Smarter acquisitions: ten steps to successful deals 9780273715436, 0273715437

Table of contents :
Cover......Page 1
Smarter Acquisitions......Page 4
Contents......Page 8
Preface......Page 12
About the authors......Page 14
Publisher's acknowledgements......Page 16
Part 1 The context......Page 18
Introduction......Page 20
Drivers of growth......Page 21
The reasons for the present boom......Page 22
The outcome......Page 26
How it works......Page 32
Implications for corporate acquirers......Page 36
Why acquisitions fail......Page 42
Aborted acquisitions......Page 43
Poor returns from completed acquisitions......Page 48
Types of transaction......Page 64
Implications......Page 68
Part 2 The process – the ten steps to successful acquisitions......Page 70
The four rules......Page 72
Integration and portfolio acquisitions......Page 79
Whether to acquire or ally......Page 88
Integration acquisitions......Page 94
Portfolio acquisitions......Page 95
Guidelines......Page 99
Sources......Page 102
The approach......Page 105
Negotiating team......Page 108
Implementation team......Page 110
Valuation methodologies......Page 112
Practical guidelines......Page 119
Cost of capital......Page 122
Step 6 Negotiating a good deal......Page 126
Determining price......Page 127
Intermediate undertakings......Page 129
Learning from private equity firms......Page 134
The logic of due diligence......Page 135
Financial condition......Page 137
Specialist matters......Page 141
Commercial due diligence......Page 144
Key areas for negotiation......Page 148
Strategic relevance......Page 155
Cash versus shares......Page 158
EPS enhancement strategies (‘bootstrapping’)......Page 160
Acquisition bank finance......Page 162
Step 10 Implementation and integration......Page 164
Lessons from the front......Page 165
Avoiding failure......Page 176
Ensuring value creation......Page 178
Managing a tight process......Page 179
Applying good parenting......Page 180
Appendix A AT&T’s acquisition of BellSouth......Page 182
Appendix B Imperial Group’s acquisition of Altadis......Page 186
Endnotes......Page 190
Index......Page 194

Citation preview

About the authors

Andrew Campbell is Director of the Ashridge Strategic Management Centre, the world’s leading centre on corporate level strategy, and has been researching and teaching acquisitions for 15 years. He is a graduate of Harvard Business School, spent 6 years with the consulting firm McKinsey & Company and is the author of more than 10 books on strategy, including the classic text Corporate Level Strategy and the insightful book on growth, The Growth Gamble.

Ten steps to successful deals ‘… essential reading for those contemplating the acquisition trail.’ Dr. Greg J. Hitchings, Growth Initiatives, Infineum UK Ltd ‘… a must-read for all senior managers interested in pursuing acquisitions.’ Dirk Van den Berghe, Senior Vice President, Strategy & Synergy Development, Delhaize Group ‘A down to earth, practical and very readable guide to travel through the world of acquisitions.’ Ivar Vetter, Senior Vice President, DSM ‘… a well structured and wise book.’ David Barclay, Agenda Set Limited Is your company involved in an acquisition? Are you under pressure to grow and to make acquisitions? If so, do you know what you need to do to make sure the deal works? Larger acquisitions, especially the hostile deals, may get all the headlines. But whether the deal you’re making is large or small, this book guides you through the ten steps you need to make sure your acquisitions really deliver value. Smarter Acquisitions will improve your odds of success. It takes you into the world of acquisitions so that it will become familiar ground. It itemizes the causes of failure so you can avoid them. It tells you about private equity players and what you can learn from them. And it covers the ten steps of the acquisition process from beginning to end: from the crucial, often-missed step of developing an acquisition strategy, to valuing the target company, to negotiating the deal, through to integrating the new company.

THE TEN ESSENTIAL STEPS TO ACQUISITIONS THAT GENUINELY ADD SHAREHOLDER VALUE Visit our website at www.pearson-books.com

An imprint of Pearson Education

CVR_SADT5436_01_SE_CVR.indd 1

David Sadtler David Smith Andrew Campbell

SMARTER ACQUISITIONS Ten steps to successful deals

The abysmally poor record of acquisitions in creating value for shareholders should be unacceptable to anyone concerned with generating profit and growth in the corporate world. Studies show that a staggering 50 per cent of mergers and acquisitions fail to meet their objectives. Some even bankrupt the acquiring company. Why is this? Often because managers have limited experience with the acquisition process or because they make acquisitions for the wrong reasons. But it need not be that way for you. There is a real learning-curve for doing acquisitions. The more you do, the better you get at it. That is why many serial acquirers consistently get much better value from their acquisitions than the lamentable average. You need to learn how they do it. This book will show you how. Smarter Acquisitions gives you clear, practical guidelines on how to: • Formulate a clear strategy for doing deals that create value • Find the ideal target company •

Sadtler Smith Campbell

David Smith worked with the Shell group as a senior manager, advising on all significant mergers and acquisitions undertaken within the group on a worldwide basis, and is an Associate of the Ashridge Strategic Management Centre. He also works with private clients on major acquisition projects. He is a Chartered Accountant and holds a BSc in Physics from Birmingham University.

Smarter acquisitions

SMARTER ACQUISITIONS

David Sadtler is a graduate of Brown University and Harvard Business School, a two-time alumnus of McKinsey & Company and an Associate of the Ashridge Strategic Management Centre. He consults, writes and conducts research in acquisitions, alliances and business strategy.

david sadtler david smith Andrew campbell

Carry out financial and commercial due diligence

• Determine and negotiate a price (a key reason for failure is paying too much, so the price really does need to be right) • Develop an implementation plan • Negotiate the purchase and sale contract • Finance the deal • Close the deal and make the integration work

Smarter acquisitions – BECAUSE YOU CAN’T AFFORD FOR YOUR DEALS TO FAIL

BUSINESS Visit our website at www.pearson-books.com

Front cover image: © Getty Images

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Praise for Smarter Aquisitions

‘This is a comprehensive and very practical book, a must-read for all senior managers interested in pursuing acquisitions.’ Dirk Van den Berghe, Senior Vice President, Strategy & Synergy Development, Delhaize Group ‘A down to earth, practical and very readable guide to travel through the world of acquisitions.’ Ivar Vetter, Senior Vice President, DSM ‘Smarter Acquisitions leads the reader step-by-step in a clear and pragmatic way through a minefield. The framework provided makes this book essential reading for those contemplating the acquisition trail.’ Dr. Greg J. Hitchings, Growth Initiatives, Infineum UK Ltd ‘Smarter Acquisitions is a well structured and wise book which will undoubtedly help readers up their game when considering the purchase of a company … The authors’ great weight of experience shines through and there is a comforting credibility to many strong points made in the book.’ David Barclay, Agenda Set Limited

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Smarter Acquisitions

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In an increasingly competitive world, we believe it’s quality of thinking that gives you the edge – an idea that opens new doors, a technique that solves a problem or an insight that simply makes sense of it all. The more you know, the smarter and faster you can go. That’s why we work with the best minds in business and finance to bring cutting-edge thinking and best learning practice to a global market. Under a range of leading imprints, including Financial Times Prentice Hall, we create world-class print publications and electronic products bringing our readers knowledge, skills and understanding, which can be applied whether studying or at work. To find out more about Pearson Education publications or tell us about the books you’d like to find, you can visit us at www.pearsoned.co.uk

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Smarter Acquisitions Ten steps to successful deals

David Sadtler David Smith Andrew Campbell

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PEARSON EDUCATION LIMITED Edinburgh Gate Harlow, CM20 2JE Tel: +44 (0)1279 623623 Fax: +44 (0)1279 431059 Website: www.pearsoned.co.uk First published in Great Britain in 2008 © Ashridge Business School 2008 The rights of David Sadtler, David Smith and Andrew Campbell to be identified as authors of this work have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. ISBN: 978-0-273-71543-6 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data Sadtler, David. Smarter acquisitions : ten steps to successful deals / David Sadtler, David Smith, Andrew Campbell. p. cm, Includes index ISBN 978-0-273-71543-6 1. Consolidation and merger of corporations. I. Smith, David, 1951- II. Campbell, Andrew, 1950 Aug. 3- III. Title. HD2746.5.S33 2008 658.1’62--dc22 2008020840 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without either the prior written permission of the publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the publishers. 10 9 8 7 6 5 4 3 2 1 12 11 10 09 08 Typeset in 9.5pt/13pt New Century Schoolbook by 30 Printed and bound in Great Britain by Ashford Colour Press Ltd, Gosport, Hants The publisher’s policy is to use paper manufactured from sustainable forests.

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Contents Preface About the authors Publisher’s acknowledgements

Part 1 The context 1 Introduction

xi xiii xv

1 3

The reasons for the present boom

4 5

The outcome

9

2 Private equity

15

How it works

15

Implications for corporate acquirers

19

Drivers of growth

3 Why acquisitions fail

25

Aborted acquisitions

26

Poor returns from completed acquisitions

31

4 Acquisition mechanics

47

Types of transaction Implications

47 51

Part 2 The process – the ten steps to succcessful acquisitions 5 Step 1 Formulating strategy The four rules Implications of the four rules Integration and portfolio acquisitions Whether to acquire or ally

53 55 55 62 62 71

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CONTENTS

6 Step 2 Setting criteria Integration acquisitions Portfolio acquisitions Guidelines

7 Step 3 Conducting a search Sources The approach

8 Step 4 Acquisition planning Investigation team Negotiating team Implementation team

9 Step 5 Using the right financial logic Valuation methodologies Practical guidelines Cost of capital

10 Step 6 Negotiating a good deal Determining price Intermediate undertakings

77 77 78 82 85 85 88 91 91 91 93 95 95 102 105 109 110 112

11 Step 7 Performing responsible due diligence 117 Learning from private equity firms The logic of due diligence Financial condition Specialist matters Commercial due diligence

12 Step 8 Sale and purchase agreement Key areas for negotiation Strategic relevance

13 Step 9 Financing Cash versus shares The impact of different financing methods on EPS outcomes EPS enhancement strategies (‘bootstrapping’)

viii

117 118 120 124 127 131 131 138 141 141 143 143

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Further guidelines Acquisition bank finance

14 Step 10 Implementation and integration Lessons from the front

15 Summary of best practice Avoiding failure Ensuring value creation Managing a tight process Applying good parenting

145 145 147 148 159 159 161 162 163

Appendices Appendix A AT&T’s acquisition of BellSouth 165 Appendix B Imperial Group’s acquisition of Altadis

169

Endnotes Index

173 177

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Preface

cquisitions are widely used for pursuing growth. But performance is decidedly mixed. Some do well, especially when undertaken by companies with experience and dedication to rigour and hard work. But a great many fail. There is thus a real and widespread need for a methodical and disciplined approach. The Making Successful Acquisitions course at the Ashridge Strategic Management Centre has worked well for over a decade. It views the acquisition process as a series of ten steps, which collectively cover everything that needs to be done for success. It deals with the entire process, from getting strategic thinking clarified and identifying targets through to integrating the new company. An orderly framework of this sort will help managers to do a better job of a most difficult and challenging task. We thought it would be useful to structure a book about acquisitions around these ten steps. We also thought it useful to present acquisitions in the current context. We believe it particularly important to take note of the private equity industry and to learn lessons from the way it operates. We also felt it necessary to explain why acquisitions fail, so that warning signs can be recognized and pitfalls avoided. Learning how successful practitioners operate, avoiding the classic and recurring mistakes in this area, and proceeding methodically and with discipline is, we feel, the key to beating the odds. We have written this book with these ideas in mind. We hope you find them useful and wish you every success in using them.

A

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About the authors

David Sadtler is a graduate of Brown University and Harvard Business School, a two-time alumnus of McKinsey & Company and an Associate of the Ashridge Strategic Management Centre. He consults, writes and conducts research in acquisitions, alliances and business strategy. David Smith worked with the Shell group as a senior manager, advising on all significant mergers and acquisitions undertaken within the group on a worldwide basis, and is an Associate of the Ashridge Strategic Management Centre. He also works with private clients on major acquisition projects. He is a Chartered Accountant and holds a BSc in Physics from Birmingham University. Andrew Campbell is Director of the Ashridge Strategic Management Centre, the world's leading centre on corporate level strategy, and has been researching and teaching acquisitions for 15 years. He is a graduate of Harvard Business School, spent 6 years with the consulting firm McKinsey & Company and is the author of more than 10 books on strategy, including the classic text Corporate Level Strategy and the insightful book on growth, The Growth Gamble.

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Publisher's acknowledgements We are grateful to the following for permission to reproduce copyright material: Figure 1.1 from Amistat Dataset, HMSO (ONS 2007). Crown copyright material is reproduced with the permission of the Controller of HMSO and the Queen’s Printer for Scotland under the terms of the Click-Use Licence; Figure 2.1 from The Blackstone Group, http://ir.blackstone.com/secfiling.cfm?filingID=1047469-07-5160, page 154; Appendix A from AT&T, http://www.att.com/gen/press-room?pid=4800 &cdvn=news&newsarticleid =22860. Use of the AT&T press release information is granted under permission by AT&T Intellectual Property. AT&T Intellectual Property is the exclusive owner of the AT&T information; Appendix B from Imperial Tobacco Group, http://www.secinfo.com/d11MXs.u1m2z.d.htm. In some instances we have been unable to trace the owners of copyright material, and we would appreciate any information that would enable us to do.

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PA R T The context

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Introduction

he pace of activity and the size of transactions in the opening decade of the twenty-first century have surpassed all previous cycles of acquisition activity. The global mergers and acquisitions (M&A) market in 2006 was an astounding $3.8 trillion. Only two countries (the USA and Japan) boast a GDP above this figure. Just over a third of this amount involved cross-border transactions. Of the total, $1.6 trillion took place in Europe, tellingly, just a bit more than in the USA. Telecommunications, financial services and property were the most prominent sectors. 1 Everything about the current wave of mergers dwarfs its predecessors – everywhere in the world. Figure 1.1 demonstrates that the pace of UK mergers is not only growing fast, but that the levels reached in the 1990s were much higher than those of the previous boom in the 1980s.

T

Fig 1.1

UK M&A activity (£bn)

120

7,000

100

6,000 5,000

80

4,000 60 3,000 40

2,000

20

1,000

06

04

02

00

98

96

94

92

90

0

88

86

0 UK acquisitions: UK companies UK acquisitions: non-UK companies FTSE 100 index

Source: Office for National Statistics (2007) Amistat Dataset, Tables 7A and 8, London: HMSO. © Crown copyright.

The figure shows the way that merger activity built up during the stock market boom of the 1980s. The recovery brought with it an even higher level of transaction value, reaching record levels in 1999 and 2000. Then it fell back at

3

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PART 1 THE CONTEXT

the time of the World Trade Center incident in 2001 and the dotcom crash in 2002. It picked up again immediately after that as the prospects of global recession dimmed, reaching current levels (late 2007). It shows that cyclicality in acquisition activity is pronounced; banks that depend on transaction fees really feel it. So do London property prices, especially at the high end. Can the next dip be far away? It is also clear that the long-term secular growth of acquisition activity continues and at a high rate of increase; in this context, the falloff after the 1987 market crash looks like a mere blip. There are many forces at work to reinforce this trend, both managerially and macroeconomically. We examine both later in this chapter. Cross-border transactions are increasing in importance in the UK and acquisitions among companies in Europe are becoming more prominent, whereas not so long ago there were obstacles and inhibitions to such deals. Mergers and acquisitions in Europe in 2006 were valued at $1.59 trillion, slightly more than the value of deals in the US. The US picture is very much like that of the UK, albeit with substantially larger numbers. In 2006, the value of deals in the US reached an amazing $1.5 trillion, versus the previous peak figure of $1.4 trillion for 1999. In addition, average transaction size has grown enormously. A $5 billion merger in the 1980s was a major transaction. Now the big ones are in the $50 billion range. Some (ExxonMobil, BP Amoco, Citigroup, Vodafone, and competition in 2007 for ABN/AMRO) exceed even that huge figure. Further, the acquisitions by private equity firms are now reaching these levels (see Chapter 2). The pace of activity in the Far East has also begun to resemble that of Western economies with major deals. In 2005, five deals were worth nearly $400 billion, followed by over $500 billion in 2006. Even in Japan, where the business community has been traditionally averse to acquisitions, activity is picking up: over $100 billion in deals were completed in 2006. The frenetic pace of acquisitions is now truly a global phenomenon.

Drivers of growth Thus we can see that acquisition activity is huge and has tremendous momentum. In the business world, there has always been an imperative for growth. Top managers feel pressure from many directions to grow and make the enterprise bigger. Shareholders, perhaps concluding that the core business is unattractive, ask where growth will come from. Journalists routinely ask for growth strategies. And ambitious operating managers who want new mountains to climb will constantly propose something new and different.

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The problem is that the quest for growth is beset with difficulty and failure. One observer concluded that ‘significant opportunities are rare because so many factors need to fit for the probability of success to be high: a large market, advantages over competitors, managers capable of exploiting the market 2 and the advantages, and minimum disruption to the existing businesses’. But despite the odds, companies keep trying. The same forces are at work in smaller acquisitions. The vast majority of deals involve the negotiated purchase of a privately owned company or a business unit being divested by a larger public company. As we will see later, these are the deals that require a methodical approach, such as the ten steps we describe in this book. The larger acquisitions, especially the hostile deals, get all the headlines, but it is the smaller deals which continue every day, behind the scenes. Like their larger counterparts, smaller acquisitions are part of the perennial quest for growth. The managers of all businesses constantly seek opportunities in new product areas, in new markets and customer segments, and through new business models. As often as not, the only way to do this effectively and quickly, and to be responsive to the pace of market developments, is by way of acquisition. Smaller companies are also beset by all of the problems experienced in larger deals, albeit on a smaller scale. We will look at these in more detail in Chapter 3.

The reasons for the present boom This merger boom did not just happen. There were and are fundamental forces at work – both macroeconomic and microeconomic – which have converged to produce these amazing circumstances. All are fundamental and some even irreversible.

Availability of funds First, the world has been awash with money for the past two decades. Many recent developments have contributed to this glut. Companies are learning how to operate more tightly and with less capital. The need to raise funds for expansion has lessened accordingly. Also, privatization and deregulation have led to leaner operations and the release of still more funds. And fewer infusions of capital into uncompetitive state-run enterprises are necessary. As a result, real interest rates have been low. Rates in Japan actually approached zero, and banks are having difficulty finding desirable borrowers — at any price. The net effect of this is to lower the cost of capital for aspiring acquirers. The money is there, so why not use it?

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Cheap money is probably one of the two greatest contributors to the boom. Not only does it lower the cost of capital, especially for cash-only acquisitions, but it also motivates corporate and financial managers to put excess cash to work to achieve more attractive returns. On the other hand, any major disruptive event, and we have had a few of these in recent years, could act to quell enthusiasm and cause anxiety in global capital markets. Cheap money also makes it sensible and possible to increase debt and reduce equity – lowering the cost of capital and multiplying returns to equity holders. Gearing up has become more common and is stimulating the deal market. The recent turmoil in debt markets and the growing wariness of investors to fund highly leveraged transactions does not alter the fact that there is huge capital availability. It just means that lenders and investors have decided to be more careful and to price their offerings more prudently.

Market levels The merger boom has also been driven by the towering heights of the stock market itself, especially in the US. High stock prices have accompanied high asset values and the so-called ‘wealth effect’. This is the other principal contributor to the current boom. When people feel rich, they buy things. Companies are the same. The question on everyone’s mind now is: ‘When the real market correction occurs, will acquisition activity cease?’ Our answer is that it will not cease because the economic imperatives will still be there, but deals will be less bold and priced more conservatively. A companion of high stock market values is high price/earnings (P/E) ratios. As interest rates have declined and P/E ratios increased, many management teams have assumed that required returns could be correspondingly more modest. This has led to bolder initiatives and greater takeover premiums. This idea is reminiscent of the 1970s, when conglomerates were able to acquire lower P/E businesses and improve earnings per share even if they did nothing to improve performance (which they always claimed they did). Some of the same mentality appears to exist today. We will comment in Chapter 3 – on causes of acquisition failure – on this thinking and the problems it can cause.

Expansion through concentration In recent years, companies have learned – pushed by their shareholders – that business focus is essential to efficiency and effectiveness. The highly diverse portfolios of the 1970s and 1980s are fast disappearing. The trend towards greater focus in corporate portfolios has engendered a plethora of divestiture initiatives, itself an important stimulus to the acquisition market.

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Growth through diversification has been replaced by something even bigger: expansion through concentration. Today’s biggest companies are deciding that the best merger targets are competitors, either domestic or overseas. Merging with competitors offers more tangible and credible synergies. Operational overlap can be eliminated and substantial cost savings achieved. Cross-distribution arrangements are seen to allow for penetration of existing product lines in new geographic markets. And sometimes, the spreading of skills and know-how can improve the market performance of a whole business. Small wonder then that the investment community approves of such mergers and rewards participants accordingly. The largest US mergers over the past several years have nearly all been same-industry mergers, or at least transactions in the same general sector. This is a remarkable development compared to the kinds of merger and acquisition initiatives being undertaken in the 1970s and 1980s. Companies have got the message. Diversification is out and buying your competitor is in. Diversification loses money for shareholders because the new owners often don’t understand the business they have bought and they damage it. Concentration is in because cost savings can be achieved, market performance improves and sometimes a greater degree of pricing discipline can be introduced. Some observers believe that focus is just another fad. When we speak about mergers and corporate restructuring at conferences, one of the most popular questions after the talk goes something like this: ‘We admit that most companies are focusing now. But isn’t this just another corporate fad? Won’t the pendulum swing the other way? Won’t they soon all start diversifying again?’ We doubt it. The investment community will not allow it. They have seen the benefits of focus and are not going to let the same mistakes happen again. One 3 astute observer points out that the number of Fortune 500 companies that lost money grew each year from 42 in 1988 to 149 in 1992. Then the tide turned: in 1993, the figure was 114; in 1994, only 40. These improved results coincided closely with the era of refocusing and portfolio narrowing in big American companies. The movement to restore an atmosphere of honest challenging in the boardroom, euphemistically referred to as corporate governance, has been a great stimulus to the focus rationale for acquisitions. Managers of corporate portfolios have been forced to sell off businesses that were demonstrably not a good fit with the rest of their businesses. Why did it take so long for corporate managements and City specialists to figure this out? Why is focus now the new management paradigm? We believe it has a lot to do with our growing understanding of corporate level strategy. Over the past ten years, largely through the influence of our colleagues at the Ashridge Strategic Management Centre, the business and investment communities alike

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have discovered that diversified portfolios of business are difficult to manage, and in such companies value destruction is often rife. Corporate centres unfamiliar with the businesses they have bought fail to do a good job of appointing general managers, approving major investment proposals and guiding strategy. Often the newly acquired business is worse off than it would have been under its old ownership or even on its own. We take this subject up in more detail in Chapter 5, where we discuss the role of the corporate parent in the context of acquisition strategy.

Industry consolidation A companion of focus and concentration is industry consolidation. A number of IT-based fledgling technologies promise to transform further the way business is done. Internet-based corporate logistics systems, widespread use of speech recognition technology, and industrial robotics are all expected to pick up speed in the universality of their use, and thus in their impact on the rules of competition. This will put ever more competitive pressure on the slower movers in most industries and force further business consolidation. Dramatic changes are also afoot in specific industries, which will inevitably lead to more consolidation. The progressive deregulation of the telecoms sector around the world has led to dramatically reduced telephone charges and defensive mergers. Also, traditional players will be looking for quick entry into new technologies by acquiring state-of-the-art companies which have mastered them. The restructuring of the global telecoms industry is proceeding at high speed. A substantial proportion of the biggest deals in the US recently have involved telecoms companies. Traditional retailers are also facing profound changes and technology-based challenges to their entire concept of serving the customer. The advent of online buying and comparison price shopping, which is now rampant in America, is growing rapidly in Britain and, more recently, the Continent. The primacy of socalled ‘e-tailing’ will make traditional bricks and mortar less relevant and a financial millstone around the necks of today’s big retailing players. Traditional retail banks are feeling the same pressure as customers switch to telephone banking and online transactions from a personal computer. One American study has it that transactions with a teller cost $1.27 compared with 45 cents over the telephone, and the same transaction online: 1 cent! All of the above turmoil in response to these radical changes will lead to ever more defensive mergers and place-your-bets positioning moves.

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Privatization The widespread movement to return previously nationalized industries to the private sector, pioneered by the Thatcher administration in the UK in the 1980s, has been widely copied, especially in Europe and in the USA. Accompanying most of these privatization initiatives has been the introduction of competition, a pressure virtually unknown in these industries in the past. There have been two forces at work to force privatized industries to become more efficient: the attentions and demands of the capital markets, and the necessity to do so because of competition. The quest for greater cost competitiveness, especially through economies of scale, has greatly stimulated acquisition activity in these sectors. Privatization also creates deals in its own right. When the electricity industry emerged from government ownership, it triggered a wave of mergers and acquisitions which is still going on. Market forces and investor pressures have shaped the market for corporate control and forced efficiencies and synergies largely achievable only through consolidation by takeover.

Private equity The emergence of private equity as a major and almost dominant force in the acquisitions scene has constituted an enormous stimulus to activity in the market for corporate control. It may even be the single greatest cause of the high pace of M&A activity. While it may be seen as an unwelcome competitor and intruder, it can also be a source of good ideas on how you can improve your acquisition success rate. In Chapter 2, we will specify what you can learn from the private equity players and in which sectors the competition from them is likely to be the most intense.

The outcome Clearly we must ask if this enormous level of financial and managerial commitment has born fruit. Has value been created? Have shareholders been amply rewarded? Have the stated reasons and objectives for embarking on these enormous corporate adventures been achieved? Some acquirers undertake acquisitions which are undeniably a success. They deliver shareholder value and achieve what they promised to their stakeholders at the outset. The shareholders are better off because the acquisition was undertaken.

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RBS/NatWest In March 2000, Royal Bank of Scotland (RBS) succeeded in taking over the much larger National Westminster Bank (NatWest) and then embarked upon a hugely complex and comprehensive programme of integrating the 4 operations of the two banks. A key component of RBS’s value-creating strategy is the notion of managing the banking transactions of all customer-facing divisions within one common ‘manufacturing’ division. Thus the challenge for those charged with integrating NatWest into RBS was to manage the migration of NatWest systems into those of RBS, while at the same time maintaining a satisfactory level of customer service. The other main payoff from the acquisition was cost rationalization: major redundancies were expected. In the event, cost savings of over £1 billion per year were achieved, staff redundancies exceeded those promised to stakeholders at the time of the acquisition, and the systems integration effort was completed satisfactorily and ahead of schedule. In contrast to many other mergers in the financial services industry, this acquisition achieved its financial objectives, while at the same time giving RBS the size to enjoy major economies of scale and providing an excellent platform for further growth, both organic and by acquisition. This acquisition was well done, an exemplar transaction. We will refer to it several more times as we examine examples of best practice.

Another big winner was the Exxon/Mobil ‘merger’ (actually a takeover by Exxon) in 2000. The cost savings achieved were enormous ($4.6 billion) and considerably above those projected at the time of the merger, and the technologies of the two companies were found to be highly complementary: each was able to contribute useful insights and capabilities to the research work of the other. Most of all, Exxon’s timing was superb, acquiring Mobil’s reserves and productive capacity at a time when oil prices were unimaginably lower than at present. Another likely winner is Altria’s 2008 acquisition of cigar maker John Middleton. Not only is the US cigar business growing respectably – in contrast to the declining cigarette sector – but the company is highly profitable and clearly in a sector intimately understood by Altria (formerly Philip Morris). By making use of Altria’s distribution channels, the acquisition will enhance earnings from the start. But overall, the results from mergers and acquisitions seem to be strongly negative. Study after study shows that acquisitions fail to meet with expectations. Objectives are not achieved, shareholders are disappointed and, in some cases, the initiative turns out to have been fatally destructive. The investment

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INTRODUCTION

community loses confidence, the shares are marked down and a predator appears and finishes the job. We will consider the reasons for acquisition failure at greater length in Chapter 3. Essentially, they fall into two categories. The first is that acquisitions are undertaken for the wrong reasons or with the wrong motivations. The second is the complexity of the acquisition process itself. Acquisitions consist of a series of steps, each of which must be undertaken with skill and careful planning. If one of the steps fails, then the whole process may be in jeopardy. Often, acquisitions are carried out or planned by individuals who have little experience in the steps for which they are taking prime responsibility. This happens because transactions require high levels of management resource from business or functional specialists during short periods of time at certain stages of the process. Inexperienced individuals may then be drafted in without the necessary planning or without consideration of their limitations. Disaster may then ensue. The steps involved in successful acquisitions constitute the bulk of this book. The poor record of acquisitions in creating value for shareholders should be unacceptable to anyone concerned with generating wealth in the corporate world. Studies have shown that over 50 per cent of mergers and acquisitions fail to meet their objectives. Some even bankrupt the acquiring company. In 2007, The Economist commented: ‘The history of M&A makes depressing reading. It is full of deals done for bad reasons, often to satisfy a boss’s imperial 5 6 ambitions.’ We are thus addressing a vitally important subject. But it need not be that way for you. The fact is that there is a real learning curve for doing acquisitions. The more you do the better you get at it. That is why many serial acquirers get consistently much better value from their acquisitions than the lamentable average. You need to learn how they do it and this book will help. In line with the Making Successful Acquisitions course at the Ashridge Strategic Management Centre, we have structured this book around ten steps. The Ashridge course, which has worked well for over a decade, views the acquisition process as a series of ten steps which collectively cover everything that needs to be done for success. It covers the entire acquisition process, from getting your strategic thinking clarified and identifying targets through to integrating the new company. An orderly framework of this sort will help you do a better job of a most difficult and challenging task. To start you on your way we have already noted the size of the acquisitions market and what is driving it. We have warned you that success is difficult to achieve, even though there have been noteworthy examples of fine performance. In the next three chapters we provide further context for the world of

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acquisitions before we get on with the job of explaining how to do it right. The remaining chapters are as follows: Chapter 2 – Private equity. We explain the growing importance of private equity in the acquisitions market and its implications for corporate acquirers. The intensity with which private equity players do business has raised the bar for everyone in the acquisitions market. We can learn from them. Chapter 3 – Why acquisitions fail. We list the sources of error: knowing where the trouble comes from will provide you with a framework for avoiding it. We specify a dozen major reasons for failure and offer illustrative examples. Chapter 4 – Acquisition mechanics. We describe the difference between privately negotiated deals and public acquisitions and emphasize the overwhelming preponderance of private deals, with which the subsequent sections of the book are primarily concerned. We also describe the auction process, since so many businesses are sold in this way. We then go on to describe the ten steps: Chapter 5 – Step 1 Formulating strategy. This all-important section describes the starting point in the process, where strategic thinking is clarified. It offers four rules for creating value. It then explains the distinction between integration acquisitions to achieve synergy with existing operations and portfolio acquisitions where a new presence is staked out for further growth. We also address the question of how to choose between acquisitions and strategic alliances. Chapter 6 – Step 2 Setting criteria. Good strategic thinking can be turned into a set of specific criteria. We offer examples and guidelines. Chapter 7 – Step 3 Conducting a search. This section flows from the formulation and assessment of strategy and the setting of criteria. It offers specific steps and cites examples. It notes that the identification of suitable candidates can come from a variety of sources and comments on which are the most appropriate under individual circumstances. Chapter 8 – Step 4 Acquisition planning. Here we address the project management issues of the process and present a team approach to organizing the work involved. Acquisitions large and small are an enormously complex and time-consuming process. Organizing the work for effectiveness and inefficiency is thus a key task. We describe an approach to organizing this work. Chapter 9 – Step 5 Using the right financial logic. Here we address valuation methods and how to use them in making a judgement about

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necessary financial returns. Too often financial logic is seen to be an arcane subject in the hands of technical specialists. But it is also the lifeblood of value creation. Everyone involved in the acquisition process needs to understand the financial logic. It can’t just be left to accountants. We explain in detail how to address the subject and offer guidelines. Chapter 10 – Step 6 Negotiating a good deal. This section discusses the determination of price and other key elements of the relevant agreements. Probably the greatest cause of acquisition failure from a financial standpoint is paying too much. We deal with the determination of price and also the process of gaining agreement and the undertakings that are likely to be involved. Chapter 11 – Step 7 Performing responsible due diligence. Here we explain the major areas of necessary due diligence prior to committing to acquire and describe the advice and expertise that will be needed along the way. In negotiated agreements, this is a make or break step: overlooking a major problem can lead to disaster. The many areas of necessary investigation are described. Chapter 12 – Step 8 Sale and purchase agreement. The promises of the seller and the hopes of the buyer come together in the sale and purchase agreement. Many detailed points are covered and require understanding. We address them here. Chapter 13 – Step 9 Financing. Here we briefly address a number of issues in selecting the form of financing and how this can be seen to impact valuation. There are a number of ways to finance acquisitions. We explain what must be done in each to be successful. Chapter 14 – Step 10 Implementation and integration. Here we talk about the all-important process of integrating acquisitions effectively, examine some alternative approaches to doing it and offer some experience-based lessons. Apart from getting the right price, this is the most critical area for achieving success and attractive financial returns. We offer lessons and guidelines. And finally we summarize our views and specify the lessons to be learned from our observations of the M&A world: Chapter 15 – Summary of best practice. This is our advice in the form of best practice, including how to avoid failure, ensure value creation, manage a tight process and apply good parenting. Our goal is simple: we want to help you improve the odds of success in this challenging arena. We describe the world of acquisitions so that it will be familiar

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ground. We itemize the causes of failure, so that you can avoid them. We explain what you can learn from the players in private equity. And we provide you with a methodical framework for managing the entire process from beginning to end.

Chapter takeaway 1 The acquisitions boom is bigger than ever and is now a global phenomenon. 2 The many forces driving it ensure that it will continue, albeit with occasional blips. 3 Acquisitions don’t generally perform very well. 4 You can improve the odds by taking a methodical approach, which we describe.

We have shown that the merger and acquisition phenomenon around the world is enormous and virtually certain to continue at these massive levels, albeit with an occasional cyclical blip. But mistakes are widespread and are likely to continue for those companies which ignore the lessons of the past and fail to learn and absorb best practice. As we examine how best to deal with all of these pressures and opportunities, we must first look at one final cornerstone of growth in the M&A market, that of private equity.

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Private equity

2

rivate equity is a system for financing transactions in the market for corporate control without the use of publicly traded securities. There are two main types of private equity – venture capital and leveraged deals, often referred to as buyouts. Here we are only concerned with the latter. The key distinction between private equity and public companies is that there are relatively few owners in private equity, and the public is not involved in the 1 companies acquired, until, in some cases, the liquidation of the investment is by way of a public flotation. We address this subject in an acquisition book because of its growing importance in the market for corporate control: in the US private equity transactions are approaching 30 per cent of the total (see Figure 2.1 on page 17). As we shall see, private equity not only presents formidable challenges to traditional corporate acquirers, but it also offers opportunities. To maintain high skill levels in the acquisition arena, one must take note of this sector of the economy and how it operates.

P

How it works Private equity funds are raised by soliciting investment from institutional investors and wealthy individuals, who act as limited partners. The funds are managed by a management company, the private equity firm, which itself invests modest amounts and acts as general partner. The private equity firm acting as general partner has full control over the use of the money in the fund but is bound by a contract which imposes some limitations on investment decisions. Usually there are, for example, rules as to what percentage of the fund’s investments can be committed to a single business investment. The private equity firm also supplies the oversight of the portfolio companies in which the fund has invested during the period of ownership. Once the funds are committed, limited partner investors have little or no say over the use of the money. 1 For this, the management company is paid a management fee of 1–2– –2 per cent of the total funds under management, plus the carry: typically, the general partners are entitled to 20 per cent of all profits made by the fund, provided the fund achieves a specified hurdle rate. For funds with exceptional historic performance records, the carry can be as much as 30 per cent. The early focus of operating management teams in each business is usually to generate cash to pay down the debt. Often no dividends are paid to investors.

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Their payout comes only when the fund sells the business. The holding period for individual investments is typically 3 to 5 years before the exit by trade sale, public offering or secondary sale to another fund. The funds typically are wound up and all investments are cashed after a maximum of 10 to 12 years. In some cases, investors may be partly paid in shares of portfolio companies which have undergone a public offering of their stock. Private equity funds typically acquire companies that have little need for new capital investment, where cash flow is positive and stable, and where there is significant opportunity for performance improvement. They also look for companies with surplus assets which can be sold to raise cash. Private equity funds have an advantage over public companies in that they use leverage more aggressively than most public corporations – typically 70–80 per cent debt. This means that performance improvements are magnified for the equity investors: a 10 per cent improvement can generate a 25 per cent return for the equity holder. High leverage is possible because private equity firms choose businesses with stable cash flows, low new investment requirement and performance improvement potential. The debt assumed at the time of acquisition is usually reduced fairly quickly and is more like a bridging loan which is rapidly paid down. Debt leverage thus provides two benefits: it enables the acquisition purchase to be made with relatively modest amounts of equity and it allows for higher returns on equity as performance improves and company valuation increases. Another major feature of private equity investments is the lack of public knowledge and regulatory monitoring of these investments. In the current environment of heightened governance oversight, this is seen to be a substantial advantage, since management teams can spend more time focusing on their respective businesses: they do not have to comply with the onerous provisions of new regulatory pressures like Sarbanes–Oxley, a benefit of particular importance for smaller businesses. Nor do they have to produce and explain quarterly financial reports to the public. Thus companies under private equity ownership spend less on compliance, are able to undertake restructuring initiatives out of the public eye and, perhaps most importantly, can take a multi-year view of improvement plans, rather than having to focus on quarterly results.

