The
six types of successful acquisitions
Companies
advance myriad strategies for creating value with acquisitions—but only a
handful are likely to do so.
There is no magic formula to make acquisitions successful. Like any other
business process, they are not inherently good or bad, just as marketing and
R&D aren’t. Each deal must have its own strategic logic. In our experience,
acquirers in the most successful deals have specific, well-articulated value
creation ideas going in. For less successful deals, the strategic
rationales—such as pursuing international scale, filling portfolio gaps, or
building a third leg of the portfolio—tend to be vague.
Empirical analysis of specific acquisition
strategies offers limited insight, largely because of the wide variety of types
and sizes of acquisitions and the lack of an objective way to classify them by
strategy. What’s more, the stated strategy may not even be the real one:
companies typically talk up all kinds of strategic benefits from acquisitions
that are really entirely about cost cutting. In the absence of empirical
research, our suggestions for strategies that create value reflect our
acquisitions work with companies.
In our experience, the strategic rationale
for an acquisition that creates value typically conforms to at least one of the
following six archetypes: improving the performance of the target company,
removing excess capacity from an industry, creating market access for products,
acquiring skills or technologies more quickly or at lower cost than they could
be built in-house, exploiting a business’s industry-specific scalability, and
picking winners early and helping them develop their businesses.
Six
archetypes
An acquisition’s strategic rationale
should be a specific articulation of one of these archetypes, not a vague
concept like growth or strategic positioning, which may be important but must
be translated into something more tangible. Furthermore, even if your acquisition
is based on one of the archetypes below, it won’t create value if you overpay.
Improve
the target company’s performance
Improving the performance of the target
company is one of the most common value-creating acquisition strategies. Put
simply, you buy a company and radically reduce costs to improve margins and
cash flows. In some cases, the acquirer may also take steps to accelerate
revenue growth.
Pursuing this strategy is what the best
private-equity firms do. Among successful private-equity acquisitions in which
a target company was bought, improved, and sold, with no additional
acquisitions along the way, operating-profit margins increased by an average of
about 2.5 percentage points more than those at peer companies during the same
period.1This
means that many of the transactions increased operating-profit margins even
more.
Keep in mind that it is easier to improve
the performance of a company with low margins and low returns on invested
capital (ROIC) than that of a high-margin, high-ROIC company. Consider a target
company with a 6 percent operating-profit margin. Reducing costs by three
percentage points, to 91 percent of revenues, from 94 percent, increases the
margin to 9 percent and could lead to a 50 percent increase in the company’s
value. In contrast, if the operating-profit margin of a company is 30 percent,
increasing its value by 50 percent requires increasing the margin to 45
percent. Costs would need to decline from 70 percent of revenues to 55 percent,
a 21 percent reduction in the cost base. That might not be reasonable to
expect.
Consolidate
to remove excess capacity from industry
As industries mature, they typically
develop excess capacity. In chemicals, for example, companies are constantly
looking for ways to get more production out of their plants, even as new
competitors, such as Saudi Arabia in petrochemicals, continue to enter the
industry.
The combination of higher production from
existing capacity and new capacity from recent entrants often generates more
supply than demand. It is in no individual competitor’s interest to shut a
plant, however. Companies often find it easier to shut plants across the larger
combined entity resulting from an acquisition than to shut their least
productive plants without one and end up with a smaller company.
Reducing excess in an industry can also
extend to less tangible forms of capacity. Consolidation in the pharmaceutical
industry, for example, has significantly reduced the capacity of the sales
force as the product portfolios of merged companies change and they rethink how
to interact with doctors. Pharmaceutical companies have also significantly
reduced their R&D capacity as they found more productive ways to conduct
research and pruned their portfolios of development projects.
While there is substantial value to be
created from removing excess capacity, as in most M&A activity the bulk of
the value often accrues to the seller’s shareholders, not the buyer’s. In
addition, all the other competitors in the industry may benefit from the
capacity reduction without having to take any action of their own (the
free-rider problem).
Accelerate
market access for the target’s (or buyer’s) products
Often, relatively small companies with
innovative products have difficulty reaching the entire potential market for
their products. Small pharmaceutical companies, for example, typically lack the
large sales forces required to cultivate relationships with the many doctors
they need to promote their products. Bigger pharmaceutical companies sometimes
purchase these smaller companies and use their own large-scale sales forces to
accelerate the sales of the smaller companies’ products.
IBM, for instance, has pursued this
strategy in its software business. Between 2010 and 2013, IBM acquired 43 companies
for an average of $350 million each. By pushing the products of these companies
through IBM’s global sales force, IBM estimated that it was able to
substantially accelerate the acquired companies’ revenues, sometimes by more
than 40 percent in the first two years after each acquisition.2
In some cases, the target can also help
accelerate the acquirer’s revenue growth. In Procter & Gamble’s acquisition
of Gillette, the combined company benefited because P&G had stronger sales
in some emerging markets, Gillette in others. Working together, they introduced
their products into new markets much more quickly.
