Reflections on
digital M&A
What
exactly is digital M&A and how does it compare with garden-variety deal
making?
The buzz in the world of mergers and acquisitions
these days is often around so-called digital M&A. But it’s not clear the term
means the same thing for everyone or if people even understand how it differs
from garden-variety deal making.
McKinsey’s Werner Rehm
checks in with Robert Uhlaner, who’s worked on digital deals, to sort this out.
An edited transcript of
the podcast follows.
Werner Rehm: Robert, we have been talking
a lot about digital M&A in the last year and a half or so. And part of the
reason is that since 2016 we see about 4 or 5 percent of M&A volume in what
we call digital M&A. It does seem there are two different types of digital
M&A. One is a company buying analytics, skills, and software to improve how
they make their product. Another is where you buy sensors or Internet of Things
applications and put them into the products that you make to make the products
better and secure for the future. Are those two different things?
Robert Uhlaner: Yeah. I think there’s
actually a third one. I made the same point just this week and almost everybody
added a third piece, which is social—dealing with other means by which there
are disruptions from an Uber-like play or other types of online marketing or
online business models, which is a little different than Internet of Things,
where you’re improving the value proposition of the product.
Werner Rehm: An online business model for
traditional companies?
Robert Uhlaner: Yeah.
Werner Rehm: Typically, what I see is that
it’s traditional companies trying to do this rather than Microsoft buying yet
another software company.
Robert Uhlaner: Yeah, that’s right. And
that’s why it’s so hard. I was reflecting that in the last wave of tech
M&A—and in a flurry of activity 15, 20 years ago—it was a lot about
industrial clients trying to carve out technology and get a valuation. This
time they’re actually trying to change their business model or operations, as
opposed to discovering that they had a little bit of software revenue in a
hardware company and trying to monetize that. Now it’s a lot more around
legitimate business building or acquiring a new capability.
Werner Rehm: And when we talk to these
companies, while fundamentally it is still M&A and the traditional process
still applies, there’s a lot of other things that make this difficult, let’s
say, for a traditional industrial company, things like high levels of
uncertainty about the product and the target. Or low target
visibility—sometimes you don’t even know exactly what you’re buying. What is
different about this than an industrial company buying another small industrial
company and plugging into the product there?
Robert Uhlaner: Fundamentally, the biggest
difference is it’s very hard to do traditional M&A. You need to do valuation. But an industrial company buying a small industrial
company will look at a stand-alone intrinsic valuation, maybe using a
discounted cash flow. They’ll look at cross-sell and cost synergies to arrive
at the value of a company to them and be able to set a price.
Digital M&A,
particularly if it’s around a new business model, there’s uncertainty where
you’re creating, potentially, a whole new profit-and-loss statement (P&L)
that’s unproven. But even in the case where you’re just acquiring a capability
to improve your production or efficiency, the value of the company is going to
be based on a different methodology—in terms of the value to you, versus the
perception that your target company will have, which they’ll see as selling
stuff into some market.
Werner Rehm: Practically, how do I go
about this? A traditional method is I buy a company, I can maybe cut some costs
and attach some product, and that gives a discounted-cash-flow value to me.
Then I hope I pay less than that. Here it feels like you need the business plan
first, and then you figure out how to fill it up. It’s less about a single deal
and more about how much you can spend to get the whole business going. Is that
the right way to think about this?
Robert Uhlaner: I would argue that’s a
discipline that should always have been used. Figure out the strategy and build
an understanding of the valuation, and then apply that to various targets to
see how well it fits. But in this case, if you don’t have that discipline, it’s
unlikely you’ll be able to start a productive conversation internally.
I think that despite
the trend—that’s the increasing digital M&A that we’re seeing—there is a
much larger number of companies looking at digital deals and struggling to
figure out how to justify them. The valuation, in particular, is a real barrier
to a go/no-go decision because it does require discipline around an operating
plan and then, in turn, an integration plan, which is the second challenge
these companies have.