Its impact The huge and growing presence of private equity in the acquisition arena is being seen everywhere in the world. In the USA, for example, 25 per cent of all acquisitions involved private equity buyers in 2006, versus only 5 per cent in 1999.

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Private equity M&A as a percentage of total M&A

Fig 2.1

Private equity M&A as a percentage of total M&A 30.0% 25.5% 25.0 20.7%

CAGR: 27%

20.0

15.0%

15.0

16.2%

12.7%

10.0 5.0

4.9%

5.3%

1999

2000

6.7%

0.0 2001

2002

2003

2004

2005

2006

Source: The Blackstone Group (2007) Form 424B4: Prospectus Filed Pursuant to Rule 424, 25 June. Reprinted with permission.

This growth is staggering. Transactions are increasing, they are ever larger in size and enormous pools of capital are still available for further deals. Here are some noteworthy deals from the past two years, demonstrating the frenetic pace and perhaps even the competitive urge to be the biggest.

•

The $33 billion buyout of HCA in 2006 by a consortium of private equity firms; HCA runs 182 hospitals with revenues of $24 billion.

•

Goldman Sachs and Carlyle Group then paid $26.5 billion for Kinder Morgan, a pipeline transportation and energy storage enterprise.

•

Then came Blackstone with Equity Office Properties (EOP), America’s largest commercial landlord, a new record at $39 billion; it was also the biggest acquisition of a real estate investment trust (REIT).

•

Next was KKR with the $45 billion takeover of TXU, a Texas energy firm, which generates, distributes and markets electricity, primarily in Texas.

•

Then the $48.5 billion acquisition by a consortium led by the Ontario Teachers’ Pension Plan of BCE (Bell Canada), a Canadian telecoms giant.

Not only is the private equity phenomenon changing the M&A scene, but the private equity world itself is also quickly evolving. It’s not all good news for the industry. Competition for attractive targets is increasingly fierce. Bidding pressures are even more intense with smaller deals, since many more funds can realistically bid.

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As a consequence, since 2004, the typical target for private equity acquirers has shifted from buying out divisions of companies to taking entire companies private. A major disadvantage for the private equity firms of this development is that they may be buying extraneous businesses unrelated to their real valuecreation potential. Purchases of divisions are more focused on a segmented view of industry opportunity, whereas taking entire companies private often involves a more spread out portfolio than they would like. Since the former offer intrinsically higher returns from their managerial approach, ever more intense and focused analysis is required in order to maintain traditional investor returns. The tougher competition for suitable subsidiaries is a disappointment also because of the inability to exploit the intrinsically lessened competition for good governance: hedge funds, for example, can put pressure on public underperformers but not, directly, on subsidiaries. The emerging trend towards higher interest rates, tighter money and tougher borrowing terms in both the UK and the USA is a major negative for those funds that finance deals with a high amount of debt. The cost of borrowing is beginning to rise and a number of recent high-profile transactions have looked less attractive to investors, as the underwriting banks have had trouble syndicating these debt packages. Since higher interest charges increase costs, returns are bound to suffer, at least in the long run. Eventually, lower returns will make raising capital from investors more difficult as they seek greener pastures, even cash. It must be acknowledged, however, that rising interest rates in relation to the cost of equity are a cyclical phenomenon. They go up and down. The tax treatment enjoyed by private equity firms on both sides of the Atlantic is also being questioned. The debate rages on at present with high emotional content. Private equity firms are labelled asset strippers, pirates and the like, and populist politicians see the opportunity to woo voters by getting tough. The pressures are largely on the personal tax rates of the general partners, however, not those applicable to the limited partnerships. To the extent that the general partners view these developments as a disincentive, they become an indirect cost of doing business. Government regulators are also posing a threat. The Justice Department in the USA is examining the question of whether consortium bidding constitutes an antitrust violation. The US Congress is also looking at changing the tax treatment on the flotations of private equity firms, having noted the favourable terms of the recent public offering of The Blackstone Group. Major external events, both of a political and economic nature, can transform market sentiment and erode investor optimism. Terrorism, global warming related crop failures and the like do not seem unlikely. Even the failure of a large private equity firm could dramatically change attitudes in the capital markets.

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Whatever these pressures, however, the funds are very active in the market and the pool of available capital is enormous. The kinds of industries in which PE firms specialize, however, remain the same. A competitive environment where high growth is expected and high prices are paid for participating businesses, together with long-term growth strategies and the necessity for heavy capital investment, are generally not targeted. Rather, those industries with low to medium growth characteristics and, in particular, those where competition is less intense and perhaps even genteel, invite private equity attention. Participants in such industries tend to be managed in a relatively more relaxed fashion and are particularly vulnerable to the advent of a newly invigorated competitor or even an external interloper. A parallel development has to do with the fact that much of the ‘low hanging fruit’ of sleepy companies in low-growth industries may have already been picked. This, in some cases, has led to increased activity in the acquisition of stronger companies in higher-growth industries. Thus private enquiry firms must upgrade their ability to oversee operational management decisions. This in turn requires the recruiting of specialist skills to ensure that the needed improvement takes place. Private equity firms are now recruiting such luminaries as Jack Welch and Lou Gerstner, the uber-famous former CEOs of General Electric and IBM, respectively. Two former CEOs of Ford were said to be fronting competitive private equity offers for Jaguar. Ironically, in this respect, private equity firms are beginning to look more like the conglomerates of old. Firms like KKR and Texas Pacific both oversee very large diversified portfolios of businesses. They are conglomerates themselves. For the time being at least, however, they work better than the more traditional model. That may well be because, by and large, private equity firms ‘buy to sell’ and thus free up their capital at the point it has finished achieving its highest returns. Conglomerates largely ‘buy to keep’ and thus eschew the opportunity to restrict ownership to the best years.

Implications for corporate acquirers These behavioural characteristics and trends are critical for understanding the nature of the acquisition game as played by all companies, whether public or private. There are implications in five areas:

• • •

as a competitive threat as a source of best practice as a source of cooperation in corporate development

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• •

as a predatory acquirer as a prompt for strategy change.

A competitive threat Private equity firms are aggressive players and are serious competitors for the managers of corporate portfolios. Most fundamentally, corporate acquirers can expect tougher competition in the M&A marketplace. Clearly, if more aggressive acquirers with deeper pockets are chasing the same number of available business properties, price competition will become more intense. The wall of money is now immense, and until the inflow of capital to these investment vehicles wanes, its effect on stock market values and acquisition prices will remain inescapable. Auctions will result in higher prices. PE firms shy away from auctions where there are strategic buyers with large synergies. But competition between the two categories of buyer is not entirely avoidable, particularly for those companies in clear need of a shake up, irrespective of whether or not substantial synergies are available for trade buyers. Especially aggressive activity in industries targeted for buy-to-build strategies by private equity firms should be expected. A favourite strategic approach to the M&A market by private equity firms is the identification of industries populated by relatively sleepy firms enjoying less than intense competitive conditions. An entry-level firm is acquired and given intense treatment, both at the cost level and in terms of identifying and strengthening the drivers of competitive advantage. When the new property is at fighting weight, it then becomes the platform for further acquisitions in the same industry and market segments. Competition in such industries can be expected to be transformed and particularly intense. Corporates should also expect tougher competition in any industry where private equity firms operate. Not only will competition in the M&A market for plausible targets intensify, but once acquired, their pursuit of competitive advantage can be expected to make lives more difficult for indigenous players. Time and again, research in the private equity industry shows that, contrary to popular opinion, private equity firms do not make most of their money from lowering the cost of capital and stripping out costs. Rather, the big action is in 2 the pursuit of competitive advantage and the achievement of superior growth. Such industries will become less attractive for sleepier players. At the same time, however, more serious owners can redouble their own efforts and expectations. More aggressive targets for improvement can be set and expectations ratcheted up. Understanding this distinction is key to knowing whether or not

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to expect intense PE competition. While only 30 per cent of available competitive deals go to private equity firms, they tend to win competitive bidding situations 70 per cent of the time. This means they are industry-selective in the way that I have described above but play to win when they play. Finally, they should expect tougher competition for successful managers. The very best managers in industries attractive to private equity firms are likely to be targeted for top jobs and key roles in improving the fortunes of selected companies. In many industries, the identity of such people is well known, and their reputations will make them possible candidates for the new breed being sought by private equity firms. Private equity firms are able to pay managers substantially more than they were earning in their corporate jobs. Because of increasing shareholder pressure on CEO compensation in the new world of intensified corporate governance, public corporations may become more inhibited about offering outsized compensation packages. This will make it tougher for corporate players to find good people to reinvigorate their own businesses and will also make their own successful managers more attractive to private equity firms. Good men and women will be lost.

A source of best practice Private equity firms must be really good at the key acquisition tasks in order to overcome the economic burdens of the carry by the general partners and the premiums they pay for acquisitions. Many private equity firms claim that much of their advantage comes from more thorough and more objective due diligence on market opportunities. That portion of the due diligence process which concerns itself with verifying upside potential in the marketplace is sometimes carried out on a perfunctory basis by corporate managers in order to justify the entry investment. Private equity firms take this more seriously and are more dogged in resolving areas of uncertainty. Corporates can learn from them and improve the seriousness and effectiveness of their own efforts. We will have more to say on this subject in Chapter 11, on due diligence. Private equity firms are also great believers in assiduous implementation planning. Focusing attention as early as possible in the acquisition process on those initiatives which will have the greatest impact on value creation and on reducing debt is the key to financial returns. When ownership passes, there is little doubt in anyone’s mind about what has to be done and when. We will comment more in Chapter 14. For the most part, private equity firms simply do more deals and screen more candidates, and thus enjoy a reservoir of highly expert and experienced people. The learning curve applies to acquisitions like any other complex endeavour.

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A source of cooperation in corporate development The frenetic pace of deal activity in today’s capital markets offers potential benefit for corporates themselves in search of deals. Alert managers of corporate portfolios should view private equity firms as buyers for businesses they don’t want. One good piece of news is that the private equity firms targeting particular industries, especially when engaged in buy-to-build strategies, will become plausible buyers for businesses in the corporate portfolio targeted for divestiture. Now, not only do other players in the industry become possible buyers on a trade sale basis, but private equity firms do as well. Higher proceeds from targeted divestitures are possible. Also, as a divesting corporate, there may be an opportunity to keep a share of the businesses sold to a private equity firm in order to participate in the upside. Private equity firms in some circumstances may welcome the opportunity to lessen the required funding for the deal. Increasingly, private equity firms are using alternative deal structures for their investments. Among them is the idea of cooperating with managers of corporate portfolios who may be interested in the pieces of a potential target company that they don’t want. Anticipating likely moves by the major private equity firms in industries of interest could be time well spent. In some circumstances it might even be appropriate to suggest such an initiative to possible firms. Both Blackstone and KKR state that they have ongoing relationships with a number of large companies for this purpose.. Corporates can also become trade sale buyers for businesses with improved management. Sometimes private equity firms sell their improved properties on a trade sale basis to existing players in the industry. Although a significantly higher price will have to be paid than was the case before ownership by the private equity firm, the resulting improvement in management could make it worthwhile. Corporate owners with portfolio companies in a promising position which could benefit from a more successful and focused management style might achieve significant managerial synergy from providing the private equity firm’s investment exit.

As a predatory acquirer For many companies, the private equity industry represents a threat to their survival – at least as public companies. The uncomfortable fact is that companies which are seen to be underperforming and managed at less than their full potential are likely to be acquisition targets for private equity firms. This is not all bad news. Disfavour in the capital markets and even the prospect of a bid from a private equity firm can spur boards into action. They can stop dubious

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acquisitions, dismantle structures designed to discourage bids and even, in extreme cases, fire the chief executive. In this respect, they would be taking action often urged upon them by activist shareholder organizations. Companies in this situation know who they are. The shareholders are likely to benefit from such pressures. They will either see an appreciation in their stock from the bid premium inherent in any acquisition or see improvement engendered by the threat. Either way, they gain.

As a prompt for strategy change Private equity firms seldom look for synergy among their investments. They are not interested in finding ways to stimulate their portfolio companies to do things like share best practice, operate joint facilities or trade with each other. They simply want the managers of their businesses, as one of the best-known fund managers told me, to ‘concentrate on getting as rich as possible’. There may be a lesson in this for public companies. Our research at Ashridge in corporate level strategy has long demonstrated that the search for synergy 3 in big companies is surprisingly unproductive. While the rationale for many portfolios is the strength and benefit of the relationships among the businesses, we see very little of it. Thus one of the biggest lessons from the behaviour of private equity firms for big corporates may be: forget synergy and simply concentrate on competing aggressively. Corporates may also want to consider bolder debt to equity ratios and the use of the high levels of debt that drive the private equity industry. Aggressive leverage can multiply investment returns by several times. But it requires confidence in management’s ability to achieve planned improvements without fail. It means instituting a ‘no excuses’ culture. But the biggest difference between traditional corporates and their private equity counterparts may represent the boldest opportunity for strategy change. More companies could approach acquisitions as a buy-to-sell opportunity rather than as part of a buy-to-keep strategy. This is the logical outgro wth of the Ashridge thinking on corporate value-added. When all of the opportunities for improvement have been exploited and all the parenting opportunities implemented, what is the rationale for further retention of any business? This question is one which could benefit from more assiduous discussion in corporate 4 boardrooms. It also affects deal pricing. If the private equity bidder is pricing a deal on the basis of buy to sell, then its pricing will reflect the return from a one time profit opportunity which is certain to exceed that accruing to a buy-to-keep buyer. Corporates then need to run the numbers like a private equity house and

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consider what that means for them. Are they prepared to follow a buy-to-sell strategy if that is what gives the high returns? Clearly, adopting a buy-to-sell mentality requires being good at selling as well as buying. Corporates going down this road will need to view the selling and disposing process as another skill set to be mastered. Watching how private equity firms do it is a good start.

Chapter takeaway 1 Private equity is huge and of growing importance in the acquisition scene. 2 Returns are under pressure but its influence will continue to be substantial. 3 For corporate acquirers, private equity is a major competitor in the marketplace for companies and for top managerial talent. 4 It is also a source of best practice, especially in due diligence and in the art of acquisition integration. 5 Private equity firms offer the opportunity for cooperation in corporate development, both as buyers and sellers. 6 Corporates should also regard private equity firms as potentially predatory acquirers. 7 The behaviour of private equity firms also suggests possible strategy changes for big companies — more aggressive use of debt and buying to sell.

Before we address the subject of making successful acquisitions, we must first find out why they fail. We have to know not only what to do but also what not to do.

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Why acquisitions fail

3

here is no doubt that many acquisitions succeed. They do what they were intended to do. They create returns in excess of the cost of the capital employed in making them. We have mentioned several such successes earlier: the acquisition of NatWest by Royal Bank of Scotland, the Exxon/Mobil merger, and the acquisition of John Middleton, the cigar maker, by Altria. There are many more. Some serial acquirers, like GE Capital, have an excellent track record in making acquisitions because they’ve learned to do it well. They have developed method and discipline, and they know what works for them. In this book, we’re trying to do the same thing by providing a methodical approach so that you can also be a successful acquirer. But part of doing a good job requires being alert to what can go wrong. That is why this chapter describes at length the major pitfalls in making acquisitions. Knowing what can go wrong should render you less likely to make the same mistakes. If all practitioners used the material in this chapter as a negative checklist – the danger signals to look for in any deal – acquisition success would be substantially greater. If reading this chapter frightens you, the caution it imparts to your aquisition programme should serve you well. Acquisition failures are of two types. The first type causes the acquisition to abort, while the second prevents the acquisition from living up to its financial promise. The two types are not mutually exclusive. The threat of an aborted acquisition can itself do lasting harm and sap returns. And the revelation of alarming factors during the due diligence process can cause the deal to fall apart. But one thing is clear: an aborted acquisition is nearly always better than one which falls far short of its financial expectations. At least in the former, the only downside is a waste of management time and professional fees and perhaps a bit of embarrassment. A major shortfall in financial performance from an aggressively promoted acquisition can damage the acquirer’s reputation and stock price for years to come. The high failure rate for acquisitions seems to occur simply because there are so many things that can go wrong. We have noted at least 12 major causes of failure. They affect deals of all sizes, on both sides of the Atlantic, in both public and private sales, and in virtually any industry.

T

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Aborted aquisitions Here, first, are the reasons why the deal may abort before completion.

External approvals A welter of regulatory, financial and political hazards lie in wait for all large acquirers, whether the transaction in question is domestic or cross-border. Virtually all large mergers require the approval of the competition authorities of the countries in which both businesses operate. This can be an important and, at times, daunting hurdle to overcome. Depending upon the size of the transaction, the market shares of the businesses in which both companies are involved, and even political sensibilities in the host countries, it can be delayed or even stopped by government regulatory agencies charged with approving such deals. A good example is the Federal Trade Commission in the United States, which must be notified of any qualifying transaction. Certain timetables prescribe what happens next. In addition, the US Justice Department may, at its own initiative, interfere in a transaction which it deems to be against the public interest. There are similar institutions in all developed countries. The antitrust doctrine is especially well developed in Germany and in the United Kingdom, where the oversight is provided by the German Cartel Office and the Office of Fair Trading, respectively. The European Union is also in the competition arena, and any merger of substantial size operating in the EU must go through similar hurdles in Brussels. Sometimes the answer is no.

Canadian banks In December 1998, two different mergers between Canada’s largest banks were turned down by the Canadian competition authority. The Bank of Montreal thought it could merge with the Royal Bank of Canada, and the Canadian Imperial Bank of Commerce and the Toronto-Dominion Bank had similar plans. Although it would have been reasonable to assume that the chief executives of these organizations would have good enough connections with the government to know whether or not their plans would succeed, all appear to have been surprised. One chairman immediately resigned and the banking sector declined sharply on the stock exchange. The stated reason for these deals – the necessity to become more competitive in the face of American global banking consolidation – led to the announcement from one of the banks that the merger failure would be followed by a sweeping reorganization, presumably meaning major job losses. One has to wonder about the quality of the advice received or if they acted on it.

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Sometimes there is a degree of bargaining involved to secure the necessary approval. AT&T’s acquisition of BellSouth (see Appendix A) involved a number of concessions to ‘win bipartisan support’ from the Federal Communications Commission (FCC), the regulatory agency in the US which supervises telecommunications and which would be in a position to block a deal of this sort. The company agreed to provide universal broadband service to the 22 states in which it would now operate and to do so at a highly competitive price. It also agreed to repatriate 3,000 jobs, currently outsourced abroad. In its circular (Appendix A), it even stressed the amounts the company gives to charity through its foundation and cited an article praising its generosity. These decisions are demonstrably not made on the basis of the economic merits of the transaction alone. A parallel problem is that of satisfying acquisition target company creditors. Often such companies find themselves being acquired because of waning competitive strength and rising debts. Many would-be Western acquirers in the Far East have found that an agreed transaction was blocked by an unwillingness of creditor banks to come to the table and discuss financial restructuring. Presumably this was because such banks were carrying these debts on their books at original value and to agree to any restructuring would require writing down these assets. For some banks, this would, when extended broadly across their loan portfolios, lead to insolvency. These situations can be deal stoppers. The significance of all of these external approval hurdles is clear. Any one of them can stop a transaction. At the very least, they require time. In some cases a great deal of time. There is a general realization that approval of mega-mergers in the US — such as those of BP/Amoco and Exxon/Mobil — requires between six months and one year, or even more. Much can go wrong during such delays. Key people can leave, and rumours can abound in target companies and lead to distraction and deteriorating competitive performance. Finally, the delay can make it possible for competitive bidders to enter the scene on a leisurely basis and make counter-offers for the target company. Approval problems have been particularly relevant in a number of recent transactions where the negotiations between the parties were accomplished extremely rapidly, sometimes in a week or two. The deal to merge Daimler-Benz and Chrysler was allegedly agreed over a weekend between the chief executives of the two companies. It then took one year – minus one day – to clear the regulatory hurdles. Although the merger was eventually approved by the relevant authorities, much challenging ensued and it was never a foregone conclusion. The fact that the merger was such an abject failure may have had something to do with the speed with which the deal was agreed. Clearly, Daimler would have been better off had the challenges succeeded.

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While such speed, especially in today’s huge transactions, might seem imprudent, it can make sense. Acquisition participants are often motivated to move quickly for several reasons. First, depending on the requirements of local securities laws, disclosure of pending transactions must often be made as soon as some semblance of agreement has been reached, even though such information might attract competitive bidders. Also, companies are often required to respond to press comment suggesting such discussions. In these cases, it is in the interests of all concerned to be able to present agreed terms and thus eliminate the uncertainty surrounding the share prices of both parties. The hazard, of course, is that the regulatory approvals have not been cleared and could present insuperable problems. Acquiring companies typically secure expert advice on the likelihood of regulatory difficulties, but many are surprised by unexpected outcomes. In any case, lawyers seldom give unequivocal advice on such questions. In the UK, the Office of Fair Trading (OFT) makes the initial decision about whether or not a merger or acquisition is a problem. It has threshold levels for consideration: if the company to be acquired has a turnover of £70 million or a combined market share in any specific business segment over 25 per cent, it becomes susceptible to investigation. If the OFT decides there is a case to be answered, it is referred to the Competition Commission and an investigation ensues. An investigation can last many months and require much managerial oversight to prepare the required submissions. In addition, legal representation can be expensive. It’s not something you want to experience. It should be noted that competition law changes. For example, the Enterprise Act of 2002 in the UK made a number of significant changes to competition law enforcement and the various avenues of appeal available to unsatisfied litigants. Active aquirers need to keep up to date.

Nationalistic barriers The major countries of continental Europe are traditionally protective of large indigenous companies. Spain, France, Italy and sometimes even Germany will throw up obstacles or even prevent takeover of substantial companies in their countries by foreign acquirers. The best-known defender is France. Whenever a potential foreign acquirer appears, the French government typically attempts to find ‘a French solution’. A recent example was the rumoured bid for Danone, the yoghurt company, by PepsiCo of the USA. Spain operates in the same way. E-oN, Germany’s biggest electricity provider, endeavoured to buy Endesa, a large Spanish utility. The Spanish authorities solicited a lower bid from Gas Natural, another Spanish utility,

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hoping to create a ‘national champion’. In the event, the latter backed away and E-oN’s bid went through. The authorities were made to look foolish.

Pressure groups Completing large acquisitions is not just a matter of satisfying shareholders’ financial aspirations and the requirements of regulatory authorities. Groups organized to represent the interests of particular segments of the population, often very idealistic in nature, can exert powerful influence on the success and even feasibility of an acquisition project.

Wal-Mart Wal-Mart’s acquisition in 1999 of ASDA had wonderful commercial logic – indeed, it may in retrospect be viewed as one of the deals of the decade. ASDA represented one of the few opportunities for a hypermarket operator like Wal-Mart to buy the kind of large-scale retail space in the UK needed for operations of its sort. But this very need for big facilities attracted the attention of groups dedicated to the preservation of the countryside. Organizations like the Council for the Preservation of Rural England and Action for Market Towns furiously lobbied the UK government to block the merger. These pressures often have popular support and cannot easily be ignored.

The Wal-Mart case is not unique. Pressure groups have recently become more visible and proactive in their opposition to proposed mergers.

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In the UK, the Campaign for Real Ale (CAMRA) has consistently opposed industry consolidation and the takeover of regional brewers, reasoning that local brands would be lost in the amalgamation process.

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In the US, the merger of LS Power and Dynegy, developers of coal-fired power stations, has led to strong opposition by organizations concerned with global warming, like the National Environmental Trust.

Sometimes these campaigns are successful and sometimes they exact concessions from the acquiring organization. But at a minimum they constitute a major distraction from the already demanding process of acquisition and integration.

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Executive power An intractable problem can be the question of who emerges on top. Sometimes one of the chief executives is about to retire anyway and does not mind passing the reins over to his opposite number on the other side of the acquisition. More frequently, however, some form of power-sharing formula is decided upon. This often gives mixed signals. In 1998, the insurance company Travelers merged with the global banking giant Citicorp. In order to attract Citicorp to the merger deal, Travelers’ CEO, Sandy Weill, proposed to his opposite number that they operate as co-chief executives. It is said that no one at Travelers and Citibank was quite sure whether John Reed or Sandy Weil was running the merged organization, until Reed finally announced his retirement. Sometimes the problem is so great that the acquisition is aborted.

Glaxo Wellcome/SmithKline Beecham A dramatic example of this was the breakdown in the merger, after a deal was agreed, between Glaxo Wellcome and SmithKline Beecham. Both chief executives wanted to be boss, and an accommodation was never reached. Industry observers have commented that a power-sharing arrangement between two executives of such different style was doomed to failure. Richard Sykes, the Glaxo chairman, was a relatively modestly paid, conservative manager, running a decentralized pure drug company; Ian Leschly was an outgoing, highly paid Dane, a former tennis star and resident in America, running a business that mixed drugs and branded consumer products. Finding common personal ground unsurprisingly turned out to be difficult for two men intent upon sharing management responsibility for the combined enterprise. The clash of executive egos and resulting broken deal is said to have cost shareholders some £13 billion. Unsurprisingly, the investment community was disappointed and upset, and key institutional investors pressured the companies to find ways to resurrect the merger. At a time when the cost of introducing new drugs was escalating, pressure was increasing on big pharmaceutical companies to find ways to rationalize costs. Mergers offered an attractive route to this end. Leschly announced his retirement in 1999 and the only real obstacle to the merger was thus removed. The deal was resurrected and completed in 2000.

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The embarrassing failure of the merger between Deutsche Bank and Dresdener Bank of Germany was also said to have failed because of disagreement over who would be boss.

Poor returns from completed acquisitions Now, we will examine the factors that are unlikely to cause the project to fail to complete, but which will make returns disappointing.

The wrong industry It is true that most acquisitions now target the same industry as that of the acquirer. Most organizations have learned the lessons of focus, the idea that you are far more likely to be successful in businesses with which you are intimately familiar than in new ones. Furthermore, investors are no longer willing to support corporate diversification programmes. The investment community tells companies to stick to what they know how to do. They say: ‘We can diversify our own portfolios; you stick with what you understand.’

Crédit Lyonnais French bank Crédit Lyonnais has provided a harrowing example of how indiscriminate entry into unfamiliar industries can go wrong. In an effort to build a broad international portfolio of attractive businesses, it made major entries into the Parisian property market and even into MGM, the Hollywood movie studio. Since Crédit Lyonnais is a nationalized bank, the French taxpayer was left with the bill – one of at least £10 billion.

Even with the knowledge of folly such as that of Crédit Lyonnais, some companies do still make acquisitions in unfamiliar fields – in industries in which they have no experience and where the success requirements are different from those with which they are familiar and expert. Often such acquisitions are made in an effort to flee from an undesirable core business – one that is experiencing no growth or where there are other clouds on the horizon.

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The wrong company Buying the right company requires a clear understanding of why the combination of the acquirer and the acquired makes sense. There must be a rationale for creating shareholder value. It cannot be a general one. It must play to the particular strengths and weaknesses of the two companies and demonstrate how bringing them together will build on their respective strengths and cater for their weaknesses. This is key to building a value-creating acquisition strategy. For every competitor in an industry, there are some potential partners with whom a good fit can be projected. This means that the combined value chain would be stronger than either of them separately. Superior quality and cost positions must be the output of any same industry merger. Of course, not all industry participants have complementary strengths and weaknesses. Some may suffer from the same weaknesses at the same stage of the value chain and have similar strengths. There are some competitors that represent a good fit and some that don’t. Prior knowledge and analysis is necessary to illuminate this question.

International retailing Overseas acquisitions appear particularly attractive to successful retailers, especially those who have large market share positions in their home markets and are seeking opportunities for expansion. The one lesson that most observers have drawn from the recent experience of expanding retailers is that it is much harder to apply proven competences and skills from a home country to another country. The record of good retailers going abroad is simply dreadful. Marks & Spencer, notwithstanding their ups and downs, one of the most successful UK retailers, surprised everyone when it purchased the upmarket US menswear retailer Brooks Brothers in 1988 for $750 million. What were they thinking of? Brooks Brothers’ products and markets are utterly different from those of Marks & Spencer, and the US retailing scene is considerably different as well. There was no apparent value chain rationale for this acquisition, although nominally in the same industry. Brooks Brothers was an iconic American brand of clothing, favoured by affluent prep school and college students and the favourite at eastern country clubs. John F. Kennedy wore a Brooks Brothers suit at his inauguration in 1960. The flagship store at 346 Madison Avenue in New York City was an exemplar of high-end dignified retailing. Marks & Spencer hired aggressive management, opened stores aggressively around the world, set up a factory outlet operation and even installed modern glass and steel frontage to the main store. They ruined it. Profits plunged and it was sold in 2001 for $225 million to an Italian billionaire.

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Without such a rationale, an attractive payoff to the acquisition investment is unlikely. Just putting together two companies in the same industry does not necessarily create value.

Drugs 1

One study of the global pharmaceutical industry concluded that not a single one of the major drug companies mergers of the past decade has actually resulted in increased market share, which in most cases was held out to be the principal rationale for these transactions. They said that combining their research skills and exploiting cross-selling opportunities would create business growth. All that was accomplished was cost-cutting.

We pay more attention to the subject of picking the right company in Chapter 5, on strategy.

Bad strategic rationales There is a limited number of valid reasons for making an acquisition. These reasons are potentially productive and even laudable. Carried out correctly and responsibly, they have a sporting chance of increasing shareholder value. Acquisitions with genuine value-creating rationales are of two types: integrating acquisitions and portfolio acquisitions. In the first, synergy with existing businesses is sought through cost reduction, economies of scale, cross-distribution, the acquisition of important skills and the like. In portfolio acquisitions, the acquiring company believes it has the ability to oversee and improve the performance of the acquired business to a significant degree. These two types constitute the only valid rationales for undertaking acquisitions. We take them up in greater detail in Chapter 5, on strategy. There are, alas, some other acquisition rationales that make little sense. The most noteworthy examples are as follows.

Vertical integration This is a centuries-old business idea that lingers on. The idea is this: ‘Let’s buy our customer and then we don’t have to worry about getting the business.’ Or: ‘Let’s buy our supplier and secure our raw material source.’ There are four reasons why vertical integration generally fails to deliver the promised benefits.

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First, the likelihood of not being able to find a satisfactory supplier is far lower than it once was. We live in an information-laden world where

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competitors abound and can come from any country. There are more suppliers than ever before who want your business; this is the inevitable result of globalization. Also, everyone who wants to can access information on a desktop PC in ways undreamed of ten years ago.

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Second, doing business within the corporation is invariably more troublesome than doing it with outside suppliers. Transfer price arguments persist and customer divisions complain of poor service and lack of competitive pricing. In our experience, businesses would far rather trade with outsiders than within the corporation. The resulting tensions burn up management time and make corporate life more stressful than it needs to be. More and more, enlightened parents are doing two things: they are telling trading divisions to work out their own arrangements and to trade with anyone they want; and they are abandoning any hope of profit advantage from the position of being vertically integrated.

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Third, customers often refuse to do business with companies whose sister operations compete with them. That is why AT&T demerged Lucent (Deutsche Telekom would not buy telephone equipment from AT&T because another division was trying to capture their international call business). Baxter International had trouble selling to hospitals at the same time that they were competing with them in the home care field. They decided to break the company in two, rather than continue to lose that business.

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Finally, a vertical integration initiative can take a company into a new business area, one that it does not understand. Its parenting oversight is inadequate and it makes mistakes. We treat this subject in more detail in Chapter 5, where we discuss portfolio acquisitions.

Despite all of these disadvantages, there continues to be a herd mentality to these movements in one industry after another.

Media The global media concerns are vertically integrating. Content producers (TV and movie studios) are buying their distribution channels (TV stations and cinema chains). Equipment manufacturers are buying film studios and record companies. Why do they need to own these operations in order to make money together? Already there have been major regrets, like Sony’s catastrophic 1989 acquisition of Columbia Pictures. Sony believed that the ownership of entertainment content, the Columbia film library, would help them sell their video hardware. But they were never able to bundle the two product lines in

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any productive way. The studio also performed poorly, with a succession of box office flops, and there was said to be major cultural conflict between Japanese and American management. In 1994, Sony decided to write off $2.7 billion of its $4.8 billion investment. Similar problems afflicted Matsushita’s ill-advised 1990 acquisition of MCA, now sold on to Seagrams. The 1999 merger of Viacom and CBS was dismantled in 2006 for similar reasons.

Some vertical integration is aimed simply at market control. Producers believe that by buying operations downstream towards the customer, they can secure more business than they would be able to do in the free market.

Pharmaceutical benefit managers A few years ago, a number of drug companies bought pharmaceutical benefit managers (PBMs) in the USA –an effort to integrate forward to the customer. SmithKline Beecham (now GSK), Eli Lilly and Merck & Co. all took multi-billion dollar plunges. PBMs manage the purchase of ethical drugs for big companies and managed care firms. The idea was to use these firms to promote the parent’s drugs. Unsurprisingly, the US competition authorities spotted this and made it clear that PBMs must offer all appropriate drug products, not just those of the parent. Where were the lawyers on this exercise? Lilly has now sold its PBM to Rite-Aid, a drugstore chain, at a big loss. GSK sold its PBM to another PBM for $700 million, having paid £2.3 billion. That kind of mistake could have bought a lot of research.

Sector balance This is another strategic theme that leads to mediocre performance. The thought is this: ‘We are too dependent on one industrial sector like engineering or building, so we will enter another and thus not be so dependent upon the cyclical behaviour of the market in the first.’ A similar thought is this: ‘The growth is disappearing from our core sector, so we will move into a very different one and thus open up new opportunities for growth.’ There are three problems.

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First, moving into an entirely new business sector always carries the risk of inexperience. Greater mistakes are made when companies are not intimately familiar with the businesses they are running and overseeing.

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Second, such a diversification effort distracts key managers from tasks directed at diminishing the negative impact from a down cycle in the original, heritage business. There are only so many hours in the day. The more distractions, the more problems will go unnoticed and unattended to.

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Finally, the company’s stock price is apt to suffer: investors these days shun diversification. In recent years, price/earnings ratios for companies in the Financial Times industrial diversified sector have been 30–50 per cent lower than that of the all-share index. City advisers will leave companies such as these in no doubt. They do not want sectoral diversification. They want focus.

Geographic balance This has similar pitfalls. Some companies say: ‘Our goal is to be one-third in the UK and Europe, one-third in North America and one-third in the Far East. That way we will not be dependent upon the state of the economy in any one place.’ This is the wrong rationale for geographically dispersed acquisitions. We do not mean that companies should refrain from overseas acquisitions which strengthen their value chains in a given business. What we are arguing against is the idea of acquiring businesses in diverse parts of the world solely for reasons of geographic balance. Geographic balance can result in a number of serious problems.

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First, company treasurers charged with managing foreign exchange exposure are often tempted to take speculative positions. When they turn out unfavourably, large unexpected losses (the oft-cited ‘black hole’) can appear and damage and embarrass the company.

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Similarly, the cost and complexity of managing exchange rate exposure as well as the cost of translation constitutes a major penalty for operating abroad.

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Companies whose principal managerial perspective is in a single home country can often be blind-sided by alien cultures and respond inappropriately to problems in an unfamiliar environment.

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Finally, problems in far-away countries usually need extensive managerial attention and much wearying travel can result, which in turn saps management energy and deflects attention from domestic problems and opportunities.

