The M&A Collection Themes in Best Practice: Themes in Best Practice 9781472920355, 9781472916686, 9789927101823

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Introduction By Scott Moeller

The Maturing of the M&A Industry Consolidations, whether hostile takeovers, friendly mergers, or forced divestitures, have taken place since time immemorial. Initially, as mankind began to settle into communities, this was often achieved through strategic marriages between the sons and daughters of formerly competing family traders. It is likely that size mattered as much when two trading families joined forces in ancient Mesopotamia or at the time of the early Chinese dynasties as it does today when two global telecommunications companies merge. It wasn’t until late in the Industrial Age that mergers and acquisition (M&A) deals became more than one-off and relatively infrequent occurrences. John D. Rockefeller, Andrew Mellon, J. P. Morgan, and Andrew Carnegie—these are just some of the men who began to develop M&A into a science, and indeed an industry unto itself. Their effectiveness can be measured in part by the governmental responses to their actions, with the development of antitrust legislation in the United States that started in the last two decades of the 19th century, and later in many other industrialized countries. Over a number of merger waves since that time, M&A practitioners have developed ever more effective tools to consolidate companies. Indeed, this trend has moved beyond the private sector to include the merging of government departments or organizations in the third (charity) sector, all the time touting the projected benefits of being bigger and, hopefully, more efficient. The M&A industry is composed of myriad advisors and corporate specialists, driving more than US$2 trillion in deal volume annually. The last few years have given many M&A dealmakers pause for thought. Are we now at a new stage in the development of the M&A market? It has certainly matured to a degree that would make it unrecognizable to earlier practitioners, whether ancient traders or the conglomerate-builders of the 1880s. And because the M&A industry has truly matured, this is a good time for a definitive compilation of essays about mergers and acquisitions to be published.

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This can be demonstrated further by looking at the chart in Figure 1. Figure 1. Global announced M&A deal volume (US$ trillions). (Source: Sanford Bernstein, Thomson Reuters)

Before 2007 the M&A industry was very cyclical. Volume during the trough in 2003 was a mere 27% of the peak volume three years earlier, down therefore by almost three-quarters. But after the 2007 peak something changed. The next trough, in 2009, was down by much less— “only” slightly more than 50%. What is more striking is the fact that this level of activity—within a narrow range of between US$2 trillion and US$3 trillion—has remained relatively flat for six years running. This market stability hadn’t occurred before in the modern era of finance, and remains the longest period of such stability even if the following years are above that level. Naturally, this is not, to use Francis Fukuyama’s term, the “end of history” for M&A. Merger waves in the past were driven by factors such as globalization and the development of the capital markets. There will be further merger waves, triggered by, possibly, economic and political events or even technological developments or natural disasters. Volumes will likely stray outside the boundaries of the past six years. Since the mid-1980s we’ve had a unique period for M&A activity, with three waves peaking—as shown in Figure 1—in 1989, 1999, and 2007. The preceding merger wave peaked in 1969, 20 years earlier. And the wave before that peaked in 1929, followed by a trough that lasted 40 years. Thus, we are perhaps seeing, to quote from the famous 1985 movie, a period which is “back to the future.” The 1980s merger wave saw huge changes in M&A attack and defense: the emergence of highly leveraged deals, allowing smaller companies for the first time to buy larger ones, and the development of creative legal techniques such as the Pac-Man defense, named after the eponymous video game where the attacked could become the attacker. The 1990s wave saw the growth of cross-border deals as the market became international, with global industry champions being created, not just national

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ones. And the most recent merger wave was driven in large part by financially focused firms such as private equity funds and activist investors. These factors all continue to be important today, enabling the volume of activity to remain at levels, as noted above, only half of the earlier peak, but nevertheless staying at a level which is historically high—all six of the past six “down” years would have been record levels as recently as a decade earlier. There are other factors that usually characterize a mature industry, including the consolidation of the market players (this is certainly happening among the M&A advisors, where the top five firms have greater market share now than ever before) and internationalization, whereby new players enter from developing markets (note especially the growth of Chinese and other Asian advisors). These demonstrate that a level of maturity appears to have been already achieved in the industry, and that it isn’t continuing to develop at the same pace as during the past 30 years.

The Book Why is this maturing of the industry important where the essays in this book are concerned? Because now is an excellent time to take stock and ask the experts for their opinions about the M&A market—with confidence that their observations will be relevant for several years to come. This is not something that could have been said during the past 20 years, as developments were occurring too quickly for any publication to have a useful half-life of more than a few years. This can be seen in the frequency with which academic M&A textbooks required new editions, for example. We have asked those experts to tell us what they feel is critical knowledge about M&A. The book contains four main sections that reflect the key areas of M&A: Strategy, Finance, Deal Quality, and Integration.

•

 M&A Strategy discusses the question of whether a merger or acquisition should be done, and if so, with whom. Alternatives to a merger or acquisition are covered, as well as the different types of deals. There are also essays on special issues for start-ups and for acquisitions in the developing world.

• • •

 M&A Finance contains essays about valuation and pricing: how much should be paid. The financial structuring of deals is covered, as is the topic of synergy, which is a critical driver in many, if not most, strategic deals.  M&A Deal Quality is about whether buyers know what they are getting when doing an acquisition, plus concerns such as negotiation issues and selection of the deal team.  M&A Integration covers the step that determines if a strategic deal will be successful or not. This includes the critical issues of culture, human resource alignment, and communication.

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Each of the essays includes suggestions for further reading, should you wish to delve deeper into a specific topic. Following those essays is a section of “checklists” to assist in the practical application of the material discussed in the essays. These checklists are useful tools for managers engaging in the planning and execution of acquisitions, mergers, and divestitures. The final section of the book provides recommendations for additional readings on the general topic of M&A. These include books that provide a history of some of the most influential deals, such as KKR’s acquisition of RJR Nabisco in 1988 (which was also the subject of the 1993 film starring James Garner, “Barbarians at the Gate”, and Chocolate Wars, which chronicles the rise of Cadbury.

Closing Comments Although the M&A industry has matured during the past 30 years and is perhaps in a long-term phase of middle age, there will always be creative practitioners of deals who will develop new and better ways to combine firms. Thus, although we hope that this book will pass the test of time, we encourage all readers to follow the continuing writings, whether published in book form such as this or online, of the renowned authors who are included in this compilation. This will also assist with any “mid-life crises” that the M&A industry might encounter over the next decade.

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Contributor Biographies Duncan Angwin is professor of strategy, Oxford Brookes University, UK, and an associate professor at Said Business School, Oxford University and the University of Warwick. He researches strategic practice in mergers and acquisitions (M&A) and has recently won a four-year research award at Said Business School to study M&A communications practices. He sits on the advisory boards of the M&A Research Centre, CASS Business School, City University, London, and at ENPC School of International Management, Paris. Angwin has published six books and over 40 journal articles on strategy and M&A in leading US and European journals. He lectures and consults for a wide range of businesses and universities worldwide. R. Brayton Bowen is author of Recognizing and Rewarding Employees (McGraw-Hill) and leads the Howland Group, a strategy consulting and change management firm committed to “building better worlds of work.” His documentary series Anger in the Workplace, distributed to public radio nationally in the United States, continues to be regarded as a benchmark study on the subject of workplace issues and change. A best-practice editor and contributing author to the hallmark work Business: The Ultimate Resource (Bloomsbury Publishing and Perseus Books), he has written for MWorld, the online magazine of the American Management Association. He currently serves as executive adviser for the Center for Business Excellence at McKendree University. Stavros Brekoulakis, LLB (Athens), LLM (London), and PhD (London) is a lecturer in international dispute resolution. Dr Brekoulakis lectures at Queen Mary, University of London, on the Master of Laws (LLM) courses on international comparative and commercial arbitration, international commercial construction, international commercial litigation, and conflict of laws. He is also academic director of the diploma course (taught by distance learning) on international arbitration. His academic research focuses on international commercial arbitration, conflict of laws, multiparty and complex dispute resolution, issues on jurisdiction of tribunals and national courts, and enforcement of awards and national judgments. He is a member of the Athens Bar, having practiced shipping law and dispute resolution.

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Susan Cartwright is professor of organizational psychology and wellbeing and director of Centre for Organizational Health and Well-Being, having previously been a professor at Manchester Business School. She worked in industry for 12 years before joining the Manchester School of Management (now MBS) in 1987, where she completed a master’s degree in 1988 and a PhD in 1990, which was supported by an ESRC competitive scholarship. Professor Cartwright is a fellow of the British Academy of Management, of which she is currently president. She has been an associate editor of the British Journal of Management for more than seven years, is a past editor of the Leadership & Organization Development Journal, and is the recipient of the first Meritorious Reviewer Award presented by Human Relations. Aswath Damodaran is a professor of finance at the Stern School of Business at New York University, where he teaches corporate finance and equity valuation. He also teaches on the TRIUM Global Executive MBA program, an alliance of NYU Stern, the London School of Economics, and HEC School of Management. Professor Damodaran is best known as author of several widely used academic and practitioner texts on valuation, corporate finance, and investment management. He is also widely published in leading finance journals, including the Journal of Financial and Quantitative Analysis, the Journal of Finance, the Journal of Financial Economics, and the Review of Financial Studies. John Gilligan is a corporate finance partner in PKF (UK) LLP and has worked in the private equity and venture capital industry for 24 years. He started his career in 1988 at 3i Group plc as a financial analyst. He joined what is now Deloitte in 1993 and was a partner from 1998 to 2003. He is a special lecturer at Nottingham University Business School and has also taught at Cranfield University Business School. He has a degree in economics from Southampton University and an MBA in financial studies from Nottingham University. He is the coauthor with Mike Wright of Private Equity Demystified. Peter Howson is a director of AMR International, a London-based strategic consultancy that specializes in commercial due diligence. His particular focus is on manufacturing, building, and construction. He has over 20 years of M&A experience, gained both in industry and as an adviser. Previously he worked in corporate finance at Barings, where he focused on domestic and cross-border deals in manufacturing industries. He has also worked for TI Group plc, transforming the company from a UK supplier of mainly commodity engineering

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products into a global specialist engineering company through a series of acquisitions and disposals. He has also held senior finance and M&A roles with British Steel and T&N. Scott S. Johnson is the founder and CEO of middle market private equity group SJ Partners, LLC. Previously, he was a securities analyst at Salomon Smith Barney and Merrill Lynch, and has served as CFO of an in-store advertising company. Johnson is the winner of the 2012 40 Under 40 East Region M&A Advisor Recognition Awards. He is listed in the Marquis Who’s Who in America and is a member of the Association for Corporate Growth and Business Executives for National Security. He is an adjunct professor at Columbia University, where he also received his BA, MBA, and MIA. Shân Kennedy is an independent consultant who advises on IFRS and valuation issues. Her background includes more than 20 years with Ernst & Young and Deloitte. She has also spent four years working at the UK Accounting Standards Board developing UK GAAP guidance on accounting for goodwill and intangible assets; this included developing the impairment test. Kennedy has presented at many IFRS conferences in London and Europe. She has recently acted as technical consultant to the International Valuation Standards Council to develop its guidance on the valuation of intangible assets, both generally and for IFRS purposes. Peter Killing is professor of strategy at IMD, Lausanne, Switzerland. His major interest is the interface between strategy and leadership. His teaching, research, and consulting activities focus on leaders who are working with their teams to create the right strategy and at the same time set the ground for effective implementation. In the area of mergers, acquisitions, and alliances, Professor Killing has written and edited four books and several articles, including one in the Harvard Business Review. He also runs in-company programs for a variety of clients including BMW, Allianz, Sika, and Vestas, the Danish wind turbine company. Andrew Mayo is associate professor of human capital management at Middlesex Business School, where he teaches human resource strategy, and his main research interest is in people-related measures. He is also a fellow and program director for in-company programs at the Centre for Management Development at the London Business School, where he has worked since 1996. He runs his own consultancy company, MLI Ltd (Mayo Learning International), specializing in organizational strategies for growing human capital and translating the rhetoric of

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“people are our most important asset” into reality. Mayo is president of the HR Society in the United Kingdom and is a frequent speaker at conferences around the world. Scott Moeller is the director of the M&A Research Centre at Cass Business School, London, and a former senior executive at Deutsche Bank and Morgan Stanley. While at Deutsche Bank, Professor Moeller held roles as global head of the corporate venture capital unit, managing director of the Global eBusiness division, and managing director responsible for worldwide strategy and new business acquisitions. Prior to his career in investment banking he was a management consultant with Booz, Allen & Hamilton (now Booz & Co). He is a non-executive director of several nonprofit and financial services companies in the United States, the United Kingdom, and Continental Europe. Andy Nash is a serial entrepreneur and has chaired 12 management buyouts and buyins since 1996. During this period he has also successfully chaired two FTSE plcs. He was one of three principles of the Taunton Cider MBO which, at £72 million in 1991, was one of the first big private equity deals in the United Kingdom. The exit via flotation and a recommended takeover for almost £300 million four years later achieved a handsome return for shareholders. His book, The Management Guide to MBOs, was published to acclaim in 2005 and is due to be revised and updated in late 2009. Nash also chairs Somerset county cricket club and, with friends, has built a new day hospital in Zanzibar. In later life he qualified as a ski guide, and he occasionally lectures at Nottingham University’s Business School. He is married with four grown-up children and the family has homes in Somerset and Spain. Price Pritchett is founder and CEO of Pritchett LP, a Dallas-based consulting firm recognized internationally for its expertise in mergers, culture, and organizational change. Dr Pritchett’s book, After the Merger: Managing the Shockwaves, named one of the 10 best business books of the year, was the first ever written on merger integration strategy. He is also author of the all-time best seller on mergers, The Employee Guide to Mergers and Acquisitions, plus various other titles. More than 20 million copies of his books are in print worldwide, with translations into many foreign languages. Almost all of the Fortune 500 have used some combination of Pritchett LP’s consulting, training, and handbooks.

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Luc Renneboog is a professor of corporate finance and director of graduate studies at Tilburg University, the Netherlands. Before joining Tilburg, he taught at the University of Leuven and at Oxford University. Dr Renneboog graduated with a BSc/MSc in management engineering from the University of Leuven, followed by an MBA from the University of Chicago, a BA in philosophy from Leuven, and a PhD in financial economics from the London Business School. He has also been a visiting researcher at the London Business School, HEC Paris, and Venice University. He is a widely published author, with research interests are corporate finance, corporate governance, mergers and acquisitions, and the economics of art. David Sadtler is an associate of the Ashridge Strategic Management Centre. His research, teaching, consulting, and writing activities are concentrated on questions of corporate-level strategy. A graduate of Brown University (mathematics and economics) and of Harvard Business School, his career has been divided between consulting and industry. Sadtler was the corporate development director and a main board director of London International Group plc, a diversified healthcare company, for eight years and is a two-time alumnus of McKinsey & Company, having served a broad range of clients on questions of strategy in the New York, Amsterdam, and London offices. James S. Sagner is an internationally recognized expert in financial management and economic analysis. He teaches undergraduate and MBA-level management, finance, and international business courses in the School of Business at the University of Bridgeport, Connecticut, and is currently a lecturer in the Executive Education Finance Program at the University of North Carolina. He has written six business finance and economics books and dozens of papers and articles, and is a former editor of Treasury Views. He is a graduate in accounting of Washington and Lee University, Lexington, Virginia, has an MBA from the Wharton School of the University of Pennsylvania, holds a PhD in business and economics from the American University in Washington, DC, and has been a Rockefeller Foundation fellow. He holds CCM and CMC certifications. His book Cashflow Reengineering (1997) was selected as a most influential finance book of all time by QFinance Business Library.

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Louise Scholes is a senior lecturer in entrepreneurial management at Durham University Business School. Her main research interests include entrepreneurial activity, family firms, private equity, venture capital (particularly management buyouts), and science and business. She has published articles in a number of journals, including Human Relations, Entrepreneurship Theory and Practice, Small Business Economics, the International Small Business Journal, and the Journal of Applied Corporate Finance. Scholes is a member of the Royal Society of Chemistry and the British Academy of Management. James E. Schrager is clinical professor of entrepreneurship and strategy at the University of Chicago Booth School of Business where he has won numerous awards for his teaching. He is an active strategy adviser to companies small and large. His articles have appeared in the Wall Street Journal and the Chicago Tribune, among others, and is frequently quoted in the press. He was founding editor of the Journal of Private Equity, published by Institutional Investors, for fifteen years. Dr Schrager’s education includes a bachelor’s degree in economics, an MBA in accounting, a CPA certificate, a juris doctor of laws, and a PhD in organizational behavior and policy from the University of Chicago. Paul J. Siegenthaler has helped numerous merging or acquired companies to integrate successfully, and has driven major business transformation programs across Western Europe and North America, ensuring they deliver the business case their shareholders had been promised. Following a master’s degree in economics from HEC Lausanne and an MBA at London Business School, Siegenthaler spent the first 17 years of his career as managing director reshaping the companies acquired by an international group, before focusing solely on the business integration of broad scale international mergers and acquisitions, across a number of industries. Satu Teerikangas is a senior lecturer in management at University College London. Her research centers on the management of mergers and acquisitions (M&A), including the human, cultural, and emotional dimensions thereof. She is coeditor of the Handbook of Mergers and Acquisitions (Oxford University Press, 2012), the first initiative to combine strategic, financial, and sociocultural perspectives in the approach to M&A. Her work has been published in leading academic

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journals, and she chairs the M&A tracks at the annual conferences of the European Academy of Management and the European Group for Organizational Studies. Before her academic career, Teerikangas worked in telecommunications and oil and gas in Finland, the Netherlands, and the United Kingdom. Siri Terjesen holds a PhD from Cranfield School of Management (2006), a master’s in international business from the Norwegian School of Economics and Business Administration (Norges Handelshùyskole), where she was a Fulbright scholar (2002), and a BS in business administration from the University of Richmond, Virginia (1997). She is an assistant professor in the Kelley School of Business at Indiana University and a visiting research fellow in the entrepreneurship, growth, and public policy group at the Max Planck Institute of Economics in Jena, Germany. She has been widely published in leading journals and is a coauthor of Strategic Management: Logic & Action (Wiley, 2008). Mike Wright is professor of entrepreneurship at Imperial College Business School, and director of the Centre for Management Buy-out Research at Nottingham University Business School, which he founded in 1986. His research interests include international dimensions of entrepreneurial management buyouts and venture capital, technology transfer, and corporate governance in emerging markets. Professor Wright is the author of over 300 papers in international journals. He is also author or editor of some 50 books, the most recent of which are Private Equity Demystified (with John Gilligan, second edition 2010) and Private Equity and Management Buyouts (with Hans Bruining, 2008). He is a member of the British Venture Capital Association Advisory Board and a visiting professor at EMLyon.

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Corporate-Level Strategy by David Sadtler

Executive Summary •

The parent company should add more value than other owners could.

•

The skills at the center need to match the improvement opportunities in the businesses.

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Geographic and sectoral diversification are to be avoided; there are other ways to grow.

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Vertical integration is unlikely to succeed.

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When value added no longer seems feasible, demerge or break up completely.

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Good central managers never stop demanding real and substantial value added.

Introduction Implementing a successful corporate-level strategy has become an urgent priority for all corporations. Parent companies must demonstrate that they are creating stockholder value by their own actions and initiatives, and not just reaping the profits of the businesses in their charge. The sanctions for being seen to fail in this challenge can be severe. At the very least, stock prices will suffer; at the other extreme, predators will force a breakup.

A Framework The challenge of corporate-level strategy is to ensure that value is being added to every business in the company’s portfolio. That value must, of course, exceed its cost. Corporations with good corporate strategies do even better: they add more value than other companies in the same businesses. Ensuring that this value-added process is productive requires several actions by top management: 1.

It must identify ways in which each business can be helped. This help must make possible a major improvement in business performance. Without an understanding of where improvement potential exists, the search for value added cannot be real and substantial. These improvement opportunities should be identified and agreed on through managerial dialog and businessplanning systems.

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2.

Central management must make sure that it possesses the skills to provide the help needed. Different kinds of improvement opportunities require different forms of help. Management must see that it has those capabilities.

3.

It must construct a portfolio of businesses in which this constructive fit— useful skills attuned to the needs of the businesses—exists. How businesses can be helped is bound to change over time. The strength of the fit must be continually reappraised.

4.

Management must ensure that it is sufficiently familiar with the requirements for the success of each business and that it will not damage that business, whether by approving the wrong investment proposals, appointing the wrong general managers, or giving poor strategic guidance.

Questions for Management The pursuit of added value often presents managers with challenging issues to resolve. How can we grow if our core business is limited in terms of further expansion? This question arises when management has divested businesses that didn’t fit and is left with one core business. If it has a commanding market share, competes in a non-growing market, and has little opportunity for overseas expansion, the dilemma can be a real one. This is especially true in an era in which capital markets reject diversification and demand that companies stick to their knitting. Capital markets are wary of any form of corporate diversification. They are simply being pragmatic: experience has shown them that diversification doesn’t work well. What is the single-business company to do to find growth opportunities? There are four possible answers: 1.

Seek a way to reinvent the business by looking for new customers, new markets, new ways to present the product, and a better package of customer value to offer. Even commodity products can be differentiated by offering them in a different service context. First, make certain that growth limits really have been reached.

2.

Consider moves into related businesses that share existing resources and skills. Such initiatives should possess the same requirements for success. If not, the management skills both at the business-unit level and in the parent company may be inadequate for the challenge.

3.

Operate a nursery of new ideas. Business unit managers are always on the lookout for new products and markets. The more promising should be regarded as new-product research and development initiatives. Those that offer promise can then receive modest investment until there is a persuasive reason to make a serious commitment.

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4.

Although unconventional in today’s environment, it may be smart simply to operate the existing low-growth business for cash flow, eschewing major growth aspirations. Mature industries can often be sustained for a long time without heavy investment and achieve above-average returns.

What’s wrong with vertical integration as a way of extending the opportunities for a stagnant business? In other words, why shouldn’t we acquire our customer to guarantee an outlet for our products? Vertical integration has increasingly lost favor among thoughtful managers. While it may seem like a sensible proposition to guarantee a supply of raw materials or markets for your products, vertical integration frequently exhibits three major shortcomings: 1.

When one division sells products to another division, disagreement often arises about transfer pricing and product and service quality. The selling division realizes it has a captive customer and often works less hard to retain the business. Much time is wasted resolving such intramural issues.

2.

Entry into new upstream or downstream businesses often involves competing with your existing customers. Several corporate breakups have been the result of the realization that this problem was insoluble under the existing ownership arrangements.

3.

Entry into new businesses often involves dealing with differing requirements for success; it thus requires a new range of managerial skills and capabilities, both at the business-unit level and in the parent company. Mistakes are made, and the business suffers competitively.

Is it wise to limit the number of eggs in our basket? Management teams often seek positions in different industrial sectors simply to spread risk. They reason that when one sector is unattractive owing to a cyclical market turndown, other sectors can take up the slack. While this can give comfort to management teams, it’s an unwise strategy in today’s markets. Capital markets will say: “We can spread our own risk; you do what you know how to do.” The management team that focuses its effort and investment on areas in which it has demonstrable skills will be rewarded appropriately in capital pricing. The same caution should be applied to overseas diversification. Some management teams intentionally direct investment to different parts of the world in order to limit exposure in any one area. Unless such geographic expansion is initiated to strengthen one’s competitive positioning in a particular global marketplace, the investment community is likely to scorn this form of expansion. There are simply too many downsides to investment abroad to undertake it without a solid competitive business rationale. Currency exposure, entry into alien market environments, and bone-wearying travel all represent significant costs from expanding internationally.

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The pressures to build a bigger company are enormous: managers are taught to believe that their enterprise must grow or die; ambitious executives want new challenges—they expect to be paid more when the company gets bigger, and they may believe that economies of scale are always the reward from sheer size. But the pressures of bureaucratic cost, operating manager motivation, decisionmaking complexity, internal competitive conflicts, suspicion of remote top managers inequitably enriching themselves, and the like all represent potential downsides to greater size. To be responsible stewards of stockholder interest, directors and top managers must continually examine and manage this implied trade-off. Failure to do so can be the ultimate destroyer of value-added strategy.

Demerger and Breakup When it becomes clear that a failed corporate strategy is in place—when you recognize that substantial and discernible value is not being added—the question of portfolio changes arises. In some cases this may involve simply a trade, sale, or demerger of the business for which there is no fit. Sometimes, when the valueadded formula has substantially dissipated, total breakup is indicated: the company ceases to exist in its entirety and breaks into several pieces. Successful corporate strategists believe in the primacy of value added. They constantly seek out ways to provide the kind of help the businesses in the corporate portfolio need. They continually search for major improvement opportunities among the businesses. They adjust both their portfolio of businesses and the capabilities of the parent company to provide a continuing match between the needs of the business units and what the parent can provide. And when the businesses need no further help of the sort they can offer—and this often happens— they wish them Godspeed and release them into the outside world.

Case Study The UK conglomerate Hanson Trust offers a superb example of how to do it right. During the 1970s and 1980s it built a portfolio of low-tech, mature businesses by means of acquisition and disposal. It sought out undermanaged companies with major positions in mature businesses that were looking for opportunities to strengthen their competitive position by tight, disciplined management. When its acquisitions brought in businesses that didn’t fit Hanson’s profile, they disposed of them. Hanson was clear about its value-added formula: it found businesses whose fortunes could be dramatically improved through tight financial discipline and strong general management motivation. It worked well and stockholders benefited greatly.

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In the 1990s it became apparent that the formula no longer had much to offer stockholders. Major opportunities for the Hanson treatment were waning, especially in the United Kingdom and the United States. All the fat targets had been exploited. At the same time computer-facilitated financial control systems made Hanson’s approach an ordinary corporate capability. Finally, the businesses in the Hanson stable became so well run that there was little improvement potential left. Realizing that the value-added formula had become obsolete, the company broke itself up into five pieces, each of which has thrived competitively on its own.

Making It Happen

• • • • •

Make sure that value is being added to every business in the portfolio by identifying ways in which each can be helped to achieve major improvements in performance. Restrict the portfolio to activities in which a constructive fit—useful skills attuned to the needs of the businesses—exists at the center.  If growth prospects appear limited, try reinvention, moves into related businesses, new ideas, or a cash-cow strategy. Focus effort and investment on areas in which you have demonstrable skills: don’t diversify into unknown areas. When substantial and discernible value is not being added, change the portfolio.

More Info Books:

Galbraith, Jay R. Designing Organizations: An Executive Guide to Strategy, Structure, and Process. San Francisco, CA: Jossey-Bass, 2002. Goold, Michael, et al. Corporate-Level Strategy. New York: Wiley, 1994. Kare-Silver, Michael de. Strategy in Crisis. New York: New York University Press, 1998. Kraines, Gerald A. Accountability Leadership: How to Strengthen Productivity through Sound Managerial Leadership. Franklin Lakes, NJ: The Career Press, 2001. Mintzberg, Henry. The Rise and Fall of Strategic Planning. New York: Prentice Hall, 1994. Useem, Michael. Leading Up: How to Lead Your Boss So You Both Win. New York: Crown Business, 2001.

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Mergers and Acquisitions: Patterns, Motives, and Strategic Fit by Siri Terjesen

Executive Summary •

Mergers and acquisitions (M&A) are two broad types of restructuring through which managers seek economies of scale, enhanced market visibility, and other efficiencies.

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A merger occurs when two companies decide to combine their assets and liabilities into one entity, or when one company purchases another.

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An acquisition describes one company’s purchase of another—for example, the absorption of a smaller target firm into a larger acquiring firm.

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The nature and scope of M&A activity has changed over time, with a growing trend to cross-border transactions.

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M&As are motivated by the expectation of financially rewarding synergies in terms of reduced fixed costs, increased market share, cross-sales, economies of scale, lower taxes, and more efficient resource distribution.

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At the individual level, executives may pursue M&As because of psychological drivers such as empire-building, hubris, fear, and mimicry.

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There are five broad types of strategic fit: overcapacity, geographic roll-up, product or market extension, research and development, and industry convergence.

•

M&A execution can be hampered by incompatible corporate cultures, with failure to achieve synergies, high executive turnover, and too much focus on integration at the expense of customers.

•

Before the deal, managers should formulate a clear and convincing strategy, pre-assess the deal, undertake extensive due diligence, formulate a workable plan, and communicate to internal and external stakeholders.

•

After the deal, managers should establish leadership, manage culture and respect employees, explore new growth opportunities, exploit early wins, and focus on the customer.

Introduction Mergers and acquisitions are two broad types of restructuring through which managers seek economies of scale, enhanced market visibility, and other efficiencies. A merger occurs when two companies decide to combine their assets and liabilities into one entity, or when one company purchases another. The term is often used to

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describe a merger of equals, such as that of Daimler-Benz and Chrysler, which was renamed DaimlerChrysler (see case study). The term “acquisition” simply refers to one company’s purchase of another — as when a smaller target firm is bought and absorbed into a larger acquiring firm.

Patterns The worldwide M&A market topped US$4.3 trillion and over 40,000 deals in 2007. Figure 1 depicts the growth of M&A activity, quarter by quarter, over the last five years.

Figure 1. Global M&A activity 2002–07 (Source: Thomson Financial (Bain & Company analysis)) 5

Global deal value, $ trillion

Global deal count, '000 4.3

4 2.7

3 2 1 0

1.2

1.4

0.3 0.3 0.3 0.3

0.4 0.3 0.4 0.3

2002

2003

1.9

0.8

0.4

0.6

0.3 0.4

3.5

Q4 1.0

40

1.1

Q3 0.9

30

Q2 1.4

20

0.7 0.8

0.7

0.5

0.6

2004

2005

50

1.0

Q1 1.0

2006

2007

10 0

The nature and scope of M&A activity has changed substantially over time. In the United States, the Great Merger Movement (1895 to 1905) was characterized by mergers across small firms with little market share, resulting in companies such as DuPont, Nabisco, and General Electric. More recently, globalization has increased the market for cross-border M&As. In 2007 cross-border transactions were worth US$2.1 trillion, up from US$256 billion in 1996. Transnational M&As have seen annual increases of as much as 300% in China, 68% in India, 58% in Europe, and 21% in Japan.1 The regional share of today’s M&A market is shown in Figure 2.

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Figure 2. Global M&A market 2007—share by region (Source: Thomson Financial)

USA 33%

Central Asia & Asia-Pacific 16%

Japan 2%

Europe 39%

Americas (excl. USA) 7%

Africa & Middle East 3%

Motives Mergers and acquisitions are often motivated by company performance, but can also be linked to executive decision-makers’ empire-building, hubris, fear, and a tendency to copy other firms. The dominant rationale used to explain M&A activity is that acquiring firms seek improved financial performance through synergies that enhance revenues and lower costs. The two companies are expected to achieve cost savings that offset any decline in revenues. Then Hewlett-Packard CEO Carly Fiorina justified the merger with Compaq at a launch effort on September 3, 2001: “This is a decisive move that accelerates our strategy and positions us to win by offering even greater value to our customers and partners. In addition to the clear strategic benefits of combining two highly complementary organizations and product families, we can create substantial shareowner value through significant cost-structure improvements and access to new growth opportunities.”2 The formula for the minimum value of the synergies required to protect the acquiring firm’s stockholder value (i.e. to avoid dilution in earnings per share) is: (pre-M&A value of both firms + synergies) = pre-M&A firm stock price post-M&A firm number of shares

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Managers may be motivated by the potential for the following synergies:

•  •  •  •  •  • 

Reduced fixed costs: Duplicate departments and operations are removed, staff are often made redundant, and typically the former CEO also leaves. Increased market share: The new larger company has increased market share and, potentially, greater market power to set prices. Cross-sales: The new larger company will be able to cross-sell one firm’s products to the other firm’s customers, and vice versa. Greater economies of scale: Greater size enables better negotiations with suppliers over bulk buying. Lower taxes: In some countries, a company that acquires a loss-making firm can use the target’s loss to reduce liability. More efficient resource distribution: A larger company can pool scarce resources, or might distribute the technological know-how of one company, reducing information asymmetries.

At the individual decision-making level, M&A activity is also linked to the following:

• 

Empire-building: M&As may result from glory-seeking, as managers believe bigger is better and seek to create a large firm quickly via acquisition, rather than through the generally slower process of organic growth. In some firms, executive compensation is linked to total profits rather than profit per share, creating an incentive to merge/acquire to create a firm with higher total profits. Furthermore, executives often receive bonuses for completing mergers and acquisitions, regardless of the resulting impact on share price.

• 

Hubris: Public awards and increasing praise may lead an executive to overestimate his or her ability to add value to firms. CEOs who are publicly praised in the popular press tend to pay 4.8% more for target firms. Hubris can also lead executives to fall in love with the deal, lose objectivity, and overestimate expected synergies.

•  • 

Fear: Managers’ fear of an uncertain environment, particularly in terms of globalization and technological development, may lead them to believe they have little choice but to acquire if they are to avoid being acquired. Mimicry: If leading firms in their industry have merged or acquired others, executives may be more likely to consider the strategy.

Executives may overpay for a target firm. Microsoft has acquired more than 128 companies, but recently withdrew a US$44.6 billion offer of cash and stock for Yahoo. Microsoft CEO Steve Ballmer commented on the logic of the decision: “Despite our best efforts, including raising our bid by roughly $5 billion, Yahoo!

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has not moved toward accepting our offer. After careful consideration, we believe the economics demanded by Yahoo! do not make sense for us, and it is in the best interests of Microsoft stockholders, employees, and other stakeholders to withdraw our proposal.”3

Strategic Fit Regardless of their category or structure, all M&As share the common goal that the value of the combined companies will be greater than the sum of the two parts. M&A success depends on the ability to achieve strategic fit. Harvard Professor Joseph Bower identifies five broad types of strategic fit, based on the relationship between the two companies and the synergies sought: overcapacity M&A, geographic roll-up M&A, product or market extension M&A, M&A as R&D, and industry convergence M&A.4

Overcapacity M&A

In this horizontal M&A, the two companies often competed directly, with similar product lines and markets. The new combined entity is expected to leverage synergies related to overcapacity by rationalizing operations (for example shutting factories). This often one-time M&A can be especially difficult to execute as both companies’ management groups are inclined to fight for control.

Geographic Roll-up M&A

In a geographic roll-up the new entity seeks geographic expansion, but often keeps operating units local. For example Banc One purchased many local banks across the United States in the 1980s. Banc One was, in turn, acquired by JPMorgan Chase & Co. in 2004.

Product or Market Extension M&A

Market-based roll-up focuses on extending a product line or international coverage. Often the two companies sell similar products but in different markets, or different products in similar markets. Brands are often a key motivation. Philip Morris purchased Kraft for US$12.9 billion — four times its book value. Philip Morris CEO Hamish Marshall justified the premium: “The future of consumer marketing belongs to companies with the strongest brands.”5

M&A as R&D

A fourth type of strategic fit is research and development. Companies may acquire or merge with others to access technologies. Microsoft has aggressively pursued this strategy, acquiring smaller, entrepreneurial firms such as Forethought, which had presentation software that would eventually be known as PowerPoint.

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Industry Convergence M&A

Finally, the new entity may be motivated by a “bet” that a new industry is emerging and the desire to have a position in this industry. For example Viacom purchased Paramount and Blockbuster in the expectation that integrated media firms controlling both content and distribution were the wave of the future.

Case Study The failed merger of DaimlerChrysler

Germany’s Daimler and the United States’ Chrysler merged in 1988, creating the world’s largest commercial auto manufacturer. At the time of the merger, Daimler’s CEO claimed that the merger of a luxury car maker (Daimler) with a mass-market brand (Chrysler) would become the world’s most profitable auto manufacturer due to new economies of scale and scope across brands, product niches, manufacturing expertise, and distribution networks. For example it was hoped Daimler’s high-end manufacturing expertise and worldwide network would help to distribute Chrysler products and compete successfully against increasingly strong Asian competitors, especially Toyota and Honda. However, at the time, not all executives were positive. One DaimlerChrysler executive was quoted as saying, “It is unthinkable for a Chrysler car to be built in a Mercedes-Benz factory, and for as long as I’m responsible for the Mercedes-Benz brand, only over my dead body will a Mercedes be built in a Chrysler factory.”6 By the end of 2003 DaimlerChrysler’s market capitalization was just US$38 billion, significantly lower than the pre-merger US$47 billion in 1998. Despite product costs, DaimlerChrysler was unable to realize expected synergies. Furthermore, many competitors followed Chrysler’s lead, introducing minivans, pickup trucks, and SUVs that eroded Chrysler’s formerly attractive market share. Further barriers to success came with management and national cultural differences: Daimler’s mostly German management used approaches that did not go down well with Chrysler managers. By early 2003 most of Chrysler’s top executive team had left the firm. Seven years after the merger the picture became more positive, with Chrysler contributing one-third of the company’s earnings in the first half of 2005. Dieter Zetsche was promoted to chairman of DaimlerChrysler’s board. By August, market capitalization reached US$54 billion and worldwide sales of the newly launched Mercedes were up 9%. Still, the American market proved difficult, with the three major American auto manufacturers experiencing significantly declining sales. Meanwhile, Toyota and Honda sales were up 16% and 10% respectively, gaining in the upscale market that DaimlerChrysler had hoped to dominate. In the summer of 2006, DaimlerChrysler sought to make a positive out of a negative in its US television advertisements, with Zetsche presented as an amusing cultural misfit to America. Still the company faced high labor and healthcare costs and soaring fuel costs. By April 2007, DaimlerChrysler confirmed that buyers were being sought, as German investors declared “this marriage made in heaven turned out to be a complete failure.” In fact, some suggested that Daimler could itself become a takeover target if it did not sell Chrysler. By May, DaimlerChrysler had paid Cerberus Capital Management, a private equity investment firm, US$650 million to end its exposure to healthcare and other costs as well as to ongoing operational losses.

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Conclusion Mergers and acquisitions can be accretive in that they increase financial performance, or dilutive in the reverse case, where a measure such as earnings per share (EPS) actually falls. It is a fact that 70% of mergers and acquisitions actually destroy value. In implementation, M&As typically face the following critical issues:

•  •  • 

Incompatible corporate cultures: The cultures of the two companies may be inconsistent, resulting in resources being diverted away from the focal synergies. Business as usual: The target company may allow redundant staff and overlapping operations to continue, thwarting efficiency. High executive turnover: The target company may lose critical top management team-leadership. A recent study reports that target companies lose 21% of their executives each year for at least ten years following an acquisition (twice the turnover experienced in nonmerged firms).

• 

Neglect business at hand: A recent McKinsey study reported that too many companies focus on integration and cost cutting, and neglect the daily business at hand and customers.

Making It Happen Despite the grim statistics, several companies are skilled M&A executors. For example, General Electric has integrated as many as 534 companies over a six-year period, and Kellogg’s delivered a 25% return to stockholders after purchasing Keebler.7 The following are key steps to facilitating a successful process before and after a merger:

Before the merger

1. Begin by formulating a clear and convincing strategy. Strategists must first develop a compelling and sustainable strategy. Key questions include: What is your firm’s strategy? What role does the M&A play in this strategy? What is the vision of the strategy of the new entity? 2. Pre-assess the deal. Prior to signing a memo of understanding, managers should examine operational and management issues and risks. Seek answers to the following questions: Is this the right target? What is the compelling logic behind this deal? What is the value? How would we communicate this value to the board of directors and other key stakeholders? What will our strategy be for bidding and negotiations? How much are we willing to spend? If we are successful, how can we accelerate integration?

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3. Do your due diligence. Executives must acquire and analyze as much information as possible about potential synergies. In addition to managers across key functional areas in the firm, outside experts can be brought in to help appraise answers in the pre-assessment, and especially to challenge assumptions, by asking questions such as: Are our estimates of future growth and profitability rates reliable? Are there aspects of the company history/ culture or of the environment (for example legal, cultural, political, economic) that should be taken into account? 4. Devise a workable plan. Formulate plans that take into account some of the following: What is our new entity’s organizational structure? Who is in charge? What products will be taken forward? How will we manage company accounts? What IT systems will we use? 5. Communicate. M&A transactions tend to be viewed favorably when executives can convincingly discuss integration plans, both internally and externally. Managers should be prepared to answer the questions identified above, as well as: How can we prepare our people psychologically for the deal? What value will be created? What are the priorities for integration? What are the primary risks? How will progress be measured? How will we address any surprises?

After the deal

6. Establish leadership. The new entity will require the quick identification and buy-in of managers, especially at top and middle levels. Ask: Who will lead the new entity? Do we have buy-in and support from the right people? 7. Manage the culture and respect the employees of the merged/acquired company. An atmosphere of respect and tolerance can aid the speed and ease of integration. Executives should formulate plans that address the following concerns: How can we encourage the best and brightest employees to stay on in the new entity? How can we build loyalty and buy-in? 8. Explore new growth opportunities. Long-run performance is linked to identifying and acting on both internal and external growth opportunities. Managers should seek out any untapped growth opportunities in the new entity. 9. Exploit early wins. To build momentum, the new entity should actively seek early wins and communicate these. To identify them, consider whether there are early wins in sales, knowledge management, or the work environment. 10. Focus on the customer. To survive, firms must create value for customers. Managers must continue to ask: Are we at risk of losing customers? Are our salespeople informed about the new entity? Can our salespeople get our customers excited about the new entity?

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More Info Books:

Bruner, Robert F. Deals from Hell: M&A Lessons That Rise Above the Ashes. Hoboken, NY: John Wiley & Sons, 2005. Galpin, Timothy J. and Mark Herndon. The Complete Guide to Mergers and Acquisitions: Process Tools to Support M&A Integration at Every Level. San Francisco, CA: JosseyBass, 2007. Miller, Edwin L. Mergers and Acquisitions: A Step-by-Step Legal and Practical Guide. Hoboken, NJ: John Wiley & Sons, 2008. Sadtler, David, David Smith and Andrew Campbell. Smarter Acquisitions: Ten Steps to Successful Deals. Harlow: Pearson Education, 2008.

Websites:

Google Scholar articles—search on terms “mergers and acquisitions” or “M&A”: http://scholar.google.com/scholar Yahoo! Finance M&A news: http://biz.yahoo.com/topic/m-a

1 Caroline Firstbrook. “Transnational mergers and acquisitions: How to beat the odds of disaster.” Journal of Business Strategy 28:1 (2007): 53–56. 2 Quoted on ThinkExist.com: http://thinkexist.com/quotation/this_is_a_decisive_move_that_accelerates_our/346964.html. 3 Tim Smalley. “Microsoft withdraws from Yahoo! acquisition.” Bit-tech.net May 5, 2008. 4 J. L. Bower. “Not all M&As are alike—And that matters.” Harvard Business Review, 79:3 (2001): 92–101. 5 J. M. Biggar and Selame, E. “Building brand assets.” Chief Executive 78 (1992): 36–39. Cited in S. Cem Bahadir, Sundar G. Bharadwaj and Rajendra K. Srivastava, “Financial value of brands in mergers and acquisitions: Is value in the eye of the beholder?” Journal of Marketing 72:6 (2008): 147–154. 6 David Waller. Wheels on Fire: The Amazing Inside Story of the Daimler–Chrysler Merger. London: Hodder & Stoughton, 2001, p. 243. 7 Jeffrey S. Perry and Thomas J. Herd. “Mergers and acquisitions: Reducing M&A risk through improved due diligence.” Strategy & Leadership 32:2 (2004): 12–19.

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In Search of Growth: Choosing Between Organic, M&A, and Strategic Alliance Strategies by Duncan Angwin

Executive Summary

This chapter details the three main growth strategies available to companies: •

organic growth strategies;

•

mergers and acquisition strategies;

•

strategic alliance strategies;

and how to choose between these growth strategies.

Introduction Blockbuster movies are key to success in Hollywood. But in 2012 a single superhero film beat all others with US$1.5 billion global ticket sales, becoming the thirdhighest grossing title of all time. The Avengers, from Disney’s Marvel unit, stormed the box office, bringing Iron Man, The Incredible Hulk, and Thor together. The Avengers’ success largely overturned analysts’ criticisms of Disney’s 2009 US$4 billion acquisition of Marvel as overpayment. But why would Disney risk so much on an acquisition when most acquisitions are doomed to fail? This chapter examines one of the big strategic issues facing CEOs and boards of directors: deciding among strategies for successful growth. Many companies often have strong preferences with respect to growth strategies. For example Cisco Systems relies heavily on growth through acquisitions, while others, such as car and aerospace companies, often engage in alliances and joint ventures. In September 2013, Microsoft acquired part of Nokia for US$7.2 billion and its share price fell 5.5%, suggesting that analysts are not fully convinced about the deal. Why, rather like the Disney example above, would Microsoft pay so much for this acquisition rather than engaging in a strategic alliance that would have been cheaper? Alternatively, should Microsoft have tried to “do it itself”—organically? These issues are reviewed in this chapter by examining a series of questions: What growth strategies are open to companies? How should they choose between them? Which is best for business? First we review the classic growth strategies of organic growth, M&A, and strategic alliances, and then contrast their advantages and disadvantages in order to show whether growth through one means or another is the best strategy for a company.

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Organic Growth Strategies Often perceived as the default growth option for companies, an organic growth strategy relies on developing a company’s internal resources and capabilities. This “do it yourself” strategy has five main advantages.

• 

First, organic growth strategies improve the company’s knowledge through direct involvement in a new market or technology, thus providing deeper first-hand knowledge that is likely to be internalized in the company rather than it working through a partner in a hands-off strategic alliance.

•  • 

Second, these strategies help to spread investment over time, which allows a reduction of upfront commitment, making it easier to reverse or adjust a strategy if conditions change. A third advantage is that there are no availability constraints, which means that the company is not dependent on the availability of suitable acquisition targets or potential alliance partners. Organic developers do not have to wait for a perfectly matched acquisition target to come onto the market.

• 

A fourth advantage is strategic independence through organic development. This means that a company does not need to make the same compromises as might be necessary in an alliance, for example, which is likely to involve constraints on certain activities and may limit future strategic choices.

• 

Finally, a fifth advantage is culture management. This allows new activities to be created in the existing cultural environment, which reduces the risk of culture clash—a common difficulty with mergers, acquisitions, and alliances.

Organic growth strategies have drawbacks. For instance developing internal capabilities can be slow, expensive, and risky. It is not easy to use existing capabilities as the platform for major leaps in terms of innovation, diversification, or internationalization. However, this is not to say that organic development cannot be radical. Indeed, Amazon’s Kindle is a good example of a successful radical entrepreneurial step through organic growth, which has taken the company from retailing into the design of innovative consumer electronic products. This sort of “corporate entrepreneurship”—radical change driven principally by the company’s own capabilities—is valuable because it encourages an entrepreneurial attitude inside the firm. There are many examples of corporate entrepreneurship, such as the creation of the low-cost airline Ryanair from inside the aircraft-leasing company Guinness Peat. Often, however, companies have to go beyond their internal capabilities to find growth, and two popular strategies are M&A and joint ventures.

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In Search of Growth 21

Mergers and Acquisitions M&A as a growth strategy has been used by companies for centuries1 and remains a major way for companies to expand rapidly. Since the first recorded wave of activity in the United States in 1897, trillions of dollars have been spent to allow companies to grow their businesses, often through step-change. Although there are differences within M&A, the discussion in this chapter will focus on majority-share acquisitions2 as these constitute the majority of all M&A deals.

Advantages of M&A as a Growth Strategy

M&A offers a number of advantages as a growth strategy that improves the competitive strength of the acquirer. They include:

• 

Business extension: M&A can be used to extend the reach of a firm in terms of geography, products, or markets. An example of this is the September 2013 acquisition of US company Smithfield Foods by Shuanghui International Holdings of China, allowing Shuanghui to build a global presence.

• 

Consolidation: M&A can be used to bring together two competitors to increase market power by reducing competition; to increase efficiency by reducing surplus capacity or sharing resources, for instance head-office facilities or distribution channels; and to increase production efficiency or increase bargaining power with suppliers, forcing them to reduce their prices.

• 

Building capabilities: M&A may increase a company’s capabilities. Instead of researching a new technology from scratch, for instance, acquirers may wait for entrepreneurs to prove an idea and then take them over to incorporate the technological capability within their own portfolio. For example Google’s US$3.2 billion acquisition of connected devices company Nest Labs in January 2014 allows Google to gain a foothold in smart home services.

• 

Speed: M&A allows acquirers to act fast—and this may be an advantage in itself, wrong-footing competition and changing the industry landscape faster than competitors can evolve in response.

Financial Advantages M&A can also provide financial advantages to acquirers, in three ways.

• 

Financial efficiency: This may allow a company with a strong balance sheet to combine with another company with a weak balance sheet, enabling the latter to save on interest payments by using the stronger company’s assets to pay off its debt. The acquired firm could also access investment funds from the stronger

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company that were otherwise unavailable. The company with the stronger balance sheet may be able to drive a good bargain in acquiring the weaker company. Also, a company with a booming share price can purchase other companies very efficiently by offering to pay the target company’s shareholders with its own shares, rather than paying with cash upfront.

•  • 

Tax efficiency: For example profits or tax losses may be transferable within the combined company in order to benefit from different tax regimes between industries or countries, subject to legal restrictions. Asset stripping or unbundling: Some companies are effective at spotting other companies whose underlying assets are worth more than the price of the company as a whole. This makes it possible to buy such companies and then rapidly sell off (unbundle) different business units to various buyers for a total price that is substantially in excess of what was originally paid for the whole. Although this is often dismissed as merely opportunistic profiteering (asset stripping), if the business units find better corporate parents through this unbundling process, there can be a real gain in economic effectiveness.

Attractions for Senior Company Personnel Top managers’ pursuit of M&A can provide some personal advantages, regardless of the real value being created. First, senior managers’ personal financial incentives may be tied to short-term growth targets or share-price targets that are more easily achieved by large and spectacular acquisitions than by the more gradualist and lowerprofile alternative of organic growth. A second advantage is that large M&As attract media attention, with opportunities to boost personal reputations through flattering media interviews and appearances. This can result in the “managerial hubris” (vanity) effect: managers who have been successful in earlier acquisitions become overconfident and embark on more and more acquisitions, each riskier and more expensive than the one before. A third advantage is that M&As provide opportunities to give friends and colleagues greater responsibility, helping to cement personal loyalty by developing individuals’ careers. Fourth, there is a “bandwagon” effect, with three kinds of pressure on top executives. When many other firms are making acquisitions, financial analysts and the business media may criticize more cautious managers for undue conservatism. Thus, shareholders will fear that their company is being left behind, as they see opportunities for their business to be snatched by rivals. Managers will worry that if their company is not making acquisitions, their company will become the target of a hostile bid. For managers who want a quiet life during a merger boom, the easiest strategy may be simply to merge. But the danger lies in making an acquisition that the company does not really need, and it can be one reason for paying too much.