Werner Rehm: We’re going come to
integration in a second. But I do want to explore this notion of what changes
in how you look at deals. Because a lot of companies that I’ve talked to still
have the mind-set that any deal has to be earnings-per-share accretive in two
years. Or maybe operating-income accretive. Or the synergies have to outpace
the implementation cost. And it feels like here you’re likely to buy something
that you actually have to invest in before it becomes something bigger in four
or five years. So how do you guide companies to think about the value creation
from these deals when they’re a little bit stuck in the old way of thinking
about this?
Robert Uhlaner: Whether it’s a business model
or a capability internally, you need to build a P&L and an operating plan
so you can understand what the value at stake is. Then you need to figure out
how much capability you’re going to have to invest in internally, versus what
the contribution is of buying a company. At the end of the day, it’s going to
be a judgment call as to whether buying capabilities will either reduce the
cost or increase the speed by which you can achieve the business objectives.
The good news is that
these aren’t large transformational deals; they’re smaller deals. You are
really trading this off around internal investment to build capabilities. Many
of these things are expensive. I predict, though, that you’re going to have
rules of thumb emerge, like we saw in tech M&A and software M&A decades
ago—more metrics around things like a million dollars per engineer, as opposed
to anything that’s tied to the target company’s P&L or revenue.
Werner Rehm: Particularly when a lot of
these things don’t have any revenue or profit to speak of.
Robert Uhlaner: I’d argue that just like we
saw in software M&A, generally you see that if you have legacy revenues with
digital companies, it’s more a liability because it’s unlikely that you’re
going to be wanting to continue that business. That’s the other wrinkle—things
without revenue are probably, in many ways, more attractive because it’s more
likely that it’ll be easier to have it fit into what you want to use the asset
for, without having to worry about legacy customers.
Werner Rehm: It does feel like that kind
of conversation, in the broader context of a strategic plan and a business
plan, is not something you can just go to your head of business development and
say, “go find me five companies that have this technology.” It feels like a
broader investment in finding the right skills, finding the right companies,
and driving the discussion toward the outcome rather than going and valuing a
company and just buying it. It feels broader than classic M&A target
hunting.
Robert Uhlaner: Yeah. I think you need to be
very focused on what you’re building, with a business leader or functional
leader really taking that ownership. But again, I’d argue that’s best practice
even if it’s traditional M&A. You need to have a clear strategy and be able
to fit it into a business plan. But in this case, it’s nearly impossible to
execute these—given the range of assets that you might be looking at—unless
you’re actually screening them against a real operating plan.
Werner Rehm: A couple of minutes ago you
mentioned integration. I’ve heard both “let’s integrate everything and put them
in our system” and “let’s keep everything separate because it’s a small company
and we don't want to put our old, traditional company spirit over the young
spirit.” How do you think about that? What have you seen that works?
Robert Uhlaner: First of all, you want to
make sure you’re integrating these acquisitions into one thing, as opposed to
buying a bunch of things and hoping that they’ll somehow collaborate. It’s
unlikely that only one acquisition is going to drive a digital strategy under
any of the different objectives we’ve talked about. So you are going to be
buying multiple companies, and you’re going to have to figure out how to structure and organize those companies into a clear operating
organization.
I think that many of
these companies are young and would welcome the benefit of mature processes, if
they are delivered, to relieve them, as opposed to having more administrative
overhead. So traditional finance, recruiting, even operational skills, I think,
should be selectively integrated to help these companies so they can focus on
innovation.
But a lot of mistakes
are made when traditional companies—whether they’re industrial or pharma or
travel or infrastructure companies—buy more technology-oriented or different
cultures in these assets. There is this sense that they need to leave them
alone, which almost accelerates the failure rate. It’s almost self-fulfilling.
Werner Rehm: Can you give an example of
where this integration worked or didn’t work?
Robert Uhlaner: There are traditional
examples that are true today. Take the whole payment space. You get an anchor
acquisition and then you string together 30 or 40 other payment companies
throughout the world, but it’s done systematically to create a unified payments
platform. The vision is to create a global platform, so you bring these assets
together. I think that concept of building a platform and a vision for how you
string these things together is applicable today even in areas like trucking.
