’t go away, executives should be aware that in many situations, alliances are a smart alternative to m&a, they say. Alliances have evolved quite a bit over the past 10 years, says McKinsey & Co. principal David Ernst. If originally they were used as ventures to enter overseas markets or as funding vehicles to support collaborative research, they now have blossomed to include such activities as co-branding, co-marketing, strategic outsourcing, and joint purchasing. And unlike many of the alliances of the 90s, which tended to be forged between a large company and a small one with a new technology or business model that needed a cash infusion, partnerships today are being formed between equal-sized companies, and, in many cases, the partners are some of the largest companies in the world, says Pekar. Pekar predicts that alliances increasingly will become more global in nature, will evolve to more frequently include more than just two partners, and will be widely recognized as a prudent way of husbanding a company’s resources. He believes that they more and more will be seen as an attractive option to betting the farm on an acquisition. The Time Is Now? While the current dealmaking environment – rocked by a weakened economy, accounting scandals, and a growing suspicion of some companies’ growth-by-acquisition strategies – might seem like a perfect backdrop for a surge of alliances, the experts have differing opinions on whether today’s business climate is truly alliance-friendly. In Pekar’s view, the alliance renaissance is nearly upon us. Weaknesses in the capital and equity markets, stronger emphasis on corporate responsibility, and the increased realization that most acquisitions fail to increase shareholder value are some factors that may lead to a golden age of cooperative pacts, he remarks. Ernst agrees, noting that mergers and acquisitions may look less attractive now, especially since alliances are more widely used today to achieve growth objectives. However, according to Benjamin Gomes-Casseres, a Brandeis University business professor, the best climate for alliances might still be in the distant future. The result of the Enron, WorldCom, Tyco, and other scandals may be a slowdown of alliance formation, he notes. “As growth stalls and companies have less appetite for trying new things, they will probably form fewer alliances,” he says. The bull market led to more m&a than was warranted, often in cases where an alliance would have sufficed, he adds. Since m&a is more expensive than forming alliances, he believes that some companies spent more than they needed to during the boom years. But some of the excesses of the m&a and alliance deals done during that time will lead to better deals in both areas now, he believes, because companies will be careful to avoid frivolous alliances and insist on thoughtful partner selection, more-intensive due diligence, and better alliance management. The accounting scandals, the effects of the September 11 terrorist attacks, and a sluggish economy have definitely slowed m&a in the logistics business, says Gene Tyndall, EVP of global supply chain solutions at Ryder System Inc. But while those same factors may have contributed to the general dearth of new alliances being formed in the industry, one type of partnership – outsourcing – is on the rise, he notes. “We are seeing more situations where we take a company’s supply chain process and run it for them, especially for companies like contract manufacturers.” Although the pros may not wholeheartedly agree on whether now is an optimal time for forming joint ventures, they concur that alliances can offer compelling strategic and financial advantages over mergers and acquisitions. Noting that there are two ways that a merger or acquisition can go wrong – i.e., you overpaid or the synergies projection was wrong – Andrew Liveris, a business group president at Dow Chemical Co., says that he likes the fact that there is no deal premium in alliances. “You don’t dig a hole on the financial side, so you can start the relationship without a noose around your neck.” He says that in acquisitions that don’t work, it’s what you don’t know that kills you. Since a buyer must pay the deal premium before it can learn all the potential bad news, in a bad deal, the acquirer can never make up what it had to pay up front. With alliances it is easier to manage what you don’t know, or are gradually becoming aware of, he says. “When you don’t have the financial overhead, an alliance can be taken apart by mutual consent if it isn’t going anywhere.” Liveris adds that alliances are a good tool for defraying deal risk. He points to Dow’s 22-company partnership, Elemica, to create an electronic marketplace in the chemicals business as an opportunity to test a concept without having any one partner invest a dangerously large amount of resources. But as compelling as alliances can be, Wall Street doesn’t know how to value them, says Liveris. Very few companies care to break out the results of alliances separately because they fear that doing so would give up some competitive advantage. “Often you’re working under some secrecy constraints either with an agreement with your partner or maybe with a customer, so there are real disadvantages to too much transparency when you set these things up.” Pekar says that one of the problems that Wall Street has with valuing alliances is that they are often “off-the-balance-sheet” entities that don’t show up on normal measures such as price/earnings ratios. Gomes-Casseres agrees that “there is no good way of accounting for and measuring the role of alliances in a company’s financials because they are not consolidated.” He notes that Enron’s use of off-the-balance-sheet partnerships hasn’t helped Wall Street’s perception of these structures, even though they were a very different kind of partnership than most alliances create. Pekar adds that companies that do alliances haven’t communicated the impact