Financial synergy There are several financial rationales for bringing companies together. First is the idea of financial balance. This rationale became popular in the 1980s with the widespread use of the so-called ‘BCG matrix’ (devised by the Boston Consulting Group), which stressed the importance of classifying businesses in

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a company’s portfolio according to their cash-generation or cash-absorption characteristics. The goal of such a portfolio management scheme was to achieve a financially balanced portfolio, in which the cash-generating businesses could fund the cash needs of the cash-using businesses. This way of thinking has even led some companies to acquire cash-generative businesses – about which they knew little – simply to fund problems elsewhere in the portfolio. This framework, although now largely discredited for its lack of managerial substance, is still adhered to in some quarters and has been used to justify acquisitions. Second is the notion of financial leverage from buying poorly rated businesses. The company with a high price/earnings ratio can take over a company with a low price/earnings ratio and achieve increased earnings per share (EPS) even if it achieves no performance improvement in the acquired company. This represented a major basis for acquisition logic in the 1970s. Since there was no additional value created in this EPS game, those who played it, famously LTV in the US and Slater Walker in the UK, eventually ran into trouble. Today the EPS game has also been discredited. At one time, the preservation of tax losses represented a major financial incentive for mergers. A company with major recent losses and little prospect of near-term profit to utilize the tax shield involved would be bought by a profitable company and the tax position used to reduce the buyer’s tax charges. This has become less prevalent as tax authorities have progressively tightened the rules for qualifying situations. Finally, there is co-insurance, the idea that diversification over a broad range of industrial sectors will reduce investor risk and thus lower the cost of capital. An attempt has been made on a number of occasions to quantify this effect. In each case, the results appear to have been equivocal, at best. In fact, an investor can achieve exactly the same effect by holding a diverse portfolio of investments without the M&A transaction cost and management risk. The case for financial synergy is a weak one and is seldom argued any more. These three balance rationales (sector, geographic and financial) are now largely unacceptable in the City of London. Companies that seek the support of their stockbrokers and merchant bankers for a merger founded on the balance idea will usually encounter a disappointing response. They will be told that shareholders no longer want companies to diversify for them. Investors can do that perfectly adequately for themselves. They want companies to confine their activities to what their managers know how to do. Nonetheless, these rationales still appear from time to time, more often as a secondary benefit from the proposed transactions. Where they proceed, it is usually because of a lack of tough challenging from the board of directors and the team of professional advisers.

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Filling the growth gap This is perhaps the silliest acquisition rationale of all. Top management adds up the business plan profit figures and sees a considerable shortfall versus what the stock market expects from the company. They say: ‘If this is all that can be delivered, the share price will suffer. We must make an acquisition to provide the needed earnings boost.’ This is not the right reason for making an acquisition. If acquisitions that enhance shareholder value are available to the company, they should be undertaken irrespective of whether or not an earnings gap looms. The shareholders will be better off and that is what counts. But when gap filling is the only motivation, it is likely that the acquisition’s cost of capital will exceed its returns. Some buyers hope to gloss over the problem with aggressive accounting presentation. One favoured procedure in the past was to make large provisions at the time of the acquisition and then benefit in the subsequent years as actual costs proved to be more modest than what was allowed for. The problem is that the rules for this sort of thing have been and are being tightened up. In any case, adroit analysts are not fooled. Closing the gap with accounting ‘cuisine’ is a sure route to later disappointment. Furthermore, when accounting irregularities or even excessive aggressiveness come to light, the market takes vengeance. The collapsing share price of Tyco International in 2002 was a response to a catalogue of managerial chicanery, including misrepresentation of results. The catastrophic decline in AOL Time Warner in the same year was also linked to dubious accounting revelations. In any case, the rules keep changing. In 2000, a seismic change in UK acquisition accounting required acquiring companies to amortize purchased goodwill against their reported profits. Hitherto, goodwill was written off directly against reserves, thus leaving reported profits unimpaired. For the first time, acquisitions which yield improved shareholder value lead to lower reported profits, at least in the short term. Consequently, acquiring companies had to consider the adverse impact of an acquisition on their reported earnings. Some commentators believed this accounting change would inhibit acquisitions. In reality, analysts began to strip this effect out of the companies’ earnings statements in explaining underlying performance. By 2005, for UK companies, this situation completely changed again. The introduction of new international accounting standards (IAS) to the UK required reporting companies to show purchased goodwill as an asset on the balance sheet but not to amortize it. Instead, an impairment test is applied annually to determine whether or not, and if so by how much, goodwill should be written down against income. These complete turnarounds in the accounting treatment of purchased goodwill have resulted in informed readers of accounts treating it with circumspection.

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Excessive price Many of today’s acquisitions involve large takeover premiums – prices in excess of an already high price. Some of these premiums can be in the order of 30 or 40 per cent and sometimes higher. RTZ’s 2007 acquisition of Alcan in Canada was at a premium of 65 per cent above the pre-offer price. To justify such payments, considerable combination benefits must be expected: either huge cost savings or the ability to impart a new rate of growth. Wall Street analysts typically calculate the earnings growth rate needed to compensate for the high takeover premiums and often conclude that they are unachievable. When a large corporation decides to dispose of a division, it retains a major US or UK merchant banker. They prepare a well-written and attractive sales memorandum and distribute it to scores of potential buyers around the world. Those who express interest are then progressively narrowed down to those prepared to offer a high price. When the number of bidders has been reduced to three or four, a serious auction can begin. Almost invariably, a price far higher than anyone expected is paid. It is easy to see why in such circumstances someone pays a ‘crazy’ price. Such events are understandable from an emotional standpoint. Companies frequently invest person-years and much expensive professional advice participating in such auctions. Staff within the organization become excited about the prospect of winning and begin to make plans about what they will do if successful. A momentum builds to ensure success. Often, the original pricing discipline dissipates, unrealistic optimism about the future arises and an inordinately high price is paid. Even with the most effective strategic rationale and careful post-deal implementation, it is difficult in such circumstances to make the investment pay off.

AT&T When companies pay too much for an acquisition, they pay another price in the stock market. When AT&T announced in 1998 its £40 billion acquisition of Tele-Communications, Inc. (TCI), America’s largest cable television group, the market judged the price too high, even though the logic of the deal was praised. The market liked the commercial logic and the way the new chief executive, Michael Armstrong, was shaking up the huge telecoms company, but the price was widely believed to be a ‘full’ one. AT&T’s stock fell 11 per cent in 2 days.

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Pricing discipline can falter simply because big companies often want to get bigger for their own sake. Their top managers want to run bigger operations. This is often for the simple reason that big company managers are paid more than small company managers, irrespective of performance. The likelihood of a board seat with another large company, together with its attendant perquisites, is greater. That can be a particularly handy benefit in later years after retirement, or should for any reason one’s services no longer be required by the present employer. Some observers state that takeover premiums make no difference when no cash is involved in the transaction. The selling shareholders are merely exchanging one piece of paper for another, and what they are betting on is that the combination will enhance collective profit. This view is valid for large institutional shareholders who already hold shares in both companies. But it does a disservice to the interests of individual shareholders of the buying company. They have to be convinced that there is more than enough in the combination to compensate them for the dilution implied by the premium. As always, it’s a question of whose ox is gored. Sometimes the problem is one of timing. The seller knows that the near-term future is not bright and is thus more receptive to an attractive offer when recent performance has been impressive. Daimler certainly made this mistake in its catastrophic acquisition of Chrysler. Not long after the deal, which was allegedly agreed over a weekend without due diligence, the market for Chrysler’s principal products went into sharp decline and its performance along with it. Warren Buffett, the legendary investor and chief executive of Berkshire 2 Hathaway, had this to say: In any case, why potential buyers even look at projections prepared by sellers baffles me. Charlie and I never give them a glance, but instead keep in mind the story of the man with an ailing horse. Visiting the vet, he said: ‘Can you help me? Sometimes my horse walks just fine and sometimes he limps.’ The vet’s reply was pointed: ‘No problem – when he’s walking fine, sell him.’ In the world of mergers and acquisitions, that horse would be peddled as Secretariat. Sometimes the timing problem arises out of disregard for the industry’s business cycle. Some industries are notoriously cyclical, especially those which experience marked fluctuations in productive capacity. Shipping is an outstanding example: as rates increase ship owners add to their fleets until excess capacity drives prices down. Buying at the wrong time in the cycle can result in substantially lower prices than those envisaged in financial projections, thus destroying expected value creation. This risk can be made worse by drawn-out acquisition transactions, such as those which require extensive regulatory approval. Being aware of the cyclicality characteristics of the industry being targeted is therefore essential.

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Sometimes the cause of an excessive price is poor financial thinking. The complex financial calculations undertaken to determine the maximum price which can be paid for any target is badly constructed or based on faulty assumptions. Common among these are the following:

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underestimating the cost of capital, which leads to using too low a ‘hurdle rate’ in the discounted cash flow calculations

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avoiding discounted cash flow and using primitive and often misleading methods like payback

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relying on the impact on earnings per share and then using accounting tricks to minimize earnings dilution

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using an unsustainable revenue growth assumption (usually the most critical factor in any discounted cash flow calculation) to underpin cash flow projections

•

ignoring likely future cyclical downturns

We address the subject of getting the financial logic right in Chapter 9.

Due diligence failures All agreed transactions involve some degree of so-called ‘due diligence’ by each party. This means taking analytical steps, often carried out by professional experts and advisers, to confirm information made available across the table. Commercial due diligence means determining whether or not the company’s position with its products in the marketplace and key customers is as represented. Financial due diligence means verifying the financial statements on which the transaction calculations are based. It also addresses the subject of undisclosed liabilities, particularly those large enough to cause major damage, should they surface after transaction consummation.

Ferranti Ferranti was a substantial and well-known UK electronics firm, selling much of its output to defence buyers in the UK and the United States and to numerous other arms-buying countries around the world. In 1985 it acquired ISC, a secretive armaments company in the US. Ferranti’s due diligence efforts were limited, owing to the sensitive nature of the target company’s customer relationships around the world. Four years later, it turned out that these relationships were not what was represented, and a financial ‘black hole’ in the form of £290 million in fictitious sales was revealed. Ferranti was eventually driven to insolvency and the company was broken up, most of the pieces being picked up by GEC. Not only did Ferranti fall, but Citicorp was subsequently ordered to pay Smith New Court £10 million for ‘fraudulently misrepresenting’ the prospects for the shares.

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We address the subject of due diligence in Chapter 11.

Computer compatibility Big companies operate big computer systems. They come in all shapes and sizes. Some operate so-called ‘enterprise systems’, which seek to integrate important computer subsystems within a business. Some do this at divisional level and others even attempt to implement this concept across the corporation. Most companies have different systems from one place to another, however. Often the computers have problems ‘talking’ to one another. Divisions within the same corporation trying to do business with one another are often halted by their computer systems. Companies also experience problems arranging for reporting systems to link business units to the head office. All of these problems have become more pronounced in recent years as computers have taken over more functions within the corporation. In the early days, computers were used only for payroll processing and limited accounting chores. Now, however, information about customers and suppliers is automated, and in many companies these systems are integrated with manufacturing and logistic systems. Enterprise systems are achieving widespread penetration. The question of computer system compatibility can thus have far-reaching implications. If one operation’s computer cannot talk to another operation’s computer, big trouble can ensue. Small wonder then that merging companies often encounter computer compatibility problems. The financial rationale for most of today’s mergers – which are very largely in the same or similar businesses – invariably requires combination at the business level. This means merging computer systems. Thus securing the combination benefits of today’s mergers requires reconciling computer system differences. Part of the problem appears to be sheer complexity. Financial services organizations in particular have enormous systems challenges when dealing with huge product lines which differ from country to country. Many of these firms are themselves the product of prior mergers which multiplied the variety of products on offer. When two such firms merge – even if the computer systems are theoretically compatible – they can be held back by these ever-increasing levels of complexity. Sometimes these differences are insurmountable. Especially in businesses like banking where computer systems are at the core of the business, differences can present problems so great as to be insoluble. Computer system incompatibility was at the heart of the problems in the well-documented merger failure between the Union Pacific and Southern Pacific railways in the USA.

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Agreed mergers have actually been abandoned in the face of irresolvable incompatibility.

Implementation planning, pace and communication Bringing two large organizations together is an immensely complex task. Because of the heat of battle and past competitive rivalry, great sensitivity must be exercised to ensure that wounds are healed and that people can get on with doing business in the usual way as quickly as possible. Careful and detailed planning to this end is thus essential. These details must be thoroughly addressed prior to the completion of the acquisition so that changes are well considered and can be initiated immediately. Too many chief executives consider that this part of the acquisition process will occur naturally. The excitement of the hunt and the negotiation and execution of the acquisition is what turns them on. The later activity is delegated to subordinates who may or may not do a good job. Even with the most detailed planning, complete with analysis, accountability assignments and so forth, the implementation phase of an acquisition can lose its effectiveness if not undertaken quickly and with visible resolve. Many companies have made the mistake of giving the acquisition time to ‘bed in’ in order to make the acquired people feel comfortable. They say: ‘We can always get on with the merger initiatives later.’ This can give the impression that the newly acquired company is being forgotten or that the success of its integration with the rest of the organization is not considered a high priority. Faced with this kind of indecision, operational executives may build barriers to cooperation and information flow. Clear and constant communication is seen by successful merger participants as a most important feature of any post-acquisition implementation programme. People in the acquired organization must be clearly told what is to happen and what is expected of them. They must see progress and be given enough information to prevent alternative rumours from starting which can affect morale and operational performance. Chief executives who see it as their role to be visible during the implementation process and to explain the longerterm strategic intentions for the newly merged business find it time well spent. Those that don’t often see the opposite result. Redundancies in plants, property, staffing and equipment also weigh many acquisitive companies down. Such issues should be dealt with up front as each new company is brought into the fold. Waiting to act until there is pressure on the bottom line is probably too late.

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Cultural obstacles People in different organizations often behave differently from one another, sometimes dramatically. ‘The way we do things around here’ can vary widely. On the whole, most people are comfortable with doing things the way they have always done them. Therefore, when two organizations with substantially different cultures merge, there is bound to be resistance and guerrilla warfare. Cultural differences between Daimler-Benz and Chrysler created difficulties in the merger of these two motor giants and were an important cause of its ultimate failure. The (now apparently abandoned) Microsoft bid for Yahoo! offered similar 3 potential for culture clash. The Economist noted: There will be cultural problems to overcome, too. Yahoo! is an onlinemedia company that prides itself on its fun-loving ethos and has built its business on open-source technology, whereas Microsoft attracts hard-charging geeks and makes its money from proprietary software. So combining the two firms’ technology infrastructures to make further savings will also be tricky.

BP/Amoco The BP/Amoco merger created the UK’s largest public company. However, a major cultural problem arose when the differences between the US and UK managements’ approaches to salary and expenses began to become divisive. The Americans, used to huge salaries, corporate jets and the most expensive hotels, were seen by the UK side as a potential embarrassment, especially in view of the announced plans to reduce staff by some 9,000 people. There was also the possibility of resentment on the part of the lower-paid UK directors and senior managers. The biggest differences were surmounted and negotiated away. In its 1999 annual report, BP Amoco reported that £54 million in shares had been awarded to 300 top executives, accompanied by substantial salary increases, especially for the UK directors. But handled badly, these differences could have become a deal stopper. In the event, all concerned (at the top) were relieved to be able to get on with running the business.

Clearly there are many obstacles to acquisition success. Some of those noted above – especially external approvals, computer incompatibility and executive power struggles – may prevent the deal from being completed. Others are more serious – they ensure that the acquisition is a financial failure.

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WHY ACQUISITIONS FAIL

Chapter takeaway 1 Acquisitions fail both because they never happen and because, once completed, they fail to deliver expected returns. 2 Reasons for failure include not getting external approvals, nationalistic barriers, opposition from pressure groups and disputes over executive power and position. 3 The reasons for poor returns include acquiring in the wrong industry, aquiring the wrong company, bad strategic rationales (vertical integration, sector balance, geographic balance, financial synergy and filling the growth gap), paying an excessive price, due diligence failures, computer compatibility problems, implementation planning, pace and communication mistakes, and cultural obstacles.

In the chapters to come, we examine the steps to take to minimize the impact of these problems and we suggest a positive framework for ensuring that an enduring increase in shareholder value is achieved. But first, a brief explanation of the various kinds of transactions that occur in today’s market for corporate control.

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Acquisition mechanics

W

4

hen considering the mechanical process of making an acquisition – the actual steps and actions to be undertaken – there are broadly four types of transaction. The steps involved differ.

Types of transaction Private purchases This is the commonest kind of acquisition. It involves the purchase by a single party of a business from a single seller, irrespective of whether that seller is a corporation, a government, an individual or a family. In such transactions, elaborate purchase and sale contracts are negotiated and extensive due diligence investigations undertaken to confirm that the buyer is getting what he thinks he’s getting. In substantial transactions, the sellers often find it to their advantage to conduct an auction. For a corporation to sell one of its businesses to another trade buyer or private equity firm is often seen to be preferable to public flotation. Not only are likely synergies conducive to a higher final price than might be achieved in the public markets, but to do so can be quicker and more cost effective than a public flotation. The increasingly onerous provisions of governance laws such as Sarbanes–Oxley are an additional point in favour of the private auction. Auctions are generally orchestrated by financial advisers. The usual procedure is to contact possible buyers to ascertain their interest and provide them with a glossy descriptive memorandum about the business for sale, subject to an appropriate confidentiality agreement. Draft sale and purchase agreements are often presented at this point to prospective bidders who express interest. They will be asked to indicate areas in the draft document which require alteration. This response can be used to rank bidders and eliminate unattractive candidates. Price indications are requested and those at the higher end are selected for a second round. At this point, a data room is set up, wherein operational and financial information about the company can be examined by prospective bidders. Its content will have been suggested by the advisers based on their experience of what the buyers are most interested in. All relevant contractual and legal documentation is generally made available, as is data likely to be relevant to the buyer’s valuation

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model. If any material adverse information is not made available in the data room, the seller can be open to legal action following the sale. Consequently, it is in the seller’s interest to make full disclosure in the data room. Because a number of buyers are invariably involved in a controlled auction, the duration of access for any one buyer tends to be strictly limited. This is a problem for the typical buyer and requires careful planning, coordination and resource allocation. In the digital world, this process is commonly conducted online. Virtual data rooms offer a number of advantages over the more old-fashioned paper-driven process, whereby potential buyers at different times come to a data centre and pore through boxes of paper documents. With the virtual method, information is made available and updated over the internet and requests for further information handled accordingly. The process proceeds faster this way. Virtual data rooms also have the advantage of establishing a trail of what information was requested by which party, in the event of later disputes about disclosure. The hope and expectation of sellers, of course, is that there will be a vigorous auction and that someone will pay a ‘silly’ price. For this reason, some buyers refuse to participate in auctions but may be willing prior to the start of one to offer a strong price in the interest of becoming an exclusive buyer. Prospective buyers should realize that a controlled auction is an informal and unregulated process. The rules of the auction are decided by the seller and their adviser, and these rules are invariably conceived to benefit the seller. Thus the seller usually ensures that they are not under any obligation to sell, nor do they have to sell to the highest bidder. Furthermore, the seller does not have to disclose any information relating to the bids either during the process or afterwards. The auction does not have a referee to ensure fair play, nor is there any form of audit at the end of the process. Often, auction participants feel that the process did not provide them with a fair opportunity to make a successful bid or that other participants were favoured or were even made aware of their bid amount. It can be a difficult and frustrating experience. Advisers want potential buyers to believe the auction process will be fair so that they will be motivated to submit their top bids. Otherwise they may try to submit a lower bid but with the suggestion that it could be increased following an approach and further negotiation. If the auction is completely on the level, this tactic should fail and no party making such a suggestion will be contacted. However, the seller or their adviser needs to have nerves of steel to turn down such a potential offer. For the adviser, even a small increase in obtained price can often lead to a disproportionate increase in fees. On the other hand, if the adviser gains a reputation for running an unfair process, this will be remembered next time they act on an auction, and their attempts to make it seem above board will be increasingly difficult.

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Buyers hate controlled auctions compared with negotiated deals. The seller’s advisers will impose ambitious timetables on the buyer; they will set the rules; they will dictate when access to the data rooms is available and under what conditions; they will control all access to the target company’s staff and so on. In a negotiated deal, the buyer and seller trade together without rules, agreeing timetables and negotiating access. In some ways, if the controlled auction is subverted, it can become more like a negotiated deal with discussions taking place around a price. Many powerful sellers will try to establish this at the outset.

Hostile acquisitions These are the spectacular takeover battles which capture the headlines but which are becoming increasingly uncommon. Company A makes a formal offer for the shares of Company B, an event usually considered unwelcome by B. The latter fights back and tries to prevent success. Such transactions involve no contracts and cooperation in due diligence. All of the legal and process considerations are carried out via the publication of a succession of shareholder circulars, where the position of the buyer is described, along with its reasons for the transaction. The target responds to such circulars with its reasons why the transaction should not go ahead and the argument that its prospects are better than those implied by the bid. In the UK, the acquisition of a publicly traded company is subject to the rules of the Stock Exchange Takeover Code (commonly known as the ‘blue book’). In addition, the Stock Exchange Takeover Panel, an appointed body of officials, sits to provide guidance and interpretation of the rules for companies involved in takeovers. The rules of the Takeover Code are voluminous, complex and occasionally arcane. Any transgression of the rules could render a company liable to onerous sanctions. Thus no business should contemplate the acquisition of a publicly quoted company without taking guidance from qualified advisers. Indeed, it is a requirement of the Stock Exchange that bidders should be appropriately advised. Such advice should be taken early because of the potential damage from unguarded remarks and other unintended actions on subsequent acquisition activity. The rule for any manager contemplating such a transaction is to come to his own judgement about the business merits of the case, but to seek qualified advice on the mechanics of the process. The acquisition of a publicly quoted company is not a ‘DIY’ exercise. Buying private companies can be.

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Agreed public company acquisitions These deals begin in a manner similar to a hostile acquisition, except that the board of the target company agrees to the terms of the offer – often after a hostile start, it recommends it to its shareholders and the transaction is consummated. In theory, the shareholders of the target company can withhold their permission for the transaction, but this virtually never happens. In agreed deals, there is some degree of information disclosure from both sides, always subject to the restrictions imposed by the Stock Exchange on making price-sensitive information available to all parties to such transactions, as well as to shareholders in general. In such cases, the critical discussions surround the management arrangements for the newly acquired business: who gets what job.

Full mergers In this case, the shareholders of each company in the merger swap their shares for those in a combined enterprise. The main difference between a full merger and a takeover – whether hostile or agreed – is the lack of a takeover premium. The values of the two businesses are negotiated and agreed, and the respective shareholdings in the new entity are then set to reflect these values. In such cases, there is no purchase and sale agreement, and due diligence is limited to the verification of accounting procedures and a general indication that performance prospects are broadly in line with broker estimates. As in the case with agreed takeovers, negotiation tends to focus on organizational matters and on the question of key positions. Such transactions are sometimes referred to as ‘real mergers’, to distinguish them from takeovers called mergers to lessen lost face on the part of the target. The key is whether the target’s shares disappear and whether a takeover premium is involved. In either of these two cases, it is a takeover, whether hostile or agreed. Full mergers are becoming more prevalent. This is because the market is sceptical about merger benefits and punishes companies which undertake hostile or even agreed acquisitions at large takeover premiums, unless enormous combination benefits are in prospect. Also, it is possible that the urge to be the largest in any given industry is inexorable. Whether or not it makes any difference to be, say, the third or the eighth largest pharmaceutical company, there are tremendous pressures from every side to rise in the industrial pecking order. Analysts and journalists alike promote this, often without carefully thinking through whether such developments really create value and lead to lasting competitive advantage.

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It seems likely that we’ll see more full mergers and fewer hostile acquisitions. At the moment, there is a plethora of hostile deals in continental Europe. But when the managements of large continental corporations become more responsive to shareholder demands for value creation, such exercises will be more carefully crafted. In the longer term, the necessity for real value creation in all acquisitions will become the order of the day.

Implications Different types of deals imply different levels of emphasis in the various steps involved in the acquisition process.

•

At the outset, of course, strategic clarity is required for all mergers and acquisitions, regardless of the type of transaction. The reasoning must be clear and the source of combination benefits and value drivers must be articulated and quantified.

•

The acquisition process involved in auctions is similar to that of any other private transaction between buyer and seller except in one important respect: there is unlikely to be any search process because entry into an auction arises at the initiative of the seller. Clarity in strategic thinking in auctions is thus essential. The strategist who has done a good prior job of thinking through the business’s strengths and weaknesses, and the partners with whom a good fit could be anticipated, will be at an enormous advantage. Auctions of businesses that could be of real strategic value will be clear at the outset and less time will be wasted in pursuing those which make less sense.

•

The search process flowing from the setting of acquisition criteria must proceed in the same way. Even if the transaction is unexpected – for example, when the acquiring company is a so-called ‘white knight’ and intervenes on an invited basis as an alternative buyer to a hostile predator – the prior thinking and screening should have already been done. Any company that does not have a clear idea about who is an ideal merger partner, and has not done the background thinking and analysis to support it, will have a hard time deciding upon participation in any such exercise.

•

The main difference comes between public transactions and private acquisitions. In the former, the process is managed in a formal and legalistic manner, usually by merchant or investment bankers, and follows the procedures laid out in the Stock Exchange Takeover Code. In the case of private transactions, most of the effort is involved in price discussions, due diligence procedures and negotiation surrounding the purchase and sale agreement and

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related documents. None of these steps apply to public company transactions, except in a very minor way.

•

Careful implementation planning applies to all merger and acquisition transactions. Thoroughness of preparation for these stages is essential to the success of the acquisition and must be undertaken energetically, irrespective of the time demands being made by the parallel steps in the process.

Chapter takeaway 1 The four types of transactions are: private purchases, hostile acquisitions, agreed public company acquisitions and full mergers. 2 Most acquisitions are private purchases, often via the auction process, which can be difficult and time-wasting, and can often result in the winner paying an excessive price. 3 This book is principally concerned with the process of making private acquisitions. 4 Public and private transactions are different because the former do not allow for price discussions, due diligence procedures and negotiation of a purchase and sale agreement. But all acquisitions require careful implementation planning and execution.

Having described the current acquisition scene, the role of private equity and the dynamics of the market, we now go on to explain the ten steps in a successful acquisition project.

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PA R T The process – the ten steps to successful acquisitions

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Step 1 Formulating strategy

5

he first step in any acquisition project is to get the thinking right: to formulate a sound strategy. This means being clear about why we’re doing it in the first place and how the deal will make money. Accordingly in this chapter, we introduce strategy by offering four rules to guide the process. We then address how value is created, both in integration acquisitions and in portfolio acquisitions. Finally, we explain why alliances are sometimes better than acquisitions and vice versa.

T

The four rules There are four rules that should guide all strategic thinking.

Rule 1: The value that an acquirer gains from an acquisition is equal to the incremental value that can be created from the deal less the premium paid for the target company Figure 5.1 illustrates this rule. In most deals the acquirer pays a premium above standalone value1 for the business that is acquired. This premium is justified by the improvements and synergies that can be created when the two companies are combined. Hence, the value that the acquirer pockets is the difference between the incremental benefits of the deal and the premium. There is, of course, one other factor to take into account – the cost of the deal in terms of advisers’ fees and management time on both sides. There are exceptions to Rule 1. If the premium is negative, if the target company is acquired at a discount to its standalone value, then it is possible to create value with few improvements and synergies. But, as we will explain with Rule 2, it is rare to acquire at a discount.

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Fig 5.1

Creating value from acquisitions Value created 10 100

Price 110

30 5 Premium 10

Standalone value of target

Cost of transaction

Improvements and synergies

Price paid

Source: Ashridge Strategic Management Centre

The implications of Rule 1 are important. Companies should be looking to acquire businesses where the incremental value from the combination – the improvements and synergies – are large. This means that the best target companies are ones where either large synergies can be created from areas such as cross-selling and eliminating duplication or large improvements can be made to the target company because the acquiring managers know how to run the business better than existing management. Strategic ideas such as buying a business because it is in a growth sector or because it spreads risk fail Rule 1 unless the businesses can be acquired at a discount.

Rule 2: The premium the acquirer pays is a function of the improvements and synergies other bidders can create There are two reasons why most deals are struck at a premium over standalone value. First, a premium is often required to persuade the seller to sell. This is not true of distressed sellers; but it is true of the majority of sellers. Their alternative strategy is to retain the business, which is a more attractive strategy unless the buyer is offering a ‘full’ price. The second reason is the existence of rival buyers. Competition between buyers drives up the premium. Let’s take an example. Assume a business manufacturing soup is currently worth £100 million. Three companies would like to buy this business – a private equity firm, a competitor in the soup market and a company in a related product area such as ready meals. The private equity firm will add debt to

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the deal and give the managers incentives to reduce cost and gain market share. This firm believes these changes will add £30 million to the value of the soup company. The soup competitor will integrate the two companies, reducing management cost and improving the way the target company is managed. These changes are expected to create incremental value of £50 million. Finally, the ready meals company intends to add soups to its range of products, improving sales of both ranges because of the extra impact the larger offering will have with retailers. They expect to create £40 million of incremental value. Which company will end up buying the soup business? The answer we expect is the soup competitor. Why? Because the soup competitor can afford to pay more for this soup business: the soup competitor can drive more improvements and synergies than the other two buyers. What price will the soup competitor have to pay? The answer to this depends on the price at which the rival bidders stop bidding. Assuming they are both rational bidders, the private equity firm will stop bidding at £130 million or less, while the ready meals company will stop bidding at £140 million or less. Hence, the soup competitor may have to pay £140 million for a business that is today only worth £100 million – a premium of £40 million. Now, there are not always rival bidders – at least not in an overt sense. However, the seller will always be taking soundings about how much the business might sell for, and, if the offer from a preferred acquirer seems too low, the seller will look elsewhere. There are many advisers ready to help a seller get the best price. The implications of Rule 2 are also important. The value the buyer pockets is likely to be the difference between the increment the buyer can generate from the combination less the increment that the next highest bidder can generate. In the example, the soup competitor is only likely to create £10 million of extra value for its shareholders (£50 million less £40 million) as a result of this £140 million deal. This means that a good acquisition strategy should target those deals where the acquiring company can create significantly more incremental value (improvements and synergies) than likely rival bidders. In other words, the best acquisition strategy is likely to be one that targets businesses that others do not want to buy or businesses that ‘fit’ much better with your company than with any other.

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NatWest Bank NatWest Bank was targeted by two bidders, Bank of Scotland and Royal Bank of Scotland. Bank of Scotland had a reputation for excellent cost management, whereas Royal Bank of Scotland had a branch network that overlapped sufficiently with NatWest to offer significant synergies. Both bidders could add value, but in different ways. Moreover, both bidders proposed to sell off some of the non-core assets of NatWest. In its defence, the NatWest board argued that they could do to themselves what the bidders were intending to do. They appointed a new chief executive, announced that they would sell off the non-core businesses and proposed a significant reduction in costs. In the end, Royal Bank of Scotland outbid Bank of Scotland and convinced NatWest’s shareholders that the combination would create some increment (branch network rationalization) that could not be created by the new management on its own. The deal was a huge success and catapulted Royal Bank of Scotland into the ranks of Europe’s top banks.

Rules 1 and 2 assume that it is possible to calculate accurately the standalone value of the target company, the extra value your company can create from improvements and synergies, and the extra value other bidders can create from improvements and synergies. In practice, as we will demonstrate in Chapter 10, all three of these numbers are uncertain. Sometimes it is not even possible to predict who the rival bidders might be. Far from undermining the value of Rules 1 and 2, uncertainty makes them even more important. Because of uncertainty, it is likely that at least one bidder is a little optimistic in its analysis: overestimating the standalone value of the target and the improvements and synergies that can be created. If we outbid this optimistic rival, we are only likely to be paying a reasonable price if the improvements and synergies we can create are much larger than the improvements and synergies the rival can create. The guiding principle of only targeting companies where you have a significant advantage in terms of generating incremental improvements and synergies is more important in an uncertain world than in a world of perfect information.

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KP Foods KP Foods was a leading competitor in the UK snack market (crisps, nuts and other snacks). Management wanted to develop a European business through acquisition. In Europe there were many family snack businesses with strong regional positions. Although KP could add value to these family businesses through manufacturing know-how and product innovation, management concluded that a rival bidder, the American snack company Frito Lay, could do more. It was hard to identify any businesses where KP to could add more than Frito Lay. The first reaction was to consider abandoning the European acquisition strategy. However, after some hard thinking, KP managers came up with two strategies that made sense despite the stronger position of Frito Lay. The first involved using European competition laws. If KP let Frito Lay make the first acquisition in a country such as Spain, there was a good chance that the competition laws would prevent them from making another large acquisition in the same region. The second strategy involved finding family businesses that did not want to sell to a hard-edged American company like PepsiCo (Frito Lay was owned by Pepsi). The two strategies made it possible for KP to avoid competing head on for deals with Frito Lay and contributed to a successful entry into Europe.

One question that is always asked at this point in the logic is about defensive deals. ‘If we do not buy this business, our competitor will buy it and we will be worse off’. So how do we factor into our thinking the loss of value we are likely to experience if our competitor does the deal instead of us? This likely loss of value should be added to our calculation of improvements and synergies. In other words, we should add up the improvements we can make, the synergies we can get from cross-selling or cost reduction and the likely loss of sales or profitability we would experience if our competitor did the deal. If this combination is greater than the equivalent combination for our competitor, we should expect to be able to outbid the competitor and acquire the target. If not, we should expect to be outbid by our competitor, and we should be looking for other ways to make up the value that we are likely to lose. Paying over the odds for defensive reasons is equivalent to throwing money out of the window. When we take Rules 1 and 2 together, we realize that many deals, like that of the soup competitor, involve big risks (£140 million) for small prizes (£10 million). Frankly these deals make no sense. Managers would be much better off

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putting their energy into less time-consuming and higher-return activities, such as new product development or greater customer intimacy. Acquisitions are risky. It only makes sense to do a deal if the prize is likely to be at least 30 per cent of the money put at risk. In other words, there should be a good prospect that the value of the target plus improvements and synergies less related costs and less the price paid is 30 per cent of the price paid.

Rule 3: Companies face significant learning costs in unfamiliar activities Learning costs are often overlooked in acquisition analysis. Learning costs are not the man hours it takes to train in a new area or to understand a new business. Learning costs are the mistakes managers make by applying the rules of thumb from one area to another context. When British American Tobacco acquired the insurance company Eagle Star, managers applied tobacco marketing techniques to boost Eagle Star’s performance. The result was a significant gain in market share for Eagle Star, followed by a £2 billion loss three years later. In the tobacco market, each point of market share is worth many millions of pounds in shareholder value. In financial services, large parts of the market are unprofitable. Gaining market share in these areas reduces shareholder value. When Mars entered the ice cream business in Europe, managers applied a rule of thumb that had worked well in their other businesses: ‘build a large factory to ensure you have lower costs than competitors’. Unfortunately, they had test marketed their products during the two hottest summers in Europe for 70 years; hence they did not know whether their sales success was due to the quality of the products or the fact that competitors ran out of ice cream. The factory turned out to be two or three times too big, condemning the business to years of losses. Learning costs like these can destroy 50 per cent or more of the value of the target company. So how do we estimate them in our acquisition equation? Our estimate of learning costs depends on the familiarity of the business of the target company (the more unfamiliar, the higher the likely learning costs) and the degree to which our managers will interfere with or dominate the managers of the target company (the more interference or domination, the higher the likely learning costs). The worst situation is one where we are entering an unfamiliar business in a way that puts our existing managers in control (the Mars situation). Learning costs here are frequently more than 30 per cent of the value of the target company. But even a situation where the target company remains separate with its own managers, as in the case of Eagle Star, there are still dangers.

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Accurate estimation of learning costs, however, is not possible. The implications for strategy, though, are clear. First, avoid unfamiliar businesses unless they have strong managers and you will not be an ‘interferer’. These acquisitions are usually only possible if the target is selling at a discount or if the incremental value does not involve interference. Private equity deals are often good examples of incremental value that does not involve interference. The added value normally comes from sophisticated debt structures and stronger incentives to existing managers. Private equity owners do not normally think they can run the business better than its managers. The second implication is to avoid improvements and synergies that involve doing unfamiliar things or applying existing rules of thumb to unfamiliar activities or sectors. The learning costs will often be greater than the improvements and synergies, as illustrated by the Eagle Star example.

Oil companies and minerals In the 1980s, most of the major oil companies diversified into minerals. For example, Shell bought Billiton, an aluminium and mining company, now part of BHP Billiton. For a period of more than five years, the minerals companies owned by oil companies produced a return on sales of minus 5 per cent, while independent minerals companies earned on average plus 7 per cent. The difference, over 10 per cent on sales, was due to learning costs. For example, Shell encouraged Billiton to integrate vertically by entering downstream markets for aluminium. The strategy was a disaster. What works in the oil industry does not necessarily work in minerals, and it took the oil company bosses a few years to learn this.

Rule 4: The value created from the deal should be greater than the value that can be created by applying the resources to a joint venture or some other activity Acquisitions involve a lot of money and a lot of management time. Often the net value created, as a result of Rules 1, 2 and 3, is small. So how big does the value have to be to justify a deal? The answer is that is has to be bigger than the alternative. Hence a useful place to start is to estimate how much value could be created by applying the money and the management time in some other way. For money, the calculation

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is often easy because the alternative is to give it back to shareholders or invest it in the markets. In other words the opportunity cost of money is the ‘weighted average cost of capital’ (see Chapter 9 for more details). But what is the opportunity cost of management time? Probably the most frequent regret we are told about by acquiring companies is the loss of performance in their existing businesses as a result of acquisitions. Daimler-Benz is a classic example. While management toiled over the Chrysler turnaround, the performance of Mercedes steadily declined. Once the company shed Chrysler, Mercedes bounced back. This suggests that the opportunity cost in terms of loss of focus on existing activities can be high. The implications for acquisition strategy are clear. Avoid acquisitions that will absorb the time of managers running existing businesses unless these businesses are running smoothly. The frustration here is that the best improvements and synergies often involve the time of managers running existing businesses, yet this time frequently comes at a high opportunity cost.