You see companies putting a lot more sensors into physical class-A trucks and
then providing performance data and predictive-maintenance data to pool across,
not only, potentially, the trucks they sell but fleets that may have a variety
of different manufacturers. That’s really the choice point. It’s a bunch of
decisions around “are you actually going to build a platform? Is it going to be
open or closed?” Closed being just your products and open being to pool data
between you and your partners.
We see failure
occurring when you only put a toe in from the very beginning. You deal with
uncertainty by not only looking for something that’s cheap. But on top of that,
you may hedge your risk by doing an earn-out on the current profit-and-loss
statement because you really don’t know how else to defer payment. And as I
said earlier, the likelihood that you’re going to be running the business or
using that capability and generating the same profit and loss once you acquire
it is pretty low. And if you put an earn-out around it and don’t have a plan
for integrating it, even if you did get lucky and get what you needed cheap,
it’s going to be nearly impossible to integrate the thing.
Werner Rehm: Interesting. It does raise a
question that we haven’t addressed up front. To use some old terms, “how do I
know what I should buy versus make?” Because some of this doesn’t feel too hard
to do yourself. When you think about hiring software engineers for the Internet
of Things and putting sensors on products, you could be better off contracting
than buying—especially when you have areas, like technology, that are moving
quickly and you need intellectual property that is protected. To a certain
extent, you don’t quite know what you really need in five years. Wouldn’t you
be better off just having a contractual relationship rather than buying some of
these companies?
Robert Uhlaner: The simple answer is it’s a
lot harder to do a joint venture or even a contract because it requires not
only this vision of an operating plan but, just like any other procurement, you
have to step into a fairly granular definition of what the business
requirements are. In this case, sure, if you can do that—and do even better
through an equity investment, so you have a stake in the company and can,
ultimately, potentially convert that into an acquisition if things go well—then
I think that’s a great strategy. It’s just a lot harder. It requires a lot more
work up front. Classically, in terms of work, you get what you pay for.
My guess is that for
really promising technologies and capabilities, it’s going to be really tough
to control and shape the IP and the road map without ultimately having control
of the asset. But to the extent that you can fund specific activity, or license
certain technology, that’s a great option. You still run into the same problem,
though, because if you don’t have the internal capability to manage those
projects contractually, it’s going to be really tough to make sure you’re
getting what you want.
Werner Rehm: That makes sense—especially
the point about controlling the intellectual property and taking away some
promising technology from your competitors, as well, by having unique access.
We said earlier that
digital M&A is less than 10 percent or so of all M&A volume right now.
What do you think of as a bold prediction? Is digital M&A going to be the
majority of M&A that industrial companies are doing or is it always going
to be small compared with large deals?
Robert Uhlaner: Given that, for the most
part, these will be capability plays, they will be small deals. As new and
successful business models emerge, you can imagine you’ll begin to see, across
all sectors, much more significant movement to things that we’re going to call
digital deals. It’s going to be hard to score. Given where this trend is going,
you’re going to see companies that have a mix of the two. My guess is that at a
minimum, in ten years, 20 to 30 percent of M&A will have a real material
digital component to it. But it’s going be tough to isolate digital deals from
nondigital deals.
Werner Rehm: That makes a lot of sense. So
the only thing we do know, then, is that it’s important for everybody to have
the skills to look at the digital space—the technologies, the intellectual
property—as they do on most any kind of deal.
Robert Uhlaner: I would say ten years from
now, it’s almost inconceivable that any company, in any industry, will be able
to ignore a digital business model or digital capability to remain competitive.
That’s the big difference this time. It’s not just taking advantage of some
bubble in software valuations and hoping to get a piece of that. It’s really
going to be core to being competitive in five years, let alone ten.
Werner Rehm: Digital M&A is here to
stay. Robert, thanks very much for joining us.
Robert Uhlaner: I appreciate it. Take care.
https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/reflections-on-digital-m-and-a?cid=other-eml-alt-mip-mck-oth-1712
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