No longer can companies afford to see their strategies, acquisitions, and operational change programs consistently fail to deliver the expected results to their stakeholders. Research shows that up to 75% of mergers and acquisitions failed to deliver their identified value. Perhaps at no other time before, given the depleted war chests and scarcity of available corporate funds, has it been as critical to ensure you don’t overpay for the business acquired and/or fail to successfully capture the identified value and integrate the acquired business. This article looks at why so many acquisitions fail and what must be done to achieve success and sustainable performance from the acquired assets.
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Falling asset values
Not surprisingly, acquisitions and mergers have not been a high priority for most companies in the wake of the global financial crisis that has plagued business values over the past 12 to 18 months, depending on the country you owned assets in. Tumbling share prices, deteriorating company earnings and sharply falling asset values have left many corporate Boards, CEOs, and senior management in shock, rattled and now licking their wounds, and not in a position to consider acquisitions while their own businesses are under siege. To date, their focus has been on cutting costs, reducing headcount and tightly controlling expenditures on existing businesses. With falling asset values, the only growth most companies have seen has been in their debt-asset ratios.
Wearied by the relentless demands of a recession, management, tired of cutting costs and announcing another profit downgrade are desperate for growth and the feel-good sensations of acquisitions. With nascent signs of a recovery now appearing and the recent lift in equity markets and improvement in some economic indicators, testosterone is beginning to flow again in corporate veins, undervalued businesses are appearing on corporate radars, private equity IPOs are emerging from the cold, while Boards and shareholders are getting restless for some real growth. Many are feeling the warming winds of optimism, fanned I am afraid by economists and journalists, the vast majority of whom were not helpful in anticipating the crash and reading the many [leading indicators->http://ckpartners.com//strategy-case-studies-and-articles/strategy-development-the-role-of-leading-economic-indicators/] of economic change, especially in Australia. Few recognised those warning signals of an impending downturn in consumer spending, banks willingness to lend and economic growth.
Commentators talk of a ‘new normal’ where old benchmarks have been reset and touchstones and orthodoxies about our marketplace are no longer relevant. So it is with some warning that while attractive, undervalued acquisition targets will emerge, there should be no place for hasty, inadequate ‘competitive’ due diligence.
Without a clear acquisition strategy, there will be many reasons why an acquisition might fail, some of which are outlined below.
Failings of recent acquisitions
Attractive acquisition targets appear in times of both high and low economic growth. But success will only come from having a clear understanding of the underlying value of what you are buying and the incremental value you can add over and above this stand-alone value plus the acquisition premium you paid. This understanding will determine what you should pay and the plan you should develop for integration of this business with your own. This might seem a self-evident truth. However, the evidence suggests that it is all too often ignored.
(1) No strategic rationale or flawed business logic: Too many business executives are making acquisitions with no apparent strategic rationale. Consistent with our own observations, a recent study revealed that less than 1 in 3 executives had a sound logic for making the acquisition and 40% revealed they did not fully quantify how the deal would boost profits, underlying business value and hence their share price. Half of those with a strategic rationale had to rethink their strategy within two years.
It’s not all about the deal. Executives can’t simply be deal makers who move on to the next deal and leave the “details” of integration to others. Advisors motivated by short-term personal gains of success fees for doing the deal will have little regard for the strategic logic or integration challenges of their clients.
Before any bid is made, the acquirer must be clear, not only about his strategic objectives but also the core competencies and strategic assets his company brings to the table, the strategic boundaries of the current business that justify the target business even being considered, and the company’s acquisition criteria such as size of business revenues, market position, profit impact and capability of the existing management team.
It must be remembered that an acquisition is not the only option for growth, especially for acquisition targets sought outside the company’s core competencies. Organic growth is an alternative, but this growth option is not always of lower risk. When did you last see a company announce or write-down a failed organic growth strategy? Failed organic growth strategies usually don’t see the light of day yet can cost hundreds of millions of dollars in product development, marketing, distribution and staffing.
(2) An inadequate or flawed understanding of the target business: ‘Due diligence’ is all too often focussed on accounting, financial, legal and technical elements of the deal. Problems will arise if inadequate attention and analysis is given to what you are buying and the value-adding strategies that justify your bid as the natural owner of these assets. As argued below, rarely do management or its success fee-driven advisors have the objectivity, skills or focus to adequately understand the target’s customer segments, growth, and profitability or its competitors’ likely responses to this acquisition.
This mistake comes in a number of forms. First, undervalued or poor performing businesses may have been failing for any number of reasons. Uncovering the cause of this situation during due diligence is essential. It may be a big mistake to assume you can turn this poor performance around easily. Second, the acquired company may not have the same or a compatible culture simply because it’s in your industry. Independent Liquor was created by a self-styled entrepreneur whose strategy was to proliferate the market with many brands over a short time period to see which succeeded. This is quite a different culture and style to that of established alcoholic beverage companies, Lion Nathan or Foster’s. Third, it cannot necessarily be assumed that the new acquisition will generate the same or higher returns as it did previously. For example, notwithstanding customer defections, contracts with third-party suppliers or with key customers may end or change on the sale of the business.