Implications of the four rules The four rules provide guidelines for strategic thinking. The best acquisition strategy involves a target company where:

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the acquirer can create big improvements and synergies relative to the standalone value

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the acquirer can create much bigger improvements and synergies than other likely bidders

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the business being acquired is one the acquirer knows well so that the learning costs are small

•

the deal does not involve the time of managers running existing businesses or the existing businesses currently need little management attention.

Integration and portfolio acquisitions The focus we have given to incremental value – improvements and synergies – now requires that we be more specific about how these improvements can be generated. To do this, we must distinguish between two types of acquisition deals. The first type – integration acquisitions – involves buying businesses that can be combined in some way with one or more of our own businesses. The acquired business will lose its identity and become integrated into a part of the acquiring

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company. The reason for doing the deal is to make the combination more competitive. Incremental value will come mainly from economies of scale or other integration benefits. Most acquisitions of direct competitors are of this sort. The second type – portfolio acquisitions – involves buying businesses that will retain their identity in the new company. They will become additional business units in the acquiring company’s portfolio. The incremental value will come from the skills and experience of the acquirer and its ability to improve performance and financial results. Most private equity investments are of this sort.

How value is created in integration acquisitions The starting point with integration acquisitions is a look at the competitive position of the existing business with which the acquisition is to be combined. In some companies, especially those with informal or undemanding planning systems, the competitive position and basis for competitive advantage may be unclear. In these cases, a strategic audit of the business will be needed. The audit would address the following questions:

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Where do we stand competitively? Are we winning or losing? (Answering such questions objectively obviously requires adequate metrics like market share and relative market position and whether or not it is changing.)

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What are the critical success factors in our business? Why do customers buy – or decline to buy – our products? What are the specific reasons for having lost customers in the past? Or gained new ones? How do we match up to the success factors? How do we compare with our principal rivals?

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How do we stand at each stage of the value chain? Is there a clear case for cost or quality advantage – or at least parity – at each stage?

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What are the key improvements we must make in order to achieve or defend a position of competitive superiority?

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Are we able to make these improvements ourselves or will it be necessary to acquire, ally or set up a joint venture in order to remedy any shortcomings?

The strategic audit will expose competitive strengths and weaknesses that can suggest an acquisition. An alternative approach is to focus on opportunities. Here we ask similar questions:

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Are there any customer segments, geographical markets or business models in our general area of competence that look interesting?

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In the new customer segment, geographical markets or business model, what would it take to please customers in a superior way? What would it take to

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enter such a competitive arena with confidence that market share could be gained? What do we bring to the party?

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Do we have what it takes at every stage of the value chain to mount a promising effort?

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Can the development of a sufficiently strong competitive offering be accomplished in sufficient time to make sense?

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Can we do this alone or do we need to combine with a partner possessing the needed capability?

When all of this is clear, a strategy or a series of strategies for acquisition can be articulated in the form of a written acquisition profile statement. Such a statement should include the following:

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the description — in as much detail as possible — about the specific product and market segments targeted

• •

a statement of our competitive position and why a partner is needed

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actual candidates which are apparent, even from a cursory knowledge of the industry segments in question

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an examination of example candidates against the four rules to demonstrate that at least some candidates appear to comply with the rules.

size range sought: this should be tied to the strategic thinking underlying the proposed acquisition and the size, below which no real benefits can be expected, and above which managerial stretch would become a problem

A profile document of this sort can save time and prevent wasted effort. When circulated among managers whose later support and approval is required for the acquisition, early misgivings and concerns can be identified. If there are fundamental reasons why such an initiative should not take place, they should be surfaced now. More specifically, the incremental value from integration acquisitions is likely to derive from one of the following combination benefits.

Operating synergy The savings from operating synergy drives many of today’s deals. Elimination of overlapping cost — when salesforces are merged, headquarters operations combined or factories rationalized – normally involves significant reductions in employment. The investment community recognizes this. The higher the likelihood of major job losses and associated cost reduction, the more enthusiastically such transactions are supported in the capital markets.

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TUI/First Choice Early in 2007, a German travel firm, TUI, undertook to merge with First Choice, a UK firm. Together they will have combined sales of €17 billion; they will thus be a substantial firm. There are few industries under more price pressure than the package tour travel business. The internet has hit them hard. Not only can consumers compare prices on the internet, but they can often save substantial sums by assembling their own trips with specialized websites. And they can do this without even having to leave the house. The travel industry is beleaguered. Its only real choice is to cut costs aggressively and to market packages in retail locations and by direct mail that are seen to be competitive with those available on the internet. This means lower prices and very thin margins and requires cost rationalization, a technique facilitated by horizontal mergers. TUI first embarked on a major restructuring to rationalize cost within its own operation and is now furthering this effort with the First Choice merger.

Controlling markets Gaining a strong position in a market is another important source of value. Market control is often code for eliminating competition and getting prices up. If it works, the profit implications can be substantial. But there are major legal and institutional obstacles to securing these benefits. Competition authorities and litigious competitors all watch such transactions with eagle (and legal) eyes.

BHP Billiton/Rio Tinto Pricing power in the face of huge buying power is currently taking place in the mining industry. The bid by BHP Billiton for Rio Tinto, one of the biggest takeover offers ever, promises economies of scale, especially in the mining and processing of iron ore and aluminium. More particularly, it promises enhanced bargaining power on price with China, an enormously large and growing consumer of raw materials of all kinds for its burgeoning manufacturing industry. Prices in commodities in general have been rising quickly in recent years and metals are no exception; more is in prospect. A combination of this kind will certainly not result in increased price competition. It is perhaps for this reason that China’s biggest aluminium producer has taken a stake in Rio Tinto in an attempt to influence the outcome.

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The tobacco industry offers another example of such pricing power. Although under attack from sumptuary taxes, advertising bans, public service anti-smoking programmes, and liability litigation, the power of industry brands virtually precludes the possibility of competitive new entry. Industry concentration offers consumers fewer choices and a diminished likelihood of price competition.

Acquiring a critical skill or technology Value can come from acquiring a superior skill or technology that can benefit the whole enterprise. These transactions often create interesting post-acquisition challenges, as the new owners try to learn from their new subsidiary. There are frequently forces at work which make this hard. The acquirer says: ‘The target managers are better at new product development or reducing manufacturing cost or at rationalizing logistics systems than we are. We’ll buy them and thus acquire that capability ourselves.’ The danger is that the needed skill transfer does not take place, either for reasons of organizational resistance and jealousies or because the key knowledge workers decide to depart for greener pastures.

AMD Chipmaker AMD has long battled valiantly to gain a share of the microprocessor market dominated by Intel. Numerous courtroom battles with the far larger chipmaker have distracted management time and led many observers to conclude that it was dead in the water. Then, in 1996, it acquired NexGen, a fledgling chipmaker with a revolutionary design that was itself running out of financial staying power. AMD finished the job and carved out a position for itself in the rapidly growing market for sub-$1,000 PCs. AMD now has 15 per cent of the PC market and is targeting double that figure.

Skill transfer can also be pursued in cross-border deals.

Deutsche Bank/Bankers Trust Deutsche Bank was criticized for paying a high price – $10 billion – for Bankers Trust (BT) in 1999. Deutsche’s record in paying back the investment in Morgan Grenfell has not encouraged market observers. Nonetheless, there may be a valuable skill transfer possibility in this transaction. BT is expert in leveraged financing, an important skill as the socalled ‘junk bond market’ has revived in the USA. The current level of merger activity in Europe should provide ample opportunity for the use of this kind of financing and Deutsche will be better placed to exploit it if it can make use of the skills and experience of the BT bankers in this area.

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Economies of scale In some industries size is important. Economies of scale give an advantage that it is harder for smaller competitors to match. A well-known example of scale benefits is the automobile industry. The manufacturer with the largest volume per platform has a significant cost advantage. It is believed that 2 million cars per platform is the minimum for a mass market car operator. That is why Volvo, with its 400,000 units per year, was simply not economically viable, no matter how good the product, and was forced to seek a merger. But sheer size and scale economies do not guarantee profitability. Jack Welch’s masterstroke of insisting that all General Electric divisions be in first or second-place in their industries or be sold is not foolproof. Look at General Motors. It is still the largest automobile producer in the world but seldom achieves the levels of profitability of some of its more nimble rivals.

Accessing other markets Players in global industries often need, but lack, worldwide sales and distribution networks. Acquiring a company in the local country can be a good solution. However, it is often also possible to achieve the same benefits with less risk through joint ventures, licences or agency relationships. These sources of incremental value are the main types of synergy in integration acquisitions. But, as we have noted, they’re not automatic. We will have more to say about the likelihood of achieving the increment when we discuss due diligence in Chapter 11. A final thought about integration acquisitions. The strategy for these acquisitions should be developed by the managers who are going to lead the integration. More often than not, these are the managers who are currently running an existing business in the acquiring company’s portfolio. Since these managers will create the value by integrating the target company, they should lead the strategic thinking. In other words, the strategy for integration acquisitions should emerge from the bottom up: it should emerge from an analysis of the challenges and opportunities facing existing businesses.

How value is created in portfolio acquisitions In portfolio acquisitions, the key to value creation is the ability to add something to the acquired business. This added value will come primarily from influence applied by the group-level managers to whom the new business reports. We call the influencing activity of group-level managers ‘corporate parenting’.

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We will now, therefore, explain what group-level managers can contribute to a new acquisition and how critical it is to be clear about how value will be added. Most big companies — and indeed many small ones — are multi-business enterprises: they oversee a number of separate businesses. The job of the corporate parent in such organizations is twofold: first, it must choose which businesses to own; and, second, it must add something to each of these businesses so that they are worth more than they would be as independent companies. These conclusions are the result of more than 15 years of research on corpo2 rate-level strategy. A multi-business company only makes economic sense when the sum is greater than the parts. Since there is a cost involved in managing a portfolio of businesses, the net performance of the businesses should be greater than the extra management cost from bringing them together. Moreover, the best corporate parents seek to meet an even tougher test. Not only do they attempt to add significant net value to their businesses, but they try to add more value than other parents of the same kinds of businesses. We call this ‘parenting advantage’. Whereas the leader of a business unit seeks to defeat his commercial rivals in the marketplace for goods and services — the pursuit of competitive advantage — so the enlightened corporate leader seeks to defeat his corporate rivals in the marketplace for businesses – the pursuit of parenting advantage. So how can corporate parents add value to businesses and hence justify portfolio acquisitions? The answer is in almost as many ways as there are deals. Hence in this chapter we can only give some illustrations.

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•

Change management and/or strategy. Probably the commonest way of improving an acquired business without integrating it with an existing business is by changing the management and the strategy of the business. Maybe the business has been focused on a local market, but has the potential to expand internationally. Maybe managers have been focusing on customer service, whereas the potential for advantage lies in new product innovation. Maybe managers have been targeting the full range of market segments, when all the profit is in the higher value added niches. Thoughtful guidance in such situations can be beneficial.

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Change targets. The second commonest way of adding value is to raise the performance targets for the business and, probably, at the same time raise incentives for managers. This is a common approach of private equity buyers. These buyers have found that an existing management team can often perform much better when given stretching sales and cost targets along with exciting incentive packages.

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Change financial structures. Another popular approach of private equity buyers is to add more debt and reduce the amount of equity in the business.

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This results in much higher returns for the equity holders if the business increases profits. Public corporations are noting this approach and giving more active consideration to increasing gearing.

•

Add brands or patents. Sometimes parent companies own valuable brands or patents. Virgin, for example, offers its brand to all the businesses in its portfolio. This helps these businesses enter new markets and increase market share.

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Add expertise. One of the special skills of Richard Branson and the top team at Virgin is publicity. They are able to help businesses get column inches in the press – a much cheaper form of marketing than paid advertising.

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Build relationships. Large companies often have privileged relationships with governments and other large companies. These relationships can be helpful to the businesses they own, opening up opportunities and markets that might otherwise be hard to access.

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Provide services. Parent companies can often borrow money more cheaply than their businesses. They can sometimes also provide services such as accounting, information technology and other back-office support more effectively. This may reduce the cost of these services to their businesses and free up business-level managers to focus on products and customers.

•

Promote links with other businesses. Parent companies frequently set up links between a new business and existing businesses in the portfolio. These might be transfer pricing arrangements or best practice sharing or cross-selling. Here the type of value the parent company is adding begins to overlap with the value that justifies integration acquisitions. Inevitably, many acquisitions are a mix of both kinds: the incremental value that is created comes partly from integration and partly from parent added value.

Grand Metropolitan Grand Metropolitan (now merged with Guinness as Diageo) was a highly acquisitive company. It was also not afraid to dispose of businesses when a better home could be found elsewhere. Throughout the 1980s, the company was unloved in the investment community because of so much buying and selling of businesses. It was hard to categorize Grand Metropolitan and to decide which businesses they were in. Analysts thus had a difficult time and marked them down accordingly. Nonetheless, GrandMet was an excellent asset shuffler and its timing in both buying and selling was frequently impeccable. Thus doing a good job of deal execution was critical. The company was fortunate in having as a corporate development director a former director of a leading London merchant bank. This capability was used frequently and deals were done well and done quickly. Significant value was added.

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Portfolio acquisition strategy should be developed and led top down not bottom up. This is because the incremental value will be created by the influence of the top managers. They must, therefore, understand the type of value they are good at adding and take responsibility for ensuring this value is created. Frequently, portfolio acquisitions are built on wishful thinking rather than a solid understanding of how value can be added. Wishful thinking can be avoided by:

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Defining the kinds of businesses the parent is good at improving, as well as those categories of business it should stay away from. Every multi-business company should be clear about this. ‘Here is what we are good at – the kinds of businesses we really feel comfortable with and can help.’ And also: ‘These are the kinds of businesses we do not understand, where we are not intimately familiar with what it takes to succeed. We should stay away from them.’

•

Monitoring the effectiveness of its parenting approaches. When does its ‘medicine’ improve things and when does it make them worse? Exactly how much improvement can be attributed to each type of added value? Are the sources of added value that have helped the company succeed in the past still relevant?

Hanson Sometimes the alteration can be drastic. Hanson Trust was a remarkably successful buyer and seller of companies during the 1970s and 1980s. It found undermanaged, diversified companies which had fallen out of favour with the market. It bought them cheaply, sold off pieces it did not want and improved the performance of those that remained with tight financial controls and substantial management incentives. But then Hanson ran out of the big targets it needed to keep its earnings growth going. All the obvious targets had been ‘done’. And the existing portfolio of businesses had been tightened up and were well run. There was nothing left for them to do. So they broke up the company into five successor companies – one in the USA and four in the UK – each with its own strategy for growth and each with a charter to determine its own future. A good move.

We conclude that success in portfolio acquisitions relies heavily on being clear about how the group-level managers will add value to the target company. Thus an acquisition strategy statement for portfolio acquisitions should address the following issues:

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What are our distinctive characteristics and capabilities that we can bring to a new acquisition? How confident are we that we can improve things? What exactly are we good at improving?

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What sort of companies will benefit from our skills? In what industries? With what financial and operational characteristics?

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In what ways might we harm a new business? What kinds of companies should we avoid acquiring?

The leading private equity firms are instructive exemplars of portfolio acquisition logic. They’re quite clear about how they can add value and about the kinds of industries and businesses they are targeting. Once they have made an acquisition they apply intense oversight to their investments, they move quickly to make the changes required for their value-creating rationale, and they exit their investments when they no longer have the ability to improve performance.

Berkshire Hathaway/Marmon The 2007 decision by Warren Buffett of Berkshire Hathaway to acquire Marmon, the industrial conglomerate owned by the Pritzker family of Chicago, relies on the undeniable investment skills that he has demonstrated over many years. Buffett simply knows how to identify undervalued companies and in particular those which fit well with Berkshire Hathaway’s managerial approach. Marmon is a conglomerate in many basic industries with strong positions in each market segment in which it competes. It is well managed and will thus not need major surgery. If, as seems likely, this acquisition eventually proves to have been a big success, value will have been created because businesses that fit well into the Berkshire Hathaway portfolio were acquired at an attractive price.

Whether to acquire or ally Our views on acquisition strategy would be incomplete without identifying those situations better served by an alliance or joint venture of some sort. An acquisition may not be the best or safest way to pursue our strategic objectives, especially at the business unit level. An alliance may do the job just as sensibly and a lot more cheaply. We have already noted that there has been enormous recent growth in the acquisition movement in capitalist economies. The pace of alliance formation is

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every bit as intense and widespread. Indeed, some observers believe that alliances are growing even faster than acquisitions. Clearly managers see this vehicle as an attractive way to create shareholder wealth. Often there can be as great a benefit in an alliance, but without the attendant risks. There are two forms: equity alliances and contractual alliances. Equity alliances involve ownership of assets. Both partners contribute assets and know-how to a separately constituted, standalone joint venture company, jointly owned by the partners, sometimes (but not always) in equal measure. They then split the profit according to their ownership stakes. They will usually be required to contribute capital on the same basis. Contractual alliances are simply a series of agreements between the parties with no change in asset ownership. This approach can embrace distributorship agreements, licensing rights, contract manufacturing and many other forms. The rationale for alliances applies to both types.

Situations favouring an alliance The rationale for most strategic alliances is identical to that of integration acquisitions. But let’s go through it again. In order to understand the economic rationale behind virtually all well-constructed alliances, we must revisit the idea of value chain analysis. The principle is a simple one. All businesses focused on a particular market segment can be disaggregated into the sequential components of operation — usually from the sourcing of raw materials all the way to after-sales service to the customer. The objective of achieving sustainable competitive advantage over one’s industry rivals then requires that we ensure our operations at each stage of the value chain are making a competitively superior contribution to our customer offering. That is, at each stage we should strive to be more cost effective, or contribute more to customer-perceived quality, or both. Of course, few rivals in any competitive business ever achieve superiority at every stage of the value chain. When a particular competitor concludes that its performance at a particular stage is inferior to that of its competitors, it has several choices. First, it can conclude that its disadvantage is overwhelming and potentially lethal; it therefore chooses to exit the business. Second, it can benchmark superior competitor operations and attempt to replicate what they are doing right and close the gap. Or third, it can approach that competitor and, in effect, say: ‘You are good at this, we are good at that, why don’t we combine forces?’ This is how good alliances are born and how they should be designed. This kind of analytical thinking results in alliances of the following sort (see Table 5.1):

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•

Cross-distribution. The commonest example of this thinking is followed in cross-selling and distribution agreements. One company has superior selling arrangements in one part of the world and its rival is better in others. By combining their selling and distribution arrangements in those two parts of the world, both can benefit from economies of scale, trade clout and the sharing of market knowledge. It works particularly well if the products of the two in those two areas are complementary, rather than directly competitive.

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Technology access. One company possesses superior technology, often with the capability to apply that superiority to ever better products. The other company finds that it cannot replicate the technology advantage, one that is increasingly crucial to its competitive success.

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Scale economies. Sometimes the scale of investment for a superior position in the value chain is just too much for one company to finance.

Table 5.1

Allying industries

Industry

Typical alliance rationale

Drugs

Share cost of expensive research

Software/hardware

Develop new products

Films and media

Promote individual creative products

Automobiles

Pursue economies of manufacturing scale

Airlines

Control markets through code sharing; buy engines

Telecommunications

Serve customers with global requirements

Retailing

Use partner for local market knowledge

How to choose between an alliance and an acquisition The first step is to look at both the advantages and disadvantages of alliances. A number of advantages, versus acquisition, pertain to alliances.

•

Ease of exit: all alliances provide exit procedures in the event that a relationship does not work or that it outlives its usefulness. In virtually all cases, it is easier to exit an alliance, whether equity-based or contractual, than to reverse an acquisition.

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Royal Bank of Scotland The Royal Bank of Scotland targeted the American market for remote banking. To access it, it arranged an alliance with Pat Robertson, the American teleevangelist, said to command a loyal following of some 55 million people. Shortly after concluding the alliance, however, Roberston made an offensive speech in America about Scotland and some of its citizens, and the bank was immediately picketed and faced with customer losses. Ignominiously, it invoked the exit provision from the contract and terminated the relationship.

•

In the same way, alliances preserve the ‘freedom to be promiscuous’, in that the commitment to the other partner is less binding and irreversible than with an acquired company; the alliance agreement itself may permit cooperation with others. This state of affairs can be vital in industries which are changing fast and where the outcome is uncertain: cautious players simply may not want to place all their eggs in one basket.

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The ideal value chain combination may simply be unaffordable through acquisition, either because the required acquisition price is beyond the reach of the synergy seeker or because the acquisition would require the purchase of a company with many other business units in its portfolio where no synergies existed and where on-sale was not considered a sure thing.

In addition, alliances may be the only way to pursue the desired combination benefits because of the impossibility of completing the desired acquisition.

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National governments, for reasons of both prestige and security, often prevent foreign takeovers of companies deemed to be in critical industries. Telecommunication, weapons and airlines are prominent examples.

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Sometimes certain employees, whose skills are key to securing the combination benefits, may not want to work for the acquirer.

Finally, alliances offer at least a partial antidote to the inherent destructiveness of vertical integration (see Chapter 3). However, alliances also possess certain predictable disadvantages.

•

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Decision making can be cumbersome when approvals by the boards of both partners are required for major initiatives. Often partners have different strategic objectives and decision criteria and view opportunities differently. At best, the hurdle is tougher and potentially more time consuming.

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•

Cost rationalization is usually tougher. Taking cost out of a joint venture or alliance usually involves a degree of ‘horse trading’, a process which is less likely to arrive at the lean staffing levels desired. One observer notes that when you ‘…buy another company…rationalisation is simply a matter of 3 aiming the hatchet at the right place…’.

Guidelines It is therefore possible to describe the kinds of companies and competitive situations which call for alliances in lieu of outright acquisition. In addition to complying with the situations noted above:

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alliances seem to be the corporate development initiative of choice for ambitious smaller companies which understand the kinds of combination benefits that would enhance their competitive position, but are either beyond their reach or represent a level of strategic and financial commitment they are unwilling to undertake.

•

alliances may also appeal to the company which believes that its future in a particular business is critically dependent on one or two core competences that it believes it possesses, and which is happy to outsource the rest of the functions and activities involved in the competitive game

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Hamel and Doz believe that ‘Alliances are favoured by the avid but cautious learner who uses resources sparingly, places multiple bets, and makes a big 4 commitment only when a positive outcome is reasonably certain’

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acquisition is for the company with substantial resources, a clear and confident view of the unfolding strategic requirements for success in the business, and an impatient management style that would be intolerant of collaborative decision making.

The purpose of all corporate combinations – acquisitions, alliances and the like – is to create shareholder value by improving business competitiveness. If the desired combination is unlikely to be achieved at a sensible and affordable price by acquisition and if the benefits can be created and captured by alliance, then the argument for the latter is a good one. But if the pricing limitations do not apply, as they don’t for many, acquisition is apt to be favoured. Thus for many, the results of this analysis will be a decision to go down the acquisition route. We must therefore next discuss how to translate the strategic thinking of this chapter into specific criteria for our acquisition programme.

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Chapter takeaway 1 The first step in an acquisition programme is to get the strategic thinking right. 2 There are four rules which explain how to relate the value to be created by the acquisition to the price to be paid for it and to the price competitive bidders might offer for it. 3 Value is created in integration acquisitions principally through operating synergy, gaining market control, acquiring critical skills or technologies, achieving economies of scale and accessing other markets. 4 In portfolio acquisitions, value is created by using the skills and capabilities of the acquiring company to add value to the acquired business and thus to create net value in excess of the cost of the acquisition. This can be done by changing management, strategy, targets or financial structures, by adding brands, patents and expertise, by building relationships with other organizations, by providing cost-effective services and by promoting links with the other businesses. 5 Sometimes an alliance is better, especially when the outlook for the industry is unclear and freedom of choice is to be preserved. Also, the target is sometimes unavailable and most of the benefits may be secured through a contractual relationship. 6 Otherwise, acquisitions are usually best.

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Step 2 Setting criteria

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he job of the strategist, simply put, is to find ways to ensure a fit between the internal capabilities of the organization and the opportunities in the marketplace and the requirement for success in exploiting them. We have already seen this in Chapter 5 when we discussed strategy. Your acquisition criteria should reflect this kind of thinking.

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Integration acquisitions In integration acquisitions, an assessment of competitive position leads to conclusions about alternative ways of improving performance. We can do this by finding a partner who will help us to remedy our shortcomings and fill any gaps in a competitive offering; we can also be seeking opportunities to exploit different market opportunities in different product segments and geographical areas, building on our own internal capabilities. In the first, we are really saying that we need some help to do a better job in the business that we’re in. In the second, we’re saying that we can give someone else help and enhance their fortunes because of our capabilities. Both are valid strategic bases for acquisition and both should be used as a basis for devising acquisition criteria in pursuit of projected value-creating benefits. As we shall see in this book, there is a mandatory linkage between business unit strategy, acquisition criteria, projected value-creating benefits, due diligence, the purchase and sale agreement, and the integration plan.

Imperial Group/Altadis The linkage between acquisition criteria and expected benefits in an integration acquisition is well exemplified in Appendix B, which describes the thinking at Imperial Group in their 2008 acquisition of the Spanish tobacco company, Altadis.

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The company is clearly a focused acquirer. It states that ‘we seek acquisitions that enhance our brand equity, increase our geographic footprint and offer the opportunity to reduce costs and extract synergies’. It then goes on to describe how this acquisition will build on its brand equity, especially in fine cut tobacco products and cigars. Its geographic footprint will be

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improved by virtue of Altadis’ position in the USA, France, Spain, Germany, Benelux, Russia and Morocco. As to synergies, it expects to reap some £300 million in cost reduction in the areas of production, purchasing, sales and marketing, and corporate overheads. This is clearly an acquisition where the fit between criteria and target is excellent. The value–creation rationale and the promise of tangible benefit from combining with the existing business are clear-cut and persuasive.

Portfolio acquisitions In portfolio acquisitions, we’re seeking to exploit our ability to add value to certain kinds of businesses from the corporate centre. Thus the criteria we set are less apt to be targeted on a particular market segment or even industry, but rather on financial and operational characteristics of the business. Some portfolio acquirers, especially private equity firms, are beginning to specialize in certain industries and gearing up organizationally to become expert in them. But the criteria will nonetheless be more wide-ranging than for integration acquisitions. Acquisition criteria flow from the value-creation strategy worked out as above. The kinds of benefits sought – together with a characterization of the features of a target that will respond well to the acquirer’s system of management – dictate the criteria. For a robust value-creation strategy, these criteria must not be so general and non-specific to a company’s skills and strengths as simply to constitute the profile of a desirable business. In such cases, an acquisition becomes merely an investment in an attractive industry, without regard to whether or not it will prosper sufficiently in the hands of the new owner to justify the price paid for it.

Some examples The following three statements of acquisition criteria reflect further portfolio acquisition strategies. Each is sufficiently specific to guide an acquisition search and also appears to reflect a clear view of the acquirer’s parenting characteristics and what it believes it is good at.

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Example 6.1 E & A Industries1 E & A Industries is a privately held corporation that has been successfully acquiring and growing companies throughout North America and Europe since 1977. We are not a private equity firm. We are acquirers who seek longterm capital appreciation through acquisition, organic growth, and disciplined management. Our acquisition strategy is to identify companies with sustained profitability, unrealized growth potential, low-tech production, business-to-business customers, and an ownership that desires a short- or long-term exit strategy. E & A only seeks investments where we can obtain a controlling interest. E & A Industries has twice been recognized as one of America’s 100 fastestgrowing companies by Inc. magazine.

Preferred industries of interest Light manufacturing / low-tech manufacturing Sales / distribution Chemistries & materials for microelectronics industry Specialty chemical Retail, commercial, industrial lighting

Target revenue: $2 to $20 million

Target EBITDA (Earnings before interest, taxes, depreciation, and amortization): $500,000 to $5 million

Characteristics: Industrial or commercial customer base Proprietary or unique technology with limited risk of obsolescence High-quality, value-added products Unrealized growth potential Sustainable barriers to entry Niche or specialty market National and/or international market Positive cash flow Three years of sales and profit growth (no turnarounds or startups)

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These criteria are extremely specific, as to target industry, the kinds of company characteristics sought and desired financial parameters. The company’s statement about itself and what it is about is also illuminating. It appears to reflect a clear view about what the parent organization is good at: it knows how to improve the performance of a low-tech, non-consumer business that is already performing reasonably well but which can be improved by aggressive exploitation of product line extensions, the entry into new markets and the building of a more competitive value chain. The incremental value from the acquisitions of this company will derive from improving the cost base and finding more opportunities to sell its products. Any broker presented with this statement of criteria would be quite clear about what targets would fit and which ones wouldn’t. Here’s another:

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Example 6.2 TPW Investments

TPW seeks to acquire companies that meet the following key criteria and are within the identified industries of interest.

General criteria Companies where the owner is seeking some form of liquidity or a future management transition, but does not have a defined succession plan in place. In certain cases, we would consider partnering with the existing company owners to jointly grow the business for a period of time after the acquisition. Acquisitions that can be used as platform companies with the potential for future growth through follow-on acquisitions within the same or an adjacent industry. Companies operating in expanding markets with a fragmented customer base. Companies with stable and long-standing customer relationships.

Financial criteria Annual sales between $10 million and $50 million EBITDA of at least $2 million EBITDA margins of at least 10% 3 years of profitability and positive cash flow

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Industries of interest Industrial Manufacturing Chemical and Plastics Food Processing General Distribution

In this case the criteria are not only specific but they also indicate the intentions of the acquirer post acquisition. They’re looking for platform acquisitions and can thus be expected to acquire businesses that could be built with further follow-on acquisition. They have also developed a management model for working, at least for a time, with incumbent owner managers. The incremental value for acquisitions by this organization probably depends upon identifying a selection of future improvement opportunities, which the existing management team has not yet addressed and may regard as something for its successors. Due diligence for this organization would require the clear identification of these opportunities and the formulation of a possible action plan to exploit them. And one more: 3

Example 6.3 Sage river partners

Sage River Partners acquires companies headquartered, or with significant operations or markets in New England. While we focus on established companies with up to $3.0 million of net cash flows, we have an appetite for smaller businesses that possess unique strategic or financial characteristics. Sage River pursues change-of-control investments, cashing out (entirely or in part) existing owner-operators or corporate owners. We seek to operate a company with New England-based operations or markets. While growth is attractive, Sage River prefers stable and consistent sales and earnings to situations with rapid growth, but volatile or less predictable earnings.

This acquirer is less specific in that it has limited its search to a confined geographical area. Presumably the principals are not interested in extensive business travel! The incremental value from such acquisitions may well flow from

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the knowledge, experience and connections of the acquirer in and around the New England area. Realizing this value would require them to be quite clear and specific about what sort of profit-improvement opportunities this might lead to, since it is not clear from their specification.

Guidelines We conclude with a few guidelines.

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Your criteria must reflect your strategy, pointing to the areas where incremental value will be created. As a result, the best criteria often seem counter-intuitive and quirky because they reflect the unique situation of the acquiring company.

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The criteria must not be so general as to prevent a focused search. Indeed, a lack of specificity may well suggest undisciplined thinking. For example, a criterion that states ‘must provide opportunities for cost synergies’ is less useful than one that states ‘must have an overlapping branch network so that costs can be released by closing branches’.

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Rarely will a target be identified which meets all pre-established screening criteria. Prioritization is thus essential. It is useful to split your list of criteria into ‘must have’ and ‘must not have’ features. For example, ‘must have a culture compatible with our culture’ or ‘must not have bad union relationships’. Some active acquirers will not buy a business too far from the head office for reasons of management stretch and distraction. Some preclude businesses that have not been in existence for many years. Others will not countenance a deal without a strong management team that is willing to continue with the business.

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In total, many acquirers will have a list of 20 or more criteria. It is rare to find a target that fits all the criteria. Usually fewer than 5 of these 20 are likely to be critical to the incremental value that will justify the deal. The rest provide focus for the search and address areas of potential value destruction, such as culture clash or loss of customers or key staff.

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Chapter takeaway 1 Acquisition criteria must reflect the need for a fit between the capabilities of the organization and the needs of the business to be acquired. 2 In integration acquisitions, they should reflect the anticipated synergistic benefits that come from combining two similar businesses to make them more cost-effective and to create competitive advantage. 3 The criteria for portfolio acquisitions must reflect the distinctive skills and capabilities of the acquiring company and its ability to add more value to the business than someone else could. 4 The list of criteria should be prioritized because seldom will an available target meet every desired standard.

Having established a set of criteria which flow from acquisition strategy, we now address the question of how to find suitable targets.

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Step 3 Conducting a search

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he process of conducting an acquisition search, like that of setting criteria, is somewhat different for integration acquisitions and portfolio acquisitions.

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For integration acquisitions, where specific skills and capabilities are being sought to remedy a weakness or when the main objective is industry rationalization, it is likely that the best targets will already be known. In such cases, acquirers seldom spend time actually searching for targets. They know who the best targets are or how to identify them. The only question is how to make an approach.

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In the case of portfolio acquisitions, a major search effort is often needed. In one example, the search effort involved identifying and then screening 400 distribution companies in Germany in order to find 5 potential targets to approach.

We will therefore first focus on some guiding thoughts for managers involved in searching amongst a large number – more than ten – possible companies. We will then share some suggestions about the best way to approach potential targets.

Sources There are, broadly, three ways to identify companies: from brokers or other intermediaries, from the results of a tailored desk research effort, or from the knowledge and contacts of operating managers.

Brokers and intermediaries Brokers maintain lists of companies for sale and – often – the buying requirements of companies on the acquisition trail. They earn fees by matching the two. This is a simple and straightforward way to find a target. If the broker knows of a business which could be acquired and it matches your acquisition criteria, the next steps are clear. He will introduce you and try to make the transaction happen. Generally he is paid only if the deal completes. There are a good number of brokers and intermediaries, ranging from investment banks, industry experts, accountants and lawyers. Hence, once you have

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defined your acquisition criteria, don’t be shy about letting the brokers and intermediates know. However, remember that it can be like buying a house. Once the estate agents know roughly what you are looking for, they will suggest all manner of properties, many of which do not fit your criteria. So you may need to set up some resource for handling the activity. Sometimes, investment bankers will take the initiative and present acquisition ideas to you, either because they are representing the seller or in the hope of earning the right to represent you during a transaction. The intensity of this effort reflects how busy they are, how big a company you are and how likely you are to do a deal. While these attentions can be flattering and can sometimes result in interesting new thinking, you should avoid losing focus. Should you get your own broker to find the target you want? The answer is no, on two accounts. First, beware of delegating the search process. If you have done a good job of developing your acquisition strategy, you will have a much deeper understanding of the potential than it will be possible to communicate to a third party. Second, brokers prefer to work for sellers than for buyers. Sellers have decided to sell, so a broker knows that a deal will happen – and hence a fee will be forthcoming. Buyers may do a deal or may not. Hence brokers, working on a success fee basis, may or may not get paid. Tapping into the brokers can reduce the cost of finding targets – you wait until a broker brings you an interesting prospect. However, it is unlikely to lead you to the best possible deal – the perfect match. To find the best deal you will need to do original research.

Original research Original research involves identifying all the companies in your target area and then screening them to see which ones fit your acquisition criteria. There are a few important tips. First, analyse the economics of the sector. What are the critical factors for success? What is the average profitability in the sector? Why? Which segments are the most attractive? Why? What is likely to happen in the sector in the next five to ten years? This analysis is essential background. Without it, you will not be able to interpret and challenge the information you collect about individual companies. Second, identify all the companies. When searching for ‘small family brewers’ or ‘waste management companies in southern France’ or ‘parcel distribution companies in Ireland’, it is tempting to find a list of such companies and, then, start to collect information about each company. Experience, however, suggests that the most important part of the search process is to invest in collecting as complete a list of all the companies in the target area as possible.

