Mergers and Acquisitions

Session 5

Types of Foreign Direct Investment

Green-field investment Establishment of a

new operation

Merger / Acquisition Acquiring or

merging with an existing firm

a minority 10-49% majority: 50-99% full out-right

(completely)stake: 100%

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Objectives behind M&A

Product diversification Geographical diversification Economies of scale Acquisition of specific assets/competencies

(management, technology, distribution channels, workers, etc.)

Sourcing of raw materials or other products for sale outside the host country

Financial (portfolio) diversification

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Types of M&A Horizontal

The product lines and markets of the acquired and acquiring firms are similar.

Vertical Acquired firm becomes a supplier of the

acquiring firm (backward integration) Or a customer of the acquiring firm (forward

integration) Concentric

The acquired firm has the same market but different technology or the same technology but different market Conglomerate

The acquired firm is in the different industry from that of the acquiring firm

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Advantages and disadvantages of M&A’s (as a foreign market entry mode)

Advantages Disadvantages

1. A faster start in expoiting the foreign target market, because the investor gets a going enterprise with existing products and markets.

2. Acquisition entry promises a shorter payback period by creating immediate income for the investor.

3. It may provide a resource that is scarce in the target country and is not available in the open market

4. Acquisition of new product lines.

1. Locating and evaluating acquisition candidates can be extraordinarily difficult.

2. Host and home government policies.

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Key success factors in M&A The quality of the pre-acquisition process:

how companies make the M&A decision, give it a value and negotiate the deal

The quality of the post-acquisition process: how the integration is managed. This process is considered the most important source of success or failure

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The pre-acquisition and post-acquisition processes in global M&As

DECISION-MAKING PROCESS

Justifying the economic

rationale of the acquisition

• Value-creation logic• Target selection• Due diligence and valuation

INTEGRATION PROCESS

Achieving the value through the management of the acquired

company

Integration Framework• Preservation• Absorption• Symbiosis

Transition Management• Interface management• New sense of purpose• Operational focus• Mutual understanding• Respect• Measurement and control• Winning spiral• Credibility

ConsolidationInserting the acquired company in the overall global strategic/organisational corporate network

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Deciding on the M&A: Value creation The economics of M&As: a merger or an acquisition is

justified if, and only if, the value of the new merged or combined entity is bigger than the sum of the value of the independent entities prior to the merger.

From a strategic point of view M&As can create the following types of value: Consolidation of companies operating in the same business

area – horizontal M&A Global reach – extension to international markets Vertical integration – merging of businesses which are

suppliers or buyers of each other’s products Diversification – companies operating in different business

domains Acquisition of a firm in a new technology or market to monitor

its evolution (a.k.a. Option acquisitions)

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Value creation modalities Short-term one-off value

comes from the one-off post-merger realization of cash benefits coming from a tax shield, asset disposals and immediate cost savings or debts leverage.

Long-term strategic value comes from the competitive advantage gained from the

merger: enhanced differentiation capabilities a larger market new growth opportunities enhanced competencies cost advantages through economies of scale or scope

These advantages are often referred as the synergistic’ effects of a merger.

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Value creation in M&As

Types of value creation

Benefits

Short-term value creation

Tax shield Diminution of tax bill (cost benefits)

Asset disposals Lower capital invested (higher return, lower cost):– Lower cost of capital (assuming cost of debts lower than cost of equity)– Total market value increased after the merger (assuming a P/E differential between buyer and seller and a positive market reaction)

Financial engineering:– Debt leverage– Price/earnings (P/E) ratio leverage

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Value creation in M&AsTypes of value creation Benefits

Long-term value creation

Pooling and sharing resourcesand assets– Joint purchasing– Manufacturing rationalisation– Joint distribution and logistics– Common IT and central services– Common Treasury

Economies of scale and scope (cost benefits)

Enlarged market– Geography– Products

– Growth potential enhanced– Richer value proposition (higher reach and possibly higher differentiation)

Transfer of competencies– Technology– Best practices

– Higher differentiation– Processes more effective– Innovation (higher differentiation and lower costs)

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Due diligence Due diligence – the process of investigation,

performed by investors, into the details of potential investment, such as an examination of operations and management and the verification if material facts.