Get
skills or technologies faster or at lower cost than they can be built
Many technology-based companies buy other
companies that have the technologies they need to enhance their own products.
They do this because they can acquire the technology more quickly than
developing it themselves, avoid royalty payments on patented technologies, and
keep the technology away from competitors.
For example, Apple bought Siri (the
automated personal assistant) in 2010 to enhance its iPhones. More recently, in
2014, Apple purchased Novauris Technologies, a speech-recognition-technology
company, to further enhance Siri’s capabilities. In 2014, Apple also purchased
Beats Electronics, which had recently launched a music-streaming service. One
reason for the acquisition was to quickly offer its customers a music-streaming
service, as the market was moving away from Apple’s iTunes business model of purchasing
and downloading music.
Cisco Systems, the network product and
services company (with $49 billion in revenue in 2013), used acquisitions of
key technologies to assemble a broad line of network-solution products during
the frenzied Internet growth period. From 1993 to 2001, Cisco acquired 71
companies, at an average price of approximately $350 million. Cisco’s sales
increased from $650 million in 1993 to $22 billion in 2001, with nearly 40
percent of its 2001 revenue coming directly from these acquisitions. By 2009,
Cisco had more than $36 billion in revenues and a market cap of approximately
$150 billion.
Exploit
a business’s industry-specific scalability
Economies of scale are often cited as a
key source of value creation in M&A. While they can be, you have to be very
careful in justifying an acquisition by economies of scale, especially for
large acquisitions. That’s because large companies are often already operating
at scale. If two large companies are already operating that way, combining them
will not likely lead to lower unit costs. Take United Parcel Service and FedEx,
as a hypothetical example. They already have some of the largest airline fleets
in the world and operate them very efficiently. If they were to combine, it’s
unlikely that there would be substantial savings in their flight operations.
Economies of scale can be important
sources of value in acquisitions when the unit of incremental capacity is large
or when a larger company buys a subscale company. For example, the cost to
develop a new car platform is enormous, so auto companies try to minimize the
number of platforms they need. The combination of Volkswagen, Audi, and Porsche
allows all three companies to share some platforms. For example, the VW Toureg,
Audi Q7, and Porsche Cayenne are all based on the same underlying platform.
Some economies of scale are found in
purchasing, especially when there are a small number of buyers in a market with
differentiated products. An example is the market for television programming in
the United States. Only a handful of cable companies, satellite-television
companies, and telephone companies purchase all the television programming. As
a result, the largest purchasers have substantial bargaining power and can
achieve the lowest prices.
While economies of scale can be a
significant source of acquisition value creation, rarely are generic economies
of scale, like back-office savings, significant enough to justify an
acquisition. Economies of scale must be unique to be large enough to justify an
acquisition.
Pick
winners early and help them develop their businesses
The final winning strategy involves making
acquisitions early in the life cycle of a new industry or product line, long
before most others recognize that it will grow significantly. Johnson &
Johnson pursued this strategy in its early acquisitions of medical-device
businesses. J&J purchased orthopedic-device manufacturer DePuy in 1998,
when DePuy had $900 million of revenues. By 2010, DePuy’s revenues had grown to
$5.6 billion, an annual growth rate of about 17 percent. (In 2011, J&J
purchased Synthes, another orthopedic-device manufacturer, so more recent
revenue numbers are not comparable.) This acquisition strategy requires a
disciplined approach by management in three dimensions. First, you must be
willing to make investments early, long before your competitors and the market
see the industry’s or company’s potential. Second, you need to make multiple
bets and to expect that some will fail. Third, you need the skills and patience
to nurture the acquired businesses.
Harder
strategies
Beyond the six main acquisition strategies
we’ve explored, a handful of others can create value, though in our experience
they do so relatively rarely.
Roll-up
strategy
Roll-up strategies consolidate highly
fragmented markets where the current competitors are too small to achieve scale
economies. Beginning in the 1960s, Service Corporation International, for
instance, grew from a single funeral home in Houston to more than 1,400 funeral
homes and cemeteries in 2008. Similarly, Clear Channel Communications rolled up
the US market for radio stations, eventually owning more than 900.
This strategy works when businesses as a
group can realize substantial cost savings or achieve higher revenues than
individual businesses can. Service Corporation’s funeral homes in a given city
can share vehicles, purchasing, and back-office operations, for example. They
can also coordinate advertising across a city to reduce costs and raise
revenues.
