Acquisition Strategy

I was asked the other day what can be learned from the possible merger of GM and Chrysler. Specifically, what might this union of giants teach the M&A market lower down the food chain?

As I’ve said elsewhere, this is a time when corporate mergers can appeal to those struggling with a hostile economic climate. Reducing competitive pressure, cutting costs, gaining market share… All seem like good outcomes when two players in the same market consider forming a single new entity.

My concern about the GM-Chrysler engagement is that it models a marriage based on weakness. Both companies are in trouble, and in my experience two failures don’t make a success. The underlying problem is that mergers of this kind are driven by an agenda to cut costs. No company grew rich on that agenda alone. To win the business game, you have to keep developing new products or finding new markets — or both.

On the positive side, a merger of this kind can buy you time. That may be good enough reason for the auto makers to tie the knot. But only if they immediately launch a proactive campaign of true innovation in products and/or marketing.

And that should be happening anyway.

When it comes to funding acquisitions, banks are still holding tight to their money — unless you count the special case of banks buying other banks, which is causing quite a stir in the wake of the government bailout. The fact is, this is still a tough time for M&A, especially in what I have called “the wedge”: M&A transactions between $1bn and $10bn. Smaller deals continue under the radar, and the mating season of the behemoths never ends. Witness the prospect of GM and Chrysler merging.

In the wedge, a huge area of M&A activity, private equity is being told to wait. Banks aren’t playing and neither are the battered hedge funds. So we can expect a hold on most LBOs (leveraged buyouts) until at least the early part of next year. However, not all private equity firms are taking this lying down. They are turning away from traditional sources and seeking capital elsewhere — specifically, the public markets.

The result: we’re seeing renewed interest in SPACs, or Special Purpose Acquisition Companies. These are basically IPOs launched purely for the purpose of buying companies. How quickly this trend will increase is an open question, but it’s certainly a development to watch over the coming months.

Writing this post on November 5th, one is bound to be thinking about the outlook for M&A under a new Democratic government. 

The people I do business with are looking at two major unknowns: tax and regulation. Both are cause for concern as the political map gets redrawn, and both may have a depressing effect on mergers and acquisitions.

At the same time, we should also ask ourselves who might do well under a new regime. Which industries are positioned to take advantage of the change in political climate? For companies considering business acquisitions, it’s a question worth pondering because your acquisition strategy should always be focused where market demand is strong.

Here are a few sectors to watch. Healthcare is almost certainly going to experience quite a shakeup, with significant growth in some areas. Green energy could be in for a substantial infusion of government funds.  If there’s increased investment in infrastructure such as rail and road, opportunities may grow for capital equipment. Generally, companies that directly serve government could do well such as those that supply large IT systems.

These answers are all speculation of course. My point is, the question itself is worth asking — especially as you think about your own acquisition plans.

I’ve noticed some company buyers willfully slowing down the acquisition process at this time. Why? They smell bankruptcy in the air. The longer they can string out the negotiations, the more desperate the seller’s condition and the lower the price. It’s tough for sellers to defend themselves in this environment. I’ve noticed some company buyers willfully slowing down the acquisition process at this time.

Best thing to do: let your buyer know there are other, more attractive suitors knocking at your door.

In every crisis there are winners as well as losers. Today companies seeking growth through acquisition can pick up bargains — if they have the cash. Small, over-leveraged companies are choosing to sell rather than go to the wall. As for the publicly traded corporations, they are under pressure from shareholders to get out of business units that don’t make business sense. So there may be some attractive divisions up for grabs — the unwanted stepchildren of major corporations. From the buyer’s perspective the key is to come to market with a strong balance sheet. This isn’t the time for highly leveraged acquisitions. Cash is king and the buyer with dollars to spend can not only pay less but also command favorable terms like a quicker closer or more reps and warranties. I talk more about this in my post The Return of Simplicity in M&A.

That doesn’t mean we should expect a huge volume of mergers and acquisitions right now. There will be a slowdown in the coming months while the current financial turbulence plays out. But watch the beginning of 2009. I have clients right now engaged in intensive planning for acquisitions early in the New Year.

There is an old way and a new way to go about the M&A process, and it’s essential to know the difference.