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In Search of Growth 23

Strategic Alliances Mergers and acquisitions bring together companies through complete changes in ownership. However, companies can also share resources and activities to pursue a common strategy without sharing in the ownership of parent companies. This strategic alliance option is a popular growth strategy—estimates suggest that large corporations manage around 30 alliances at any one time. The alliance strategy challenges the traditional company-centered approach to strategy in at least two ways. First, practitioners of alliance strategies need to consider strategy in terms of the collective success of their networks, as well as their individual company’s self-interest. Collective strategy concerns how the whole network of alliances, of which a company is a member, competes against rival networks of alliances. For example Apple’s iPad competes in terms of its access to an ecosystem of apps and games, as much as through the technology itself. Collective strategy also challenges the individualistic approach to strategy by highlighting the importance of effective collaboration. Thus, success involves collaborating as well as competing. For Apple, it is not enough to have a stronger network than its rivals; Apple must also be better at working with its network in order to ensure that its members keep on producing the best apps and games. The more effectively Apple collaborates with its partner companies, the more successful Apple will be.

The Two Main Types of Ownership in Strategic Alliances

In terms of ownership, there are two main kinds of strategic alliance: equity and nonequity alliances. Equity alliances involve the creation of a new entity that is owned separately by the partners involved. The most common form of equity alliance is the joint venture, where two companies remain independent but set up a new company that is jointly owned by the parents. For example Virgin Mobile India is a cellular telephone service provider which is a joint venture formed in 2008 between Tata Teleservices, part of Tata Group India, and Richard Branson’s Virgin Group. The joint venture company uses Tata’s network to offer its services under the brand name Virgin Mobile. Alliances can also be formed with several partners, and these are termed a consortium alliance. The second alliance type, nonequity alliances, are typically looser, and do not involve the commitment implied by ownership. Nonequity alliances are often based on contracts. One common form of contractual alliance is franchising, where one company (the franchisor) gives another company (the franchisee) the right to sell the franchisor’s products or services in a particular location in return for a fee or

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royalty. McDonald’s restaurants and Subway are examples of franchising. Licensing is a similar kind of contractual alliance, allowing partners to use intellectual property, such as patents or brands, in return for a fee. Long-term subcontracting agreements are another form of loose nonequity alliance, common in automobile supply. For example the Canadian subcontractor Magna has long-term contracts to assemble the bodies and frames for car companies such as Ford, Honda, and Mercedes.

The Four Types of Strategic Alliance

Strategic alliances allow a company to extend its strategic advantage rapidly and generally require less commitment than other forms of expansion. A key motivator is sharing resources or activities, although there may be less obvious reasons as well. There are four types of alliance: scale, access, complementary, and collusive. Scale alliances involve companies combining to achieve necessary scale. The capabilities of each partner may be quite similar, but together they can achieve advantages that they could not easily achieve on their own. Thus, combining together can provide economies of scale in the production of outputs (products or services). Combining might also provide economies of scale in terms of inputs—for example by reducing purchasing costs of raw materials or services. Thus, healthmanagement companies often combine together to negotiate better prices with pharmaceutical companies. Combining also allows the partners to share risk: for example instead of companies stretching themselves to find enough resources on their own, partnering can help each partner avoid committing so many resources of its own that failure would jeopardize the existence of the whole company. Access alliances involve a company allying in order to access the capabilities of another company that are required to produce or sell its own products and services. For example in countries such as Mexico, a Western company might need to partner with a local distributor to access effectively the national market for its products and services. The local company is critical to the international company’s ability to sell. Access alliances can also work in the opposite direction, with a local company seeking a licensing alliance to access inputs from an international company—for example technologies or brands. Complementary alliances involve companies at similar points in the value network combining their distinctive but complementary resources so that each partner is bolstered where it has particular gaps or weaknesses. For example the General Motors–Toyota alliance known as New United Motor Manufacturing Inc. (NUMMI) allowed General Motors to gain access to Japanese manufacturing expertise, while Toyota obtained the American car company’s local marketing knowledge.

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In Search of Growth 25

Collusive alliances involve companies colluding secretly to increase their market power. By combining into cartels, they reduce competition in the marketplace, enabling them to extract higher prices from customers or lower prices from suppliers. Such collusive cartels among for-profit businesses are discouraged by regulators. For instance mobile phone and energy companies are often accused of collusive behavior. In 2012 Thailand’s three largest mobile phone operators bid 41.63 billion baht (US$1.3 billion) for a 3G license, just 2.8% higher than the minimum price, giving rise to criticism that they had colluded. In not-for profit sectors collusive alliances do take place, and they may also be justified politically in sensitive for-profit industries such as defense or aerospace due to national interests, and where the costs of development are far greater than an individual firm can sustain. Taking the above together, strategic alliances—like M&A—may be entered into with mixed motives. Cooperation can be a good thing, but it is important to be aware of collusive motivations, as these are likely to work against the interests of other competitors, customers, and suppliers.

Comparison of Acquisitions, Alliances, and Organic Development All three methods of growth—organic, M&A, and strategic alliances—offer advantages as well as disadvantages. There are also some similarities. M&A and strategic alliances have high failure rates, with approximately half failing. M&A can go wrong because of excessive initial valuations, exaggerated expectations of strategic fit, and underestimated problems of organizational and culture fit. But strategic alliances also suffer from miscalculations in terms of strategic and organizational fit, and, given the lack of control on either side, have their own particular issues of trust and coevolution as well. With these high failure rates, acquisitions and alliances need to be considered cautiously alongside the default do-it-yourself option of organic growth.

Key Factors in Deciding Which Option to Choose

The best approach to growth will differ according to circumstances. Five key factors can help in choosing between acquisitions, alliances, and organic development.

• 

Strategic importance of the resource: If the resource is critically important to the company, control is vital to avoid competitor interference. If the resource is not freely traded, it might be created organically, but this could take a lot of time, investment, and risk. Acquisition guarantees control, and quickly, but it can be expensive and there could be integration risk. Alliances may allow access to the resource, but they also expose the company to the risk that the partner might be acquired, and so access to the resource would be compromised.

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• 

Speed: Acquisitions are a rapid method for pursuing a strategy. It would probably take decades for Tata on its own to build up two international luxury car brands equivalent to Jaguar and Land Rover. The acquisition of Jaguar Land Rover in 2008 kick-started its strategy. Alliances too may accelerate strategy-delivery by accessing additional resources or skills, though usually less quickly than a simple acquisition. Typically, organic development (do it yourself) is slowest: everything has to be made from scratch.

• 

Uncertainty: It is often better to choose the alliance route where there is high uncertainty in terms of the markets or technologies involved. On the upside, if the markets or technologies turn out to be a success, it might be possible to turn the alliance into a full acquisition, especially if a buy option has been included in the initial alliance contract. If the venture turns out to be a failure, then at least the loss is shared with the alliance partner. Acquisitions may also be sold off if they fail, but often at a much lower price than the original purchase. On the other hand, a failed organic development might have to be written off entirely, with no sale value, because the business unit involved has never been on the market before.

• 

Type of capabilities: Acquisitions work best when the desired capabilities (resources or competences) are “hard”—for example, physical investments in manufacturing facilities. Hard resources, such as factories, are easier to put a value on in the bidding process than “soft” resources like people or brands. Hard resources are also typically easier to control post-acquisition than people and skills, where there is the risk of significant cultural problems. Sometimes too the acquiring company’s own image can tarnish the brand image of the target company. Acquisition of soft resources and competences should be approached with great caution. Indeed, the organic method is typically the most effective with sensitive soft capabilities such as people. Internal ventures are likely to be culturally consistent at least. Even alliances can involve culture clashes between people from the two sides, and it is harder to control an alliance partner than an acquired unit.

• 

Modularity of capabilities: If the sought-after capabilities are highly modular—in other words, if they are distributed in clearly distinct sections or divisions of the proposed partners—then an alliance tends to make sense. A joint venture linking just the relevant sections of each partner can be formed, leaving each to run the rest of its businesses independently. There is no need to buy the whole of the other company. An acquisition can be problematic if it means buying the whole company, not just the modules in which the acquirer is interested. The organic method can also be effective under conditions of modularity, as the new business can be developed under the umbrella of a distinct “new-venture division” rather than embroiling the whole company.

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Disney–Marvel as an Illustration of the Key Factors

Returning to the Disney–Marvel case vignette at the beginning of the chapter, the key criteria outlined in the chapter help to inform why Disney chose to acquire Marvel rather than make an alliance or do it themselves via the organic route. Marvel is a unique resource that is not freely accessible through the market. An alliance was not possible, as Marvel would not give up its characters, and it is probable that in an unequal relationship Marvel would have lost control of them. Organically, Disney could not create these specific characters, and even if it were possible to create something similar, they would not resonate with US consumers in the same way. The depth of loyalty to the characters from the American public guarantees that these Marvel resources will create value for the new owner. It would also take many years, with very substantial investment and significant risk, for Disney to attempt to create its own. Through ownership of the Marvel characters, control is guaranteed, and there is little risk that a competitor could steal the characters from Disney. An acquisition was attractive in terms of speed, as it rapidly gave Disney a market presence in this line of characters which they could deploy in movie creation, theme-park attractions, and merchandizing. Although the characters can be viewed as hard assets, they are supported and developed through the creative talents of Marvel employees. These could be damaged in the post-acquisition integration phase, through culture clash, but this risk was largely overcome by allowing Marvel employees to continue working in the way they preferred prior to the deal. Marvel was not modular in nature, so there was no opportunity to buy just part of the business—and indeed this might have weakened Marvel if some of its characters had been acquired. Also, had Disney not acquired Marvel, it might have continued as a competitor, or have been purchased by a rival company, which might have weakened Disney’s competitive position.

Summary

Of course, the choice between the three options of acquire, ally, or organic do-ityourself is not unconstrained. Frequently, no suitable acquisition targets or alliance partners are available. One problem for voluntary companies and charities is that the changes of ownership involved in M&A are much harder to achieve than in the private sector, so their options are likely to be restricted to alliances or organic development in any case. In other cases there just isn’t the time or the resources to develop capabilities and resources in-house. It is important therefore to weigh up the available options systematically and to avoid favoring one or the other without careful analysis.

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Making It Happen In order to decide between the acquisition, alliance, and organic options, companies should consider:

•  •  •  •  • 

the strategic importance of the capability or resource required; their requirements in terms of speed; contextual uncertainty; the type of capabilities required; the modularity of the capabilities.

More Info Books:

Angwin, Duncan N. (ed.). Mergers and Acquisitions. Oxford, UK: Wiley-Blackwell, 2007. Capron, Laurence and Will Mitchell. Build, Buy, Or Borrow: Solving the Growth Dilemma Boston, MA: Harvard Business School Publishing, 2012. Child, John, David Faulkner and Stephen B. Tallman. Cooperative Strategy: Managing Alliances, Networks, and Joint Ventures. Oxford, UK: Oxford University Press, 2005. Sudarsanam, Sudi. Creating Value from Mergers and Acquisitions: The Challenges. 2nd ed., Upper Saddle River, NJ: Financial Times Prentice Hall, 2010. ul-Haq, Rehan. Alliances and Co-Evolution: Insights from the Banking Sector. New York: Palgrave Macmillan, 2005.

Articles:

Angwin, Duncan. “Speed in M&A integration: The first 100 days.” European Management Journal 22:4 2004: 418–430. Angwin, Duncan. “Motive archetypes in mergers and acquisitions (M&A): The implications of a configurational approach to performance.” Advances in Mergers and Acquisitions 6 2007: 77–105. Angwin, Duncan. “Merger and acquisition typologies: A review.” Chapter 3 in Faulkner, David, Satu Teerikangas and Richard J. Joseph (eds), The Handbook of Mergers and Acquisitions. Oxford, UK: Oxford University Press, 2012. Angwin, Duncan and Maureen Meadows. “The choice of insider or outsider top executives in acquired companies.” Long Range Planning 42:3 2009: 359–389. Angwin, Duncan and Maureen Meadows. “Acquiring poorly performing companies during economic recession: Insights into post-acquisition management.” Journal of General Management 38:1 2012: 1-24. Angwin, Duncan and Maureen Meadows. “New integration strategies for post-acquisition management.” Long Range Planning May, 2014. Available online DOI: 10.1016/j.lrp.2014.O4.001

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Angwin, Duncan and Eero Vaara (eds). “‘Connectivity’ in merging organizations: Beyond traditional cultural perspectives.” Special issue, Organization Studies 26:10 2005: 1445– 1572. Online (issue contents): http://oss.sagepub.com/content/26/10.toc Angwin, Duncan, Philip Stern and Sarah Bradley. “Agent or steward: The target CEO in a hostile takeover: Can a condemned agent be redeemed?” Long Range Planning 37:3 2004: 239–257. Angwin, Duncan, Basak Yakis-Douglas and Maureen Meadows. “Analysis: Reputation in strategic communications.” Reputation 4 2012: 3. Online: www.sbs.ox.ac.uk/sites/default/files/CCR/Docs/2012-04-Reputation.pdf Arino, Africa, José de la Torre and Peter S. Ring. “Relational quality: Managing trust in corporate alliances.” California Management Review 44:1 2001: 109–131. Online: www.iese.edu/research/pdfs/DI-0434-E.pdf Bower, Joseph L. “Not all M&As are alike—and that matters.” Harvard Business Review 79:3 2001: 93–101. Online: http://tinyurl.com/ocpg942 Dyer, Jeffrey H., Prashant Kale and Harbir Singh. “When to ally and when to acquire.” Harvard Business Review 82:7/8 2004: 109–115. Online (in two parts): http://tinyurl.com/opsa5gg and http://tinyurl.com/njtn3de Gomes, Emanuel, Duncan Angwin, Emmanuel Peter and Kamel Mellahi. “HRM issues and outcomes in African mergers and acquisitions: A study of the Nigerian banking industry.” International Journal of Human Resource Management (special issue on managing human resources in Africa) 23:14 2012: 2874–2900. Gomes, Emanuel, Duncan N. Angwin, Yaakov Weber and Shlomo Yedidia Tarba. “Critical success factors through the mergers and acquisitions process: Revealing pre- and postM&A connections for improved performance.” Thunderbird International Business Review 55:1 2013: 13–35. Inkpen, Andrew C. and Steven C. Curral. “The coevolution of trust, control, and learning in joint ventures.” Organization Science 15:5 2004: 586–599. Online: http://eprints.ucl.ac.uk/11580/1/11580.pdf Kim, Ji-Yub, Jerayr Haleblian and Sydney Finkelstein. “When firms are desperate to grow via acquisition: The effect of growth patterns and acquisition experience on acquisition premiums.” Administrative Science Quarterly 56:1 2011: 26–60. Online: www.merjerz.com/research_center/10/download Stahl, Günter K. et al. “Sociocultural integration in mergers and acquisitions: Unresolved paradoxes and directions for future research.” Feature article, Thunderbird International Business Review 55:4 2013: 333–356. Yin, XiaoLi. and Mark Shanley. “Industry determinants of the ‘merger versus alliance’ decision.” Academy of Management Review 33:2 2008: 473–491. Online: http://ox-bc.com/pdf/mergers vs alliances.pdf

Websites:

duncanangwin.com

1 The East India Company can trace its origins to a merger in 1708. 2 This is the acquisition of 50% plus one share or more in a target company.

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Going Private: Public-to-Private Leveraged Buyouts by Luc Renneboog

Executive Summary •

Listed firms go private through a leveraged buyout (LBO)—for example, a management buyout or an institutional buyout).

•

Reasons for going private are the value of the tax shield, increased incentives for management through equity ownership, to reduce cash flows, to avoid the direct and indirect costs of maintaining a listing, or as an anti-takeover device.

•

At announcement of the LBO of a listed firm, the premium (the offer price relative to the pre-buyout share price) amounts to about 40% and abnormal returns to about 25%.

•

Good candidates for LBOs have stable cash flows, low and predictable capital investment needs, a liquid balance sheet with collateralizable assets, an established market position, and are in a recession-proof industry.

Introduction When a listed company is acquired and subsequently delisted, the transaction is referred to as a public-to-private or going-private transaction. As most such transactions are financed by substantial borrowing, which is used to repurchase most of the outstanding equity, they are called leveraged buyouts (LBOs). An overview of the different types of LBO is given in Table 1. Four categories are generally recognized: management buyouts (MBOs), management buyins (MBIs), buyin management buyouts (BIMBOs), and institutional buyouts (IBOs).

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Table 1. Summary definitions of types of public-to-private transactions Term LBO

Definition Leveraged buyout. Acquisition in which a nonstrategic bidder acquires a listed or non-listed company utilizing funds containing a proportion of debt that is substantially above the industry average. If the acquired company is listed, it is subsequently delisted (in a going-private or publicto-private transaction)

MBO

Management buyout. An LBO in which the target firm’s management bids for control of the firm, often supported by a third-party private equity investor

MBI

Management buyin. An LBO in which an outside management team (often backed by a third-party private equity investor) acquires a company and replaces the incumbent management team

BIMBO

Buyin management buyout. An LBO in which the bidding team comprises members of the incumbent management team and externally hired managers, often alongside a third-party private equity investor

IBO

Institutional buyin. An LBO in which an institutional investor or private equity house acquires a company. Incumbent management can be retained and may be rewarded with equity participation

Reverse LBO

A transaction in which a firm that was previously taken private reobtains public status through a secondary initial public offering (SIPO)

Why Do Listed Firms Go Private? Reduction of stockholder-related agency costs

The central dilemma of principal-agent models is how to get the manager (the agent) to act in the best interests of the stockholders (the principals) when the agent has interests that diverge from those of the principals and an informational advantage.

• 

The incentive realignment hypothesis states that the gains in stockholder wealth that arise from going private are a result of providing more rewards for managers (through an increased ownership stake) that induce them to act in line with the interests of investors. Furthermore, in the case of an institutional buyout, the concentration of ownership leads to improved monitoring of management.

• 

The free cash flow hypothesis suggests that the expected stock returns follow from debt-induced mechanisms that force managers to pay out free cash flows. Free cash flow is the cash flow in excess of that required to fund all projects that have positive net present value (NPV) when discounted at the appropriate cost of capital. The high leverage does not allow managers to grow the firm beyond its optimal size (so-called “empire building”) and at the expense of value creation.

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Tax benefits

The substantial increase in cash flow creates a major tax shield, which increases the pre-transaction (or pre-recapitalization) value. After the buyout, firms pay almost no tax for a period of at least five years. Consequently, the (new) stockholders gain, but the government loses out.

Reduction of transaction costs

The cost of maintaining a stock exchange listing is very high. Although the direct costs (fees paid to the stock exchange) are relatively small, the indirect costs of being listed are substantial (e.g. the cost of complying with corporate governance/ transparency regulations, which requires larger accounting/legal departments, the cost of investor-relations managers, and the cost of management time in general, etc.). For a medium-sized listed company these indirect costs are estimated at US$750,000–1,500,000 annually. The going-private transaction eliminates many of the transaction costs.

Wealth transfers from bondholders to stockholders

Gains in stockholder wealth that arise from going private result from the expropriation of value belonging to pre-transaction bondholders. There are three mechanisms through which a firm can transfer wealth from bondholders to stockholders: an unexpected increase in the asset risk (the asset substitution risk); large increases in dividends; or an unexpected issue of debt of higher or equal seniority, or of shorter maturity. In a going-private transaction, the last-mentioned mechanism in particular can lead to substantial expropriation of bondholder wealth if protective covenants are not in place.

Defense against takeover

Afraid of losing their jobs if a hostile suitor takes control, the management may decide to take the company private. Thus, an MBO is the ultimate defensive measure against a hostile stockholder or tender offer.

Undervaluation

As a firm is a portfolio of projects, there may be asymmetric information between the management and outsiders concerning the maximum value that can be realized with the assets in place. If management believes that the share price is undervalued in relation to the firm’s true potential, they may privatize the firm through an MBO. Alternatively, if an external party believes that it is able to generate more value with the assets of the firm, the firm may be taken over by means of an IBO or MBI.

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How High Are the Premiums Paid in LBOS? The premiums (relative to the pre-transaction share price) are in line with those on ordinary takeover transactions: Over last 25 years they have been in the range 35% to 45%. The cumulative average abnormal returns (CAARs) calculated over two months around the event date (the announcement of the going-public transaction) average around 25%, which is similar to those of ordinary takeover transactions. The abnormal returns are equal to the realized returns corrected for the market movement (the return of the market index) and the riskiness of the firm (the beta)

The Phases of the Buyout Process Figure 1 shows the structure of the buyout process, the main research questions for each phase of the process, and their explanations. The first phase (Intent) consists of the identification of good LBO candidates; the second phase (Impact) comprises the actual LBO and an analysis of the expected returns; the third phase (Process) consists of the value creation while the firm is privately listed; and the fourth phase (Duration) concerns the duration of the private phase until the main shareholder exits through an IPO or trade sale. At every phase, eight main hypotheses or triggers can be examined: realignment of incentives, acquisition of control, reduction of free cash flow, wealth transfers from various stakeholders, tax benefits, a reduction of transaction costs, the importance of takeover defense mechanisms, and undervaluation of the target firm.

Figure 1. Phases and hypotheses of going private

• Firms that decide to relist usually do so after 3-6 years in the United States. In Europe major stockholders exit through a trade sale

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What makes firms good buyout candidates? The “Intent” phase encompasses the characteristics of firms prior to their decision to go private and compares these characteristics to those of firms which remain publicly listed. Out of the eight value drivers (mentioned above) to go public in the United States, the reduction in taxation resulting from the tax shield is the main one. Thus, firms with a high tax bill may consider going private with a lot of leverage provided that a stable cash flow stream enables the firm to service the debt. In addition, firms with substantial free cash flow (excess cash) that could lead to value-destroying investments have also been shown to be prime candidates for a public-to-private transaction. In the United States, decisions to go private in the 1980s were frequently motivated by anti-takeover defense strategies. How does the market react to a buyout? The impact of an LBO offer can be estimated by analyzing the immediate stock price reaction or the premiums paid to pre-transaction stockholders. The CAARs and premiums reflect the expected value creation when the firm becomes privately held. They are larger at the announcement for firms in which pre-transaction managers hold small equity stakes, which implies that the buyout may induce a realignment of incentives. Furthermore, the fact that the buyout will reduce large free cash flows triggers positive share-price returns. Also, for firms paying a large amount of tax, the buyout announcement leads to positive abnormal returns. Finally, bondholder wealth transfers appear to exist but are playing only a very limited role in the wealth gains of pre-buyout stockholders. Is value created during the private phase? Once a company is privatized, what postbuyout processes lead to more wealth creation? The post-transaction performance improvements are in line with those expected at the announcement of a goingprivate transaction. The causes of the performance and efficiency improvements are primarily the organizational structure of the LBO (high leverage and strong (managerial) ownership concentration). In the private phase, a firm’s productivity increases due to a focused strategy and the avoidance of excess growth. Post-buyout performance improvements arise from an improved quality of the R&D function and intensified venturing activities. This revamped entrepreneurial spirit follows from reduced stockholder-related agency costs. Also typical of firms that go private is a significant improvement in the management of working capital. How long is it before a firm is relisted on the stock exchange? An investor may decide to end a company’s private status through an exit via a SIPO (secondary initial public offering, or reverse LBO). Especially in the United States, some firms seem to use the organizational form of a privatization transaction as a temporary shock therapy to enable them to restructure efficiently, while others view the LBO as a sustainable and superior organizational form. Firms that do a reverse LBO have usually been private for three to six years. In Europe, major stockholders usually do not exit via a SIPO but perform a trade sale. The longevity of private ownership and its determinants are studied in the literature on duration.

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Conclusion Firms that undergo leveraged (management) buyouts have significant advantages over publicly listed firms. First, the high leverage creates value through the tax shield. Second, the management is incentivized to focus on value creation because it (co-) owns the firm (in the case of a MBO/MBI) or because strict monitoring of the incumbent management is induced by the major stockholders (in the case of an IBO). The organizational structure reduces the firm’s free cash flow such that money is not squandered by investing in negative-NPV projects. The private status of the firm requires little information disclosure compared to a listed firm, which allows the firm to avoid expenses related to compliance with the regulations on corporate governance/transparency. It should be emphasized that not every firm is a good candidate for LBO. The requirements are: stable cash flows, low and predictable capital investment needs, a liquid balance sheet with collateralizable assets, an established market position, and being in a recession-proof industry.

Making It Happen Establish whether the firm is a suitable candidate privatization via an LBO:

•  •  •  •

Does it have a stable stream of operational cash flows that is sufficient to service the post-transaction debt even in a recession? Does it have a large debt cushion, and liquid and collateralizable assets? Does it have, and will it be able to maintain, a stable market share? I s the economic value of the plant, property, and equipment high, and is future capital expenditure modest?

Contact an investment bank or LBO specialist (private equity group) to write a prospectus that contains the valuation of the company and maps the risks. Take on bank debt (issue bonds) to finance the deal and buy out the pre-transaction stockholders (and bondholders). This results in a small equity stake and a capital structure that has 70 to 80% of debt on total assets. Once it has been privatized, restructure the firm (e.g. through asset sales), focus on the core business, improve the efficiency of its operations, and increase the efficiency of working-capital management.

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Case Study Safeway and Kroger

One of the key characteristics of going private through an LBO is the high-leverage structure that results. Nevertheless, the discipline of high leverage can also be induced by a leveraged recapitalization without privatization. Denis (1994) investigated the difference between the two approaches by contrasting two grocery-store firms—Kroger, which undertook a recapitalization, and Safeway, which took the LBO route. The higher leverage and the pressure to generate cash led to a performance increase at Kroger, but the performance improvement at Safeway was significantly higher. Why should this have been so? •

Top managers at Safeway put part of their wealth at stake and hold substantial equity stakes (amounting to a total of about 20%) such that every managerial decision has a significant direct impact on their wealth. In addition, management is even more directed towards a focus on value, as its bonuses are linked to the market value of assets and managers receive stock options.

•

There is a major external stockholder (the private equity firm Kohlberg Kravis Roberts, or KKR) that monitors the firm closely and ensures that management does not maximize its private benefits at the expense of other stockholders and the firm itself.

•

Safeway restructured the board to consist of management and representatives of KKR, who provided expertise on corporate restructuring.

•

Safeway restructured its operations more drastically than Kroger, closing stores that did not generate sufficient operational cash flows. It also cut back on discretionary expenses, such as advertising and maintenance, to meet its short-term debt obligations, and it cut non-core business.

•

Safeway removed leverage-induced cash flow streams as fast as possible through asset sales in order to increase capital expenditures.

More Info Books:

Amihud, Yakov (ed). Leveraged Management Buyouts: Causes and Consequences. Washington, DC: Beard Books, 2002. Wright, Mike and Hans Bruining (eds). Private Equity and Management Buy-Outs. Cheltenham, UK: Edward Elgar, 2008.

Articles:

Denis, David J. “Organizational form and the consequences of highly leveraged transactions: Kroger’s recapitalization and Safeway’s LBO.” Journal of Financial Economics 36:2 October 1994: 193–224. Online at: dx.doi.org/10.1016/0304-405X(94)90024-8

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Renneboog, Luc, Tomas Simons and Mike Wright. “Why do public firms go private in the UK? The impact of private equity investors, incentive realignment and undervaluation.” Journal of Corporate Finance 13:4 (September 2007): 591–628. Online at: dx.doi. org/10.1016/j.jcorpfin.2007.04.005 Simons, Tomas and Luc Renneboog. “Public-to-private transactions: LBOs, MBOs, MBIs and IBOs.” Working paper no. 94/2005, European Corporate Governance Institute, August 2005. Online at: ssrn.com/abstract=796047 Wright, Mike, Luc Renneboog, Tomas Simons, and Louise Scholes. “Leveraged buyouts in the UK and continental Europe: Retrospect and prospect.” Journal of Applied Corporate Finance 18:3 (Summer 2006): 38–55. Online at: dx.doi.org/10.1111/j.1745-6622.2006.00097.x

Websites:

The MBO Guide: www.mboguide.co.uk Nottingham University Centre for Management Buy-Out Research: www.nottingham.ac.uk/business/Cmbor

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Leveraged Buyouts and Recession by Louise Scholes and Mike Wright

Executive Summary •

After unprecedented levels of deal activity in 2007, the descent into recession in 2008 and 2009 presented both challenges and opportunities for the buyout and private equity market.

•

We have seen higher failure rates of buyouts as a consequence of highly leveraged transactions running into difficulties.

•

Private equity-backed and larger buyouts appear less likely to fail than other buyouts. Secured creditors on average recover about 60% of their loans in failed buyouts.

•

The increase in general business failure associated with recession introduces opportunities for buyouts to rescue and turn around these failing firms, with retail-sector deals especially prevalent in recent years.

•

Private equity firms can take advantage of the increased supply of failing firms, provided that they have the necessary means (financial and management skills) to turn the businesses around.

•

Private equity firms have been less inactive in recent years in buying failed firms, although there have been some significant transactions.

•

Buyouts of failed firms are disproportionately more likely to fail again than buyouts from other vendor sources.

•

Debt buybacks and payment in kind loans (PiK) have been employed to reduce debt burdens.

•

Debt-for-equity swaps and covenant resets are a feature of the recent recession.

•

The buyout market is now showing signs of consolidation after the 2008-9 collapse, but recovery is slow.

•

Specialised turnaround private equity firms have become a feature as more opportunities for restructuring arise.

The Buyout Market in Europe The buyout market in Europe involves management buyouts and buyins of firms with or without the assistance of private equity. A management buyout is the purchase of a business by its own management, whereas a management buyin involves the purchase of a business by an external management team. Buyouts are economically very important in terms of business regeneration and survival in

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Europe and the United States. In the United Kingdom, buyouts account for about half of all M&A activity. According to the European Private Equity and Venture Capital Association (EVCA), investments in buyouts before the recent recession accounted for 79% of all private equity and venture capital investments in Europe in 2007. The buyout market in Europe reached a record €179 billion from 1,515 transactions by the end of 2007 (Figure 1). Following the recession, the value of the European buyout market dropped sharply in 2009 as banks stopped lending for the larger deals, but the market has since shown signs of recovery/consolidation and in 2012 reached €52.5 billion from 565 deals. The UK buyout market has always been the largest contributor to the European total, with €20.5 billion from 374 buyouts in 2012, with secondary buyouts having a reasonably high profile.

200,

1,600

180,

1,400

Number (’000)

160,

1,200

140, 120,

1,000

100,

800

80,

600

60,

400

40,

Value (million euros)

Figure 1. Buyouts/buyins in Europe 1980–2012. (Source: CMBOR/ Equistone Partners Europe/Ernst & Young)

200

20, 0 2012

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

0

Year of buyout Number

Value (million euros)

Note: Europe is defined here as Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom.

As recessionary conditions took hold, there was a fall in the number of large deals, and a rise in failures of buyouts and in buyouts of failed firms. The private equity industry may struggle as investments fail or underperform, but potentially it can restore the balance by buying and reviving failing companies. The industry has survived despite the recessions of the past and, provided it can adapt, will survive the most recent recession and in fact is showing signs of recovery.

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Leveraged Buyouts and Recession 41

Buyout Failures The number of buyouts that entered administration/receivership in the United Kingdom (the UK corporate bankruptcy regime) during the 27 years to 2012 are shown in Figure 2. Over the period before the recent recession (i.e 1985 to 2006) CMBOR data show that 1,662 of the total of 13,030 buyouts completed (12.8%) had entered receivership by the end of 2006. Numbers reached initial peaks in 1991 and again in 2001–2. In the 2007–09 period, there was a sharp increase in the number of buyout receiverships. These peaks coincide with the greatest falls in GDP in the United Kingdom, as shown in Figure 3.

Figure 2. New buyouts/buyins and receiverships of buyouts/buyins in the United Kingdom 1985–2012. (Source: CMBOR/Equistone Partners Europe/Ernst & Young) 800 700

Number

600 500 400 300 200 100 2011

2009

2007

2005

2003

2001

1999

1997

1995

1993

1991

1989

1987

1985

0

Year of buyout or receivership Buyouts

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Receiverships

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42 The M&A Collection

10

160

8

140

6 4

120

2

100

0

80

–2

60

–4

Receiverships

2011

2009

2007

2005

2003

2001

1999

1997

1995

1993

–12 1991

–10

0 1989

–8

20 1987

40

GDP annual growth rate (%)

180

1985

Number of receiverships

Figure 3. Buyout receiverships versus GDP growth in the United Kingdom 1985–2012. GDP growth rate expressed as an annual % change in GDP volume (output approach). (Sources: CMBOR/ Equistone Partners Europe/Ernst & Young, OECD.StatExtracts)

GDP annual growth rate

Note: The year is the year of the buyout receivership

It is notable that there have been significantly more buyout failures as a result of the recent recession, partly because there have been more buyouts in recent years, but also as a consequence of the increased use of leverage in the decade leading up to recession which many buyouts then struggled to service. Uncertainty both in the macroeconomic context and in relation to further regulation in the banking sector has led to buyouts being completed with far lower levels of debt or without any debt with the expectation that deals can be refinanced when debt markets loosen. Studies of larger US buyouts completed during the first buyout wave of the 1980s and of the whole UK buyout market up to the early 1990s provide strong evidence that higher amounts of debt were associated with an increased probability of business failure or the need for restructuring. More recently, our examination of the 1,448 UK private equity-backed deals completed from 1996 to 2008 that had exited through initial public offering (IPO), trade sale, secondary buyout, or receivership up to the end of 2012 provides some systematic indication of whether high leverage is associated with buyout failure (Table 1). It is particularly notable that three out of the four size ranges that entered receivership had higher proportions of debt in their initial financing structures, particularly the smallest and largest buyouts.

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Table 1. Debt and buyout receiverships in the United Kingdom 1996–2008 (exited by end 2012). (Source: CMBOR/Equistone Partners Europe/Ernst & Young) Deal size range

No. of buyouts

Total debt* as % of total financing

£0–9.9 million All exited deals Receiverships

452 141 (31% of all exits)

52.4 57.3

£10–49.9m All exited deals Receiverships

604 130 (22% of all exits)

57.8 58.3

£50–99.9 million All exited deals Receiverships

163 18 (11% of all exits)

64.8 57.0

£100 million+ All exited deals Receiverships

229 15 (6.6% of all exits)

66.2 75.5

* Includes senior debt, mezzanine debt, high-yield debt, and vendor loans.

Companies that are bought out are not a random subset of the population but are usually firms that have been identified as underperforming in some way. Our analysis of the population of UK private companies from 1995 to 2009 shows that while management buyins are significantly more likely to fail than companies that have not gone through a buyout, management buyouts and private equity-backed buyouts completed from 2003 (when the bankruptcy regime in the United Kingdom was changed to favor administration) were not significantly more likely to fail than companies that had not gone through a buyout. Since 2001 the number of non–private equity-backed failures has been greater than the failure of private equity-backed buyout transactions (Figure 4). There are also indications that larger buyouts are less likely to fail than smaller deals (Figure 5). The primary reason for this is that a larger firm is often an older firm and therefore has a more stable relationship with its customers, suppliers, and financiers. A larger firm may have a larger portfolio of related products and may have diversified into unrelated products, thus reducing the risk of failure if sales in certain areas fall. A larger firm may also contain more separable assets that can be disposed of to generate cash to pay down debt and help restructure the core business.

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Figure 4. Private equity and receiverships of buyout/ins in the United Kingdom 1980–2009. (Source: CMBOR/Equistone Partners Europe/Ernst & Young) 30.0

Receiverships (%)

25.0 20.0 15.0 10.0 5.0

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

0.0

Year of buyout Private equity-backed

Non private equity-backed

Note: Receiverships (%) = (number of PE backed buyout receiverships/number of PE backed buyouts) * 100. Based on year of buyout.

Figure 5. Buyout/buyin receiverships by initial deal size in the United Kingdom 1989–2009. (Source: CMBOR/Equistone Partners Europe/Ernst & Young) 100 90 Receiverships (%)

80 70 60 50 40 30 20 10 2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

0

Year of receivership Less than £5 million

More than £5 million, less than £25 million

£25 million or more

Note: Receiverships (%) = (number of buyout receiverships for each deal value range/total number of receiverships) * 100. Based on year of receivership.

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An important issue for financiers of buyouts that eventually fail is the share of their investment that can be recovered. In UK buyouts completed in the period 1990–95 that subsequently defaulted, secured creditors recovered on average 62% of their investment, and many of these companies were eventually restructured and sold as going concerns. In comparison with the general population of small firms, buyouts appear to experience fewer going-concern realizations from receivership (30%), make a lower average repayment to secured creditors, and make fewer 100% repayments to these creditors. In the recent recession some distressed private equity-backed buyouts were the subject of debt-for-equity swaps. These may arise where PE firms are unable or unwilling to make cash injections because of unbridgeable gaps between the bank’s exposure and the market value of the business. While debt–equity swaps re-price risk and reward for the banks, it is risky for the banks as they are taking equity risk on to their balance sheet, while treating this as loans. While PE firms that do not inject further cash may be left with a modest “rump” stake and little influence, banks may want to keep PE firms involved in helping to run the business as the banks do not have the requisite skills. Following a debt-for-equity swap it is important to maintain management’s incentives if they are performing well, since these will contribute to the size of any eventual recovery of the bank loans. Even where the underlying business is sound, a debt-for-equity swap may mean a shift away from initial growth strategies, with consequent delays in exit. However, sooner or later banks will need to recover value through equity sales, either through trade sales or by putting firms into the bankruptcy process, depending on recovery in market conditions and the firms’ trading positions.

Buyouts as a Means of Firm Survival Failing companies can also be rescued through a management buyout. In times of recession there has been an increase in the number of buyouts from failed companies (Figure 6). Buyouts from firms in receivership/administration initially peaked in the depth of the recession of the early 1990s, with 107 deals in 1991 accounting for 18.4% of the deal volume. A second, lower, peak occurred in the much shallower recession of the early 2000s, with 78 deals completed in 2002, accounting for 12.1% of deal volume. The deep recession of 2008 and 2009 saw a sharp increase in buyouts of companies in receiverships/administration reaching 112 deals in 2009, accounting for this source’s highest-ever share of the market at 28.8% of deals.

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Figure 6. Sources of buyouts/buyins versus GDP in the United Kingdom 1985–2012. GDP growth rate expressed as an annual % change in GDP volume (output approach). (Sources: CMBOR/Equistone Partners Europe/ Ernst & Young, OECD.StatExtracts) 6

350

Source of buyout (number)

4 3

250

2 200

1 0

150

–1 100

–2 –3

50

GDP annual growth rate (%)

5 300

–4 –5

Family

Divestment

Receiver

2011

2009

2007

2005

2003

2001

1999

1997

1995

1993

1991

1989

1987

1985

0

GDP

Note: The year is the year of the buyout

The total value of buyouts from receivership reached its highest-ever level in 2012 at £1.81 billion (10% of total deal value) but was also significant in 2009 where the total value reached £1.1 billion (19% of total deal value). Most of these buyouts from receivership involve the purchase of parts of failed groups rather than attempts to rescue whole firms (see for example the Denby case study below). Buyouts of firms in receivership have occurred across a wide range of industries, being most numerous over the last decade in manufacturing, followed by retail, technology, media, and telecommunications (TMT), and business and support services (Table 2). However, there are notable similarities between the earlier and later parts of the last 12 years. The number of buyouts from failed firms in TMT was high in the 2000–03 period, reflecting the collapse of the dot.com boom, and is equally high in the most recent five-year recessionary period (2007–12). In the recent recession this was due to consolidation in the TV/radio/newspaper/magazine businesses, as well as difficulties in the marketing sector. There are however some differences across the twelve-year period, specifically that buyouts of failed firms in business and support services, property and construction, and in the retail sector have been particularly prevalent recently compared to the previous years.

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Table 2. Sector distribution of buyouts/buyins from failed firms by number in the United Kingdom 2000–12. (Source: CMBOR/ Equistone Partners Europe/Ernst & Young) Sector group

2000–12

2000–03

2007–12

86 28 49 12 67 269 46 27 107 74 17 67

21 6 15 4 9 100 20 4 13 33 3 15

47 19 25 7 45 99 15 18 71 31 10 31

Business and support services Financial services Food and drink Healthcare Leisure Manufacturing Paper, print, publish Property and construction Retail TMT Transport and Comms Others

Private equity firms were most active in buying failing firms during the recessions of the 1990s, when there was a good supply of firms in receivership and where bargains were to be found (Figure 7). At other periods, most noticeably the last 10 years, private equity firms have not been the main purchasers of these target firms. As the most recent recession bit, private equity firms were able to take advantage of the situation by buying failing companies.

Figure 7. Buyouts/buyins from the receiver in the United Kingdom 1980–2012. (Source: CMBOR/Equistone Partners Europe/Ernst & Young)

Receivership source (%)

120 100 80 60 40 20

2012

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

0

Year of buyout Private equity-backed

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Non private equity-backed

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Although it is too early to assess the effects of buyouts from receivership in the recent recessionary period, our survey evidence from the last deep recession of the early 1990s—using a representative sample of 64 buyouts from receivership—shows that major restructuring activities were needed to turn around the business. Almost two-thirds (64%) had appointed new directors, 56% had not reappointed existing directors, 48% had reduced debtor days, 38% had reduced their vehicle fleet, and 34% had cash flow problems post-buyout. The average employment level fell from 202 on buyout to 158 at the time of the survey. However, some 63% had not made job redundancies on buyout. Subsequently, 36% reduced employment, 36% did not change employment, and in 19% of cases employment was above pre-buyout levels. On a cautionary note, evidence from deals completed in the recession of the early 1990s shows that buyouts of firms in receivership are more likely to fail again than are buyouts from other vendor sources.

Case Studies Fat Face: Debt Buyback and PiK

This case highlights the fact that recession and falling profits will significantly affect a firm’s ability to repay bank debt. It also introduces the concept of debt buyback—a means of reducing a firm’s debt burden. Fat Face is a retailer of life-style oriented outdoor clothing and accessories based in Hampshire, England. The company was created in 1987 by selling T-shirts and sweatshirts on the ski slopes. It opened its first stores in 1993, building up to 128 outlets in 2007, together with a catalogue business and an online store. Following rumors of a possible exit by IPO or trade sale, the company was bought out in 2005 in a £100 million deal backed by Advent. Fat Face was sold to Bridgepoint in 2007 for £360 million in an auction reportedly involving at least three rival private equity firms. Bridgepoint recognized that this was a full price but believed it had acquired “an incredible asset,” with sales having grown at a compound rate of 35% a year. At this point the company had 1,500 employees and forecast an increase in turnover from £81 million to £111 million and an EBITDA of £30.4 million for the year to end of May 2007. As it was, the EBITDA for that year was £26 million. The management team, including the founders, reinvested a significant share of their sale proceeds in the new buyout. Following the buyout, it was intended to expand the business by opening up to 15 new stores per year in the United Kingdom and developing interests in the Middle East, Hong Kong, and Singapore. In the year to end May 2008 sales increased 16% to £126.4 million and EBITDA rose 2.1% to £26.6 million. This increase was helped by the opening of 12 new stores in the United Kingdom. As the recession developed, there were concerns about the company’s ability to service its debt, though it had continued plans to expand the brand. At the end of May 2008, the company faced a banking covenant test of 7.5 times net debt to EBITDA. In the third quarter of 2008, Bridgepoint and management bought back a nominal £21.8 million of mostly second-lien debt at 56 pence in the pound, reducing total debt from £190 million to £168.2 million. This included a repurchase of £10 million of debt in the first quarter at an average price of 60 to 65% of nominal value. Under its revised capital structure, debt represented six times EBITDA,

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reportedly high compared to the general retail sector but with some headroom in covenants. In early 2009, Bridgepoint made a £4.6 million equity injection to ensure Fat Face did not breach its financial covenants. By the end of 2009, sales had fallen from £131.5 million to £129.4 million and the pre-tax loss had widened from £29.6 million in 2008 to £225 million in 2009 (Bridgepoint was forced to make a £211 million write-down on its investment). In 2010, Bridgepoint injected a futher £8.5 million and the group put in place controversial “payment in kind” (Pik) loans (through conversion of debt), under which interest payable accrues until the end of the term. Fat Face continues to struggle with the combination of high leverage and sluggish sales.

Denby: Buyout from Receivership

The case of Denby highlights what can happen when a large organization goes into receivership. A management buyout provides a means by which more viable divisions can survive. Denby is a world-famous British pottery manufacturer based in Denby, Derbyshire, which started producing pottery in 1809. In June 1990, Coloroll, Denby’s parent company, went into receivership and Denby was purchased by its own management, backed by 3i (a private equity group), for a total of £7.4 million. Denby’s managing director and three associates invested £140,000 for a 55% stake in the company, while 3i held the balance. The firm began to sell its products in the United States, and by the time it floated on the London Stock Exchange in 1994 it was valued at £43.4 million. It used some of the proceeds of the sale to repay its debts and continued its expansion abroad, updated its range of products, and opened a visitor centre complex at Denby. The center became a major tourist attraction, with 300,000 visitors a year by the end of the century. The company has since undergone many more management buyouts: the second in 1999 for £40.7 million involved a delisting from the stock exchange; the third in 2004 for £48 million was a management buyout. More recently, the firm had difficulty servicing its debts in tough retail conditions (particularly for the UK pottery industry) and had its fourth buyout in 2009 for £30 million, led by the managing director and private equity firm Valco Capital Partners, specialising in restructurings. Half of the group’s £72 million debt was written off as part of this transaction. Denby has added glassware and porcelain to its product range and continues to trade.

Making It Happen

• 

Seen in the light of experience from the first buyout wave of the late 1980s and the second wave of the late 1990s to 2007, current trends highlight the importance of financial analysis and forecasting at the time of the deal in relation to the ability of a firm to service debt. This especially concerns the need to consider the consequences of sharp economic downturns.

• 

Buyouts of distressed companies, whether in bankruptcy proceedings or close to them, are an important feature of the private equity market in the short to medium term. Failing companies can be bought at discounted prices. If they involve viable parts of failed groups, it may be possible to make a purchase that is free of major parent liabilities.

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• 

There is a need for considerable turnaround activity both on buyout and subsequently if a viable entity is to be created. Private equity firms with the financial means and management skills could turn these failing firms into profitable entities.

• 

Private equity firms buying out failed companies typically will need to make investment decisions much more quickly than is generally the case, and often with less scope for due diligence and few, if any, warranties. Particular attention may need to be given to ensuring that suppliers and customers will remain committed to the company.

• 

There is a premium on private equity firms having expertise in a particular sector and in having done distress deals that enable rapid assessment of prospective risks and returns. It is also important to assess the calibre of incumbent management. If they are not a contributory factor to failure, their knowledge of the business may be crucial in avoiding the pitfalls due to the contracted deal process noted above.

More Info Articles:

Gilligan, John and Mike Wright. “Private equity demystified: 2012 Update” ICAEW Corporate Finance Faculty, 2012. Online at: tinyurl.com/4xgeu8f Wilson, Nick, Mike Wright and Ali Altanlar. “Private equity, buy-outs, leverage and failure.” CMBOR/CMRC, March 2010. Wright, Mike, Andrew Burrows, Rod Ball, Louise Scholes, Miguel Meuleman and Kevin Amess. “The implications of alternative investment vehicles for corporate governance: A survey of empirical research.” OECD, July 2007. Online at: www.oecd.org/daf/ca/39005553.pdf

Websites:

British Private Equity and Venture Capital Association (BVCA): www.bvca.co.uk Centre for Management Buy-Out Research (CMBOR), Imperial College Business School: www3.imperial.ac.uk/business-school/research/innovationandentrepreneurship/cmbor European Private Equity and Venture Capital Association (EVCA): www.evca.com

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Identifying and Minimizing the Strategic Risks from M&A By Peter Howson

Executive summary •

The high failure rate of acquisitions can be mitigated considerably by dealing with the strategic risks that are present at every stage of the acquisition process.

•

It is best to start with a well-developed business strategy, a clear idea of the place of mergers and acquisitions (M&A) in this strategy, and an acquisition target that furthers strategic aims.

•

Before embarking on negotiations, acquirers should avoid the risk of overpaying by setting a price above which they will not go.

•

Before negotiating the final details, due diligence should be used as a final confirmation of the strategy and the target’s fit.

•

The most important thing is to make sure that the post-acquisition plan is put together early and in as much detail as possible. Acquirers need to add value, and they can only do this if they are clearly focused on the sources of extra value and how to realize them right from the very start.

Introduction M&A is extremely risky. Studies carried out over the last thirty years suggest that the failure rate is above 50% and probably close to 75%. However, by identifying and acting to minimize the strategic risks early on in the process, the rewards can be spectacular. There are four stages in the M&A process:

•  •  •  • 

acquisition strategy; due diligence; negotiation; post-acquisition integration.

Strategic risks are present in each.

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Acquisition strategy

M&A is glamorous. Market analysts see M&A as a sign of a dynamic management and mark up share prices accordingly. For management, M&A can be a means of bolstering short-term performance and/or masking underlying problems. It is hardly surprising that the failure rate is so high when the mystique of M&A encourages acquirers to rush into acquisitions.

M&A is a strategic tool

This brings us to the first strategic risk—a failure to recognize that M&A is a strategic weapon. Strategy is all about giving customers what they want, and to do it better or more cheaply than anyone else. It is about competitive advantage gained through superior capabilities and resources. M&A should fit into this framework. Given the high risk of failure, acquirers should ask themselves if acquisition is the best means of achieving aims. There will generally be a tradeoff between risk and time. Acquisition is the highest-risk route to corporate development, but it is often the quickest. Acquisition should be examined alongside all the other options— organic development, joint venture, merger, etc.

Is the timing right?

Implementation is the key to successful strategy and this is the clue to the next strategic risk—is this the right time to be acquiring? Getting the transaction done and integrating it afterwards will take up a disproportionate amount of time, resources, and expertise. This means making sure that:

•  • 

a strong base business exists (if existing operations are struggling, acquisitions will only add to the problems); the resources to add value are available (where there are insufficient resources to manage an acquisition, the chances of adding value are slim).

Select the right target

The next risk may sound obvious, but one of the biggest ever M&A disasters stemmed in part from selecting the wrong target. In 1991 AT&T, the US telecommunications company, bought NCR for $7.48 billion. AT&T was implementing a so-called “3Cs strategy” where communications, computers, and consumer electronics were expected to coalesce into a new market. It bought NCR to provide a capability in computers. But NCR was not a computer company. Its core business was in retail transaction-processing and banking systems, and it happened also to manufacture a range of “me too” personal computers. While this may be an extreme example, it is not uncommon for buyers to misunderstand the target company’s capabilities.

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Due Diligence

The strategic risks in due diligence all stem from making the focus of due diligence too narrow. The success of any acquisition depends on buyers creating value. Due diligence presents a potential buyer with the access and information it needs to confirm that a transaction can be a long-term success. This means using due diligence not just as an input to the sale and purchase agreement but, more importantly, also to confirm both the robustness of synergy assumptions and their deliverability. As people will deliver the extra value, buyers should also make sure that due diligence covers cultural and people issues.

