Week Thirteen class notes

Acquisitions and alliances

These are complex enough topics that they get about four or more weeks of work in a strategy class. Nonetheless, you will get a whirlwind tour of some major issues in acquisitions and alliances.


Acquisitions

In the press, there is often little distinction drawn between mergers and acquisitions. Indeed, they concept has become a complex noun: mergers and acquisitions are M&A. To be precise, though, a merger occurs when two firms agree to integrate operations and is comparatively rare. Examples include Daimler-Chrysler, Time-Warner-AOL, Exxon-Mobil , and Glaxo-Smithkline-Beecham. Note how the merged firm names reflects histories.

An acquisition occurs when one firm buys complete control of another. These are much more common. In fact, global M&A (merger and acquisition) volume for 2008 was about $2.8 trillion in value - and that was down about one-third from the year before. The U.S. is the largest M&A market but the effects of the credit crisis slowed deals by 38%.

Firms choose M&A as an international diversification method for a variety of strategic ends. For instance, acquisition may be the fastest, least complex way to enter a new product-market. When barriers to entry into an industry are high, acquisition can make overcoming them easier. For example, buying in does not add capacity to an industry nor drive down prices.

Another motivation is to exert more control over the value chain through vertical integration (acquiring forward or backward in the value chain). Firms might do this to exert more control over important inputs or distribution. For example, most paper companies have integrated backward into tree plantations to assure consistency and reliability in lumber supply.

A third common reason is to take advantage of fragmented industries and roll-up production processes. In industries where the life-cycle curve is transitioning to growth, the needs of customers are well-defined but served by a large number of small producers. A firm that buys up targets with customers or demand can consolidate production can achieve economies of scale. This is particularly true where regulation formerly protected companies at a national level. For example, consider the roll-up of the international telecom industry.

What's really interesting about acquisition, though, is that they usually don't work! M&A's often fail to increase value for shareholders more than if the companies involved had remained independent. In fact, M&A's usually lose value for the buyers; research results as to the frequency with which this happens range from 50% to 70% of the deals. Why is acquisition performance generally so poor? And, since the prospects are poor, why do managers pursue them so ardently?

In answer to the first question, acquirers often have trouble setting the right price for the target so there is a reasonable chance of deriving real value from the deal. The second problem is usually in integrating the target once the deal is closed.


Valuing the deal

The first phase in the acquisition lifecycle is setting the price for the target.  This is termed "due diligence" and refers to the care a reasonable person should take before entering in an agreement or transaction with another party. For example, if you buy a used car, it is your responsibility to make all reasonable effort to discern the condition of the vehicle before you sign the papers. In our terms here, it is the responsibility managers owe to owners when undertaking acquisitions on their behalf. Acquiring managers need to answer four fundamental questions:

·   What are we really buying?

·   What is the stand alone value? (SAV)

·   What are the synergies and problems? (ESB)

·   What is the walk away price?  (WAP)

The first steps of the acquisition process involve a rudimentary due diligence in that the buyer tries to establish benchmarks or a reference class for the current buy based on similar deals without specific data from the target (just as we might get basic information on a house or car without actually seeing the specific one).

However, getting good access to information doesn't resolve the problem of valuation.  Think about how difficult it is for us to properly value a car or a house and yet these have comps (comparable deals) that are very close to what you might be buying. Firms are far more individual, so real "comps" are rare. Here are some approaches to estimating stand alone value:

·         Book value of firm or what the auditors say the firm is worth, based on assets.

·         Liquidation (or breakup) value is even more conservative for it equates the value of the firm to     what those assets would bring if sold on the market.

·         Replacement value focuses on equating the value of the firm to what it would cost to replicate it     today.

·         Market value is the easiest to do since it entails using relatively available data (assuming the         target is publicly held) on share prices and the number of outstanding shares. The value is then     just the multiple of the two.

·         Discounted cash flow (DCF) is generally regarded as the best of the lot in that it requires a very         detailed analysis of firm assets and generates a Present Value estimate for the firm. DCF is the         best way but it is still extremely difficult to do well.

Stand alone value is just part of the problem. Acquirers must also estimate expected synergistic benefits, if any. Acquirers should be identifying and valuing synergy and restructuring opportunities. Probably, buyers are best able to estimate and achieve restructuring benefits because they happen fast and it is easier to establish value. Estimating synergies is more difficult, though cost synergies are easier to calculate than revenue synergies.  This is where is it easy to get carried away in valuation as managers often have a bias toward creating synergy.

The last step in this process is to set the price. Often, managers in pursuit of an acquisition lose a little control here and will bid too much. This can happen because ego, hubris and greed obscure ends, particularly in bidding wars. A key insight is to generate a Walk Away Price (WAP) from the SAV and ESB analyses. If you've done those well, you will have a very good idea of the maximum value to the firm the target could be - so, rationally, you should spend no more than that and preferably less. The WAP provides a ceiling on target price that, if a rule, helps keep managers from making mistakes. Use the WAP to instill discipline. Experienced acquirers know this.


Deal Integration

Just as poor due diligence can derail a deal, so too can problems after the deal is consummated. The language that often surrounds mergers and acquisitions (pursuit and capture, courtship, engagement, white knights, marriage) gives rise to a marriage metaphor but the rapture is all about the wedding - not the subsequent domestic arrangements. Marriages can fail because the participants didn't know enough about each other before marching down the aisle and then find themselves ill-suited; so too can an acquisition fail if clashes after the fact are severe.

