The authors suggestions for M&A strategies that create value reflect the McKinsey acquisitions work with companies. According to their experience:
in M&A, acquirers in the most successful deals have specific, well-articulated value creation ideas going in.
The strategic rationale for an acquisition that creates value typically conforms to at least one of the following six archetypes:
1 Improving the performance of the target company, 2 Removing excess capacity from an industry, 3 Creating market access for products, 4 Acquiring skills or technologies more quickly or at lower cost than they could be built in-house, 5 Exploiting a business’s industry-specific scalability, and 6 Picking winners early and helping them develop their businesses.
Furthermore, even if your acquisition is based on one of the archetypes below, it won’t create value if you overpay.
1 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. This means that many of the transactions increased operating- profit margins even more.
2 Consolidate to remove excess capacity from industry
As industries mature, they typically develop excess capacity. 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.
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).
3 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. 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.
4 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.
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.
5 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.
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. Economies of scale must be unique to be large enough to justify an acquisition.
6 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.
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 strategies consolidate highly fragmented markets where the current competitors are too small to achieve scale economies. This strategy works when businesses as a group can realize substantial cost savings or achieve higher revenues than individual businesses can. Clear Channel Communications rolled up the US market for radio stations, eventually owning more than 900. Size is not what creates a successful roll-up; what matters is the right kind of size.
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
Transformational mergers are rare, however, because the circumstances have to be just right, and the management team needs to execute the strategy well. Using the merger as a catalyst for change, can be possible not only captured value in cost synergies but also redefined the company’s mission, strategy, portfolio, and organization, as well as all key processes, from research to sales.
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. 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. 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
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. A related problem is hubris, or the tendency of the acquirer’s management to overstate its ability to capture performance improvements from the acquisition.
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
This is a summary of the original article “The six types of successful acquisitions” written by Marc Goedhart, Tim Koller, and David Wessels from McKinsey & Company in May 2017. You can read the full article https://www.transactionadvisors.com/insights/six-types-successful-acquisitions