Most common adjustments required after due diligence: Inventories may be overvalued Employees’ retirement benefits may not appear or may be

underfunded and provisions have to be made for future liabilities

Real estate has to be valued at market prices, and necessary tax adjustments have to be made

Hidden liabilities such as legal actions may be uncovered.

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Economic valuation

Economic valuation is necessary in order for a potential buyer to decide at what price it is willing to conclude the deal – or, in the case of a merger, the relative proportions of shares to be exchanged.

Three main methods are used for such valuations: Asset-based valuation Market-based valuation Cash flow-based valuation

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Asset-based valuation This method determines the actual value of assets

minus liabilities, using a replacement price for physical assets and adjusting for inventories or debtors book value.

Intangible assets and goodwill are estimated using comparable value for similar businesses or using formulas such as dollars per customer.

When use of Asset based valuation is preferred? When company’s assets are predominantly

physical

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Market-based valuation This approach relies on direct market valuation if the

company is listed on a stock exchange or otherwise on market equivalent valuation.

When using stock exchange market value, the transaction will require that the bidder puts a premium on the deal. Premiums are based on an anticipation of value added from the merger.

When the target company is not listed on the stock market, one can use market equivalent measurements such as P/E ratio, price/cash flow ratio or price/revenues ratio calculated from similar deals or comparable companies listed on the stock exchange.

When use of Market based valuation is preferred? When company is listed on a stock exchange

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Cash flow-based valuation Economic theory would say that this is the only valid

method, apart from the actual market price put on the stock market when the market is efficient.

*More on cash flow analysis see Session on Investment Entry

Two kinds of future cash flows needs to be valued in M&As: The future cash flow of the

merging or of the acquired company calculated as if the company continued its activities without the merger. This is the standalone value.

The future value of the added value brought in short-term and long-term by the merger of the two companies. This is the synergies value.

Stand-alone value

NPV of stand-alone cash

flows

Value resulting

from merger NPV of

synergies cash flows

Bargaining range

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Integrating the companies: The integration phase Integration process is structured in three

phases:

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Failures in the integration process (1)Source of failure in integration process

Effects

Lack of strategic direction Actions and decisions not understoodResistance to changeUnco-ordinated decisions

Lack of integration plan ImprovisationTime lostAnxiety not reducedLack of quick response to events

Leadership vacuum Anxiety not reducedBureaucratic hasslesPolitic fights

Determinism (stubborn implementationof the integration plan)

Trying to impose ‘pre-fabricated’ solutionsArrogant behavior from acquirers’ employeesDiscouragement of front-line staff

Lack of communication Anxiety not reducedFears and rumours

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Failures in the integration process (2)Source of failure in integration process

Effects

Cultural mishandling Stereotyped clashes, ‘Them and us’ syndromePolitickingRetreat

Lack of operational focus Too much talk, no actionLack of concrete resultsNo ‘quick wins’

Loss of key management talent

Less productive workforceNegative signaling to internal and external stakeholders

Wrong synergies Loss of efficiencyDysfunctional operationsWaste of financial resources

Lack of buy-in No motivation, passivityPoliticking

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Integration frameworks

Integration frameworks belong to two broad categories: Linear frameworks: step-by-step or checklist

approaches to integration that apply to all M&As. Contingent frameworks: differentiate

integration processes according to environmental and strategic factors. This type of framework does not assume a unique approach to integration.