Negotiation

In negotiation, the strategic risk is overpaying. Buyers are almost certainly going to have to pay a premium for the control of a company. The challenge is to make sure that the synergies are big enough to cover both the premium and the deal costs. Work out a price in advance and, as it is all too easy to get carried away, always set a maximum walk-away price before negotiations begin.

Post-Acquisition integration

The major cause of acquisition failure is poor integration. Integration is poorly carried out because it gets forgotten. Doing the deal may be sexy, but integration is where the real money is made or lost. The strategic risks stem from not starting work on the integration plan early enough in the process. As integration is central to valuation, the integration plan must be put together well before negotiations begin, and the other golden rules of acquisition integration also demand an early plan:

•  • 

Integrate quickly to minimize uncertainty. In particular, integration changes related to personnel need to be made as soon as possible; early communication is paramount; and there should be early victories to demonstrate progress. Do not neglect the soft issues. The culture of a company is the set of assumptions, beliefs, and accepted rules of conduct that define the way things are done. These are never written down, and most people in an organization would be hard pressed to articulate them. However, they can substantially increase postacquisition costs or hold back performance

• 

Manage properly. Buyers should appoint an integration manager. Like any other big project, acquisitions need one person to be accountable for the project’s success.

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Case Study In 1996, Federal-Mogul, a US auto parts company, appointed a new Chairman and Chief Executive, Dick Snell, whose basic premise was that in the automotive industry, a firm must be big. Automobile makers were focusing on assembly, branding, and marketing, and were encouraging parts manufacturers to play a bigger role in the design and development of components. They were also encouraging the larger suppliers to supply modules and systems rather than components. Federal-Mogul’s “growth by acquisition” strategy had the simple aim of increasing sales from $2 billion to $10 billion in six years. The company already made gaskets and seals, but not enough to market a full engine or transmission-sealing package. Federal-Mogul also made engine bearings, but did not have the ability to market the bearings as a system complete with piston, piston rings, connecting rods, and cylinder liners. Federal-Mogul first bought T&N plc (in 1997), a supplier of engine and transmission products and Europe’s leading supplier of gaskets. With sales of $3 billion, T&N was bigger than Federal-Mogul itself. Soon after (in 1998), Federal-Mogul paid $720 million for privately held Fel-Pro Inc., of Skokie, IL. Fel-Pro was a leading brand of replacement sealing products. Following these two acquisitions, Federal-Mogul had a $1 billion global sealing business and the basis for providing an integrated engine package. Later that year, Federal-Mogul went on to buy Cooper Automotive for $1.9 billion. Cooper added three completely new product areas (see table).

Table 1. Federal-Mogul’s acquisitions Existing operations (as of 1996)

1997: T&N 1998: acquisition Fel-pro acquisition

1998: Cooper Automotive acquisition

Engine and transmission Engine Bearings

X

Pistons and piston rings

X X

Seals

X

X

Camshafts

X

X

X

Other Lighting

X

Fuel pumps

X

Friction (brake and clutch pads)

X

Powdered metals

X

Ignition

X

Chassis

X

Wiper blades

X

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In July 1998, Federal-Mogul’s share price was $72. By September 2001 it was $1. On October 1, 2001, the company filed under Chapter 11 of the US Bankruptcy Code. What went wrong?

Overambitious strategy

Following the Fel-Pro acquisition, the logical thing would have been to continue building the engine and transmissions business. Instead, Federal-Mogul kept its electrical businesses and the friction businesses acquired with T&N, and went on to add three entirely new product ranges. Focusing only on revenue and growth rarely, if ever, produces a strong organization and financial results over the long term.

Problems picked up in due diligence not acted on

T&N had at one time manufactured building products containing asbestos and for years it paid out an increasing number of compensation claims for asbestos-related diseases. Following the takeover, the number of asbestos claims against T&N and its former subsidiaries exploded. In October 2001 there were 365,000 asbestos claims pending. By the end of 2001, Federal Mogul had paid out $1 billion in claims. While Federal-Mogul was aware of the asbestos issue, Federal-Mogul leaders did minimal due diligence, failed to appreciate just how serious it was, and believed that, because it operated in the United States, it would be able to manage the litigation better.

Poor integration

Federal-Mogul paid a high price for T&N and the other big acquisitions, promised too much, and failed to deliver. Federal-Mogul leadership repeatedly promised the market that integration would bring tens of millions of dollars worth of synergies. In fact, according to a stockholder class action, the company’s integration activities destroyed the acquired businesses. The class action claimed that, “After an acquisition, the Company would slash sales staff at the acquired company, close manufacturing and warehouse facilities, reduce investment in research and development, reduce customer service and implement aggressive sales practices.” Federal-Mogul’s management lacked an understanding of how international businesses operate. It was obsessed with the Detroit Big Three and dismissive of the other vehicle assemblers, yet the strategic logic of acquiring parts manufacturers should be to broaden geographic reach and bring closer relationships with vehicle assemblers. Federal-Mogul management also failed to appreciate that the rest of the world was not like the United States and, in particular, that Europe was not like a group of US states. FederalMogul centralized all its operations, including customer service. When Federal-Mogul moved aftermarket operations to the United States, it was surprised that its telecom ordering system did not recognize overseas telephone numbers. In contrast, T&N had given a great deal of autonomy to its regions. Finally, Federal-Mogul lost key staff by insisting that anyone who stayed had to move to Detroit. Most former T&N leaders opted to take the money. While it is not impossible to buy a company larger than yourself, it is difficult to manage something the size of T&N without retaining most of the management team—and T&N was actually quite good at managing asbestos claims. Federal-Mogul emerged from Chapter 11 bankruptcy on December 27, 2007 after a financial reorganization designed to protect it from asbestos claims.

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Making it happen

•  •  •  •  •  •  •  •  •  • 

Think of M&A as a means to competitive advantage rather than short-term improvements in financials. M&A is the most risky form of corporate development, so be sure to consider the alternatives such as organic growth or joint ventures. M&A will divert resources from the existing business, so make sure it is strong before embarking on acquisitions. Be sure to understand the target company—what it does, how it operates, how it makes money—and be able to articulate why it fits the strategy. Do not neglect soft issues like management and culture. Do not assume that “they are just like us,” because they won’t be. Prepare a detailed integration plan in advance. Keep the due diligence scope wide. Always use it to confirm the sources of added value identified and quantified in the integration plan. Never be lured into overpaying. Set a clear walk-away price and do not exceed it. Once the deal is done, communicate immediately, clearly, consistently, and abundantly to everyone concerned. Do not forget external parties, above all customers. Implement changes quickly and smoothly and do not underestimate the size of the task.

More Info Books:

Camp, J. Start with NO: The Negotiating Tools that the Pros Don’t Want You to Know. New York: Crown Business, 2002. Carey, Dennis et al. Harvard Business Review on Mergers & Acquisitions. Boston, MA: Harvard Business School, 2001. Cleary, P. J. The Negotiation Handbook. Armonk, NY: M. E. Sharpe, 2001. Freund, James C. Smart Negotiating: How to Make Good Deals in the Real World. New York: Fireside, 1993. Howson, Peter. Due Diligence: The Critical Stage in Acquisitions and Mergers. Aldershot, UK: Gower Publishing, 2003.

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Howson, Peter. Commercial Due Diligence: The Key to Understanding Value in an Acquisition. Aldershot, UK: Gower Publishing, 2006. Howson, Peter. Checklists for Due Diligence. Aldershot, UK: Gower Publishing, 2008. Howson, Peter, with Denzil Rankine. Acquisition Essentials. London: Pearson Education, 2005. Hubbard, Nancy. Acquisition: Strategy and Implementation. Basingstoke, UK: Palgrave Macmillan, 1999. Hunt, J. W., S. Lees, J. J. Grumbar and P. D. Vivian. Acquisitions: The Human Factor. London: London Business School and Egon Zehnder International, 1987. Lajoux, Alexandra Reed and Charles Elson. The Art of M&A Due Diligence: Navigating Critical Steps and Uncovering Crucial Data. New York: McGraw-Hill, 2000. Rankine, Denzil. Why Acquisitions Fail: Practical Advice for Making Acquisitions Succeed. London: Pearson Education, 2001.

Article:

Davy, A. J. et al. “After the merger: Dealing with people’s uncertainty.” Training and Development Journal 42 (November 1988): 57–61.

Report:

KPMG. “Unlocking shareholder value: Keys to success.” London: KPMG, 1999. Online at: tinyurl.com/3yn35rz [PDF]

Websites:

Commercial due diligence—AMR International: www.amrinternational.com Financial due diligence—BDO Stoy Hayward: www.bdo.co.uk

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MBOs: A High-Octane and LifeChanging Mode of Business by Andy Nash

Executive Summary

This chapter is aimed at prospective managers of a management buy-out (MBO). •

MBOs are inherently risky, with a relatively high failure rate.

•

It’s the leverage in the deal structure that makes success so rewarding. Unfortunately, leverage works just as impressively in reverse!

•

Every year around 600 deals will be completed, and every year broadly that number will reach the exit stage. Unfortunately, one of the most common “exits” over the last 20 years has been receivership!

•

Research, good advice, and planning will increase your chances of success

•

You can increase your chances of success by knowing what the common elephant traps are.

•

Setting out on an MBO without the best advice and support you can muster is akin to walking blindfold through a minefield. You have been warned!

MBOs: The Beast Explained MBOs—shorthand for MBIs, BIMBOs, IBOs and the like, as well as management buyouts—make or lose fortunes for the risk-takers because of the leverage involved. Leverage is the fulcrum on which these deals seesaw between success and failure. Every venture capitalist’s portfolio has a range of leveraged companies, and average returns to their investors are determined by the balance between their star investments and those which stagnate or go bust. Leverage is a business-school type word—my eldest daughter would probably say it was cool! If your company were an automobile, leveraging it would be like filling the trunk with high explosive and then driving off on a long journey with your fingers crossed. Management buyouts and buyins are a high-octane part of the business world. Since 2001, the most common exit from MBOs/MBIs hasn’t been flotation, or even trade sales, but receivership. It is a high-risk/reward arena. Metaphorically, an MBO/MBI is like fitting an eight-liter V12 engine into an aged VW Beetle and expecting it to perform much better than before. I’ve worked with twelve MBOs since 1991 in a variety of roles: as chairman, executive director, nonexecutive director, and as a personal coach to a managing director. The

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experience has varied greatly: from staggering success to the verge of financial oblivion—and fortunately back again. The deals have ranged across very different markets: from the sophisticated world of global drug discovery in mythical Tintagel to heavy metal bashing (dustcarts) in the West Midlands of England, and from the rarefied academia of international publishing to horticulture in the Welsh valleys. The deals have been backed by many different venture capitalists and financed by UK and international banks. I have been very fortunate to have seen many MBOs through the prism of management. There are many good books written by academics and professionals that describe the process, structure, and chronology of an MBO. It is important that you understand these topics; however, it’s crucial that you also understand other aspects: where the main elephant traps are; what the key success factors are likely to be; and how an MBO’s chances of success can be maximized. After 12 deals I have no idea what constitutes “best practice” because I’ve discovered that every MBO is unique. I have reflected long and hard on the lessons I’ve learned on these deals over 18 years, and they are set out below.

MBOs: The Main Lessons I Have Learned 1. Do an MBO with your eyes wide open

Conducting an MBO is extremely demanding. The demands on you, your colleagues, and your family and friends will be severe. And this is just to complete the deal. After completion, the difficulties and pressures are unlikely to abate. The risks are significant, even for a well-managed and successful business. You can materially reduce the odds against you by understanding the lessons learned by those who have gone before you. For a manager, an MBO/MBI is a life-changing experience.

2. Ensure that you are an effective team

A talented group of individuals isn’t enough! You must be a team. I don’t need to amplify this—any senior manager will understand the difference. If there are fault lines within management, they will be exposed. You should make any changes that may be needed before you set out on the deal— or at worst during the deal. Afterwards is far more difficult, and it might be too late.

3. Don’t overpay—Work to a realistic business plan

There is an inevitable conflict between preparing a plan which, on the one hand, is achievable, and, on the other, is capable of supporting a price high enough to ensure that you can buy your target company. You need to strike the right balance— but this is easier said than done.

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It is said that it is better to overpay for the right business than underpay for the wrong one. The thrust of this must be right; however, if you knowingly overpay, with the purchase price predicated on optimistic numbers, you will almost certainly regret it. In any business, performance will deviate from budget or plan. In a highly leveraged business, the margin of underperformance that can be accommodated is relatively small. Some excellent businesses have failed in this way. There was nothing wrong with the company, its management, or its prospects. Its financing structure simply couldn’t withstand an unforeseen financial shock.

4. Choose advisors and backers with whom you feel comfortable

There is no shortage of accountants, legal firms, bankers, and private equity houses that will have an appetite for a good deal. It is, however, important that you feel very comfortable with your advisors and backers. Your respective commercial and career prospects will be in each other’s hands. There must therefore be openness, trust, and mutual respect. This is obviously a totally personal and intangible matter. It may well be that you need to kiss a lot of frogs before you find your prince.

5. Do your deal on a contingent basis

This might be stating the obvious, but some management teams have been caught out in this area. Provided that you are well advised, it is usually possible to ensure that you are not exposed, or left holding the baby, if the deal falls over and fails to complete. At the right time in the process, advisors are quite adept at securing some degree of cost underwriting from the vendor. These break-fee arrangements are useful in that they tend to provide some security and the incentive to see a deal through.

6. Your strategy must be capable of being understood and implemented

Warren Buffett says that if a plan can’t fit on a side of A4 it can’t be understood. Given that 80% of strategy is about implementation, what he’s probably referring to is the difficulties businesses have of actually achieving their objectives if there are not absolute clarity and understanding of strategy throughout the company. Put another way, if you can’t explain your strategy during an elevator ride (i.e. in 20 seconds), you probably can’t explain it at all.

7. Take heed of the due diligence report

You will meet many managers who have been scarred by the due diligence process. While due diligence is in many ways akin to a lifebuoy for the backers, it nonetheless shines a torch of some intensity into every corner of your business. Recognize that

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any management team’s first instinct when faced with criticism is to deny it. Make sure it isn’t you who is in denial. Further, task a member of the management team with analyzing the due diligence report, and draw up a list of points to be addressed post-completion.

8. Your board must be effective

As Patrick Dunne of 3i Group wrote: “Bad boards destroy value.” Directors must be individually and severally effective. The nonexecutive directors must add value and fit in as part of the team. An annual board calendar should be prepared and adhered to. Board papers should be circulated at least three working days before meetings and must contain information, not data. Really important performance indicators (e.g. cash forecasts and covenants) should be graphed so that they can easily be understood. The board agenda should focus on key issues and decision-making and not allow endless waffle or a mere exchange of information. Research shows conclusively that the most effective board meetings last between two and three hours. Communications between the board and fund providers must also be frequent, candid, and well managed.

9. Incentivize your important managers

Businesses are run by people. Retaining all of the potentially very valuable sweet equity amongst just the top team can be divisive. It may create an us-and-them mentality, which can be very counterproductive. Consider incentivizing managers who are significant in the running of the business. Some companies have incentivized all employees, which is said to have had a very positive effect on the company’s performance.

10. If it goes wrong, act fast and get outside help

Many MBOs/MBIs experience a drift from plan which invokes a recovery situation. If a company drifts from plan, remedial action must be taken very fast. If analysis indicates that this is not a one-off but a recurring problem, then your survival is at stake. Recognize this and act accordingly. Frequently, the skills needed to reduce costs and generate cash are not available in the management team. You can train a rabbit to climb trees, but it’s better to hire a squirrel! There are experienced individuals who specialize in these situations. You should consider getting them on board to help you negotiate the choppy waters ahead.

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11. The exit: Seize the moment

It is highly unlikely that there will ever be a perfect time to exit. Inevitably, there will always be some clouds in view: a potential loss of a contract, a delisting, significant price increases in raw materials, etc. However, if you have the opportunity to unload your trunk load of high-explosive (debt) and it is within the time frame originally envisaged, then you will be well-advised to take it. In short, carpe diem.

12. Be true to yourselves and the company

There will be several occasions when you face a moral maze. Whichever way you turn, someone stands to lose. Advice may conflict, and you will be subjected to the most passionate advocacy from parties with different objectives. This is especially likely if you require a second or third round of fund-raising. In these situations, do the right thing for the business, as invariably this will, over differing timescales, benefit just about everyone involved with the company. Again, easier said than done, but it’s the best compass. A great example is that of one serial entrepreneur I know: when trading was tough in the early stage of an MBO, he had a choice: pay the wages or pay the VAT. He got it right—he paid his employees!

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Avoiding the Mistakes of the Past: Lessons from the Startup World by James E. Schrager

Executive Summary

Congratulations if you didn’t personally feel the hardship of the dot-com implosion. Many millions went to their demise but at least this left a legacy of what not to do. Fear not if you won’t be using the internet in your next venture. Many of these lessons generalize well beyond their former faulty incarnations. For those of you with a new product, technology, or division to launch, most translate into corporate organizations.

Introduction Failure is a wonderful teacher. The new-economy revolution had many of the trappings of a genuine economic revolt: vast fortunes forged in a fortnight, dashing young heroes and heroines, rotten institutions brought to their knees. It held such great promise, yet today even the dreams feel thoroughly eviscerated. What to learn from the revolution that never was? What lessons can be applied to new ventures? There is no better place to look for historical clues than the business plans presented by aspiring business managers. These serve as the revolutionary documents of record, holding within their propositions the seeds of ultimate success or failure. We will reassess these pillars of revolutionary wisdom.

The Lessons to Learn We Will Establish First-Mover Advantage

The problem with this mantra is that first mover by itself means little; what matters instead is the power of your strategy. The first team to execute a dumb idea has accomplished nothing. In some cases, when you have an exceptional new technology, being first brings power. In other cases—say, when your strategy is nothing more than another way to sell books—being first has little effect. Post-revolution, you can safely ignore the first-mover boasts. Instead, worry about the inherent strength or weakness of the business strategy.

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Amazon was concerned with being the first big player selling books on the Web. However, Amazon’s profit struggle has shown that being first made little difference. If you have an invention, for example the xerographic copy process, being first is wonderful. But note the difference: Xerox got a patent for its process, thereby making it not only the first, but also the only company to offer a plain-paper copier. Since no one could duplicate its service, it was able to charge a premium. Amazon will never be the only seller of books, so its margins will always be subject to pressure. First mover is fine when defensible, but meaningless without a way to stop competitors entering the market.

We Will Be the Technology Leader

Venture capitalists (VCs) are at their best when making carefully calibrated bets on technology companies. They have mostly ignored the rough-and-tumble world of retail business on their way to investments in computer memory chips, software codes, medical devices, pharmaceuticals, genomics, magnetic storage media, telecom satellites, optical bandwidth, and truly new technologies. In each case, tech-company founders had to produce something new and wonderful that worked as promised, would be in great demand, and could be protected via patents, trade secrets, or switching costs. Internet retailers may claim to have some bits of technology in a one-click purchase screen or real-time chat lists, but these are hardly protectable. As such, e-retailing cannot be the basis of a technology strategy. Claims of new technologies that cannot be protected are not worth much. Instead, strategies may center on building a brand; however, this is expensive to construct and requires constant maintenance to remain viable.

We Will Create a Powerful Image

Instead of worrying about technology that can be protected, retailers concentrate on the precise construction of a tailored image to appeal to a consistently fickle public. Priceline discovered how expensive it is to spend for a national audience and capture just a tiny slice. The overreach inherent in most mass-media advertising makes it a very dull tool for carving a startup’s image. So how will the image be created? Post-revolution business plans need to find a more efficient way than simply throwing money at the problem! Your marketing plan must also develop a carefully conceived media approach to allow for your image to be built in an economically efficient manner.

We Will Attract the Best VCs—With Their Reputations We Can’t Fail

As long as VCs can sell the idea to Wall Street, they’ll build the company. When they cannot, they’ll do their best to be long gone. Post-revolution, VCs who dabbled in

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e-commerce look just like other Wall Street pawns, appearing to be infallibly brilliant when the market goes up and hapless fools when the market collapses. The final customer for your product rarely cares who was behind the financing. It’s clearly better to have a brilliant idea funded by people no one has ever heard of than a specious idea promoted by a well-known VC shop.

We Plan a Full-Scale National Rollout to Leverage Our First-Mover Advantage and Ensure Our Ability to Grow

An accurate market test is your very best insurance against a giant belly flop. But don’t think you’ll impress anyone by faking it. For example a pacemaker distributor in Japan gauged demand for a new product by displaying it to its current customers. Even though the doctors involved in the test showed overwhelming approval of the new device, it didn’t meet sales projections once launched. In looking at why the test failed, the distributor noticed that the new device sold almost exclusively to existing customers. The distributor failed to realize the extent to which doctors are brand-sensitive. Make it a real test or don’t bother.

We Will Form Alliances with Key Players

This is a fine idea, except that in the early days no one knows who will win. In times of rapid change, even an alliance with a leading company may not deliver the promised advantages. The underlying business strategy, not just its alliances, must be more carefully understood. Very few partnerships in which the giving and taking aren’t balanced will survive.

The Internet Changes Everything

Well, not really. The information superhighway is certainly here to stay, and we’ll use it more and more, but gone are the stories of TheStreet.com buying Dow Jones, e-STEEL buying Bethlehem, and Amazon buying Wal-Mart. Other than Wall Street bonuses, the immediate changes wrought by the internet were fairly modest and will play out over a much longer period than the matter of weeks we were promised at the outset. In fact, it’s comforting to know that the internet won’t change everything overnight. The pace of change continues, even though not all change is progress. The internet does enable very rapid access to information and the rather carefree exchange of e-mail messages. If either of these two attributes can drive your business plan further or faster, by all means use the internet to get there. But what the internet will not do is take people out of the center of the business process.

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Making It Happen

• • • • • • •

Protect any new technology with patents or trademarks—create barriers to market entry. Determine your strategy, then your goals (growth isn’t a strategy; it’s a goal). Aim to reach your target market in an economical way. Promote your marketable idea, not your financial backers. Stage an accurate market test. Use the internet if it can drive your business plan further or faster. Be realistic: by all means consider different scenarios, but do not lose sight of reality.

Conclusion The basic rules of business strategy remain intact and do indeed apply to the internet. Like selling things in a store, selling products on a computer screen isn’t about technology. A technology business develops something new that cannot be easily imitated. This is the great lesson of the internet failures. New businesses can be understood by looking at success and failure patterns of the past. A careful review of the strategy you propose can help.

More Info Books:

Gupta, Udayan (ed). Done Deals: Venture Capitalists Tell Their Stories. Cambridge, MA: Harvard Business School Press, 2000. Slywotzky, Adrian et al. Profit Patterns: 30 Ways to Anticipate and Profit from Strategic Forces Reshaping Your Business. New York: Random House, 1999.

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The Art of Acquiring in Emerging Markets by Satu Teerikangas

Executive Summary: •

This chapter focuses on the art of company acquisition in emerging markets.

•

Current practice and theory consider that successes in acquisitions rests on three pillars: strategy, predeal financial considerations, and postdeal integration.

•

The chapter is based on a real-life case study of a Nordic industrial multinational’s experiences of selecting, negotiating, and running an acquired business in China. A total of 30 face-to-face interviews were conducted with the European and Chinese parties, as well as with relevant suppliers and local authorities in China.

•

In emerging and developing market contexts, the above three-fold conceptualization of acquisition success needs to be supplemented with relationship-management and cultural and institutional intelligence.

Introduction The first merger and acquisition (M&A) deals were recorded in the late 19th century in the United States. At present, more than a century later, spurred by economic and legislative advances and the liberalization of trade, acquiring firms are expanding their interest toward new opportunities in emerging markets and the developing world. “Moving east” is not entirely new. A similar move toward the “east” was witnessed in the early 1990s, as Western multinationals engaged in joint ventures with Chinese and Eastern European counterparts and established alliances with Japanese partners. This active joint venturing and alliancing was not without its difficulties, as witnessed by the poor success rate of many such ventures (Lunnan and Haugland, 2008; Reus and Rottig, 2009). An extensive body of literature examines how to navigate cooperation with competitors successfully (Hughes and Weiss, 2007; Kale and Singh, 2009), particularly along the East–West cultural divide. Today, some 20 years later, multinational firms are further expanding their international reach. They are seeking opportunities for corporate expansion via mergers or acquisitions in the emerging markets and the developing world. Beyond mere opportunity, though, there is an element of competitive threat as giants from the emerging markets are at the same time aggressively purchasing well-known

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Western brands (Kale and Singh, 2012). Clearly, the logic of competition has become global, and this is reflected in large firms’ acquisitive behavior in targeting a truly global span of prospects, instead of focusing only on the developed world. As acquiring in the emerging markets is on the rise, what are the repercussions for the executives involved? How should firms manage acquisitions in emerging markets? Questions such as these are the focus of the present chapter. Extant practice and theorizing consider that success in acquiring rests on the three pillars of strategy, predeal financial considerations, and postdeal integration (Faulkner, Teerikangas, and Joseph, 2012). Based on a real-life case study of an anonymized Nordic industrial multinational’s experiences of selecting, negotiating, and running an acquired business in China, I argue that—in emerging and developing market contexts—such a three-fold conceptualization of acquisition success needs to be supplemented with relationship-management and cultural and institutional intelligence. I provide an overview of the key learning points from the case study before concluding on the managerial repercussions of managing the acquisition process in the emerging world.

Case Study Background

Zodium is a Nordic multinational of Finnish origin, set up in the 1930s. Now, in the early 21st century, it boasts multiregional to global reach among its four industrial divisions. Zodium has operated on and in the Chinese market since the 1970s: first via exports, then via a representative office in Beijing since the 1980s, and since the 1990s through joint ventures with local partners. These are positive signals, in that Zodium was among the first international entrants to China when the country began its open-door policy in the 1970s. Despite the decades of gradual exposure to the country, its more recent acquisition experience left much to hope for. Opportunities to invest in China are regulated by the central governmental authority, which publishes its strategic intentions through ‘five-year plans’ (Li & Woetzel, 2011). From having sought foreign direct investments through either wholly owned subsidiaries or via jointly owned joint ventures since the 2000s, the Chinese government has opened the doors for M&A activity. After scanning potential candidates for purchase, Zodium soon set its eyes on Xinxia, a local state-owned firm based in a southern coastal town. Zodium’s reasoning rested on tangible elements: •

Xinxia operates a manufacturing plant which, through upgrades, could be operated for Zodium’s purposes;

•

it is attractively located close to a harbor city;

•

the adjoining region has market potential for Zodium’s products;

•

Xinxia’s products and technology parallel Zodium’s.

Ideally, the purchased company could be used for sales in mainland China and as a hub for exports to other Asian countries.

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Early encounters and negotiations ended on a positive note, but subsequent negotiations became strenuous. Conducting a transaction in a foreign market was more challenging than assumed. Eventually, after months of negotiation, Zodium did purchase Xinxia. With hindsight, what could Zodium have done differently?

Appreciating Regional Cultural Differences The question of partner selection, whether for joint ventures, alliances, acquisitions, or mergers, is critical. Zodium focused on tangible elements in its decision-making; however, it omitted the cultural and institutional differences that distance a local, southern Chinese firm with a legacy of state ownership from a Nordic multinational boasting global reach. When acquiring across borders in a large country like China, one encounters a myriad of regional cultures and constituencies. Purchasing a firm in Beijing, Shanghai, or the developed eastern coast of China is different from purchasing firms in areas which historically have received less government attention and international investment. The Chinese themselves emphasize the cultural and institutional differences between their regions and cities. A local authority representative observed: “This is a huge country. There are cultural variations even within provinces, not to mention the cultural distance separating various regions of the country from one another.” Although Zodium had contacts in China, these drew mainly on networks in Beijing, Hong Kong, and the east coast. Its network of contacts did not extend to the region where it was making its new purchase. The harbor town where Xinxia was based was locally known for its shady past and unethical culture, coupled with a history of illegal trade. The town had remained geographically isolated for years and had developed a unique culture quite different from the neighboring areas. The local development zone was administered at the time by the city itself, rather than by the Chinese central government. As a result, emerging issues had to be dealt with locally, as there was little inclination to listen to such complaints at higher levels of government in China.

Using Local Expertise Local interviewees whom I interviewed observed that ideally, when seeking a corporate partner in China, it is critical to engage in a longer-term “triangulated” perusal of potential partners. The Chinese noted how they are personally wary of new corporate partners until the trustworthiness and motives of the latter can be established. The best practice is to refer to local experts and consultants who, through their networks, can seek to establish the credibility of a partner through calls to clients, suppliers, distributors, and the local scene. Intriguingly, the Chinese also seek to gauge each other’s networks—a person’s networks tell much about their credibility, but, beyond that, also about their span of authority and importance.

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Building Relationships and Trust Beyond triangulated information-gathering, the building of relationships is critical. Zodium operated a Western logic of finding a partner and closing the deal as soon as possible. This led it to close the deal with Xinxia so rapidly that by the time of the deal, neither party knew one another or could trust the other’s intentions. Whereas the Western business partner’s trust is based on a contract, for the Chinese the contract matters little unless there is interpersonal trust between key representatives of both firms. This explains why the Chinese partners observed that it took them a long time to trust Zodium. In the meantime, they were reluctant to engage in cooperation with Zodium. They considered this impossible as long as the parties did not know and trust one another. This accounts for the lengthy negotiations. Notwithstanding, Xinxia came to be regarded by Zodium as a tedious and difficult seller. Cultural differences with regard to the notion of time became manifest. The Chinese company representatives treated time as an unlimited resource in negotiations, and as such exhausted the goodwill of their Finnish counterparts after 24 hours of talks, when the latter had planned to leave for the airport. Clearly, negotiation tactics differ across countries, and the other party’s negotiation strategy ought not to be underestimated (Graham and Lam, 2003). Relationship-building is critical in countries such as China where the existing legislative structure is weaker than in the developed world. In such institutional environments, weak legislation is compensated by strong social ties and personal connections. For Westerners, written contracts are a matter of law to which they need abide. For the Chinese, although a contract has been signed, it does not imply that the contract has to be followed—unless this has benefits for the local party. When it is beneficial for them, the contract is followed to the letter. Trust is developed via strong personal relationships and ties, rather than contracts. When coupled with a weak institutional environment where legislation is lacking and there is a gift-giving culture, it is clear that the differences in ethics become manifest. Finnish managers were aghast that a culture of seeking personal benefit from negotiations, contracts, and cooperation flourished, be it with respect to the selling party, local firms, or local authorities. One of my Chinese interviewees observed: “In China, people decide everything, not the law. This is based on the premises of the old feudal system, whereby the village elders regulated conflicts.” If one wants to move matters forward, it is in one’s interest to develop a strong web of connections to all stakeholders critical to the company, starting from the seller, through to employees, suppliers, customers, and distributors, and then all the way to local, regional, and national authorities. In a hierarchical culture, “those with relationships high up the authority ladder in the central government in Beijing have access to higher degrees of freedom than others” (quote from a local Zodium manager).

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In Zodium’s case, matters began moving to its advantage once the Zodium negotiators recognized the significance of relationship-building. Zodium began nurturing relationships and building a web of friends across its map of stakeholders. Gradually, cooperation with the seller, clients, suppliers, and local authorities began to work in its favor. Once the purchase had been signed and Zodium began operating with Xinxia, the Zodium managers had to deal with operational concerns such as how to bring the Chinese workforce, accustomed to being led hierarchically, within Zodium’s remit of participative decision-making and individual empowerment; and how to marry the Finns’ habit of direct and open communications with the more indirect style of the Chinese. Clearly, any activity that involves purchasing across borders needs to attend to such differences in cultural and institutional logic.

Conclusions The anonymized experience of a Nordic multinational firm’s acquisition of a company in Southern China has provided an opportunity to gauge the cultural and institutional dynamics at play when making an overseas acquisition. For Western firms, the prospect of acquiring in an emerging market carries elements of significant cultural and institutional risk. The cultural and institutional distance separating Western from Eastern countries, coupled with an inability to attune one’s approach to the local context might explain the many disappointments and high failure rates seen in joint ventures and acquisitions among businesses from the two regions. The focus in this case study was on predeal partner selection, negotiations, and relationship-building. The case highlighted the cultural differences between West (here, Nordics) and East (here, Chinese) in terms of differing perceptions of trust, ethics, and time, and the importance placed on networks and relationships versus contracts. Going forward, cultural and institutional intelligence is needed.

Making It Happen

•

 When acquiring overseas, pay attention to cultural differences between the acquiring and target sides. In addition to differences in national and organizational cultures, there are cultural differences between regions within countries. Cities and towns might also have particular cultures that have relevance for a transaction. This is particularly critical in large countries such as China, India, or Brazil.

•

When acquiring in countries that lack a strong legislative basis, such as China, relationship-building matters. In China, observing long-term strategic relationships is customary business practice. Seek to develop ties throughout the firm’s value chain and across the variety of its stakeholders. Developing ties with local, regional and national authorities is critical.

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• •

The importance of relationships explains why an early-mover advantage matters in China. The longer the span of one’s ties to the country, the better. Build a transaction based on trust and an established relationship, rather than on a contract only. At best, contracts serve to confirm a healthy interfirm relationship. In countries with a weak legislative basis, breaches of contract are common. Contracts are less important than the quality and significance of one’s strategic ties.

•

Data-gathering on a future partner is done differently in different countries. Observe the best practices of leading local players, and do not assume that you know the approach that is suited to a particular foreign country. A local partner’s credibility needs to be gauged on both tangible and intangible factors. Again, learn from local key players.

• •

Cultural differences exist with respect to the importance placed on trust, what is considered ethical, the significance of time in negotiations, and the centrality of relationships versus contracts. Remember that while the Western culture is centered on the individual, most Eastern cultures consider individuals amid their larger networks. Hence, the term “collectivist” cultures. It is hard for the Chinese to understand Westerners’ more self-centered, individualistic perspectives.

•

Seek to adjust your approach to the new country. Observe the need for cultural and institutional intelligence.

More Info Books:

Faulkner, David, Satu Teerikangas, and Richard J. Joseph (eds). The Handbook of Mergers and Acquisitions. Oxford, UK: Oxford University Press, 2012. Hofstede, Geert. Culture’s Consequences: Comparing Values, Behaviors, Institutions, and Organizations Across Nations. 2nd ed. Thousand Oaks, CA: Sage Publications, 2001. House, Robert J., Paul J. Hanges, Mansour Javidan, Peter W. Dorfman, and Vipin Gupta (eds). Culture, Leadership, and Organizations: The GLOBE Study of 62 Societies. Thousand Oaks, CA: Sage Publications, 2004. Thomas, David C. and Kerr Inkson. Cultural Intelligence: Living and Working Globally. 2nd ed. San Fransisco, CA: Berrett-Koehler, 2009.

Articles:

Brouthers, Keith D. and Gary J. Bamossy. “Post-formation processes in Eastern and Western European joint ventures.” Journal of Management Studies 43:2 2006: 203–229. Online: http://tinyurl.com/orhddjb Cyr, Dianne J. and Susan C. Schneider. “Implications for learning: Human resource management in East–West joint ventures.” Organization Studies 17:2 1996: 207–226.

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Doz, Yves L. “The evolution of cooperation in strategic alliances: Initial conditions or learning processes?” Strategic Management Journal 17:S1 1996: 55–83. Graham, John L. and N. Mark Lam. “The Chinese negotiation.” Harvard Business Review October 2003, 82–91. Online at: http://tinyurl.com/ppvth6n Hughes, Jonathan and Jeff Weiss. “Simple rules for making alliances work.” Harvard Business Review November 2007: 122–131. Online (reprint) at: www.spibr.org/HBR_Simple_Rules_for_Making_Alliances_Work.pdf Kale, Prashant and Harbir Singh. “Managing strategic alliances: What we know now, and where do we go from here?” Academy of Management Perspective August 2009: 45–62. Online at: http://tinyurl.com/nzes2rc Kale, Prashant and Harbir Singh. “Characteristics of emerging market mergers and acquisitions.” Chapter 22 in: Faulkner, David, Satu Teerikangas, and Richard J. Joseph (eds). The Handbook of Mergers and Acquisitions. Oxford, UK: Oxford University Press, 2012; pp. 545–564. Li, Guangyu and Jonathan Woetzel. “What China’s five-year plan means for business.” McKinsey Quarterly July 2011. Online at: http://tinyurl.com/qfxo5mw Lieberthal, Kenneth and Geoffrey Lieberthal. “The great transition.” Harvard Business Review October 2003: 26–40. Online at: http://tinyurl.com/pyln5hw Lunnan, R. and Haugland, S. Predicting and Measuring Alliance Performance: A MultiDimensional Analysis, Strategic Management Journal 29(5) 2008: 545-556. Pye, Lucian W. “The China trade: Making the deal.” Harvard Business Review July 1986. Online (preview) at: http://hbr.org/1986/07/the-china-trade-making-the-deal/ar Reus, Taco H. and Daniel Rottig. “Meta-analyses of international joint venture performance determinants: Evidence for the theory, methodological artifacts and the unique context of China.” Management International Review 49:5 (2009): 607–640.

Websites:

The Economist Intelligence Unit publishes country reports providing current briefings on the investment climate: www.eiu.com The Economist follows China weekly: www.theeconomist.com The Chinese government’s official investment pages: http://english.gov.cn/service/business_ic.htm Harvard Business Review articles and case studies: www.hbr.org Analyses and reports by the major consultants, such as McKinsey, BCG, Deloitte, KPMG or PWC provide excellent sources for updated market analyses: www.mckinsey.com www.deloitte.com www.bcg.com www.pwc.com www.kpmg.com

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Using Financial Analysis to Evaluate Strategy by David Sadtler

Executive Summary •

Financial analysis is widely used to assess investment proposals, but less commonly to evaluate strategy.

•

Strategy, both at business unit level (are we competing successfully?) and at the corporate level (does this portfolio of businesses make sense for the shareholders?), needs continuing evaluation.

•

Business-level strategy can be judged by economic value added (EVA) analysis.

•

Corporate-level strategy can be assessed by breakup analysis.

•

Line managers are not necessarily motivated to do these analyses; it is thus up to others, especially the nonexecutive members of the board, to advocate them

Introduction Many well-known tools and techniques of financial analysis are used by investors, stockbrokers, and corporate managers to assess corporate performance. Their use is particularly prevalent in M&A and in the analysis of capital expenditure. But how often do we say: “Let’s do some financial analysis to see if this strategy is any good. Let’s take a view on the corporate portfolio and the extent to which value is added by the corporate center and use financial tools to do it.” In my experience, this doesn’t happen much. When companies undertake an acquisition, extensive financial analysis accompanies the investigation by managers, the proposals put to the board, and, if necessary, the story that is told to investors and the financial community. Comparisons are made with valuations of similar businesses and with transactions of a similar nature. Discounted cash flow techniques are used to assess the impact of different outcomes and the extent to which the investment is likely to recover the cost of capital employed in it. So the use of financial analysis for decision-making in the corporate environment is well-known and widespread. Indeed, the essence of the core technique—present value and discounted cash flow analysis—has been around for at least 50 years. The tools are well-known, credible, and widely accepted. What about using financial analysis to assess strategy? In nearly all companies there are two levels of strategy that must be kept under constant surveillance by the custodians of stockholder investment. First, the viability of the individual

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businesses must be constantly examined. Are they earning satisfactory returns—or, indeed, returns in excess of the cost of capital employed in them? Second, does the corporate portfolio make sense? Would some parts of the business be better off elsewhere? There are straightforward tools to help in answering these questions and they should be regularly applied by the board of directors. Why then does such an analysis not seem to be a widespread and regular practice? I think that the answer is pretty obvious. Top managers often do not want to admit that some parts of their business portfolio are unviable or that they are not the right owners. It’s an agency problem, where management’s motives diverge from the interests of the stockholders. But there are others whose job it is to question performance and to be sure that these agency problems do not stand in the way of the interests of stockholders. Nonexecutive directors on the board of directors are in this position, as are representatives of the investment community who decide on whether to advocate support for the organization. But to assess strategy— both at the corporate level and at the level of the individual business—they need suitable tools.

Corporate-Level Strategy Corporate-level strategy, as comprehensively described in the writings and teachings of the Ashridge Strategic Management Centre (see the More Info section) involves ensuring that value is added by the corporate center to each and every business unit within the portfolio. A number of useful frameworks and techniques have been available for some time to test the quality and intensity of corporate value added. Managers at both the business-unit level and at the corporate center can be challenged to explain the exact nature of corporate value added (what do you do to make this business more successful and thus more valuable?). Long-term competitive performance (market share in key segments) can be used to assess the center’s role in ensuring lasting commercial and financial viability. Comparison of the management structure and style with key comparator companies (especially those with more successful financial performance) can be used to assess both strengths and weaknesses in value added. It is thus possible to take a reading on whether or not the corporate owners are doing an adequate job. The owners must address two questions: first, do we really add substantive value to each of our businesses; and, second, what businesses should we be in? But these tests are qualitative. They make use of individual judgments, recollections, and viewpoints. While often pertinent and relevant, they can also be dreadfully biased. An alternative is to make the evaluation a quantitative one. A straightforward financial tool is available to assess the overall success of the parenting capability of any big company, namely, breakup analysis. Breakup analysis

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takes an arm’s length view of the market value of each of the company’s businesses and compares the total of these values with corporate-market capitalization, which is the value the marketplace places on the corporation as a whole. If the latter is less than the former, corporate strategy isn’t working. The market is saying that the corporate center is destroying value. Synergies are not believed.

How to Do a Breakup Analysis 1.

Subdivide the company into discrete businesses, focusing on particular customer groups and operating in identifiable industries. You will know that you are defining the business at the right level when it is easy to identify comparable companies.

2.

Determine a baseline profit-after-tax figure for each business. Outside analysts will be constrained by the availability of reported information, but insiders should have all the necessary information. If profit performance has been uneven, use the budgeted figure for the coming year, tempered by a judgment about how likely it is to be realized.

3.

Corporate overhead costs, if allocated, should be removed from the cost basis of the individual businesses, subject to the limitation that any activities which would have to be added in—were the business to be operating on its own—must be accounted for. One famous Dutch electrical equipment company assesses a fixed charge for corporate-level R&D on all businesses. If the business in question demonstrably receives little benefit from such services, the charge should be reduced (or eliminated if the business is not really research-dependent) accordingly.

4.

Identify comparable companies whose stock is publicly traded. Make a judgment about whether the business being analyzed deserves a rating below, equal to, or above that of the average of comparable companies. Decide on an earnings multiple and calculate pro forma market value accordingly.

5.

Take note of the current market capitalization of the company as a whole. Make a judgment about whether any exceptional circumstances have caused a temporary departure from the norm. Determine a baseline marketcapitalization figure. For example the sudden appearance of very bad news (like a financial scandal) concerning a key competitor can sometimes cause a selloff of major sector participants until the market’s nervousness is allayed. Such an apparent “blip” must be considered.

6.

Compare this latter figure with the total of the pro forma market values of the individual businesses and compare the two figures, after adjusting for borrowings at the corporate level.

Stockbroker analysts often perform similar analyses when judging whether a company is a plausible takeover candidate.

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Perhaps the most famous example of a failed corporate-level strategy was that characterizing Imperial Chemical Industries (ICI) in the 1980s, at the time Britain’s largest industrial company. ICI was a dominant player in basic chemicals, a notoriously cyclical and increasingly competitive business, where returns have often been unsatisfactory. It also owned a highly successful pharmaceuticals business which produced most of ICI’s profit. Outside observers noted that an arm’s length valuation of the pharmaceutical business alone was worth more than all of ICI together.1 This is just another way of saying that the corporate-level strategy was a failure (or that the chemicals business was worth less than nothing). Had ICI’s board made this calculation, and honestly confronted it, it would have broken the company up itself rather than waiting for a threat from outside to necessitate it.

Business Unit Strategy Similarly, many tools and techniques are available to assess the viability of strategy at the level of each business in the corporate portfolio. Each company has its own favourite measures against which managerial bonuses are often paid. Much attention is paid to these measures, and therefore what they are, and the objectivity with which they have been selected is important for stockholders. Alas, there are many ways to rig the numbers to make the outcome appear satisfactory even if the reality is somewhat different. But there is one measure that is hard to rig. Economic value added (EVA) analysis simply calculates business profitability after the imposition of a charge for the capital employed in the business. The tools for doing this are highly developed and, indeed, are championed by a number of consulting firms. The measures can be applied to any business in any company. A division earning $10 million pretax on turnover of $100 million and capital employed in the business of $60 million might, at first glance, be viewed as displaying creditable performance. But at a 35% tax rate and with a cost of capital of 12%, EVA is negative ($10 million × 65% – 0.12 × $60 million = $6.5 million – $7.2 million – $0.7 million). The implications of such an analysis are clear. If a business consistently demonstrates negative EVA, it is “parasitical”—eroding stockholder wealth. New investment is folly unless a fundamental game change can credibly be expected to result in positive EVA. There is the possibility that it is not the fault of the operating management team. Some industries, in the aggregate, produce negative EVA. Airlines are the classic example. Warren Buffett recently observed that the total profitability for the entire industry since its inception has been zero. No one in their right mind would start an airline now. Since deregulation in 1978, there have been at least 100 bankruptcies in the airline businesses.2 Management teams operating in one of these unhappy

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industries may actually be doing a good job on a relative basis but, alas, not for their stockholders or for the economy as a whole. How is it possible that an entire industry, perhaps with one or two exceptions, can fail to earn an “economic rent”? How can investors continue to commit capital to industries in which acceptable returns are unlikely? A number of explanations have been offered. In developed economies major employers, with the major political pressure they can bring to bear, often prop up failing performers and keep marginal plants open—as in the car industry. Barriers to exit can be formidable, especially in industries where capital equipment is only of use in that industry and lasts a long time. Measures of profitability may be misleading. Managerial bias and incentives can prevent problems from being addressed in an objective way. Managers in unsatisfactory industries may not want to admit to the situation because it could make them look foolish—or worse, unemployable. And investors may simply be incompetent. It is not enough to suggest that they might simply buy stocks with high dividend yields on the basis of a very low valuation of assets. Any investor looking to the longer term, as most institutional investors seem to do, will eventually focus on total stockholder return. Term lenders presumably do the same. They’ll want capital investment to pay out.

How to Calculate EVA 1.

The formula to calculate EVA is fairly simple. The formula is: EVA = net operating profit after taxes less the after-tax cost of capital employed.

2.

The operating profit includes deductions from revenues for the cost of goods sold and for the operating expenses. Interest expense is then subtracted to cover the cost of the debt capital used, income taxes are then subtracted, and, finally, a cost for the equity capital is subtracted from the net income after tax to obtain the EVA.

3.

The cost of equity capital can be derived by using any one of several approaches. Perhaps the simplest approach is to use the interest rate that a company can borrow at and then add a risk premium. The risk premium is added because investors require a higher return to invest in stock than they require for bonds. This is often called the bond yield plus risk premium approach. A typical equity risk premium is about 4%, so if a company can borrow at 10% its cost of equity capital would be 14%.

Alternatively, use the weighted average cost of capital (WACC), a figure that is often well-known to big companies and available from public data sources. Alternatively, the cause of negative EVA may simply be poor management and a consistently weak competitive position. The managers of such a business are simply

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not offering a product or service which pleases enough customers for the business to be viable. We call this a failed competitive strategy. Whether the problem at business unit level is participation in a low-profit industry or a failed competitive strategy, the business does not deserve further investment. It should be liquidated in the best way possible. Such businesses are likely to display longer-term negative EVA.

Objections Understandably, there are those who resist the notion of assessing strategy at either level by means of quantitative measures and analysis. Many such arguments claim unfairness, or a lack of true comparability. We see this for example in the daily news, when head teachers complain about league tables (often, of course, because the tables give their school a low rank) because, they say, the circumstances of their school are exceptional. They may even be right. But the school’s performance is still lousy. Similarly, business people will often argue in this way against the imposition of regular objective checks.

Conclusion Financial calculations of the kind described above which give a clear indication of failed strategy at either the corporate or business-unit level require action.

• 

Failed corporate strategies call for remedies ranging from reinvigorated management to structural breakup. It is up to the board to decide on the seriousness of the problem and the nature of the appropriate remedies. Failure to take appropriate action will often result in stockholder dissatisfaction and attempts by outsiders to restructure the company.

• 

Failed business-unit strategies likewise demand action, since continuing on this basis constitutes a de facto drain on capital. Obviously, this cannot continue indefinitely. Whatever the remedy, the key is a managerial realization that “business as usual” is not an option.

• 

This thinking and approach to analysis is simple. Good stewardship demands that these questions are raised regularly and acted on.

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More Info Books:

Collis, David J. and Cynthia A. Montgomery. Corporate Strategy: A Resource-Based Approach. 2nd ed. Boston, MA: McGraw-Hill/Irwin, 2005. Goold, Michael, Andrew Campbell and Marcus Alexander. Corporate-Level Strategy: Creating Value in the Multibusiness Company. New York: Wiley, 1994. Johnson, Gerry, Kevan Scholes and Richard Whittington. Exploring Corporate Strategy: Text and Cases. 8th ed. Harlow, UK: Pearson Education, 2008. Sadtler, David, Andrew Campbell and Richard Koch. Break Up! When Large Companies Are Worth More Dead Than Alive. London: Capstone, 1997. Stern, Joel M., John S. Shiely and Irwin Ross. The EVA Challenge: Implementing Value Added Change in an Organization. New York: Wiley, 2004.

Article

Campbell, Andrew, Michael Goold and Marcus Alexander. “Corporate strategy: The quest for parenting advantage.” Harvard Business Review March–April 1995: 120–132. Online at: hbr.org/1995/03/corporate-strategy/ar/1

Websites:

Ashridge Strategic Management Centre, linked from Ashridge Business School home page: www.ashridge.org.uk Investopedia article on EVA: www.investopedia.com/university/EVA

1 Geoffrey Owen and Trevor Harrison. “Why ICI chose to demerge.” Harvard Business Review (March– April 1995): 133–142. 2 Jon Bonné. “Airlines still struggle with paths to profit: After 100 years, it’s no easier to get rich flying planes.” msnbc.com (December 12, 2003).

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Valuing Start-Ups by Aswath Damodaran

Executive Summary •

Young and start-up companies pose the most problems in valuation, for a variety of reasons.

•

Start-ups have a limited history, are generally not publicly traded, and often don’t survive to become successful commercial enterprises.

•

Faced with daunting estimation challenges, analysts often fall back on simplistic forecasts of revenues and earnings, coupled with high discount rates, to capture the high failure rate.

•

In this article I suggest that traditional valuation models can be used to yield better estimates of the value of these firms.