I had a client that perfectly exemplified the old way. She would be regularly approached by investment bankers hawking “the book” on a company they had for sale. She would listen to the pitch, peruse the documentation and try to figure whether the purchase was a good idea. Eventually she allowed herself to be sold on the acquisition of a small operation. The target company was losing money, but she was persuaded that she would easily be able to turn it around and generate a profit.

Twelve months later, her acquisition was not only losing money but distracting her management team from the core business.

What was missing here can be summed up in one word: strategy. It’s amazing to me how common this deficiency is. Many sophisticated people drift into a purely reactive relationship to growth. They talk to whoever comes to lunch. They size up whatever opportunity comes across their desk. And they do their best to match what’s new with what they already have.

It’s to counter this tendency that I’ve developed my 14-stage “Road Map” approach to buying companies. Whether you use my approach or someone else’s, be sure of one thing: before you set out on the journey of acquisition, get yourself a map.

The right acquisition can dramatically accelerate your company’s growth. Sadly, great opportunities are widely missed, especially in the mid-market. Many companies shy away because the whole field of M&A seems too intimidating. There are others who attempt acquisitions and are disappointed by the outcome, often because they try to follow a rote system overly focused on the numbers. What’s missing is an approach that is tightly disciplined on the one hand, and sufficiently holistic on the other.

When I say “holistic” I mean you have to go beyond the numbers. The finances are an essential dimension of the M&A picture. But they are only one dimension. For success in this field, you must open your eyes to many other potential benefits.

A good acquisition might bring you a technology that you couldn’t otherwise obtain. It could bring you to a market sector that has been out of reach. It might win you exceptionally talented people. It could subtly but significantly enhance your brand and reputation, making you more attractive to customers and high-value employees. Or your acquisition could be simply defensive, blocking a competitor from obtaining the same assets.

All these and more benefits will certainly show up on the bottom line, sooner or later. However, they represent values that may not be subject to instant financial calculation.

Often the single most important benefit of a judicious acquisition can be to “recalibrate” your business. What I mean is that every healthy business has to redefine itself over and over again to flourish in a changing world. Acquisitions – and divestitures – can be a swift and powerful way to positively reinvent your company to meet new pressures and leverage new opportunities.

Much of the buildup that’s been happening over recent years in the residential mortgage market is similar to what has been going on in the commercial market. It’s all about financial engineering. Typically, the financial investor looks at an acquisition and says: “Let’s restructure the balance sheet so that the company doesn’t fundamentally change. We get a higher return because we’re using debt as opposed to equity.”

Because of the current crisis, we are moving away from this financial emphasis and into a strategic model where an acquisition must bring real value to the business. The focus now will be external growth for tangible results, and truly effective integration. That’s to say, the newly combined entity will be able to do things in the real world that weren’t possible for the two separate companies. It can get better purchasing power. It can consolidate sales and marketing efforts. It can make cost savings, for example, in the usage of facilities. These improvements in capacity or utilization are not what a financial investor brings to the table — they are unique to strategic buyers. This is the type of acquisition that will now come into vogue.

Here we see the upside of the current crisis. Long term, the M&A markets will become more solid and stable. In recent years, too many companies have been so worried about covering the financial cost of doing business —the interest payments on debt — that they have not been reinvesting in the fundamentals of their business. We will begin to see more investment in people and technology — the things that make the companies profitable. Long term this will be very good for U.S. businesses because it will make us more competitive and more globally focused.

When the smoke clears and the dust settles, what does the Wall Street meltdown mean?

We’re back to cash is king. The Golden Rule has been restored: he who has the gold, makes the rules. It’s a return to old-fashioned investing. Companies with strong balance sheets and lots of cash are moving in to make acquisitions. In some cases they are paying 100% equity — no money down, no debt whatsoever, a completely unleveraged transaction. And they’re able to really have an impact on businesses that they weren’t necessarily able to touch before.

We certainly saw that with Warren Buffett. He had the gold, and he set the rules. He got a real sweetheart deal with Goldman Sachs. Granted he has money at risk, but he was able to get a highly preferential deal structure that a year ago he wouldn’t have been possible. It’s all about the cash position. The people that have dry gunpowder right now will do very well. Companies with little debt and good fundamental financials have the opportunity right now to really make a move and become even stronger.