of their alliance portfolio to analysts and investors. “It’s important to show that alliances are going to contribute a significant amount of wealth for the corporation,” Pekar says. In Tyndall’s view, the problem with alliances is the difficulty companies have in measuring their results. “If you can’t measure them, you can’t understand them.” He says that sometimes the partners themselves can’t agree on how to measure their collaborations. Because of this drawback and others, Ernst suggests that corporate chieftains ask themselves if they really need an alliance before going down that route. He says that the negatives of alliances can be substantial: a lack of decisionmaking control, the need to share future profits, possible creation of a competitor, barriers to pursuing other opportunities, incompatible views on alliance management, and uncertainly about how long the partners will share the same goals. He notes that half of all partnerships fail due to governance issues. The trick to doing an alliance well is in creatively tailoring the deal structure, making sure that an appropriate governance structure is in place, and ensuring that it will be able to evolve. Alliance Best Practices Liveris says that alliances are such a new area that there are few guidelines to benchmark against. The process of finding alliance candidates is more complicated than simply looking for a company to buy, he states. “You have to look at how the companies would complement each other, so you need to have a feel for the value of each side’s business model, technology, or whatever makes them an attractive partner.” One difference between alliance formation and doing a merger or acquisition is that in alliances there is a primary focus on business issues and operational concerns as opposed to the legal and financial issues that take center stage in acquisitions, Liveris adds. Tyndall agrees, saying that m&a practitioners are more hard-wired financially, whereas alliance-builders come from a more operational mindset. Additionally, alliance leaders tend to come from business development and project management backgrounds rather than being experienced m&a hands, Liveris says. In Ernst’s view, alliances require considerable planning and due diligence skills. He also says that because the partners have to share control, dealmakers need to be flexible as they structure the deal. But from this perspective, it may be that exposure to alliance building could strengthen the skill set of m&a technicians. This could occur most obviously in due diligence, an area where alliances require a broader and more thorough look than even post-Enron mergers and acquisitions do. Alliance Management Liveris says that while senior management must support and sign off on milestones of alliances, in a large corporation, they shouldn’t be hands-on managers. “Titration is important. Results must be presented to the board and they must be aware of reaching or not reaching goals, but they shouldn’t be managing the alliance.” Tyndall says that while alliances need top-down support, they shouldn’t be top-down supported. Liveris notes that Dow often creates a separate management structure with outside people for an alliance. They try to limit influence from the parent companies and tell the executives running the alliance to concentrate on validating the premise of the deal with a similar level of autonomy as if it were an independent company. As frequent advisers to senior management, Pekar states, investment bankers can aid alliance formation. Bankers can play a role in alliances even if it means looking at strategy differently than they would in an m&a transaction. They can search for companies that would be a suitable partner, create a competitive environment, and screen potential candidates. They can also look at the non-cash assets of a business, such as distribution chains, and assign value to them. The Alliances Numbers As attractive as partnerships might be, they can be hard to manage, and even the best-conceived teamings could be headed for trouble. Most of the alliance advocates say that the success rate for alliances is higher than that of m&a, but given the unimpressive m&a success rates, that may provide little comfort. According to a PricewaterhouseCoopers study of a few years ago, nearly two-thirds of m&a deals failed to increase shareholder value. Ernst has found that between 30% and 60% of alliances do not succeed. Gomes-Casseres says he thinks a 50% success rate is more or less average, with a range from 30% to 70%, but he cautions companies to not become fixated on the success rate of alliances, noting that if a company were to compare the alliance success rate with that of internal projects such as a major product launch or entry into a new market, it would be about the same – about 50%. Pekar says that while the companies he’s studied have a 57% success rate in alliances, those that use best practices can achieve a success rate of 80%. Improving the Odds of Success The most successful alliances, dealmakers say, result when companies carefully choose their partners, set clear objectives for the venture, appropriately value the alliance’s potential, and establish metrics for evaluating the alliance’s success. While even the most enthusiastic alliance boosters don’t expect alliances to replace acquisitions, they note that companies enjoying successful partnerships attribute their success to the application of sound management principals that are as effective in alliances as they are in mergers and acquisitions. Pekar says that m&a is not on the way out, but says that in many instances, alliances present a viable alternative to m&a. In Tyndall’s view, alliances are another way to achieve corporate growth. “It makes sense to sharpen your alliance skills as well as your dealmaking skills, given that we are going to have both m&a and alliances till doomsday because companies are never going to be able to do everything themselves.”