M&A activity represents globally more than US $ 3 tn every year, however research shows that between 50% and 85% of the transactions carried out do not reach the objectives that were initially established to acquire a business.
To try to explain the reasons for these high rates of “failure” in the M&A market, professors Christensen, Alton, Rising and Waldeck at the Harvard Business School, propose a theory that in summary says: “Many M&A fail to meet expectations because the acquisition targets are not chosen properly and as a consequence, many companies pay the wrong price and integrate the acquired company in a wrong way”
The researchers establish two main reasons that lead a company to undertake an acquisition:
1.- To boost company´s current performance
a) to hold on to a premium position or b) to cut costs. An acquisition that delivers those benefits almost never changes the company´s trajectory in part because investors anticipate and therefore discount the performance improvements
2.- To reinvent the company´s business model and fundamentally redirect the company
Almost nobody understands how to identify the best targets to achieve that goal, how much to pay for them, and how or whether to integrate them
The following is a summary of the paper published on the Harvard Business Review, in which the implications of the theory mentioned above are explored and is intended as a guide to improve the selection of acquisition targets, pay the correct price in a transaction and to properly integrate an acquisition in order to improve the success rate.
What are we acquiring?
The success or failure of an acquisition lies in integration. To foresee how integration will play out, we must be able to describe what are we buying. The best way to do so is to think of the target in terms of its business model. As defined by authors a business model consist in four interdependent elements that create value: 1) Customer value proposition 2) Profit formula 3) Resources and 4) Processes. According to this, two types of acquisitions are proposed: i) those aimed at appropriating the “resources” of another company (LBM “Leverage the business model” ) and ii) acquisitions that seek to acquire new business models (RBM “Reinvent the business model”).
The authors indicate that in the right circumstances, the element “resources” can be extracted from an acquired company and plugged into the parent´s business model, because the resources exist apart from the company. On the other hand, profit formulas and processes do not exist apart from the organization and they rarely survive its dissolution. But a company can buy another firm’s business model, operate it separately and use it as a platform for transformative growth.
How to achieve the objectives of an acquisition?
To achieve the objectives in a purchase transaction, it is necessary to be clear about for what purpose a company is being acquired. The authors mention two 2 basic objectives: a) Improve the current performance of the company or b) Reinvent the business model of the company
Improve the current performance of the company
So many companies turn to LBM acquisitions to improve the output of their profit formulas, but the conditions under which an acquisition’s resources can help a company accomplish either goal are remarkably specific.
Acquiring resources to command premium prices
The surest way to command a price premium is to improve a product or service, in other words one whose customers are willing to pay for better functionality. Companies do so by purchasing improved components that are compatible with their own products or acquiring the needed technology and talent (IP). In this case it is necessary to ask:
- What are the critical measures of performance that customers value in your product (speed, durability, functionality)?
- Would most customers be willing to pay more if you improved the product on those measures? (Do they value the extra speed, longevity, or functionality enough to pay more for it?)
- Can the resources of the acquired company substantially improve your product in ways that customers would pay more for?
Acquiring resources to lower costs
An acquisition of resources whose objective is to reduce costs is based on the fact that the acquiring company “plugs” certain resources of the acquisition in its existing model, discarding the rest of the acquired model and shutting down, laying off or selling redundant resources. To determine whether an acquisition of resources will help reduce costs, it must be established whether the acquisition resources are compatible with those of the acquirer and its processes, and then estimate whether the scale increases will actually have the desired effect.
If the resources of the target company are compatible with the resources and processes of the acquiring company, the acquisition is likely to improve turnover or use of assets and fixed costs. For companies in industries where fixed costs represent a large percentage of total costs, scaling up through acquisitions results in substantial cost savings in manufacturing, distribution and sales. But in industries where cost competitiveness can be achieved at relatively low levels of market share, a company that grows beyond that does not reduce its cost position, but replicates it. Acquisitions that are justified by economies of scale in administrative costs such as purchasing, human resources, or legal services often have disappointing effects on the profit formula.
Some critical questions posed by the authors of the research that should be formulated before an acquisition of this type:
- Will the acquisition´s products fit into my product catalog without creating confusion?
- Do its customers buy products like ours, and vice versa?
- Can the output of the acquisition´s factories be used with minimal adjustment by our supply chain and distributors?
- Can the acquisition´s offering be sold according to our sales cycle?
- Can my people readily service the acquired customers?
- Can its products be produced in our factories, and vice versa?
