UK: Merger and Acquisition Strategies - Adding Value and Reducing Risk

© Rossmore Group

This paper will explore some of the key practical issues encountered in developing and implementing merger and acquisition (M&A) strategies. The critical success factors and how failure can be avoided will be examined.

In terms of achieving intended increases in shareholder value, the M&A track record is poor; a fact repeatedly highlighted by research. Key determinants of success in realising value include:

• Achieving sufficient M&A process cohesion avoiding fragmentation and multiple hand-off
• Using a structured targeting process a purely top-down focus may fail, especially in international situations, to take account of local knowledge, cultural issues and the need for ownership by local operating management
• Getting the mix of specialist due diligence right in order to understand the situation-specific operational value drivers, value potential, constraints, and risks
• Applying early a holistic perspective to integration planning and implementation that addresses both technical and people issues.

Companies are driven by shareholders (and indirectly by other investors such as banks) to increase shareholder value. The holders of an organisations equity capital seek a return to compensate them for the relatively high risks that they are taking with their money. All being well, this desired return would take the form of some combination of two components - dividends received and capital growth.

To corporately combine with another company offers a route to rapid growth. This growth will be immediately evident on the top line (sales/revenues) of the combined business, however growth in the joint bottom line (the profit available to shareholders), and thus shareholder value, can be much more illusory. Nevertheless mergers and acquisitions remain, in varying degrees over time, a very popular way of achieving growth. The principal reason being that the alternative route is the much slower, and often also perilous, organic growth.

There has been much research into the success/failure rate of M&As over many years, the results of which are not encouraging. There are of course practical limitations upon how accurate the research findings can be and the extent to which smaller deals, which may be below the line of sight in the work, are successful. Even so it is difficult to avoid the conclusion that mergers and acquisitions are inherently risky. However, in the world of investment, risk and reward are inextricably linked and the good news is that whilst always a difficult and imperfect area, there is much that can be done operationally to maximise value and minimise risk resulting from corporate transactions.

This introductory paper assumes little M&A experience and sets out to explore key critical success factors and pitfalls to help the reader enter the fray with eyes open and equipped to improve the general M&A track record. The intention is to provide a practical guide to adding shareholder value through mergers and acquisitions, rather than to create an academic treatise. After exploring some background and strategic context, the subject matter is broken down into four key areas - M&A process cohesion, targeting, due diligence, and integration planning. The depth of exploration is inevitably constrained by the time allocated to the topic and the required length of the paper. Working definitions (rather than full technical descriptions) of the terms shown in Italics are provided at the end.

In reality corporate combinations, whether described technically as a merger or an acquisition, are usually acquisitions in as much that one of the parties/cultures is eventually dominant. For brevity, and recognising this reality, the word acquisition is used throughout this paper as shorthand for either scenario. The abbreviation M&A and the terms corporate transaction¦ and corporate/business combination are also used interchangeably with the same interpretation.

Shareholder value analysis is explored briefly here in order to more fully answer the question "Why do companies merge and acquire?"

The term shareholder value is of course the current mantra in corporate performance measurement. However it is also, when appropriately applied, a very useful and practical conceptual framework for understanding and monitoring how value is, or is not, being added by a business enterprise. It is also quite often used for motivating management and incentivising them accordingly. Shareholder value analysis may be defined as:

"An approach to financial management which focuses on the creation of economic value for shareholders, as measured by share price performance and flow of dividends."

There are various interpretations of shareholder value analysis into techniques for measuring and managing corporate performance. These variants do not concern us here, however the Value Maximising Framework in Figure 1 offers a pictorial and straightforward model for understanding the main operational drivers of, and constraints upon, increasing shareholder value in practice.

Among other things, this interpretation removes various technical complications encountered in the application of shareholder value analysis. (Such as, for example, arriving at a share price for a company without a quotation on a public stock exchange, and adjusting relatively readily available accounting profit to be more meaningful in the context.) The model also serves to help explore the M&A rationale.

The basic premise here is that no shareholder value will be added until such time as the cash thrown off by the business (after all operating costs, charges and investments have been met) exceeds the cost of the finance being used to fund it. The high-level operational value drivers shown are the main factors that serve to drive the free cash flow up above the cost of capital and the high-level constraints indicated will tend to prevent this highly desirable outcome.