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Linear integration framework (1)

Post-merger integration

element

Guiding principles/best practices

Vision • Agree on strategic intent and let it guide vision for merger integration• Work to get both sides of the deal to buy into vision and intent• Explicitly identify critical sources of expected value

Architecture for change

• Begin planning early and create detailed plans• Set the right pace; work with a sense of urgency• First attack opportunities that combine the lowest risk with the highest reward

Architecture for the new company

• Focus on relentless identification of sources of value(revenues, cost, etc.)• Incorporate strengths of both companies• Restructure the organization to maximize value• Handle personnel issues swiftly

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Linear integration framework (2)

Post-merger integration

element

Guiding principles/best practices

Leadership • Choose new leadership quickly• Pick the right people and dedicated resources for the integration process• Show fairness and objectivity by using data to make decisions and by including people from both companies in the decision-making process• Set credible milestones and maintain pressure for progress by providing incentives to reach targets• Keep focus of the integration team on economic value-creation• Address cultural issues directly with an explicit plan• Communicate clearly, early, honestly and often; use a decisive tone; do not forget those outside the two companies

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Contingent integration framework (Haspeslagh and Jemison, 1991) Haspeslagh and Jemison identified three

modes of integration, depending on:

The degree of required operational interdependencies between the two companies that are needed to achieve synergies (e.g. rationalization of manufacturing or the transfer of competencies between companies)

The degree of required organizational autonomy that the acquired company would need because of the difference in market and environment conditions with the acquirer (e.g. an acquisition in a different business or country)

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Contingent integration framework (Haspeslagh and Jemison, 1991)

Required organizatio

nal autonomy

Required operational interdependencies

Low

Low

High

High

Preservation

• Keep businesses separate• Stimulate businessdevelopment• Accumulate learning and organise transfer ofcompetencies (if valuable)

Symbiosis

• Start with preservation• Identify joint sources ofsynergies• Develop common culture• Implement progressivelyneeded interdependencies• Preserve autonomyAbsorption• Consolidate and rationalise quickly• Adopt best practice• Instill dominant culture• Recognise complementarities

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Preservation mode The preservation mode fits with situations in which:

Very few operational synergies can be gained Business context calls for a large autonomy of decision-making

(diversification or option acquisitions). Key objective is first to ‘preserve’ the identity and autonomy of

the acquired company, keeping in place the existing management and learning progressively the ‘rules of the game’ of the business.

The source of value here essentially comes from an enlargement of markets and products as well from the transfer of resources or new competencies.

Transfer of resources comes essentially from the injection of capital or stimulation of business development by giving access to logistical, IT or distribution facilities to the acquired company.

Transfer of people has to be done more for learning than for controlling purposes

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Absorption mode

The absorption mode of acquisitions takes place when value is to be expected from the realization of operational synergies in companies operating in similar business contexts.

The objective is to achieve the necessary consolidation and rationalization as rapidly as possible.

Since the businesses are very similar, the top management of the acquirer or the top management of the merging firms are competent rapidly to find sources of savings and to understand which best practices have to be adopted.

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Symbiotic mode

The symbiotic mode of acquisitions tries to achieve a balance between interdependencies and autonomy.

This is often the case in cross-border horizontal acquisitions…

… where a lot of value is gained from the achievement of synergies but the differences in contexts require a high degree of autonomy.

In this mode, the starting point is to use a preservation mode and to find jointly the real sources of synergies and their practicalities.

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Integrating the companies: The transition phase

The transition period is the one during which the acquirer or the merging partners establish their credibility and demonstrate their ability to manage the new concern.

Main issues to be solved during this stage: The appointment of an executive team capable of leading the integration

process and managing the interface between the two companies The expression of a new sense of purpose, demonstrating to stakeholders that

the acquisition or the merger was well planned The focus on concrete operational results that motivate employees and

distract them from sterile rumours. The development of a mutual understanding, bridging or palliating the cultural

gap The showing of respect for the acquired company personnel, avoiding

arrogant behavior and preventing the ‘brain drain’ of valuable employees The installation of measurement tools to measure and control progress The creation of a ‘winning spiral’ that reinforce a sense of success and

achievement The demonstration of credibility that reassures stakeholders and reduces

anxiety.28

Transition phase: (1) Appointment of an executive team and interface management

In the case of a merger, the critical issue is to install a management team that is capable of understanding the cultures of the two parties and transforming them into a new culture.