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Don’t rely only on one source. Don’t focus only on companies for sale. The best target may not be for sale today, but may be persuadable in the future. The task of identifying all the companies can be outsourced to a specialist consultant. Normally, for less than half a year’s salary, a specialist consultant can do a thoroughly expert job, identifying all the companies and collecting a limited amount of information on each. If you decide to do the work yourself, make sure you use multiple sources. There are industry associations, suppliers to the sector, customers of the sector, sector reports, knowledgeable individuals, online sources and library sources. Make sure you have tried all of these. Don’t forget some obvious sources, such as the Yellow Pages. The third tip is to collect a standard amount of information on every company. The information you need will be driven by the acquisition criteria you have developed, but it should be limited to the information you can display on one page of A4 paper in a type size no less than 12 point. Since your research will have identified some hundreds of companies, you will have information overload and cost overload if you collect more than the essential information on each company. The one-page information summary needs to be carefully designed. This one page must enable you to screen hundreds of companies and identify only a handful of serious prospects. Do not delegate the design of the one page to a junior member of staff or to your consultants. The design of this page is a critical part of the search process. The fourth tip is to avoid screening out companies on availability. As you screen each company, it will be tempting to reject many because they are not for sale and not likely to be for sale in the next few years. Don’t. Screen solely on which companies have the best fit with your company. Where the logic for merger or acquisition is strong, it is often possible to find some way of working together that creates value. Not infrequently, these relationships ultimately lead to mergers. What you are looking for are targets where the logic for getting together is overwhelming. You are not interested in acquisitions as an end in themselves. You are interested in acquisitions where the fit with your company is better than the fit with other potential acquirers. If the logic is strong enough, you ought to be able to tempt these companies into a relationship one way or another. An in-house search and screening process takes time. Do not try to do it yourself without allocating sufficient resources. One capable person working full time for three months is likely to be a minimum. Some search processes may involve two or three times this resource.

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Operating managers Most ambitious operating managers want to find ways to grow their businesses, often faster than sister businesses in the same portfolio. An obvious fast route is acquisition. Thus operating managers will often take the time to track companies in their market sectors – direct competitors, those with complementary product lines, or those with good access to markets where they have little presence. Since the most likely candidates are apt to be in the same or very similar businesses as the acquirer, operating managers are likely to be a key source of candidates. Alert managers in this position will make an effort to monitor potential candidates. They will look for signs of weakness, restlessness or simply fatigue on the part of the owners. They will stay in touch informally at conventions and the like. The object is to be the first one to be aware of a changing situation – one that invites an approach. They will find a way to keep communication channels open. A good time to raise these ideas is when business plans are reviewed, which in most companies is an annual exercise. It makes sense to use the planning process to explore both integration acquisitions and portfolio acquisitions. A thorough review of competitive strategy should lead to obvious opportunities to strengthen the business value chain by integration acquisitions. Additional time should then be allocated to discuss portfolio acquisitions – businesses that are adjacent to the operating unit in question that could fit with the corporatelevel or division-level strategy. A dialogue on both types of acquisition helps ensure that the businesses and the corporate centre are thinking along the same lines. It can improve the ability to evaluate opportunistic situations as they arise. The operating managers need to know what sort of target companies are likely to fit with the corporatelevel strategy, and corporate managers need to understand what integration deals would be ideal for each operating unit.

The approach There are no hard and fast rules about how to approach target companies. One acquirer we know wrote to his list of targets explaining that his company was interested in expanding and asking them if they wanted to discuss some relationship. He had a 10 per cent positive response! In other cases, the acquiring company might use a non-executive director who happens to share another board or a golf club with the chairman of the target company, or with the major shareholder in the target company, to feel out the situation. As before, some practical tips may be useful.

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First, recognize that there are lots of different ways of making an approach. Consider the alternatives before jumping in. An approach can start with a request for mutual benchmarking or a discussion about licensing technology or subcontraction. It can also start with a direct expression of interest to acquire. Pick one that would promise mutual benefit. Second, if in doubt be more rather than less direct unless doing so conflicts with local culture and custom. Human beings easily become suspicious and often presume hidden intentions. If you demonstrate that you often operate with hidden intentions, it will make negotiations more difficult in future. Third, if in doubt make contact. Often, you are in the position of trying to decide whether or not you have enough information about the target, if you are sufficiently well prepared to open a discussion. Usually these concerns lead you to collect more information. However, information is expensive and the process of collecting information can raise suspicions in the target company. Certainly, you do need some minimum amount of information. For example, the first question the target is likely to ask is ‘How much?’ If you are completely unprepared for this question, you may lose their interest. However, if in doubt make contact with the company: ask the girl to dance! You never know your luck, and you may save yourself many hours of labour.

Chapter takeaway 1 Keep the criteria narrow. This makes the search easier. If the search is for ‘value opportunities’, the team will have to consider every industry and every company for sale. If the search is for ‘chilled food companies, serving international retailers such as Tesco in Poland’, the task is more focused and can be completed in a few days of work. 2 Identify every company in the target area. Use multiple sources. Get help. 3 Get comparative information on each company, but only the minimum you need to identify those that you would like to acquire. 4 Do not use availability as a criteria, at least not until you have made contact with them. 5 Consider the full range of ways of making an approach before jumping in. 6 Be direct unless you are genuinely prepared to consider alternative relationships. 7 Avoid analysis paralysis. Deals cannot be done without approaching targets with offers.

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Having identified a suitable candidate – one which comes close to meeting the pre-set screening criteria, especially the mandatory ones – we must now decide how to organize our efforts. We do that in the next chapter.

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Step 4 Acquisition planning

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n order to enable swift, concentrated action to be taken and at the same time safeguard confidentiality, three specialist teams are normally required. The investigation team and negotiating team oversee those respective stages of the process. An implementation team is then required to ensure that the appropriate action is taken to achieve the value goals of the acquisition (see Chapter 14, on implementation and integration).

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Investigation team At the outset, an investigation team should be established, often comprised of individuals temporarily relieved of their normal duties for the period of the investigation. The prime task of this team is to investigate the prospective target in order to establish both the general feasibility of the takeover and its potential value. To this end, it will assemble available data on the target business through published records, other generally accessible information and market intelligence, and eventually information from the seller. The number of team members will depend upon the nature of the benefits sought, but should in any case include a financial representative. He will be responsible for coordinating the cash flow calculations and for checking the basic assumptions and their compatibility with available records on the past performance of the target business. The team leader is responsible for overall coordination, planning and timing, will normally be the focal point for outside contacts and will report to management at each completed stage of evaluation. This team can be enlarged with co-opted specialists to provide advice on issues where core team members are not themselves expert.

Negotiating team This team need not be the same as the investigation team. It should initially be limited in numbers and should include a representative from the finance function. The team will normally also include a legal adviser and, depending on the nature of the transaction, other specialists (such as tax and personnel). There may be situations, however, particularly at the very early stage, where the fielding of a

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full team is not yet warranted or desirable. In such a case, the team leader will have been briefed on legal and other aspects and on implications prior to the negotiations. In order to facilitate coordination, it may be preferable to have at least one common member on both teams. This team will want to take an early view on the following:

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Who will be the leader of the negotiation team and what specific roles will be assigned to the other members of the team?

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What is the planned type of acquisition consideration – assets or shares – and will the price to be offered include or exclude shareholders’ loans and other finance?

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What business units or activities are not to be acquired?

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In what form should the offer be made to the seller (e.g. a ‘take it or leave it’ proposition, or a mere price indication to sound out the reaction of seller)?

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What arrangements are required for redundant personnel, the disposal of unwanted subsidiaries before takeover and the future management of the company?

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What is the planned timing of the closing of the deal?

What is the ‘standing’ of the seller’s representatives and who is the real decision maker behind the scenes?

Who is responsible for drafting the agreement (preferably the purchaser)? What are the fallback positions? Who should offer these and at what stage of the negotiations?

• What is the ‘top price’, beyond which the purchaser will not go? The main task of this team will be to bring the negotiations to a successful end. During the process, however, full attention should also be given to integration issues. This is not only required in order to keep a continuous check on the basic synergy assumptions made during the investigation stage – the value-creatiing rationale – and the financial evaluation derived therefrom, but is also a prerequisite for a smooth and efficient implementation process once the target company has been acquired. The negotiating team will be the coordination point for all external and internal clearance requirements, including applying for approval, initiating consultation, soliciting advice or merely providing information. Approvals may be required from official authorities, national banks, antitrust agencies, stock exchange commissions, trade unions, staff councils, boards and shareholder meetings. Just managing the external information flows is always a major undertaking.

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STEP 4 ACQUISITION PLANNING

Controlling public pronouncements is important. At an early stage, the parties should agree on the text and preferred timing of the general publication of the proposed deal and on what bodies (government, staff council, trade unions, etc.) need to be informed before a general announcement. In addition, a contingency plan should be agreed upon in case of premature leakage, as well as the answers to be given in such a case.

Implementation team Once the transaction is complete and ownership changes, the major job of integrating the new business into existing operations must ensue. A dedicated team is generally utilized at this stage as well (see Chapter 14). There are two schools of thought about the makeup of an implementation team. Some believe that the team should be largely or entirely composed of members of the management team who will be ultimately profit responsible for the newly acquired business. In this way, a commitment to achieve the value objectives of the acquisition is established at an early stage, and any ‘handover’ delays and difficulties are minimized. Involved managers who are prepared to stake their reputations on the successful outcome of the acquisition project can be a powerful source of value creation. Others say that integration specialists are better. The argument here is twofold. First, specialists gradually develop learning-curve skills which enable them to get the job done more quickly and effectively. They know from experience where the pitfalls are and can move decisively to avoid them. Specialists also preclude the necessity for operating managers to be deflected from the competitive demands of the mainstream business – the one with which the acquisition is to be integrated. We are of the view that relatively inexperienced acquirers should place responsibility for integration with existing management teams – the first alternative. As time passes and more deals are done, a cadre of individuals experienced in acquisition integration can be developed and gradually seeded into a specialist group. Ideally, acquisition integrators should aspire to seek the best of both approaches. Once the acquisition process is bedded in and suitable experience has been developed, the process can be managed by dedicated specialists, but with continuing participation from members of the management team that will be ultimately responsibility for its success.

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Chapter takeaway 1 Organizing the acquisition effort requires different skills, reflected in each of three teams. 2 The investigation team is analytical and, working from the acquisition strategy and agreed criteria, identifies suitable prospects. It also designs the financial projections to ensure both disciplined price negotiation and, ultimately, adequate returns. 3 The negotiating team requires technical know-how and experience in the details of deal execution. It makes the approach to the target, investigates its suitability, supervises price discussions and manages the design and execution of the sale and purchase agreement. This team also coordinates the efforts of the many technical advisers involved in the project. 4 The implementation team, whose members reflect the view of operating managers, plans for the time that the business will be taken over. It ensures that the critical work of integrating the target into the existing organization is completed in a timely and effective manner. 5 These teams can be combined in various ways. The critical consideration is that the needed skills and experience are brought to bear.

Before we get to the next steps of negotiating price and an acceptable agreement, we must first make sure that the financial logic underpinning the proposed acquisition is robust.

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Step 5 Using the right financial logic

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eedless to say, it is essential to get the numbers right. The whole purpose for any acquisition programme should be to improve financial performance. The use of financial parameters to plan the project and measure performance is thus fundamental to the whole process. We begin with a discussion of valuation methodologies.

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Valuation methodologies All acquisition practitioners – indeed all those in decision-making power in any acquisition programme – must understand and make good use of the various quantitative methodologies available to decide how much the target is worth. It is not enough for the innumerate director to say, ‘Oh, our accounting chaps will tell us what it’s worth.’ We do not intend to treat these methodologies in great detail. Many valua1 tion textbooks address this subject admirably and in as much detail as is conceivably needed. We will mention them briefly and offer some guidelines for their use. There are two distinctly different reasons for putting a value on a company, and differing techniques apply to each. First, there are external measures – those which use normative values to determine the going rate for a business – what investors think it is worth. Merchant bankers advising on mergers and acquisitions provide thick books of analyses of comparable businesses to determine the likely view from the market of the acquisition you contemplate. Then there are internal valuation methods. These techniques enable directors and management teams to draw conclusions about what the business in question is worth to them, given their assessment of the future prospects for the business, how effectively they can manage and improve it, and what the likely combination benefits are when the acquired business is combined with their existing operations. Sometimes these two approaches yield similar answers. Sometimes they are wildly different. The astute acquirer is more likely to find a bargain if the internal valuation greatly exceeds the external one. If it is the other way around, the deal is unlikely to be consummated and the managers involved are probably wasting their time.

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External methods Several methods are used by the market for valuing businesses, including the following.

Earnings multiples Acquisition candidates can be valued by applying the price/earnings ratios of listed companies comparable to the target in question. In private transactions, the usual multiples for listed companies are traditionally discounted (substantially – often 30–50 per cent) to compensate for the relatively poorer liquidity of the investment. The multiple used is often that which applies to known mergers and acquisition transactions, rather than their normal trading values. In this way, the value reflects a likely acquisition premium and is thus more suitable for gauging probable price requirements. This approach is a rule of thumb measure, of value principally to casual observers who feel called upon to comment on the deal. It is an important one, however: a stockbroker’s analyst can damage the stock price by observing that the announced transaction was agreed at a multiple far above usual deals of its sort.

Cash flow multiples Highly leveraged acquisitions – for example, when the buyer is a financial engineer or leveraged buyout (LBO) player – depend for their success on quickly generating cash to pay off high levels of debt. The measure needed is one that reflects the ability of the target to generate the required cash flow. Rules of thumb are generally available as to the multiple of cash flow that can be safely paid when high levels of debt are used to fund the transaction. They vary depending upon applicable interest rates. An important variant on the cash flow multiple is that involving free cash flow, that which is left after payment of cash outgoings such as essential capital expenditure. The ratio cash flow return on investment (CFROI) is a good crude metric of the intrinsic ability of the business to produce sufficient cash flow to meet its debt obligations. Again, the importance of this figure will vary depending upon market variations in the cost of capital. Many stockbroker analysts rely heavily on this figure as a measure of companies financial performance because of the belief that earnings figures and thus earnings multiples can be too easily manipulated by accounting tricks. A distinction must be drawn between multiples that are arrived at using stock market prices and those derived from an analysis of similar transactions, where they can reasonably be identified and where they occurred at a reasonably recent time. Since businesses always change ownership at a premium over

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their standalone value, these values will be different. Stock market multiples help the observer to gauge whether the target is seen to be superior or not to the comparable companies in its sector. Transaction-based multiples are a guide to what is currently being paid by acquirers for such companies. Obviously both measures are of value in the acquisition process but for different reasons.

Net assets The custodian of the buyer’s balance sheet and capital structure will be interested in the net accounting value of the assets purchased. Differences between that figure and the purchase consideration have to be reflected – according to complex and ever-changing rules – in the buyer’s books. But the value of net assets has little to do with the economic value of the acquisition or the kind of returns that can be expected. Most notable is its role in liquidation value. If the acquisition goes terribly wrong and must be liquidated, net assets provide a first cut approximation of how much might be realized from such an ignominious exercise.

Industry norms In many industries, rules of thumb exist which provide a consensus view of the value of a business in that industry. In the hotel industry, for example, multiproperty hotel groups are often valued on the basis of the number of bedrooms in the hotels and rules of thumb about how much one room is worth in hotels of varying degrees of luxury. Mobile phone companies reflect a view of the value of each subscriber, while pub companies may assume a value for annual barrels of beer sold. In the chemicals industry, companies are often valued on the basis of a multiple of their turnover. These varying bases for valuation are examples of industry norms. In each case, the multiple used is a proxy for the ability of the business to generate profits and shareholder value. Competitively superior businesses can generate a greater return than average and consequently will be valued at the top end of the range indicated by the industry norm. Poorer businesses may not necessarily be valued much lower than the industry norm because of their improvement potential, especially when they can reasonably be considered to be bid targets. Conversely, when performance is so poor that the business is unlikely to be acquired, a considerably lower than average valuation can be expected. Valuation is always assisted by the knowledge of the relevant industry norm. It is simply what those knowledgeable about the industry think businesses in that industry are typically worth. The student of valuation is thus well advised to discover the industry norm attached to the particular business under consideration.

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Internal methods The remainder of the methodologies we describe are techniques for internal valuation purposes. The first three of these methods depend upon the principle of discounted cash flow (DCF). Discounted cash flow techniques incorporate the time value of money. A pound today is worth more than a pound tomorrow because the pound today can be invested to start earning interest immediately. The approaches used by companies to value a prospective acquisition as a basis for the investment decision include the following.

Net present value (NPV) This technique converts all future cash inflows (including the capital cost associated with the project) into present value equivalents and totals them to give the net present value of the project. If the present value of benefits exceeds the present value of costs (the NPV is positive), then the project creates value. If the present value of benefits is less than the present value of costs (the NPV is negative), then the project destroys value. NPV is a powerful tool since it allows the comparison of the economic value of one asset against the economic value of another. For example, the NPV shows whether to retain the cash or invest in a given project, for a given discount rate. It is the preferred method for valuing acquisition projects.

Internal rate of return (IRR) The internal rate of return of a project is the discount rate that, when applied to the project’s cash flows, gives an NPV of zero. In most projects, the higher the discount rate, the lower the NPV. At a certain discount rate the project will neither create value nor destroy value; it will have zero NPV. The discount rate at this point is the project’s internal rate of return. If the IRR of a project exceeds the discount rate, the project will create value. IRR is thus a most useful metric because it can be taken as the ceiling for the cost of financing the project, and it is a useful measure of the profitability of a project. However, it fails to quantify the value arising from a particular investment. Investors want to know how much money is at stake and what the potential payoff from the project is expected to be.

Profitability index The profitability index is simply the ratio between the project’s net present value (without the acquisition cost) and the acquisition consideration.

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Uses of valuation techniques 1 Multiple of earnings: to understand how the deal will look (rich? a bargain?) compared to similar transactions. 2 Multiple of cash flow: for establishing maximum price for highly leveraged transactions. 3 Net assets: an indicator of fail-safe liquidation value. 4 Industry norms: what knowledgeable industry observers may think the business is worth. 5 Net present value: the best all-round method for valuing an acquisition candidate to decide the maximum price to be paid. 6 Internal rate of return: a method for determining the rate of return to be achieved from the proposed investment. 7 Profitability index: a device to rank alternative proposals. 8 Real options theory: a way to assess value in volatile market conditions. 9 Payback period: a quick way to measure near-term project risk. 10 Earnings per share impact: to satisfy the needs of commentators who do not have access to the deal projections.

Obviously, a ratio of 1 means that the projected price is equal to the project’s value, per the NPV calculation. This exercise can be useful in times of capital rationing – when investment projects are ranked in order of attractiveness. If not all are affordable, then start at the top of the list and work down. This approach suggests that the acquisition is just one of many potential investment projects competing for the limited capital of the firm. It also contains a more doubtful assumption – that project proposals actually propose widely varying rates of return. In our experience, this seldom happens in big organizations. Everyone knows what the investment hurdle rates are and project supporters generally pitch their proposals to meet them more or less exactly. To fall short would be a recipe for rejection by some clerk. And to exceed them simply makes life tougher when it comes to negotiating performance bonuses.

Real options theory The emergence of the high valuations often attached to technology businesses frequently cannot be explained by reference to conventional DCF methodologies.

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This conclusion has given rise to the realization that other sources of value must exist. One such source may derive from the ability of the business to adapt to changing circumstances. A business can react to ameliorate a loss or, having made an investment, can expand if conditions are favourable. This means that the evaluation of expected cash flows, using a discount rate to take account of the risk or probability of occurrence, fails to recognize that the cash flows will be changed by management in reaction to their outcome. In essence, this process is analogous to management exercising a series of complex options. The valuation of real options is, however, difficult and mathematically complex. Their use will ordinarily require expert advice and assistance. Where future cash flows are uncertain and can be reacted to by management, a simple DCF evaluation results in an NPV which can easily understate the true value of the investment. Thus when conventional DCF valuation indicates a marginal return and when the market outlook is uncertain and industry conditions can be considered volatile, real options techniques should be considered. Nevertheless, the difficulty of demonstrating to an approving board the value attributable to future options should not be underestimated.

Payback period The payback period is the period of time that an investment takes to recover its initial investment, irrespective of the time value of money. Payback occurs when the cumulative cash flows break even. It is when cash recovered equals cash spent. The payback method focuses upon short-term cash flows which tend to be less risky than later cash flows. A shorter payback period strains liquidity less. Although relatively primitive, payback has the following advantages:

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it is a quick and easy technique to apply and to understand

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it readily emphasizes liquid projects by focusing upon near-term cash flows.

it is useful as a first screening tool it focuses upon near-term cash flows which tend to be easier to forecast and are inherently less risky

On the other hand:

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it ignores the time value of money it gives equal weight to all cash flows before the payback date and no weight to subsequent flows. For example, projects A and B both have a payback period of two years, but project A has no further cash inflows, whereas project B continues to generate cash for another five years. Project B will have the higher NPV, but on the basis of payback period, both projects are equal.

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In order to use payback alone as a means of accepting or rejecting projects, a cut-off date has to be chosen. This will be arbitrary and could lead to an undue bias towards short-term projects. Don’t do it.

Earnings per share impact It is a conceptually straightforward task to compare projected corporate earnings per share (EPS) with and without the acquisition (even though the actual model may be a complex and elaborate one). From this analysis, it can be determined whether the acquisition is expected to contribute positively to earnings per share. The question in the minds of traditional observers is: ‘When does the 2 deal become earnings-enhancing?’ The principal value of this analysis is to satisfy the needs of those who ask such questions. But it is only a rough approximation of value, since it is dependent upon accounting conventions and efforts to improve presentational aspects of earnings reports. It also largely ignores non-earnings cash flows. There’s another problem: EPS enhancement or dilution is influenced not only by the success or otherwise of the acquisition but also by the way in which the deal is financed. It is perfectly possible, through the choice of appropriate financing, to demonstrate EPS enhancement even though no value is created by the acquisition. We take this point up in Chapter 12. It has to be said that any advocate of earnings per share impact as the sole or even prime measure of investment attractiveness may well be counting on accounting trickery. It’s a delicate area.

Non-financial considerations The economic value of a proposed acquisition is best determined through the use of cash flow-based techniques such as those indicated above. There are, in addition, a number of other factors which could affect the potential value to the buyer and the price they might be willing to pay.

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The possibility of a threatening marketplace scenario, such as the introduction of a breakthrough product, either by the target company or by a close rival, in which case the commercial projections could be considerably altered. In this case, the acquisition outcome would have to be compared to a considerably more pessimistic ‘do nothing’ case.

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Departure of key people considered crucial to the deal. The need to spend a long time building a distribution network or other necessary operational capability which the target company will provide.

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The implications of the target company being acquired by an aggressive competitor.

Implications of this sort can be described and catered for through the use of scenario-planning techniques. The likely effect on projected cash flows can be modelled and the results used for low- and high-track projections.

Practical guidelines Using these financial methodologies effectively – especially discounted cash flow – requires keeping a number of guidelines in mind.

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The impact of specific funding arrangements are ignoreb. Financing considerations remain separate from the valuation calculations. Funding cost has already been accounted for in the cost of capital. Valuation calculations should never contain financing cash flows, e.g. interest, dividends, debt repayment and the like. Furthermore, payments in respect of long-term irrevocable commitments such as leases should be treated as financing flows and not operating cash flows. The assumption of such commitments should be treated as the acquisition of a long-term liability at market value in the acquisition year and the associated cash outflows dealt with as financing flows.

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Only incremental amounts are included. Overheads which may be allocated to the project will be included only if they are extra expenses resulting from the project. Internal staff costs are included to the extent that additional staff costs are incurred to enable the project to proceed.

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Opportunity costs should be included. Any income foregone as a result of an acquisition should also be included as an opportunity cost in the evaluation of cash flows.

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Protected income can be included. Occasionally, an acquisition is justified by the defence of existing business. In other words, if we don’t make this acquisition then a competitor will steal/attack our current business. Therefore we should include existing cash flows that we currently receive as incremental income because if we didn’t make the acquisition, we would lose them. This logic is risky: if we habitually make such investments, we will fall into the trap of accepting reduced returns on our investments and ending up with an unattractive business. Nevertheless, there could be a valid justification for such an investment. For example, if we are convinced that the industry will remain attractive or become more attractive and we believe we will become a dominant player, then this strategy can be justified. It implies both

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a strong commitment to the industry and a belief in the ultimate ability to succeed competitively.

•

Only cash flows attributable to the acquisition should be recognized. Only cash flows, including internal cash flows, that are genuinely attributable to the project are included. Cash flows that are properly attributable to another project or activity are not included. If two projects are so interdependent that both are necessary to achieve the savings or gains – an acquisition and a major investment in capital equipment, for example – then the projects should be combined for evaluation purposes.

•

Foreign currency cash flows. Dealing with cash flow forecasts in foreign currency and translating into sterling or dollars is fraught with hazards. Clearly, if a dollar or sterling investment is made, then a commensurate return is required. It is unrealistic to suppose that it is possible to forecast future exchange rates with any great reliability. There is consequently a problem in dealing with foreign currency flows. There are, however, three ways to reduce this problem. The first is that investments in foreign assets are often financed using local currency. Thus local currency returns can be judged against the local investment. To the extent that hard currency has to be introduced, the investment returns can be measured in the form of dividend returns using the principle of constant purchasing power parity, recognizing the differential inflation between the local currency and the home currency. Secondly, it is often the case that the production of the investment business can be priced as an internationally traded commodity, e.g. oil. If this is the case, the future cash flows may be priced in dollars. Third, the expected net cash flows can be hedged using an appropriate derivative device.

•

Sensitivity analysis may be useful. The process of forecasting the future will necessarily have to accommodate uncertainty and risk. The sensitivity of the acquisition’s NPV should be tested by systematically varying the inputs. The project should be assessed in terms of sensitivity to potentially variable revenues and costs. This approach also makes it possible to determine what variable will prove the greatest potential danger to the investment. Then the potential risk can be assessed in greater detail and perhaps mitigated.

•

Scenario planning may also be appropriate. In addition to sensitivity analysis, which is restricted in terms of altering only one variable at a time, the project proposal should consider the robustness of the investment to alternative future scenarios. The scenarios used should reflect the most unfavourable set of future circumstances that could befall the project, and as a corollary the most favourable set of circumstances. These are commonly known as the ‘upside’ and ‘downside’ scenarios.3 The purpose of the exercise

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is not simply to select the average of the two scenarios as the base case. Rather, it is to evaluate, in the case of the downside scenario, whether the investment would be an abject failure, with the potential to cause unacceptable damage to the acquirer, in which case the investment should not be undertaken. The purpose of the upside scenario is to look at the potential benefits foregone if the acquisition were not undertaken and to evaluate the benefits consequently available to a competitor. Clearly, if only the downside scenario were considered, there would be a bias against investment.

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•

Terminal value must be estimated. The terminal value includes any further cash flows arising outside the forecast period, like continuing revenues, proceeds from the disposal of assets and so on. The terminal value of an acquisition is usually calculated as if a constant net cash flow will arise indefinitely beyond the end of the forecast period. This is often referred to as a constant perpetuity. The present value of perpetuity is calculated as: c/r, where c is the constant cash flow beyond the forecast period; and r is the discount rate. The perpetuity value arises at the end of the forecast period for the investment and must be discounted to present value at the start of the project in an identical fashion to a cash flow arising in the last year of the forecast period. Alternatively, the terminal value of the business can be valued on the basis of market multiples, the price/earnings ratio enjoyed by companies in comparable businesses. Terminal value can be a contentious subject. The debate concerns the proportion of total present value attributed to it. If this becomes too large, nervousness will arise because of its theoretical nature. The pressure will increase to stretch out the time period of actual cash flow calculations before reverting to the terminal value calculation. In assessing the quality of acquisition valuations, merchant bankers often highlight the percentage of total value represented by terminal value as a way of underlining the risk inherent in the calculations, or the lack of it.

•

Inflation is included. Cash flows should be forecasted in nominal terms (including inflation). Input costs, especially labour, may inflate more rapidly than output prices (revenue), which would have a negative effect on margins. This should be explicitly addressed. Doing the calculations on a real or netof-inflation basis assumes that all costs and revenues inflate identically, an irresponsibly simplistic proposition. In any case, a high inflation environment causes a business to require higher levels of working capital. This will only become apparent if the cash flow model is constructed in nominal terms. Similarly, in a situation of high inflation, future tax benefits in the form of

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depreciation allowances become less valuable in real terms. Again, this becomes readily apparent only if the cash flow model reflects nominal flows.

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Taxation. All cash flows should be subject to full tax provision and payment. Taxation saving through forms of financing (interest payments) is generally reflected in the cost of capital calculation, which is computed to achieve an after-tax return.

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Impact on working capital must be reflected. Normally, increased investment and revenue leads to an increase in working capital. Such is nearly always the case in an acquisition proposal. This is a consumption of cash and should be properly reflected in the projected cash flows.

Cost of capital To calculate present value, cash flows are discounted by the rate of return offered by an equally risky investment alternative. This rate of return is referred to as the discount rate, hurdle rate or the opportunity cost of capital. There may be instances where a particularly high level of perceived risk could warrant the use of higher discount rates. Any investment must promise investor returns in excess of the cost of the capital committed to it. It is thus essential to determine what that cost is. This can be an arcane and complex subject, but it won’t go away. No business can create value without committing itself to the proposition that only businesses which produce positive economic value added – that is, that produce returns in excess of capital cost – are worth being in. From a technical standpoint, there are a number of ways to calculate a firm’s cost of capital. Most notable among them is the Capital Asset Pricing Model (CAPM), which was developed in the 1960s. It has come under attack in recent years because of questions about the assumption that the volatility of firm’s stock (its so-called ‘beta’) is a good predictor of shareholder returns. As a consequence, other models have come into prominence – in particular, those that rely on forecasting dividend generation for the market as whole and for the individual firm and then convert those expectations into a discount rate. It is a difficult and complex subject, but one that requires a company view. Technically, these discount rates are expressed in nominal terms (they include inflation) rather than in real terms, and consequently the cash flows should also include inflation. Thus, if inflation increases significantly, discount rates have to be revisited. Changes in borrowing rates and the rate of corporation and advance corporation tax (affecting the pre-tax returns which commercial

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companies would have to achieve to deliver the same post-tax return) should also be reflected. Hurdle rates should be adjusted to reflect these changes in the components of the cost of capital. In recent years, however, as interest rates have declined, many companies have failed to reflect the downward impact on their respective costs of capital and have kept hurdle rates artificially high. This may well have led to underinvestment in some sectors. This observation assumes that companies proceed objectively and systematically through their various discounted cash flow analyses of investment proposals and reject those which do not produce a positive present value – or discounted cash flow in excess of the cost of the investment – even if the shortfall is modest. In practice, however, such analyses are often ‘nudged’ in the right direction if there are other forces at work which create organizational momentum for acceptance. Others are more aggressive and ignore such changes. Some deal-doing companies deliberately keep their official hurdle rates as low as possible so as not to lose out on situations which may not arise again. In the current climate of record deal size and pace, this is not surprising. Typical costs of capital are now widely seen to be at a level of 10 per cent nominal or 7–8 per cent real, but they range widely by industry. Highly volatile sectors, especially those involved in high-tech products, typically have costs of capital as much as twice that of more predictable sectors like public utilities. Companies with diverse business portfolios which encounter a wide variety of acquisition and investment projects may perceive some to be inherently riskier than others. In such cases, project discount rates are often varied around the firm’s cost of capital to reflect these risk differentials. In an acquisition evaluation, this question sometimes arises: ‘Whose cost of capital, the acquirer’s or the target company’s?’ Using that of the acquiring company will not necessarily result in an incorrect answer, but it is technically wrong. The distinction becomes important when an acquisition of a business situated in a less-developed or unstable nation is considered. It is then intuitively obvious that a higher rate of return than the acquirer’s hurdle rate is required. The appropriate discount rate to apply to any acquisition is the rate of return expected by a rational investor in that country and in that industry. Consequently, it is likely to be the same as or close to the cost of capital of the target company.

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Common mistakes in valuing acquisitions 1 Using any valuation technique that does not discount cash flow, since the time value of money is ignored. 2 Basing the decision on earnings per share impact, since it is dependent upon accounting treatment and ignores cash flow. 3 Using the wrong cost of capital to discount cash flow – either too high (which causes value-accretive projects to be passed up) – or too low (which will lead to shareholder wealth dilution). 4 Including interest and other forms of financing flows (e.g. debt repayment) in cash flow projections, since they are already accounted for in the prescribed cost of capital.

Chapter takeaway 1 The many valuation methodologies (earnings and cash flow multiples, net assets, industry norms, the various forms of present value analysis, real options theory, payback and earnings per share impact) all have their uses. 2 But only discounted cash flow can take account of all the likely financial influences on investment returns in acquisitions. 3 Mistakes are often made in using cash flow methods and should be checked by experts. 4 A major input to valuation is the decision on the cost of capital for the acquiring firm (and that of the business to be acquired). 5 Financial analysis does not provide certainty but offers the opportunity to decide on the relative attractiveness of investment choices and helps to identify the critical factors in making them work.

Having established the acquisition’s value, we now proceed to discuss the question of what could go wrong and how to protect ourselves from downside events. We take this subject up in the next three chapters, as we address the question of price, the management of the due diligence process and the negotiation of the purchase and sale contract.

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eal negotiation varies dramatically according to acquisition type but common to all is the question of price. Contract terms are only negotiated in private sales, however, public bids often involve arranging for investigations by experts (and in extreme situations making offers conditional on their outcome) aimed at broadly the same subjects. Direct negotiations on price, and indeed on the purchase and sale agreement, are relevant only to the acquisition of privately owned companies. The owners of publicly quoted companies comprise a myriad of small shareholders, as well as large institutional investors. This shareholder base is constantly changing and hence negotiations cannot take place directly. In any case, the rules of the Stock Exchange Takeover Code define the way in which offers are made to the shareholders. For example, a minimum period of time must be allowed for shareholders and their advisers to consider any offer. During this period, it is possible for a counter-bid to be made by another company. A potential acquirer must judge an offer for a publicly quoted company in the light of its attractiveness to the shareholders compared with the pre-existing share price. The expectation that other bidders may be attracted by an offer pitched at too low a premium compared with the share price will also influence the bid level of the acquirer. A rule of thumb in the City of London corporate advisory departments is that, to be credible, an initial bid should represent at least a 20 per cent premium to the pre-existing share price. Final premiums can rise to 50 per cent and even more. In a competitive bidding situation, the prospective buyer with the greatest combination of synergy benefits should win. They can afford to pay the most and will presumably do so. We explained this in Chapter 5 where we described the four rules for thinking about how much an acquirer can afford to pay. However, these principles are subject to a number of caveats.

D

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Buyers must determine not only how big the synergies are but also how much of them they are willing to cede to the seller. Some buyers may be more generous than others. Thus a bidder with lower synergies but with a more generous disposition can sometimes win.

•

Buyers may use different financial tools from the ones you’re using and thus come up with a different answer. Not all companies use discounted cash flow

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techniques, and even those that do don’t necessarily get them right (see Chapter 9, on getting the financial logic right).

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Different companies in different industries have different costs of capital – or at least think they do. Several percentage points difference in the discount rate can make a huge difference in the resulting present value calculation.

•

Research suggests that some acquisitions are made with the prime purpose of getting bigger, even if to the detriment of shareholder value creation. In such instances, pricing discipline may be abandoned. The buyer with modest synergies may simply be determined to win.

•

Estimating value and synergy potential is itself a tricky task. Companies approach such analyses with wide-ranging attitudes. Some are very conservative. Perhaps the line manager who will be responsible knows that his bonus will depend upon his beating the synergy targets. Others may be more aggressive and optimistic about the outcome – for reasons of company culture and past successes. Given the same facts, they will draw different conclusions.

We must thus approach pricing from a number of directions, including the perspective of the seller and their reasons for wanting to sell out.

Determining price At the detailed level, the evaluation of the business should clearly establish:

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the specific elements which are included in the purchase price, such as goodwill, plant, property and equipment (PP&E), other long-term assets and liabilities, working capital, shareholders’ loans/advances, guarantees, pension funds, subsidiaries and specific business sectors

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one-off costs to be reflected in the purchase price, e.g. regarding staff redundancy, disposal of assets, advisory fees and transfer duties

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a summary of sensitivities to the main assumptions (what could go wrong with this acquisition), like gross margins, unit costs, volumes, working capital requirements, redundancy cost, capital expenditures, proceeds of disposable assets, and residual or terminal values

•

multi-year annual balance sheet projections, taking into account the actual gearing of the company and showing the estimated financing requirements over the evaluation period (including seasonal swings in working capital requirements during any one year)

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multi-year profit and loss accounts consolidated – where appropriate – with those of the purchaser, including the effect on earnings of amortizing any premium to be paid over net book value

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converting the multi-year projections into cash flow and then discounting it to achieve a figure for net present value.

The calculations previously described will determine the maximum price that the purchaser can afford. This price does not automatically represent the price to be offered to the seller. A lower price may well be justified, based on general market conditions or special circumstances influencing the seller’s position. Before making any offer, therefore, it will be necessary to investigate what prices have been paid in the past for similar or comparable transactions, what P/E ratios are quoted for listed businesses, what specific yardsticks are locally used for the valuation of businesses (e.g. a weighted average between earning power value and net worth of the business) and what prices the same seller may have realized in past transactions. As a next step, the seller’s position should be analysed:

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what specific reason(s) the seller may have in offering the target company for sale

•

what price may be acceptable, given their particular circumstances (e.g. management succession issues, family disputes, trends in competitive performance, etc.)