Size is not what creates a successful
roll-up; what matters is the right kind of size. For Service Corporation,
multiple locations in individual cities have been more important than many
branches spread over many cities, because the cost savings (such as sharing
vehicles) can be realized only if the branches are near one another. Roll-up
strategies are hard to disguise, so they invite copycats. As others tried to
imitate Service Corporation’s strategy, prices for some funeral homes were
eventually bid up to levels that made additional acquisitions uneconomic.
Consolidate
to improve competitive behavior
Many executives in highly competitive
industries hope consolidation will lead competitors to focus less on price
competition, thereby improving the ROIC of the industry. The evidence shows,
however, that unless it consolidates to just three or four companies and can
keep out new entrants, pricing behavior doesn’t change: smaller businesses or
new entrants often have an incentive to gain share through lower prices. So in
an industry with, say, ten companies, lots of deals must be done before the
basis of competition changes.
Enter
into a transformational merger
A commonly mentioned reason for an
acquisition or merger is the desire to transform one or both companies.
Transformational mergers are rare, however, because the circumstances have to
be just right, and the management team needs to execute the strategy well.
Transformational mergers can best be
described by example. One of the world’s leading pharmaceutical companies,
Switzerland’s Novartis, was formed in 1996 by the $30 billion merger of
Ciba-Geigy and Sandoz. But this merger was much more than a simple combination
of businesses: under the leadership of the new CEO, Daniel Vasella, Ciba-Geigy
and Sandoz were transformed into an entirely new company. Using the merger as a
catalyst for change, Vasella and his management team not only captured $1.4
billion in cost synergies but also redefined the company’s mission, strategy,
portfolio, and organization, as well as all key processes, from research to
sales. In every area, there was no automatic choice for either the Ciba or the
Sandoz way of doing things; instead, the organization made a systematic effort
to find the best way.
Novartis shifted its strategic focus to
innovation in its life sciences business (pharmaceuticals, nutrition, and
products for agriculture) and spun off the $7 billion Ciba Specialty Chemicals
business in 1997. Organizational changes included structuring R&D worldwide
by therapeutic rather than geographic area, enabling Novartis to build a
world-leading oncology franchise.
Across all departments and management
layers, Novartis created a strong performance-oriented culture supported by
shifting from a seniority- to a performance-based compensation system for
managers.
Buy cheap
The final way to create value from an
acquisition is to buy cheap—in other words, at a price below a company’s
intrinsic value. In our experience, however, such opportunities are rare and
relatively small. Nonetheless, although market values revert to intrinsic
values over longer periods, there can be brief moments when the two fall out of
alignment. Markets, for example, sometimes overreact to negative news, such as
a criminal investigation of an executive or the failure of a single product in
a portfolio with many strong ones.
Such moments are less rare in cyclical
industries, where assets are often undervalued at the bottom of a cycle.
Comparing actual market valuations with intrinsic values based on a “perfect
foresight” model, we found that companies in cyclical industries could more
than double their shareholder returns (relative to actual returns) if they
acquired assets at the bottom of a cycle and sold at the top.3
While markets do throw up occasional
opportunities for companies to buy targets at levels below their intrinsic
value, we haven’t seen many cases. To gain control of a target, acquirers must
pay its shareholders a premium over the current market value. Although premiums
can vary widely, the average ones for corporate control have been fairly
stable: almost 30 percent of the preannouncement price of the target’s equity.
For targets pursued by multiple acquirers, the premium rises dramatically,
creating the so-called winner’s curse. If several companies evaluate a given target
and all identify roughly the same potential synergies, the pursuer that
overestimates them most will offer the highest price. Since it is based on an
overestimation of the value to be created, the winner pays too much—and is
ultimately a loser.4A
related problem is hubris, or the tendency of the acquirer’s management to
overstate its ability to capture performance improvements from the acquisition.5
Since market values can sometimes deviate
from intrinsic ones, management must also beware the possibility that markets
may be overvaluing a potential acquisition. Consider the stock market bubble
during the late 1990s. Companies that merged with or acquired technology,
media, or telecommunications businesses saw their share prices plummet when the
market reverted to earlier levels. The possibility that a company might pay too
much when the market is inflated deserves serious consideration, because
M&A activity seems to rise following periods of strong market performance.
If (and when) prices are artificially high, large improvements are necessary to
justify an acquisition, even when the target can be purchased at no premium to
market value.
By focusing on the types of acquisition
strategies that have created value for acquirers in the past, managers can make
it more likely that their acquisitions will create value for their
shareholders.
By Marc Goedhart, Tim Koller, and David Wessels
http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/the-six-types-of-successful-acquisitions?cid=other-eml-cls-mip-mck-oth-1705&hlkid=6ffc3916095549958a897c91d7b04b8c&hctky=1627601&hdpid=6a16fb22-b4a6-4a71-aa4d-30e5bb97efdf
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