Introduction Although the fundamentals of valuation are straightforward, the challenges in valuing companies shift as they move through their life cycle: from the initial idea and start-up business, often privately owned, to young growth companies, either public or on the verge of going public, to mature companies with diverse products and serving different markets, and finally to companies in decline, marking time until they disappear. At each stage we may be called on to estimate the same inputs—cash flows, growth rates, and discount rates—but with varying amounts of information and different degrees of precision.

Determinants of Value If we accept the premise that the value of a business is the present value of the expected cash flows from its assets, there are four broad questions that we need to answer in order to value any business:

1. What are the cash flows generated by existing assets?

If a firm has significant investments that it has already made, the first inputs into valuation are the cash flows from these existing assets. In practical terms, this requires estimates of: how much the firm generated in earnings and cash flows from these assets in the most recent period; how much growth (if any) is expected in

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these earnings/cash flows over time; and how long the assets will continue to generate cash flows.

2. How much value will be added by future investments?

For some companies, the bulk of the value will be derived from investments they are expected to make in the future. To estimate the value added by these investments, you have to make judgments on both the magnitude of these new investments relative to the earnings from existing assets, and the quality of the new investments, measured in terms of excess returns, i.e. the returns the firm makes on the investments over and above the cost of funding them.

3. How risky are the cash flows, and what are the consequences for discount rates?

Neither the cash flows from existing assets nor the cash flows from growth investments are guaranteed. When valuing these cash flows, we have to consider risk somewhere, and the discount rate is usually the vehicle we use. Higher discount rates are used to discount riskier cash flows, and thus give them a lower value than more predictable cash flows.

4. When will the firm become mature?

The question of when a firm is mature (i.e. when the growth in earnings/cash flows is sustainable forever) is relevant, because it determines the length of the highgrowth period and the value we attach to the firm at the end of the period (the terminal value). It is a question that may be easy to answer for a few firms, including larger and more stable firms that are either already mature businesses or close to it, and firms that derive their growth from a single competitive advantage with an expiration date (for instance, a patent). A framework for valuing any business that takes into account these four considerations is shown in Figure 1.

Figure 1. The fundamental questions in valuation What is the value added by growth assets? When will the firm become a mature firm, and what are the potential roadblocks?

What are the cash flows from existing assets? How risky are the cash flows from both existing assets and growth assets?

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Although these questions may not change as we value individual firms, the ease with which we can answer them may change, not only as we look across firms at a point in time, but also across time—even for the same firm.

Valuing Young Companies Every business starts with an idea stimulated by a market need that an entrepreneur sees (or thinks that he or she sees) and a way of filling that need. Although many ideas go nowhere, some individuals take the next step of investing in the idea. The capital to finance the project usually comes from personal funds (from savings, friends, and family), and if things work out as planned the result is a commercial product or service. If the product or service finds a ready market, the business will usually need more capital, and the providers of this are often venture capitalists, who provide funds in return for a share of the equity in the business. Building on the most optimistic assumptions, success for the investors in the business may ultimately be manifested as a public offering to the market or sale to a larger entity.

Estimation Issues At each stage in the process we need estimates of value. At the idea stage, the value may never be put down on paper, but it is the potential of realizing this value that induces the entrepreneur to invest time and money in developing the idea. At subsequent stages of the capital-raising process, valuations become more important because they determine what share of ownership the entrepreneur will have to give up in return for external funding. At the time of the public offering, the valuation is key to determining the offering price. From the template for valuation that we developed in the last section, it is easy to see why young companies also pose the most daunting challenges. There are few or no existing assets, and almost all of the value is based on the expectations of future growth. The current financial statements of the firm provide no clues about the potential margins and returns that may be generated in the future, and there are few historical data that can be used to develop risk measures. To complete our consideration of estimation problems, we should remember that many young firms do not make it to the stable growth stage. Estimating when this will happen for firms that do survive is difficult. In addition, these firms are often dependent on one or a few key people for their success, and losing them can have a significant effect on value.

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Figure 2. Estimation issues for young and start-up companies Making judgments on revenues/profits is difficult because you cannot draw on history. If you have no product/service, it is difficult to gauge market potential or profitability. The company's entire value lies in future growth, but you have little on which to base your estimate.

What is the value added by growth assets? When will the firm become a mature firm, and what are the potential roadblocks?

What are the cash flows from existing assets? Cash flows from existing assets are nonexistent or negative.

How risky are the cash flows from both existing assets and growth assets? Limited historical data on earnings and no market prices for securities make it difficult to assess risk.

Will the firm make it through the gauntlet of market demand and competition? Even if it does, assessing when it will become mature is difficult because there is so little information.

Figure 2 summarizes these valuation challenges. Given these problems, it is not surprising that analysts often fall back on simplistic measures of value, guesstimates, or on rules of thumb to value young companies. In the process though, they risk making serious valuation errors.

Meeting the Estimation Challenge Given the challenges we face in estimating cash flows and discount rates for the purpose of valuing young companies, it should come as no surprise that many analysts use shortcuts such as applying multiples to expected future earnings or revenues to obtain dubious estimates of value. We believe that staying within the valuation framework and making the best estimates of cash flows is still the best approach.

Cash Flows and Growth Rates For many young companies, the biggest challenge in estimating future cash flows is that there is no historical base of any substance on which to build. However, we can still estimate expected cash flows using one of two approaches.

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Top-Down Approach

In this approach, we begin with the potential market for the firm’s products and services and work backwards.

•  •  • 

Estimate the share of this market which the firm hopes to gain in the future and how quickly it can reach this share; this gives expected revenues in future years. Make a judgment on the profit margins the firm should see once it attains the targeted market share; this provides the earnings that it hopes to generate each period. Finally, evaluate what the firm needs to invest to accomplish this objective; this represents the capital that it has to reinvest in the business, which is a cash drain each year.

Generally, as the firm’s revenues grow and it moves toward the target margins, we should expect to see losses in the earlier years become profits in the later ones. With high growth, it is entirely possible that cash flows will stay negative even after profits turn the corner, since the growth will require substantial reinvestment. As growth subsides in the later years, the reinvestment will also decline and cash flows will become positive. The key to succeeding with this approach is getting the potential market share and target margin right, and making realistic assumptions about reinvestment needs.

Bottom-Up Approach

For those who believe that the top-down approach is too ambitious, the alternative is to start with what the young company can generate as output, given its resource constraints, and make estimates of the revenues and profits that will be generated as a consequence. This is more akin to a capital-budgeting exercise than to a valuation, and the valuation will depend on the quality of the forecasts of earnings and cash flows. The projected earnings and cash flows from both approaches are dependent on the promoters of the company not only being able to come up with a product or service that meets a need, but also that they can adapt to unexpected circumstances at the same time as delivering their forecast results.

Discount Rates The absence of historical data on stock prices and earnings makes it difficult, but not impossible, to analyse the risk of young companies. To make realistic estimates of discount rates, we need to be able to do the following.

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Assess Risk from the Right Viewpoint

The risk in an investment can vary, depending on the point of view that we bring to the assessment.

•  •  • 

For the founder/owner who has his or her entire wealth invested in the private business, all risk that the firm is exposed to is relevant risk. For a venture capitalist who takes a stake in this private business as part of a portfolio of many such investments there is a diversification effect, where some of the risk will be averaged out in the portfolio. For an investor in a public market, the focus will narrow even more, to only the risk that cannot be diversified away in a portfolio.

As a general rule, the discount rates we obtain using conventional risk and return models, which are built for the last setting, will understate the risk (and discount rates) for young companies, which are usually privately held.

Focus on the Business/Sector, Not on the Company

Since young firms have little operating history and are generally not publicly traded, it is pointless trying to estimate risk parameters by looking at the firm’s history. We can get a much better handle on risk by looking at the sector or business of which the firm is a part and evaluating the riskiness of publicly traded firms in the same sector at different stages in the life cycle.

Adjust Risk Measures and Discount Rates as the Firm Matures (At Least in the Projections)

Our task in valuation is not to assess the risk of a young firm today, but to evaluate how that risk will change as the firm matures. In other words, as revenues grow and margins move toward target levels, the risk that we assess in a company and the discount rates we use should change consistently: lower growth generally should be coupled with lower risk and discount rates.

Terminal Value In most discounted cash flow valuations, it is the terminal value that delivers the biggest portion of the value. With young firms this will be doubly so, partly because the cash flows in the early years are often negative, and partly because the anticipated growth will increase the size of the firm over time.

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Consider Scaling Effects and Competition

When firms are young, revenue growth rates can be very high, reflecting the fact that the revenues being grown are small. As revenues grow, the growth rate will slow, and assessing how quickly this will happen becomes a key part of valuing young companies. In general, the speed with which revenue growth will decelerate as firms get larger will depend on the size of the overall market and the intensity of competition. In smaller markets, and with more intense competition, revenue growth will decline much more quickly and stable growth will approach sooner.

Change the Firm’s Characteristics to Reflect Growth

As a firm moves from start-up to stable growth, it is not just the growth rate that changes, but the other characteristics of the firm as well. In addition to the discount rate adjustments we mentioned in the last section, mature firms will also tend to reinvest less and have lower excess returns than younger firms.

Consider the Possibility That the Firm Will Not Make It

Most young firms do not make it to become mature firms. To obtain realistic estimates of value for young firms, we should consider the likelihood that they will not make it through the life cycle, either because key employees leave or because of capital constraints.

Conclusion It is far more difficult to estimate the value of a young company than a mature company. There is little history to draw on and the firm’s survival is often open to question. However, that should not lead us to abandon valuation fundamentals or to adopt fresh paradigms. With a little persistence, we can still estimate the value of young companies. These values may not be precise, but the lack of precision reflects real uncertainty about the future of these companies.

Making It Happen To value young growth companies:

•  • 

Assess the potential market and the company’s likely market share (if successful). Estimate what the company has to do (in terms of operations and investments) to get to this market share.

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•  •  • 

Estimate the cash flows based on these assessments. Evaluate the risk in the investments and how it will change as the company goes through the growth cycle; convert the risk into discount rates. Value the business and the various equity stakes in that business.

More Info Books:

Damodaran, Aswath. The Dark Side of Valuation; Valuing Old Tech, New Tech, and New Economy Companies. Upper Saddle River, NJ: Prentice Hall, 2001. Gompers, Paul and Josh Lerner. The Venture Capital Cycle. 2nd ed. Cambridge, MA: MIT Press, 2006. Metrick, Andrew. Venture Capital and the Finance of Innovation. Hoboken, NJ: Wiley, 2007.

Guidelines:

Multiple authors. “International private equity and venture capital valuation guidelines.” October 2006. Online from: www.privateequityvaluation.com

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Accounting for Business Combinations in Accordance with International Financial Reporting Standards (IFRS) Requirements by Shân Kennedy

Executive Summary

The International Accounting Standards Board (IASB) has introduced requirements in the last few years to make those involved in business combinations more accountable for the transactions that have taken place. In particular: •

All business combinations must now be accounted for using the acquisition accounting method.

•

The intangible assets arising from a business combination must be identified and recognized separately from purchased goodwill.

•

Purchased goodwill is no longer permitted to be amortized; instead, it must be tested for impairment each year.

Introduction The accounting for business combinations under IFRS is governed by four key standards:

•  •  •  • 

IFRS 3, Business Combinations; IAS (International Accounting Standards) 27, Consolidated Financial Statements; IAS 36, Impairment of Assets; IAS 38, Intangible Assets.

IFRS 3 sets out the requirements to be followed in accounting for a business combination. Its introduction in 2004 represented a substantial change from the standard it superseded, IAS 22. IFRS 3 signaled the end of the benign method of accounting for business combinations known as “merger accounting.” Instead, all business combinations must be accounted for using the acquisition accounting

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method. This requires that both acquirer and acquiree are identified for each transaction, that a fair-value exercise is performed on the acquiree’s assets and liabilities, and that purchased goodwill arising from the transaction is capitalized in the balance sheet. A further consequence of the introduction of IFRS 3 is that intangible assets must be recognized separately from purchased goodwill instead of being subsumed within purchased goodwill. Purchased goodwill itself is not amortized, but must be reviewed for impairment annually. The performance of the impairment review is covered by IAS 36, Impairment of Assets, and the identification and recognition of intangible assets is covered by IAS 38, Intangible Assets. The tightening up of business combination accounting was noted by accountants PricewaterhouseCoopers: “The acquisition process will need to become more rigorous, from planning to execution.”1 The following steps are involved in accounting for a business combination under IFRS 3:

•  •  •  •  • 

identification of the acquirer and the acquiree; performance of a fair-value exercise on the acquiree’s assets and liabilities; identification and measurement of the fair value of the intangible assets arising; measurement of the amount of any non-controlling interest in the acquiree; measurement of the amount of goodwill arising from the transaction.

A revised version of IFRS 3 was issued by the IASB in January 2008, and its requirements will be mandatory for accounting periods from July 2009 onward. While the revision is quite comprehensive, it does not change the overall approach set out above. The revision is part of the Convergence Program underway between the IASB and the Financial Accounting Standards Board (FASB), aimed at reducing the number of differences between IFRS requirements and US Generally Accepted Accounting Principles (US GAAP). In addition to tightening up certain areas, the revision developed the previous IFRS 3 by:

•  • 

providing additional guidance regarding the recognition and fair-value measurement of the acquiree’s assets and liabilities; changing the requirements for measuring goodwill and the remaining noncontrolling interest when less than a 100% stake in the acquiree is purchased or when an increase in an existing stake is involved.

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Identification of Acquirer and Acquiree IAS 27 demands that the acquirer in a business combination be identified as the party that gains control, with control being defined as “the power to govern the financial and operating policies of an entity so as to benefit from its activities.” Control is presumed to exist if one entity owns more than 50% of the voting power of the other, unless it can be demonstrated that this voting power does not constitute control. Conversely, control can be seen to exist when one entity owns less than 50% of the voting rights in the other but controls it through some other means, such as a shareholder agreement. This situation was seen when ABN AMRO was acquired by the Royal Bank of Scotland (RBS)—RBS owns only 38% of the issued share capital of ABN AMRO but is able to control it through a consortium agreement with the other owners, Fortis and Santander. Thus, RBS consolidates ABN AMRO in its financial statements. Other guidance provided in IAS 27 for identifying the acquirer includes that, generally, the acquirer is:

•  •  • 

larger than the acquiree; the party issuing equity or paying cash as consideration; the party that has more seats on the board of directors of the combined entity. IFRS 3 does, however, also deal with reverse acquisitions in which smaller companies acquire larger ones through the issue of significant amounts of equity.

Fair-Value Exercise on the Acquiree’s Assets and Liabilities Consistent with any acquisition accounting exercise, IFRS 3 requires that the acquired assets and liabilities are recognized initially at fair value in the consolidated financial statements of the combined entity. The standard provides some clarification regarding identification of these assets and liabilities. For instance IFRS 3 prohibits the setting up of acquisition reorganization provisions since these are not liabilities of the acquirer at the acquisition date. Prior to IFRS 3, acquiring companies often set up substantial acquisition-reorganization provisions. Costs, such as those relating to redundancy and factory closures, were charged to these provisions post acquisition rather than to the profit and loss account. Now, such costs must be charged to the profit and loss account of the combined entity post acquisition.

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Identification and Measurement of the Intangible Assets Arising from a Combination IAS 38 defines an intangible asset as “identifiable” if it can be separated from the entity—i.e. can be leased or sold separately from the entity—or if it is secured legally. By defining identifiability in terms of separability as well as legal security, the number of potentially recognizable intangible assets increases. For instance, software technology may not be legally protected by a patent, but this does not prevent it from being licensed or sold to a third party. Consequently, if a software company is acquired, those intangible assets that may be recognized include both patent-protected and unprotected software. Since IFRS 3 assumes that the fair value of intangible assets arising from an acquisition can be measured reliably, if in existence such assets must be recognized in the fair-value balance sheet. It is the broadening of the net of intangible assets to include those that are not secured legally—together with the assumption that all identifiable intangible assets arising from a business combination can be measured reliably—that has greatly increased the number of intangible assets recognised separately from goodwill following a business combination. IFRS 3 clarifies that certain intangible assets might be recognized in the consolidated financial statements but not recognized in the financial statements of the acquiree. Thus, internally developed brands and customer relationship assets of the acquiree would not be recognized as intangible assets in the financial statements of the acquiree, because the cost of their development would be recorded as an expense. However, provided they satisfy the IAS 38 requirement to be identifiable intangible assets—i.e. if they are intangible, identifiable, controlled by the entity, and expected to give rise to future economic benefits—they are recognized in the consolidated financial statements. Potentially, a very large number of intangible assets might need to be valued for balance-sheet recognition purposes. IAS 38, however, allows the preparer of accounts to combine certain complementary intangible assets as a composite intangible asset—a brand—if the fair values of the underlying component intangible assets cannot be determined reliably or if they have similar useful lives. In practice, this concession is often used to reduce the number of intangible assets that need to be valued following a business combination. A proposed amendment to IAS 38 suggests that the concession could be extended to complementary assets other than brands. An example of the increased number of intangible assets recognized following business combinations can be seen in the results of Yell Group plc (see Table 1).

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Table 1. Analysis of Intangible Assets in Yell Group Financial Statements, March 2008 Contracts £47m Non-compete agreements

£6m

Customer lists

£366m

Brand names

£856m

Software costs

£44m

Total identifiable intangible assets

£1,319m

Goodwill £3,899m

In contrast, the Yell Group financial statements for March 2005—the last before transition to IFRS—show a goodwill balance of £1,635 million and no identifiable intangible assets. Neither IFRS 3 nor IAS 38 provides any substantive guidance on determining the fair value of intangible assets. Instead, best practice has developed in the marketplace and tends to be driven by the auditors of the accounts. Many intangible-asset valuation consultancies have commented on the difficulty of valuing these intangible assets. One such consultancy, Brand Finance, notes in its website literature: “In many instances the valuation of such assets is a complex undertaking” and “it will be important to demonstrate that best-practice techniques are being applied.” In January 2009, the International Valuation Standards Council (IVSC) issued two Exposure Drafts on the valuation of intangible assets generally and on the valuation of intangible assets for IFRS reporting purposes. These set out the key valuation methods that are used and address some of the more complex issues that can arise. They follow their issue, in July 2007, of a discussion paper on the topic of the valuation of intangible assets for IFRS reporting purposes. In response to the IVSC’s discussion paper, the International Actuarial Association noted “We support the issuance of guidance on valuation of intangible assets for IFRS reporting purposes.”

Measuring the Amount of Any Non-Controlling Interest in the Acquiree If, as a result of a business combination, the acquirer owns less than 100% of the acquiree, there is a remaining non-controlling interest, previously known as a minority interest, in the acquiree to be recognized.

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Accounting for this non-controlling interest has changed following the recent revision to IFRS 3. Previously, the non-controlling interest had to be measured at its proportionate share of the identifiable net assets, i.e. excluding its goodwill. The revision introduced the option to measure the non-controlling interest at its fair value and thus include its goodwill. Several commentators were concerned about the difficulty of measuring this fair value, especially where the acquiree company’s shares were unlisted, and for this reason the option to measure at fair value was not made mandatory. Under US GAAP, however, the non-controlling interest must be measured at fair value—no option is permitted. This represents a continuing difference between IFRS and US GAAP requirements.

Measuring the Goodwill Arising from a Business Combination The revised IFRS 3 requires that goodwill is measured as the following: The sum of:

•  •  •  • 

the fair value of the consideration paid; the amount of any non-controlling interest measured as described above; the fair value of any previously held non-controlling interest in the acquiree;

Less:

the net sum of the acquisition-date assets acquired and liabilities assumed, measured as required by IFRS 3.

It is important to note that goodwill itself is not measured at fair value—it is the residual amount that results from applying the calculation above. As a result of the option with respect to measurement of any noncontrolling interest, the amount measured for goodwill may or may not include goodwill in such noncontrolling interest.

More Info Reports:

International Valuation Standards Committee (IVSC). “Guidance note 4: Valuation of intangible assets.” Revised February 2010. Online at: www.ivsc.org/pubs/gn4-2010.pdf International Valuation Standards Committee (IVSC). “Proposed guidance note 16: Valuation of intangible assets for IFRS reporting purposes.” January 2009. Online at: www.ivsc.org/pubs/exp_drafts/0901_gn16_intangible_assets.pdf

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Websites:

Company Reporting, comments on the types of intangible asset being recognized in company accounts are regularly made by this UK-based organization: www.comrep.co.uk International Accounting Standards Board (IASB), from whom copies of the relevant IFRS and technical summaries of each standard can be obtained: www.iasb.org International Actuarial Association (AAI/IAA): www.actuaries.org International Valuation Standards Committee (IVSC): www.ivsc.org

1  Source: PricewaterhouseCoopers. “Acquisitions: Accounting and transparency under IFRS 3.” April 2004. Online at: www.pwc.com/fi/fin/ifrs/pwc_acq_acc_transp_ifrs3.pdf

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Maximizing Value when Selling a Business by John Gilligan

Executive Summary •

Advisers advise, principals decide: Advisers may not understand industry-specific risks and are therefore badly placed to make judgments on some risk issues. Be prepared to debate with your own advisers and to overrule them if your knowledge is superior, no matter how much they are being paid.

•

Don’t buy a dog and bark yourself: Corporate sales are complex and risky. Appoint experienced advisers and get them to manage the process under your control.

•

Information: The importance of information cannot be overemphasized. Buyers are motivated by fear and greed: The quality, tone, and flow of information critically impact both motives.

•

Valuation: Agree what the walkaway price is with your advisers before starting a process, review it constantly, and be prepared to walk away if necessary.

•

Competitive tension: The best deals are achieved where more than one buyer with cash (but not an uncontrollable host) wants to purchase a business. Use this rivalry to maximize the bids received and to eliminate risks that might prevent the buyer from delivering the deal.

•

Blunderbuss versus rifle shot: Most businesses have a limited target population of buyers who may pay a strategic premium. Use the approach when marketing needs to favor those most likely to pay the best price.

•

Financial bidders are active: In the past 20 years more businesses worldwide have probably been sold to private equity firms than any other type of acquirer. Use them to create competitive tension.

•

Auctions have to be managed: Theory and practice suggest that many tactics in auctions are counterintuitive. Think through what you are going to do and clearly communicate it to potential purchasers.

•

Say nothing: There are always matters that are uncertain in any deal. Staff are always unsettled by uncertainty. It is best to say nothing at all to them, but if you do decide to explain what is happening, you must be completely honest. Remember, any ambiguity is interpreted negatively.

•

Only the fittest survive: Transactions are long and often tedious. Do not let boredom, fatigue, or lack of patience deflect you from your final goal, especially when the winning line is near.

•

The one that got away: The world is full of people who nearly did the best deal ever. To achieve success, you need to give and take; it is not a war, it is a negotiation.

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Introduction All corporations seem complex to those looking in from the outside. The cocktail of relationships, contracts, and assets coming together to generate value is different in every company, and the process of realizing the value embedded in that cocktail requires planning, foresight, and pragmatic judgment. Failure to sell a business that has been publicly put up for sale can destroy huge amounts of value. Each situation is unique and no text can provide a comprehensive guide, any more than you could write the complete guide to sailing in all weathers. This article will deal with general principles and strategies, not technical details. Furthermore, it will address the question of how to sell a business, not why you should sell a business.

Advisers—What They Do, What They Don’t Do It would be perverse not to believe that corporate finance advice is valuable. Here is one casual, empirical data point that supports this view: Private equity firms, many themselves ex-corporate financiers, and whose core business is buying and selling companies, almost always use advisers. The question is not whether to appoint advisers; it is what should they be tasked with doing, and what is the limit of their role. Their role is not to make decisions. They are there to limit the number of decisions the vendor has to make regarding the key commercial factors that make deals happen. Good advisers should be prepared to debate decisions and use their experience to guide their clients toward the paths of least resistance. However, only the owners can make the final decisions. Having described what advisers don’t do, the natural question is: So what do they do? The answer to this is—pretty much everything, except making the final commercial decisions. Expect advisers to prepare, collate, and analyze data that will be presented to potential purchasers. They should project-manage every aspect of the sale process, providing a clear and coherent strategy to achieve a successful outcome with an acceptable level of risk. This is the necessary skill set of any adviser and it enables the company to concentrate on delivering to its customers, not preparing itself for sale. As the saying goes, “Don’t buy a dog and bark yourself.” The added value in corporate finance comes in three ways. First is the ephemeral thing called judgment. As one partner of a major British practice used to describe it, having a good “bullshit detector” helps. Second is the ability to take the burden away from the client. Advisers should do all the heavy lifting, leaving their clients to concentrate on the business itself and the key decisions. Finally, and of crucial importance in many deals, advisers need to be able to access the right people in the right places who may wish to acquire the business.

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Information—What You Say, and How You Say It In 2001 three US economists, Akerlof, Steiglitz, and Spencer shared the Nobel Prize in economics. Their body of work deals with an area formally known as “information asymmetry,” or more colloquially: What do you do when I know things you don’t know? This section tries to answer a simple question: If a purchaser can’t tell a good car from a bad car, how can a seller get a premium for a good car? The same problem arises when you are selling a company, only more so. Companies are the most complex things that are traded, and selling one may transfer all the future and historical risks and rewards to the new owner. If you cannot persuade the new owner that the net value of those risks and rewards is quantifiable and positive, you won’t sell the business. This is one of the commonest areas in which transactions fail. A failure to think through the strategy of managing and transmitting information results in transactions falling apart further down the line, as purchasers narrow the information asymmetry in due diligence and find that what they were told originally is not what they found to be true subsequently.

Figure 1. Typical business sale process Typical business sale process Analyze company

Present information

Identify purchasers

Pre-qualify buyers

Implement marketing strategy

1st

round

offers

Evaluate & negotiate round 1 offers

Round 1

Release further information

Negotiate

2nd

round

offers

Evaluate & negotiate round 2 offers

Round 2

Confirmatory due diligence

Agree principles of legal agreement

Confirm

price

Final negotiations

Completion

Preparation

Due diligence

Post-completion matters

Completion

There are a number of ways to deal with information asymmetry. The simplest and crudest solution is to ignore the issue entirely. Provide limited data and tell purchasers to rely on their own judgment. In essence, this is what happens in an unsolicited hostile takeover, and may well be the reason that so many hostile approaches subsequently turn out to be failures.

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To bridge the asymmetry you can either transmit information (under a suitable confidentiality agreement) or agree to take residual risks away from the purchaser by, for example, giving warranties. At the extremes, the negotiating positions are either: “We will give you access to do whatever due diligence you like, but we are not warranting anything,” or “We will warrant that the information we give to you is materially correct, but you are not getting any more access than that.” The approach to this question needs to be decided early, since it flows through the entire transaction approach and materially influences the form of legal agreement that will emerge at the end of the process. It is also important to communicate your approach to purchasers clearly and consistently. If you do not, they will impose their view on you and purchasers will seek both a belt and suspenders: full access, and full warranties.

Valuation … is in the Eye of the Beholder In theory, the value of any asset is the present value of its future cash flows. To maximize value, you need to show the maximum future cash flow and the minimum cost of capital. This leads to the infamous “hockey stick” projections—projections that reverse a declining trend and rise thereafter. These are fed into a spreadsheet and out pops a valuation. The danger of believing your own propaganda is that you set unrealistic targets. You must aim high, but not every attempt can be a world record. In addition to DCF (discounted cash flow) valuations, advisers should prepare a variety of analyses. Comparable transactions that have occurred recently and analysis of comparable quoted companies valuations are the most frequently seen. Another way to discover what advisers think your business is really worth is to look at where their fee proposal starts to generate significant uplift. Where fees are correlated to value, you can often work out the implicit valuation of any adviser from their fee proposal. It is frequently contended that the most important output of the theoretical valuation process is not the maximum number calculated, but that it validates a “walkaway” price—the price at which the vendor will simply stop the process and refuse to sell. This number needs to be at the forefront of your mind in any negotiation. It also needs to be refreshed periodically if the prospects for the business or its markets change materially. It is also important to remember that all these analyses are simply checking out the potential valuation. To achieve a transaction at a particular valuation, you normally need competitive tension or a compelling strategic premium.

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Competitive Tension—Creating Fear, Encouraging Greed Once you have surveyed the landscape, the task is to identify and communicate with those purchasers most likely to place a valuation on the business that they can afford to pay and which exceeds the walkaway price. When considering the number of parties to approach to create a market, again there are two extremes: blunderbuss or rifle shot. The blunderbuss approach says that since you never know who might be looking for a business like yours, you should maximize the probability of hitting the target by firing as widely as possible. The downside is that circulating information widely makes a confidential process most unlikely. The rifle shot approach targets a limited number of buyers, maximizing the probability of reaching those specific purchasers wishing to acquire the business. You risk missing a purchaser that you don’t know of, but the process can be managed much more efficiently in a small and tightly controlled market. Whichever approach is used, maximum tension requires only a few, well-funded potential purchasers to emerge from the initial marketing. There is not much to gain from an auction with seven purchasers compared to an auction with six, but it is much harder to manage a large number of parties efficiently. The number of parties taken into the final process needs to be consistent with the information strategy adopted. It’s no use offering open access with no warranties to a large number of bidders; it is unmanageable in practice. The special case of a market with one buyer presents different challenges. Here there are different ways to motivate a deal. In a market of one, you have to adopt either the “takeaway sale,” or enter a courtship. The takeaway sale is a tactic used by realtors and used car salesmen across the globe. You quickly show your wares and then you rapidly remove them. The message is clear: It is a once in a lifetime opportunity to buy this house/car/company, and it won’t come again; act quickly. This is a risky approach. If the purchaser doesn’t believe you, your negotiating position can be seriously undermined if they react with a studied show of indifference to the opportunity presented. However when it does work, it can produce spectacular results because a strategic premium is paid by the purchaser. Courtship is subtler and has its own risks and rewards. It involves exploring possibilities and exchanging information and plans to build a consensus on the way forward and what that means in terms of valuation.

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When the logic of bringing two companies together is compelling, two questions often arise: First, which is the diner and which is the dinner? Second, even if the cake is bigger, you still have to negotiate how it is going to be shared. A courtship strategy requires a significant investment of senior management time and emotion. The biggest risk in a failed courtship is, as we all know, the effect of a broken heart. The impact on corporations of a failed courtship should not be underestimated: It can paralyze a corporation just as surely as it can turn a teenager into a gibbering wreck.

Financial Purchasers—Elephants or Dung Beetles Financial buyers come in many forms and provide liquidity to many different markets. The private equity (PE) industry contains both large strategic purchasers (elephants) and opportunists who seek to snap up companies when no strategic purchaser emerges (dung beetles). Whichever strategy they are pursuing, and despite being much misunderstood and maligned, over the past 20 years financial purchasers have acquired more companies than trade acquirers. Any vendor who does not consider the PE market as a potential purchaser may be missing, at a minimum, a valuable source of competitive tension, and possibly the optimal purchaser.

Auctions—Theory and Practice In a traditional, so-called English auction, bidding stops when the last but one bidder drops out. The vendor receives fractionally more than the second highest bidder was willing to pay. There are various ways to attempt to capture the value that the highest bidder might have paid. For example a reverse auction (also known as a Dutch or clock auction) operates by the price declining until it is accepted by a bidder. This results in the so-called winner’s curse—the only thing that the purchaser knows for certain is that they paid more than anyone else would have. A counterintuitive solution to the problem was proposed by Canadian-born economist William Vickrey. In a Vickrey auction, sealed bids are received and the asset is sold to the highest bidder, but at the price bid by the second highest bidder. This system ensures that each bidder bids their own true valuation, rather than speculating on the possible bids of other parties. The theoretical underpinnings are outside the scope of this chapter, but Vickrey was (jointly) awarded the 1996 Nobel Prize in economics for his work in this area. Information from the first round of bids can be used to intensify informed competitive tension in subsequent rounds. For example, in a group of four secondround bidders, all the bidders might be informed of the value of the third highest

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bid received in round one. This tells the two highest bidders that they were one of two, but not who was higher. It tells the third highest bidder that they were third, and similarly tells the fourth highest that they are playing catch-up. The information provided by the first-round bids gives each party a clear steer on their position in the process and a strong guide regarding the landscape of the bids. In practice, much of auction theory is of only partial relevance to any corporate sale because the theory is predicated on the assumption that completion of the transaction occurs simultaneously with acceptance of the bid. In practice, of course, there is usually confirmatory due diligence and negotiation of legal agreements to follow.

Defending the Price Whereas the auction process is designed to drive up the price, the period between accepting an offer and completion is usually defensive. The purchaser may try to find a justification to “chip” the price, and will rarely give any credit for positive variances against any plans they have relied on in the bid. The standard negotiating position of any purchaser when faced with positive information is, “We anticipated improvements in our original bid.” Negative variances are rarely anticipated in a bid and often result in variations to the terms of the indicative offer. Be aware that the legal status of an indicative offer varies from country to country. Whereas most UK and US acquirers view indicative offers relatively lightly, many non-Anglo Saxon countries view the making of any offer, however qualified it may be, as significant and, in some jurisdictions, potentially legally binding. It helps to understand this when judging both the offers received and the ability to meet any timetable that you might have set for purchasers. A contract race may alleviate exposure to price chipping, but it requires purchasers to risk paying significant fees in pursuit of a transaction that they have (on average) around a 50% possibility of completing. They may not wish to play that game. Furthermore, the process may increase acquisition risk for the purchaser due to the uncertainty caused to the business, resulting in a reduced final price. The ability to defend the price depends on the relationship between the purchasers’ and vendors’ teams, and the effective implementation of the information strategy agreed at the start of the process. If the “hockey stick” projections are not being met, expect a conversation about price to occur.

Dealing with Staff Companies are possibly the only assets you can sell where the value of the asset is dependent on the goodwill of the people employed in the business. It is extremely

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difficult to maintain complete secrecy in any transaction. The requirement to collate information not routinely produced often causes questions to be asked. Similarly, e-mails and telephone calls from unfamiliar advisers may trigger suspicion. Uncertainty invariably causes discontent, and transactions involve great uncertainties. Against this background, it is generally advisable to say nothing to staff unless required to do so. Any ambiguous information is often interpreted negatively, causing even more speculation and disruption. The alternative is to communicate honestly, including all the unknowns and uncertainties, giving legitimacy to the speculation but fanning the uncertainty. Once a deal is certain, communication with staff must form a key part of the posttransaction integration plan.

Making It Happen Any transaction involves extensive amounts of work and lengthy negotiations peppered with key decisions. There are periods of little apparent activity followed by periods characterized by long meetings that often drag into the night. Transactions are done by people, not by processes, and it is of utmost importance that the key decision-makers do not let boredom, frustration, or fatigue cloud their judgment. Many deals have failed because the principals or their advisers could not keep their head when the finish line was in sight. Risks often seem more significant when you stare at them for too long. At the end of any transaction, there are often negotiations regarding matters that no senior manager would normally consider material. Principals need to use commercial judgment to cut through any of these issues that are holding up a deal. Finally, the world of M&A is full of people who nearly did the best deal ever. M&A is often spoken about using the language of conflict, with winners and losers. In fact, it is about negotiation, a process that requires give and take. There is no point in beating your “opponent” at the negotiating table if all you end up with is a large bill for an aborted transaction.

More Info Books:

Brealey, Richard A. and Stewart C. Myers. Principles of Corporate Finance. 8th ed. New York: McGraw-Hill Education, 2005. Gilligan, John and Mark Wright. Private Equity Demystified—An Explanatory Guide. London: Institute of Chartered Accountants in England and Wales, 2008.

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Glover, Christopher G. Valuation of Unquoted Companies. London: Gee Publishing, 2004. Horner, Arnold and Rita Burrows. Tolley’s Tax Guide. London: LexisNexis (published annually). Klemperer, Paul. Auctions: Theory and Practice. Princeton, NJ: Princeton University Press, 2004. Wasserstein, Bruce. Big Deal: Mergers and Acquisitions in the Digital Age. New York: Warner Books, 2000.

Article:

Akerlof, George A. “The market for ‘lemons’: Quality uncertainty and the market mechanism.” Quarterly Journal of Economics 84:3 1970: 488–500.

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International Arbitration: Basic Principles and Characteristics by Stavros Brekoulakis

Executive Summary •

International arbitration is a contractually based dispute-resolution mechanism that offers an alternative to national courts.

•

International arbitration has experienced a remarkable growth in the last three decades, due to its unique advantages over litigation.

•

The advantages of arbitration include privacy and confidentiality of proceedings, procedural flexibility, and high rates of enforceability of arbitral awards.

•

Despite its many advantages, there is growing concern that arbitration is becoming increasingly expensive and time-consuming. This concern, although not unfounded, is often overplayed. Ultimately, it is down to the users of arbitration to draft effective arbitration agreements and to put an effective arbitration procedure in place.

•

To arrive at a successful resolution of disputes through arbitration, the parties involved should pay particular attention to the choice of arbitrators and the arbitration institution, and, most importantly, give due consideration to the drafting of the arbitration agreement.

Definition and Distinctive Features of Arbitration International arbitration can be defined as a specially established mechanism for the final and binding determination of disputes concerning a contract between two or more parties that has an international element. The disputes are determined by independent arbitrators in accordance with standards and procedures chosen by the parties involved in the dispute.1 The distinctive feature of arbitration is that it is a private dispute-resolution mechanism, which nevertheless provides arbitrators with judicial power. More specifically:

• 

arbitration is a private dispute-resolution method, in which the arbitrators’ mandate to resolve a dispute derives from a contract (i.e., an arbitration agreement or arbitration clause).

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• 

arbitrators have the power to deliver an award that finally resolves the dispute that is binding on the parties.

The above characteristics of arbitration distinguish it from the following. Litigation proceedings before national courts. In litigation, national courts are an expression of state power and they are bound to apply the rules and procedures of the state to which they are attached. National judges owe allegiance to their state and they have limited or no discretion to deviate from the procedural codes and rules of that state. By contrast, in arbitration parties are free to determine how the proceedings are to be conducted, subject only to minimum safeguards (due process). Party autonomy is a fundamental principle in arbitration, which gives the parties the opportunity to tailor the proceedings in accordance with their commercial needs and the special characteristics of the case. Arbitrators are private judges whose mandate is determined by the arbitration agreement concluded by the parties, and who owe allegiance to the parties that have appointed them, rather than to a state. Alternative dispute resolution (ADR) methods. Despite the fact that their authority derives from a contract, arbitrators have the power to grant an award, which is a final decision that is binding on the parties. Arbitral awards are enforceable in the same way that national judgments are. Therefore, arbitration must be distinguished from other forms of ADR, such as mediation. Here, as in arbitration, a third party (mediator) is involved in the resolution of the dispute between the two commercial parties. However, the mediator has no power to impose a decision on the parties. Mediators work with the parties to resolve their dispute by an agreement; they cannot issue a binding decision. Thus, the outcome of a successful mediation is a settlement rather than an enforceable award.

Different Forms of Arbitration There are two basic types of arbitration: ad hoc and institutional. Parties are free to choose between these two types in their arbitration agreement. If the parties fail to specify in their agreement which type of arbitration they prefer, the arbitration will be presumed to be ad hoc. Ad hoc arbitration is an arbitration that is specifically designed by the parties for a particular dispute. Here, there are predetermined rules for the arbitrators to rely on when conducting the proceedings (although sometimes the United Nations Commission on International Trade Law (UNCITRAL) arbitration rules are used). Thus, it is up to the parties to determine the proceedings and to the arbitrators to fill any gaps. Ad hoc arbitration is more flexible than institutional, as the parties are completely free to adapt the proceedings to the particulars of the case. It can also be less expensive than institutional arbitration, as the parties avoid the fees of the institution and they can negotiate the fees of the arbitrators. However, for an ad hoc

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arbitration to work, the parties must have provided for a clear set of proceedings in advance, as there are no institutional rules to fall back on if they disagree on the arbitration process after the dispute arises. Institutional arbitration is an arbitration that is conducted under the auspices of a particular arbitration institution and in accordance with the rules of that institution. Institutional arbitration is more popular among international parties.2 This is because the parties feel more comfortable with experienced institutional administrators (known as “case managers”) who are willing to take care of any issue that might arise during the proceedings. Parties are also attracted by the reputation and the strong brand name of many established arbitration institutions, which, as many parties believe, increases the enforceability of an arbitration award. The most popular institutions are the International Chambers of Commerce (ICC), the London Court of International Arbitration (LCIA), the American Arbitration Association (AAA), and the Stockholm Chamber of Commerce.3

Advantages of International Arbitration International arbitration has experienced a remarkable growth in the last three decades, and it is now perceived as the natural dispute-resolution mechanism for disputes arising out of international transactions. The remarkable growth of arbitration is due to the following advantages compared to national litigation and other ADR methods: Privacy and confidentiality: Unlike litigation proceedings that take place in public, arbitration proceedings are private and, unless the parties agree otherwise, they remain confidential. Thus, the existence of the arbitration, the evidence and the documents exchanged in the arbitration, and the final award cannot be divulged to third parties. The duty of confidentiality is binding on the arbitrators, the parties, and their counsel, and it is considered an important commercial advantage of arbitration. The parties appoint the arbitral tribunal: Unlike litigation, where the dispute is determined by national judges appointed by the state, in arbitration the parties have the opportunity to appoint those who will decide on the dispute (i.e., the arbitrators). Usually, arbitral tribunals consist of either one arbitrator, who is chosen by both parties or three arbitrators, where each party appoints one arbitrator and a chairman is then chosen by the two party-appointed arbitrators. The fact that the parties may participate in the constitution of the tribunal enhances their confidence in the arbitration process, as they can appoint arbitrators who are familiar with their legal or cultural background. It also gives the parties the opportunity to select arbitrators who have the expert knowledge required by the particular characteristics of the dispute. For example, an engineer or an architect is often appointed as an arbitrator to determine a complex construction dispute.

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Enforceability of arbitral awards: International arbitration awards are more easily enforceable than national judgments. This is due to the 1958 New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards, which has now been signed and ratified by 143 countries. The New York Convention has thus established an internationally harmonized regime for the enforcement of arbitral awards, where recognition and enforcement are only exceptionally disallowed on limited grounds. By contrast, there is no international convention that enables the enforcement of national judgments. Procedural flexibility: Arbitration proceedings are determined by the arbitration agreement of the parties. Thus, the principle of party autonomy provides parties with considerable liberty to tailor their own dispute resolution process in accordance with their needs and the particulars of their dispute. Therefore, procedural flexibility and party autonomy make arbitration the most suitable dispute-resolution mechanism for international commercial transactions. Neutrality: Arguably this is the most attractive feature of international arbitration. Proceedings generally take place in a country with which neither party has links; the dispute is determined in accordance with transnational rules, or according to the national law of a neutral country; and arbitrators are appointed from different countries and with different nationalities. Neutrality is of utmost importance in the context of international arbitration, where each party wants to avoid a national court of its co-contractor.

Areas of Concern Arbitration has always been considered a quicker and less expensive means of dispute resolution than national courts. Although in theory and in many cases this is still so, there is growing concern that arbitration proceedings are becoming increasingly costly and time-consuming. International arbitration is now widely perceived to be even more expensive than litigation.4 The international arbitration community is concerned about these issues, and arbitration institutions have issued guidelines for the parties and the arbitrators to reduce the time and cost of arbitration proceedings. Costs related to arbitration can be divided into two groups: Fees for the counsel; and arbitration costs, which include the fees of the arbitrators, the administrative fees of the institution (if the arbitration is institutional), and expenses related to the hearings (hiring the venue, translation costs, traveling costs for the witnesses, fees for the experts appointed by the tribunal, etc.). Ultimately, arbitration is a party-led mechanism, and therefore it is up to the parties, who also are the fee payers, to take the necessary steps for the proceedings to take less time and money.

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Increasing the Chances of Successful Arbitration Here are some of the factors that parties should consider to arrive at a successful resolution of their disputes through arbitration: Appoint the right arbitrator: Parties should look for arbitrators who are available to embark on the proceedings quickly. Many arbitrators have a busy schedule, which inevitably will lead to delays in the hearings and the issuance of the final award. Parties are advised to do thorough research before selecting their arbitrators. Nowadays, it is general practice for parties to interview potential arbitrators and gather information relating to their previous work. The number of arbitrators appointed may also impact the cost of the proceedings. A panel of three arbitrators will normally improve the quality of the award and reduce the risk of an arbitrary decision. However, three-arbitrator tribunals will generally be more expensive and time-consuming as it is more difficult to convene meetings, arrange hearings, or reach a final agreement when three arbitrators are involved. Choose the right arbitration institution: Parties should be aware that while in ad hoc arbitrations parties may negotiate the arbitrators’ fees; in institutional proceedings fees are calculated in accordance with predetermined rules. Different institutions have different methods for calculating arbitrators’ fees. For example the LCIA’s rules set out a recommended range of hourly rates which may only be deviated from in exceptional circumstances, while under ICC rules the arbitrators’ fees are calculated as a proportion of the sum in dispute (the so-called ad valorem method). Thus, parties are advised to look into the methods that different institutions use to calculate arbitrators’ fees before deciding to which institution they should submit their dispute. Draft efficient arbitration clauses: Parties often focus on the substantive clauses of their contracts but pay little attention to the arbitration clauses. Arbitration clauses are usually the last provisions to be incorporated in a contract, and they are drafted without debate or much consideration of the specific needs of the particular contract. Ambiguous arbitration clauses will most likely result in lengthy litigation, causing delays and increasing the cost of the arbitration proceedings. Parties are advised to draft clear arbitration clauses that set out an effective and rapid set of arbitration proceedings (see the Making It Happen section). Make use of technology: As mentioned above, arbitration proceedings are flexible and can be specifically designed to suit the particular case. There is no need for the hearings to be conducted in person at a particular venue. Arbitrators and parties are advised to make use of technology in order to reduce the costs of the proceedings. For example arbitration hearings, including witnesses and expert examination, may be conducted via video-conference; and documents, including the submissions of the parties, may be communicated by email or other convenient means.

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Making It Happen Drafting Effective Arbitration Clauses

 •  •  •  • 

Ill-drafted arbitration clauses can prolong litigation proceedings and thwart the resolution of a dispute in a quick and efficient way. In order to draft effective arbitration clauses, parties should consider the following points carefully: The intention to arbitrate must be clearly and unambiguously stated in the arbitration clause. Avoid permissive language such as “parties may submit any dispute to arbitration.” It should be stated clearly whether the arbitration is to be ad hoc or institutional. If the parties opt for an institutional arbitration, it is very important that unambiguous reference is made to an arbitration institution that exists (see the Case Study). If ad hoc arbitration is chosen, the seat of the arbitration must be clearly stated. The safest solution is for the parties to use one of the arbitration clauses recommended by well-known arbitration institutions. However, parties should not attempt to modify these set arbitration clauses, as there is a risk that the clause will be rendered unenforceable. Here, for example, is the arbitration clause recommended by the ICC: “All disputes arising out of or in connection with the present contract shall be finally settled under the Rules of Arbitration of the International Chamber of Commerce by one or more arbitrators appointed in accordance with the said Rules.”

Case Study Ill-Drafted Arbitration Clauses Result in Further Litigation

The parties in Lucky Goldstar v Nag Moo Kee Engineering (High Court of Hong Kong, 1993) had included the following arbitration agreement in their contract: “Any dispute or difference arising out of this contract shall be arbitrated in a 3rd Country, under the rule of a 3rd Country and in accordance with the rules of procedure of the International Commercial Arbitration Association.” This was a “pathological” arbitration clause that made no sense, for the following reasons: •

The institution provided for in the clause, namely the “International Commercial Arbitration Association,” did not exist.

•

No seat of arbitration was specified; the rather ambiguous reference to “a 3rd Country” made no sense; and there was no indication which this “3rd Country” might be.

Therefore, when a dispute arose over the contract, the parties could not commence arbitration proceedings, as there was no arbitration institution to which the parties could submit their dispute. Inevitably, therefore, the parties had to resort to a national court, which came up with a rather creative interpretation of the ambiguous arbitration clause in order to give effect to the parties’ original intention to submit their dispute to arbitration. The High

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Court of Hong Kong held that since there was no “International Commercial Arbitration Association,” the parties should be referred to the best-known international arbitration institution, which it judged to be the ICC. It is, of course, fortunate in this specific case that the national court managed to give meaning to and enforce this ill-drafted arbitration agreement. However, the parties eventually lost time and money, as they had first to resort to a national court before finally starting arbitration proceedings.

More Info Books:

Born, Gary. International Arbitration and Forum Selection Agreements: Planning Drafting and Enforcing. 2nd ed. The Hague: Kluwer Law International, 2006. Lew, Julian D. M., Loukas A. Mistelis and Stefan Kröll. Comparative International Commercial Arbitration. The Hague: Kluwer Law International, 2003. Redfern, Alan and Martin Hunter, with Nigel Blackaby and Constantine Partasides. Law and Practice of International Commercial Arbitration. 4th ed. London: Sweet & Maxwell, 2004.

Websites:

American Arbitration Association: www.adr.org ICC Commission on Arbitration: www.iccwbo.org/policy/arbitration/id2882/index.html London Court of International Arbitration: www.lcia-arbitration.com School of International Arbitration, Queen Mary University of London: www.schoolofinternationalarbitration.org United Nations Commission on International Trade Law (UNCITRAL): www.uncitral.org

1 Lew, Mistelis, and Kröll, Comparative International Commercial Arbitration (2003), para 1-1. 2 In a survey conducted by the School of International Arbitration, Queen Mary University of London, and PricewaterhouseCoopers, entitled “International arbitration: Corporate attitudes and practices 2006”, it was found that 76% of parties prefer institutional arbitration to ad hoc arbitration. This study and a second published in 2008 are available online at: www.pwc.com/arbitrationstudy. 3 See the above study for a list of the relative popularity of the various arbitration institutions. 4 In the 2006 survey mentioned in note 2, it was found that 65% of respondents perceived arbitration to be more expensive than litigation.

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Joint Ventures: Synergies and Benefits by Siri Terjesen

Executive Summary •

A joint venture (JV) is a formal arrangement between two or more firms to create a new business for the purpose of carrying out some kind of mutually beneficial activity, often related to business expansion, especially new product and/or market development.

•

An important first step is for each firm’s managers to review the firm’s business and corporate strategies to determine synergy with the objectives of a joint venture.

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A second key step is to assess the suitability of the potential joint venture partner(s) for fit with the firm’s strategy, and compatibility during the life of the JV.

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There are four basic JV types: consolidation (deep combination of existing businesses); skills-transfer (transfer of some key skill from one partner); coordination (leveraging complementary capabilities of all partners); and new business (combining existing capabilities, not businesses, to create new growth).

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JVs can offer an array of benefits to partner firms through access to new and/or greater resources including markets, distribution networks, capacity, staff, purchasing, technology/intellectual property, and finance.