• • •

what urgency may be felt by the seller

•

what experience the buyer has had, if any, with this seller in similar transactions.

who else may be interested in acquiring the target company what tax consequences different methods of disposing of the business may have for him

The above investigations will not lead to a specific price, but to a price range. Where the first offer is to be placed will depend on the negotiation tactics to be adopted, e.g. whether a ‘take it or leave it’ offer will be made or a lower opening bid is considered. The possibility of increasing the price before striking the deal is preserved. Occasionally, an ‘earnout’ approach to pricing makes sense. This means deferring part of the purchase price until specific performance milestones have been achieved. Such an approach makes sense under two possible circumstances: 1 The buyer and seller fail to agree about the future potential for the business, the seller claiming that enormous sales growth will ensue, the buyer being sceptical; in this case, both sides are protected: if the sales do not ensue, no further payments are due; if they do, the buyer must pay more.

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2 When the assets of the business are principally the people involved – who could easily walk away if disaffected – a contingency it is worth providing for. Earnout formulas are unpopular with some who have tried them, however, because of the disputes which often arise when deciding whether the agreed milestones have been met and whether there have been extenuating circumstances preventing their achievement. Earnouts can also delay integration of the acquired business and the harvesting of the projected benefits. This often happens because the acquired business must be kept separate in order to measure the performance to which the earnout is tied. Earnouts should be approached with caution and only used when a simple purchase is clearly inappropriate. They are most appropriate when buying businesses built around the work of talented professionals whose continued motivation is critical to the success of the acquisition.

Intermediate undertakings Acquirers often find themselves with a dilemma involving price and information. They are reluctant to discuss price in any substantive way until they have examined enough commercial and financial information about the target company to be able to draw firm conclusions on likely future performance. Sellers, for their part, are usually reluctant to part with confidential information until they are persuaded that the buyer is genuine and that they’re not on a fishing expedition for competitively useful information. This is usually resolved by one or more undertakings to progress the negotiations.

Confidentiality Thus the seller will be requested to provide certain information on the target company which, if disclosed to any competitor, could be harmful to the ongoing business. The purchaser usually signs a document undertaking that all such information will be kept in confidence, and will only be made available to such affiliates and outside advisers as may be required for the evaluation of the business. The undertaking also specifies that confidential information will be returned if the transaction is not concluded. Sometimes a phrase is added as to the purchaser’s serious intentions to study the proposed transaction.

Exclusivity Normally a prospective purchaser will make a considerable commitment of its own manpower and outside advice before a deal can be struck. In order to

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obtain some degree of certainty that the intentions of the sellers are serious, the purchaser may ask for exclusivity of negotiation during a certain period of time. If it is not granted, it may be necessary to impose a strict time limit for acceptance so as to prevent the seller from soliciting an offer as a ‘stalking horse’. This means using it to put pressure on another prospective purchaser with whom the seller in fact intends to conclude the deal.

Provisional commitments The purpose of an intermediate undertaking, such as a letter of intent or heads of agreement, is to establish and confirm as clearly as possible in the minds of both seller and purchaser the price agreed, the state and contents of the company, and the broad terms and conditions attached to the sale. These points are dealt with in great legal detail in the purchase and sale agreement. It will, however, probably take weeks for a binding purchase and sale agreement to be negotiated between the parties. The intermediate undertaking is intended to be drawn up quickly to cover the above objectives while they are fresh in the minds of the parties. It is not intended to be legally binding. It is often referred to for guidance during the more detailed negotiations on purchase and sale. Consequently, it is not necessary to use carefully crafted legal language. In order to be effective, the parties should draft an intermediate agreement using ‘street language’ that they can easily understand and agree. Associated undertakings such as confidentiality and exclusivity are intended to be binding and consequently, greater care must be taken as to the drafting and, to the wording chosen. Under certain legal jurisdictions, a heads of agreement or letter of intent can be enforced on the parties. These jurisdictions are primarily those whose legal code is based on the Napoleonic principle that what is construed as the intent of the parties is what binds them. For these reasons, and because intermediate undertakings can take much longer to draft than might be expected, many acquisitive companies have a policy of not entering into letters of intent or heads of agreement. Others regard them as important in defining, in simple terms, what has been agreed. There can be no clear-cut guidance as to whether or not a provisional agreement should be undertaken. Much depends upon what management is comfortable with. Even if the decision is taken not to proceed with a formal interim agreement, it is a good idea to note down your understanding of what point has been reached, the assumptions you have made to get you to that point and the remaining work, verification and validation that needs to take place before a final binding contract can be signed. It is then prudent to share your assumptions and the detail you need to verify with the seller to ensure that any

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surprises found during due diligence have a reference point. You will almost certainly need to refer back to this list as you make progress with due diligence and with the sale and purchase agreement. Provisional commitments thus typically take either or both of two forms.

Letter of intent This agreement will contain the purchaser’s serious intention to complete the purchase. Generally, such a letter of intent should be avoided, but if indispensable in order to proceed with the negotiations, utmost care should be given as to its wording so as to preserve the purchaser’s right to withdraw from the negotiations, should circumstances require it. The implied commitment is usually made conditional upon:

• • •

the successful negotiation of the detailed sales and purchase agreement

•

a satisfactory outcome to the due diligence procedures.

the approval of the board or shareholders’ meeting, as the case may be often, the approval of regulatory authorities, especially those overseeing compliance with competition laws

The general proviso ‘subject to contract’ helps too, but is not entirely reliable in all jurisdictions.

Heads of agreement Once an understanding has been reached on the broad principles of a transaction, negotiations on the detailed sales and purchase document can start. Depending on the complexity of the transaction, this may take considerable time and it may be advisable to sign an intermediate heads of agreement covering those points of principle agreed upon. As in the case of the letter of intent, care should be taken as to the wording of the document so that it cannot be construed as an unconditional commitment to conclude the deal. Obviously, any sort of intermediary understanding which binds the purchaser to the transaction, however summarized it may be, should be preceded by gaining approval of the appropriate corporate authority of the purchasing company. Often, in place of heads of agreement, a draft sale and purchase agreement is circulated as soon as the broad deal parameters are clear. Lawyers all have ready-made contract templates which can be produced at a moment’s notice. It is generally considered a tactical advantage to present the first such draft. This puts the other party into the position of having to negotiate from the start.

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Chapter takeaway 1 The biggest issue in direct negotiation is the question of price. Buyers should consider their own limitations, as described in Chapter 5 (the ‘four rules’), the seller’s reasons for being willing to sell and why other bidders might be prepared to offer more. 2 Various undertakings are likely to be necessary, involving confidentiality, exclusivity and provisional commitments on the deal to be offered. 3 Negotiations can be expected to be intense around other aspects of the sale and purchase agreement (see Chapter 12), especially around warranties and representations, tax issues and the possibility of environmental cleanup.

Having agreed on the broad terms of the proposed acquisition, the next step is to investigate the target company, both to validate future expectations and to identify any worrisome problems.

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11

ue diligence is the process by which prospective acquirers investigate the target company, for two purposes. First, they want to confirm the competitive and commercial position of the company in its market and with its customers so as to be sure its plans for improving performance are realistic and grounded in fact. Second, the audit is designed to uncover problems not otherwise disclosed in financial statements that could make the company worth less than it appears to be or that could stand in the way of it achieving its financial objectives. Needless to say, it’s a critical step in the process.

D

Learning from private equity firms Due diligence is one area where corporate acquirers can raise their respective games by observing the approaches taken by the better private equity firms. The increasingly tough and even bitter competition between private equity firms when bidding for target companies has put a premium on doing a better job in operational improvement. They realize that simply buying low and selling high or instituting aggressive financial engineering procedures is no longer enough. Now they have to make a real difference to company performance by getting better on strategy and operational execution. Their approach to due diligence is a cornerstone of this new stress on performance improvement. For them, due diligence is not a perfunctory exercise designed to justify the deal and perhaps uncover a few areas of unpleasantness for quick repair. Rather, it plays a key role in deciding whether or not to proceed with the deal and also in identifying priorities for early action in the integration process. The serious and successful private equity firms have developed elaborate models for assessing the opportunity for improvement and competitive advantage. They do what any careful analyst of competitive challenge would do, but with extreme care and attention to detail. A typical approach is to map out the market for the target company’s products and services, together with its growth prospects and susceptibility to disruptive change by substitute products. They then segment it by geographic market, customer and product so that each competitive battle that will be important for strategic success is described. They go into great detail to understand the strengths and weaknesses of the target company, as well as those of important competitors in each important segment.

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Then they model margin and profitability by each noteworthy segment and initiate detailed measurement of customer preference and satisfaction within each. From this emerges an assessment of the seriousness of the competitive challenge for the target company, as well as the actions that will have to be taken to improve its position. These conclusions will form the basis for the integration plan (see Chapter 14) if the deal goes ahead. For good private equity firms, this is what due diligence is all about. Corporate acquirers: take note. There’s no reason why corporate acquirers cannot take on all these ideas as an article of faith and become just as good as the best private equity firms in investigating prospective targets. This means, to start with, being clear about the role of due diligence within the larger acquisition process. And it means hard work.

The logic of due diligence When you buy a box of eggs in a supermarket, some can be cracked. This is a disconcerting and annoying discovery. How can one discover if one or more eggs in the box are cracked? First, examination of the eggs in the box on the shelves can reveal cracked eggs, and the customer can purchase a different box, one which, upon examination, reveals no cracked eggs. Second, in some shops, checkout staff routinely examine egg boxes in search of cracked eggs. Presumably, this is to avoid the occasional annoying return of an irate customer to the shop with cracked eggs discovered at home. Finally, without either of the first two checks, the customer can discover the eggs at home when they are removed from the egg box, either for immediate use or for insertion in the plastic tray in the refrigerator. They may take them back to the store and demand their money back. Thus the consumer has a series of strategies to prevent the occurrence of cracked eggs. Some egg purchasers adopt these precautionary strategies. Others are cavalier about the egg-purchasing decision and leave the risk in the lap of the gods. So it is with the purchase of companies. The acquirer has several strategies available to reduce the probability of finding the corporate version of cracked eggs, once the purchase transaction has been completed. First of all, preliminary analysis of the target company before even an approach has been made will have revealed potential problems, or at least issues for focus and further investigation. Acquirers will have developed an early list of the areas for concentration in the due diligence process.

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The most painless way to discover a problem is through disclosure by the selling party. After the warranties have been negotiated in the sale and purchase contract (see Chapter 12), the selling company provides a letter for the acquirer, disclosing, to the best of its knowledge, any situation which would violate any of the agreed warranty provisions. The seller says, in effect: ‘I promise to make good on any problems you find of the sort we have agreed to in writing, except for those on this list, which I freely acknowledge.’ For this to be a good way of finding problems, a good list of warranty provisions needs to be agreed. This means that they must be particularly strong in areas of relevance to the economic rationale for the acquisition. Such a list will be heavily influenced by an understanding of potential problem areas developed at the outset of the process. Next, the company can undertake its own investigations. This is the process of due diligence. Specialists are usually involved in such investigations. Ordinarily, the buyer will retain investigative accountants to pass judgement on the probable accuracy of the company’s financial statements and the auditing standards that have been used in their preparation. More importantly, the accountants and legal advisers will endeavour to discover any undisclosed obligations of the company which could result in a significant claim against its assets. This is a tricky business. The investigating accountants will say that they cannot guarantee to find everything that’s wrong without themselves performing a full audit. They can only pass on the way the company’s audit was conducted and point up obvious areas for concern. The buying company, on the other hand, wants comfort. What if something is well hidden? If a huge problem arises after completion, whose fault is it? That this is a murky area is attested to by the number of lawsuits against accountants in recent years. Because of this, in engaging accountants to carry out due diligence work, the buyer should be aware of the limitations inherent in the degree of comfort which can be drawn from this work. No respectable accounting firm is likely to express any formal opinion or judgement on any due diligence findings. Instead, the accountants will carry out any verification work on the instruction of the buyer and will report simply what they have discovered. The reality is that the buyer must take responsibility for the interpretation of any discovery and ultimately for the judgement of how it might affect the acquisition; whether the price should be amended or the acquisition should proceed. Other investigations might include the use of a property adviser to make a judgement about the real market value of the properties in the company’s portfolio and the use of environmental consultants to judge the likelihood of environmental problems, such as land contamination. Problems discovered this way can be used to extract a lower price from the seller, or they may lead the buyer to

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abandon the acquisition when the problems appear unacceptable and the seller is unwilling to put them right. Finally, the buyer can simply do a fast deal and ignore painstaking due diligence investigations. There can be a great temptation to go down this route to avoid protracted investigations delaying the desired completion, large professional fees, difficulty in managing the share price during the uncertainty involved in the transaction and difficulty in managing employee morale during a protracted investigation. Sad stories have been recorded about companies and managers who took the chance and failed (see the discussion of the disaster at Ferranti in Chapter 3). Accordingly, what follows is a description of the usual due diligence procedures and the main areas of investigation typically pursued. Although these procedures apply to private sales, public bidders often commission investigations by experts aimed at broadly the same subjects. We first address financial due diligence, which is usually in the hands of expert accountants. Then we describe various functional areas of investigation, and finally commercial due diligence, which is largely the responsibility of the profit accountable managers sponsoring the transaction and who will probably be accountable for the acquisition’s performance after completion.

Financial condition This is the information needed to confirm that the target’s balance sheet statement really does accurately represent the company’s financial position. The analysis is usually carried out by specialist accountants, often from the acquirer’s auditors. As will be seen below, the agenda for investigation can be wide-ranging and thus an expensive proposition in professional fees. Accordingly, accountants often do this work in discrete phases, so that if emerging information suggests abandonment of the project, fees will have been reasonably contained.

Working capital Scrutiny should be undertaken of the minimum working capital required in the takeover base case projections. The main items for consideration and the investigative tasks are as follows:

•

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Operational stocks. Establish the level in terms of day’s sales, compare with market standards, check the possibility of absorbing the buyer’s requirements in existing stock levels of the purchaser. If a reduction of stock levels seems possible, check on any tax consequences.

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•

Cash. Assume to represent minimum working balances, either by introduction of overdraft facilities or by combined cash management with the purchaser.

•

Trade debtors. Prepare segmented analysis in day’s sales, compare with market standards, establish proportion overdue, determine whether any correlation exists between margins and credit terms granted. If an overall reduction of trade debtors is foreseen, establish realistic timing of implementation; also, are any debts likely to be unrecoverable?

• •

Suppliers’ credit terms. If not commercial, adjust to market standards. Tax credit terms. Check on compliance with legal regulations.

If major changes are indicated, such variations should be included in the cash flow in the year they occur. Similarly, volumetric changes in stocks should be reflected in the cash flow at current prices. The effect of changed unit prices on value held should, however, be disregarded during the period of calculation since they will have been fully reflected in current cost of supplies.

Plant, property and equipment The net present value calculation referred to earlier will result in a value for the business and its assets. Nevertheless, the plant, property and equipment (PP&E) area requires further scrutiny since maintenance, future replacement or disposal of redundant parts after takeover may have a substantial impact on the cash flow and the residual value of the business at the end of the period. For this purpose, an inventory of all assets, such as office buildings, depots, plant, land and vehicles, should be made and should reflect future requirements according to the buyer’s commercial projections in the DCF analysis – the so-called ‘base case’ – normal maintenance requirements and relevant health, safety and environment standards. The first task is to identify excess assets, the net proceeds from the disposal of which can be included in the cash flow. Alternatively, plant may be operating at or near capacity, and further expenditure may soon be required. Any specific efficiency improvement investment should be excluded from the takeover cash flow and be subjected to a separate proposal unless it is considered crucial for the economic justification of the project as a whole. The extent and depth of the technical audit of the target company’s operating capability and assets will largely depend on the time available. The purpose of such an audit is to establish the broad value of the enterprise and any major changes or improvements which will have to be funded. The fact that such an inspection has taken place should not affect any claims the purchaser may

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make under the warranties supplied by the seller unless any default or deficiency is specified in the disclosure letter.

Other long-term assets and liabilities Similarly, all remaining assets and liabilities should be analysed in order to determine whether they are required to carry on the business as established in the takeover base case. Some of the main items are:

•

Loans to customers. Does the level correspond to the takeover base case? What is the agreed repayment schedule? Is there any possibility of replacing such loans by direct bank loans (possibly with an interest subsidy)?

• •

Work-in-progress. Are levels reasonable and consistent with industry norms?

•

Guarantees. Can the risks be quantified? Is the maintenance of such guarantees required?

•

Bank borrowing. All bank borrowing should be assumed to be repaid in the year of acquisition unless based on contracted facilities; in the event, a change of ownership will usually trigger the need for repayment.

•

Deferred taxes. Any tax minimization or delaying measures in the past should be reflected as increased cash tax liabilities.

•

Pensions provisions. Estimate current pension payments minus employee contributions during the lifetime of the projections. Pensions require an actuarial report on the adequacy of funding. If underfunded, the purchaser will be obliged to compensate the fund in cash for any such deficit, possibly by a one-time contribution. In the case of overfunding, the benefit will be reflected in the current cash flow when establishing the level of future contributions to the fund. The seller may want any surplus so encountered to be reflected in the purchase price. Assuming appropriate funding over the period of calculation, pension obligations in the horizon year should have no effect on calculating the residual value.

Capital programme. What are the company’s capital expenditure commitments? If not required in the base case, what are the possibilities and penalties for withdrawing?

Taxation Fiscal aspects may be of importance in establishing the structure of the transaction as well as the purchase price.

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•

Examine the tax returns over the last five years and establish whether or not the principles underlying these returns have been consistent.

• •

Which tax years have not been subject to a final tax audit?

•

What are the fiscal implications of any cross-border trade, particularly as regards transfer prices, service fees and royalties?

•

Reconcile the fiscal with corporate accounts to determine to what extent special fiscal allowances have been used, like accelerated depreciation, stock reserves, LIFO (last in, first out) evaluations and write down of debtors, which may affect the company’s future tax liability and cash flow.

•

Establish whether or not any tax loss carried forward is available and, if so, if this could be lost after takeover.

•

Establish the taxes, duties, fees, etc. which will become due at the time of the takeover of shares or assets, given the place of execution of the relevant agreements.

•

Check on tax treatment of any special payment to employees and pension fund following the takeover.

•

Check on the tax treatment of any interest payable by the purchaser on deferred settlement of part of purchase price.

Under what conditions may the tax authorities request reopening of the books, even if the accounts have already been subject to an official tax certificate?

The same rigour should be applied to the payment of value added taxes, or their equivalents in countries where this is applicable.

Computer systems The ever greater dependence on large-scale computer systems has made their examination an important subject for due diligence. In particular, the following questions should be addressed:

•

How susceptible are existing systems to date-related problems? Have they been given thorough examination and testing?

•

Are existing systems running at or close to capacity? Is major expansion or improvement required?

•

Could there be problems linking the target’s systems to those of the acquirer? (We noted earlier that this area of investigation can prove critical. The integration of many acquisitions has been slowed or even, in some cases, stopped owing to the incompatibility of systems of the acquirer and the target.)

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Roles of professional advisers 1 Merchant bankers: act as project manager. 2 Business brokers: introduce potential targets. 3 Tax specialists: recommend structure to minimize taxes and assist in verifying stated tax liabilities. 4 Investigating accountants: oversee financial due diligence. 5 Pension fund actuaries: value pension fund. 6 Property surveyors: assess property values. 7 Environmental consultants: investigate potential environmental problems. 8 Solicitors: prepare contract, address competition law issues. 9 Stockbrokers: manage stock exchange issues, assess stock market reaction. 10 Public relations advisers: supervise press relations and external announcements. 11 Management consultants: develop strategic framework, screen candidates, assess target’s competitive position.

Increasingly, the complexity and importance of these questions requires the retention of expert advisers to conduct the appropriate tests and investigations.

Specialist matters Specialized advice is also frequently needed in the following areas.

Personnel The main aspects to be investigated can be summarized as follows:

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•

Standard conditions of employment, remuneration scales and other general benefits.

•

Legal redundancy conditions and additional arrangements the company may have committed itself to.

• •

Special benefits granted to any individual employees of the company. Special privileges for top and middle management, like service contracts with long notice periods, bonus schemes, car arrangements, housing allowances, etc.

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• • •

Special arrangements for travelling representatives.

•

Whether or not the acquired company will keep its own employment conditions. If so, is there the risk of spillovers (in both directions)? If not, what will be the phasing of standardization of employment and retirement conditions (possibly not confined to those of the acquired company)?

•

Procedures and timing of required consultation with staff council (or any similar body) of the purchaser, seller or target company.

Extent of accidents, sickness and strikes. If redundancies are foreseen as a result of the takeover, establish the impact on the pension fund.

After having established minimum staff requirements, it is necessary, first, to inform personnel of both the purchaser and the target company as soon as possible regarding their future position after takeover. In that way, insecurity and possible demotivation of the people involved can be limited during the period immediately before and after takeover. Second, a clear understanding should exist as to the future positions of existing members of management and the board; this is especially important if the purchaser depends on their cooperation for a smooth takeover process.

Legal affairs Some of the main points requiring attention are as follows:

•

Target company. Incorporation, articles of association and bylaws, share register and transferability of shares, procedure regarding nomination of board members, shareholders’ meetings, nominations of external auditors.

•

Authorization. Permits, licences, approval of government or other official bodies required to implement the purchase agreement.

•

Antitrust/merger code. Submissions required to antitrust or other bodies in the country where target company has its activities, and to supranational bodies (for instance, the EU) to obtain the required clearances.

•

Corporate procedures. Required submissions to government authorities from boards, shareholders’ meetings, staff councils, trade union representatives.

•

Existing contracts and agreements. – All contracts, such as principal supplies, distribution, depot throughput, leases, rentals, financing, guarantees and other securities, retail operations, services, research, etc. with government, competitors, shareholders and affiliates, suppliers, customers, retail operators, or any other third party.

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– Which contracts should be terminated, extended or renegotiated.

•

Outstanding litigation, disputes and claims. Itemize and assess for major potential impact.

Environmental matters The specific areas for investigation will depend in large measure on the rules in the countries in which the target operates. Special attention should be given to the following:

•

Soil contamination. In many countries, and especially in the USA, the sale of assets can trigger the need for soil investigation and the necessity for a cleanup if contamination is found. The process of doing so can run into unimaginable sums; thus both the extent of any problems and the responsibility for putting them right can be crucial to the economics of the transaction.

• •

Air and water pollution.

•

Access and facility impact on local traffic patterns.

Noise. This is a growing problem. Many local communities are pursuing noisemakers with determination; it appears to be a populist issue.

An environmental investigation can be frighteningly large in scope and expensive in terms of fees. Even more expensive is the experience of ignoring the issue and later discovering a major problem. The typical content of such an investigation – for example, for soil contamination – is as follows:

• • •

identification of sites where problems could exist

• •

remedial options and the estimated cost thereof

•

alternative deal structures to leave problem with the seller.

determination of scope and spatial area of contamination identification of chemical and physical nature of problem and its potential impact – on animals, on people, on local ecological balance and the like likely reaction of regulatory authorities and the design of a negotiating strategy with them

Regulatory oversight of environmental questions can be expected to intensify further. The UK has its new Environmental Protection Act, while the US supervises these activities through the Environmental Protection Agency. Other major countries are replicating these rules and approaches, and the EU is now laying down its own requirements. National agencies are cooperating with each other, both to share technical know-how and to strengthen oversight.

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The stakes are high. Non-compliance can result in heavy fines. In the 1 extreme, a site can be ordered closed – a potentially catastrophic development and a source of major potential business disruption. Environmental investigation – especially for soil contamination – has moved to the top of the list of due diligence concerns for many prospective acquirers.

Commercial due diligence The position of the company in its markets must also be carefully investigated, generally by an in-house team knowledgeable about the target’s business. The purpose here is to underpin the projected income and cash flow statements.

Economic assumptions The assumptions about economic indicators such as GNP development, energy supply and demand, unemployment rates and inflation rates should be consistent with those assumed by the buying company for its own forward plans and should be extended over the remaining period in a consistent manner.

Current business Investigation of the target’s current business position is critical in building confidence in forward projections and in particular, on improvements planned. In this respect, the approach taken by private equity firms noted earlier in this chapter is a good starting point. The basic steps to be taken in order to evaluate the current business can be summarized as follows:

•

segment analysis of existing business with corresponding volumes, gross current margins, revenue expenditure and working capital

•

assessment of competitive position within each segment and a note of both strengths and weaknesses which could affect performance and which act as prompts for further action; where possible this should include measures of customer satisfaction in key segments

• •

identifications of segments which do not perform adequately and are to be shed

•

assessment of volumes, gross current margins, variable costs (with particular emphasis on inflation effect) and working capital

•

analysis of overheads and manpower, and assessment of amounts and phasing of redundancy payments required.

assessment of incremental business margins to be realized due to the buying company’s synergies

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Sometimes a takeover is considered to have an additional strategic value – for example, if such acquisition:

• • •

results in a position of market and price leadership of the acquiring company eliminates an existing aggressive competitor in the market bars the entrance of a newcomer, whose presence is likely to have a disruptive effect on market conditions.

Whether such strategic value, as part of the overall financial evaluation, is justified will, of course, depend on the merits of each individual case and the factual support obtainable for it. Where a problem arises in any of the above areas that has not been adequately provided for in the warranties, the buyer has three choices:

• •

they can re-open negotiation of the contract and ask for warranty coverage

•

they can walk away and abandon the deal.

they can ‘take a view’ on the problem discovered and conclude that they can live with its consequences

We have one final piece of advice in the conduct of due diligence. The fact is that the investigations and analyses involved in examining the affairs of the target company can constitute a bottomless pit of work and activity. Obsessive investigators can almost go on forever examining the issues we have described in this chapter. The trick, of course, is to focus in on the most important things – the biggest risks and the most important drivers of value – and then be careful and efficient with the rest. Determining these areas of priority in your investigations is thus a critically important task and one that should be discussed and shared among team members and decision makers. Dealing with these choices is often difficult for acquirers, but doing it right can certainly have far-reaching consequences.

Chapter takeaway 1 In private transactions, due diligence is essential to confirm the commercial likelihood of achieving the desired value creation, as well as identifying undisclosed exposure problems and potential ‘black holes’. 2 Private equity firms are known to conduct particularity intensive due diligence investigations and go to great lengths to identify every potential obstacle to the success of their plans and projections. This intensity is thought to be a key to their superior returns and is worth emulating.

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3 Due diligence covers a wide range of subjects, including overall financial condition, the adequacy of plant and equipment, exposure to taxation problems, the compatibility of computer systems, legal matters, environmental issues, and the adequacy of pension funding. 4 It also addresses commercial issues such as the competitive standing of the target and the degree to which expected synergies are achievable. 5 Due diligence requires intense work and substantial use of outside experts. Its cost must be factored into the financial projections associated with the acquisition.

We must now deal with the closely related area of negotiating an adequate sale and purchase agreement.

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12

roducing a good sale and purchase agreement is a cornerstone of a successful acquisition and represents the culmination of prior investigative and analytical steps. A good agreement will anticipate all imaginable risks and difficulties and protect the acquirer against most problems, both foreseeable and unforeseeable. It is possible that an inability to agree on key terms can derail an acquisition. But if it has been preceded by a heads of agreement and by detailed discussions between the parties, this is less likely. Nonetheless, negotiating it is usually a big job. Legal, fiscal and other technical support will be required in order to proceed to this stage of negotiations and, ultimately, in execution of the final sale and purchase agreement.

P

Key areas for negotiation The following points highlight those parts which may have an impact on the price to be agreed upon and which should therefore be discussed with the seller at the earliest possible stage during the negotiations.

Price In an ideal situation, a fixed price will be agreed which will become payable at the moment the shares are transferred. In practice, however, this may not be possible, if, between agreement in principle, the signing of the purchase and selling document and the actual transfer of the shares, several months have elapsed. In the meantime, the net worth of the target company may be subject to substantial variations. Consequently, the sale and purchase agreement may contain a price formula, such as:

•

a fixed price for plant, property and equipment (PP&E) and goodwill, to which the market value of the stocks plus the book value of all other assets minus liabilities will be added as soon as these have been established by jointly appointed auditors; or

•

a fixed price for goodwill only, to which the total net worth of the company will be added as soon as the joint auditor(s) have established it.

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The choice between these alternatives will depend on the expected variation in net worth between the signing of the agreement and the closing date. Since the capital expenditure programme of the target company will have been established in the meantime, and any changes most probably will be subject to consultation between seller and purchaser, in many cases the first alternative can be used. If, due to the application of the price formula, a large part of the purchase price will only become payable after the joint auditors have made their report on the final net worth, an advance payment may be made. Interest is often charged on any balance due on final settlement date. Whatever price formula is chosen, it is important that the parties have a clear understanding of the accounting principles that will be used for establishing the net worth and on what basis the market value of the stock will be determined. These two points have to be spelt out in detail in the sale and purchase agreement and their correct application verified by the joint auditors. Normally, shareholders will have funded the company not only with share capital but possibly also with term loans and shareholders’ credit on supplies of materials and services. The seller, disposing of its shares in the target company, will wish to be refunded for all such credits after the closing date. To this end, the agreed purchase price can also cover the assignment to the purchaser of all such claims, though this may produce legal, foreign exchange or other difficulties. In such a case, the agreement will normally stipulate that the purchaser will provide sufficient funds to the target company so that the latter is able to settle its debts towards its previous shareholders.

Contents of the company A clear understanding should exist as to the scope of the business which will be transferred. If the seller does not want to retain any activity previously carried out by the target company, a provision to the effect that the seller has not effected any material change to the business will suffice. If, however, certain sectors of the business are to be retained by the seller, a clear specification of each such sector should be made in the agreement, as well as those parts of PP&E pertaining to this business, with corresponding working capital, staff and contracts.

Warranties In the previous chapter, on due diligence, we examined the unfolding process of protecting the seller against a risk, using the broken eggs analogy. In this section of the agreement, we specify the risks where we need protection. When acquiring a company, the purchaser will rarely be fully knowledgeable of the company’s past. The resulting financial and public exposure of the

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purchaser is usually more prominent in a share acquisition as it does not result in a change of the company’s corporate identity. The risks involved usually cannot realistically be quantified at the time of the transaction. In order to reduce this exposure, the purchaser must stipulate warranties and representations by the seller which, if they are proven to be untrue, will give the purchaser the right to claim redress. The content of these warranties will vary, depending on the transaction envisaged and applicable law, but it is useful to mention in broad terms some of those generally required by purchasers. The list below is by no means intended to be exhaustive.

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Shares. The company is duly incorporated; the seller has good, free and marketable title to the shares, clear of any liens or encumbrances; and there are no restrictions on dividend payments or capital restrictions other than those imposed by law.

•

Financial statements. Such statements have been prepared in accordance with generally accepted accounting principles on a consistent basis and in accordance with applicable laws and regulations; they fairly represent the financial position of the company; and there have not been any changes in accounting methods or practices during the last, say, five years.

•

Tax. The official returns and reports required have been filed, reflecting correctly the tax liability of the company; all taxes due have been settled; and the provisions for remaining tax liabilities are adequately reflected in the financial statements. This can be a difficult subject area, particularly in those parts of the world where two sets of books are kept and cheating the tax authorities is a way of life.

•

Fixed assets. The company has good and marketable title to all assets free and clear of all liens and encumbrances; they are in a good state of repair; the activities carried out on the company’s premises are not in violation of any legislation or regulations; and there are no outstanding proceedings issued in respect of such properties.

•

Inventories. They are in good condition and of marketable quality, and their value is reflected in the financial statements at the lower of cost or market value. Subsequent disputes often arise in this area when the managers inheriting the business claim that stocked products are in bad condition, obsolete or otherwise unsaleable. Sellers usually want limitations both in money terms and in the expired time in this area.

•

Receivables. These are properly reflected in the financial statements and are valid, genuine, collectable, arising out of bona fide sales, and subject to no claims, and the provisions for bad debts are adequate.

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•

Intellectual property rights. The company has clear title to its patents, trademarks and copyrights.

•

Other assets. The company has good title to all other assets included in the sale, free and clear of liens or encumbrances, and equipment is in good operating condition.

•

Contracts. The company has title to all contracts and to all rights and interests granted under such contracts; no parties to such contracts are in default; they are valid and enforceable; the transfer of the business will not entitle any party to terminate the contract or result in automatic termination; to the best of the seller’s knowledge, none of the parties to those contracts intends to discontinue them or significantly modify their terms; and there are no onerous or unusual contracts binding upon the company.

•

Insurance. The company is fully covered with a financially sound and reputable insurance company against all risks customarily insured and all insurance is in full force.

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Soil contamination and other environmental problems. The company has investigated its facilities and property and concluded that, to the best of its knowledge, there are no conditions which could lead to a claim from authorities concerned with maintaining environmental standards. Penalties for environmental damage can be enormous, and this area can thus be extremely contentious. Deals sometimes fall apart on the question of whose problem it is if damage is discovered, now or in the future.

The toughest points to negotiate 1 Tax: uncertainties about past practices may inhibit sellers from standing behind their stated income. 2 Indemnification: size and time limit. 3 Environmental exposure: especially soil contamination. 4 Price.

•

Liabilities and claims. – Pending litigation and claims: there are no claims, actions or procedures brought before any court. – Product liability: no goods have been manufactured, processed, packaged, stored, marketed, transported or supplied in circumstances where the

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company may in future be held to be liable for injury, loss or damage. This is another area of potential difficulties, especially in industries like medical products, where liability litigation is commonplace. This caveat applies particularly to acquisitions in the USA. – Health, safety and environmental claims: the premises are free of pollution or contamination and nothing has been produced or disposed of in circumstances where the company may be held liable for injury, loss or damage. – Intellectual property rights: the company’s activities do not infringe on any intellectual property rights or copyrights. – Government approvals: the company possesses all licences, franchises and certificates necessary to conduct the business; there are no claims threatened or brought in the past years to revoke such rights; and this transaction will not automatically lead to termination or entitle the governmental bodies involved to terminate these licences. – Contracts: the company has duly performed its obligations under its contracts and other obligations. – Compliance with law: the company has conducted its business in accordance with good industry practices and has complied with applicable laws and regulations, and the company is not expected to become subject to any court order, judgment or award which will materially interfere with the continued conduct of the business. – Other liabilities: there are no other absolute or contingent liabilities which are not shown in the financial statements and there are no commitments to guarantee any debt or pay any dividends not disclosed in the appropriate exhibit.

•

Employees. The company employs no other people than specified in an exhibit; it is not liable to make any payments to any (former) employee by way of damages or in disputes relating to the provisions of labour law; accurate particulars of terms of employment contracts including pension arrangements and other benefits have been fully specified in an exhibit and no commitments have been entered into to augment such rights.

•

Funding of pension plan. The fund being transferred is sufficient to meet future pension obligations.

Indemnification If the representations and warranties as indicated above prove to be untrue, the purchaser will be entitled to compensation for loss or damages, to the extent

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that they result from events which occurred before the closing of the transaction and in so far as they are not specified in the disclosure letter. A number of key points must be kept in mind.

•

Normally, the seller will insist on certain limitations of their liability. A minimum amount of any individual claim or of the aggregate of such claims is usually laid down, and there will be time limits imposed on such claims. They must be liberal enough to allow for the uncovering of all likely problems. Care should be exercised in accepting a limitation on warranties relating to tax, antitrust, product liability and environmental claims. Bad news could have enormous consequences.

•

The inclusion of warranties in the sales agreement should not be a reason for the purchaser to defer detailed examination of a target company until after the closing date. All points mentioned above should be subject to scrutiny during the investigation and negotiation period, since it will then still be possible to withdraw from the proposed transaction if any major deficiencies are found. Furthermore, it may be a cumbersome, costly and protracted process to obtain compensation from the seller once the transaction has been completed, since the seller will have no incentive to agree.

•

There can be a real question about who gives the warranties and if they can be relied upon to deliver on their indemnification obligations. If the seller is a group of people – a family, for example – the safest course is to insist on joint and several obligations. This means that they are collectively responsible for whatever payment might come due, not just their individual pro rata shares. If a single shareholder is involved, planning to live abroad, the likelihood of not standing behind these obligations must be considered. In such cases, part of the consideration is sometimes held back as insurance. This can be a contentious and difficult issue.

Use of the seller’s brand name In certain cases, the seller may not want to surrender existing trademarks and brands together with the disposal of the business. The purchaser, on the other hand, may not be able to discontinue their use immediately after the closing date and indeed may want to delay rebranding in view of the expenditure involved. Therefore, parties generally agree on a limited period of time, during which the purchaser is allowed to retain the use of the existing tradenames and brands. If necessary, a separate licence agreement will set out the details.