Managerial personnel problems (who is in charge?) need to be sorted out before the beginning of the transition phase, at least for the key roles.

In acquisitions, the critical issue is to trade off the need to control and the need to preserve the key contacts and knowledge of the previous management team. There is also the need to make sure that the appointed management team will be an efficient interface between the acquired company and the foreign acquirer.

The best way to achieve an efficient interface is to appoint, as managing director, an executive or a team of executives having the capabilities to understand the cultures of both the seller and the buyer organization, and to serve as a bridge between the newly acquired entity and the new owners.

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Transition phase: (2) New sense of purpose Anxiety and resistance reduction can best be

achieved if new management communicates credible goals, demonstrating to stakeholders that the merger or the acquisition was well planned, thus reassuring them of a determination to lead the company to success.

Systematic and structured communication campaigns need to be organized.

Through meeting with managers, and employees, publications or social events, the new management can disseminate the main messages: what are the objectives, what main direction is the company going to take?

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Transition phase: (3) Operational focus Focusing the attention on concrete operational details

and performance targets have following advantages: It is likely to erase the uncertainty created by the takeover

by demonstrating that the company is back in business. One of the most powerful methods is to create integration teams. Task forces are appointed made up of personnel from the acquirer and acquired companies for each of the key operational activities (accounting, purchasing, quality, etc.) and ask the working party to discuss and propose concrete solutions to operational aspects.

Such an approach gives people a tangible sense of participation in the integration process.

It also helps to develop mutual understanding among the employees of both the buyer and seller organizations.

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Transition phase: (4) Mutual understanding and respect Cross-cultural issues are likely to arise, and especially in

cross-border mergers. The ability of the two entities to understand each other is critical for the success of any integration.

The objective at the transition phase is not so much to merge the two cultures as to create a climate of mutual understanding.

The kind of culture that will surface from the merger is contingent upon the mode of acquisition. A preservation mode will not attempt to blend the two cultures but on the contrary will keep them separate, while absorption would seek to create a common culture.

Acquirers should instill a climate of mutual understanding by studying carefully the existing practices of the acquired company, and seeking opinions from the employees before introducing change.

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Transition phase: (5) Measurement and control Discussing issues or progress in reaching goals

and objectives using facts and figures helps communication, allows a measure the improvement and reduces the risk of ‘cultural excuses’.

The cultural excuses are used in the event of difficulties or disagreements, and are based on impressionistic or stereotypical judgments.

The collection of marketing, operational and financial hard facts and figures is a necessary condition for an efficient and productive dialogue.

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Transition phase: (6) Winning spiral The search for tangible immediate performance

improvement should also be on the agenda of the transition-period management.

‘Quick wins’ are usually derived from the joint efforts of the integration teams.

Rapid performance improvements in quality, costs and market success give people a sense of achievement and enhance their confidence in the whole acquisition process.

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Transition phase: (7) Credibility Confidence is not likely to be established if the

various stakeholders do not perceive that what the new owners say, and do, is credible.

Credibility relies essentially on the quality of the people who are put in place to run the company, and the perception of their real power within the mother organization.

It is essential that managers appointed to run the acquired company work closely with the back-up of central headquarters to make sure that the acquisition is well supported by the centre, and that sufficient resources are devoted to making it work.

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Integrating the companies: The consolidation phase The consolidation phase is the one that sees

the final integration of the two companies and the definition of the respective strategic roles of the merged company. In the case of a merger, it consists of creating and

finalizing a new organizational structure in which the ex-merging firms dissolve themselves into the new design.

In the case of an acquisition, the consolidation phase consists of providing the acquired company with a strategic identity and making sure that it has a specific role in the overall regional or global strategy of the acquirer.

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