The combined effect of the drivers and constraints is to hold the free cash flow of the enterprise in a sub-optimal balance. Once improvement activity in the business has optimised the free cash flow to the extent that is practically possible in the circumstances, the company will have to look elsewhere to satisfy the appetite of shareholders for ever greater returns on their investment. Acquisitions are, arguably, the only way to achieve rapid (and potentially profitable) growth.

Viewing the M&A process holistically at the outset (as it applies in the particular circumstances, rather than formulaically) is the first way to avoid many of the difficulties encountered downstream in business combinations. In practice, the process tends to be dealt with as if it were a sequential and fragmented exercise, rather than a parallel and cohesive one. There tend to be multiple hand-offs between different advisors, who can sometimes exacerbate the problem, and the variously skilled managers involved along the process steps. The problems stored up along the way tend to manifest at the later stages, by which time their impact is greater and often much more difficult to deal with.

Figure 2 contrasts the two perspectives on the M&A process.

The planning and integration of acquisitions involves a complex mix of technical and people issues. This should be recognised early on so that a holistic view is taken from the very beginning of the exercise, the appropriate resources are brought to bear, and sufficient team continuity and people involvement are provided for.

Importantly, learning and capturing (organisationally) the lessons from each experience must be part of the process. Even groups of companies that become serial acquirers (usually over a considerable period of time) and private equity houses (who back acquisitions for a living - via later growth-stage management buy-outs, buy-ins, etc.) admit that their track record could still be much better. Hegel¡'s observations about leaning from history may well also apply, at least in part, to companies and the world of corporate combinations:

All stages of the acquisition process tend to suffer from the application of an evolved formulaic approach that has not necessarily been adapted well to take account of specific circumstances. Targeting is certainly no exception to this tendency - for example applying an approach that has worked successfully in the UK may not be nearly so effective in international / multinational circumstances. Indeed if local knowledge, level of national economic maturity, and culture (national as well as organisational) are not adequately taken into account, the consequences can be severe.

One of the keys to getting the approach to targeting right is to develop a sound set of strategic parameters that are owned, through appropriate involvement, by the right people given the specific circumstances. Ranked strategic parameters and, importantly, the process of developing them will answer or start to answer certain vital questions. Using Rudyard Kipling¡¦s six honest serving men: What do we want? - Why do we want it/them?When do we want it? - How will we acquire and integrate it? Where will it be? Who do we need to involve? While these questions seem obvious enough, they are often not asked or answered, if at all, early enough or collectively by the right people.

As a starting point in developing and prioritising specific strategic parameters, the desired growth and financial outcomes for any merger or acquisition should be fully explored. To further stimulate the development process, other classic justifications for national and international business combinations are, at a high level:

• Increase portfolio balance related core skills (family) or unrelated financially driven (conglomerate)
• Build on common technology or know-how share resources in technology, equipment, product markets, distribution channels economies of scale
• Increase market share - by acquiring a competitor
• Capture a particular customer(s) by acquiring its supplier
• Enter a new market platform for buy and build
• Move up, down, or across the supply chain.

Often a purely high-level identification approach to targeting is taken. However, in many situations there is great benefit in complementing this with a tailored, structured, facilitated process that includes the development and utilisation of ranked strategic parameters. The principal benefits of such a process being that the acquisition pipeline is filled with desired targets, omissions and gaps in understanding are avoided, and integration/improvement issues are understood early-on and owned by the right people.

This is usually a top-down approach to targeting, involving a close group of senior managers and their advisors. The industry's demand and supply evolution, in conjunction with the acquiring company's position in it, is analysed. High level strategic objectives and parameters are explored and a value creation/synergy plan created for ideas that emerge. Advisors are usually briefed to carry out a desk-research analysis and use databases/networking to opportunistically target companies for acquisition. A professional M&A transaction typically ensues, with varying degrees of involvement of the operating management who will eventually be charged with the integration of the resultant acquisition(s).

This approach to targeting is less common and accommodates the identification process well but is also designed to fill the gaps in understanding that can appear when using a top-down approach. These gaps are usually around the stage of technology/market development, the interplay between corporate and operations strategy, and the involvement of people who have detailed local knowledge and will be charged with making the business combination work in practice.

The example targeting process guide in Figure 3 illustrates the structured facilitated process concept.