- Will the quality of its offerings be enhanced by our rules for managing procurement, IT systems, and quality control systems?
The temptation of one-stop shopping
The authors warn that in circumstances in which companies seek to increase the current benefit through LBM agreements aimed at the acquisition of new customers, the success stories identified include the fact of selling to customers “acquired” the products they were already buying before the acquisition. Purchases made for the purpose of cross-selling products succeed occasionally and only if customers need to buy those products at the same time and place.
They cite as an example the Citigroup case and the acquisitions that it made to create a kind of “financial supermarkets,” thinking that customers’ needs for credit cards, checking accounts, wealth management services, insurance, and stock brokerage could be furnished most efficiently and effectively by the same company. Those efforts have failed, over and over again. Each function fulfills a different job that arises at a different point in a customer’s life, so a single source for all of them holds no advantage. Cross-selling in circumstances like these will complicate and confuse, and will rarely reduce sales costs.
Reinventing the business model
The groundwork for long-term growth is creating new ways of doing business, since the value of existing business models fades as competition and technological progress erode their profit potential, RBM acquisitions help managers tackle that task.
If cash flow groes at the rate the market expects, the firm’s share price will grow only at its cost of capital, because those expectations have already been factored into its current share price. To persistently create shareholder value at a greater rate, managers must do something that investors haven’t already taken into account—and they must do it again and again.
Acquiring a disruptive business model
The authors mention that the most reliable sources of unexpected growth in revenues and margins are disruptive products and business models. Disruptive companies are those whose initial products are simpler and more affordable than the established players’ offerings. They secure their foothold in the low end of the market and then move to higher-performance, higher-margin products, market tier by market tier. Although investment analysts can see a company’s potential in the market tier where it’s currently positioned, they fail to foresee how a disruptor will move upmarket as its offerings improve. So they persistently underestimate the growth potential of disruptive companies.
Acquiring to decommoditize
One of the most effective ways to use RBM acquisitions is as a defense against commoditization. Over time, the most profitable point in the value chain shifts as proprietary, integrated offering metamorphose into modular, undifferentiated ones. The innovative companies supplying the components start to capture the most attractive margins in the chain. Firms in this situation should instead migrate to “where the profits will be”—the point in the value chain that will capture the best margins in the future.
Some critical questions posed by the authors of the research that should be formulated before an acquisition of this type:
Can This Acquisition Change Your Company’s Growth Trajectory?
- Is the acquired company’s product or service simpler and more affordable than the established players’ offerings?
- Do this simplicity and affordability enable more people to own and use the product or service? Is it good enough to suit the needs of a variety of customers?
- Can the acquired company’s business model scale upmarket to yield a stream of progressively higher-capability products and services?
- Do established players and the company’s offering profitable enough to replicate, or is the company playing in low-end markets that incumbents are content to ignore?
- Does the acquired company reposition you to capture the most attractive (future) profts in the industry’s value chain?
Paying the right price
The authors state that because RBM acquisitions increase the shareholder value creation rate more effectively, they should have a relatively higher price than LBM acquisitions.
They indicate that in some cases of LBM acquisitions, prices have been paid well above the level that could justify the cost synergies. For that kind of deals, they say, it is crucial to determine the target´s worth by calculating the impact on profits from the acquisition.
For LBM acquisitions, the correct comparables would be companies that make similar products in similar industries. For RBM acquisitions,however, such comparables make disruptive companies seem overpriced, deterring companies from pursuing the very acquisitions they need for reinvention. In fact, they say, the right comparables for disruptive companies are other disruptors, regardless of the industry.
Avoiding integration mistakes
Authors say the approach to integration should be determined almost entirely by the type of acquisition made. If another company is acquired for the purpose of improving the current business model’s effectiveness, it is generally necessary to dissolve the acquired model as its resources are folded into the acquiring operations. But if a company is being acquired for its business model, it’s important to keep the model intact, most commonly by operating it separately. Failing to understand where the value resides in what’s been bought, and therefore integrating incorrectly, has caused some of the biggest disasters in acquisitions history.
Companies can make acquisitions that allow them to command higher prices, but only in the same way they could have raised prices all along—by improving products that are not yet good enough for the majority of their customers.
And companies can acquire new business models to serve as platforms for transformative growth—just as they could if they developed new business models in-house.
At the end of the day, the decision to acquire is a question of whether it is faster and more economical to buy something that could, given enough time and resources, be
In the following link you can find the article including some illustrative examples for the topics discussed.