(3) Short-term perspectives only: Based on short-term share-price movements, acquisitions are at best a borderline bet for acquiring shareholders. The question you have to answer today with the recent lift in local stock markets is “is this the beginning of a sustained recovery or is this a bear rally with worse to come?” Certainly, the view that “I’m not prepared to accept dilution of earnings by absorbing a goodwill component into the balance sheet which doesn’t give me the returns in the time-frame I’m looking for” is going to lead to underbidding on sound businesses and overbidding on unsound businesses.
(4) Risk is at best implicitly factored in: Traditional measures of company performance such as ROA, EPS and PE multiples commonly used in acquisition evaluations do not account for risk. Moreover, adjusting a company’s investment hurdle rate to account for risk in an acquisition confuses and misleads the true riskiness of the underlying cash flows. For example, if the true risk resides in future volumes then it is forecast volumes that should be risk adjusted, not the discount rate on future cash flows.
(5) ‘Serial’ acquirers deliver the highest returns to shareholders: This is only partly true. A series of smaller continuing acquisitions at the right price and fit can be more successful than one big deal that brings the company undone, such as happened to AMP with GIO, NAB with HomeSide Insurance and CBA with Colonial First State. Some years ago, Burns Philp bought a number of small regional spice businesses in the US, South America and Western Europe but it failed to integrate these business within a global structure, so they remained small regional spice businesses that collectively underperformed against their potential. On the other hand, Corporate Express purchased a number of stationery distribution businesses servicing corporate and SME businesses. This worked well, however, some of these businesses remained as state-based fiefdoms with their own overhead structures and local practices. It was not until a national sales, distribution and service go-to-market strategy and structure was developed and implemented that the full potential of these small regional businesses was realised.
Also, serial acquirers adopting a ‘conglomerate-private equity’ style model, such as Wesfarmers, Alesco and Brickworks, may have developed a competency in buying and developing businesses in quite unrelated markets. The key to this strategy is to be willing to trade out of these businesses at their the peak of their value. Unfortunately, the success they enjoyed in a rising share market can evaporate in a sharply falling market as experienced recently. This model only works if you are also prepared to sell these businesses when the value has been created and a more natural owner can be found. Buying is relatively easy, but selling a good business at its peak can be much harder.
(6) Capturing the synergies through effective integration, not price determines value of the deal: Price is a poor seventh place to post-deal issues and a mis-placed strategy to base an acquisition on. A business that is ‘fairly’ priced is not a good acquisition if the company is fully priced. Foster’s wine acquisitions were fully priced when purchased with little additional value available to the purchaser.
Aside from overpaying for the business, the major reason for an acquisition not meeting shareholders’ expectations is poor, ineffective integration. If this occurs then a destruction of shareholder value is the only outcome likely. To avoid this outcome, early planning and speed of implementation is key. Clear, decisive and consistent communication is also essential, along with strong leadership and a significant commitment of dedicated resources to the integration team. However, in some circumstances less rather than more integration may be better at least for a period until customers can be transitioned successfully and back office systems can be cut over without disrupting the business. Although some synergies may be forgone in the short term, the decision or agreement by Westpac to maintain St George’s brand, products, and branches will minimise customer losses and management distraction.
A final element of a successful integration program is to ensure that the existing businesses are carefully managed throughout the integration. As in nature after a kill, there are plenty of predatory competitors out there waiting to swoop up disenchanted and disgruntled customers of your business or of the target.
(7) Revenue synergies are the real prize: Cost synergies are relatively easy to identify and to achieve. Any bidder can identify administration cuts, duplication of back-office functions, excess capacity and then sack staff. By contrast, in acquisition due diligence and for that matter in any business planning, revenue usually is the dominant driver of future earnings and hence future value created.
The shortcoming of most acquisition due diligences, however, is the poor understanding of the reliability of future revenue streams and revenue growth rates used in financial modelling. Usually a single revenue growth figure is chosen, often in haste and naively based on historic growth rates or worse still based on some other number the business modeller thinks management want to hear. Unfortunately, little effort goes into quantifying future growth of the target’s market segment and sub-segments. Given the impact of small changes in revenue growth rates on enterprise value, this can result is substantial errors in projected revenues and can in turn lead to overpaying or at times underbidding for the target business. These forecasts must be robustly tested and challenged.
Rarely is account taken to understand the end users of the target’s products and services. Even more rarely is account taken of the derived demand of end users’ customers, particularly when the target’s products and services are inputs to end users’ products and services along the value chain.
Finally, relevant economic impacts (such as interest rates, foreign exchange rates, taxes and duties) and environmental factors (such as policy changes on recycling and carbon emission taxes on industry and hence target growth) are given a cursory and qualitative consideration, at best. These factors are becoming critical in markets today.
(8) No objective, external view of either the business acquisition strategy and competitive due diligence of the acquisition: The investment required to obtain an objective, external view to reduce if not remove the risk of making one of the above mistakes is negligible given the high opportunity cost of failure. CEOs are all too often seen at AGMs trying to explain away the underperformance of costly acquisitions they have made. Equally common are the pronouncements of newly appointed CEOs who quickly distance themselves from the decisions of their predecessor who allegedly failed to identify the significant business risks of the deal and overpaid only to later have to write off millions of dollars against the purchase price.
Objective, external views do not include those of success fee-driven investment banks and similarly motivated advisors. To take a football cliche, it is this type of advice that can fuel ‘white line fever’ that can grip an executive team hell bent on getting the deal across the line, often to appease top management and Board expectations.
If you would like to find out more and how the issues raised might apply to your business then contact us via the Contact Form.