A thoroughly planned and executed integration model is essential to achieving expected value. This is particularly true if human capital retention is part of the value of the deal.  In There is substantial research to suggest that speed is essential because it minimizes uncertainty and that integrations are best wrapped up in the first 100 days after the deal closes10. Transition planning, the second major phase of the acquisition life cycle, is the foundation for actual integration.

The first step in transition planning is to name a transition leader or manager (almost always from the acquiring firm) and assemble the transition team which is best composed of members from both organizations. The transition team has a charge from acquirer management about the scope of integration.  Here, the logic of the deal (i.e.., why the acquisition is being done at all) guides the rationale as to what should and should not be integrated.  

In each functional area, the team needs to establish baselines or current states and practices in both acquirer and target.  Integration teams need members from both firms (note that this is more sensible as the firms approach equalsOnce the baselines are established, the team needs to choose the goal or standard for the combined function. Thus, the team will choose (usually with significant executive input) the HR policies or the CAD software - or choose a hybrid approach with a bridging solution. Finally, the team needs to develop a detailed timeline and project plan for the migration from one system to the other.

Once the deal is closed, the actual work of integration goes forward as the goals and ends of the transition plan are implemented. This also requires a leader to coordinate and drive the process. The integration leader (IL) has to be someone from the acquiring firm as he or she has to be viewed as influential enough to get agreement and cooperation from senior executives in the acquirer. On the other hand, in order to be credible to the personnel from the target, the integration leader must also be seen as impartial. This person can be the same as the Transition leader, but need not be.

That said, not all buys need to be integrated. If the acquisition buys market position with established (and incompatible or new) processes, then it may make more sense to let target stand more independently. This is also true with respect to cultural integration if the target is large (relative to the buyer) or is old. Finally, there is a set of acquirers that regard the buy as a financial rather than operational play and focus on finding under-valued targets and turning them around in a few years to new owners. Usually, for these buy-out firms, there is no need for integration.


Alliances

Alliances are typically bilateral (though, under some conditions, can be multilateral) arrangements between firms that may have similar or individual objectives. Alliances form because what a focal firm desires in terms of knowledge or other asset is not available under competitive market conditions  but the cost of integrating hierarchically (i.e., acquiring) exceeds the prospective gains - hence a long term bilateral relationship. As noted in class, alliances are the middle ground on the governance spectrum - neither market based or completely hierarchical. As such, they present some interesting problems in control and management because partner identity matters and because the exchange is long term, contracts can be ambiguous and incomplete. Therefore, alliances warrant governance mechanism beyond those suitable for the market (i.e., dispute resolution mechanisms such as arbitration as well as a greater administrative investment)

Motivations - as in any other diversification move, firms are incented to ally if the value of the firms together is greater than their sum individually) and the costs of alliance are lower than alternative approaches - that is, the gain from this must be greater than alternative approaches. Some specific motivations include:

·         Pooling demand to achieve economies of scale. Example: Integrated chip manufacturing. Chip design is a single firm process but the cost to build a new fab has increased from about $6 million in 1970 to approximately $3 billion for a state-of-the-art 300mm fab in 2002 -chip manufacturing is often in the form of a JV to pool enough demand to warrant the investment in the plant.
·         Pooling resources to achieve economies of scope. Example: biotech alliances often include startups with established pharmaceutical firms to combine complementary assets. That is, the startups might have the hot new drug while the pharma firms have sales forces, manufacturing skills, etc.
·         Gaining access to new markets. This is especially used in foreign markets. Recall the discussion about joint ventures as "real options". One partner brings product/process, the other brings local knowledge, distribution, and local political influence. The option is to make initial investment, wait to see how things turn out, and then invest further or abandon. In addition, JVs are sometimes the entry method (e.g., India, China, Saudi Arabia)
·         Learning or shortcutting to relevant skills without dead-end investments. Obviously, this can accelerate the learning. An interesting version of this is the Corporate Venturing model  where the idea isn't to learn directly but to keep track of who is learning what with an eye toward importance. Alliances this way can be compared to a "farm club"  - or an option to acquire

Note that Motivations can be asymmetric (firms can enter for different reasons). The classic example is Toyota and GM in the NUMMI alliance of the 1980s. GM entered to learn how to make small cars while Toyota gained stronger foothold in US market as a domestic manufacturer.

How can alliances lead to competitive advantage? Alliances can provide quasi-firm benefits or access to more specialized resources than market transactions can provide without the additional cost of strict hierarchical governance. The key attributes for success in alliances include:

·         systematic approach to management of the alliance. Firms need to pick better partners so due diligence still applies here though it is of a different sort
·         develop a reputation for reliability and trustworthiness. This allows managers to pick better partners. One's own good reputation creates a better pool of candidates because trustworthy partners are highly desirable. This creates the ability to govern with less cost (reputation)
·         alliance experience. Managers need to understand the ways in which alliances differ from standard practices and how to work around/with those special needs.  

Alliances are another form of diversification that, like acquisition, often fails to deliver value  - why? Given what you know about how to make acquisitions work - what organizational approach would you suggest for making alliances work?

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