Factors that will determine the approach taken to targeting include:

• The number and scale of acquisitions to be made
• Whether the acquisitions are strategic or tactical in nature
• Whether the acquisition will be national or international/multinational
• The degree of confidentiality/ease of deduction of the acquirer's intentions
• The degree of integration that is appropriate.

Due diligence may be defined as the process of investigating and understanding the asset to be acquired. Basically this is the opportunity to build on the earlier research, that should have been done, with the objective of developing a detailed understanding of what you are actually buying.

Again this area tends to be approached in a formulaic manner. The most common types of specialist due diligence carried out in practice are legal, financial and commercial/market. What is actually included is brief-specific and varies from acquirer to acquirer as well as from deal to deal. Important as these areas clearly are, usually they do not surface the situation-specific operational value drivers and risks that exist in the target/combination. The implication of this being that the business is not always understood at the operational level, nor are integration / improvement issues and risk mitigation possibilities identified in all cases.

There are of course practical limitations to executing due diligence, such as the degree of access and time available in what may well be a competitive bid situation. However this makes it all the more important that the right work is done at this stage, and earlier, on understanding just what you are buying. Some common issues that arise post acquisition that should have been understood earlier are around the following areas:

• Linkage of the operations strategy to the business plan
• Operational capability, condition and state of development
• Likelihood of successful plan implementation
• Improvement and rationalisation potential
• People and technical barriers.

One of the keys to success in this area is to rapidly scope the mix of due diligence that will be most effective in the particular circumstances. In practice this usually has to be done under considerable time pressure and in appropriate depth depending on whether the exercise is being carried out pre and/or post exclusivity. This becomes much easier to do if the earlier stages of the acquisition process have been executed well.

The Value Maximising Framework graphic in Figure 1 above serves well as a high-level checklist for getting the mix of due diligence right.

The approach taken to integration will depend on a number of factors. Such as the nature and complexity of the business, the number of countries and sites involved, the degree of compatibility of the organisations, the business plans and corporate intentions, and whether the combination is seen as a merger or an acquisition. Depending on the specific situation, of course, a formulaic approach to integration planning is unlikely to be inappropriate.

Working with both corporate acquirers and private equity houses provides an interesting perspective on the M&A process. A key to getting the integration/improvement plan right is to take a holistic and tailored approach to the exercise and involve the right people at the right time. The approach taken should focus on:

• Getting the best out of the combined operations
• Maximising value and mitigating risk
• Surfacing issues before they become problems
• Improvement and rationalisation potential
• People and technical barriers.

Listed below are the aspects of the plan that will need to be considered in a large and complex integration. The list can also be used to help ensure comprehensiveness in smaller and less complicated cases.

The first 100 days of the business combination will be absolutely critical, and it is of key importance that the right things are done in the right sequence. Two of the essential early activities necessary in practice are around the retention of key employees and customers. Again, getting the earlier stages of the acquisition process right will pay substantial dividends here and help very significantly in the integration and improvement of the combined business.

By way of conclusion, below are some Dos and Don'ts in acquisitions.

Acquisition: A business combination in which one company is acquired by another.

Cost of capital: The blended cost of all the forms of finance used to invest in operating capital required for a business.

Equity capital: The investment in a company by the ordinary shareholders. (It is the equity part of the financial structure of a company that is most at risk.)

Exclusivity: The period during which a bidder for a target is granted exclusive access to carry out due diligence etc. with a view to advancing the transaction.

Free cash flow: The operating cash flow generated by a business after all charges and investments have been met.

Merger: A union of two or more firms in a transaction by which one absorbs the other(s), or a new firm is created utilising the assets of the absorbed firms.

Private equity: The term generally used to describe equity investments in unquoted companies (both buy-outs and venture capital) often accompanied by the provision of loans and other forms of finance.

Private equity house: A firm that makes private equity investments in companies and usually plays a central co-ordinating role in a deal.

Shareholder value: The value of the investment made by shareholders in the business.

Shareholder value analysis: An approach to financial management which focuses on the creation of economic value for shareholders, as measured by share price performance and flow of dividends.

Strategic acquisition: An acquisition that is of importance to the business's strategy in general.

Tactical acquisition: An acquisition that is carried out to achieve a particular, shorter-term aim. (Such as acquiring a company to in-fill a gap in the acquirer's product or service portfolio.)