A few things are going to follow. First, valuations will fall — it will be interesting to see how valuation companies (the experts who calculate what a company is worth) adjust to the new climate. Second, cash-rich buyers will be able to acquire companies that others cannot. And there is a third consequence to this whole upheaval: we will see a new layer of transparency and simplicity in the markets. Acquisitions in recent years have been largely driven by financial engineering. Now we’ll see a change in acquisition strategy. Today, the question hanging over possible transactions will be: “Does this make good business sense?” That’s a sea change in the M&A world.

In the current crisis, people are rightly concerned about a declining dollar and its impact on all aspects of business, including Mergers and Acquisitions.

Outbound, the weaker dollar is making it more difficult for US companies to make acquisitions abroad, because they’re now more expensive. On the inbound side the impact has been positive. We’ve seen a strong increase in foreign investments in the US. With a weak dollar, many foreign players see an opportunity to buy companies at a discount.

The US firm seeking growth through acquisition might assume that this means increased competition, because that attractive competitor you want to buy is also being courted by cash-rich foreign buyers.

In reality, you’re seeing not more competition but different competition. In the past, competition came largely from private equity or hedge funds — and that was a very difficult competitor. These were sophisticated buyers, with a low weighted average cost of capital because they had good access to cheap debt. they understood capital asset pricing models, and they were tough people to compete against.

Now the scene has changed. The private equity players have withdrawn and the foreign buyers are stepping in. But these foreign competitors may not know the US market as well. They will tend to be strategic buyers, looking to improve their business or marketing picture, rather than purely financial buyers aiming to turn a quick profit, and as such they may prove far less sophisticated.Right now, it’s a little premature to determine exactly how they will behave. My sense is they will tend to be fairly cash rich because the dollar is weak. That means that in some cases they are likely to overpay. So from a seller’s perspective, we see strong activity right now by US companies looking to divest. They’re eager to accept inquiries at this point, especially from foreign buyers because they spot an opportunity to get a high price for their business.

I was asked the other day about the meaning of “enterprise value”. We have two different terminologies that are used in the marketplace: enterprise value and equity value. Enterprise value is the value of a business including its debt. Equity value is the value of the business debt free.

In some situations, you might be buying a company while also assuming its debt. That would be its enterprise value. Equity value says: “I’m going to pay you a price, but I want it debt free. You pay off the debt, do whatever you want with it, but I want to buy your company debt free.”

In today’s M&A markets, the predominant transaction type is equity value. The exception would be if a company has a capital structure that is very favorable, and the seller therefore has reason to assume it. This is not a whole lot different from buying a house and assuming someone else’s mortgage. There aren’t a lot of fees associated with it — you just slip right in. Sign a few papers and you’re done!

In the commercial world, if I can buy a company and they have very good debt I might be glad to take it on. A common example is an industrial development bond from the local government that is on very favorable terms. As a buyer, that’s most likely something that I’m going to want to keep in place. Why would we want a low-cost loan paid off? On the contrary, we could use that as part of the deal structure. So, the primary reason for selecting enterprise value would be if the buyer can secure a deal structure that’s such that the existing debt provides a benefit. If the debit is not favorable, then as a buyer I would probably opt for equity value and bring in my own debt structure.

There’s some confusion around about the direction of the M&A market, and it comes from seeing the market as an undifferentiated whole. For example, a recent article in the New York Sun predicts a comeback in M&A activity after a year in the doldrums. 

The article is generally correct and I do see a strong emanating market. However I question their premise that the comeback is widespread over the whole market. There’s going to be a divide. At the high end — which I characterize as transactions of $10B and up — we’ll continue to see a healthy amount of activity. It’s Hewlett Packard buying EDS. It’s Anheuser-Busch getting bought by Inbev. It’s Microsoft trying to buy Yahoo.  Many of those big companies recognize that they will only continue to grow by adding strategic components to their business. They’re looking to get immediate expansion in either brands or — even more important — global penetration, which is partly what we saw on the Inbev deal. 

The other area where we will see continued growth is at the lower end of the market. These are transactions under $1B in size. Here people are trying to fill their market gaps, buying competitors that have gotten weaker. In particular within that sector, watch for transactions under $100m  — I predict the strongest activity within this range. The primary reason is their access to credit, or perhaps more significantly their ability to do without it.  In many cases privately held companies of this size can buy for cash out of their operating income. Or they can use equity positions they’re going to put into the business. Either way, the transactions are proving much easier to get financed.

So this is what I see as the major divide — greater than $10B, less than a billion. In my next post I’ll talk about the missing middle: transactions from $1B to $10B.