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Re-entry It is customary to stipulate the period of time during which the seller will not be allowed to re-enter the sector of business disposed of, either directly or through subsidiaries, affiliates, agents or dealers. This is the so-called ‘non-compete clause’. The period of no re-entry may depend on statutory or treaty (especially EU) constraints. This is an area which occasionally leads to subsequent litigation, especially when the seller is an individual whose skill, experience and reputation is closely identified with the products and services of the target company.

Access to books and records The seller will usually agree to allow the purchaser access to books, records and operational data during the period between signing of the agreement and the closing date, so as to allow the purchaser to become familiar with the company before actually taking ownership.

Personnel The seller may insist on a provision that after takeover the purchaser will not decrease the remuneration package of the staff (including social benefits, pensions entitlements, etc.); this may be acceptable if limited to a period of, say, two to three years. Sometimes the seller will require a commitment that there be no redundancies for a period of time. This proviso is common in agreements with sellers from continental Europe, where employee consultation and empowerment arrangements can be onerous.

Conduct of business Since considerable time may elapse between signing of the agreement and the closing date, a provision is usually included, obliging the seller to carry on the business normally, not to enter into any commitments which could be considered outside the scope of ordinary business and to keep in close consultation with the purchaser on any material decisions.

Conditions precedent The closing of the transaction will normally be conditional on a number of requirements such as official approvals, licence registrations, foreign exchange clearance, reconfirmation of warranties, contents of the disclosure letter, shareholder or board approvals, counsel’s opinions and the absence of any adverse changes to the business.

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Expenses A takeover will normally entail substantial expenses, not only on the actual transfer of the shares, but also due to the employment of legal, tax and other consultants, and joint auditors. A clear understanding as to the sharing of these charges should exist either by sharing total expenses in a certain percentage or, more commonly, by stipulating that both parties pay those expenses which they have initiated.

Strategic relevance No one negotiating a sale and purchase agreement can expect to get exactly what they want in every clause. In preparation for the negotiation of individual clauses – especially warranties – it is thus sensible to prioritize them. The ‘musts haves’ should include not only those which could have devastating financial consequences but also those which underpin the strategic drivers of the transaction. For example, each of the following bases for value creation suggests the importance of corresponding contract provisions.

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•

If major cost rationalization is required – and this usually means large-scale redundancies – assurance is needed that there are no obstacles, financial, legal or otherwise, to such an exercise, and that no payment beyond those specified by statute will be necessary (irrespective of whether the buyer may, as a matter of policy, plan to be more generous).

•

If the skills of a few key people are driving the acquisition, a provision that the seller knows of no reason why they would not want to continue in their jobs would be appropriate. The deal might also be made conditional upon their signing some form of lock-in employment agreements – which provide for the forgoing of major financial rewards in the event of an early departure. Key people could also be asked to sign non-compete agreements.

•

If market control is sought, the contract should be conditional on clearance from competition authorities in jurisdictions where concentration could reasonably be expected to attract their attention.

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Chapter takeaway 1 The sale and purchase agreement sets out in great detail the entire understanding between buyer and seller. It requires intense study and attention to detail. 2 Of the many subjects covered, the most difficult to negotiate are typically those surrounding price, taxation, which warranties are to be given, the extent of indemnification underlying those warranties, and responsibility for any environmental cleanup, should that be necessary. 3 As in the case of due diligence, due attention must be paid to those aspects of the target company that are critical for the achievement of the intended value-creating goals. The objective should be to be comfortable that you are buying what you think you are buying and that you’ll be duly compensated in the event of disappointment.

Having finished with the structure of the deal, we must now decide how to finance it.

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enerally speaking, the choice of financing has little or no impact on the likely value created from the acquisition. If the cost of capital is correctly computed and used to discount the cash flows associated with the acquisition investment, it should make no difference how the acquisition is financed. Of course, it is tempting to say that, if we use debt, the after-tax cost of that interest of, say, 3–4 per cent, constitutes a significantly lower cost of capital. We would be better off simply using cash. For very small acquisitions this looks particularly tempting. But the cost of capital is the cost of capital. Too many decisions like this and their effect on interest cover will have a deleterious effect, both on interest costs and even investor confidence in the company.

G

Cash versus shares Funding choices reflect other considerations.

•

If there is currently an enthusiastic market for the company’s shares, then equity is going to look more attractive than it would when market conditions are unfavourable, both in general and for the individual company. AOL’s stratospheric stock price in 1999 was said to have impelled management to seek a very large acquisition, knowing that it could not stay at that level indefinitely. AOL Time Warner was the unfortunate result.

•

On the other hand, companies with major cash holdings, perhaps even under pressure from investors to dividend some of it back to them, would be well advised to use cash for any acquisition that doesn’t put the balance sheet under undue strain.

Specifically, cash can come from the company’s own reserves or from borrowing. Banks are not the only source. Sometimes cash-short businesses will ask for seller financing for some portion of the sale. Anxious sellers may be willing to oblige, especially when they know that the prospects for the business they are selling will be good, provided there is substantial investment made in it. Sometimes companies contemplating a large acquisition in proportion to their own size simultaneously dispose of businesses to raise cash. Rio Tinto’s $38 billion acquisition in 2007 of Alcan in Canada is one such example. While the acquisition is expected to deliver major synergies, balance sheet gearing will become uncomfortably high. Accordingly, Rio Tinto is expected to dispose of one or more businesses with lesser immediate potential.

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The important process distinction is between those acquisitions which are undertaken for cash and those which are undertaken for shares. In the case of a cash transaction, the process contains no further complications than those indicated above – so long as the buyer already has ample cash resources and does not need further recourse to institutional lenders. This is nearly always the case when a large company buys a small one, although, for personal tax reasons, the vendors may want shares or loan notes in lieu of cash. A purchase for cash within the available resources of the buying company is a relatively simple financial matter. When a cash offer requires further funding, however, extensive negotiation and analysis with lenders ensues. Banks have become better at judging the creditworthiness of such buyers and the value-creating potential in acquisitions. This is another reason for ensuring that any acquisition is in reality a value-creating proposition. Banks will investigate both parties carefully, examine plans for the acquisition and model probable outcomes to ensure the safety of their loan securities. When an acquisition is made for shares, the important steps surround the disclosure of prospects for the buying company and the target’s likely appraisal of the value of the shares its shareholders will receive. Selling shareholders are unlikely to succumb to a takeover offer if they think that the combined enterprise is less likely to succeed competitively than the target company. They will want to know about the target company’s current position, as well as the logic for the proposed transaction and the combination benefits that are likely to be achieved. Again, this situation requires clarity in projecting merger benefits. While not all plans for the company after the transaction necessarily have to be disclosed, the plans themselves must be clear, well thought through and amenable to intensive challenging, so that whatever representations are made in the offer document can be substantiated. Further, they have to be sufficiently defendable in a court of law should subsequent legal disputes ensue after the transaction is consummated. In the event of an offer which comprises both cash and shares, the same considerations apply as with an all-share offer, unless the cash component requires outside funding. In that case, the considerations for a cash offer apply as well. How to fund the acquisition is a continual process. At the outset of any such project, it must be clear that funding will be available. As it proceeds, further information can impact funding plans and change thinking about the optimal approach.

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The impact of different financing methods on EPS outcomes As stated earlier in Chapter 9, analysts and commentators often examine the impact of an acquisition on a group’s earnings per share (EPS) to determine its success. An acquiring company which achieves an increase in EPS following an acquisition would be seen to be successful. After all, EPS is the most frequently chosen measure to provide a quick indication of a company’s annual performance compared with previous years. Students of acquisitions should be aware, however, that different chosen methods of financing can produce different EPS outcomes for the same acquisition. In the event that an acquirer buys a target company with a lower price/earnings (P/E) ratio than its own, even though no value may be created through the acquisition, this factor alone will result in the combined EPS of the enlarged group increasing. If value is created as well, then the EPS increase will be accentuated. This effect is independent of the choice of financing. If the P/E ratio of the target company is greater than or equal to the P/E of the acquiring company, then it is still possible to enhance the EPS of the enlarged group even though no value may be created through the acquisition. This can be done through the appropriate choice of financing. If the acquisition is financed using debt, even though the P/E ratio of the target company may be higher than that of the acquirer, EPS enhancement can still be achieved. Provided that the P/E ratio of the target company is less than the inverse of the after-tax cost of the debt used to finance the acquisition (as a percentage), then the EPS of the enlarged group will be enhanced.

EPS enhancement strategies (‘bootstrapping’) The following examples demonstrate how different forms of financing can produce different EPS outcomes. In each case, it should be assumed that the respective acquisitions neither create nor destroy value. It should also be assumed that the transactions can be financed either through the issue of new shares or by the assumption of debt at a cost of 5 per cent. For simplicity, taxes have been ignored.

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Profit

EPS

P/E ratio

Company A 10 million shares @£1 each

£1.0 million

£0.1

10

Company B 10 million shares @£0.5 each

£1.0 million

£0.1

5

Company C 5 million shares @£1 each

£0.5 million

£0.1

10

Example 1: Suppose Company A were to acquire Company B through the issue of 5 million new shares at £1 each. Following the acquisition, the total number of shares in Company A would be 15 million. The profits of the now enlarged AB group would be £2 million and so the earnings per share would have risen from £0.1 to £0.133. This has happened even though value has been neither created nor destroyed through the transaction. An uninformed observer might assume that the performance of Company A has improved as a result of the transaction since the earnings per share have risen. In fact the economic performance has remained unchanged. Example 2: Suppose Company A were to acquire Company C through the issue of 5 million new shares at £1 each. Following the acquisition, the total number of shares in Company A would be 15 million. The profits of the enlarged AC group would be £1.5 million but the earnings per share would remain at £0.1. Example 3: Suppose Company A were to acquire Company C, but this time finance the acquisition through the assumption of £5 million of debt at 5 per cent interest. The number of shares in issue remains at 10 million. The profit for the group would be £1.5 million as above, minus £250,000, being the cost of the debt, a total of £1.25 million. The earnings per share of the enlarged group would now have risen to £0.125. This would appear to be a better outcome than in Example 2. Despite this result, value has been neither created nor destroyed. Contrast this situation with Example 2 above, where the only difference in the transaction was the source of the financing. The above examples of course assume that the market does not see any change in the prospects for the enlarged company. If, for example, the acquisition of a low P/E company by a high P/E company is seen to diminish the outlook for the combined enterprise, the dilution or accretion effect would be different. This would not be a surprising outturn, since the acquired company’s lower market rating presumably reflects a more modest outlook. We must thus conclude that judging an acquisition solely on its projected EPS effect is apt to be a superficial

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and incomplete analytical step. The analyst must look to the promise of value creation and come to their own conclusions.

Further guidelines The question of an optimum funding structure for any major investment and for the corporation as whole is an exceedingly complex one. Large textbooks are devoted to it. We will confine ourselves to several key observations.

•

Most important, DCF-based valuation calculations should ignore funding. Any costs and associated tax benefits are already taken into account when the project’s cash flows are discounted by the company’s cost of capital. The job of the specialists is to fund the project in the most effective possible way – whether with cash, shares, a combination of the two, convertible debentures and the like – but the cost of capital does not change in the process.

•

Those who fashion funding structures need to be apprised of the progress of the project as it proceeds, so as to be able to influence any structural arrangements which could affect funding choices; these ideas often change during the course of a deal, often as more attractive opportunities present themselves or are even invented on the spot to exploit emerging financial opportunities.

•

Price considerations occasionally dictate constraints on funding. When the required price begins to escalate beyond that planned – even if still at levels where returns versus capital cost are satisfactory – funds availability may dictate limits. This is particularly true for highly geared companies which may be constrained by lender covenants.

Acquisition bank finance The timetable for many acquisitions, particularly those which are large or which are of publicly quoted companies, can be shorter than needed for the arrangement of suitable financing. In the case of large acquisitions, substantial sums of money may need to be raised in the debt markets through the issue of corporate bonds or by syndicated bank loans. There may be insufficient time to do so before the deal is required to be closed. In the case of the acquisition of publicly quoted companies and even for some private company acquisitions, confidentiality is paramount for fear of market-sensitive information leaking before an announcement can be made. This makes large fund-raising activities

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difficult to arrange without specific acquisition rumours emerging. Consequently, in both of these cases, large sums of money may be required at short notice and under the strictest confidentiality. It is under these circumstances that bank acquisition finance can be provided. Such finance is expensive but can be repaid as soon as alternative financing is put in place. Banks are generally happy to arrange acquisition finance, as arrangement fees can be substantial. They will work quickly and intensively to cover their own due diligence so that the funds can be made available as soon as required.

Chapter takeaway 1 Funding and acquisition can be by way of cash, shares or a combination of the two. 2 If for cash, financing is straightforward unless bank borrowing is necessary. In this case, the lenders will have to be satisfied as to the wisdom of the investment and the borrower’s ability to repay. 3 If the acquisition is for shares, the target company’s shareholders will have to be satisfied that, if they are required to hold the shares for a period of time, the investment is a good one and that their shares will retain their value. They will have to be so persuaded. 4 Although there can be different accounting and presentational implications from the choice of funding, it should not affect the discounted cash flow calculations and therefore the attractiveness of the proposed investment, since funding cost is already included in the cost of capital and the discount rate employed.

Having discussed the principal steps in the process of acquiring another company, we must now turn our attention to the matter of integration – ensuring that the target company is integrated into the buyer’s in a way that secures the desired combination benefits.

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ntegrating the newly acquired business into existing operations or into its new position in the corporate portfolio is a huge task, and – of those we have cited herein – probably the most important for success. Surveys and academic studies alike point to the need for more thorough preparation for implementation – the activities which take place after completion to integrate the target into the acquiring company. Done well, it can prevent problems and lead to financial rewards – the projected combination benefits arrive more reliably and sooner. Similarly, a cavalier attitude towards integration (‘We’ll worry about that after the deal’) can result in frustration and disappointment.

I

AOL/Time Warner We have only to look at the gigantic AOL/Time Warner merger to see the importance of integration. One of the largest mergers ever executed is seen, in retrospect, as a catastrophe. From its peak, the combined market capitalization of the two companies declined nearly $200 billion in the face of all their respective difficulties and the market’s declining enthusiasm for the company. Some of the decline in favour admittedly derived from exogenous circumstances. During the year (all of 2000) that it took the regulatory authorities to clear the merger, dotcom stocks collapsed; in the following year the US entered into a recession. But a more fundamental problem had to do with integrating the two organizations. The prime value-creating opportunity in this merger was the planned migration of AOL’s customer base to Time Warner’s cable network, capable of supporting broadband transmission. As part of the deal to get the merger through the Federal Communications Commission (FCC), the US regulatory agency charged with overseeing the telecommunications industry, access to the cable network had to be made available to all ISPs. The Time Warner people allegedly fought back and resisted this effort, thus scuppering the principal economic rationale for the deal.

Integration is yet another area where private equity firms have gone some way towards developing best practice. The rigour with which good private equity firms approach the due diligence process pays off when planning integration. If

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they decide to go ahead, they will have become so knowledgeable about the market for the company’s products in each substantial segment that they will be clear about priorities for improvement actions. Thus this fastidiousness should result in an integration plan that is ready to go when the deal completes. Corporate acquirers should think the same way. Acquisition arithmetic is built on the idea that combination benefits or synergies must exceed any premium paid over and above the market’s judgement about the value of the target, plus applicable transaction costs. The size of those synergies in turn is largely dependent upon three things: the likelihood that earlier assessments of the potential were correct; the cost of achieving them; and when they actually come through on the bottom line. It is thus not surprising that many observers believe that acquisition integration is the most critical stage in the whole process.

A UK retailer A prominent UK retailer acquired a company in a different retail sector. The source of combination benefits was to be the application of the buyer’s systems skills and the introduction of up-to-date technology and methods, such as EPOS and tight inventory management. Implementation was undertaken without urgency and without pressure for performance from the top so as to avoid unsettling the management team of the newly acquired company. The integration process became bogged down, arguments ensued about which system was best, and the benefits were long in coming. The acquisition was disparaged in the business press. Looking back, management said: ‘We should have been far better prepared: we should have laid out the whole programme on the first day after completion, set tough targets, and insisted on meeting them’.

Lessons from the front Acquisition integration has been studied extensively and case histories abound. We believe that there are 14 principles to follow in making the most of the integration phase.

1: Decide as early as possible on the critical changes Every responsibly managed acquisition programme identifies value drivers that will produce the leading contributions to shareholder value from the

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transaction. These key areas and their successful implementation should be kept at the forefront of integration planning. The enormous amount of detail involved in integrating a newly acquired organization can easily submerge the most important factors – the value drivers that will make the acquisition pay. The critical changes that support these drivers must be identified and made clear to all concerned with integration responsibility and kept visibly clear throughout the process. Some acquirers insist on reinforcing the importance of the key value drivers throughout the process with signs and slogans which summarize where the money is to be made. Such reminders have often been used to reinforce strategy. Komatsu of Japan continually reminded staff of the company’s competitive goal with signs which proclaimed ‘Encircle Caterpillar’. In Tintoretto’s studio in Renaissance Italy he chose to remind assistants and students alike what he was trying to accomplish with the phrase ‘the motion of Michelangelo, the colour of Titian’. Komatsu and Tintoretto understood the value of pushing key themes and the positive effect that could have on output. So it should be through the acquisition process and most critically during the integration phase. If the principal expected benefits are overhead reduction and exploitation of the target’s distribution channels to sell products in new markets, that message should be repeated again and again.

2: Determine the degree of integration required Is the new operation to be a free-standing operation within its new environment, or is to be fully integrated with existing operations? Or is it to be partly absorbed – sharing overheads but keeping basic operations like selling and manufacturing separate? Such a decision has major implications for the elimination of direct costs and for the accountability for performance of the acquired business. Any planned delay or rejection of full integration must be reconciled with the desire to secure the targeted combination benefits quickly. Clearly, the less complete the integration of the acquired business with existing operations, the less opportunity for synergistic cost savings. Several possible reasons might exist for holding back on the degree of integration.

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The strength and motivation of the target management team is judged to be the key driver for the deal, and it is feared that it would be compromised by breaking them up.

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The seller has extracted a commitment to leave the management team intact; they may do this for sentimental reasons; alternatively they may have promised the team their autonomy in return for their cooperation and support in making the deal work.

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Tax savings may be at stake: tax losses are jeopardized in some jurisdictions if the target is not kept wholly intact.

This decision must be made as early as possible in the process, since it has implications for structure, integration planning and management staffing.

3: Design the integration programme during the due diligence phase For many companies, a methodical and systematized approach works well. One 1 company requires the preparation of a ‘value capture summary’ by the integration team leader, working with the due diligence team. That document then becomes the ‘manifesto’ for the integration team. It requires specification of the following information:

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Strategic rationale for the acquisition. The value-creating logic for the project: why this deal will make money for the company.

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Deal terms. A summary of basic deal parameters, and, notably, specifying the total consideration involved, so as to clarify the size of investment on which the benefits will be required to pay back.

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Team members. Team leadership and the individuals involved, by name and the organizational units they represent.

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Financial targets. A summary of the key financial milestones in profit, cash flow and other relevant measures, over the first several years after completion.

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Operational objectives and milestones. The key checkpoints along the way to realization of the project’s strategic objectives.

Every means should be used to spot the most appropriate team members from both the acquiring company and the newly acquired one. The results of past performance appraisals, the opinions of supervisors and peers, and the general observations of those involved in the earliest contacts should all be pressed into service. Moving quickly is essential, and a few mistakes will usually be made. It is up to the integration team leader to sort them out as they arise.

4: Assign separate project responsibility for integration 2

GE Capital, a major business unit of General Electric of the USA, has concluded that the job of integration manager is a separate, full-time job and one that is a professional and challenging function in its own right. They decided to examine their own ample acquisition history to understand the requirements for success. They concluded that the job is best filled either by ‘fast track

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managers’, who are on their way up and thus anxious to show what they can do when managing a project where a substantial change exercise is in progress, or by ‘an old hand’, who knows their way around the organization, has seen both successful and less than successful acquisitions, and knows what works and what doesn’t. They also learned something about how not to do it – that when the baton is merely passed from the due diligence team to the responsible manager, it doesn’t work. It is all a part of an ongoing process that requires professional, handpicked talent. This concept usually involves separating the roles of the ‘integration leader’ and the ‘business leader’. The former is charged with project responsibility for bringing the organizations together. The latter runs either or both of the businesses to be combined, thus ensuring that operational control is not lost during the process of assimilation. GE Capital is not the only big company to opt for the concept of merger integration as a full-time management discipline. Allied Signal, Lucent Technologies, AT&T and Cisco Systems have all similarly concluded that dedicated professional integrators can boost the odds of success considerably. Companies without extensive experience in acquisitions may have to proceed more slowly down this route. In the early days, they may want to use managers from the operations with which the acquired business is to be combined. After skills have been built over time, a cadre of experts will become available for the specialist approach described above.

5: Begin the planned actions right after completion There can be temptations to defer the start of integration. ‘Doing the deal exhausted everyone. We deserve a break. We need time to decide who the best managers are. How can we begin integration without knowing who is to do it? We want the new team to have time to learn its way around our organization.’ The penalties for this kind of deferral are not only the delay in securing the projected benefits (thus lowering the net present value of the transaction) but also increased lack of focus and commitment in the organization as rumours abound. Failure to act quickly can often make the acquirer look indecisive and even devious when cost-saving actions are taken after initial business-as-usual signals are given.

6: Decide who will run the business and ensure you have their commitment Often the question of what kind of individual to pick to deliver the benefits is not examined carefully. Everyone simply assumes that the relevant incumbent

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– either of the target company or of the buying company’s business unit involved – will get the job. We suggest, however, that there are several questions which should be answered prior to such confirmation:

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Does the candidate show promise of being able to hold together and motivate the newly combined management team, one that may have been through a considerably stressful and anxious time prior to completion of the acquisition?

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What are the key operational and strategic milestones over the next few years that will have to be achieved in order for the planned value drivers to bear fruit? Does the candidate show promise of being able to achieve these milestones and to give professional and experience-based help to those charged with their implementation?

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If the scope of the new job is considerably expanded – either geographically or in terms of product market segments – over the pre-acquisition situation, does the candidate offer the requisite experience and proven track record to give confidence that they will be successful?

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Does the candidate understand the acquisition objectives, and are they committed to success through, for example, holding a major position on the acquisition team? There is no better motivation in a manager to achieve success than a prior promise to the board that the acquisition will make a great addition to the group. Having obtained commitment, the challenge for the manager to deliver is that much more intense.

Too often, these questions are glossed over. Serious consideration should be given, and a methodical effort undertaken, to examine a range of candidates for such a critical job.

7: Tie priorities to strategic objectives A huge amount of administrative detail is involved in the integration of any business of substantial size into a new organizational home. This can cause the team to become swamped with detail. The danger is that the rationale for the deal – the principal value drivers – loses relative importance. It must be made clear to the team that the two or three basic value-creating ideas for the deal are at the top of the agenda and must receive the team’s most careful attention and priority treatment.

8: If cross-border, be especially alert to cultural differences This advice seems so obvious that it hardly needs saying. Yet the annals of cross-border acquisitions are replete with stories of misunderstanding,

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alienation, intransigence and the like, all stemming from fundamental differences in culture concept between the countries involved. Some academic observers have gone so far as to suggest specific countries and geographic regions that do not appear to fit well together. In general, companies in the USA, Britain and Northern Europe seem to have fewer difficulties with each other than in cross-border deals with Japan and with the countries along the Mediterranean coast. The history of Anglo-French mergers is not an encouraging one. Cultural disparity is, of course, not confined to international deals.

Cisco Systems The potential for culture conflict is taken very seriously at Cisco Systems. There is a team that evaluates prospective acquisitions, assesses cultural fit and recommends abandonment if the gulf is seen to be too wide. In one notable example, they saw the original art on the walls of the prospective target and concluded that it would not fit with the lean and austere management style at Cisco. The company says they have walked away from a number of possible acquisitions for reasons of this sort.

The best advice appears to be to anticipate the potential differences from the start and to recognize that there will be differences in viewpoint that are valid. Then suspicion and recrimination can be sublimated into an experience of learning and assimilation. But it won’t be easy. Cultural differences can be addressed in meetings between the two sides, either before or after completion of the acquisition. Preparation for such discussions involves the preparation by each party of a cultural audit, using a template like the McKinsey Seven S model. Each side comes to the table, describes the results of its culture audit of itself, and identifies those areas where they believe there might be difficulty reconciling them with practices on the other side. The task for the meeting then becomes how best to reconcile the differences and move forward. We have seen this work well.

9: Plan the announcement with great care Almost invariably in large acquisitions and mergers, the public announcement of the transaction takes place at the same time as the internal announcement to the buying and bought organizations. If the buyer is a public company and insiders learn of it before the public knows, there is the danger of leaks to the

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press which will affect the share prices of both companies and can actually cause legal and regulatory problems. If the public is told first, employees will be offended at the prospect of learning about it through the papers. For many, a change in ownership will be greeted with shock and disbelief. It may even be seen as a form of betrayal by senior managers. It is thus essential that the internal announcement be carefully crafted and designed to allay as much anxiety as possible. It should attempt to mitigate uncertainties which would otherwise be subject to morale-damaging rumour. The announcement should then be followed up by meetings with all employees as quickly as possible. Down the line operating managers must be briefed as to their role and pressed into service to convey both the fact and the spirit of the message. Good acquisition communication has been increasingly recognized as a vital component of any deal. Its importance, as well as the sheer complexity and size of workload, has led to widespread use of specialist advisers in financial public relations. Professional firms are retained to carry out this all-important responsibility. They help to tell the ‘story’ to the investors of both their own company and that of the target, to stock market analysts and journalists, to industry regulators and, perhaps most crucially, to employees.

10: Communicate excessively Keeping everyone up to date with managerial thinking on integration is critically important. The cliché that people want to know where they stand is never more true. The communications job should be vested in a highly talented manager. The CEO should play an active role, and the organization should be left with the impression that they are being told everything as quickly as possible and that they can rely on the information they get to be candid, professionally devised and fair.

Royal Bank of Scotland (1) In 2000, the Royal Bank of Scotland (RBS) successfully launched a takeover bid for NatWest, the then largest UK commercial and retail bank. NatWest was several times larger than RBS, a factor which many commentators considered would prove a major problem in implementing a successful integration into a single bank. The prime difficulty for RBS was to retain and motivate key NatWest staff at a time when major reorganizations were beginning to result in major layoffs of the most senior NatWest management. Compounding the problem was the fact that RBS had very little time prior to

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the acquisition to undertake detailed planning of the new enlarged organization and to reach fundamental decisions on the branding of different parts of the business. Early in the acquisition implementation, RBS initiated a website, on which decisions affecting individual departments within the organization were posted daily. Sometimes the website contained admissions that decisions had been delayed and that plans were not always proceeding as anticipated. These admissions of fault lent credibility to the information posted on the website. As a result, staff had confidence that they were being told the truth and that if they wanted information, it would be provided as soon as it was available. Consequently, RBS did not see a mass defection of key staff as morale was maintained. Much of the credit for this success can be attributed to the effectiveness and openness of the communication.

Remember, if you don’t communicate excessively, the rumour mill will do so instead.

11: Conduct a retrospective audit Control systems sharpen the mind. When those charged with the success of the acquisition know its performance will be reviewed and compared to what was originally projected, planning is apt to be more thorough. The audit process itself is apt to identify opportunities to improve the process for future deals and to bring to the surface possibilities to strengthen existing operations.

12: Be especially careful about integrating business systems Most acquisitions are predicated on bringing two organizations together. This invariably means facing up to the problems of how to deal with two different IT systems. Developing a greater understanding of how integration of business systems can be achieved should start with due diligence. Ultimately a decision must be taken on adopting a common system to prevent duplication and to facilitate integration of the two organisations. Even the default position of leaving things as they stand should be taken deliberately and for good reason.

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Royal Bank of Scotland (2) When the Royal Bank of Scotland acquired NatWest in 2000, it discovered that almost all the banking systems in the two banks were different. In some cases the systems of RBS were superior; in some cases NatWest had manifestly superior systems. At first sight this would seem to present the ideal scenario of rationalizing the systems of both banks, taking the superior systems from each bank to achieve the best of both worlds. However, in this case, such action was not taken. The acquirer, RBS, was considerably smaller than its target, NatWest, and RBS faced the challenge of maintaining control of a complex acquisition of a much larger entity. For this reason, RBS chose to impose its own systems on the enlarged merged entity, abandoning, in some cases, systems and processes in operation at NatWest that were clearly superior. While this seemed a high price to pay, the principle of maintaining control and making the job of integration easier for its own managers was regarded as of the highest importance.

In reaching decisions on managing systems integration, maintaining control, integrity and clarity within the acquiring company must be the greatest consideration of the integration team.

13: Be prepared for a lot of work Acquisition integration is a huge job. Massive amounts of detail and information require processing. Interviews, meetings and written and oral communication abound. A big transaction can involved hundreds of people and take many months.

ABB Zamech ABB, the pan-European electrical equipment manufacturer, took over what became ABB Zamech, a large equipment manufacturing firm in Poland, in 3 1990. In an interview with ABB’s CEO, the size of the task was spelled out. ABB decided that to bring Zamech up to ABB operating standards would require: organizing Zamech operating units into profit centres with budgets, reporting systems and the like; finding good people within the target and forming them into interdisciplinary teams to effect the change; transferring ABB specialist expertise from wherever in the world it existed to provide needed know-how; teaching all managers to speak English, the company

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language; setting up satellite communication from Zamech to ABB’s Zurich headquarters (to circumvent the Polish telephone system); and large-scale training and management development to bring Zamech’s managers up to date with Western management tools and methods. An enormous task, but one that quickly resulted in a motivated team and improved performance.

The DaimlerChrysler merger was similarly a gigantic effort. The transatlantic traffic became so great that the company bought an Airbus (its owns 20 per cent of the consortium) and ran four round trips a week between Detroit and Stuttgart.

14: Above all, acquisition implementation is about people The success of any acquisition is dependent upon the ways in which the people from the respective organizations can work together and can align their actions to the objectives and requirements of the acquisition. This means that the implementation plan should deal first and foremost with the people issues: board appointments, management changes, redundancies, changes to terms and conditions, etc., and how all of these things will be handled. In any acquisition, when two organizations are brought together, the default position for the people is that they will want to continue doing exactly what they were doing before the acquisition. In order to foster the changes necessary to generate the acquisition synergies, specific mechanisms must be put in place to force new actions, otherwise the benefits of the merger will not be realized. These mechanisms must be planned and monitored for success. Conversely, where the people in two organizations are brought together to work to achieve synergies, misunderstandings, especially as the result of cultural differences, will inevitably manifest themselves, sometimes in an uncontrolled fashion. Thus the potential problems arising from integrating people must be anticipated and allowances made or mechanisms put in place to protect against damage occurring. All of this means that implementation planning in dealing with people must start at the earliest opportunity. Furthermore, the people planning must assume the foremost priority, greater even than the business logic planning. Remember, if the people issues start to go wrong, the business imperatives will count for nothing.

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Chapter takeaway 1 Once the acquisition is complete and ownership has changed hands, the integration process begins. It is probably the most critical step for value creation. 2 The most important requirement is thorough preparation for the integration process, one that is designed to address the drivers of value creation as soon as possible. Planning for it should begin as early as possible in the acquisition process. 3 The use of integration specialists to manage the transition process has proved effective for companies that make many acquisitions. Doing it well is a critical skill and one to be nurtured. 4 The other one is being quick. The faster the job is done, the higher the present value of cash flow. Also, integration speed signals to the organization that the new owners are serious about creating value and getting on with running the business. 5 Integration is the toughest and most important job in any acquisition.

If these integration principles are followed conscientiously, the benefits of the deal are far more likely to be realized. We must now go on to summarize our thoughts on acquisitions in the form of a best practice summary.

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mbarking upon a programme of acquisition is a huge and vital effort for any company. Getting it right can secure the future. Doing a poor job can have results ranging from performance stagnation and managerial embarrassment all the way to insolvency. Fortunately, however, this is a muchstudied area of activity, and a great deal is known about how to do it right and how to avoid mistakes. Benefiting from the experience of others not only constitutes good common sense but is also essential for all professional managers involved in such programmes. We therefore now draw solid conclusions about what constitutes acquisition best practice. Our advice is in four areas: (1) avoiding classic causes of failure; (2) clarifying the sources of value creation; (3) executing the process well; and (4) applying good parenting to the whole process.

E

Avoiding failure Causes of acquisition failure are well known. It makes sense to benefit from the negative experience of many others and thus avoid their mistakes. We have set them out in detail in Chapter 3 and explained why shareholder value suffers when these forces are at work. To avoid failure of this nature, we suggest the aspiring acquirer do the following:

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Be sure you are looking in the right industry. Acquiring in an industry with which you are unfamiliar and one where the company does not have the requisite skills and experience is a nearly certain recipe for failure. In any case, the capital markets will no longer support major adventures of this sort. But don’t be tempted.

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Don’t acquire the wrong company. Just because you are targeting a familiar industry does not mean you’ll buy the right company. Ensure a sensible fit – complementary strengths and weaknesses.

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Avoid bad strategic rationales. Spurious reasons still appear from time to time to justify acquisitions when it is clear that they have no shareholder value-creating potential. With few exceptions, it is best to avoid vertical integration; and sector balance, geographic balance and gap filling must always be avoided.

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Don’t pay an excessive price. This means maintaining discipline in auctions and in public bids. Great organizational momentum can tempt the

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buyer to pay more than originally intended – and a price higher than can be recovered through combination benefits. It may even mean avoiding auctions altogether.

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Beware of external approvals. Get good advice and do your homework about potential government, regulatory and bureaucratic pitfalls. Especially when doing business abroad, government authorities can suddenly materialize to prevent the deal. Nationalistic barriers are commonplace, especially in continental Europe. More than one acquirer has been unpleasantly surprised by regulatory intervention.

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Don’t ignore due diligence. Many companies have regretted ignoring the advice of investigative advisers, in their eagerness to complete the deal. Some have actually gone under. An especially important minefield these days is soil contamination. Putting it right can be unbelievably expensive. Quantify all such problems and consider the implications should the worst happen. Be prepared to abandon the acquisition – painful as this might be – if the problem proves unacceptable and irresolvable.

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Beware of computer incompatibility. Don’t get yourself into a situation where your computer won’t talk to the computer of the newly acquired company. If you don’t know what you are doing in this area, you could be in for a nasty surprise.

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Dedicate time and effort to integration planning. Too many failures in this area have been attributed to a slow start on integration after deal completion. Get going on this as soon as possible, preferably during the due diligence process.

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Communicate openly, thoroughly and often. George Bernard Shaw once said: ‘The problem with communication…is the illusion that it has been accomplished.’ There is no substitute for doing all you can to keep your organization — both the acquired company and the rest of the original company — informed of your plans for integration. Even if the news is bad, it is better to be honest. After mergers, organizations can grind to a halt because of rumour anxiety and lack of information.

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Beware of cultural obstacles. Companies have their own ways of doing things, and sometimes there can be dramatic differences between organizations. If this seems likely – especially if the acquisition is across borders – try to anticipate it and put integration in the hands of people sensitive to and experienced in such issues. Where cultural obstacles to integration become apparent, take steps to deal with them.

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Don’t get caught in an executive power struggle. When acquisitions come apart because the two chief executives cannot agree on who will be

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boss, it is a sure sign of poor planning and amateurish leadership. Make sure these things are worked out before the public is aware of them, or great embarrassment can ensue.

Ensuring value creation Although many rationales for acquisitions are proffered in public statements, there are relatively few that really deliver major increases in shareholder value. They are as follows:

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Direct cost savings. Elimination of overhead and direct costs through merging similar organization units and shutting redundant facilities. This is the most common and most substantial source of value in today’s acquisitions and the one that is most readily accepted by the capital markets. Also included here can be reduced purchasing cost through economies of scale.

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Market control. Through the amalgamation of competitors and lessening of price competition. This is an exciting and lucrative rationale when feasible, but vulnerable to public pressures and restrictions imposed by competition authorities – as British Airways and American Airlines discovered during their protracted and failed effort to forge a code-sharing alliance.

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Cross-distribution arrangements. Where each party to the acquisition sells the other’s products in market areas where the other has had difficulty gaining access. This one is much loved by analysts and journalists but is less powerful than it might otherwise seem, for the reasons stated earlier.

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Skill sharing. Where the acquiring company needs the intellectual capital possessed by the target. There are substantial risks in this one – usually the skills of a selected number of valued employees and, more rarely, the embedded skills of the organization – but the payoff can be enormous if managed well and if good luck holds.

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Desired technology. In the same way as skill sharing can pay off, a desired proprietary technology which is deemed to be essential for sustaining competitive advantage in fast-changing markets can transform the prospects of even the largest company.

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Platform acquisitions. Modest initiatives which begin modestly and are intended to build competitive capability on which larger future acquisitions might be based. This approach is something of a lottery, and it is assumed that only some will succeed, but it is a valuable way of testing core competences without ‘betting the store’.