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JV risks can arise from disparate communication, culture, strategy, and resources, and result in loss of control, lower profits, conflict, and transferability of key assets.

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NUMMI is an example of a successful JV offering mutual benefits to its partners, General Motors (GM) and Toyota.

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To succeed, JV partners must mitigate potential risk factors, including poor communication, different objectives, imbalanced resources, and cultural clashes.

Introduction A joint venture (JV) is a formal arrangement between two or more firms to create a new business for the purpose of carrying out some kind of mutually beneficial activity, often related to business expansion, especially new product or market development. A JV is the most popular type of contractual alliance among firms; other types include formal long-term contracts, informal alliances, and acquisitions. JVs may take the form of a corporation, limited liability company (LLC), partnership, or other structure. The 100 largest JVs worldwide account for more than US$350 billion in revenues (Bamford, Ernst & Fubini, 2008). An increasing number of JVs involve foreign partners, in part due to laws in some countries that require foreign firms to partner with local firms in order to conduct business in that country.

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Synergy to Strategy An important first step is for management to review the firm’s business and corporate strategies to determine synergy with the objectives of a joint venture. In this process, managers can apply a range of strategy methodologies such as SWOT (strengths, weaknesses, opportunities, and threats), Porter’s Five Forces, stakeholder analysis, and the value chain to assess the firm’s strategy and future vision. Managers may then determine that the joint venture is not the most optimal organizational form for achieving the firm’s objectives, and that another form, such as a long-term contract, may offer a better strategic fit. A second key step is to assess the suitability of the potential joint venture partner(s) for fit with the firm’s strategy, and compatibility during the life of the JV. Key questions here include:

•  • •  • •  • •

Does the potential JV partner share the same business objectives and vision for the joint venture? Is the potential partner firm trustworthy and financially secure? Does the potential partner firm already have JV partnerships with other firms? If so, how are these performing?  ow would you rate the potential partner firm’s performance in terms of H production, marketing, customers, personnel, innovation, and reputation? What are the general strengths and weaknesses of the potential partner? How do they complement our firm? What benefits might the potential partner firm realize from the JV? What risks might we be exposing our firm to in the JV?

A joint venture should only be formed when the parties mutually agree that this form offers the best possibility of optimizing opportunities. Thirdly, the parties set out JV terms in a written agreement which addresses structure (for example if it should be a separate business or not), objectives, financial and other resource contributions (of each partner), including the transferability of any assets or employees to the JV, ownership of intellectual property created in the JV, management and control responsibilities and processes, sharing or re-allocation of liabilities, profits and losses, resolution of disputes, and exit strategy. Joint ventures can be flexible, covering only a limited life span or a limited scope of firm activities. Four basic types of JVs and their respective benefits are (Bamford, Ernst & Fubini, 2004):

•

Consolidation JV: value derived from deep combination of existing businesses.

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•  •  • 

Skills-transfer JV: value derived from the transfer of some key skill from one partner to the JV (or to the other JV partner). Coordination JV: value derived from leveraging the complementary capabilities of all partners. New business JV: value derived from combining existing capabilities, not businesses, to create new growth.

Joint Venture Benefits Joint ventures can offer an array of benefits to partner firms through access to new or greater resources including markets, distribution networks, capacity, staff, purchasing, technology or intellectual property, and finance. Often, one firm supplies a key resource such as technology, while the other firm(s) might provide distribution or other assets. The following are key resources that can be shared. Access to markets: JVs can facilitate increased access to customers. One JV partner might, for example, enable the partner to sell other goods/services to their existing customers. International JVs involve partners from different countries, and are frequently pursued to provide access to foreign markets. Distribution networks: Similarly, JV partners may be willing to share access to distribution networks. If one partner was previously a supplier to the other, then there may be opportunities to strengthen supplier relationships. Capacity: JV partners may take advantage of increased capacity in terms of production, as well as other economies of scale and scope. Staff: JVs may share staff, enabling both firms to benefit from complementary, specialized staff. Staff may also transfer innovative management practices across firms. Purchasing: As a result of their increased resource requirements, JV partners may be able to collectively benefit from better conditions (for example price, quality, or timing) when purchasing. Technology/intellectual property: As with other resources, JV partners may share technology. A JV may also enable increased research, and the development of new innovative technologies. Finance: In a joint venture, firms also pool their financial resources, potentially eliminating the need to borrow funds or seek outside investors. Taken together, the benefits suggest an improved competitive position for the JV, and each of the partners.

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Joint Venture Risks There are, however, a number of risks related to joint ventures that can result in loss of control, lower profits, conflict with partners, and transferability of key assets. In fact, studies in the 1980s and 1990s revealed failure rates of 49% and 47% (Bamford, Ernst, Fubini, 2004). More recent work reports failure rates varying from 2% to 90%, depending on the partners involved (see, for example, Perkins, Morck & Yeung, 2008). JV risks stem from many sources, including the following:

• 

Communication: The firms may not communicate their objectives clearly, resulting in misunderstanding. These communication issues can be exacerbated by geographic and cultural distance among partner firms, and by the use of language such as “us versus them”.

• 

Strategy: The firms may have divergent strategies for the joint venture, and fail to reach a set of mutually agreeable objectives regarding business and exit strategies. Risks can also emerge from a lack of agreed processes regarding governance, accountability, decision-making, HR, and conflict resolution.

• 

Imbalanced resources: The firms may bring imbalanced resources to the table, a source of great conflict. Another source of conflict may be that the JV disproportionately allocates resources among the firms. For example one firm may find that its technology is being appropriated by another firm.

• 

Culture: The JV partner firms may have distinct corporate (and in the case of cross-border JVs, national) cultures and management styles, resulting in poor integration and cooperation.

Case Study NUMMI Joint Venture

Established in Fremont, California, in 1984, the New United Motor Manufacturing Inc. (NUMMI) is a joint venture between General Motors (GM) and Toyota. The NUMMI JV began as an experiment. The allure for GM was a chance to learn how to build cars, especially of a small size and high quality, using Toyota’s “lean” production system. Toyota was interested in testing its production methods in an American setting. According to Eiji Toyoda, then the Chairman of Toyota Motor Company: “Competition and cooperation is the underlying principle of the growth of the world economy. Our joint venture is founded on this approach. We hope to make this project a success as a model of economic cooperation between Japan and the United States—one that contributes to the American economy.” (Source: www.nummi.com/us_roots.php). To start the joint venture, US$450 million in funding was required. GM contributed its plant in Fremont, which it had closed in 1982. Toyota provided US$100 million of start-up capital. The remaining capital was raised by NUMMI as an independent Californian corporation. The US Federal Trade Commission (FTC) approved the formation of the company for an

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initial 12-year period, stating that the venture would offer a wider range of automobile choices to customers. The 12-year limit was eventually lifted, and NUMMI continues to operate. Ford and Chrysler opposed the joint venture and filed an unsuccessful lawsuit to block NUMMI. NUMMI invited former GM workers to apply for jobs, and expressed a special “need for employees willing to contribute to an atmosphere of trust and cooperation”. Following a rigorous hiring assessment, the new employees attended orientation sessions about NUMMI’s concept, system, principles, policy, and philosophy. Team members were introduced to NUMMI’s core values, which are based on teamwork, equity, involvement, mutual trust and respect, and safety. Approximately 450 group and team leaders traveled to Toyota’s Takaeoka plant in Japan to spend three weeks learning in the classroom and on the job about Toyota’s production system, team building, union–management relations, and safety. NUMMI’s first effort was the Chevrolet Nova, built by 700 team members in 1984. NUMMI has established a collaborative partnership with United Auto Workers (UAW) in which UAW agrees to be a cooperative and active participant in labor-management relationships, to accept Toyota’s production methods, and to work to improve productivity and quality. NUMMI has been presented as a case-study model of labor-management cooperation to the International Labor Organization Conference. NUMMI’s unique corporate learning and cultural environment optimizes the best of GM, Toyota, and nearby Silicon Valley. The JV is considered to have been instrumental in introducing the Toyota production system and a team-based working environment to the US automobile industry. NUMMI remains a key source of innovative knowledge about quality, continuous improvement, and human resource management. GM and Toyota regularly send managers to visit NUMMI in order to learn lessons to be applied in their home unit’s strategies. Today, NUMMI has more than 5,440 team members, and annually produces approximately 250,000 cars and 170,000 trucks under the brands of Toyota Corolla, Toyota Tacoma, and Pontiac Vibe. More details about NUMMI can be found at www.nummi.com.

Conclusion As the NUMMI case study illustrates, JVs offer benefits to both partners as well as other stakeholders—providing customers with more and a higher quality variety of car choices and manufacturers, with a model of labor-management relations. There are, however, many risks to be considered. Interrelationships among small and large firms are increasingly common, and offer unique benefits to each partner. For a small firm, a joint venture may offer a unique opportunity to grow quickly with other small firms, or to partner with a larger firm. Often the large partner benefits from the smaller firm’s flexibility and intellectual property, while the small partner benefits from increased access to markets, reputation, and other key resources. Increasingly, JV partners of all sizes join together as a defensive response to blurring industry boundaries.

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Making It Happen To succeed, JV partners must mitigate several potential sources of risk: poor communication, different objectives, imbalanced resources, and cultural clashes. Firstly, JV partners must establish clear communication channels at the top of the firms involved, and also with employees whose daily work is related to the joint venture. This communication is often facilitated through regular, face-to-face meetings to establish not only the benefits from the JV, but also the risks if the JV does not work. Secondly, it is essential that partners agree on objectives and milestones. Key performance indicators (KPIs) can be established to measure performance and provide early warning guidance. Imbalanced resources, such as different levels of financing or expertise, can also lead to conflict. Finally, each firm has a unique culture, and cultural clashes in management style may become apparent. These issues may be exacerbated across foreign JV partners as a result of language and cultural differences. Flexibility and an open approach to trying to make things work are essential.

More Info Books:

Child, J., D. Faulkner and S. Tallman. Strategies of Cooperation: Managing Alliances, Networks, and Joint Ventures. Oxford: Oxford University Press, 2005. Wallace, Robert L. Strategic Partnerships: An Entrepreneur’s Guide to Joint Ventures and Alliances. New York: Kaplan Publishing, 2004.

Articles:

Bamford, James, David Ernst and David G. Fubini. “Launching a world-class joint venture.” Harvard Business Review February 2004: 90–100. Online at: hbr.harvardbusiness.org/2004/02/launching-aworld-class-joint-venture/ar/1 Perkins, Susan, Randall Morck and Bernard Yeung. “Innocents abroad: The hazards of international joint ventures with pyramidal group firms.” NBER Working Paper 13914 April 2008. Online at: www.nber.org/papers/w13914 Steensma, H. K., J. Q. Barden, C. Dhanaraj, M. Lyles and L. Tihanyi. “The evolution and internalization of international joint ventures in a transitioning economy.” Journal of International Business Studies 39:3 April 2008: 491–507. Online at: dx.doi.org/10.1057/palgrave.jibs.8400341

Website:

Google’s latest joint venture news: news.google.com/news?pz=1&ned=us&hl=en&q=%22joint+venture %22

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Coping with Equity Market Reactions to M&A Transactions by Scott Moeller

Executive Summary •

Overall, stock returns to acquirers tend to be negative or insignificant—in contrast to target companies, where stockholders can benefit greatly.

•

Companies that believe they may be targets can influence the value of an ultimate acquisition through the design of defensive techniques and by how they react to bids when they occur. Similarly, acquirers can influence the target share prices through their actions prior to the bid.

•

Most acquirers are overconfident in their ability to conduct acquisitions successfully.

•

Careful planning, including a robust internal and external communications plan, is required to mitigate the impact on equity markets of acquirers.

•

Many factors influence equity-market reactions to an M&A bid, including how friendly or hostile the bid is, the financing structure of the bid, the relative size of the two companies, and whether the transaction is a merger or an acquisition.

•

Deals conducted in the most recent merger wave appear to have taken some of these issues into account and show better relative performance (relative to the market) than deals conducted in the 1980s and 1990s.

Introduction It would be nice if the markets were to react consistently in response to the announcement of M&A deals. But they don’t. At least not always. But you can depend on one thing: In the short run, shareholders of target companies benefit more than those of the acquiring company. It is important to know how to cope with the likely equity-market reaction to the announcement of a deal. First of all, you need to understand what those likely reactions will be … and then work out whether there is anything that can be done to influence the market. Bidders can mitigate the likely negative market reaction to their share price, and targets may be able to provoke even higher bids. This article discusses public companies only—as these are oviously the only ones with an “equity-market reaction.” However, one can properly extrapolate their experience to private companies as well. While most advisers and principals in privately held companies take into account the experience of publicly held companies, the reaction of the equity markets regarding the bidder’s share price

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is not dependent on whether the target is public or private. Either way, the shareholder value of bidders declines, on average, following the announcement of a large acquisition. “Most mergers fail. If that’s not a bona fide fact, plenty of smart people think it is. McKinsey & Company says it’s true. Harvard, too. Booz Allen & Hamilton, KPMG, A.T. Kearney—the list goes on. If a deal enriches an acquirer’s shareholders, the statistics say, it is probably an accident.” New York Times, February 28, 2008

Equity Market Reactions for Targets Relatively few deals make money for the bidding company’s shareholders. The market rather consistently shows that bidding companies lose money for their shareholders, or at best break even around the time of the announcement of a takeover, whereas target companies attract offer premiums that typically range from 20% to 40%. Stock prices often rise above the offer price if a competing bidder is anticipated. These returns are relatively consistent in the United States and the United Kingdom, with the data for other countries less clear but indicating similar results. When the bidder and target returns are combined, the overall shareholder-wealth effects are typically found to be insignificant over the short term and positive over the longer term. In the absence of a competing bid, when a takeover is announced the target company’s stock price typically rises to a level below the offer price, but slowly rises to approach the bid price as time approaches the closing date when the final deal is consummated, which for most deals is 3 – 6 months after the announcement date (Figure 1). This is because there is some risk that the deal will not go through or will be repriced (usually lower) because of negative information that the bidder finds while conducting due diligence on the target (see Due Diligence Requirements in Financial Transactions for a discussion of the best ways to conduct due diligence in M&A deals).

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Figure 1. Movement of target company share price

Influencing Target Company Stock Prices The target company itself can have an influence on the potential price offered in a number of ways:

• 

By having a strong defense in place to protect the company from an unsolicited takeover bid. Such defenses can include so-called poison pills (including underfunded pension plans), shares owned by insiders or in friendly hands, golden and silver parachutes not just for senior management but for a wider group of employees (often called “tin parachutes”), and a history of successfully fending off hostile bidders. Research has shown that these defenses, especially poison pills, do result in higher premiums for target companies.

• 

Most of these defenses are put in place to make it more difficult (that is, expensive), but not impossible, to be purchased. For example, Mellon Bank put in place tin parachutes for all its employees following an unsuccessful hostile bid by the Bank of New York in 1998; when later, in 2006, a friendly deal was proposed and accepted by Mellon Bank, the senior managers and employees were requested to waive their golden, silver, and tin parachute rights in order to put them on an equal footing with the Bank of New York employees, who had no such employment provisions.

• 

By letting the market know that a high threshold premium value will be required for any unsolicited bid before the board of directors will recommend it to the shareholders. Yahoo! used this technique when it successfully fended off an unwelcome bid from Microsoft in early 2008 that had a 62% premium associated with it (a so-called “bear hug” offer, which designates an offer above the typical premium range of 20–40%).

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• 

By encouraging competing bids. By opening up the purchase of the company to an auction, the directors admit that the company is for sale and will likely lose its independence, but that they are actively seeking the highest possible price. After, the UK supermarket chain Morrisons made a formal offer to purchase Safeway for £2.4 billion in January 2003, an auction for Safeway ensued with competing bids from ASDA (controlled by Wal-Mart) and J. Sainsbury. There was a feeding frenzy that included Tesco, retail magnate Sir Philip Green, and venture capitalists Kohlberg Kravis Roberts. The price that Morrisons ultimately paid for Safeway was £3.0 billion.

Bidders can also influence the target company’s share price, naturally wanting to keep the price of the target down. The most common technique is to conduct a “street sweep,” whereby the target company’s shares (or a controlling interest in the target) are purchased in a blitzkrieg that gives the market and the target’s management no time to react before the takeover is effectively complete. This is very difficult to conduct in practice, and is most successful when a small number of shareholders control a large percentage of the target’s shares or where the bidder already has a large share ownership in the target. Thus, for example, Malcolm Glazer, who for a long time had been holding 28% of the publicly listed football club Manchester United, purchased a similarly sized holding from Cubic Expression in May 2004, and thus in one purchase came to control the club. Many bidders, when purchasing their toeholds in potential targets, will publicly announce that they have no interest “at this time” in making a bid for the entire company, maintaining that their holding is a financial interest only “because the shares represent an attractive investment.” This was the position declared by Malcolm Glazer in the Manchester United case from the time he first disclosed a 3% ownership in the club in March 2003 up until the time he bought the shares that gave him control in 2005. In his case, the market expected a bid for the entire company, but his public position nevertheless may have lowered the price he ultimately had to pay for that controlling interest. In all of these situations, it must be noted that proper legal advice must be taken in order not to fall foul of the many regulations and laws that prohibit market manipulation.

Equity Market Reactions for Bidders The shareholders of acquiring companies are not as fortunate as those of the targets. On average, their shares decline in value around the time the company announces its intention to take over another company. Thus, in the example above, when Morrisons launched its surprise bid for Safeway (at a 30.3% premium to the prior day’s close), its shares declined 14.3%, and when J. Sainsbury entered with its competing bid, its own share price declined on the day by 3.5%. The shareholders of neither bidder benefited, in distinct contrast to Safeway’s shareholders.

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Because of the relative consistency over time of stock-market movements in response to deal announcements, the market will assume that future deals will do the same, including that only 30-40% of all deals are successful, that mid- and longterm shareholder wealth declines by 10-35%, and that the share prices for acquirers and targets move within certain ranges (on average) around the announcement day. Merger arbitrageurs—whether in hedge funds or investment banks—take large positions knowing that bidders’ share prices tend to drop immediately after a deal announcement and that targets will see share price appreciation. This then becomes a virtuous (or vicious, for the bidder) cycle, where the movement in the share prices is magnified by this arbitrage activity. In many cases these movements in share price can lead to extreme changes in share ownership. For example when the Deutsche Börse (the largest stock exchange at the time in mainland Europe) made a bid for the London Stock Exchange in 2004, the Anglo-American arbitrageurs rapidly became the largest group of shareholders, displacing the long-term German shareholders, whose ownership was reduced to only a third. It was these arbitrageurs who forced the Deutsche Börse CEO to drop the bid in March 2005, leading to a 30% price rise in the Deutsche Börse shares as it became less and less likely that the deal would succeed. As with the Deutsche Börse CEO who didn’t anticipate this change, most managers seem to be oblivious to facts which appear to be obvious to those outside the company. A DLA Piper survey in 2006 showed that 81% of corporate respondents rated their M&A experience as fairly or highly successful, and over 90% of venture capitalists felt the same, yet we know that 60–70% of all deals fail.

Influencing the Stock Price of the Bidder In most M&A situations, the bidder controls the timing of when the bid is publicized. The notable exception to this is when there is a market leak, but even in these situations the leak either happens early in the negotiations when it is easier to deny to the press that any deal is pending (as the negotiations have not progressed sufficiently far for a deal to be in place), or late enough in the proceedings that an emergency communication plan should already be in place for just such a situation. The announcement event is therefore not a surprise to the bidder. Through proper planning and the use of external advisers (including investment banks, but also specialist public relations firms), positive spin on the deal can be delivered to the market: Benefits to all stakeholders are emphasized; new markets are announced; product innovations are forecast. Support from clients, suppliers, and even outside parties (such as local government) can be rallied. Potential problems will have been anticipated, and strategies to neutralize these will have been developed and disclosed.

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Nevertheless, to paraphrase Robert Burns, “The best laid plans of mice and men / Go oft awry.” In M&A deals, there are ultimately just too many individuals involved and there is just so much that can go wrong that much often does. Therefore, the press turns negative, equity analysts forecast too much dilution of earnings, cash flow declines, and clients, suppliers, employees, and even managers become very worried about their positions—and naturally assume the worst. Thus the acquirer must have a very robust communications plan at the ready. Not every contingency will be anticipated, but many can be. Most important is to have teams in place to be able to respond quickly to any false rumors and to replace immediately any such gossip with fact. The company needs to stay in control—as best it can—during the entire deal process. The most effective way to do this is to have a continuous stream of positive stories prepared for periodic, perhaps even daily, release. Constant communication with the staff of both bidder and target can go a long way towards allaying anxiety and even panic. One must remember that those who can benefit from the flip side will be acting accordingly as well: these include competitors who see opportunities to grab market share and even valued staff, and trading arbitrageurs who have made bets in the market that the share price will fall. These arbitrageurs certainly have been very successful in pushing down the price of acquirers in many deals, as in the above example where the Deutsche Börse was forced to drop its bid for the London Stock Exchange.

Other Factors Affecting Equity Values The above discussion “averages” the results for many companies. Individual deals and individual companies will show different results and provide different returns over time from these averages, and takeover and defensive tactics will also need to be customized for each situation. There are also other factors that will impact on the equity markets for both the target and bidder’s share price. When cash is used to finance the deal instead of issuing more shares, the returns to the bidder are usually higher. In countries such as the United States, where tender offers (often hostile) are common, these do better than friendly mergers. The smaller the target is in relation to the acquirer, the more likely it is that the bidder’s share price will not decline relative to the market. There are also differences in short- and long-term shareholder-value effects. This article has looked principally at the short-term effects around the time of deal announcement, but if a longer-term perspective is taken (more than six months), then the negative returns to the bidder are reduced, although still typically remaining negative. Also, one can look at the combined returns when the bidder and target are taken together over the longer term: in this case as noted earlier, history shows that the overall shareholder-wealth effects are typically positive.

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Conclusion Despite the doom and gloom of the analyses that have looked at the success of companies that merge or acquire, there is some hope: Several recent studies (from Towers Perrin/Cass Business School, McKinsey, and KPMG) have shown that acquiring companies since 2003 are doing better with their deals. Not much, but at least measurably so. Some of the suggestions we’ve made in this article have been recently more widely adopted by the market. There is more focus on careful deal selection and corporate governance. Post-merger integration is receiving attention even before the deal closes, and sometimes even before announcement. There is hope—and evidence—with some of these recent studies that perhaps equity markets may start to award an equity premium to companies that acquire well.

Making It Happen The Key Factors

•  •  •  •  •  • 

Understand that the premium offered to the target is only one aspect of the deal’s success, and that it is often overshadowed by other factors, especially people issues. Formulate a plan for addressing surprises. Try to identify all the ways that the deal could fail … and then look for still more ways that it could go wrong. Do not be overconfident in your ability to integrate an acquisition successfully. Prior experience is helpful, but not sufficient. Each deal is different. Proper legal advice should always be taken. Plan for a dynamic deal process where changes will need to be made to the acquisition strategy. Incorporate a robust communications plan into any deal.

More Info Books:

Gaughan, Patrick A. Mergers, Acquisitions, and Corporate Restructurings. 4th ed. Hoboken, NJ: Wiley, 2007. Moeller, Scott and Chris Brady. Intelligent M&A: Navigating the Mergers and Acquisitions Minefield. Chichester, UK: Wiley, 2007. Sudarsanam, S. Creating Value from Mergers and Acquisition: The Challenges. Harlow, UK: FT Prentice Hall, 2003.

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Due Diligence Requirements in Financial Transactions by Scott Moeller

Executive Summary •

There is an urgency for companies to conduct intensive due diligence in financial deals, both before announcement (when it should be easy to call off the deal) and after.

•

Traditional due diligence merely verifies the history of the target and projects the future based on that history; correctly applied due diligence digs much deeper and provides insight into the future value of the target across a wide variety of factors.

•

Although due diligence does enable prospective acquirers to find potential black holes, the aim of due diligence should be this and more, including looking for opportunities to realize future prospects for the enlarged corporation through leveraging of the acquiring and the acquired firms’ resources and capabilities, identification of synergistic benefits, and postmerger integration planning.

•

Due diligence should start from the inception of a deal.

•

Areas to probe include finance, management, employees, IT, legal, risk-management systems, culture, innovation, and even ethics.

•

Critical to the success of the due diligence process is the identification of the necessary information required, where it can best be sourced, and who is best qualified to review and interpret the data.

•

Requesting too much information is just as dangerous as requesting too little. Having the wrong people looking at the data is also hazardous.

Introduction This is not your father’s due diligence. Due diligence is one of the two most critical elements in the success of an M&A transaction (the other being the proper execution of the integration process) according to a survey conducted in 2006 by the Economist Intelligence Unit (EIU) and Accenture. Due diligence was considered to be of greater importance than target selection, negotiation, pricing the deal, and the development of the company’s overall M&A strategy. But not even a decade ago, when due diligence was conducted in financial transactions, the focus was almost always limited to financial factors, pending law suits, and information technology (IT) systems. Today, those areas remain

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important, but they must be supplemented during the due diligence process by attention to the assessment of other factors: management and employees (and not just their contracts, but how good they actually are in their jobs), commercial operations (products, marketing, strategy, and competition—both existing and potential), and corporate culture (can the companies actually work together when they’re merged?). But even these areas are now mainstream when due diligence is conducted. Newer areas of due diligence are developing rapidly: risk management, innovation, and ethical (including corporate social responsibility) due diligence. The 2006 EIU/Accenture survey also found that although due diligence is considered as a top challenge by 23% of CEOs in making domestic acquisitions, this rises to 41% in the much more complex cross-border transactions, which make up the majority of financial transactions, even in today’s depressed markets.

Organizing for Due Diligence It’s a two-way street: Buyers must understand what they are buying; and targets must understand who’s pursuing them and whether they should accept an offer. To be successfully conducted, due diligence must have senior-management involvement and control, often assisted by outside experts such as management-consulting firms, accountants, investment banks, and maybe even specialist investigation firms. To quote from a PricewaterhouseCoopers report issued in late 2002: “We always have to make decisions based on imperfect information. But the more information you have and the more you transform that into what we call knowledge, the more likely you are to be successful.” That said, there is only a certain amount that can be handled by the number of people involved, the time restrictions under which they are working, and the quality and variety of resources available to them. Moreover, there is the danger of being overloaded by too much information if those involved do not have good management and analytical methods to deploy. By and large, it is not the quantity of information that matters so much as its quality and how it is used. Although due diligence may not be cheap (as a result of fees charged for often highly complex work by professional services firms), the alternative of litigation or the destruction of stockholder value (as a consequence of having been “penny wise and pound foolish” in the execution of the due diligence process) may prove far more costly in the long run.

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The Due Diligence Process Although due diligence may be only one part of an acquisition or investment exercise, in many ways it is by far the most significant aspect of the M&A process. Done properly, acquirers should be better able to control the risks inherent in any deal, while simultaneously contributing to the ultimate effective management of the target and the realization of the goals of the acquisition. As an instrument through which to reveal and remedy potential sources of risk, due diligence—by confirming the expectations of the buyer and the understanding of the seller—enables firms to formulate remedies and solutions to enable a deal to proceed. In many ways, due diligence lends comfort to an acquirer’s senior management, the board, and ultimately the stockholders. All should insist on a rigorous due diligence process, which provides them with relative (though not absolute) assurance that the deal is sensible, and that they have uncovered any problems pertaining to it that may derail matters in the future. Ideally, due diligence should start during the deal-conception phase, and initially it can use publicly available information. It should then continue throughout the merger process as further proprietary information becomes available. Full use of the due diligence information collected would mean that it is not just used to make a go/no-go decision about whether the acquisition should proceed and to determine the terms of the deal, but it means that the findings from due diligence should also be incorporated in the planning for the postmerger integration. Clearly it is easier to obtain high-quality data if the deal is friendly; in unfriendly deals due diligence may never progress further than publicly available data. This lack of access to internal information has scuppered many a deal—for example, the takeover attempt by Sir Philip Green of Marks & Spencer in 2004.

The Scope of Due Diligence1 Before undertaking due diligence—given the typical time, cost, and data constraints—it is important to focus on areas that are likely to have the most impact on value. Thus, due diligence should be tailored to:

•  •  •  • 

the type of transaction the motivation for doing the deal plans for the target once acquired the impact on the existing operations of the acquirer.

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Some basic questions to ask include:

•  •  •  •  •  •  • 

Is the acquirer a strategic or a financial buyer? How fully integrated will the target be once acquired, and in what time frame? Is the whole company being acquired? Does the target represent new product lines, marketing channels, or geographic territories, or is there overlap with the acquirer’s existing operations? Will certain functional operations of the target be eliminated? Will the IT systems of the target be retained? How will the rating agencies respond to the transaction?

Types of Due Diligence Information Each industry has its own special due diligence requirements. For example an insurance company will need a review of major policies, actuarial assumptions, and sales practices, whereas the purchase of a bank would require a review of its marking policies and risk management systems. As noted above, one starts with external sources. Although these rarely provide a sufficient overview of an organization at the level required to obtain a proper understanding, secondary sources do equip management with valuable information, allowing them to strategize and develop honed and more focused questions for their further internal due diligence on the prospective acquisition. In spite of the centrality of financial, legal, cultural, and other areas of due diligence, examples abound of transactions that were completed without effective due diligence being done through lack of time or because management was overconfident in its ability to understand the target, resulting in devastating losses of stockholder value.

Financial Due Diligence Financial due diligence enables companies to obtain a view of an organization’s historical profits, which can then be used as a canvas on which to paint a picture of the company’s financial future. Developed around an array of building blocks— including auditing and verifying financial results on which an offer is based, identifying deal breakers, reviewing forecasts and budgets, pinpointing areas where warranties or indemnities may be needed, and providing confidence in the

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underlying performance (and therefore future profits) of a company—financial due diligence allows the bidder to make the proper offer for the target, or perhaps uncover reasons for not proceeding with the deal.

Legal Due Diligence As companies expand into hitherto commercially less-experienced parts of the world in search of new markets and products (such as China, Vietnam, or certain countries in the Middle East and Africa), the requirement to conduct effective and sufficient legal due diligence work can prove more trying, and in certain cases be near impossible. Nevertheless, the need to check title over assets that are being sold, and to ensure that the entity being acquired is legitimate and free of any contractual or legal obstacles which might derail the M&A process, will undoubtedly remain pivotal to the due diligence process no matter where the target resides. Governmental regulatory concerns (such as monopolies, employment law, taxes, etc.) will also be investigated as part of the legal due diligence.

Commercial Due Diligence Given that companies are bought not for their past performance but for their ability to generate profits in the future, acquirers must use commercial due diligence to obtain an objective view of a company’s markets, prospects, and competitive position. As noted by Towers Perrin in a discussion of operational due diligence, there is a “need to look at all the relevant sources of value to avoid unpleasant surprises.”2 This means a deeper inquiry into certain operations that heavily determine a target’s ultimate value to the acquirer—i.e. growth opportunities and resulting future income. Whether obtained to reduce risk associated with the transaction, help with the company valuation, or plan for postmerger integration, commercial due diligence enables acquirers to examine a target’s markets and performance—identifying strengths, weaknesses, opportunities, and threats. Focused on the likely strategic position of the combined entity, commercial due diligence, by reviewing the drivers that underpin forecasts and business plans, concentrates on the ability of the target’s businesses to achieve the projected sales and profitability growth post acquisition. Despite the seemingly obvious pivotal benefits that commercial due diligence can bring to acquiring organizations, Competitive Intelligence Magazine reported in 2003 that “only 10% of respondents to an Accenture survey of M&A practitioners said that their due diligence process included four or more sources from outside the company.”

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Innovation Due Diligence Linked closely to commercial risk but meriting special attention is the due diligence of the research and development (R&D) process. This is more than just an analysis of intellectual property rights. Many nonindustrial companies may not have explicit R&D groups, but still remain dependent on the development of intellectual property to maintain their business growth. It must be understood how this is encouraged.

Management Due Diligence Naturally, acquirers need to perform discrete investigations in order to evaluate both the competence of the target’s management and the quality of their past performances, and to ensure that the management of the target and acquirer are compatible. One would think that this would be recognized by any acquirer today, but one acquisition team recently told us that their senior management felt confident enough in their own ability to conduct their management due diligence and that they could do this “over a cup of tea,” basically, by eyeing the management team from across the table. Nevertheless, in the rush to do deals in the peak merger year of 2007, many of the largest deals properly included extensive management surveys, including 360-degree appraisals, psychometrics, and even investigative reporting.

Cultural Due Diligence Since one of the more difficult areas for integrating two companies concerns combining their corporate cultures, due care needs to be applied to ensure cultural fit. Indeed, cultural fit is so important that 85% of underperforming acquisitions blame different management attitudes and culture for the poor performance of the combined entities, as reported at a conference in 2006 by Towers Perrin and Cass Business School. Thus, by assessing soft factors such as a company’s leadership style, corporate behavior, and even dress code, an acquirer may be able to build an accurate picture of a target’s values, attitudes, and beliefs, and so determine if there will be a good cultural fit within their own organizational structure.

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Ethical Due Diligence There is an emerging area, best described as ethical due diligence, that overlaps in many ways with management and cultural due diligence, but is not to be confused with legal due diligence. The most obvious requirement of ethical due diligence is to determine whether management have engaged in unethical professional acts (as defined, usually, by the ethical standards of the acquiring company), but it also necessarily includes assessment of the corporate social-responsibility activities of the company.

Risk Management Due Diligence It is critical to understand how the target reports and monitors its inherent business risks. The events in financial and real estate markets in the past several years highlight the need to check carefully not just all risk management systems, but also the culture of risk in a company.

Case Studies Failure in Due Diligence: VeriSign’s Purchase of Jamba

In June 2004, VeriSign acquired privately held Berlin-based Jamba for US$273 million. VeriSign was an internet infrastructure services company which provided the services that enabled over 3,000 enterprises and 500,000 websites to operate. Through its domain name registry it managed over 50 million digital identities in more than 350 languages. Revenues exceeded US$1 billion dollars in the previous year. VeriSign had extensive experience with acquisitions, having made 17 acquisitions prior to Jamba, including four that were valued at more than this particular purchase. Jamba had millions of subscribers and was the leading provider of mobile-content delivery services in Europe. It was best known for the Crazy Frog character used in the most successful ring tone of all time. But, beneath the surface, trouble was brewing that could easily have been uncovered by even the most rudimentary due diligence: complaints to regulators had noted that Jamster, the UK and US rebranding of Jamba, was targeting children, despite the fact that Jamster’s mobile-content services were intended for adult customers only. Perhaps more disturbingly, only days before the acquisition VeriSign discovered that a significant portion of Jamba’s profits came from the distribution of adult content in Germany— despite a VeriSign policy of not supporting adult or pornographic companies. There were backlashes in Germany over other issues and Jamba was forced to make a declaration of discontinuance regarding many of its contracts. Other legal actions were pending in Germany and the United States. Unsurprisingly, Jamba’s revenues peaked early the following year.

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No Cultural Fit for Sony in the Movie Industry

In 1988, Sony (a Japanese electronics manufacturer) acquired Columbia Pictures (an American moviemaker) for US$3.4 billion. With cultures that could scarcely have been more different, the acquisition—which involved little consideration of cultural fit between the two entities—failed to live up to commercial expectations, with Sony famously writing down US$2.7 billion on the deal by 1994.

Conclusion According to the EIU/Accenture survey, only 18% of executives were highly confident that their company had carried out satisfactory due diligence. This is probably due to the lack of attention given to this critical aspect of a deal, or to the view that it is merely a box-ticking exercise conducted by outside advisers. In short, the probing of a wide variety of due diligence areas should provide a counterbalance to the short-termism of traditionally limited financial and legal due diligence, helping acquirers to understand how markets and competitive environments will affect their purchase, and confirming that the opportunity is a sensible one to undertake from a commercial and strategic perspective, especially in cross-border deals.

Making It Happen Key factors in conducting informative and timely due diligence are identifying:

•  •  •  • 

the critical areas to probe: financial, legal, business, cultural, management, ethical, risk-management, etc. the most important information to collect in those areas, as there is never enough time to look at everything in as much detail as one might want. the right sources of the desired information. the right people to review the data: this should include those who know most about that area and also those who will be managing the business post acquisition.

Due diligence should not be a mere confirmation of the facts. Bridging the strategic review and completion phases of any merger or acquisition exercise, the due diligence process allows prospective acquirers to understand as much as possible about the target company, and to make sure that what it believes is being purchased is actually what is being purchased. The due diligence process digs deeper before the point of no return in consummating a deal.

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More Info Books:

Howson, Peter. Due Diligence: The Critical Stage in Mergers and Acquisitions. Aldershot, UK: Gower Publishing, 2003. Moeller, Scott and Chris Brady. Intelligent M&A: Navigating the Mergers and Acquisitions Minefield. Chichester, UK: Wiley, 2007. Sudarsanam, Sudi. Creating Value from Mergers and Acquisition: The Challenges. Harlow, UK: Pearson Education, 2003.

1 Adapted from Fell, Bruce D. “Operational due diligence for value.” Emphasis no. 3 (2006): 6–9. Online at: tinyurl.com/d7w36t 2  Ibid.

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Leveraged Buyouts: What, Why, When, and How by Scott S. Johnson

Executive Summary •

A leveraged buyout (LBO) is the acquisition of a company financed by debt.

•

The use of debt multiplies both the potential return and risk.

•

LBOs require active and liquid credit markets.

•

Stable, mature businesses with predictable—and ideally recurring—revenues are generally the best LBO targets.

•

LBO returns are maximized by buying low and selling high, properly capitalizing the buyout, and maximizing profitable and high-quality growth during the hold period.

What A leveraged buyout (LBO) is the acquisition of a company financed by debt. It is not unlike the typical purchase of a residence where the majority of financing is derived from a mortgage, and the balance from cash (equity) contributed by the buyer. The use of debt in an LBO leverages the equity return, providing the equity holder with the possibility of higher returns at the cost of higher risk. From 2000 to 2Q13, debt levels by financial sponsors of US leverage buyouts have averaged 64%, with a high of 70% in both 2005 and 2Q13 and a low of 54% in 2009, according to Standard & Poor’s. Debt levels vary due to numerous factors, including the vibrancy of credit markets and overall macroeconomic conditions (key contributors to 2009’s low leverage levels), the ability of the acquired company to support debt, and the strategy of the given LBO.

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Figure 1. Case study: Sample LBO vs all equity acquisition LBO Initial acquisition Profit Multiple Value Capitalization Debt Equity

All equity $10 6.0 x $60

4.0 x $40.0

0.00 x $0.0

2.0 x $20.0

6.00 x $60.0

Return after year-5 sale Value $96.63 Less: debt ($40.00) $0.0 Equity value $56.63 $96.63 Annual return Return on capital

23.1% 1.8 x

10.0% 0.6 x

Profit after five years: Annual growth Cumulative growth Year-5 profit

10.0% 161.1% $16.11

Year-5 sale price: Year-5 profit times multiple of gives sale price

$16.11 6.0 x $96.63

Note: Excludes transaction and closing fees and assumes no principal amortization or cash generated.

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Figure 2. Case study: Effect of profit decline LBO Base profit Decline in profit New profit

All equity $10.00 25% $7.50

Interest

$5.00

Profit after interest

$2.50

$7.50

Decline in profit after interest

– 75.0%

–25.0%

Debt Interest rate Interest expense

$0.00

$40.00 12.5% $5.00

Although select transactions that could be considered LBOs occurred prior to the 1980s, this acquisition strategy grew in popularity in the 1980s when ample debt financing became available, in particular with the rise of the sub-investment grade, or “junk” debt market. Over the past decade, the strategy has seen even more activity with more than US$100 billion raised by private equity funds who primarily engage in LBOs. Buyouts have, in fact, become a material element in mergers and acquisitions. Over the past ten years, US buyout volume exceeded US$1 trillion, according to Standard & Poor’s. LBOs can involve the acquisition of an entire company or a division of a company. In some cases, management—usually with the financial backing and transactional expertise of a private equity group—buys out its own entity, which is then more specifically referred to as a management buyout (MBO). Yet another permutation is leveraged recapitalization, whereby some equity plus debt are used to provide liquidity to shareholders, either to buy their shares outright, or provide cash to them (not unlike a residential mortgage refinancing).

Why Although the leveraged buyout entails risk, given the challenges of servicing debt, significant returns are possible without the need for material growth.

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Furthermore, the need to generate sufficient cash flow for debt service imposes discipline. Companies that, pre-LBO, were inefficient, or overloaded with expenses are forced to streamline their operations and cost structure to succeed. At the same time, the need to service debt can generate short-term decision-making that may not always be in the best long-term interest of the business. However, the World Economic Forum’s “Global Impact of Private Equity Report”1 reported that private equity-backed companies are generally better managed than their peers, with average productivity growth in the first two years after acquisition about 2% higher than for comparable firms.

Case Study How Debt Can Magnify Both Returns and Risk

Let’s take a company with US$10 in profit and assume it is acquired for 6x profit, or US$60. In the LBO of this company, US$40 of the purchase price is financed with debt and US$20 is an equity investment, so equity is one-third of the total capital. In the unleveraged scenario, US$60 of equity—100% of the consideration—is used to acquire the company. If the company is sold at the end of five years, and profits have grown at a compound annual growth rate of 10% to US$16 (a cumulative growth of 60%), and the purchase price multiple remains 6x, the business is sold for US$97. In the unleveraged scenario, the annual return is equal to the profit growth, i.e., 10% per annum and 60% on a cumulative basis. On the other hand, the LBO equity return is much higher. In the LBO, the company sale-price value (its enterprise value, or EV) is still US$97. Of the US$97, the first US$40 is returned to the debt holders to pay off their principal, leaving US$57 for the equity. Unlike the unleveraged case, where the sale price is 60% greater than the investment, here the US$57 is 183% greater than the US$20 investment. The annual return in the LBO is more than double the unleveraged deal: 23% versus 10% (See Figure 1). Please note that this scenario is an oversimplification, with numerous factors such as transaction costs, working capital, and annual cash-flow generation excluded (even when those factors are included, the LBO continues to outperform the unleveraged deal approximately 2:1). Our case study also illustrates the risks of the leveraged buyout strategy. Without any interest expense or debt principal due, the unleveraged company in our simplified example can weather substantial declines in operating profit, and still maintain positive cash flow. Conversely, if the leveraged company sees a decline of profits of just 25%, its profits, after interest expense, fall by three times that level, or 75%. If the leveraged company had material levels of capital expenditures, or debt and principal repayments (which are both post-tax items), it may not be able to service its cash needs. The likely result would be a cash squeeze, which would have negative or potentially disastrous implications (See Figure 2).

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When

LBOs are most commonly considered when a candidate company can support the required leverage, and credit markets can provide such leverage. Good LBO candidates operate in relatively stable businesses with consistent business models. These are generally mature companies with positive cash flow, and an established operating and profitability history. Earlier-stage companies, or those that require continued cash investments to achieve their objectives are generally not good candidates. Furthermore, companies with a cyclical business, or those materially exposed to major exogenous risks such as technological obsolescence or fashion risk, are also less-optimal buyout candidates. Explicitly recurring revenue businesses (i.e., contractual) or implicit (for example regularly repurchased consumables) are good targets. Sectors that often exhibit these characteristics and have yielded successful buyouts include consumer, business services, defense, and media.

How

LBO returns can be generated from five factors as follows: 1. Buying low: The lower the entry valuation level, the greater margin of safety provided for investors. Furthermore, a company acquired at a lower valuation will require less debt to achieve the optimal debt-to-capital mix. On the other hand, higher quality and larger companies often have greater growth prospects, are generally more stable, and thus usually sell for higher valuations. When valuations are high, buyers take the risk that even if the business is properly capitalized and shows good growth, exit valuation levels could be lower and will not be sufficient to generate an acceptable return. While careful analysis can help determine whether the steps below are to be a success, entry valuation is critical, as it is a factor that is controllable at the beginning of the LBO. 2. Maximizing equity returns by minimizing equity investment to prudent levels: An LBO investor must first decide the maximum leverage the business can support, and then try to finance the deal to that level, but not more. In strong credit markets, LBO investors should resist the temptation to overleverage their portfolio companies. In weak credit markets, investors need to ensure that, at lower debt levels, they can still achieve their minimum-return hurdles (often accomplished by “buying lower”). 3. Maximizing quality organic growth before exit: Generally, the more growth that occurs during the holding period, the more valuable the company will be at exit. However, a company must be careful to focus on generating “good” revenue. While “good” revenue may vary from company to company, it generally entails business that preserves or bolsters a company’s competitive advantages and margins, does not create unnecessarily high customer concentration, is ideally of a recurring nature, still yields a good return on investment net of capital expenditures and working capital requirements, and is the type of business that would appeal to a potential buyer. 4. Making profitable add-on acquisitions or divestitures as appropriate: Buyout investors may seek to grow a business through acquisition, or sell off divisions as appropriate. The buyout investor must carefully weigh the return on capital that will be generated by incremental investment, as well as the cash that could be generated from a divestiture, which would likely be used to deleverage the business.

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5. Selling high: After an investment holding period of typically three to seven years, a buyout firm will seek to exit its investment, so that the proceeds may be returned to its own investors. If growth has been positive and consistent, and industry trends and valuation levels are favorable, the buyout firm should achieve a good return on its investment. However, the reality is that valuation levels years after a deal is consummated are well outside of the control of the buyout firm, so having a flexible timetable, entering the deal at a reasonable valuation level, improving the performance of the company during the holding period, and appropriately capitalizing the company are essential to executing a profitable LBO.

Making It Happen

• 

Do your diligence: While confirmatory diligence to verify financial and operating assumptions is critical, exploratory diligence is often not given enough focus. The buyout investor should, in particular, understand the sustainability of a company’s competitive advantages, and make sure they understand not just the recent history of a company’s sector, but the sector’s outlook, and what underlying threats may exist to that sector.

• 

Debt structure: While the price of debt is critical, equally if not more important are the terms of that debt. Key areas worth considering include the maturity date of the debt, the level of principal amortization, if any, and how a given lender may act as a partner (especially if results are poor, and covenants are violated).

• 

“Skin in the game:” While a buyout investor can provide management equity upside, through the use of stock options, having a management team invest their own cash in the deal—putting “skin in the game”—confirms management’s confidence in the opportunity, and binds them to both the upside and downside.

More Info Websites:

The Association for Corporate Growth, the predominant industry association for the middle market buyout industry: www.acg.org Pitch Book, a leading data provider of private equity trends, http://pitchbook.com/ The Deal, magazine and online resource: www.thedeal.com The Private Equity Analyst, a periodical published by Dow Jones: www.fis.dowjones.com/products/privateequityanalyst.html The Private Equity Council: www.privateequitycouncil.org Standard and Poor’s Leveraged Commentary and Data, “A Guide to the Loan Market” www.lcdcomps.com/press/LoanMarketguide.pdf

1  http://www3.weforum.org/docs/WEF_IV_PrivateEquity_Report_2010.pdf

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Mergers and Acquisitions: Today’s Catalyst is Working Capital by James S. Sagner

Executive Summary •

In developed economies M&As are now used to acquire balance sheet assets, particularly cash hoards and other working capital; previously, M&A was oriented to strategic diversification or integration.

•

Although the volume of deals is down due to global economic conditions, the premiums paid for companies remain robust.

•

Acquirers appear to understand the risk inherent in these transactions, including the threat of investigation by US, EU, and Japanese regulators.

•

Until the recent problems with lines of credit provided by banks, many companies held excessive amounts of liquidity, making them vulnerable to unfriendly takeovers.

•

Various consulting companies have international practices in working-capital management, including advising on mergers and assisting management to achieve efficiencies after the deal is completed.

•

Global M&A looks for the following characteristics: a high current assets-to-revenue relationship; a holding of cash that is not likely to be applied to business operations; and a proven income stream that should provide adequate cash flow to pay down borrowings used to provide financing for an acquisition.

Introduction Merger and acquisition (M&A) activities in developed countries once focused on strategic transactions for diversification or for vertical or horizontal integration. While that continues to be the situation in the developing economies, the M&A game in the United States, Western Europe, and Japan is often either to gain balance sheet assets, particularly hoards of underperforming cash, or to improve the acquired company’s working-capital management. It’s a complete revolution in the way companies and investment bankers look at candidates for M&A. What’s going on?

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Changes in the M&A Landscape M&A transactions for all of 2012 declined about 10% from 2011 to $2.2 trillion, the same level as 2010. CFOs have been holding more than $3.5 trillion in cash while delaying deals for most of 2012, as the EU countries slid into recession and developing economies such as China and India experienced lower growth.1 However, improving economic prospects and the need to manage costs and reduce competition led to several recently announced deals, including the merger of AMR (parent of American Airlines) and US Airways, and the acquisition of H.J. Heinz by Berkshire Hathaway and the Brazilian firm 3G Capital Management (for US $28 billion). Prior to the recession that began in 2008, the global annual appetite for M&A was nearly US $4 trillion. The premiums being paid for companies continues to remain strong, with the Heinz deal at 19% above the publicly traded stock price as compared to pre-recession deals averaging about 25% above the share price.2 The weak American dollar has brought several foreign buyers to the United States in the search for access to attractive markets and technologies. Some of the past M&A hype has been tempered by a better understanding of the risk of these transactions, as documented by such publications as BusinessWeek3 and as experienced in the loss of value to investors.4 The lure of expanding markets, product lines, technologies, and customer bases drove much of M&A through the last three decades of the 20th century. Many of these hopes turned out to be illusory, as mergers underperformed or failed due to incompatibilities between the marketing, production, engineering, financial, and systems functions of the participants. Some mergers came under investigation by one or more US regulatory agencies, and were delayed, rejected, or abandoned. For example the Federal Trade Commission has acted against “threats” of raised concentration in markets for frozen pizza, carburetor kits, urological catheters, and casket parts. The Justice Department hit mergers threatening to raise concentration in markets for frozen dessert pies, artificial Christmas trees, vandal-resistant plumbing fixtures used in prisons, local towel-rental services, drapery hardware, and commercial trash hauling in Dallas.5 The European Commission has been even more rigorous in its merger reviews than the two US agencies. Research by Towers Perrin and the Cass Business School finds that the most recent era of M&A deals has created value, rather than led to its destruction as in earlier periods.6 The emphasis has switched to the execution of the deal and a focus on improved financial performance. Although strategic expansion will continue to be of interest, despite the threat of antitrust review, future M&A practice will likely focus on two completely different attractions that avoid the regulators’ microscope:

• 

underused liquidity on balance sheets, offering opportunities for the acquirer to redeploy cash in productive activities; and

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• 

inefficient working-capital management, leading to opportunities to improve the utilization of current assets and liabilities.

Underused Liquidity Recent studies illustrate the predicament that many businesses currently face: too much money on balance sheets and too few attractive capital investments. This situation has been developing for at least a half dozen years; for example the Association for Financial Professionals (AFP) conducted a study reported in 2007 that 36% of respondents held larger amounts of short-term investments than in the previous six months.7 As of early-2013, the typical public company had a weighted average cost of capital of just over 10%; see Table 1 for the calculation. A company with cash or near-cash investments can only earn about 1% pre-tax on these assets at the current rates available,8 or about ¾% (75 basis points) after tax, assuming some holdings of medium-term investments. Thus, companies holding cash incur a direct loss of more than 9% on that asset without receiving any possible strategic gain. Acquirers of these cash hoards can use these funds to pay down debt, acquire stock in the open market, increase dividends, or expand business operations. In fact M&A deals are often financed by loans made against the assets and cash flow of the acquired company. For example the 2006 deal involving the hospital company HCA involved only US$5.5 billion in cash, with the balance of the US$33 billion price financed by the cash and future income of HCA.

Table 1. Illustration of cost-of-capital calculation

 

Balance sheet portion

After-tax costs

Weighted component costs

Debt

40%

0.056*

0.022

Equity

60%

0.140†

0.084

 

100%

 

0.106

* Pre-tax 8% less corporate tax rate † 12% growth + 2% dividend

Inefficient Working-Capital Management Working capital (WC) is defined as current assets less current liabilities; in this section we will focus on current assets other than cash. In the last four decades of the previous century, the percentage of WC as a percentage of sales declined by three-fourths.9 Although this represents a significant improvement in the management of these balance sheet accounts, estimates are that the total of excess

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WC may still exceed US$900 billion, up one-third since 2005.10 There are merger opportunities in acquiring companies with excess WC and managing these accounts so that WC approaches as close to zero as possible. The concept of WC as a hindrance to financial performance is a complete change in attitude from the conventional wisdom before the turn of the 21st century. However, WC has never contributed to a company’s profits; instead, it just sits on the balance sheet awaiting disposition. The Checklist below gives some ideas for working-capital management. Various consulting companies have developed international practices in working-capital management, including advising on mergers and assisting management to achieve efficiencies once the deal has been completed. For example REI is a US-based advisory services organization that has developed a global brand in WC services. REI has enabled clients in more than 60 countries to free up over tens of billions of US dollars through optimization of working capital in the last 10 years alone. FTI Consulting offers an array of services designed to help companies address critical issues and improve performance prior to engaging advisory services for acquisitions, divestitures, and recapitalizations. There are several other firms that support M&A analyses while assisting the new management to squeeze efficiencies out of the current asset and/or current liability portions of the balance sheet.

Checklist of Working-Capital Ideas Accounts Receivable

The credit and collection process, no matter how aggressive, inevitably results in some uncollectable amounts. When faced with the cost of the credit-review process, bad-debt expenses, and the cost of credit and collections, some businesses outsource their collection activities to a factor. Factors purchase or lend money on accounts receivable based on an evaluation of the creditworthiness of prospective customers of the business, calculated as a discount from the sale amount, usually about 3–4%. That is, the factor will receive the entire sales amount, the selling company having received 96–97% at the time that the buyer was accepted by the factor.

Receivables Collateralization

In collateralization, a receivables package is offered as a security to investors. The critical element is a periodic, predictable flow of cash in payment of debts, such as credit cards, automobile loans, equipment leases, healthcare receivables, health-club fees, and airline-ticket receivables. The market for public collateralizations is in the hundreds of billions of dollars, which has driven the required interest return to investors to become competitive with banks’ lending arrangements. Initial costs are higher than bank loans because the services of several professionals are required: attorneys; commercial and/or

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investment bankers; accountants; rating agencies (when ratings are required); and income servicers. However, the advantage of receivables collateralization is substantial—the transformation of receivables into cash.

Inventory

Just-in-time (JIT) requires that required materials be in the place of manufacture or assembly at the appropriate time to minimize excess inventory and to reduce wastage and expense. JIT succeeds when there are: a limited number of transactions; few “disturbances” due to unscheduled downtime, depending instead on periodic maintenance; the grouping of production processes to reduce the movement of work-in-process; and a significant focus on quality control (QC). QC minimizes downtime and the holding of buffer or safety stock to replace defective materials. In traditional JIT, the company owns the inventory of components and parts, assuring access as the next production operation begins. JIT as currently practiced places the materials at the manufacturing or assembly site, but title remains with the vendor until production begins. This relationship requires suppliers to optimize the stock of inventory, holding only those items that have been specified or are known to be required based on a statistical analysis of purchasing history. Both the provider and the user of materials are forced to develop a strong partnering attitude and minimize the adversarial stance often observed between purchasing counterparties.

Accounts Payable

Inefficient payables pervade US business. Invoices presented for payment should be matched against purchase orders and receiving reports to determine that the vendor has met the terms and conditions of the order, and that materials were received in good condition and in the correct amount. In practice, invoices are often paid without ascertaining that all requirements have been met. In about one-third of all payables situations, no purchase order was ever issued, nor was there a contract or other written agreement as to price or specifications. A substantial number of companies have inadequate policies regarding appropriate purchasing and accounts-payables practices. Relevant questions include:

•  •  •  • 

Should the payment be released on the due date or some specified number of days after the due date? Are all cash discounts to be taken, or only those that provide a stipulated discount? Can the requesting business unit choose the supplier, or does purchasing have the authority to select vendors so as to maximize volume pricing? Has purchasing determined that approved vendors are legitimate businesses, with a suitable record of providing goods and services to the business community?

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Let’s Look at a Deal The US$90 billion hostile takeover by Pfizer of Warner-Lambert (Warner), completed in 2000, was hyped as a traditional horizontal integration of two powerful pharmaceutical companies. Clearly, Pfizer was acquiring a significant asset in Lipitor, Warner’s cholesterol-lowering drug, and established cost savings through headcount reductions. Stock analysts even made statements to the effect that the deal was strictly “for strategic reasons—for Lipitor, for the therapeutic enhancements Warner-Lambert brings, and for the sheer marketing clout.”11 However, the merger was motivated in large part by financial considerations. In 1999 Warner reported cash and short-term investments of US$1.943 billion, equivalent to 17% of total assets of US$11.442 billion, versus 13.8% for the industry. Pfizer was buying the cash hoard, which was US$360 million more than the rest of the industry required for the assets carried. Pfizer was also buying an excellent balance sheet, including a current ratio of 1.5 times and current assets as a percentage of sales of 44%. And Warner earned US$2.441 billion before taxes in 1999, a very healthy 18.9% of sales versus 9.6% for the industry.

Tips for CFOs on Future M&A Deals The flood of US dollars held by foreigners continues to grow due to the persistent balance of payments deficits in the United States. Global investors looking for properties will be looking at public companies with the following characteristics:

•  •  • 

a high current assets-to-revenue relationship, particularly where the current ratio exceeds the average for the industry; a cash (and near-cash) hoard that is not likely to be applied to business operations and is unlikely to be used for dividends or stock repurchases; a proven income stream that should provide adequate cash flow to pay down borrowings used to provide partial financing for an acquisition.

Furthermore, there is a trend toward M&A that is not strategic within an industry, meaning that a hostile or friendly approach can come from anywhere at any time. Too many companies hoard cash while waiting for capital projects with superior returns. In fact, those opportunities may never appear. Financial analysts are beginning to recognize that worthwhile capital investments are unusual and are likely to be short-lived. In other words, the reality of international competition shortens any competitive advantage a company may gain, unless protected by patents or other exclusive arrangements. To quote a leading finance text:     

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“It is a basic principle of economics that positive NPV [net present value] investments will be rare in a highly competitive environment. Therefore, proposals that appear to show significant value in the face of stiff competition are particularly troublesome, and the likely reaction of the competition to any innovations must be closely examined.”12 Savvy outsiders can analyze the financial statements of targeted companies and, with the help of their investment bankers, take friendly or hostile action to seize a financially inefficient business.

More Info Reports

An earlier version of this article appeared as “Why working capital drives M&A today.” Journal of Corporate Accounting & Finance 18:2 2007: 41–45. Used by permission of John Wiley & Sons, Inc.

1 Aaron Kirchfeld and Serena Saitto, “Fourth-Quarter M&A Surge Spurs Optimism After 2012 Deals Decline,” Bloomberg.com, Dec. 27, 2012, online at: www.bloomberg.com/news/2012-12-27/fourth-quarter-m-a-surge-spurs-optimism-after-2012-deals-decline. html. 2 Data from June 2008; see “M&A premiums up despite slowdown,” online at: www.businessweek.com/investing/insights/blog/archives/2008/06/despite_the_ma.html 3 David Henry, “Mergers: Why most big deals don’t pay off.” BusinessWeek (October 14, 2002). Online at: www.businessweek.com/magazine/content/02_41/b3803001.htm 4 According to BusinessWeek, 61% of acquirers in a merger destroyed their stockholders’ wealth (ibid.). 5 These situations were noted by Frederick M. Rowe on pp. 1512–13 of “The decline of antitrust and the delusions of models: The Faustian pact of law and economics.” Georgetown Law Journal 72:5 (1984): 1511–1570. For a review of American antitrust policy, see James S. Sagner. “Antitrust as frontier justice: Is it time to retire the sheriff?” Business and Society Review 111 (March 2006): 37–54. 6 Online at www.innovations-report.com/html/reports/economy_finances/report-112476.html (June 17, 2008). Towers Perrin is a global consulting firm that specializes in human-capital strategy, program design and management, and risk and capital management. 7 AFP in conjunction with Citigroup. 2007 AFP liquidity survey: Report of survey results. Online at: www.afponline.org/pub/pdf/Liquidity_2007.pdf

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8 Commercial paper rates for up to 120 days were 2.50% in mid-June 2008 according to the Wall Street Journal (rates are from June 10, 2008, as quoted on page C10). Current (early 2013) rates are about onetenth of that paid in 2008 (about 25 basis points). 9 Standard and Poor’s Financial Analyst’s Handbook, 2002. 10 Russ Banham,. “Too much of a good thing: Working capital is piling up at America’s largest companies,” CFO Magazine (August 1, 2012). Online at: www3.cfo.com/article/2012/8/cash-flow_2012-cfo-magazine-rel-consulting-working-capital-survey. 11 Comment by Martyn Postle, Cambridge Pharma Consultancy (UK), reported in David Shook. “PfizerWarner: One drug merger that might just deliver.” BusinessWeek (May 17, 2000). Online at: www.businessweek.com/investor/content/eemi/emi0517a.html?chan=search 12 Ross, Stephen A., Randolph W. Westerfield and Bradford D. Jordan. Essentials of Corporate Finance. 5th ed. Boston, MA: McGraw-Hill/Irwin, 2007, p. 275.

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Acquisition Integration: How to Do It Successfully by David Sadtler

Executive Summary •

Successful integration of an acquisition by the acquiring company is often the most important determinant of the overall success of the acquisition process.

•

Gaining financial control of the acquired company and tight cash management are essential from the start.

•

Integrating management processes and systems can be difficult and time-consuming, but it is essential if the newly acquired management team is to be involved and empowered.

•

Use all available sources of information to make key management appointments as quickly as possible.

•

Ensure that the key drivers of value creation are known to all involved in the project, and that the process of searching, negotiating, and integrating reflects the most important of them.

•

Move as quickly as possible when integrating.

Introduction Acquisitions of any size are a major undertaking for both the acquirer and the target. Substantial returns—in particular returns in excess of the cost of capital employed in the entire initiative—are required not only to create stockholder value, but also to justify the enormous investment of managerial time and effort that goes into a takeover. Many acquisitions succeed. Indeed, many corporate acquirers do a large number of deals and become really good at them. Making money through acquisition, for them, is a key skill to be nourished and developed. But, as repeated studies have demonstrated all too well, many acquisitions—according to some, the vast majority—fail to justify the investment involved. The success or otherwise of acquisitions is a much studied field, and we can therefore readily identify the principal causes of failure and disappointment.1 Among them are the payment of excessive prices, missing problems during the due diligence phase, and even the use of faulty financial logic. But perhaps the biggest contributor to the failure of acquisitions is inadequate attention to the process of integrating the newly acquired business.

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Major Causes of Failure

•  •  •  •  •  •  •  •  •  • 

Paying too much—especially likely in an auction Targeting the wrong company because the value-creation logic is inadequate Power struggles among top management and disagreement about who is to be the boss Cultural obstacles, especially in cross-border deals Incompatibility of IT systems Applying obsolete strategic rationales such as sector diversification, vertical integration, financial synergy, and gap-filling Resistance by regulatory authorities and pressure groups Use of faulty financial logic—i.e. getting the numbers wrong Sloppy due diligence Poorly planned and executed acquisition integration

Successful integration requires that four tasks be done well. The more attention and skill that is marshalled for this purpose, the better the result is likely to be. The four tasks are: assuming financial control, integrating processes and systems, making key managerial appointments, and ensuring that the value-creation logic for the acquisition drives the whole process. Inattention to any of them can cause big trouble.

The Four Key Tasks of Successful Integration 1. Assume financial control

Serious acquirers know that it is essential to assume immediate control over financial performance and cash management. In some cases, the target may have been left vulnerable to acquisition by poor financial management. Such businesses will need special attention in this area. This phase involves steps such as installing corporate financial-reporting procedures and clarifying expenditure-level authority. In some cases it may also involve more frequent reporting of critical cash flow components, until the required systems are bedded in and the management team of the acquired business becomes familiar with what is expected of it. For example weekly sales figures may temporarily require early scrutiny to ensure that commercial performance has not deteriorated owing

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to the demands of the acquisition experience. This phase lends itself to detailed checklists and procedures, constructed with expert help, and developed and honed through corporate experience.

2. Integrate processes and systems

If the newly acquired business is to play its part in the larger organization, its principal managerial processes—business planning, budgeting, capital-expenditure approval, and human resource management—must be integrated with those of the acquirer, so that the target can begin to function as part of the larger whole as quickly as possible. The sooner operational managers can become familiar and comfortable with the new process requirements, the better able they will be to concentrate their efforts on securing competitive advantage and on realizing the benefits expected from the combination of the two organizations. A major and sometimes seemingly overwhelming aspect of this phase of integration is that of bringing together IT systems. In recent years the IT structures of large organizations have become more all-embracing and, in the case of so-called enterprise systems, may even constitute the digital backbone of the entire business. In such circumstances, the criticality of ensuring that the target’s systems are quickly and effectively integrated with those of the acquirer is obvious. But sometimes the process is simply too difficult. A number of mergers and acquisitions in the so-called “bancassurance” sector have floundered because of IT integration problems. The prime rationale for such mergers is usually that of cross-selling—selling the products of the acquirer to the customers of the acquired company and vice versa. This is a difficult goal to achieve at the best of times, and one that is critically dependent on the effective interfacing of the merging organizations’ IT systems. When this does not happen, the merger is bound to be a financial disappointment.

3. Make key appointments

The aim here is to do the best possible job in the shortest possible time by putting the right people in charge of the newly acquired business and moving aside those who have not made the cut. Some will say it is not possible for corporate overseers to know which managers are best for the key jobs until they have been observed in action for some time. The existing management team—the same people who perhaps failed to perform well enough to keep their business independent—may thus be left in place. Typically, the most demanding step in this phase is the decision about who is to run the new business. Who is to be the boss? All possible sources of information about prospective candidates must be pressed into service. Managers who have experienced prior dealings with the candidate should be interviewed, the directors of the acquired business surveyed, and even individual performance reviews scrutinized. Getting this right is perhaps the most important task of all. If the right candidate

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is appointed, delays and failures in other areas are more likely to be remedied to everyone’s satisfaction. But the wrong appointment can result in long-lasting problems and disappointment. The object must be to find the right trade-off between speed and the effectiveness of the managerial appointment process. This may mean acting with less certainty, as opposed to delaying the decision until everyone is completely satisfied with the selection.

4. Ensure the primacy of value creation

Most of all, acquirers must be crystal clear about the value-creation rationale for the acquisition, and they must ensure that this thinking drives the entire acquisition process, including that of integration. All involved in the acquisition—analysts, negotiators, professional advisers, the top management of the acquiring company, and those who will be responsible for integration—must be clear about how the acquisition is to make money for the stockholders of the acquirer, and must be constantly reminded of this throughout the process. The value-creation rationale is first proposed, clarified, agreed, and approved when acquisition criteria are developed and target candidates are identified. The thinking behind how the combination with the prospective target is to enhance competitive advantage and thus generate superior returns must be clear. That rationale should drive the contract-negotiating process and the due diligence work which backs it up, so that the important drivers of value creation continue to be reflected along the way. Finally, the small number of initiatives (perhaps only two or three) that will create the value must be given the highest priority when it comes to integrating the new business. The sooner these initiatives are successfully completed, the greater the payoff, owing to the greater present value of the cash flows achieved.

Making It Happen

•  •  •  • 

Design the entire acquisition process to focus on the key drivers of value creation, and ensure that the integration process deals with each as a high priority. Prepare a complete plan to action the four key areas—financial control, the introduction of new processes and systems, key appointments, and the pursuit of value creation—as soon as ownership changes hands. Develop a cadre of specialists to speed the acquisition process so that operational managers can focus on the business itself. Don’t delay. Move fast.

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Other Factors That Contribute to Success Finally, a comment about speed. There is widespread agreement among serial acquirers that moving as quickly as possible is best. It may be tempting to keep the pressure off the acquired organization, at least temporarily, because they have been through a demanding and possibly anxious time. But momentum can be lost, benefits delayed, and the acquired management team even led to believe that the acquirers are less than serious about achieving the projected financial benefit. Speed is best. One major UK retailer got this one wrong. To its credit, it was quite clear about its value-creation rationale for the acquisition, which was that of implementing its proven EPOS (electronic point of sale) systems in the acquired company. It saw from its observation of the company—and confirmed this during the diligence process—that introducing its technology would impart major operational benefit to the target company. Inventories would be reduced, stockouts would decline, and overall customer satisfaction would increase. But it delayed implementation, reasoning that steps to integrate the target into its organization and enabling the new employees to become comfortable in their new surroundings were necessary for good morale. Sensing a lack of commitment to change, the acquired company’s supply chain and IT specialists took the initiative to bolster their systems and make it hard for any subsequent changeover—along with the potential for staff reductions in the process. Operational integration was delayed for over a year and the financial benefits suffered accordingly. The corporate-development director, who had been the project manager for the acquisition, commented that this was the biggest mistake in the entire process and that it would never happen again. In larger organizations, and especially those that regard acquisitions as a key source of future growth and competitive advantage, specialists are often developed to perform the tasks of integration. Dedicated teams can reduce the possibility of delays of the kind described above. Smaller companies, and those with less experience, may not have the luxury of maintaining a dedicated staff, but if deals become a way of life, it is probably advisable that a specialized group be formed to capture the company’s experience and institutionalize emerging best practice.

Conclusion Integration is a tough and demanding job, but one that frequently spells the difference between success and failure in an acquisition. The task must be treated as one of the highest priority and responsibility apportioned to the people best suited to doing it. If this is done, and if the four tasks enumerated above are handled quickly and effectively, the chances of financial, strategic, and operational success will be that much higher.

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More Info Books:

Galpin, Timothy J. and Mark Herndon. The Complete Guide to Mergers and Acquisitions: Process Tools to Support M&A Integration at Every Level. San Francisco, CA: JosseyBass, 2007. Sadtler, David, David Smith and Andrew Campbell. Smarter Acquisitions: Ten Steps to Successful Deals. Harlow, UK: Pearson Education, 2008.

1 The major causes of acquisition failure are dealt with at some length in Sadtler, Smith, and Campbell, Smarter Acquisitions (2008).

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Cultural Alignment and Risk Management: Developing the Right Culture by R. Brayton Bowen

Executive Summary •

Organization culture may vary in definition from country to country, but it is essentially the sum total of the behaviors and styles of the people who drive the system.

•

Organizations that properly align organization culture with business goals and objectives can realize up to 40% improvement in performance compared to peer and competitor organizations.

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Generally, 80% of acquisitions and mergers fail to perform to management’s expectations, in most instances because of a failure to understand and manage organization culture.

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Organizational members have an innate knowledge of what is and is not working within the culture of the organization and, therefore, must be engaged in the process of building the right culture.

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Culture changes within an organization require total mastery of the change-management process.

•

Organization culture ultimately impacts the financial performance and long-term success of an enterprise.

Introduction The goal was to beat Microsoft at its own game. After rebuffing a takeover attempt by the giant corporation, Novell Nouveau went on an acquisition binge of its own. The strategy was to acquire a premier word-processing company that could rival Microsoft, and Microsoft’s “Microsoft Word” in particular. So, in 1994, Raymond Noorda, CEO for the then second-largest software company, acquired WordPerfect Corp. for US$1.4 billion in stock. Novell was to become a “software powerhouse,” delivering “stand-alone, software suites, groupware, and network applications that were to define new capabilities for information systems”, according to WordPerfect’s leading executive. Two years later, WordPerfect was sold for less than one seventh of its original purchase price. The reason for the failed strategy: “The cultures were very, very different,” as reported by Novell’s successor CEO, Robert Frankenberg (The Wall Street Journal, 1996).

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Taking the role of the dominator, management of Novell Nouveau assumed their ways and methods to be superior to those of WordPerfect. They eliminated the sales force, assuming that the Novell Nouveau organization could assume the sales and marketing function, and went on to make a host of other mistakes. Indeed, their experience was similar to those of the majority of acquiring firms. Generally, 80% of acquisitions and mergers fail to perform to management’s expectations, and the overarching factor in most instances is a failure to understand and manage organization culture.

Aligning Organization Cultures What is Culture?

Culture can be thought of as the organizational context in which behaviors can be characterized and assessed. It is the environmental code that prompts people to act in certain ways to “fit in” at different levels and perform in “expected” ways. For example customers entering a fine dining establishment understand that they are expected to dress appropriately, deport themselves in a dignified manner, wait to be seated at an assigned table, and ultimately, pay a high price for the experience. Yet, there are usually no formal rules that are posted stating how guests are supposed to dress or how they are to behave. Once seated at their table with friends or other guests, they can adjust their behaviors to a more relaxed and interactive mode. This analogy equates to organizational cultures, wherein the overarching culture may prompt people to act one way, whereas once they settle into their own departments or business units, their behavior may change somewhat from the corporate norm. Bringing about change on an organization-wide basis requires considerable understanding of what is needed and why; and it requires superior changemanagement ability. Elements of organization culture include: how people work together; how responsible they feel for the success of the enterprise; how ethically they behave; how people behave toward customers; how they feel about the quality of the company’s goods and services; how prideful they feel about the mission of the enterprise; and ultimately, how fulfilled people feel in having a say in the business or making a difference in people’s lives as a result of the work they perform. In the end, highly constructive and productive cultures lead to optimum outcomes.

Why Change?

More corporations are coming to appreciate that relationship marketing is leading to increased sales, as compared to transactional marketing. To effect a shift of such magnitude requires a carefully planned migration of both structural and cultural change. Companies such as Globus, the German-based hypermarket; DM-Drogeriemarkt, a retail chemist; Southwest Airlines and Lufthansa, both commercial airline companies; and Ikea, the Swedish multinational home

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furnishing retailer—all have created cultural environments that have enabled them to be enormously profitable compared to their industry counterparts. In each of these organizations, employees work as teams. Management provides prescriptive guidance rather than restrictive direction. Employees are entrusted to do the right thing and encouraged to be the best at what they do, namely, providing customers not only with quality goods and services but also with great customer experiences. Up to 40% improvement in performance can be achieved by changing organization culture. According to Stanford Business School professor, Jeffery Pfeffer, providing training, status equalization, employment stability, and strong recognition and reward programs can propel any number of organizations to enviable levels of success. To remain viable and competitive, even service-sector entities, for example utilities, financial institutions, and government services, are recognizing the need to shift from transaction-based systems to ones that are more relationship-focused. Such changes require enormous changes in organization culture, as well as in supporting structures, i.e., operational, technological, and policy structures. Because “structure follows strategy”, it is virtually impossible to make shifts in organizational culture unless changes in structure occur, as well, to support such seismic shifts.

When is Change Necessary?

Nowhere is the need for cultural alignment more evident than in the case of acquisitions and mergers. What usually happens is that the acquiring entity assumes its culture to be superior to that of the entity being acquired, as in the case of Novell Nouveau, cited earlier. Rather than identifying and optimizing the most constructive aspects of the acquired organization’s culture, the culture of the acquirer subsumes the culture of the acquired organization. Consequently, the outcome is not unlike that of Novell Nouveau’s in acquiring WordPerfect. Equally, compelling circumstances exist when organizations are pummelled by downturns in the economy or paradigm shifts in industry standards and/or customer preferences. Organizational transformations are required to jumpstart the business concept or power-charge employees, propelling them in a new direction. Out of the ashes of the past must arise a new phoenix if the organization is to transform itself into a vital resource for meeting, if not exceeding, customer needs and marketplace demands. Today, Starbucks, the international roaster and specialty coffee retailer, which operates in 43 countries with approximately 15,000 stores, is being assailed by competitors offering cheaper alternative products. Under Howard Schultz, returning to the company as chairman and CEO, the company is adopting a turnaround strategy of providing customers not only with the distinctive Starbucks “experience,” and innovations, but also, a can-do employee attitude. “Welcome to Starbucks! What can I get started for you?” is the greeting welcoming every customer. While it is still early in the game, the emphasis is on reigniting the emotional attachment customers have had in the past with the product and the people who are the face of the company.

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Similarly, when organizations determine that their focus must shift from product sales to customer satisfaction and retention, a significant change in organization culture is required. Employees need to be trained and empowered to improve the quality of goods and services, solve problems, and earn the respect and, ultimately, the loyalty of their customers. For example, in 1993, when CEO Louis Gerstner took the reins of IBM, the company had just lost US$8 billion. His challenge was to transform IBM from a stodgy, centralized, mainframe computer company, where customers were expected to come to “Big Blue” and turf wars among departments abounded, to a fast-paced, customer-focused, well-oiled machine, where employees were expected to work as a team to meet and exceed the needs of their customers. In Who Says Elephants Can’t Dance, Gerstner wrote, “Culture isn’t just one aspect of the game. It is the game. In the end, an organization is nothing more than the collective capacity of its people to create value.” As organizations continue to grow globally, it becomes a virtual impossibility for management to be ever-present, critically focused on day-to-day operations. Instead, organization cultures must be designed that are conducive to teamwork, self-direction, ethical decision-making, and the achievement of outstanding results. Team members throughout the organizational system must share a vision and a passion that can only come from an organization culture that is carefully designed and ardently nurtured.

A Model for the Ideal Culture Organizational Awareness

Ask any employee about his or her organizational culture, and chances are the words chosen to describe the environment will range from “political,” “highly competitive,” “collaborative,” and “team-like” to “stressful,” “mission driven,” even “rewarding.” The collective wisdom of organizational members represents a sort of meta-knowledge about the behaviors exhibited as a result of the cultural context in which they function. These descriptors, in essence, paint a picture of how functional or dysfunctional an organization’s culture is and, in turn, how successful or unsuccessful the organization is as a whole in the way it operates. Moreover, it is this collective conscience, or meta-knowledge, that contains the answers as to how the organizational culture could and should be ideally.

Dimensions of Culture Various models exist for assessing the culture of an organization. Perhaps the most widely used survey instruments have been developed by Human Synergistics International. Their Organizational Culture Inventory®, for example, measures 12 thinking and behavioral styles, which make up three groupings termed the

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“constructive,” “passive-aggressive,” and “passive-defensive” styles. An “ideal” culture is “constructive” when the dominant organizational styles are “selfactualizing,” “achieving,” “humanistic and encouraging,” and “affiliative.” Summary results from completed assessments enable organizations to understand how their cultures operate and where improvements can be made to outcomes in a variety of areas, including employee/labor relations, customer relations, organizational performance, and profitability.

Blueprint for Change The benefit of using such assessments as described above is that organizational leadership is better able to target areas for change. Knowing how the present organizational culture impacts on performance, and where enhancements can be made to improve performance can form the basis of a master plan, or blueprint for change. Moreover, by tapping into the collective conscience of the organization and enlisting the involvement of organizational members, leadership can manage the change process more effectively—simply put, it becomes an holistic process or a “bottoms-up-top-down” approach. In the end, the change effort is sustainable, because all organizational members understand what is needed and how to make it happen—more importantly, they become collaborators in the change process rather than victims or passive spectators. Any number of corporations, including American Eagle Outfitters, Disney, Men’s Wearhouse, and Hewlett Packard, have focused on organizational culture as a means of optimizing performance, while sparking the commitment and active engagement of their employees. They have adopted that strategy from day one, and it has been the foundation for success.

Further Implications In addition to profiling the culture of an organization, management can extend the evaluative process to assessing the individual behavioral styles of organizational members. Consistent with the notion that “a chain is only as strong as its weakest link,” the behavior of every member of the organizational “chain” must be aligned with the desired profile of the organization’s ideal culture to ensure optimum results, further, those achieved by their peer and competitor organizations.

Making It Happen Culture change requires a strategic perspective on why culture is important to the organization, and how it will make a significant difference in the strategic positioning and success of an enterprise. The process begins with articulation of

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the vision and mission of the organization. To achieve optimum performance, the culture of the organization needs to be aligned with the vision, mission, and strategic goals and objectives of the organization. The behaviors of senior leadership must model the new standard, and the change and implementation process must begin with senior leadership.

•  •  •  •  •  • 

Conduct a system-wide assessment of the organization’s current culture. Determine where change is necessary and why. Profile the desired culture of the organization, ensuring that the targeted profile will bring out the best in the organization. Engage organizational members in the processes of assessing the current culture, profiling the desired culture, and implementing needed change. Incorporate the desired behavioral styles into the performance planning and management process for both individual members, and the business as a whole. Continue to assess progress versus plan. Be certain to obtain feedback from key stakeholders such as customers, vendors, and investors, and make adjustments as needed to improve results.

More Info Books:

Bowen, R. B. Recognizing and Rewarding Employees. New York: McGraw-Hill, 2000. Cameron, K. S. and R. E. Quinn. Diagnosing and Changing Organizational Culture: Based on the Competing Values Framework. San Francisco, CA: Jossey-Bass, 2005. Driskill, G. W. and A. L. Brenton. Organizational Culture in Action: A Cultural Analysis Workbook. Thousand Oaks, CA: Sage Publications, 2005. Gerstner, L. V. Who Says Elephants Can’t Dance: Leading a Great Enterprise Through Dramatic Change. New York: HarperCollins, 2002. Hennig-Thurau, T. and U. Hansen (eds). Relationship Marketing: Gaining Competitive Advantage Through Customer Satisfaction and Customer Retention. New York: McGrawHill/Irwin, 2000. Pfeffer, J. The Human Equation: Building Profits by Putting People First. Boston, MA: Harvard Business School Press, 1998. Schein, E. H. Organizational Culture and Leadership. 3rd ed., San Francisco, CA: JosseyBass, 2004.

Articles:

Barriere, M. T., B. R. Anson, R. S. Ording and E. Rogers. “Culture transformation in a health care organization: A process for building adaptive capabilities through leadership development.” Consulting Psychology Journal: Practice and Research 54:2 2008: 116–130.

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Clark, D. “Novell Nouveau: Software firm fights to remake business after ill-fated merger.” Wall Street Journal (Midwest ed) 76:62 January 12, 1996: A1, A6. Kavita, S. “Predicting organizational commitment through organization culture: A study of automobile industry in India.” Journal of Business Economics & Management 8:1 2007: 29–37.

Websites:

The Howland Group, Inc.: www.howlandgroup.com Human Synergistics International: www.humansynergistics.com

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Maximizing a New Strategic Alliance by Peter Killing

Executive Summary •

Over 60,000 strategic alliances have been formed in the past decade. About half were joint ventures. Only 40% meet or exceed their partners’ expectations.

•

To be successful with strategic alliances you must be clear about your objectives, get the alliance design right, and manage the alliance effectively after it is formed.

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There is an important difference between shallow and deep alliances, and you should know which type you need and why.

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Alliance success depends in large part on skilled managers who are good with people, have a high tolerance for ambiguity and conflict, and are patient yet persistent.

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The clearest sign of alliance success is growing trust between the partners.

Introduction More than 60,000 strategic alliances were formed in the 1990s. About half of these were joint ventures. The other 50% were non-equity arrangements such as technology licensing agreements, joint marketing arrangements, and joint research or development projects. Most of these alliances were international, so it’s no surprise to learn that the world’s largest multinationals are heavy alliance users: IBM (254 alliances), General Motors (138), Mitsubishi (233), Toshiba (147), Philips (207), and Siemens (200) are just some examples. Clearly the ability to create and manage strategic alliances is an important skill for most management teams. If you cannot make effective use of alliances in today’s world, you will be at a serious competitive disadvantage.

Getting It Right A 1999 study by Andersen Consulting indicates that only 40% of alliances achieve or exceed the initial expectations of their partners, which suggests there’s a lot of room for improvement. One of the reasons for the relatively low success rate is that there are many different aspects of the design and management of alliances that you need to get right, from clearly understanding your objectives, to managing the alliance after it is formed. They can be grouped into three sequential steps:

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•  •  • 

Clarify objectives. What do we need and for how long? Is an alliance the best way to get what we need? Design the alliance. What type of alliance should we create? What should our role be? Manage after the deal is done. How do we effectively manage the alliance? Can we build trust?

Clarify Objectives and the Need for the Alliance The first challenge is to be clear about what your company needs to fulfil its strategy, which may be different from what others in your industry need. The second challenge is to decide whether an alliance is the best way to get what you need. Three common reasons for forming alliances are:

• 

To enter new markets: One of the classic purposes of joint ventures is to enter foreign markets. Typically the foreign company finds the local market attractive but does not feel confident enough to enter without local knowledge, and so takes a local partner. In some countries the government insists on such a relationship. In China, for example, joint ventures between foreigners and local companies are prevalent. Often, as foreign companies gain confidence in their ability to operate locally, they end the joint venture by buying out their local partner and creating a wholly owned subsidiary. In this case the alliance is a step on the road to something else.

• 

To create new technology and set industry standards: In technology-intensive industries like computing and telecommunications, companies often use alliances to attempt to create a new technology that will become the industry standard. An example is Symbian, a joint venture formed in 1998 by Psion, Ericsson, Nokia, and Motorola. Symbian’s objective is to create an operating system for wireless devices to exchange information efficiently. Microsoft has also shown an interest in this area and has considered building its own alliance around its CE operating system with partners including NTT DoCoMo and British Telecom. The competition has shifted from company versus company to alliance versus alliance.

• 

To shape consolidation: In consolidating industries such as airlines, telecoms, and the automotive industry, alliances are often formed between companies that fear they are too small to continue independently (and that do not want to be taken over) and those that intend to play a dominant role in the consolidation. The alliance between Fiat and GM was formed for precisely this reason. This deal involves cross-ownership holdings between the two companies, two 50:50

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joint ventures, and a variety of smaller cooperative arrangements. Fiat also had an option to sell itself to GM (before agreeing a “divorce” worth $2 billion in 2005). The immediate motives behind such alliances are to gain economies of scale and global reach, to eliminate excess capacity, and to keep the smaller company out of the hands of predators.

Why Use an Alliance? Alliances are often the least-preferred choice of the companies that enter them. Many companies would rather enter a new market themselves, or perhaps make an acquisition. GM, for example, would probably have preferred to buy Fiat, but the company was not for sale. Alliances are often seen as difficult to manage, ambiguous in terms of control and decision-making (and as a result slow-moving), and requiring an extraordinary amount of management time and attention. The usual motives, positive and negative, for proceeding with an alliance are: Positive:

•  •  •  •  •  •  •  •  •  •  •  • 

to harness the partner’s energy and knowledge; to set an industry standard by involving partners; to learn something; to gain economies of scale or global reach; to reduce risk; to gain speed.

Negative: government insists on alliance; acquisitions are too expensive or not available; it’s the only financially affordable alternative; the company fears being acquired; an alliance will prevent a competitor’s acquisition of, or alliance with, the partner; closing the business is too expensive; an alliance provides a more graceful exit.

You should be clear about your own motives as well as your partner’s. There are no data on this issue, but alliances formed for positive motives may have a higher success rate.

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Design the Alliance There are many types of alliance. The simplest are straightforward license agreements and shared marketing deals; the most complex are multipart arrangements such as cross-ownership positions, joint ventures, and cooperative projects between partners. Faced with an abundance of choice, managers entering an alliance need to make a key decision: whether they want a shallow alliance or a deep alliance.

Shallow Alliances—Traveling Light A shallow alliance might be thought of as a flirtation—a low-commitment alliance that doesn’t have a lot of resources devoted to it and that can be broken on short notice. As an example, think of current airline alliances such as the Star and One World alliances, which seem to feature new partners every month. Or consider Cisco and its internet-related businesses. Cisco often cannot judge if a young company’s fledgling technology will prove to be important a year later. The shallow alliance solution is to buy 10% of the company’s stock in a friendly transaction and get a seat on the board and an option to buy the remainder of the equity. The assigned board member can then assess the company’s management, its market prospects, and its technology. If it looks good, they buy the rest of the company. If not, they leave. Shallow alliances thus create options for companies in fast-changing industries in which the way ahead is not clear. The alliances are not usually intended to be permanent.

Deep Alliances—Commitment At the other end of the spectrum are deep alliances involving high levels of financial and managerial commitment by the partners. Deep alliances feature many links between the partners, usually including one or more seats on the board of directors, cross-ownership positions, at least two or three joint ventures, and many less formal but important cooperative projects. Deep alliances are generally slower-moving than shallow alliances, more difficult to manage, and more difficult to end. The benefits of success can be high, but so can the costs of failure. Deep alliances are not for the timid.

Manage After the Deal Is Done Once you’ve formed an alliance, you’ll sooner or later discover that you have brought together partners with different ways of doing things and somewhat different objectives, priorities, and performance standards.

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These differences make the management of alliances a difficult task. The single most important thing you can do to maximize the probability of success is to assign some of your very best people to work on it. “Best” means managers with excellent people skills, cross-cultural sensitivity, and a tolerance for ambiguity and frustration. Alliance managers need to be patient, yet persistent. Six months into the life of your alliance you should look closely at the relationship between the partners. Is trust starting to develop? If not, why not? Where are the trouble spots? Many texts advise that when choosing a partner you should choose someone you trust. This is difficult to do unless you have worked together before. The real question is whether or not you can develop trust over time. The best predictor of the future performance of any alliance is the current level of trust between the partners. Finally, don’t assume that the alliance is done when the deal is signed. This is just the beginning. Be flexible and open to change and learning. There will be plenty of opportunity for both.

Making It Happen Strategic alliances are increasingly popular, even necessary; however they are often a high-risk strategy. It is worth viewing the alliance in three distinct phases:

• 

Before the deal is struck: The vital period when goals are considered, resources prepared, and partners considered. Internal agreement on the goals, strategy, and resources to be used is important, as is choosing the right partner and evaluating them thoroughly through due diligence.

•  • 

Negotiating the deal: The terms of the agreement and, significantly, the expectations of each partner and the spirit of the agreement, will be decisive in determining the effectiveness of the alliance. Post-agreement management: Successful agreements are those that are consistently and attentively resourced, managed, and valued. If they are not, they are unlikely to survive normal commercial pressures.

Some key questions to consider include:

•  •  •  •  • 

Have you formally assessed the aims and benefits of the strategic alliance? How does the alliance fit with your overall commercial strategy? Who needs to be informed of the alliance—and when? Have you sought the advice of professional advisers? Have you taken time to understand the target and the commercial implications?

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•  • 

To what extent should the alliance be integrated into your existing business? Who will lead this? Do you have a fully costed and resourced plan for managing the alliance? What are the targets and success criteria for the alliance?

More Info Books:

Cauley de la Sierra, M. Managing Global Alliances: Key Steps for Successful Collaboration. Reading, MA: Addison-Wesley, 1995. Doz, Yves L. and Gary Hamel. Alliance Advantage: The Art of Creating Value through Partnering. Cambridge, MA: Harvard Business School Press, 1998. Lewis, Jordan D. Trusted Partners: How Companies Build Mutual Trust and Win Together. New York: Free Press, 2000.

Website:

Alliance Strategy offers resources and readings on alliance strategy and management. It is maintained by Ben Gomes-Casseres, author of The Alliance Revolution: www.alliancestrategy.com

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Merger Integration and Transition Management: A New Slant for Finance Executives by Price Pritchett

Executive Summary •

Negotiating a good deal is a dangerous act if management isn’t solidly prepared to make the deal work.

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Mergers are a fast-growth strategy—and they require fast management.

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The pre-close period is the staging platform for effective integration.

•

A merger is always based on a financial proposition, but success invariably rests on the human proposition.

Introduction Merger success—defined as value creation—depends heavily on how well conceived the deal was originally. But a good outcome is even more dependent on having a well-designed and carefully implemented integration strategy. To put it simply, no deal is a good deal if management can’t make it work. Studies over the past several decades prove, however, that far too often companies lack the ability to design and execute a viable integration plan. Over half of all mergers end up as disappointments or outright failures that destroy shareholder value. Many things contribute to the high casualty rate, but the myriad risk factors can be greatly reduced and in some cases eliminated. The odds of success dramatically improve when management adheres to some fundamental rules for effective integration.

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Figure 1. Integration framework for the CME–CBOT merger

Nevertheless, M&A remains a high-stakes game that is undertaken in pursuit of uncommon growth. As such, it calls for uncommon management.

Transition Management Should Begin Early The merger transition period starts long before the deal has final approval and actually closes. Weeks and months can pass as negotiations, due diligence, and the regulatory approval process proceed. Problems, however, don’t wait around on management to close the deal. As soon as people pick up the scent that their company is in play, they begin to think and act differently. Their attitudinal shifts and behavior changes create leadership challenges that are unique to mergers. This explains why status quo management stops working. The troublesome organizational dynamics that kick into gear need immediate attention, so transition management and integration planning should begin at least as soon as the deal becomes public knowledge. The pre-close period is a crucial phase. It’s the mobilization zone for merger success where you set the stage for an informed, well- executed integration. Particularly during the pre-close period, there are far more questions than answers, so the major workforce issue that needs to be addressed is uncertainty. People in leadership roles will need the merger management skills necessary to:

•  •  • 

navigate uncertainty and prepare for change; deal with people’s negativity and resistance; keep employees engaged and retain talent;

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• 

protect productivity and client relations.

A lot of damage can occur even before the deal papers are signed if managers at all levels don’t respond appropriately to the new organizational dynamics.

Governance of the Integration Process The transition management infrastructure should be set up, staffed, and functioning prior to the closing date. One person—a credible, experienced senior manager—should be appointed as integration manager with responsibility for overseeing integration planning and implementation. This position provides a single point of accountability for integration success. Given the unique demands of the job, the integration manager needs to possess a high energy level, strong sense of urgency, tolerance for ambiguity, and strong project-management skills. The role also calls for in-depth knowledge of the business, good communication skills, plus the ability to create structure and process. Typically a project-management office is established to support the integration manager in running the integration effort. This will consist of a small group of people who meet daily, or at least weekly, to facilitate work streams, set priorities, coordinate schedules, etc., to ensure that the project runs in a disciplined manner. An executive oversight body ordinarily serves as a steering committee. Members of this group (some drawn from the acquired company) might include the CEO, president, legal counsel, CFO, a senior level human resources executive, a senior communications officer, plus the integration manager. The steering committee designs the high-level merger integration strategy, sets timelines, and decides on synergy targets. Additionally, this group removes roadblocks, resolves sensitive merger issues, and serves as the final signoff authority on expenditures and key staffing decisions. A number of merger-integration teams should be formed to conduct the analysis and integration planning for combining the various functional areas. Also, additional teams usually are needed to address cross-functional issues or companywide matters such as communications, culture integration, etc. In small mergers with limited staff, integration planning and execution is ordinarily handled by the managers who are accountable for the various functional areas. But even in small deals the integration should be conducted with strict project-management discipline and a single person in charge as integration manager. Of course, legal restrictions or the realities of competition can limit merging companies’ ability to plan and organize prior to finalizing the deal. But preparation pays huge dividends, so management should make maximum use of the pre-close period.

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Day 1—that point on the calendar when the merger goes live—is a day of reckoning. The acquirer’s “opening moves” reveal the quality of pre-close planning and make a defining statement about management’s ability to execute. Day 1 activities also are scrutinized for what they might imply about the future, so what’s said and done should be carefully orchestrated to manage people’s expectations appropriately.

Five Ground Rules for Effective Integration There are two sides to the merger integration coin: project management and people management. Project management deals with the mechanics—that is, the administrative, operational, and technical matters involved in consolidating two organizations. People management deals with the so-called soft stuff, the highlycharged political, cultural, and personal issues that surface during a merger. It’s generally agreed that “the soft stuff is the hard stuff,” meaning that people management is more difficult than project management in mergers and acquisitions. Actually, both aspects of integration management are complicated. But the following ground rules can help the merger process go smoothly and greatly improve the odds of success.

1. Remember—the first word in merger is “me”

Employees, first and foremost, are concerned about themselves. The question they want answered is: “How will I personally be affected by the merger?” Until the individual gets answers to the “me issues,” you’re going to have only half an employee even though you’re paying full salary. People can adjust to tremendous amounts of change, and they can deal with disappointment, but they hate to be left hanging in the wind wondering how they’ll be affected in the shakeout. Provide closure as soon as possible.

2. Tighten up the integration time-frame

The longer you take to integrate, the closer you live to the edge. You are in a race—a race against the organizational problems and risk factors that are generic to mergers … a race against competitors who are building counterstrategies … and a race against the merger critics who would love to see you fail. The integration period is a destabilized, perilous time, and speed is your friend. As the saying goes, “Skate fast over thin ice.”

3. Promise problems

Mergers are designed to strengthen organizations, but invariably things get worse before they get better. You need to predict this. And you should explain why it happens. Otherwise, the merger critics will point to the normal side effects of change as proof that the deal was ill-advised or that it is being poorly executed. You can preempt the critics, protect management’s credibility, and actually make the merger less stressful by straightforwardly telling people what to expect.

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4. Educate your workforce on how to perform during the merger

The integration period is a time of ambiguity, instability, and stress. It’s not business-as-usual. Train your managers in the unique challenges of mergers, and provide guidance on how to lead during large-scale change. Give all employees an orientation on the basics of being acquired and merged—explain how organizations are affected, the difficulties that can be expected, how people react, and how they personally can have a positive influence on the merger process. If you fail to tell the workforce what’s coming, or if you don’t coach them on how you want them to handle it, why should you expect people to perform the way you’d like?

5. Communicate, communicate, communicate

People crave information and answers. If your communication efforts fail to satisfy their curiosity, the rumor mill will fill the void. Remember, “The more unpleasant the message, the more effort should go into communicating it.” But give it to people straight—the good, the bad, and the ugly. Don’t shave the truth, and don’t slip into a propaganda mode with too much “happy talk” about the merger. Communication problems spawn all kinds of additional problems, so feed a steady stream of accurate and helpful information to all key stakeholders.

Case Study Merger of Chicago Mercantile Exchange with Chicago Board of Trade

CME and CBOT competed against each other for more than a century, first in agricultural commodities and later in futures and options trading. By acquiring CBOT Holdings for roughly US$8 billion, CME created a combined company valued at approximately US$25 billion. The merger produced the world’s largest financial exchange with a market reach that encircles the globe. The diagram below shows the integration-management framework that was designed to transition the two firms into a single organization. CME invested substantial time and money in laying the groundwork for effective integration. For example managers in both companies were given briefings on best practices in mergers. Also, a day-long kickoff meeting for integration team leaders was designed to: •

work through the team charters;

•

review regulatory guidelines on information sharing;

•

provide an orientation regarding the integration planning approach, rules of engagement, expectations, etc.;

•

define the scope and boundaries for each planning work stream;

•

share information about each other’s business;

•

begin building cross-company relationships.

Overall, the CME–CBOT merger followed a disciplined integration process and adhered to an urgent timeline for completion.

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Conclusion Mergers represent unconventional growth, and they produce a highly predictable set of “growing pains.” But while all mergers are alike in this regard, every merger is different in that each brings idiosyncratic problems, which may be very unpredictable. There’s no excuse for failing to prepare merging organizations for the generic challenges. And, for that matter, management also should “expect the unexpected” and be fully prepared to improvise. If people have been trained properly, and if the appropriate transition management infrastructure is in place, the integration effort should succeed in spite of the inevitable surprises.

Making It Happen Integration planning and execution typically take shape through a financial lens, and appropriately so. The problem with this, however, is that many of the heavyduty merger-success factors revolve around the “soft stuff,” which doesn’t lend itself readily to hard financial metrics in the predictive sense. Of course, after the fact, the costs of poorly handling these people-management issues may be obvious and easily calculated.

•  •  • 

Financial executives, perhaps even more than the people in human resources, should be champions for an integration effort that respects the influence and monetary impact of cultural, political, and personal issues. Calculate the potential costs associated with not managing the “soft stuff” effectively. Studies prove that people/cultural issues can wreck a deal. Culture problems are conveniently blamed when mergers go bad, but usually executives give culture little more than lip-service during integration. Treat culture as a make-or-break issue from the beginning, and make the investment of money and true expertise needed to deal appropriately with cultural differences.

• 

Engineer some “early wins.” Defuse the critics and resistors by showcasing evidence that the merger is rapidly bringing benefits.

More Info Books:

Pritchett, Price. The Employee Guide to Mergers and Acquisitions. Dallas, TX: Pritchett, 1986. Pritchett, Price. Making Mergers Work: A Guide to Managing Mergers and Acquisitions. New York: McGraw-Hill, 1987.

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Pritchett, Price. The Employee Handbook for Shaping Corporate Culture: The Mission Critical Approach to Culture Integration and Culture Change. Dallas, TX: Pritchett, 2002. Pritchett, Price. The Unfolding: A Handbook for Living Strong, Being Effective, and Knowing Happiness During Uncertain Times. Dallas, TX: Pritchett, 2006. Pritchett, Price. Deep Strengths: Getting to the Heart of High Performance. New York: McGraw-Hill, 2008. Pritchett, Price, Donald Robinson, and Russell Clarkson. After the Merger: The Authoritative Guide for Integration Success. 2nd ed. New York: McGraw-Hill, 1997.

Websites:

Association for Corporate Growth (ACG): www.acg.org The Deal: www.thedeal.com Mergers & Acquisitions: www.themiddlemarket.com

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Why Mergers Fail and How to Prevent It by Susan Cartwright

Executive Summary •

Mergers and acquisitions (M&A) are increasing in frequency, yet at least half fail to meet financial expectations.

•

The United States and the United Kingdom continue to dominate M&A activity. As the number of cross-border deals increases, however, many other national players are entering the field, further highlighting the issue of cultural compatibility.

•

Financial and strategic factors alone are insufficient to explain the high rate of failure; greater account needs to be taken of human factors.