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Acquirers also embark on portfolio acquisitions — in businesses which are not closely related to those in the current portfolio and where direct cost savings and operational combination benefits of the sort enumerated above are less likely to be available. This rationale is less acceptable for publicly listed companies than it once was because the recent performance of such acquisitions has been disappointing. It is more appropriate for the private equity sector. Nonetheless, it is possible for the adroit acquirer with good parenting skills and a clear focus rationale for building its portfolio to create shareholder value (see ‘Applying good parenting’, below). The basic point about value creation is that it needs to be specific, sensible, supported by fact and known to everyone involved, so that it can drive the whole process of the acquisition project.

Managing a tight process Doing a good job of making value-creating acquisitions requires more than just good strategic thinking and avoiding mistakes. It requires execution as well. The principal points are these:

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Strategic rationale. A profile of desirable candidates must start with a clear understanding of the above value drivers and the way in which they can produce attractive financial returns; documenting this thinking is a critical first step. Translate this logic into clear criteria.

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Search. Use the three sources of acquisition candidates – brokers, desk research (especially via the internet) and your own operating managers – thoughtfully and with regard to the limitations of each.

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Contract negotiation. Take your time to cover every possible problem and contingency: the main purpose of the contract is to catch problems before they become painful.

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Due diligence. Be thorough and consider carefully any emergent problems; deal positively with each and do not hesitate to walk away from the transaction if the problem cannot be satisfactorily dealt with.

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Financial logic. Make sure that the financial thinking and calculations are in the hands of competent professionals and that there is a strong link between their conclusions and recommendations and the final decisions on whether to go ahead and on maximum price. It is a complex subject but one which demands careful attention.

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Integration planning. Make sure that the process starts as early as possible, that it is staffed by competent professionals and that it is focused on delivering the principal value benefits envisaged for the acquisition.

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Applying good parenting Overseeing this entire process is the corporate parent. The parent can add a great deal of value to an acquisition programme if it does a good job in the following areas:

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Business strategy. The parent must ensure that a viable competitive strategy is in place in each business — one that shows promise of sustainable competitive advantage. It must constitute a sensible and lucrative fit with existing businesses and not be built on spurious rationales. It must be clear to the decision makers that the deal itself is a value-adding rationale consistent with the planned price. Otherwise, any acquisition or merger built on such business will be a shot in the dark.

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Project management. Superior project management skills for any large transactions are essential. The parent ensures that they are in place, staffed by managerially and technically competent people and that the process itself is thoughtfully designed and well executed.

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Financial guidance. The parent must ensure that the requisite financial skills are in place. This means either having them in-house or ensuring that the right expertise is brought in from the outside. Financial skills are necessary not only for technical matters like tax and funding design, but more importantly, to ensure that the deal calculations themselves are correct and that all contingencies and uncertainties are anticipated as thoroughly as possible.

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Appointments. General management appointments should be made as soon as possible after the deal is completed. Those charged with these decisions should be knowledgeable and experienced about the business involved or, second best, should involve someone in the process who is so placed. Anxiety, confusion and mixed signals are the price of delay.

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Targets and incentives. Targets and incentives must be designed to reflect what the parent wants to see happen, especially in the early days of assimilating the new operation. Rather than being confined by standard corporate formulas, the targets and the bonuses tied to them should be specific to the success of the deal and should change as the process of integration progresses.

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Skill sharing. The parent must ensure that mechanisms are in place to facilitate any skill-sharing motives for the acquisition. Most successful mergers and acquisitions anticipate the spreading of best practice and knowledge from one part of the organization to another. It is not an easy matter to ensure that this happens, and it rewards intensive attention to it.

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Synergy achievement. The synergy benefits projected for the acquisition and used to justify the project must be controlled against. It is up to the parent to make sure that the rationale is not only a real one but also that the benefits are realized.

•

Maintaining relevance of parenting skills. The parent must continue to examine itself and its skills and capabilities to ensure that they continue to be relevant to the needs of the portfolio.

Chapter takeaway 1 Good acquirers are familiar with the causes of failure. They know what works and what doesn’t in their organizations. It makes sense to know what is to be avoided. 2 They also focus their efforts throughout the acquisition process on value creating. They never forget how the money is to be made and they ensure that this knowledge colours and informs every step of the process. 3 They manage a tight process. The more they do, the better they get at it. They make fewer mistakes and spend their time and advisory fees where they will do the most good. 4 Finally, they understand the necessity of doing a good job of parenting the newly acquired business. They take responsibility for adding substantial value to it and constantly look for ways to add even more.

We must now repeat one last time the key ingredients to a value-creating acquisition programme.

• • • •

Avoid the mistakes so many others have made. Ensure your project is underpinned by one or more real value drivers. Manage the process tightly. Be sure a responsible parent is overseeing the entire exercise.

If all acquirers followed these guidelines assiduously, value capture would soon swing preponderantly to the buyers. If you follow them consientiously, you too can be a prosperous member of this small population.

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AT&T’s acquisition of BellSouth

A

The following is a circular concerning the acquisition of BellSouth by AT&T.

AT&T and BellSouth Join to Create a Premier Global Communications Company Deal Consolidates Ownership of Cingular Wireless; BellSouth and Cingular Brand Transition to Begin Soon San Antonio, Texas, December 29, 2006 AT&T Inc. (NYSE:T) today closed its acquisition of BellSouth Corporation, creating a premier global communications company committed to driving convergence, continued innovation, and competition in the communications and entertainment market. The transaction consolidates ownership and management of Cingular Wireless, the nation’s leading provider of wireless voice and data services, and YELLOWPAGES.COM, a leading Internet Yellow Pages and local search site. “AT&T will be an engine for innovation, competition, and growth for our customers at home and abroad,” said AT&T Chairman and CEO Edward E. Whitacre Jr. “In the Southeast, we will build on BellSouth’s excellent record of serving customers and communities. And we are ready to lead the way in a new era of integrated wireless services nationwide.” AT&T will immediately start to implement a carefully planned integration process to converge the AT&T, BellSouth, and Cingular wireless and wireline Internet Protocol (IP) networks, combine product portfolios and integrate customer care capabilities. The new company will be able to accelerate the introduction of innovative broadband services, such as IP-based services, while expanding the reach of broadband access in remote and rural locations in the traditional BellSouth region. “AT&T, BellSouth, and Cingular have led in developing and deploying many of the communications services that customers depend on today, including broadband DSL and wireless technologies,” said Whitacre. “Moving forward, AT&T will work to integrate these services for customers in the Southeast, across the country and around the world.” With the merger complete, AT&T enhances its U.S. leadership position in broadband, wireless services, voice services for consumers and businesses, and data services to Fortune 1000 companies. In 2006, the AT&T Foundation provided more than $65 million in charitable contributions, ranking it among the top five largest corporate foundations in the country, in terms of annual giving. This year, Forbes magazine named the AT&T Foundation among the “25 Most Generous Corporate Foundations,” ranking the company 11th on the magazine’s list of top corporate donors.

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In addition, nearly 350,000 AT&T employees and retirees serve their communities as members of AT&T Pioneers, the nation’s largest company-sponsored volunteer organization. Whitacre will continue to serve as chairman and CEO and as a member of the board of directors. Duane Ackerman will serve as chairman emeritus of BellSouth for the transition period following the merger. Three members of the former BellSouth’s board of directors have joined the AT&T board – Reuben V. Anderson, James H. Blanchard and James P. Kelly. Reporting to Whitacre will be: Jim Cicconi, senior executive vice president – external and legislative affairs; Jim Ellis, senior executive vice president and general counsel; Karen Jennings, senior executive vice president – advertising and corporate communications; Jim Kahan, senior executive vice president – corporate development; Rick Lindner, senior executive vice president and chief financial officer; Forrest Miller, group president – strategic initiatives and human resources; Randall Stephenson, chief operating officer; and Ray Wilkins, group president. Reporting to chief operating officer Randall Stephenson will be: Dick Anderson, group president – global business services, replacing Forrest Miller; Stan Sigman, president & CEO – wireless; John Stankey, senior executive vice president and chief technology officer; and Ralph de la Vega, group president – regional wireline operations. AT&T’s current regional wireline presidents will report to de la Vega, along with Rod Odom, who has been named president and CEO, AT&T Southeast. Previously, Odom was president – network services for BellSouth Corporation. Additional executive appointments will be announced in the near future. AT&T’s corporate headquarters will remain in San Antonio. The new AT&T Southeast (formerly BellSouth Corporation) and Cingular will continue to be based in Atlanta. In the coming days, AT&T will launch extensive new advertising, which will begin the transition of the BellSouth brand name to AT&T. AT&T will re-brand Cingular through a co-branded transition, which is scheduled to start in 2007. Details regarding the Cingular branding will be announced at a later date. YELLOWPAGES.COM will not undergo a name or Web site address change.

Merger Synergies and Financials AT&T today affirmed the financial guidance it provided when the acquisition of BellSouth was announced in March 2006, including information on expected synergies. Specifically, AT&T expects that synergies from the combined operations will ramp quickly to reach an annual run rate exceeding $2 billion in 2008 and increasing to $3 billion in 2010. Merging AT&T, BellSouth, and Cingular Wireless is expected to yield a net present value of $18 billion in synergies. Stockholders of the former BellSouth received 1.325 shares of AT&T common stock for each common share of BellSouth. Based on AT&T’s closing stock price on Friday, Dec. 29, 2006, this exchange ratio equaled $47.37 per BellSouth common share. In connection with the completion of the acquisition, BellSouth’s common stock and debt securities will be immediately delisted from the New York Stock Exchange.

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Approval Process The completion of the BellSouth acquisition comes after an extensive review process, which included approval by or filings with 36 states, the U.S. Department of Justice and the Federal Communications Commission (FCC), as well as with three foreign countries. In order to receive bipartisan FCC approval, AT&T volunteered a number of commitments, including making broadband access increasingly affordable and available to consumers and supporting public safety. AT&T has committed to making broadband services available through a combination of technologies to 100 percent of residential living units in its 22-state local-phone-service territory by the end of 2007. Additionally, AT&T will offer a stand-alone broadband service for $19.95, as well as other offers to encourage broadband adoption by those who do not currently subscribe. AT&T plans to repatriate 3,000 jobs currently outsourced by BellSouth outside the United States, as well as to make its disaster-recovery capabilities available in order to facilitate the restoration of services in the former BellSouth region, in the event of a hurricane or other natural disaster. “These commitments reflect our long history of providing consumers and businesses with the most advanced and affordable communications services,” said Whitacre. “We can’t wait to show people what the new AT&T can do.” Note: This AT&T release and other news announcements are available as part of an RSS feed at www.att.com/rss.

About AT&T AT&T Inc. is a premier communications holding company in the United States and worldwide, with operating subsidiaries providing services under the AT&T brand. AT&T is the recognized world leader in providing IP-based communications services to business and the US leader in providing wireless, high-speed internet access, local and long distance voice, and directory publishing and advertising services. As part of its ‘three screen’ integration strategy, AT&T is expanding video entertainment offerings to include such SM next-generation television services as AT&T U-verse TV.

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APPENDIX

Imperial Group’s acquisition of Altadis

B

The following is an excerpt from a circular to shareholders concerning Imperial Group’s acquisition of Altadis.

Imperial Tobacco Group PLC (Incorporated under the Companies Act 1985 in England and Wales with registered number 3236483) Circular to Shareholders relating to the proposed acquisition of Altadis, S.A. by Imperial Tobacco Overseas Holdings (3) Limited, a wholly-owned subsidiary of Imperial Tobacco 1 Group PLC, including a Notice of Extraordinary General Meeting

Background to and reasons for the Proposed Acquisition Since listing on the London Stock Exchange in 1996, we have successfully pursued a strategy of international growth through targeted organic expansion and acquisitions. The success of this strategy is demonstrated by the 15% per annum compound growth in our earnings per share over the last ten years. Approximately half of this growth rate has come through acquisitions, where we have invested around £6.2 billion, expanding our international operations to the point where non-UK activities contributed 62% of our profit from operations in the financial year ended 30 September 2006, compared to 19% in 1996. Our successful track record of acquisitions has been underpinned by our insistence that potential acquisitions meet our strict acquisition criteria. Strategically, we seek acquisitions that enhance our brand equity, increase our geographic footprint and offer the opportunity to reduce costs and extract synergies. In financial terms, we seek deals with returns that exceed our cost of capital in the short term, as well as providing over the medium term a more favourable return on investment than alternative uses of funds, specifically our share buyback programme. Altadis has an attractive and highly complementary portfolio of brands with strong positions in its key markets. We believe that the combination of Altadis and Imperial Tobacco will create significant opportunities to generate increased value for our Shareholders. In line with our successful growth strategy, we believe that the acquisition of Altadis will: • strengthen and diversify our brand and product portfolios; • expand our scale and increase our competitiveness, cementing our position amongst the global leaders in the tobacco sector; • provide enhanced platforms to support future sales growth; • provide the opportunity for increased operational efficiencies; 1

Filing with SEC, on EDGAR: 07/23/2007EX-99.1 of 6-K for IMPERIAL TOBACCO GROUP PLC COMPANY NAME(s) – [IMPERIAL TOBACCO GROUP PLC (CIK – 1072670 /SIC – 2100)]

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• generate annual revenue benefits and substantial cost savings; • generate a return on invested capital that exceeds our weighted average cost of capital (WACC) by the second full financial year following Completion and approaches our WACC in the first full financial year; • enhance earnings per share in the first full financial year following Completion; and • provide a more favourable return on investment than alternative uses of funds, specifically our share buyback programme. Strengthened brand and product portfolios

The combination of Altadis’ strategically important cigarette brands, Gauloises and Fortuna, with our international strategic brands, Davidoff and West, will enhance our competitive position, notably in Western Europe, and strengthen our cigarette portfolio. Furthermore, Altadis’ other tobacco products fit well with our own and will enhance our multi-product portfolio. We are a world leader in fine cut tobacco products (principally Drum and Golden Virginia), rolling papers (Rizla) and tubes. The Enlarged Group will also be a world leader in cigars. We are confident that we can leverage the combined brand portfolios, in combination with our sales and marketing expertise, to support Altadis’ cigarette sales in its key markets and to further develop Altadis’ products and brands in our markets. Expanded scale and increased competitiveness

The acquisition of Altadis will consolidate our position as one of the world’s leading global tobacco manufacturers, allowing us to become a more broadly based global tobacco group, with a combined annual volume of approximately 312 billion cigarettes, and provide us with the benefits associated with a stronger position in a substantial number of both developed and emerging economies. Geographic fit and expansion, creating a strong growth platform

Our geographic profile is complementary to that of Altadis and we believe that the acquisition of Altadis will provide us with an attractive combination of profitable mature markets and enhanced opportunities in emerging markets. Altadis’ cigarette division holds the number one position in Morocco and the number two positions in France and Spain, supported by attractive positions in Germany, Austria, the Benelux countries and Russia. The acquisition will improve our position in five of the world’s ten largest markets by profit, namely France, Germany, the US, Russia and Italy, and provide us with a leading position in Spain. It will also enhance our growing presence in Africa, Scandinavia and South America by extending our geographic footprint in markets such as Morocco, Finland and Argentina. Commonwealth Brands provides an attractive footprint in the US which, in combination with Altadis’ US cigar business, has strong growth prospects. In addition, Altadis’ cigar and logistics activities are both strong operations in their own right, which we believe can be further developed as part of a larger group. Given our strong positions in the UK, Germany, other markets in Western Europe, Central Europe, selected countries in Eastern Europe, Australia and Taiwan, the Proposed Acquisition will create a more geographically balanced international group with enhanced growth opportunities.

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Cost savings and revenue benefits

Your Board believes that there are annual revenue benefits and substantial cost savings to be gained from the Enlarged Group and that the Proposed Acquisition will be in the best interests of both Imperial Tobacco and Altadis, and of their respective shareholders and customers. Your Board believes that, as a result of the Proposed Acquisition, the Enlarged Group will be able to generate annual operational efficiencies of approximately €300 million by the end of the second full financial year following Completion. These include our evaluation of the information presented to investors by Altadis on 23 April 2007. The cost savings are expected to be generated primarily in the areas of production and purchasing, sales and marketing and corporate overheads. It is estimated that the one-off cash cost of achieving these savings will be approximately €470 million. We also expect to benefit from disposals of non-core assets valued by Altadis at €650 million. We have a strong track record of identifying international acquisitions and integrating them successfully.

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Endnotes Chapter 1 1 We use the terms ‘merger’ and ‘acquisition’ interchangeably. There is no substantive difference: both seek the benefits of combination. Whether one company buys the other and whether they call it a merger, the objectives are the same. The important distinction is between agreed and hostile takeovers (which are becoming less common). 2 Quoted from Andrew Campbell and Robert Park, The Growth Gamble, Nicholas Brealey, London, 2005, page 41. 3 Al Ries in Focus, Harper Business, New York, 1996. 4 For an excellent description of the process by which the operations of the two banks were integrated, see Graham Kennedy, David Boddy and Robert Paton, ‘Managing the Aftermath: Lessons from the Royal Bank of Scotland’s Acquisition of NatWest’, European Management Journal, October 2006. 5 ‘The urge to merge’, The Economist, 2 January 2007, www.economist.com. 6 There is some evidence that acquisition performance is improving. We like to think that some of that arises from better practice. Companies are learning about the reasons for failure and absorbing the lessons of the past. There is also persuasive evidence that companies that make many acquisitions gain skill at it, perform better and thus become exemplars. Whatever the overall record of acquisition success, some companies clearly make money from doing deals. That is why it makes sense to learn from them.

Chapter 2 1 Although, in some cases, as with 3i in the UK and the recently floated Blackstone in the US, the fund manager itself may be a public company. 2 The British Venture Capital Association (BVCA) offers these facts in A Guide To Private Equity, 2004: In a recent survey 83 per cent of private equity backed companies said they would not have existed at all or would have developed less rapidly without private equity. Over three quarters of the companies felt that their private equity firms had made a major contribution other than the provision of money. • Private equity backed companies outperform leading UK businesses. Over a five year period, on average private equity backed companies increased their: – sales by 30 per cent p.a., more than three times that achieved by FTSE 100 companies – exports by 20 per cent p.a., compared with a national growth rate of just 2.9 per cent p.a. – investment by 25 per cent p.a., compared with a national increase of 2.3 per cent p.a.

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ENDNOTES

• Private equity backed companies create jobs at a considerably faster rate than other private sector companies. Over a five year period, the number of people employed by private equity backed companies increased by an average of 23 per cent p.a., against a national private sector employment growth rate of just 1.5 per cent p.a. It is estimated that private equity backed companies account for the employment of around 2.9 million people, equivalent to 16 per cent of the current private sector workforce. 3 For an explanation of this problem, as well as suggestions on what to do about it, see Andrew Campbell and Michael Goold, Synergy, Capstone Publishing, 1998. 4 The idea of adopting a buy-to-sell strategy for public companies is examined in greater detail in an excellent review of the current private equity scene in Felix Barber and Michael Goold, ‘The Strategic Secret of Private Equity’, Harvard Business Review, September-October 2007.

Chapter 3 1 ‘The New Alchemy’, The Economist, 20 January 2000. 2 In his letter to shareholders in the Berkshire Hathaway 1994 annual report. 3 ‘When Clouds Collide’, The Economist, 7 February 2008.

Chapter 5 1 By ‘standalone value’, we mean the present value of its cash flows in its current state. In the case of a publicly listed company, the standalone value is simply the target’s pre-bid market capitalization. When the target is being sold by a company, it is your estimate of the present value of its cash flows, before any synergies implemented by you if you buy it. 2 At the Ashridge Strategic Management Centre. 3 The Economist, 15 May 1999, page 109. 4 Yves Doz and Gary Hamel, Alliance Advantage, Harvard Business School Press, 1999.

Chapter 6 1 Information taken from www.eaindustries.com/acquisition.asp (last accessed 17 March 2008). 2 Information taken from www.tpwinvestments.com/acquisition/index.htm (last accessed 17 March 2008). 3 Information taken from www.sageriverpartners.com/acquisition.htm (last accessed 17 March 2008).

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ENDNOTES

Chapter 9 1 Tom Copeland, Tim Koller and Jack Murrin, Valuation, 3rd edition, Wiley, 2000; also Aswath Damodaran, Damodaran on Valuation, Wiley, 2006. 2 In the UK, some say ‘When does it wash its face?’ 3 The corporate development manager of a large company once suggested to us that there should always be an even number of scenarios. That way, the decision makers won’t automatically pick the middle one.

Chapter 11 1 A bizarre example is that of military firing ranges in the US. Lead debris has poisoned the soil and more than 800 have ceased operations. The US Army is actually shifting to tungsten as a replacement for lead in all small arms ammunition.

Chapter 14 1 Monsanto Company, as described in ‘A House United’, a January 1999 executive inquiry by the Corporate Strategy Board, Washington DC. 2 As explained in ‘Making the Deal Real: How GE Capital Integrates Acquisitions’, Harvard Business Review, January–February 1998. This article is a classic and explains clearly why specialists are preferable for deal integration and how they should go about their work. 3 ‘The Logic of Local Business: An Interview with ABB’s Percy Barnevik’, Harvard Business Review, March–April 1991.

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Index ABB Zamech 156–7 ABN/AMRO 4 aborted acquisitions 25, 26–31 executive power 30, 160–1 external approvals 26–8, 160 nationalistic barriers 28–9, 160 pressure groups 29 accountants and due diligence work 119 acquisition criteria see criteria, setting of acquisition mechanics 47–52 acquisition planning see planning, acquisition acquisitions growth in and reasons for 3–4, 5–9 acquisition profile statement 64 Action for Market Towns 29 advisers role of professional 124 agreed public company acquisitions 50 Alcan acquisition of by Rio Tinto 39, 141 alliances 71–5 advantages 73–4 contractual 72 disadvantages 74–5 equity 72 growth of 72 situations favouring 72–3 Allied Signal 151 Altadis acquisition of by Imperial Group 77–8, 169–71 Altria acquisition of John Middleton 10, 25 AMD 66 American Airlines 161 Amoco, merger with BP see BP/Amoco announcement, integration 93, 153–4 antitrust doctrine 26 AOL/Time Warner 38, 141, 147

appointments 163 Armstrong, Michael 39 ASDA acquisition of by Wal–Mart 29 Ashridge Strategic Management Centre 7, 11 assets and due diligence 121–2 and warranties 133 AT&T 151 acquisition of BellSouth 27, 165–7 acquisition of Tele-Communications, Inc. 39 demerging of Lucent 34 auctions 20, 47–9, 51, 159 audit 63 conducting of retrospective 155 automobile industry 67 bank borrowing and due diligence 122 Bank of Montreal 26 Bank of Scotland 58 Bankers Trust (BT) acquisition of by Deutsche Bank 66 banks and acquisition finance 145–6 Baxter International 34 BCE (Bell Canada) 17 ‘BCG matrix’ 36–7 BellSouth acquisition of by AT&T 27, 165–7 Berkshire Hathaway acquisition of Marmon 71 BHP Billiton 61 bid for Rio Tinto 65 Blackstone Group 17, 18, 22 BP/Amoco 4, 27, 44 brands/brand name 69, 136 Branson, Richard 69 British Airways 161 British American Tobacco acquisition of Eagle Star 60

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INDEX

brokers 85–6, 162 Brooks Brothers 32 Buffett, Warren 40, 71 business cycle 40 ‘business leader’ 151 business strategy 163 business systems, integrating of 155–6 Campaign for Real Ale (CAMRA) 29 Canadian banks 26 Canadian Imperial Bank of Commerce 26 Capital Asset Pricing Model (CAPM) 105 capital rationing 99 Carlyle Group 17 cash and financial due diligence 120 versus shares in funding of acquisition 141–2 cash flow multiples 96–7, 99 cash flow return on investment (CFROI) 96 cash flows 100, 103, 104–5 CBS merger with Viacom 35 chemicals industry 97 Chrysler merger with Daimler-Benz 27, 40, 44, 62, 157 Cisco Systems 151, 153 Citicorp 41 Citigroup 4 merger with Travelers 30 claims and warranties 134–5 co-insurance 37 Columbia Pictures acquisition of by Sony 34–5 commercial due diligence 41, 127–8 communication 160 and integration 43, 154–5 companies approaching target 88–9 choosing wrong 32–3, 159 investigating of target 117 See also due diligence

178

searching of as targets 86–7 competition authorities external approval needed from 26–8 competition law 28 competitive advantage 68, 72 computer compatibility/incompatibility 42–3, 160 computer systems and due diligence 123–4 concentration, expansion through 6–8 confidentiality and deal negotiation 112, 113 constant perpetuity 104 constant purchasing power parity 103 contracts due diligence and existing 125–6 negotiation 162 and warranties 134, 135 contractual alliances 72 corporate parenting 67–8, 163–4 corporation tax 105–6 cost of capital 105–6, 110, 141, 145 Council for the Preservation of Rural England 29 Crédit Lyonnais 31 criteria, setting of 77–83 guidelines 82 integration acquisitions 77–8 portfolio acquisitions 78–82 cross-border acquisitions 4, 152–3, 160 cross-distribution arrangements 161 cultural differences 44, 152–3, 160 current business and due diligence 127–8 Daimler-Benz merger with Chrysler 27, 40, 44, 62, 157 Danone 28 deal negotiation 109–15 and confidentiality 112, 113 determining a price 109–12 and exclusivity 112–13 intermediate undertakings 112–14 provisional commitments 113–14 defensive deals 59 Deutsche Bank

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acquisition of Bankers Trust 66 merger with Dresdener Bank 31 Deutsche Telekom 34 Diageo 69 direct cost savings 161 discount rates 105, 106 discounted cash flow (DCF) 98, 100, 102, 145 diversification 7, 37 Doz, Yves 75 Dresdener Bank 31 drugs companies 33 due diligence 41–2, 49, 50, 81, 119–29, 160, 162 commercial 41, 127–8 and environmental matters 126–7 financial 41, 120–4 and integration programme 150 and legal affairs 125–6 logic of 118–20 and personnel 124–5 and private equity firms 117–18, 127, 128 Dynegy merger with LS Power 29 E & A Industries 79–80 E-oN 28–9 Eagle Star acquisition of by British American Tobacco 60 earnings multiples 96, 99 earnings per share (EPS) 37, 99, 101, 107 impact of different financial methods of outcomes on 143–5 earnouts 111–12 economies of scale 67 Economist 11 electricity industry 9 Eli Lilly 35 employees see personnel Endesa 28 Enterprise Act (2002) 28 enterprise systems 42 Environmental Act 126 environmental matters

and due diligence 126–7 and warranties 134 Environmental Protection Agency (US) 126 equity alliances 72 Equity Office Properties (EOP) 17 European Union 26 exclusivity and deal negotiation 112–13 executive power 30, 160–1 expenses and sale and purchase agreement 138 external approvals 26–8, 160 Exxon/Mobil 4, 10, 25, 27 failure of acquisition reasons for 10–11, 25–45 ways to avoid 159–61 See also aborted acquisitions; poor returns Far East 4, 27 Federal Communications Commission (FCC) 27, 147 Federal Trade Commission 26 Ferranti 41, 120 financial balance 36–7 financial due diligence 41, 120–4 financial leverage 37 financial logic 95–106, 162 cost of capital 105–6 non-financial considerations 101–2 practical guidelines 102–5 and valuation methodologies 95–102 financial skills 163 financial statements and warranties 133 financial synergy 36–7 financing of acquisition 141–6 and banks 145–6 cash versus shares 141–2 guidelines 145 impact of different methods of on EPS outcomes 143–5 First Choice merger with TUI 65 fixed assets and warranties 133

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focus rationale 7–8 foreign currency cash flows 103 Fortune 500 companies 7 France 28 Frito Lay 59 full mergers 50–1 funding see financing funds availability of and merger boom 5–6 gap filling 38, 159 Gas Natural 28–9 GE Capital (GEC) 25, 41, 150–1 General Electric (GE) 19, 67, 150 General Motors 67 geographic balance 36, 159 German Cartel Office 26 Germany 26 Gerstner, Lou 19 Glaxo Wellcome merger with SmithKline Beecham 30 Goldman Sachs 17 goodwill 38, 131 Grand Metropolitan 69 growth, drivers of 4–5 GSK (GlaxoSmithKline) 35 Hamel, Gary 75 Hanson Trust 70 HCA 17 heads of agreement 113, 114 hedge funds 18 hostile acquisitions 49 hotel industry 97 hurdle rate 105, 106 IBM 19 Imperial Group acquisition of Altadis 77–8, 169–71 implementation planning 43 See also integration implementation team 93 incentives 68, 163 incremental value 55–6, 57, 62 creation of by integration acquisitions 63–7

180

and private equity deals 61 indemnification sale and purchase agreement 135–6 industry, choosing wrong 32–3, 159 industry consolidation 8 industry norms 97, 99 inflation 104–5, 105 insurance and warranties 134 integration 43, 147–58, 162 announcement of 153–4 assigning of separate project responsibility for 150–1 beginning right after completion 151, 160 of business systems 155–6 and communication 43, 154–5 and cultural differences 44, 152–3, 160 deciding who will run the business 151–2 designing of during due diligence phase 150 determining degree of 149–50 identification of value drivers 148–9 and personnel 43, 157 principles to follow 148–57 and private equity firms 147–8 and retrospective audit 155 tieing of priorities to strategic objectives 152 integration acquisitions 33, 62–7, 88 conducting a search 85 criteria setting 77–8 value creation 63–7, 161 ‘integration leader’ 151 integration plan 118 intellectual property rights and warranties 134, 135 interest rates 5, 18 intermediaries 85–6 internal rate of return (IRR) 98, 99 international accounting standards (IAS) 38 inventories and warranties 133 investigation team 91

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investment bankers 86 ISC 41 Japan M&A activity 4 John Middleton acquisition of by Altria 10, 25 joint ventures see alliances Kinder Morgan 17 KKR 17, 19, 22 Komatsu 149 KP Foods 59 learning costs 60–1, 62 legal affairs and due diligence 125–6 Leschly, Ian 30 letter of intent 113, 114 leveraged buyout (LBO) 96 liabilities and due diligence 122 and warranties 134–5 liquidation value 97 loans to customers and due diligence 122 LS Power merger with Dynegy 29 LTV 37 Lucent Technologies 34, 151 McKinsey’s Seven S model 153 management, changing of 68 managers operating 88 pharmaceutical benefit 35 market control 65–6, 161 Marks & Spencer 32 Marmon acquisition of by Berkshire Hathaway 71 Mars 60 Matsushita acquisition of MCA 35 MCA 35 media and vertical integration 34–5

Mercedes 62 Merck & Co 35 MGM 31 Microsoft bid for Yahoo! 44 mineral companies and oil companies 61 mining industry 65 Mobil merger with Exxon see ExxonMobil mobile phone companies 97 Napoleonic principle 113 National Environmental Trust 29 NatWest acquisition of by Royal Bank of Scotland 10, 25, 58, 154–5, 156 nationalistic barriers 28–9, 160 negotiating a deal see deal negotiation negotiating team 91–3 net assets 97, 99 net present value (NPV) 98, 99, 100, 103, 111, 121 NexGen 66 noise and due diligence 126 ‘non-compete clause’ 137 Office of Fair Trading (OFT) 26, 28 oil companies and minerals 61 one-off costs 110 online buying 8 Ontario Teachers’ Pension Plan 17 operating managers 88, 162 operating synergy 64 operational stocks and financial due diligence 120 opportunity costs 62, 102 overheads 102 parenting, corporate 67–8, 163–4 patents 69 payback period 99, 100–1 pension provisions and due diligence 122 and warranties 135

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INDEX

PepsiCo 28 perpetuity value 104 personnel and due diligence 124–5 and integration 43, 157 and sale and purchase agreement 137 and warranties 135 pharmaceutical benefit managers (PBMs) 35 pharmaceutical industry 33 planning, acquisition 91–4 implementation team 93 investigation team 91 negotiating team 91–3 planning, implementation see implementation planning plant, property and equipment and due diligence 121–2 platform acquisitions 161 poor returns, reasons for 25, 31–44 bad strategic rationales 33–8, 159 computer compatability 42–3, 160 cultural obstacles 44, 152–3, 160 due diligence failures 41–2, 160 excessive price 39–41, 159–60 implementation planning, pace and communication 43, 160 wrong company 32–3, 159 wrong industry 31, 159 portfolio acquisitions 33, 88, 162 conducting a search 85 criteria setting 78–82 value creation 63, 67–71 power sharing arrangement 30 premiums 55, 56–60 pressure groups 29 price determining 109–12 dictating constraints on funding 145 four rules relating to 55–62 paying excessive 39–41, 159–60 and sale and purchase agreement 131–2 price/earnings (P/E) ratio 6, 143, 144

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private equity/private equity firms 9, 15–24, 71, 78 advantages over public companies 16 as a competitive threat 20–1 and due diligence 117–18, 127, 128 features of 15–16 impact of 16–19 implications for corporate acquisitions 19–24 M&A as a percentage of total M&A 17 and portfolio acquisition 71 as a predatory acquirer 22–3 as a prompt for strategy change 23–4 as a source of best practice 21 as a source of cooperation in corporate development 22 and tax treatment 18 types of 15 private purchases 47–9, 51 privatization 5, 9 privately owned companies 109 profitability index 98–9 project management 163 protected income 102–3 public pronouncements 93, 153–4 publicly quoted companies 109 purchase and sale agreement see sale and purchase agreement re-entry sale and purchase agreement 137 real options theory 99–100 real-estate investment trust (REIT) 17 receivables and warranties 133 records access to and sale and purchase agreement 137 Reed, John 30 regulatory intervention 26, 160 research, original 86–7 retailing, international 32 Rio Tinto acquisition of Alcan 39, 141

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INDEX

bid for by BHP Billiton 65 Rite-Aid 35 Robertson, Pat 74 Royal Bank of Canada 26 Royal Bank of Scotland acquisition of NatWest 10, 25, 58, 154–5, 156 alliance with Pat Robertson 74 Sage River Partners 81–2 sale and purchase agreement 113, 119, 131–9 access to books and records 137 conditions precedent 137 conduct of business 137 contents of the company 132 and expenses 138 indemnification 135–6 and personnel 137 and price 131–2 re-entry 137 strategic relevance 138 use of the seller’s brand name 136 warranties 132–5 same-industry mergers 7 Sarbanes–Oxley 16, 47 scale economies 73 scenario planning 102, 103–4 screening of companies 87 Seagrams 35 search, conducting of 85–90, 162 approaching target companies 88–9 brokers and intermediaries 85–6 and operating managers 88 original research 86–7 sector balance 35–6 sensitivity analysis 103 shares versus cash in funding acquisition 141–2 as warranties 133 Shell acquisition of Billiton 61 shipping 40 skill sharing 161, 163 Slater Walker 37 SmithKline Beecham 35

merger with Glaxo Wellcome 30 soil contamination 160 and due diligence 126 and warranties 134 Sony acquisition of Columbia Pictures 34–5 Southern Pacific 42 Spain 28–9 specialists, integration 93 staff costs 102 ‘stalking horse’ 113 stand-alone value 58, 62 Stock Exchange Takeover Code (‘blue book’) 49, 51, 109 Stock Exchange Takeover Panel 49 stock market 6 stock market multiples 96–7 strategy formulation 55–76 Sykes, Richard 30 targets 163 changing of 68 tax losses, preservation of 37 taxation and cash flows 105 and due diligence 121, 122–3 and private equity firms 18 and warranties 133 technology 161 Tele-Communications, Inc. (TCI) acquisition of by AT&T 39 telecoms sector 8 terminal value 104 Texas Pacific 19 Time Warner merger with AOL see AOL/Time Warner Tintoretto 149 tobacco industry 66 Toronto-Dominion Bank 26 TPW 80–1 trade debtors and due diligence 121 transaction-based multiples 96–7 transactions, types of 47–51 agreed public company acquisitions 50

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transactions, types of (continued) full mergers 50–1 hostile acquisitions 49 private purchases 47–9 Travelers merger with Citigroup 30 TUI merger with First Choice 65 TXU 17 Tyco International 38 UK 26 M&A activity 3–4 Union Pacific 42 United States M&A activity 4 and private equity 16 US Justice Department 26 valuation methodologies 95–102 common mistakes 107 external 95, 96–7 internal 95, 98–101 ‘value capture summary’ 150 value chain 72 value creation 61–2 integration acquisitions 63–7

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portfolio acquisitions 63, 67–71 rules for 55–62 ways to ensure 161–2 value drivers 149 vertical integration 33–5, 74, 159 Viacom merger with CBS 35 Virgin 69 virtual data rooms 48 Vodafone 4 Volvo 67 Wal-Mart acquisition of ASDA 29 warranties 119, 132–5, 136, 138 ‘wealth effect’ 6 weighted average cost of capital 62 Weill, Sandy 30 Welch, Jack 19, 67 working capital 105 and financial due diligence 120–1 Yahoo! Microsoft bid for 4 Zamech 156–7