•

The successful management of integrating people and their organizational cultures is the key to achieving desired M&A outcomes.

Introduction The incidence of M&A has continued to increase significantly during the last decade, both domestically and internationally. The sectors most affected by M&A activity have been service- and knowledge-based industries such as banking, insurance, pharmaceuticals, and leisure. Although M&A is a popular means of increasing or protecting market share, the strategy does not always deliver what is expected in terms of increased profitability or economies of scale. While the motives for merger can variously be described as practical, psychological, or opportunist, the objective of all related M&A is to achieve synergy, or what is commonly referred to as the 2 + 2 = 5 effect. However, as many organizations learn to their cost, the mere recognition of potential synergy is no guarantee that the combination will actually realize that potential.

Merger Failure Rates The burning question remains—why do so many mergers fail to live up to stockholder expectations? In the short term, many seemingly successful acquisitions look good, but disappointing productivity levels are often masked by one-time cost savings, asset disposals, or astute tax maneuvers that inflate balance-sheet figures during the first few years.

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Merger gains are notoriously difficult to assess. There are problems in selecting appropriate indices to make any assessment, as well as difficulties in deciding on a suitable measurement period. Typically, the criteria selected by analysts are:

•  •  • 

profit-to-earning ratios; stock-price fluctuations; managerial assessments.

Irrespective of the evaluation method selected, the evidence on M&A performance is consistent in suggesting that a high proportion of M&As are financially unsuccessful. US sources place merger failure rates as high as 80%, with evidence indicating that around half of mergers fail to meet financial expectations. A much-cited McKinsey study presents evidence that most organizations would have received a better return on their investment if they had merely banked their money instead of buying another company. Consequently, many commentators have concluded that the true beneficiaries from M&A activity are those who sell their shares when deals are announced, and the marriage brokers—the bankers, lawyers, and accountants—who arrange, advise, and execute the deals.

Traditional Reasons for Merger Failure M&A is still regarded by many decision makers as an exclusively rational, financial, and strategic activity, and not as a human collaboration. Financial and strategic considerations, along with price and availability, therefore dominate target selection, overriding the soft issues such as people and cultural fit. Explanations of merger failure or underperformance tend to focus on reexamining the factors that prompted the initial selection decision, for example:

•  •  •  • 

payment of an overinflated price for the acquired company; poor strategic fit; failure to achieve potential economies of scale because of financial mismanagement or incompetence; sudden and unpredicted changes in market conditions.

This ground has been well trodden, yet the rate of merger, acquisition, and jointventure success has improved little. Clearly these factors may contribute to disappointing M&A outcomes, but this conventional wisdom only partly explains what goes wrong in M&A management.

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The Forgotten Factor in M&A The false distinction that has developed between hard and soft merger issues has been extremely unhelpful in extending our understanding of merger failure, as it separates the impact of the merger on the individual from its financial impact on the organization. Successful M&A outcomes are linked closely to the extent to which management is able to integrate members of organizations and their cultures, and sensitively address and minimize individuals’ concerns. Because they represent sudden and major change, mergers generate considerable uncertainty and feelings of powerlessness. This can lead to reduced morale, job and career dissatisfaction, and employee stress. Rather than increased profitability, mergers have become associated with a range of negative behavioural outcomes such as:

•  •  • 

acts of sabotage and petty theft; increased staff turnover, with rates as high as 60% reported; increased sickness and absenteeism.

Ironically, this occurs at the very time when organizations need and expect greater employee loyalty, flexibility, cooperation, and productivity.

People Factors Associated with M&A Failure Studies like the one conducted by the Chartered Management Institute in the United Kingdom have identified a variety of people factors associated with unsuccessful M&A. These include:

•  •  •  •  •  •  •  • 

underestimating the difficulties of merging two cultures; underestimating the problem of skills transfer; demotivation of employees; departure of key people; expenditure of too much energy on doing the deal at the expense of postmerger planning; lack of clear responsibilities, leading to postmerger conflicts; too narrow a focus on internal issues to the neglect of the customers and the external environment; insufficient research about the merger partner or acquired organization.

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Differences between Mergers and Acquisitions In terms of employee response, whether the transaction is described as a merger or an acquisition, the event will trigger uncertainty and fears of job losses. However, there are important differences. In an acquisition, power is substantially assumed by the new parent. Change is usually swift and often brutal as the acquirer imposes its own control systems and financial restraints. Parties to a merger are likely to be more evenly matched in terms of size, and the power and cultural dynamics of the combination are more ambiguous. Integration is a more drawn-out process. This has implications for the individual. During an acquisition there is often more overt conflict and resistance, and a sense of powerlessness. In mergers, however, because of the prolonged period between the initial announcement and actual integration, uncertainty and anxiety continue for a much longer time as the organization remains in a state of limbo.

Cultural Compatibility The process of merger is often likened to marriage. In the same way that clashes of personality and misunderstanding lead to difficulties in personal relationships, differences in organizational cultures, communication problems, and mistaken assumptions lead to conflicts in organizational partnerships. Mergers are rarely a marriage of equals, and it’s still the case that most acquirers or dominant merger partners pursue a strategy of cultural absorption; the acquired company or smaller merger partner is expected to assimilate and adopt the culture of the other. Whether the outcome is successful depends on the willingness of organizational members to surrender their own culture, and at the same time perceive that the other culture is attractive and therefore worth adopting. Cultural similarity may make absorption easier than when the two cultures are very different, yet the process of due diligence rarely extends to evaluating the degree of cultural fit. Furthermore, few organizations bother to try to understand the cultural values and strengths of the acquiring workforce or their merger partners in order to inform and guide the way in which they should go about introducing change.

Making It Happen Making a good organizational marriage currently seems to be a matter of chance and luck. This needs to change so that there is a greater awareness of the people issues involved, and consequently a more informed integration strategy. Some basic guidelines for more effective management include:

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•  •  •  •  •  •  •  • 

extension of the due diligence process to incorporate issues of cultural fit; greater involvement of human resource professionals; the conducting of culture audits before the introduction of change-management initiatives; increased communication and involvement of employees at all levels in the integration process; the introduction of mechanisms to monitor employee stress levels; fair and objective reselection processes and role allocation; providing management with the skills and training to handle M&A issues such as insecurity and job loss sensitively; creating a superordinate goal which will unify work efforts.

Case Study Paul Hodder was involved as director of human resource management in the formation of Aon Risk Services, a merger of four rather different retail-insurance-broking and riskmanagement companies. A major theme of their integration process was the formation of a series of task groups to review and identify best practice. Another part involved an organization-wide training program to provide individuals with life skills to help them initiate and cope with change, to improve teamwork, and to develop support networks. Enthusiasm for the program provided several hundred change champions to lead change projects and assume support and mentoring roles. Good communication of early wins and successes has reassured organizational members that the changes are working and are beneficial.

Conclusion Despite thorough pre-merger procedures, mergers continue to fall far short of financial expectations. The single biggest cause of this failure rate is poor integration following the acquisition. The identification of the target company, the subsequent and often drawn-out negotiations, and attending to the myriad of financial, technical, and legal details are all exhausting activities. Once the target company has been acquired, little energy or motivation is left to plan and implement the integration of the people and cultures following the merger. It seems nonsensical to waste all the resources and energy that have gone into the merger through inadequate planning of the integration stage of the process, yet all too often organizations do just that. Without a properly planned integration process or its effective implementation, mergers will not be able to achieve the full potential of the acquisition.

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More Info Books:

Cartwright, Susan and Cary L. Cooper. Managing Mergers, Acquisitions and Strategic Alliances. 2nd ed. Woburn, MA: Butterworth-Heinemann, 1996. Cooper, Cary L. and Alan Gregory (eds). Advances in Mergers and Acquisitions. Vol. 1. New York: JAI Press, 2000. Stahl, Gunter and Mark E. Mendenhall (eds). Mergers and Acquisitions. Stanford, CA: Stanford University Press, 2005.

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The Human Value of the Enterprise by Andrew Mayo

Executive Summary •

People are often spoken of as assets but are generally treated as costs, because we have no credible system of valuing them.

•

The problem is that in today’s knowledge-based organizations value is driven more by people than by any other factor.

•

There are five main approaches to building a measurement system for people, or human capital.

•

The attempt to value people financially has not been successful; however, an index of value factors provides a necessary balance with seeing people as costs.

•

Current best practice looks at connecting the value of people in terms of their characteristics (and the value they produce in both financial and nonfinancial terms) via measures of their engagement and motivation.

Introduction Our people are our most important asset. This frequent statement from chief executives is often received with justifiable cynicism. The problem is that people within an organization do not always experience decisions and policies in their everyday work life that support such a belief. The accountant who once described people to me (admittedly with a smile) as “costs walking about on legs” is often closer to the reality of organizational experience. The very term “human resources” reinforces this concept of people. Organizations that are driven by an often understandable drive for increased efficiency and minimized costs see “headcount” as the easy target. There are many reasons for this. One is the domination of management by current targets for bottom line results—often resulting in a very short-term mindset. Such singlemindedness is illogical because it is out of balance; the desired final outcomes are driven by satisfying other demands that generally get much less attention. A powerful system of financial processes and targets dominates the life of most managers. Measures of intangibles, such as employees’ capabilities or customers’ loyalty may exist, but they are frequently excluded from appearing in the monitoring and control systems in any serious way.

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Another problem is that people do not fit the strict financial definition of an asset. They cannot be transacted at will, their contribution is individually distinctive and variable (and subject to motivation and environment), and they cannot easily be valued according to traditional financial principles. However if we view “assets” as value-creating entities, and in an era where knowledge and its application is the key competitive advantage, we will arrive, inevitably, at the foundational role people play. Organizations do employ some just for “maintenance,” but the vast majority are value adding. Some indeed should be seen as investments rather than costs—but management accounting rarely recognizes this. Perhaps the greatest problem is the lack of credible measures that relate to people and their value. We know in detail what they cost; we have no balancing quantity for their value. We feel it when it has been lost, but often too late.

The Value of People Is There a Problem to Be Solved?

There is indeed a major problem. The valuation of companies has progressively changed over the last 20 years, putting a much higher weight on intangible assets like knowledge, competence, brands, and systems. These assets are also known as the intellectual capital of the organization. The problem is that we have no comparable system of measurement that enables us to give these the same balanced attention we give to financial matters. The result is that decisions about investment and resources are not necessarily in the long-term interest of the stockholders, even though they may appear to be at the time they are made. A classic case is the laying off of key people, particularly after M&A, only to hire them back when the value they contributed is suddenly recognized. David Norton, coauthor of The Balanced Scorecard, says of his experiences in working on performance management that “the worst grades are reserved for the typical executive team for their understanding of strategies for developing human capital. There is little consensus, little creativity, and no real framework for thinking about the subject. Worse yet, we have seen little improvement in this over the past eight years. The asset that is the most important is the least understood, least prone to measurement, and hence the least susceptible to management.”

People-Related Measures

No standardized approach has become widely accepted as yet, but the various ways in which systematic measurement has been applied to people can be summarized as follows:

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•  • 

attempting to value people financially as assets: human resource (or asset) accounting. This will be discussed in more detail below. Creating an index of good HR practices and relating them to business results. Researchers including Mark Huselid of Rutgers University and consulting firms such as Watson Wyatt have shown positive correlation between investment in HR management and stockholder value.

• 

Statistically analyze the composition of the workforce and measures of employees’ productivity and output. The best-known proponent here is Jac Fitz-enz of the Saratoga Institute, California, who has extensively deployed ratios of all kinds and conducts a worldwide benchmarking practice.

• 

Measure the efficiency of HR functions and processes and the return on investment for people initiatives and programs. Dave Ulrich of the University of Michigan is the champion of a measurement-orientated HR function, and Jack Philips is the leading proponent of RoI for HR initiatives and programs.

• 

Integrate people-related measures through a performance-management framework. These are frameworks that look for balance in performance measures between the needs of the different stakeholders, or in relation to the component parts of the total intangible assets. The best known is Kaplan and Norton’s Balanced Scorecard. An alternative approach comes from Karl-Erik Sveiby of Sweden, whose Intellectual Capital Monitor chooses a small number of measures for three kinds of intellectual capital—customer, structural, and human.

The most comprehensive approach to the human dimension is found in Mayo’s Human Capital Monitor. This links three areas of measurement:

•  •  • 

the human capital that people lend to organizations in exchange for the value added to them; the financial and nonfinancial value for stakeholders that this human capital produces; the motivation and commitment of the people, which depend primarily on the environment in which they work.

Valuing People as Assets

There are three criteria for defining any asset:

•  •  • 

It must possess future service potential. It is measurable in monetary terms. It is subject to the ownership and control of the company, or it is rented or leased.

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Traditional methods of coming to a valuation include:

• 

Cost-based: This method typically looks at acquisition or replacement cost. The costs of recruiting an employee can be assessed and then depreciated over the expected future service of the person hired. Alternatively, the person’s gross remuneration can be used as a base.

•  • 

Market-based: The price to be paid in an open market must be a reflection of the value of a person. Value is very difficult to assess, however, and does not take account of the value of service continuity in itself. Income-based: The cash inflows expected by the organization related to the contribution of the human asset, calculated as the present value of the expected net cash flows. This is good for individuals whose efforts are directly related to identifiable income.

Human resource accounting, or human asset accounting, has been primarily developed in the United States under the guidance of Professor Eric Flamholtz. He sees the value of a person as the product of two interacting variables—his or her conditional value and the probability that the person will stay with the organization for x years. Conditional value is the present worth of the potential services that could be rendered if the individual stayed with the organization, and is a combination of productivity (performance), transferability (flexible skills), and promotability. The latter two elements are heavily influenced by the first. This figure is then multiplied by a probability factor: the probability that the person will stay for the x years. This gives the expected realizable value, which is a measure of the person’s worth. There are a number of difficulties with this approach, not least of which is the estimation of potential future services. It also leads to lower values for older and more experienced people who have less time to render future services. This is not necessarily the reality. The truth is that this is not a well-known discipline, and it has not been generally adopted by either the financial or HR communities. A more useful approach was originally developed by UK researchers W. J. Giles and D. F. Robinson in 1973. They developed a factor called the human asset multiplier, which is applied to gross remuneration. This reflects a number of intrinsically valuable attributes of individuals. Mayo, in his 2001 book, came to similar conclusions, namely that although it would be really helpful if we could have a realistic, generally accepted, absolute financial formula, this is unlikely to be achieved. But it would be a major step forward if we could at least enable people’s

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relative values to be compared against their costs. He proposed a formula for what he called the human asset worth (HAW), where HAW = EC (employment cost) × IAM (individual asset multiplier)1,000 (The divisor of 1,000 is used so that the resulting number does not look like a financial one.) The individual asset multiplier is designed to reflect the relevant factors that make individuals valuable in their current context. These factors are not universal and vary for each group of employees sharing a common value output. Examples, however, include:

•  •  •  •  •  • 

specialized knowledge, skills, and experience; personal skills and behaviors; contribution to stakeholder value; potential to grow and contribute at a higher level; personal productivity in relation to stakeholder value; alignment with organizational values.

Each of these factors can be assessed on a scale, weighted for importance, and then added together to give the multiplier. Such a formula can lead to tools such as a human asset register, which can monitor changes and compare teams and units. The process of analyzing the individual components may lead to strategies for change in the organization. It can be argued strongly that such tools are at least as important as those used for cost management.

A Framework of Measures The following characteristics are suggested as criteria for a framework of peoplerelated measures:

• 

with the exception of workforce statistics, measures should not stand alone but be connected to other outcomes for the organization—particularly the value created for stakeholders;

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• 

a framework should be useful for the users. These might be external (investors, analysts, benchmarking) or internal (managers, other functions). Their needs are different, so more than one framework may be needed. Usefulness means informing actions to be taken;

•  • 

the underlying collection, definitions, and presentation of data need to be valid and reliable, and have credibility with the users; they should not be compiled through the lens of an accountant. Quantification does not equate necessarily with dollars. Value added can be both financial and nonfinancial.

None of the approaches described above meet all of these criteria. An attempt to do so is found in Mayo’s Human Capital Monitor. This links three areas of measurement for specific groups of employees:

•  • 

the human capital that people lend to organizations in exchange for the value added to them. This is measured by the Human Asset Worth approach; the motivation and engagement of the people, which depend primarily on the environment in which they work. Outcome measures are used, such as attrition, absenteeism, opinions, and management judgment—and also “input” measures of the factors that make a difference to the group under study;

• 

the financial and nonfinancial value for stakeholders that this human capital produces—often measured as a productivity factor.

This provides a tool for managers which stands alongside their financial statements and informs them about people-related actions.

Conclusion The term human capital can be used to describe the asset value of your people. Maximizing human capital through acquisition, retention, growth (and sometimes retention) should be a major priority of all executives, not an area left to the HR department alone. It is the area in which measurement is least well understood. This is all about sustainable stockholder (or public sector beneficiary) returns. People are the one factor of value growth that drives all others. The value that a company creates results from the way that people apply their skills, energies, and expertise to the capital and raw materials that customers want. Of all the business levers available to leaders, the greatest potential to build value is offered by people. It is time indeed to recognize this through demanding a rigorous and credible approach to both valuing this most significant asset, and linking that value meaningfully to the benefits for stakeholders. What gets measured gets managed— and we need reality behind the rhetoric about our people.

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More Info Books:

Becker, B. E., Mark Huselid and David Ulrich. The HR Scorecard: Linking People, Strategy, and Performance. Cambridge, MA: Harvard Business School Press, 2001. Davenport, Thomas O. Human Capital: What It Is and Why People Invest It. San Francisco, CA: Jossey-Bass, 1999. Fitz-enz, Jac. The ROI of Human Capital. New York: AMACOM, 2000. Flamholtz, Eric G. Human Resource Accounting: Advances in Concepts, Methods, and Applications. 3rd ed. New York: Kluwer, 1999. Mayo, Andrew. The Human Value of the Enterprise: Valuing People as Assets—Monitoring, Measuring, Managing. Naperville, IL: Nicholas Brealey, 2001. Phillips, J. et al. The Human Resources Scorecard: Measuring the Return on Investment. Oxford: Butterworth-Heinemann, 2001.

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M&A Communication: It Doesn’t Start With the Announcement by Paul Siegenthaler

Executive Summary •

Two companies with different motives must tell one coherent story

•

That same story will mean something different for five distinct audiences

•

Timing is crucial to avoid information overload, ensure clarity and relevance, and sustain interest

•

What makes sense for some may be obscure to others – a feedback loop is essential

•

Input from a cross-functional team is needed to capture and correctly portray the multiple facets of a business integration

Communicate? Who cares anyway… For some, external communications may be perceived as a self-gratifying justification for spending vast sums of money which distract from a focus on the core business. Internal communications can also be judged harshly, sometimes derided as the “touchy-feely” of a human resources department that’s trying to raise its profile in the company, but ultimately disseminating messages that are either irrelevant, lacking in credibility, or clichés with little substance. These perceptions illustrate that most companies and their leaders are simply not very good at communicating externally or internally. Consequently, firm leaders may fail to reach the stated objective of communication—which is to provide clarity, ensure alignment, and serve as a key tool for driving change. This chapter examines the considerations and constraints that may impact communications made in connection with M&A, as illustrated in Figure 1 overleaf.

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Figure 1. Key elements to be considered when planning M&A communication

M&A: Twice the Complexity Planning, developing, and delivering good communication during a merger or acquisition is a double act that requires two organizations to synchronize the timing and coordinate content to ensure its coherence. This process is far from simple as the two businesses may have different motives for proceeding with the M&A transaction—for example, why is one company divesting itself of a business or a shareholder exiting an investment which the acquirer considers to be an exciting opportunity? This double act starts with the first holding statements prepared before the deal is signed and continues until the transaction is completed. This time frame could span several weeks. Generally, a deal takes six to 12 weeks for regulatory approval, and six months to over a year in the case of very large or complex deals. That is a very long time for a couple to keep moving precisely in step on a dance floor.

One Event, Seen from Five Different Angles In a M&A, company A acquires company B, or B acquires A, or both merge. From a distance it all sounds quite straightforward. However, when it comes to communicating the decision to unite, rather than using everyday language to explain the rationale behind that decision and the changes that are likely to result

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over the coming months, inexperienced companies will simply build a story that draws on the business case and strategy. This is an easy task because the content of the communication is readily available in the documents prepared for the deal’s financial backers and the two companies’ board members during due diligence. Following this quick and easy route will derail communication from the start. The justifications for the merger or acquisition are of interest to financial and business media, but this style of communication fails to address the concerns of all those who need to know whether they will be impacted and how their current ways of working—or indeed their whole livelihood—will be affected. The famous “what’s in it for me” will depend on who “me” is. In most cases, the coming together of the two companies will mean very different things for five broad audiences: employees, customers, investors, contractual parties, and other external stakeholders. This is illustrated in Figure 2.

Figure 2. Each of the five audiences has its own concerns

Employees

Companies that deliver the same M&A communication to all of their employees may assume that those individuals are all clones of each other—for how otherwise could one justify the “one size fits all” approach? The relative emphasis of the key messages, the depth of detail, and the timing, as well as the channels through which the communication is delivered, should differ depending on the type of staff addressed. At the very least, firms need to design distinct communication packages for managers, office staff, manufacturing staff,

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and off-site employees such as the sales field force, not only because the integration will impact them in different ways, but also because the channels through which we can communicate with those groups of individuals will differ. Also, managers will require more detail and contextual information than will be communicated to their staff, to allow them to answer most of the questions that may be asked during their team briefings. The channels chosen to disseminate the communication may also have a significant impact on the way the messages are perceived. Some companies may opt for a “business as usual” approach, using the same email cascades, notice boards or sections of their intranet to hold the information. Others, to the contrary, might select a medium they have never used before, if only to surprise and capture the attention of their audiences and emphasize the fact that something fundamental is changing in the organization as a result of the merger or acquisition, as illustrated in the following short case study.

Case Study In May 2007, British-based company Linpac Materials Handling acquired Allibert Buckhorn, headquartered in Nanterre, France, to become Linpac Allibert. This presented the combining organizations with the challenge of communicating in an impactful and memorable manner in four languages to reach a community spread across 16 locations in nine countries, comprising office-based employees, factory staff working shifts, and sales personnel. The chief executive of Linpac Allibert wanted communication to be engaging and to address the varied range of preoccupations and interests of that broad audience. Letters to employees would have been somewhat impersonal and lacked impact. A “road show” involving visits and presentations by the executive team to all 16 locations would have taken two or three weeks and run into language barriers in some countries, and some form of video posted on the company’s intranet would not have been visible to the factory workers. Instead, the company called a film crew of two to visit a few office locations and factories and ask a number of employees to say what the merger meant for them and how they expected it would change the company’s future. The result was a DVD featuring those employees in a series of short clips, interspersed with statements made by each member of the executive team. The DVD was produced with four sound tracks to allow viewers to select between the English, French, German, and Spanish voice-over where needed. The response was overwhelmingly positive: employees got to see and hear not only the company’s top team, but also some of their colleagues, their offices and factories. The mood was upbeat—beyond the core messages there was a welcoming feeling of informality when listening to some of their colleagues’ statements. Those statements could subsequently be picked up in department or team briefings and group discussions, thereby reinforcing the relevance of the communication to specific target audiences and avoiding any impression of “one size fits all.” The DVD format also enabled employees to view the content at home rather than in the confines of the workplace, which in turn was engaging for their families.

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The feedback received after this communication exercise indicates that a number of them watched it several times, also showing the DVD to friends and relatives. Beyond conveying content relating to strategy, organization, and ways of working, this short production projected a very positive image of the company as a good one to work for. At less than $10 per employee, this internal communication activity also proved to be very cost-effective.

In some countries, local legislation requires bodies representing employees to be informed before other staff, sometimes in a great degree of detail. For example, in France, any attempt to take shortcuts is identified as a délit d’entrave (offense of obstruction), which may result in significant delays in completing the transaction, as well as possible fines imposed by a court. Germany’s Mitbestimmungsrecht (right of codetermination) goes one step further as works councils can actually veto a merger or acquisition. In these circumstances, employee communication requires far more time, effort, and consideration to be shaped and fine-tuned to the respective audiences than most of us might initially expect. In practice, the intense activity into which senior management gets drawn in the weeks or months that precede the signing of a deal may leave little mental bandwidth to take a step back, put oneself in the shoes of a salesman, a factory operative, or a salesperson in a remote territory to preempt those people’s concerns and craft and deliver relevant comprehensible communication which will resonate with each of these audiences. Many companies fail to recognize the need for senior management to focus on communication at a very early stage of the M&A process. The resulting negative initial impression could take many months to offset when the integration gets under way.

Customers

From a customer’s perspective, two factors should be considered: how will the merger or acquisition impact the value of the company’s future commercial relationship with them; and what will change in the way day-to-day business is conducted?

The Commercial Perspective Managers must consider whether a merger will be perceived as a detrimental reduction in their customers’ choice of suppliers that will upset the current balance of bargaining power, or if it will simplify life for them because they will have one same supplier across larger geographies, or because it will offer them a wider range of products and services from a single source. For smaller companies that might not enjoy a very high share of their customers’ business, the news of the acquisition or merger is the perfect trigger to engage with customers, gain saliency on their radar screen, and improve the perceived value they can derive from doing business together.

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However, if the integration is expected to generate massive savings, bargaining pressure from large customers is likely to occur if they attempt to obtain their share of those savings through lower pricing and generally improved commercial terms, resulting in an erosion of margins which could wipe out all or part of those savings. Hence there is a need to emphasize the shared benefits and position the deal as a win–win development that is therefore also in the customers’ interest.

The Transactional Perspective In addition to the above commercial messages, one critical consideration is the timing and clarity of the information given to customers about what will change and when. Any failure to consider transactions could threaten business continuity or, at the very least, cause severe disruption, ranging from serious administrative problems to delayed payments and an abundance of customer queries and complaints. That is the last thing a firm wants at a time when it is trying to position itself as a valuable and effective business partner for customers. Managers must consider customer-centric issues such as

• • • • • • • •

Who will be a customer’s contact person or team How they will place their orders How they will be invoiced To what account they will pay the invoices of the integrated company How possible automated interfaces will be affected To what address returned goods should be sent What their new credit limit will be What changes they need to record in their computer systems

Companies with customers that include large organizations must get these transactional details sorted out as much as six to eight weeks before the changes actually come into effect, because recording those changes involves a number of approval stages in complex organizations and, possibly, changes to existing interfaces, all of which are essential to preserve business continuity.

Investors

Investors are concerned with the merger or acquisition’s likely impact on future strategy and growth prospects, changes to the level of risk associated with those projections, management’s ability to drive the integration to a successful conclusion, and the financial construction of the deal, which in turn will impact the future company’s ownership structure and financial gearing. Customers have been mentioned before investors in this chapter as customers need to be considered before finalizing a message to investors. The financial returns

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which investors seek will only materialize if the firm is sure that its customers will not perceive the merger as detrimental to their interests and switch to other suppliers. Customer acceptance is a key precondition of the validation of any merger or acquisition.

Contractual Parties

Contractual parties include suppliers, distributors, sales agents, and any other companies, associations, or official administrations that are involved in the merging companies’ transactional processes or with which the business relationship is governed by a formal contract. As such, these contractual parties may disrupt the integration process or, in extreme cases, threaten business continuity. The due diligence process, if carried out thoroughly, should ascertain that essential contracts—particularly those with key suppliers, exclusive distributors, and sales agents—will not be adversely impacted or invalidated by the acquisition or merger deal. Conflicting exclusivity clauses or change-of-control clauses are the most significant threats in this area. In the same way as for customers, it will be necessary to clarify whether anything will change in how the merging companies will work together and to indicate when such changes will take place.

Other External Stakeholders

This final audience category includes any person, body, or company (beyond customers, whom we discussed earlier) that can be considered a stakeholder due to changes in the business, market, or social environment that result from the merger or acquisition. This category ranges from the general trade to local authorities that might be concerned about safeguarding jobs. Failure to communicate with these audiences may lead to speculation from these stakeholders. In the world of mergers and acquisitions, the old saying “no news is good news” does not hold. Silence is far more likely to be interpreted as a sign that something is going wrong, or that the companies involved in the merger have something to hide. Rather than reacting to rumors, it is by far easier—and indeed more effective—to remain in control by communicating proactively about the merger or acquisition and its main likely consequences. If some of those consequences are still uncertain (for example, a factory closure or business relocation), explaining how and when those decisions are likely to be taken will provide helpful clarity and demonstrate openness, thereby laying a sound foundation to conduct the relevant negotiations at the right time. Obtaining clearance for a merger or acquisition from the relevant regulatory authorities is more than a simple formality if there is any suspicion that the deal may upset the competitive balance on the market. Parties opposed to the project, such as competitors and various lobbies, will try to influence the regulators’ decision and get them to veto the proposed M&A transaction, or at least reduce its scope. This highly

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“politicized” aspect of corporate communication is best left to specialists such as investment banks, M&A lawyers, and other advisory services which have abundant experience in communicating with the regulators. Countering hostile lobbies—unless on a very local scale in which either of the merging companies can exercise direct influence—should be planned, coordinated, and driven by professionals.

Timing Is Everything Let us consider some of the key milestones that punctuate the M&A journey, from early identification of the acquisition target or merger partner, until such time as both companies are seamlessly integrated. The table below summarizes the type of information conveyed to each of the target audiences as time unfolds, from the early stages to the completion of integration.

Table 1. Summary of audience segmentation and communication topics at key milestones of acquisition and integration Early stages

Before signing

At signing

At closing

Announcement, Announcement: why celebration, corporate are we doing this, identity, vision and "what does it mean for values, what happens you" next

Employees

Customers

Holding statement available Detailed information for in case of rumors on the works councils or other staff Detailed information on market representatives any administrative changes that will occur at closing: terms of employment, employer details, pension, etc.

Announcement, Announcement, reiterate strategy and strategy underlying the its benefits to merger or acquisition, customers, details of why this will be good any changes to ways of for customers placing orders etc.

Holding statement avaialble in case of rumors on the market

Investors

Information memorandum prepared by seller

Suppliers and Contractual Parties

Holding statement available in case of rumors on the market

"Welcome pack" with information on the combined company, products, ways of working

Announcement, chairman's letter to Statement of progress in shareholders Details of deal; what quarterly reporting, if relevant. Strategic benefits will happen at closing of acquisition/sale/merger Documents relating to the transaction (share certificates etc.)

Announcement, strategy underlying the merger or acquisition,what will change at closing

Announcement, details of any changes in administrative details, new contact names if relevant Impact of the deal on the commercial relationship

One face to the customer

On-going integration

Report on progress and Details of integrated sales alignment with previously organization: new reporting lines, sales territories, strategic stated strategic intent. What happens next, "what this benefits, "what this means for means for you" you"

2 to 4 weeks ahead of "One Face" date: details of changes to way of placing and paying for orders, sales team contacts etc. On "One Face" date: reiterate the changes in transaction administration, and emphasize the bnefits to customer arising from the merger or acquisition

Report on progress and alignment with previously stated strategic intent. Reiterate benefit for customers

Report key milestone to shareholders

Report on progress and alignment with previously stated strategic intent

Information for distributors or suppliers impacted by the integration of the sales organization

Information to distributors or suppliers impacted by the integration of logistics, I.T., manufacturing footprint or logistics

Press release : outline Press release : of deal, strategy confirmation of deal underlying the merger and strategic rationale or acquisition

External

Holding statement available in case of rumors on the market

Outline of what will change at closing for external parties impacted by the deal (e.g. local communities) Lobbying activity if relevant

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Confirmation of deal, time-line of likely changes for those impacted by the acquisition / sale / merger

Details of forthcoming changes for those impacted by the acquisition / sale / merger

Anti-trust regulators, lobbying if relevant

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The First Step: The Information Memorandum

The time axis commences well before there is any certainty that a deal will be signed, because in the case of an acquisition the information memorandum developed by the selling party should aim to be far more than a dry compilation of facts and figures. It should, instead, be considered as a crucial communication exercise as it is instrumental in shaping the initial expectations of the two companies which are about to join their destiny. That information memorandum is the tool through which the acquisition target attempts to present itself in the most favorable light. If designed and developed with both a marketing mindset and a pure finance mindset, the memorandum’s impact can significantly enhance the value of the soon-to-be-acquired company.

Holding Statements

Despite the atmosphere of secrecy that usually surrounds the due diligence process leading up to the signing of a deal, it often does not take long for rumors to spread along the lines of “something is happening between companies A and B.” Companies A and B may decide to opt for total openness and proactively issue a common statement expressing their mutual interest. If they choose not to issue a statement, both companies should at least have a holding statement which they can issue at short notice in case of need. If both companies deem such rumors to be innocuous and not detrimental to the smooth running of ongoing day-to-day business, they could simply ignore them and respond with a blunt “we do not comment on speculation.” The key point here is that whatever the chosen course of action, there must be a concerted response. Any dissonance between the statements issued by the two companies may lead to further rumors.

Deal Announcement

When announcing the signature of a merger or acquisition deal, it is worth remembering that many recipients of that announcement will confuse signing and completion of the deal. On signing, the two companies are engaged but not yet married, and nothing changes in the way the customers and other contractual parties interface with the two companies. Announcing the signing of the deal merely allows the firms to clarify the strategic intent as well as the sequence and timing of events that are about to occur.

Day One Announcement

“Day One” is the moment the CEO and many senior managers await with anticipation and excitement. On Day One champagne corks will pop, there will be speeches about the better future that lies ahead for the combined company, presentations on vision, strategy, and values, internal briefings on future ways of working, and more generally a sense of celebration that emulates the ritual surrounding a new birth. It is the start of the journey during which the population

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of two entities will blend into a seamless organization, the kickoff of a major and challenging change-management process. Day One involves major internal communication activities. From the point of view of external communications, not much changes on Day One in the way the two organizations operate with the customers and suppliers. One or both firms might have a new name, registration, or tax number, and some of the key personnel may change, but the integration has yet to begin, and therefore at the starting-block things look pretty much the same as they did the previous day. However, the little changes that occur on Day One need to be communicated with clarity to all those affected (mainly customers and suppliers). Furthermore, this communication must be initiated several weeks in advance to allow the information to be disseminated through those organizations and the parameters of automated systems to be updated. Depending on the type of target audience, that information will typically need to be delivered two to six weeks ahead of Day One to ensure that everyone is ready to flip the switch on that important day.

One Face to the Customer

The point at which two organizations can present one single face to the customer is the crucial milestone in any M&A integration. In companies that span large geographies or several industry sectors, the “One Face to the Customer” milestone might not occur across the whole company on the same day; it is more likely that this will happen on a country by country basis, or one division at a time. For customers and other external stakeholders, this is the moment when the most important changes will take place: being able to place combined orders for the products or services of the two former companies, having a single point of contact, a single invoice payable into one account, a new credit limit, and possibly a completely new way of placing orders and tracking progress. In addition to the advance notice detailing the forthcoming changes, it is worth reminding customers and other external stakeholders of those changes again a few days before they come into effect so as to avoid any glitches, delays, and other complications resulting from the integration which might otherwise bring about a deterioration of the customer experience.

Ongoing Integration: Continuing External and Internal Communication

Having had the wisdom to focus on communication from the very beginning, it is tempting to consider the job done once the messages relating to the commercial integration (One Face to the Customer) has been delivered. Tick in the box. Finish line reached. This approach misses the opportunity of fully exploiting the communication channels we developed during the integration and to continue explaining the

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company’s strategy, thereby building a sense of common purpose and laying the ground to strive for shared commercial objectives in the future. From an internal perspective, maintaining the momentum triggered by the integration of the businesses is absolutely crucial and requires sustained communication. Without this continuous reinforcement, things will slip back to what they used to be, individuals will return to their comfort zones, and the integrated structure is likely to unravel. To consolidate the combined organization, the firm must truly embed the new ways of working, new processes, and possibly new values and behaviors that were defined at the onset of the integration. The objective is for management and staff to be supported for long enough in the newly established environment to consider it to be their home, the way that feels natural and comes to them spontaneously. These activities may take one or several years after reaching One Face to the Customer.

Did They Get It? Performance measurement lies at the core of good business management, and this is also true for managing communication. Managers must evaluate how the communication was perceived and understood, and whether this varied across functions, departments, and geographies. Measuring the effectiveness of communication is essential as management might be spending a lot of valuable time drafting and delivering messages to no avail. Worse still, allowing communication to be misunderstood or ignored might threaten the whole integration process and cause areas of the business to become dysfunctional. Regular “pulse-check” surveys are an absolute must. These checks provide an easy and cost-effective way of ensuring that messages are understood and seen as credible, and they highlight areas that call for more clarity. Requests for feedback also demonstrate the senior management’s willingness to listen and respond to any concerns the staff may have. However, this comes with an important proviso, which is that once the feedback has been collected and analyzed, it is imperative that any areas of concern or lack of clarity be acted on. Expect response rates to drop dramatically if staff feel that the surveys and requests for feedback merely pay lip-service to what is portrayed as a true interactive dialog between senior management and the rest of the organization.

And Who Will Do All That Work? This chapter concludes with a final word of caution for smaller or mid-size companies, in which internal communications are commonly the remit of the human resources (HR) function rather than a dedicated “comms” team.

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Under normal circumstances, entrusting employee communications to HR makes eminent sense. However, in the context of a M&A business integration, this omits the fact that HR, together with finance and information technology, are usually the three functions that face the greatest surge in activity in the early phases of the integration; all three will invariably need additional resources during the integration to deliver their plan while also coping with the requirements of day-to-day business. It would be a grave mistake to assume that internal communication can be created and delivered by an ongoing HR team without any additional dedicated resource that has the bandwidth and cross-functional understanding to seek inputs across the business from sales and marketing, finance, customer service, supply chain, R&D, manufacturing, and procurement and that can correctly address the concerns of customers, contractual parties, investors, and external stakeholders. This calls for a dedicated workstream in the integration program, one that is close to the program board so as to give it a clear view across the entirety of the integration program. In this way, communication in a M&A environment can be considered as far more than a journalistic means of reporting what is happening along the integration journey. It becomes a proactive and potentially very powerful tool that will maintain clarity and focus and be a key driver of acceptance and change.

Summary and Further Steps

• 

Anticipate the resource requirement: The workload of day-to-day management combined with the surge of activity resulting from the ongoing integration calls for additional resources to design, plan, and coordinate the delivery of communication across the business from the earliest stages of the M&A program (information memorandum) through to the closing of the M&A deal (“Day One”) and beyond, until most parts of the two organizations are integrated, to safeguard the cohesion of the business, deliver coherent messages to the market, and avoid operational disruption.

• 

Tailor the messages to each audience group, and coordinate communication across those various audiences: Whereas internal communications (directed toward management and staff) and external communications (customers, suppliers, trade) are usually handled by distinct functions in most organizations, the merger or acquisition integration journey requires coherence and time synchronization across all functions in an organization.

• 

Use multiple channels: Within any given audience, individuals will be receptive to different modes of communication. Receiving a coherent message from different channels reinforces that message.

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• 

Check the pulse: Regular monitoring of the audience’s understanding and current mood through short surveys allows the emphasis of the content of the messages to be adjusted to achieve the desired reaction in and level of clarity for each audience.

More Info Books:

Davenport, Jenny and Simon Barrow. Employee Communication During Mergers and Acquisitions Surry, UK: Gower Publishing, 2009. Hedengran Larsen, Kristian, Communication – The Key to Successful Mergers & Acquisitions?; Navigating Business Processes in the New Millennium. Saarbrücken, Germany: LAP LAMBERT, 2011.

Articles:

PwC. “M&A Communications: Communicating to engage and motivate people throughout the deal”. Deals M&A Integration Practice, April 2014. Online at: http://tinyurl.com/mbrcbm9

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Achieving Success in International Acquisitions Checklist Description

This checklist considers what steps can be taken before, during, and after the acquisition to help improve the prospect of making the deal a success.

Definition All too often, domestic acquisitions fail to deliver all of the stockholder value envisaged by management ahead of the deal. According to a 2003 survey by KPMG, 70% of M&A transactions failed to achieve the goals set by top management. Throw into the mix the further complications of international acquisitions, such as possible culture clashes and suspicions over the impact of foreign control, and the prospects of making a real success of an international acquisition would seem to diminish even further. However, there are several issues—such as the need to ensure effective communication and the importance of technology integration—which companies should consider ahead of an international deal, as together these could significantly increase the prospects for success. As with domestic acquisitions, potential acquirers should fully assess the extent of the strategic fit between the companies, considering whether the businesses could be combined in such a way as to unlock sufficient benefits as a single entity. In some cases, companies that have had a long period of successful strategic partnerships can find that their existing operational familiarity can work to their advantage in a merger or acquisition. From the employees’ perspective, experience of working in partnership with a potential acquirer may also allay some concerns over the risk of a serious culture clash. Effective communication is at least as important in international acquisitions as in domestic transactions. Such communication should extend beyond the boundaries of the companies involved to include clients, suppliers, local authorities, and governments, as well as employees and investors. Failure to communicate effectively and truthfully with any party could create suspicion over the objective of the acquisition. While cultural factors can play an important role in the success or failure of an international acquisition, conventional practicalities of day-to-day operations of the combined entities must also be given adequate consideration. For example, a survey by PricewaterhouseCoopers in 2000 found that the integration of information systems was the biggest challenge following an acquisition, with almost three in four firms reporting problems in this area.

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Advantages

• • •

International acquisitions can improve operational efficiency (for example, through economies of scale), enabling companies to compete more effectively against the backdrop of increased globalization. Acquisitions can also help a company to capitalize further on an existing competitive advantage. International acquisitions can enable the acquirer to gain access to an existing network of clients and suppliers rapidly in a new market. Establishing an effective presence in a foreign market from scratch, by means other than an acquisition, could take many years.

Disadvantages

•• •

Most acquisitions fail to deliver all the originally projected benefits. Poorly managed acquisitions can create a climate of suspicion among employees of the target company, affecting morale and productivity. Acquisitions can involve a considerable drain on management resources and can also generate high transaction costs.

Action Checklist

• • •

Take time to identify a target company that has some strategic fit with your own organization.  Consider how closely the target company should be integrated following acquisition. There is some evidence that close integration can be disadvantageous in cases where the cultural fit between companies is limited. Learn from the successes and failures of other similar cross-border acquisitions in specific industries.

Dos and Don’ts Do

• •

Take professional advice on the regulatory environment in the target market at an early stage in the process.  Ensure that all relevant information is effectively communicated to all stakeholders before and after the acquisition.

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• Don’t • • •

Utilize the experience of managers from the acquired company in the postmerger management team.  Don’t ignore the importance of cultural factors as well as operational requirements when planning an acquisition. Don’t underestimate the importance of due diligence, particularly in markets where business practices may be different from those in your domestic market. Don’t change management personnel unnecessarily, as this can be highly disruptive to existing operations.

More Info Books:

Ben Daniel, David J., Arthur H. Rosenbloom and James J. Hanks, Jr. International M&A, Joint Ventures and Beyond: Doing the Deal, Workbook. 2nd ed. Hoboken, NJ: Wiley, 2002. Child, John, David Faulkner and Robert Pitkethly. The Management of International Acquisitions. Oxford: Oxford University Press, 2001.

Articles:

Duncan, Catriona and Monia Mtar. “Determinants of international acquisition success: Lessons from FirstGroup in North America.” European Management Journal 24:6 (December 2006): 396–410. Online at: dx.doi.org/10.1016/j.emj.2006.08.002 Lynch, Richard. “International acquisition and other growth strategies: Some lessons from the food and drink industry.” Thunderbird International Business Review 48:5 September/ October 2006: 605–622. Online at: dx.doi.org/10.1002/tie.20112

Website:

International Network of M&A Partners (IMAP): www.imap.com

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Acquiring a Company Checklist Description

This checklist outlines ways to help understand the implications of a company acquisition, whether it is structured as a business or a share purchase.

Definition The acquisition of a company involves buying the company’s shares. The expression is also used when the business of a company is acquired. In legal terms, the consequences of an acquisition of shares or an acquisition of business assets are different. One of the key differences is that an acquisition of shares involves buying the underlying business of that company, with all of its assets but also its liabilities. By acquiring the business only, the assets are transferred but, in principle, the liabilities are left with the seller. There are some exceptions to this rule so it is advisable to seek specific legal, financial, and commercial advice before taking any decision. The process starts with the identification of the business to be acquired. The commercial price of the shares is linked to the value of the business of the company. Usually, negotiations will take place between the buyer and the seller, with a purchase price agreed upon. The next stage involves the investigation of the business to be acquired, a process often called due diligence. In order to reassure the seller, a confidentiality agreement should be signed to protect the seller against any leaks of sensitive companyspecific information to third parties. The process involves: a legal due diligence (undertaken by the buyer’s lawyers), which investigates the legal rights and obligations affecting the business of the company; a financial due diligence (undertaken by the buyer’s accountants), which looks at all the financial, accounting, and tax affairs of the company; and a commercial due diligence (usually undertaken by the buyer’s own team), which looks mainly at the integration and practical aspects of the business following the acquisition. These final aspects could include: the integration of key members of staff in the buyer’s operations; and the revision of commercial and insurance contracts to facilitate the planning of logistical aspects of the buyer’s operations, and to avoid any unnecessary duplication of suppliers or insurance. Following the due diligence process, the legal documentation is drafted, agreed upon, and ultimately signed. In practice, negotiations can break down as a result of the discovery of underlying liabilities that seriously devalue the business of the seller’s company. The sale and purchase agreement will incorporate certain warranties and indemnities that the

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seller will be required to give to the buyer. Warranties are factual statements regarding the state of the seller’s business affairs, while indemnities provide the buyer with rights to obtain a certain payment in specific circumstances. Warranties can also result in a payment by the seller to the buyer, but actual proof of a loss is required before any payment is due.

Advantages Advantages of a business-asset acquisition, rather than a share acquisition:

• •

An existing business can be improved by acquiring certain assets without the difficulties and costs involved in acquiring the seller’s company. The assets will be acquired at the current market value, which will give them a high base cost in terms of capital gains tax. The purchase will, therefore, attract maximum capital allowances. The seller can obtain certain reliefs against capital gains tax.

•

Overall, a less complicated and less thorough investigation is required than in a share acquisition. The latter would involve the valuation and assessment of all the existing rights and liabilities of the seller’s company, including all contractual agreements.

Disadvantages

• •

In the United Kingdom, for example, VAT is chargeable on an asset sale but not on a share sale. Stamp duty for an acquisition of shares is paid by the buyer. In the United Kingdom, Stamp Duty Reserve Tax is charged at a rate of 0.5% of the price of the shares, while for assets involving property, Stamp Duty Land Tax must be paid at up to 4% depending on the value of the property.

Action Checklist

• • •

Study carefully any business you might acquire. Obtain as much information from as many sources as you can before committing to an expensive due-diligence process. Know your market and make sure that you have analyzed the consequences for your own business of the acquisition of another business. Be prepared for a long and complicated due-diligence process, which could prove to be time consuming as well as costly.

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•

Economize by negotiating a reasonable rate with your legal and financial advisers, but remember that it is better to incur costs by conducting a thorough investigation than to accept a level of service that may fail to reveal potentially costly liabilities.

Dos and Don’ts Do

• •• Don’t ••

Involve your solicitors and accountants in the evaluation of both the risks and potential benefits of an acquisition, as well as the due-diligence process. Negotiate your rates and make a contingency plan for any cost overrun. Plan carefully the integration of the new business within your own. Don’t be attracted by a business that has not been thoroughly investigated.  Don’t overlook the importance of negotiating complex warranties and indemnities that would protect you in the event that underlying liabilities are discovered.

More Info Books:

Dewhurst, John. Buying a Company: The Keys to Successful Acquisition. London: Bloomsbury Publishing, 1997. Lajoux, Alexandra Reed. The Art of M&A Integration: A Guide to Merging Resources, Processes, and Responsibilities. New York: McGraw-Hill Professional, 2005. Rao, P. M. Mergers and Acquisitions of Companies. New Delhi, India: Deep & Deep Publications, 2002.

Article:

Rowan-Robinson, Jeremy and Norman Hutchinson. “Compensation for the compulsory acquisition of business interests: Satisfaction or sacrifice.” Journal of Property Valuation and Investment 13:1 1995: 44–65. Online at: dx.doi.org/10.1108/14635789510077287

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Acquisition Accounting Checklist Description

This checklist explores the principles of accounting for a business combination under the acquisition method of accounting.

Definition Acquisition accounting relates to the accounting procedure following the takeover of one company by another. The resulting entity is often known as a business combination. Exact standards may vary from one country to another, so it is important to obtain professional advice on the procedures relating to acquisition accounting in the country in which the business combination will be operating. In the United Kingdom, for example, the FRS 7 standard, “Fair values in acquisition accounting,” sets out the principles of accounting for a business combination under the acquisition method of accounting. In the United States, the Financial Accounting Standard Board’s statement no. 141 sets out what a reporting entity should provide in its financial reports in relation to a business combination and its effects. However, there is a process of convergence taking place across the globe, led by the International Accounting Standards Board (IASB). Its standards for business combinations, IFRS 3 and IAS 27 are increasingly recognized by governments around the world. Prior to June 2001, two accounting methods could be used when a merger or acquisition took place. They were the purchase method and the pooling of interests method. However, the purchase method is now compulsory in both the United States and the European Union, and wherever else the IFRS standard issued by the IASB is recognized. Under the purchase method, the assets and liabilities of the merged company are presented at their market values as on the date of acquisition. The acquisition must be estimated at fair value and the difference between the purchase price and the fair value should be recognized as goodwill. Under the pooling of interests method, transactions are considered as exchange of equity securities. The assets and liabilities of the two firms are combined according to their book value on the acquisition date.

Advantages

•

The increasing use of the purchase method means that it is easier to compare potential acquisition targets around the world in accountancy terms at least.

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•

Under the purchase method, a company cannot create a restructuring provision to provide for future losses or restructuring costs as a result of an acquisition. Such costs must be treated as post-acquisition costs. Consequently, it is easier to gauge the impact of restructuring costs on profits, and prevent the use of provisions to exaggerate the immediate impact of an acquisition on profits, while boosting reported profits in subsequent years.

Disadvantages

•

One of the main drawbacks of the purchase method is that it may overrate depreciation charges because the book value of assets used in accounting is generally lower than the fair value if the economy is experiencing relatively high inflation.

•

If the amount paid for a company is greater than fair market value, the difference is reflected as goodwill. Since goodwill must be written off against future earnings, the pooling of interests method is preferable to the purchase method.

Action Checklist

• •

Check which acquisition accounting standards apply in the country in which you are undertaking an acquisition. If you can use either the purchase method or the pooling of interests method take professional advice on which is the most advantageous.

Dos and Don’ts Do

• • Don’t • •

Obtain advice from legal and accounting professionals before proceeding with any acquisition. Remember that the purchase method of accounting must identify the acquirer (the entity that obtains control over the other entity). Don’t forget that under the purchase method investors are likely to disregard the impact of goodwill. Don’t forget that under the purchase method the elimination of provisions creates extra visibility and helps prevent abuses.

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More Info Books:

Lewis, Richard and David Pendrill. Advanced Financial Accounting. London: Pearson Education, 2004. Siegel, Joel G., Nick Dauber and Jae K. Shim. The Vest Pocket CPA. Hoboken, NJ: Wiley, 2005. Smith, Ian. Financial Techniques for Business Acquisitions and Disposals. 2nd ed. Hawksmere Report Series. London: Thorogood Publishing, 1998.

Articles:

Dos Santos, Marcelo B., Vihang R. Errunza and Darius P. Miller. “Does corporate international diversification destroy value? Evidence from cross-border mergers and acquisitions.” Journal of Banking and Finance 32:12 December 2008: 2716–2724. Online at: dx.doi.org/10.1016/j.jbankfin.2008.07.010 James, Kieran, Janice How and Peter Verhoeven. “Did the goodwill accounting standard impose material economic consequences on Australian acquirers?” Accounting and Finance 48:4 December 2008: 625–647. Online at: dx.doi.org/10.1111/j.1467-629X.2007.00246.x Pasiouras, Fotios, Chrysovalantis Gaganis and Constantin Zopounidis. “Regulations, supervision approaches and acquisition likelihood in the Asian banking industry.” Asia Pacific Financial Markets 15:2 June 2008: 135–154. Online at: dx.doi.org/10.1007/s10690-008-9075-z

Website:

IFRS Foundation and the International Accounting Standards Board (IASB): www.ifrs.org

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Dealing with Venture Capital Companies Checklist Description

This checklist outlines how to deal with venture capital companies.

Definition Small and growing businesses seeking to finance further development, but which cannot raise the necessary funds through a bank loan or overdraft, or by an injection of further capital from the current owner, may find that venture capitalists provide the best solution to their needs. Venture capital (VC) is the term used for unsecured funding provided by specialist firms in return for a proportion of a company’s shares. Venture capital investments are seen as relatively high risk for the lender because they are unsecured. VC funds are often used in conjunction with a management buyout or buyin, in which a management team is demonstrating its commitment to a firm’s success by investing their own money in the business. Venture capital firms consider various factors before committing funds to a business. These include the track record of the business and whether the management team has a proven record of success; for this reason, VC companies generally do not consider start-ups as suitable for investment. They will seek to determine whether the management’s plans for the business are credible. They will also try to determine whether a viable exit strategy can be achieved within a preferred timescale, usually within three to five years of making their investment. This could be executed via a trade sale, stock-market listing, refinancing by another institution, or a repurchasing of the entire capital by management. In return for their investment, VC firms make a number of demands, including the following:

• •

A high return (perhaps a compound return of 25% or more), largely generated by growth in the capital value of the business. Representation on the company’s board.

In the past, companies have approached venture capital funds to provide seed, start-up, and expansion financing, as well as management/leveraged buyout financing. However, nowadays VC companies focus almost entirely on funding businesses that have proprietary technology or knowledge. Thus they tend to favor

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businesses with a product or service that offers a unique selling point or other competitive advantage.

Advantages

• •

VC investors put money into risky or innovative businesses and projects that might otherwise have trouble obtaining funding. Apart from providing funding, a VC company takes an active role in the management of a business, to which it can bring a great deal of administrative expertise and market knowledge. It may also have valuable skills and contacts, and can assist with strategy and key decision-making.

• ••

Having invested in a project, a VC company will do all it can to ensure that it is a success. VC companies can also provide access to funding by other VC investors. Investors are often prepared to provide follow-up funding as the business grows.

Disadvantages There may be disadvantages to accepting VC investment, and the following points should be considered carefully.

• • •• •

Is the VC company acting as a lead investor? If so, are there complementary or competing companies in its portfolio? Does it have experience with similar types of investment? Will the VC company be able to come up with extra financing if it becomes necessary? What type of role does it want in the management of your business? Can your management team live up to the conditions demanded by the VC company, and does it have complementary skills?

If your firm reaches the deal-negotiation stage with a VC investor, you will have to pay legal and accounting fees, whether or not you are successful in securing funds.

Dos and Don’ts Do

Seek expert legal and financial advice when negotiating any agreement with a VC company.

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Be aware of the significant time required to complete the process. When researching venture capitalists, go for geographic and industry specializations that complement your own.

Don’t

• • •

Don’t take on venture capital unless you are sure that you can cope mentally and physically with the provider’s requirements. Don’t forget that you will lose some of your power to make management decisions. Don’t forget that there can be legal and regulatory issues to comply with when raising finance.

More Info Books:

Cardis, Joel, et al. Venture Capital: The Definitive Guide for Entrepreneurs, Investors, and Practitioners. New York: Wiley, 2001. Gladstone, David and Laura Gladstone. Venture Capital Handbook: An Entrepreneur’s Guide to Raising Venture Capital. Upper Saddle River, NJ: Prentice Hall, 2002. Hill, Brian E. and Dee Power. Inside Secrets to Venture Capital. New York: Wiley, 2001.

Article:

Iwata, Edward. “Venture capital spreads the wealth around the country.” USA Today March 11, 2008. Online at: tinyurl.com/yvj5n8

Websites:

British Venture Capital Association (BVCA): www.bvca.co.uk European Private Equity & Venture Capital Association (EVCA): www.evca.eu National Venture Capital Association (NVCA, US): www.nvca.org vFinance directory of venture capital resources and related services: www.vfinance.com

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M&A Regulations: A Global Overview Checklist Description

This checklist offers an overview of the global regulations governing mergers and acquisitions.

Definition Mergers and acquisitions (M&A) has become a mundane expression used daily in the media. In order to operate successfully in a global economy, corporations have become transnational and have to perform at a multinational level. To achieve such expansion, corporations acquire other companies or merge with them. These large corporations are publicly owned, listed on stock exchanges or alternative markets around the world, and engage in M&A activities that are thoroughly regulated by governments to protect the shareholders of target companies. The laws and regulations governing M&A are very complex and strict. High levels of expertise and specialist advice are required, and corporations use several teams of lawyers who specialize in the jurisdictions involved in M&A. In 2003, the European Parliament published a directive that regulated the way in which securities were to be offered to the public or admitted to trading. This became known as the EU Prospective Directive. Its scope was to harmonize and homogenize capital markets within the European Union. In essence, the directive allows a company that issues shares in more than one EU member state to be governed by a single member state, rather than by each member state in which the shares are offered. In the United States, federal securities laws and regulations are generally applicable if US investors own securities in a foreign target company. In the United States, the Securities and Exchange Commission is the body that supervises and oversees the most important participants in the securities world, such as securities exchanges, dealers, brokers, and mutual funds. Its most important role is to promote disclosure and transparency of market information by maintaining fair dealing and ensuring protection against fraud. In Australia, the responsibility belongs to the Australian Stock Exchange and the Australian Securities and Investments Commission, while the relevant body in the United Kingdom is the London Stock Exchange.

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In September 2006 the Regulations on Foreign Investors’ Mergers and Acquisitions of Domestic Enterprises came into force in China, as a direct result of an increase in M&A transactions and the general opening up of the country. Japan has recently eased regulation of foreign investment by introducing legislation that allows foreign-owned companies to invest in Japanese companies through stockfor-stock (share-for-share) exchanges with the Japanese subsidiaries of those companies.

Advantages

• •

M&A regulations protect shareholders and investors in the acquirer and target company. In general M&A regulations allow for the harmonization and homogenization of international markets and thus maintain transparency, fair dealing, and protection against fraud.

Disadvantages

•• •

M&A regulations are very complex. Specialist financial and legal advice is always required when participating in M&A activity. The cost of an acquisition is usually high, and specialist advice only adds to this cost.

Action Checklist

•• •

Recognize the complexity of M&A regulations. Seek specialist professional advice at an early stage when considering a possible M&A deal. Appreciate that while the costs of enlisting professional help to explore global M&A opportunities can be high, the long-term rewards from successful international deals can be considerably higher.

Dos and Don’ts Do

•

 Carefully balance the implications of a developing business against the advantages and disadvantages of acquiring an existing one before committing to any expense.

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•• Don’t •• •

Obtain relevant advice regarding the acquisition or merger. Research the market carefully before making a decision. Don’t underestimate the need for proper research and professional advice. Don’t ignore the importance of integrating the new operations within the existing business; otherwise, the consequences could be costly. Don’t be afraid to decide against the acquisition if the signs are that it will not be a good investment.

More Info Books:

McGrath, Michael. Practical M&A Execution and Integration: A Step by Step Guide To Successful Strategy, Risk and Integration Management. Chichester, UK: Wiley, 2011. Sherman, Andrew J. Mergers and Acquisitions from A to Z. 3rd ed. New York: AMACOM, 2011.

Report:

Khalili, Anita, Uvarshanie Nandram, Mariana Trindade, Pratik M. Patel, Roger Conner and Jill Lewandosky. “2012 M&A outlook.” Bloomberg, 2011. Online at: media.bloomberg.com/bb/avfile/ru20IiusvjMM

Websites:

Beyond the Deal: www.beyondthedeal.com Reuters M&A news: www.reuters.com/finance/deals/mergers

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Management Buyouts Checklist Description

This checklist outlines what constitutes a management buyout (MBO).

Definition A management buyout (MBO) is the acquisition of a business by its management. The management will usually buy the target business from its parent company. The management will incorporate a new company to buy the business or shares of the target company. The transaction usually involves another party, a venture capitalist, which, together with the management, will invest in the new company. A venture capitalist is a company or fund that invests in unquoted companies. The investment usually takes the form of an equity stake. In an MBO it is very important to establish whether the parent company, the vendor, is willing to sell. The management are usually in a very good position to buy, since they already understand the business they intend to acquire. Funding the acquisition usually requires not only the personal financial commitment of the managers, but also additional funding in the shape of a loan or an equity investment. It is essential that the management establish a coherent business plan, which will help not only in obtaining the funding required for the MBO but also in convincing the parent company that the managers are the best buyers for the business. As for investors, what they need is assurance that the business will be able to continue successfully and that it will provide them with a profitable return on their investment. In an MBO, confidentiality while negotiations are taking place between the parent company and the management team is essential. The consequences of a leak could be damaging to the business and its staff.

Advantages

•• •

An MBO will give the management the chance to run their business. The new company will have a highly motivated management team, who are not only eager to make a profit but also have a deep knowledge of the business they will be running. Since the management understand and have been involved in the running of the business to be acquired, the commercial due diligence that is usually undertaken when a company is acquired should be easier and less time-consuming.

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Disadvantages

• • •

An MBO involves a very serious financial commitment and acceptance of risk by the management. The management will move from being employees to being owners of the business. If the business is not successful, they will feel it directly. Even though the commercial due diligence required could be less extensive, the legal and financial affairs of the business still need to be examined. This will involve advice and expense. Since acquisition by an MBO is highly leveraged (i.e. has a high proportion of debt relative to equity), this does not put the new company in the best position to compete on price.

Action Checklist

• • • •

Think carefully about the business before you acquire it. Obtain as much information from as many sources as you can before committing to an expensive due-diligence process. Know your market and make sure that you have analyzed the consequences of owning your own business. Be prepared for a long and complicated due-diligence process, which could prove time-consuming as well as costly. Economize by negotiating a reasonable rate with your legal and financial advisers, but remember that it is better to incur costs by conducting a thorough investigation than to accept a level of service that may fail to reveal potentially costly liabilities.

•

Always be aware of confidentiality while the MBO is being planned, as any leak can affect the confidence of the staff and affect the performance of the business.

Dos and Don’ts Do

• •• Don’t •

Involve your lawyers and accountants in the evaluation of both the risks and potential benefits of an MBO, as well as in the due-diligence process. Negotiate your rates and make a contingency plan for any cost overrun. Draw up an accurate and achievable business plan. Don’t make the mistake of being attracted by the idea of owning a business without fully weighing up the risks you might be taking.

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• •

Don’t underestimate the importance of finance and the financial commitment that owning a business will entail. The risks to the owners of a business are high if the business does not perform. Don’t forget that many of the banks that offer finance will be looking for collateral for the loan, and the managers could be required to provide personal guarantees that will affect their personal wealth if things do not work out.

More Info Books:

Sharp, Garry. Buy Outs: A Guide for the Management Team. London: Euromoney Institutional Investor, 2002. Wright, Mike and Hans Bruining. Private Equity and Management Buy-Outs. Cheltenham, UK: Edward Elgar Publishing, 2008.

Website:

MBO Guide: www.mboguide.co.uk

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Planning the Acquisition Process Checklist Description

This checklist outlines ways to help understand what buyer must do to prepare for an acquisition of a business.

Definition After a buyer decides to acquire a business, the process starts with the search for a suitable business. The targeted business could be known to the buyer or could be a competitor of the buyer. It could also be advertised for sale in a trade journal or newspaper, or the buyer could be approached directly by the seller or its intermediary. After finding a business, the buyer must assess its value in order to establish the best offer price. If the business to be acquired is part of a company, it will have to file yearly accounts, which are of public record. Every business is affected by cash flow, profit and loss, and how its finances are run. The balance sheet and accounts will give a good indication of all these elements. A buyer should also look at: the overall market within which the targeted business operates; the business’s performance and reputation; its competitors; and any other interested buyers. Another element to look at is the legislation in the country where the business operates. The logistics of acquiring a national business and an international business can be very different. A buyer should obtain information on the management of the targeted business. If a business is well-managed, it is usually successful and well-reputed. The buyer should also consider the workforce. The buyer should consider the advantages the acquisition will have upon its own business and should start planning how it will be integrated within its own company. In order to consider the purchase more thoroughly, more detailed investigations should be made. During this process, the buyer may well like to involve advisers who will provide a more thorough and objective valuation. However, this assistance may be expensive. This investigation should give a buyer an idea of the value of the business and of the offer to make to the seller. The initial information will be verified by the later due-diligence process, which takes place with the permission and cooperation of the seller. The buyer will approach the seller either directly or via its advisers and make an offer for the business. Negotiations on the price will usually commence, with the buyer and seller subsequently signing a document called heads of term. This will deal with the main points of the acquisition, such as price, warranties to be given by the seller and other essential conditions. The buyer and its advisers will

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have to sign a confidentiality agreement, which will protect the data disclosed by the seller and will give the buyer access to more detailed information from the seller’s private records. The due-diligence process can last a few weeks, depending on the amount and complexity of the information to be investigated. The buyer will look in detail at all the business’s contracts with clients and suppliers, insurance, employees’ records, any intellectual property and IT issues, and any existent litigation. A buyer should also look at the business premises, any licenses, and environmental issues. Separately, the buyer’s accountants will investigate the financial details of the business. At the end of the due-diligence process, the buyer will usually receive a legal due-diligence report from its lawyers and a financial due-diligence report from its accountants. These, together with the buyer’s own commercial and business assessment, will provide a very clear picture of the business and will allow the buyer to decide whether the acquisition is worth making or not.

Advantages A well-informed and prepared buyer:

• • • •

Will be in a better position to decide whether the target business is worth buying in the first place. Will be able to decide on an accurate valuation of the business and make a competitive offer price. Will have a thorough understanding of the business to be sold and will, therefore, be able to conduct more advantageous negotiations. Will be better able to help in running and integration of the business once the acquisition is made.

Disadvantages

• •

Initial investigations and later due diligence could be costly, and may show that the business is not worth acquiring. An acquisition involves huge effort and a concentration of resources, which sometimes could be used to improve its own business.

Action Checklist

•

Consider carefully any business you might acquire. Obtain as much information from as many sources as you can before committing to an expensive due diligence process.

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• • •

Know your market and make sure that you have analyzed the consequences for your own business of the acquisition of another. Be prepared for a long and complicated due-diligence process taking time and being costly. Economize by negotiating a reasonable rate with your legal and financial advisers, but remember that it is better to incur costs by conducting a thorough investigation than to accept service that may fail to reveal potentially costly liabilities.

Dos and Don’ts Do

• •• Don’t • •

Involve your solicitors and accountants in the evaluation of both the risks and potential benefits of an acquisition, as well as in the due-diligence process. Negotiate your rates and make a contingency plan for any cost overrun. Plan carefully the integration of the new business within your own. Don’t make the mistake of being attracted by a business that has not been thoroughly investigated.  Don’t overlook the importance of negotiating complex warranties and indemnities that would protect you in the event that underlying liabilities are discovered.

More Info Book:

Dewhurst, John. Buying a Company: The Keys to Successful Acquisition. London: Bloomsbury Publishing, 1997.

Article:

Rowan-Robinson, Jeremy, and Norman Hutchinson. “Compensation for the compulsory acquisition of business interests: Satisfaction or sacrifice.” Journal of Property Valuation and Investment 13:1 1995: 44–65. Online at: dx.doi.org/10.1108/14635789510077287

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Planning the Disposal Process Checklist Description

This checklist outlines what a seller should be doing to prepare for the sale of a business.

Definition The preparation for the disposal process starts after the seller has decided to sell the business. There can be several reasons why someone might want to sell his business. The business could need substantial investment, and selling a percentage of shares—and, therefore, a share in the business—would bring in the necessary finance to help develop the business overall. Lifestyle factors could also be involved: a seller may want to sell the whole of their business because of a wish to retire or to do something completely different. Whatever the reason for the sale, preparing a business for disposal requires time and effort, and it can be expensive. In certain circumstances, a buyer may only be interested in the goodwill of the business sold and certain of its assets. A seller should be aware that such a sale would leave him with the rest of the business, including its liabilities. Usually, the best time to sell a business is when it is doing well, has a good set-up and is running smoothly, bringing in high profits, and has a successful financial and management record. Then a seller can fully capitalize on its success. In some cases, the buyer of a business is its own management team. This is known as a management buy-out (MBO). A seller should start preparing for the sale long in advance. He or she needs to make sure that all papers, legal documents and contracts, permits for the business, and its books are in good order. He or she should involve professional advisers, legal and financial, as early as possible. Their help and advice will be required during the disposal process, but they can also provide useful tips when preparing the business for sale. Staff knowledge of the planned sale is not necessary at this stage. Usually, managers are told because their cooperation is required when preparing the sale, but spreading the knowledge of the potential sale through the entire workforce could have a negative influence on the running of the business, as staff could begin to worry about work security. With the advice of accountants, a seller should consider any tax issues that will affect a disposal, so that the tax burden is minimized. Any buyer will be interested in a well-run business with a good grip on its credit and creditors. A seller should consider renegotiating inefficient contracts with clients and utility providers and should sort out any existent and potential litigation.

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Advantages

• • •

A well-prepared seller will be in a better position to negotiate a good price for the business. A well-prepared seller will be in a better position to assess what warranties they will be able to give to the buyer without submitting himself or herself to unexpected risk. An MBO could be more advantageous for a seller, as the managers know the business inside out.

Disadvantages

• • ••

The initial investigations and later due-diligence process could be expensive, both financially and in terms of time, if the acquisition does not go ahead. Preparing for a sale will involve huge effort and a concentration of resources, which sometimes could be used to improve the business itself. Selling is frequently emotionally difficult on a seller. In an MBO, less money is usually offered for a business, because managers may not have access to good finance.

Action Checklist

• •

Consider carefully the need to sell and why you want to sell. It may well be that the timing is not ideal and that waiting could be advantageous. Be prepared for a long and complicated due-diligence process, which could prove time-consuming as well as costly.

Dos and Don’ts Do

• •• Don’t •

Involve your solicitors and accountants in the evaluation of both the risks and potential benefits of a disposal, as well as the due-diligence process. Negotiate your rates and make a contingency plan for any cost overrun. Plan carefully the tax implications of the disposal. Don’t make the mistake of selling at the wrong time if waiting a while could bring a higher price.

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•

 Don’t overlook the importance of mitigating your liabilities under any warranties and indemnities given to the buyer, obtaining advice, and understanding your business.

More Info Books:

Smith, Ian. Financial Techniques for Business Acquisitions and Disposals. 2nd ed. Hawksmere Report Series. London: Thorogood Publishing, 1998. Steingold, Fred S. The Complete Guide to Selling a Business. 4th ed. Berkeley, CA: Nolo, 2012.

Articles:

Card, Jon. “Selling your business.” Growing Business. Online at: tinyurl.com/7ymdwhw Gole, William J. and Paul J. Hilger. “Managing corporate divestiture transactions.” Journal of Accountancy August 2008: 48–51. Online at: tinyurl.com/3keqrwy

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The Rationale for an Acquisition Checklist Description

This checklist outlines ways to help with understanding the rationale of an acquisition of a company or business.

Definition Companies and businesses are bought and sold regularly all over the world. Acquisition is a complex and expensive process that influences both the business and financial future of the buyer. Why would a person either physically or legally decide it is time to acquire a company or business? Which factors drive its decisions and define its thought process? A person with no experience of running a business may find it difficult to assess and scale the difficulties and risks of an acquisition. At the opposite extreme, an experienced business person may readily understand and be able to assess more clearly the reasons for an acquisition. It may be that the buyer wants to develop his existing interests and the acquired business will provide the key technology to help with the expansion of the overall operation. The business to be acquired may bring to the buyer the perfect supply chain, which otherwise would take time and expense to set up from scratch. It could well be that the workforce of the company to be acquired has such specialist skills and knowledge for these to be the main incentive for the acquisition, as an alternative to instigating a training programme for existing employees. Another reason could be that the brand and customers of the business to be purchased are of such value that they justify the acquisition, rather than the time and expense of the buyer building its own. Whatever the reasons for an acquisition, a buyer should consider the following practical suggestions.

Advantages

•• •• •

Any existing, successful business will already be functioning and properly set up. The workforce of the business will already be in place and well-organized. The business’s marketing and contacts will be established. Its customer base will also be well-established. Acquiring a well-developed business or company will make it easier to borrow money, because the company will already have a good business plan in place and will offer credibility to the lender.

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Disadvantages

• • •• •

The acquisition of an existing company or business could have a negative effect on the business’s reputation within the market if the acquisition is not done professionally, with due diligence and care. An acquisition can negatively influence a business’s staff, who are usually excluded from any negotiations. The cost of an acquisition is usually high and will have to be paid all at once.  Contracts with suppliers and contractors may have to be reassessed and renegotiated. Any missteps in integrating the new business can be costly.

Dos and Don’ts Do

• ••

 Carefully balance the implications of a developing business against the advantages and disadvantages of acquiring an existing one before committing to any expense. Obtain relevant advice regarding the acquisition. Research the market carefully before making a decision.

Don’t

• •• •

Don’t rush into the unknown without a proper plan. It is easier to make a good decision in a market and an area of business to which you are already accustomed. Don’t underestimate the need for proper research and professional advice. Don’t ignore the importance of integrating the new operations within the existing business, otherwise the consequences could be costly. Don’t be afraid to decide against the acquisition if the signs are that it will not be a good investment. However, make sure that no commitment to buy has been made in the relevant jurisdiction.

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More Info Books:

Dewhurst, John. Buying a Company: The Keys to Successful Acquisition. London: Bloomsbury Publishing, 1997. Miller, Edwin Mergers and Acquisitions: A Step-by-Step Legal and Practical Guide. Hoboken, NJ: Wiley, 2008. Rao, P. M. Mergers and Acquisitions of Companies. New Delhi, India: Deep & Deep Publications, 2002.

Article:

Rowan-Robinson, Jeremy, and Norman Hutchinson. “Compensation for the compulsory acquisition of business interests: Satisfaction or sacrifice.” Journal of Property Valuation and Investment 13:1 1995: 44–65. Online at: dx.doi.org/10.1108/14635789510077287

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Structuring M&A Deals and Tax Planning Checklist Description

This checklist outlines the significance of the way merger and acquisition (M&A) deals are structured in relation to potential tax liabilities.

Definition In planning for an acquisition, a decision needs to be made on whether the deal involves simply buying the target company’s shares or actually acquiring the business itself. Though the distinction may at first glance appear to be a technicality, in practice its significance can be considerable. This is because the acquisition of shares involves buying not only the underlying business of the target company, but also its assets, both tangible and intangible, and, crucially, its liabilities. In this respect, a share-based acquisition can carry higher risk for the acquirer, potentially exposing them to the risk of unforeseen skeletons in the closet. To help compensate for the higher practical risk of the share-based acquisition, buyers can demand warranties from the seller as part of the deal. However, in spite of the prospect of having to agree to these terms to help protect the buyer from unknown potential risks, there can be some financial advantages for the seller in a share-based transaction. Chiefly, US tax law dictates that, provided they have held the stock for a minimum of one year, selling stockholders need to pay tax only once on the deal. This is levied at personal capital gains tax rates on the difference between their original share-purchase price and the agreed acquisition-sale price. Although the stock transaction route can be highly advantageous from the seller’s perspective, the tax treatment of fixed assets can be disadvantageous for the buyer, who generally inherits the historically used depreciation structure. Under some specific circumstances other alternatives can apply, although the buyer nevertheless still assumes greater potential exposure to bombshells, such as pension-fund liabilities and product-related claims when making a share-based acquisition. However, this needs to be balanced against some of the pluses of a share-based deal from the buyer’s perspective. Structuring a deal on the basis of the transfer of the assets of a business permits a buyer to sidestep most unforeseen liabilities and also to benefit from much greater flexibility in writing off asset depreciation. The chief downside is that the seller can effectively be hit twice by tax, substantially reducing the benefit the seller enjoys

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after the proceeds are taxed first at the corporate level. Should the corporation then be liquidated and the proceeds shared among stockholders, these beneficiaries are then liable for tax at the personal level. Given the complexity of the issues involves, sellers should seek professional advice at an early stage when considering entering into a transaction.

Advantages

• • •

Well-structured deals can bring many pluses for both buyer and seller, allowing both parties to adjust their market exposure to reflect changes in their business objectives or personal circumstances. Stock-based transactions are frequently preferred by sellers, offering attractive tax advantages to those who have held shares for longer than one year prior to the sale.  Stock-based deals can help buyers to benefit from existing contractual arrangements.

Disadvantages

• • •

The structuring of deals and the associated negotiations are, by their very nature, complex and time-consuming, with no guarantee that a deal will ultimately result.  An asset-based deal will typically expose the seller to two levels of taxation—corporate and personal. A stock-based transaction can be unattractive to a buyer, given the tax treatment of fixed asset values.

Action Checklist

• • • •

Appreciate and understand the importance of the structure of the transactions. Aim to find a consensus over the final structure of the deal.  Seek up-to-date professional advice on taxation matters, as specific circumstances may alter the taxation implications for one or both sides. Bear in mind the importance of the after-tax numbers resulting from a proposed deal, rather than the pre-tax figure.

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•

Recognize that only with a comprehensive understanding of the taxation implications of the deal can realistic discussions take place to strike a deal that is acceptable to both sides.

Dos and Don’ts Do

• • •

Aim to maintain cordial negotiations whenever possible. Seek warranties wherever appropriate when buying, to guard against potentially crippling unforeseen surprises. Remember that sellers looking to realize the cash from the transaction at an early stage will generally be exposed to higher tax liabilities.

Don’t

• • •

Don’t skimp on the cost of professional tax advice, particularly given the substantial tax implications associated with particular deal structures. Don’t leave involving your lawyers and accountants until the last minute, as only with informed professional advice can your options be considered objectively. Don’t ignore the importance of effective communication with key stakeholders during the planning process.

More Info Articles:

Ayers, Benjamin C., Craig E. Lefanowicz and John R. Robinson. “The effect of shareholderlevel capital gains taxes on acquisition structure.” Accounting Review 79:4 October 2004: 859–887. Online at: www.jstor.org/stable/4093079 Erickson, Merle. “The effect of taxes on the structure of corporate acquisitions.” Journal of Accounting Research 36:2 Autumn 1998: 279–298. Online at: www.jstor.org/stable/2491478

Website:

International Network of M&A Partners (IMAP): www.imap.com

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Understanding Anti-Takeover Strategies Checklist Description

This checklist outlines the use of anti-takeover strategies.

Definition Anti-takeover strategies come in a number of different guises. Terms such as “shark repellent” and “poison pill” are used to describe the defensive methods or tactics that companies use to attempt to prevent mergers, that is, the joining of two or more businesses into one, or hostile takeovers, when a business is acquired against the management’s or shareholders’ wishes. Anti-takeover strategies are designed to make a company unattractive to predators. They do this in the following ways:

•

A shareholder-rights plan or poison pill, has two different strategies. The “flip-in” allows existing shareholders to purchase more shares at a discount in order to dilute the value of the shares, while the “flip-over” allows shareholders to purchase the bidder’s shares at a discount.

• • • • •

A provision in the company’s charter or articles allows shareholders to sell their shares to the bidder for more than the market price. A company takes on sufficient debts to make it unattractive, as a bidder would be responsible for those debts. The business issues bonds that have to be redeemed at a higher price if the company is taken over. The company offers its employees stock options, high bonuses, and exceptional severance pay that would cost a bidder dearly. Staggered elections to the board of directors over a period of years can mean that a potential bidder is faced with a hostile board of directors until new elections can be held.

In some jurisdictions, such as the United Kingdom, anti-takeover strategies are illegal, or some control on their use is mandated. However, in the United States, where they are legal, the recent economic decline and fear of becoming an acquisition target have renewed interest in anti-takeover strategies in all their forms.

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Advantages

• • •

Anti-takeover strategies are useful when a company feels that its stock has become undervalued and that it may become the target for a takeover. Anti-takeover strategies are useful when the predator company’s intentions are to acquire the company and then load the company with so much debt that it is unviable. Short-term poison pills may help businesses through difficult financial periods when they could be vulnerable as targets.

Disadvantages

• •

Anti-takeover strategies are sometimes used to entrench management and prevent shareholders from selling their stock and maximizing its price. Board members sometimes hide behind poison pills to retain their positions.

Action Checklist

• • • •

 Check that the use of anti-takeover strategies is legal in the country or jurisdiction in which the company is operating.  Determine which method would provide the greatest protection without hurting the company’s value. Avoid tying the company to stock options, high bonuses, and exceptional severance pay for employees whom you might later want to fire. If you are taking on debts or issuing bonds to make the company unattractive, make sure that you can service those debts, even if the economy turns down.

Dos and Don’ts Do

•

Consult with partners, directors, lawyers and accountants before initiating anti-takeover strategies.

Don’t

•

Don’t use anti-takeover strategies unless you are sure that they won’t backfire and leave the company vulnerable.

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More Info Books:

Frank, Werner L. Corporate War: Poison Pills and Golden Parachutes. Charleston, SC: CreateSpace, 2011. MacIntosh, Julie. Dethroning the King: The Hostile Takeover of Anheuser-Busch, an American Icon. Hoboken, NJ: Wiley, 2010. Ricardo-Campbell, Rita. Resisting Hostile Takeovers: The Case of Gillette. Westport, CT: Praeger, 1997.

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Using IRR for M&A Financing Checklist Description

This checklist considers the strengths and weaknesses of using the internal rate of return as a yardstick when financing mergers and acquisitions.

Definition Also known as the economic rate of return, the internal rate of return (IRR) is an indication of the level of growth that can be expected from a project or acquisition. The calculation generates a percentage figure by comparing the value of the proposal’s cash outflows with its cash inflows as they vary over the lifetime of the investment. IRR is frequently used to help assess the outright viability of a project or acquisition by taking into account the cost of capital or the investor’s required rate of return. The latter is sometimes referred to as the hurdle rate and is frequently adjusted to take into account the risk levels of different projects. Acquisitions that are expected to generate returns greater than the cost of capital or the required rate of return are generally accepted, with those falling short typically rejected. IRR is also regularly employed as a means of comparing the expected returns from a number of alternative options, helping to steer investment toward the venture that offers the prospect of the highest returns. In practice, the returns from projects or acquisitions can differ substantially from the levels predicted by the IRR calculation, but the method has retained favor among many potential investors looking for a tool to help to decide between alternative investment options.

Advantages

•

IRR generates a relatively simple percentage figure for a project. The method provides a quick and easy way to assess the viability of a project by comparing the projected IRR with the company’s risk-adjusted hurdle rate. IRRs can also help investors to select between various options.

•

The practical value of the IRR calculation is further underlined by the fact that the calculation takes into account all cash flows, subject to discounting for time.

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Disadvantages

•

The IRR method does not take into account possible changes in interest rates during the lifespan of the venture. Such changes could significantly alter a company’s required hurdle rate, given the potential impact on the firm’s cost of capital. For short-term projects, this limitation can often be overlooked, but the large scope for movements in interest rates over the lifespan of a 10-year project is considerable, compromising the value of the IRR for longer-term projects.

• •

IRR can sometimes be confused with return on capital employed, as both calculations express results in percentage terms. Care needs to be taken to differentiate between these cash-based and profit-based methods. The IRR calculation is based on a presumption that cash generated during the project is subsequently put to work to generate the same return as the average IRR over the lifetime of the project. Although this reinvestment is entirely feasible, in practice reinvested cash often generates lower subsequent returns.

Action Checklist

• •

To calculate the IRR, we need to establish the various parameters at which the net present value (NPV) of a proposed M&A deal is zero (i.e. the exact level at which the proposed venture is neither a winner or a loser in dollar terms).  Typically, this involves guessing a projected rate of return, r, from the investment, and then performing the following calculation:

NPV = (Initial investment + 1st year’s income) ÷ (1 + r)2 + 2nd year’s income ÷ (1 + r)2 + 3rd year’s income ÷ (1 + r)3+ …

• •

Should the resulting NPV figure be positive, the calculation is then repeated using a lower value of r. If the NPV is negative, a larger r is used. Clearly, the operation is more efficiently performed using a computer spreadsheet than by hand. After repeated calculations, a level of r that generates a NPV of zero will be established. This equates to the projected IRR of the deal.

Dos and Don’ts Do

•

Consider the possibility that any merger or acquisition could involve risks that are difficult or impossible to foresee. To help to compensate for such

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•

uncertainties, consider how much of a premium a project’s IRR should have over the cost of funding.

Remember that the IRR methodology can accommodate variations in projected annual incomes from proposed deals, but it does not offer the facility to model changes in funding costs throughout the lifespan of the deal. This can be a major drawback for longer-term project calculations.

Don’t

• •

Don’t interpret IRR as the be all and end all of project financing. Recognize its uses, but at the same time understand its limitations. Don’t ignore the costs and expenses involved in the acquisition process. Care should be taken to evaluate the costs in terms of management time and resources, as well as in purely financial terms.

More Info Books:

Reed, Stanley F., Alexandra R. Lajoux and H. Peter Nesvold. The Art of M&A: A Merger Acquisition Buyout Guide. 4th ed. New York: McGraw-Hill, 2007. Siegel, Joel G., and Jae K. Shim. Accounting Handbook. 5th ed. Hauppauge, NY: Barron’s Educational Series, 2010.

Articles:

Hartman, Joseph C. and Ingrid C. Schafrick. “The relevant internal rate of return.” Engineering Economist 49:2 2004: 139–158. Online at: dx.doi.org/10.1080/00137910490453419 Steele, Anthony. “A note on estimating the internal rate of return from published financial statements.” Journal of Business Finance and Accounting 13:1 March 1986: 1–13. Online at: dx.doi.org/10.1111/j.1468-5957.1986.tb01169.x

Websites:

Alliance of Merger & Acquisition Advisers (AMAA): www.amaaonline.org M&A Source, organization of middle-market intermediaries: www.masource.org

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Using the Comparable Net Worth Method in Squeeze Outs Checklist Description

This checklist examines the appropriateness of this commonly employed valuation mechanism for the purchase of shares from remaining minority holders during an acquisition.

Definition During the acquisition of a company listed on the stock exchange, a purchaser will frequently manage to acquire a large majority stake as other investors—attracted by the terms of the takeover offer—sell their shares to the acquiring company at the offered terms. However, should a sufficiently small minority of shareholders reject the terms of the acquisition, a squeeze out is a possible route for the purchaser to force a compulsory share buyback from the minority holders, ahead of the company’s delisting from one or more stock markets. This only becomes an option if the minority shareholders account for only a small proportion of the company’s outstanding capital. Under such circumstances, relations between the controlling and the minority shareholders can often be strained, due to widely differing views on the true value of the shares or, occasionally, some investors’ fundamental reluctance to sell their holding for a variety of reasons. In such cases, should the controlling shareholder decide to try to acquire all remaining shares, the comparable net worth method is often employed to put an appropriate value on the minority shareholders’ interests through a comparison of the target company’s assets minus liabilities with adjusted equivalent figures for a selection of similar companies. Though this method is only one of several options to help arrive at a valuation, it has found some favor in the United States, becoming one of the officially approved valuation methods in Pennsylvania following a long legal process.

Advantages

•

The primary advantage is that this method uses information that is already public, thus respecting the typical requirements of controlling purchasers that potentially sensitive information such as sales projections are not put into the public domain.

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•

The method can be advantageous to the minority shareholders, in that the resulting valuation can sometimes exceed the figure generated by other valuation methods.

Disadvantages

• • •

The method does not produce a definitive valuation, so the result is often subject to dispute. Even the choice of companies forming the comparison group can be contentious.  The analysis of comparable companies’ accounts can be very complex, particularly in terms of the adjustments made according to differing treatments of inventories and receivables across the comparison group. From the controlling shareholders’ perspective, the valuation resulting from this method (which is often appreciably higher than the figure generated by alternative techniques) can represent a high price to be paid in return for the retention of sensitive information ahead of the squeeze out. However, this higher price can sometimes underline the fundamental value that the acquirer was seeking to unlock with the original takeover move.

Action Checklist

•

To make use of the comparable net worth method, first select between five and 10 similar listed companies to form the comparison group. To help address disputes over the choice of companies, an independent third party could be chosen to decide on the composition of the comparison group.

•

Study their accounts in minute detail, making all necessary adjustments in an effort to improve comparability with the target company. In practice, most adjustments are made in areas such as cash and inventories, while other adjustments should be made to take account of cash surpluses or deficits. The adjustment process is best carried out by an independent third party to help address possible disagreements over the methods employed.

•

The result of this adjustment process is a range of comparable net worth numbers that can be weighed against the companies’ prevailing stock prices to help in the relative-value calculation.

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Dos and Don’ts Do

•

Remember that the comparable net worth method is one of more than a dozen widely recognized methods of valuing companies—albeit a commonly used valuation tool—when a controlling shareholder wishes to move toward a possible delisting.

•

Attempt to find truly comparable companies to form the comparison group. Ideally, the selected companies will be similar to the target company in accounting terms, thereby keeping potentially contentious adjustments to a minimum. In practice, however, closely comparable companies can be very difficult to find.

Don’t

• •

Don’t expect all interested parties to concur with the results of the comparable net worth method. As ever, the valuation is likely to be the subject of ongoing discussions. Don’t ignore the potential value of discounted cash flow methods. A timediscounted snapshot of future earnings projections, subject to risk adjustments where appropriate, can provide a useful assessment of a company’s value. Similarly, the average rate of return and payback methods can be useful starting points for discussion, although the comparable net worth method remains a key valuation tool to squeeze out unwanted minority shareholders.

More Info Article:

Bates, Thomas W., Michael L. Lemmon and James S. Linck “Shareholder wealth effects and bid negotiation in freeze-out deals: Are minority shareholders left out in the cold?” Journal of Financial Economics 81:3 September 2006: 681–708. Online at: dx.doi.org/10.1016/j.jfineco.2005.07.009

Websites:

Alliance of Merger & Acquisition Advisers (AMAA): www.amaaonline.org M&A Source, organization of middle-market intermediaries: www.masource.org

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Using the Market-Value Method for Acquisitions Checklist Description

This checklist examines the market-value method of valuing a company for acquisition purposes and considers the pros and cons of adopting this approach.

Definition The capitalization of a publicly traded company is calculated simply by multiplying the market price per share by the number of shares in issue. For the purposes of valuing a potential acquisition, however, the basic market-value method involves the study of a range of related companies, ideally at a similar stage in the growth cycle and in the same industry or sector, to determine a range of price-to-earnings (P/E) ratios for comparable companies. The resulting lowest and highest of these P/E ratios can subsequently be used to establish a base valuation band for the target company. Alternatively, an average P/E for the group could be used to calculate a central valuation. This base-valuation method assumes that the prevailing market prices across the group of comparable companies fully reflect all available information relating to their businesses and prospects, as the “efficient” market has already priced in all relevant valuation information. In almost all acquisitions, the valuation will then need to be upwardly adjusted to reflect an appropriate acquisition premium. The level of this premium typically depends on transaction ratings, which are researched based on factors such as the P/Es that are eventually paid for comparable deals, frequently adjusted to reflect present market conditions.

Advantages

•

 The market-value method is widely recognized, and was adopted as the industry-standard method of valuing companies ahead of acquisitions. Although other approaches have found favor more recently, the market-value method remains a standard valuation tool for the due-diligence processes undertaken ahead of acquisitions.

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•

The method provides a fundamentally sound basis for company valuation as long as a number of truly comparable companies can be identified.

Disadvantages

• •

Because of its reliance on prevailing market prices, the method is applicable only to publicly traded companies. Alternative valuation tools must be employed to establish the values of private companies. While P/E ratios are relatively easy to establish for actively traded large-cap stocks, smaller, less-liquid stocks may attract infrequent share transactions. For example microcap stocks traded on junior or fledgling markets may experience sparse trading activity at times, making P/E ratios more difficult to assess.

•

Disputes can arise over which companies should be included in the comparables category for calculating P/Es. Because of the lack of hard and fast rules, a prospective buyer could lean towards comparables with lower P/Es, while a more optimistic seller might prefer to include related companies with more demanding P/E multiples.

•

The appropriate level for an acquisition premium can be difficult to determine. Proposed acquisition valuations often need to be revised upwards to improve the chances of success of a deal.

Action Checklist

•

Before relying on the market-value method, you need to be satisfied that the underlying market is truly efficient. Be aware that some scope exists, particularly among less-liquid, sparsely traded, smaller companies for unscrupulous manipulation of market prices ahead of an acquisition.

• •

Consider the potential benefits of using a range of P/Es across comparable companies to give a wider valuation band. Research the acquisition premiums paid in comparable acquisitions, making adjustments for changes to the operating environment.

Dos and Don’ts Do

•

Make every effort to achieve a non-contentious valuation using reasonable comparisons with other companies in the industry.

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• •

Pay close attention to the risk of potential accounting differences between comparable companies, as these could have significant impacts on the resulting average P/E ratios. Be prepared to revise the proposed acquisition price, depending on stakeholder reaction. In many cases, an improved valuation can have a significantly higher prospect of securing the acquisition.

Don’t

•

Don’t blindly attempt to use P/E ratios from large-cap companies when seeking to apply the market-value method to smaller companies. Large differences in ratios frequently occur across the capitalization spectrum and can lead to major valuation errors.

•

Don’t overlook other means of valuing target companies. Although the marketvalue method was traditionally the industry standard, discounted cash flow techniques have increasingly found favor in recent years, to the extent that they have now largely displaced the market-value approach in all but due-diligence processes.

More Info Books:

Hitchner, James R. Financial Valuations: Applications and Models. 3rd ed. Hoboken, NJ: Wiley, 2011. Reed, Stanley Foster, Alexandra Lajoux and H. Peter Nesvold. The Art of M&A: A Merger Acquisition Buyout Guide. 4th ed. New York: McGraw-Hill, 2007.

Article:

Weaver, Samuel C., Robert S. Harris, Daniel W. Bielinski and Kenneth F. MacKenzie. “Merger and acquisition valuation: Panel discussion.” Financial Management 20:2 Summer 1991: 85–96. Online at: www.jstor.org/stable/3665732

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Acquisitions, Takeovers, and Mergers Acquisition: Strategy and Implementation Nancy Hubbard 2nd Edition Basingstoke, UK: Palgrave, 2001 320pp, ISBN: 978-0-333-94548-3 The process of acquisition is explored through an in-depth look at its key stages: pre-acquisition planning, communication during the deal, and implementation. The book also gives an overview of the history of acquisitions, global trends, and the reasons for success and failure. Case studies demonstrate different approaches and degrees of success. The new edition includes a chapter on new technology and e-commerce acquisitions.

After the Merger: The Authoritative Guide to Integration Success Price Pritchett, Donald Robinson, Russell Clarkson 2nd Edition New York: McGraw-Hill, 1997 158pp, ISBN: 978-0-7863-1239-9 This book features the six main errors that managers regularly make regarding mergers, and shows how to avoid them. It also presents best practices for handling the four major categories of a merger, ways to handle cultural problems that can destroy mergers, and offers separate checklists for executives on both sides of the deal.

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Barbarians at the Gate: The Fall of RJR Nabisco Bryan Burrough, John Helyar Revised Edition HarperBusiness New York: HarperBusiness, 2009 624pp, ISBN: 978-0-06-165555-5 Now hailed as a classic, this is an expose of the largest-ever leveraged buyout, of RJR Nabisco by private equity group Kohlberg Kravis Roberts. Also made into a film, its portrayal of oversized egos and greed seemed to sum up an era, and contributed greatly to the negative image of private equity in the 1980s.

Capitalize on Merger Chaos: Six Ways to Profit from Your Competitors’ Consolidation and Your Own Thomas M. Grubb, Robert B. Lamb New York: Free Press, 2001 224pp, ISBN: 978-0-684-86777-9 The authors suggest that, although merger mania was at an all-time high when they wrote this book, up to 80% of mergers fail because of culture clashes, mismanagement, and the chaos that ensues. They examine the growth and profit opportunities that can arise from competitors’ merger chaos, and identify strategies which managers can adopt to exploit them. They further illustrate their argument by considering the winning strategies devised by companies such as AOL, General Electric, Dell, and Vodafone, and the failures at Coca-Cola, Boeing, and Compaq.

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Complete Guide to Mergers & Acquisitions: Process Tools to Support M&A Integration at Every Level Timothy J. Galpin, Mark Herndon 2nd Edition Jossey-Bass Business and Management Series San Francisco, California: Jossey-Bass, 2007 336pp, ISBN: 978-0-7879-9460-0 The authors present an updated and expanded guide to the process of planning and managing the M&A process. The revised edition not only updates case studies and presents recent integration research, but it also adds new tools. The authors draw from their experience with numerous Fortune 500 companies; this resource will help organizations attain deal synergies more quickly and effectively. The book addresses dos and don’ts, people dynamics, common mistakes, communication strategies, and specific actions taken to create positive results throughout the integration process.

Due Diligence: Definitive Steps to Successful Business Combinations Denzil Rankine, Graham Stedman, Mark Bomer Harlow, UK: FT Prentice Hall, 2003 256pp, ISBN: 978-0-273-66101-6 Due diligence is a key part of the (often fraught) acquisitions process in business. Done properly, it means that potential risks are reduced and chances of success increased. This book is a useful guide to the process and offers advice, cases studies, and analysis.

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HR Know-How in Mergers and Acquisitions Sue Cartwright, Cary L. Cooper Developing Practice Series London: Chartered Institute of Personnel and Development, 2000 128pp, ISBN: 978-0-85292-634-5 The authors offer guidance on the human factors involved in mergers and acquisitions. The topics they cover include: influencing the decision to merge; establishing effective communication; handling job insecurity; pay and benefits; downsizing, early retirement, and relocation; support systems and counseling; creating a new corporate culture; and establishing new roles and training. Case studies are included.

Harvard Business Review on Mergers & Acquisitions Harvard Business School Press Boston, Massachusetts: Harvard Business School Press, 2001 224pp, ISBN: 978-1-57851-555-4 This book examines current various mergers, buyouts, and joint ventures, and provides guidance on what companies should take part. From valuation to integration, it helps managers understand the importance of each strategic move for their organization.

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Intelligent M&A: Navigating the Mergers and Acquisitions Minefield Scott Moeller, Chris Brady Chichester, UK: Wiley, 2007 328pp, ISBN: 978-0-470-05812-1 Mergers and acquisitions are essential for growing companies but most fail to reach their target. This book examines the full cycle of a merger or an acquisition, identifying areas where business intelligence can result in the attainment of a specific target. It discusses techniques developed by governmental intelligence services, and includes a wide range of case studies, quotations, and anecdotes.

International Business Acquisitions: Major Legal Issues and Due Diligence Michael Whalley, Franz-Jorg Semler (editors) 3rd Edition Alphen aan den Rijn, The Netherlands: Kluwer Law International, 2007 568pp, ISBN: 978-90-411-2483-8 This book examines aspects of international acquisitions, including accessing foreign markets, providing foreign production or marketing capacity, obtaining regulatory approvals, acquiring complementary product or service lines, and spreading product, service, and market risk. It also provides useful information on the key legal issues and the process of gaining informed due diligence in each jurisdiction.

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270 The M&A Collection

Mergers and Acquisitions in a Nutshell Dale A. Oesterle 2nd Edition St Paul, Minnesota: Thomson West, 2006 313pp, ISBN: 978-0-314-15956-4 This accessible reference provides a brief description of the law on mergers and acquisitions for students and lawyers who need a reliable guide.

Mergers and Acquisitions: Business Strategies for Accountants William J. Gole, Joseph Morris 3rd Edition Hoboken, New Jersey: Wiley, 2007 416pp, ISBN: 978-0-470-04242-7 This book provides a step-by-step guide to reviewing an acquisition candidate, setting up and implementing computer ‘system’ transactions for the business combination, tax compilation, and regulatory considerations. It also features practical procedures and useful examples of application.

Reducing the M&A Risks: The Role of IT in Mergers and Acquisitions Frank Vielba, Carol Vielba Basingstoke, UK: Palgrave Macmillan, 2006 216pp, ISBN: 978-1-4039-4678-2 The lack of adequate and timely IT involvement in the merger and acquisition process costs companies millions of dollars every year. Current research shows that IT accounts for a growing percentage of the post-acquisition benefits in a merger or acquisition. This book provides analysis of some of the key approaches by IT managers to reducing risk within the M&A process.

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The Art of M&A Integration: A Guide to Merging Resources, Processes, and Responsibilities Alexandra Reed Lajoux 2nd Edition New York: McGraw-Hill, 2005 450pp, ISBN: 978-0-07-144810-9 The Art of M&A Integration provides readers with updated facts on integration of compensation plans, new FASB and GAAP accounting rules, strategies for merging IT systems and processes, and more. This book is a comprehensive guide to post-merger integration, covering the following areas: planning and communications; integration of resources; processes and management systems; technology and innovation; and commitments to customer suppliers, shareholders, and employees.

The Morning After: Making Corporate Mergers Work After the Deal Is Sealed Stephen J. Wall, Shannon Rye Wall Cambridge, Massachusetts: Perseus Books Group, 2000 288pp, ISBN: 978-0-7382-0523-6 This book deals with merger management. It offers insights for recognizing when a merger is in danger, and advice on issues such as communicating effectively with stakeholders. It includes several case studies.

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