Becoming a prepared acquirer (Corporate Dealmaker)

Becoming a prepared acquirer

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Consider, if you will, the hypothetical case of a company we'll call Homeland Technologies, a rapid-growth company that competes in the government information technology services business. Founded in 1965, Homeland went public in 2000 with revenue of $500 million. Through internal growth and some small acquisitions, Homeland has successfully grown to $1 billion in revenue with respectable shareholder returns. Now, Homeland CEO Chas Ferguson is preparing to announce he intends to double revenues within three years and has asked an investment banker to bring him prospective acquisitions that will enable him meet this goal. The board has given the thumbs up for Ferguson to begin conducting due diligence on deals brought to the company.

Is there anything wrong with this familiar picture? The answer is a resounding yes. While motivated by the best of intentions, Homeland and its board are unwittingly about to join the growing ranks of what might be called "reactor" companies, that make the often fatal mistake of outsourcing their growth strategy -- specifically the merger-and-acquisition component -- to investment bankers. These companies merely react to available deals instead of identifying potentially suitable candidates through a careful strategic process. Unless it gets extraordinarily lucky, Homeland, like the vast majority of reactor companies, will likely execute one or more transactions -- major capital investments -- that destroy value for its shareholders. Indeed, it is well documented that more than half of M&A transactions actually destroy rather than create value for acquirers as these companies send clear signals to investors to sell rather than buy shares. (See sidebar, "The reactor era.") Such mistakes are most common during merger booms where inexperienced companies rapidly enter the M&A game or companies with experience look for more or larger deals and radically change their risk profiles. These unprepared companies engineer their own failures as they become part of the merger bandwagon.

The antithesis of the reactor companies is the much smaller group of truly prepared acquirers, or those I refer to as being "always on." These companies have developed a disciplined process that allows them to find good opportunities and avoid predictably poor ones, thereby enabling them to accomplish the chief objective of successful corporate development -- beating competitors and rewarding investors. To avoid becoming a casualty of merger mania, every company that seeks growth through acquisition must first look itself in the mirror to determine whether it is a reactor or an "always on" company. At a time when one bad deal can spell financial disaster for employees and investors, reactors must take a series of steps to become prepared acquirers. They must commit time and resources and undertake a series of detailed action steps, such as those outlined in this article. How companies divide responsibility among top management, the corporate development team and business unit leaders will differ, but the work required to be a prepared acquirer is the same.

1. Crucial links
Prepared acquirers apply strategic priorities and gauge the compatibility of a target's operating model. Reactive acquirers don't.
Corporate and business strategy	Strategic priorities	>	Transaction risk	<	Operating model	>	Transition risk
			Screening				Post-merger integration
			Due diligence
			Valuation
			Negotiation
Source: Mark L. Sirower

2. From reactive to prepared
Reactive	Prepared
Waiting for a sale	Shopping for value
Someone else's timing	Your timing
Competitive	Pre-emptive
Force fitting capabilities	Finding selected capabilties
Justifying synergy	Realizing synergy
Educated by the seller	Educating yourself
Inventory is what's for sale	Inventory is the market
Impulsive	Logical and rational
Source: Mark L. Sirower

Taking stock

In a nutshell, reactor companies work backwards -- from an available deal to crafting their strategic priorities -- instead of the other way around. Rather than consider on an ongoing basis the total universe of options, as do successful corporate acquirers and private equity firms, reactors tend to focus exclusively on the deal at hand. Reactors have given up their power of choice -- they don't have options. Viewed in isolation, a deal might look attractive, but compared with other potential M&A candidates, it would likely be a poor fit. This is a little like marrying the first seemingly compatible person you ever took out on a date: It could work -- but the odds are against it. And the mistake often compounds itself. Enamored with the deal in front of it, management may ignore or explain away negative information that emerges even in a thorough evaluation of the candidate. In negotiation terms, it is difficult for reactors to walk away from a deal because there is no better alternative to walk away to.

Successful corporate development requires much more than simply attempting to avoid economically unsound deals. It means the ability to spot false negatives as well as false positives. False positives are opportunities that are accepted when they should have been rejected (due-diligence failures); false negatives are opportunities that are rejected when they should have been accepted (missed opportunities). When a company reacts to a single opportunity, it implicitly has screened out a universe of other opportunities, driving up the risk of false negatives. Reactors spend all of their M&A time attempting to avoid false positives. They have great difficulty explaining to their board why they rejected other opportunities.

At reactor companies, the acquisition process typically works this way: 1) an opportunity presents itself either through a banker or some relationship outside the organization; 2) an internal "deal team" is assembled to assess the transaction (due diligence and valuation) and build a business case to support the deal and the required price; 3) the deal gets done; and 4) the company now starts to worry about how the deal should be integrated to realize the value. When results fall below expectations -- or worse -- senior management (and their bankers) blame it on faulty execution or "cultural factors." Reactors must unfortunately live through the lesson that, while a bad post-merger integration, or PMI, can indeed wreck a transaction that was strategically sound and realistically priced, a good PMI will not save a dead-on-arrival transaction that didn't make sense from the beginning.

Reactors begin looking at transactions without clear strategic priorities and work backwards into a strategy. Reactors also do not consider operating model issues -- that is, constraints that affect the ease of actually integrating a given acquisition to realize value -- in screening potentially good versus inferior opportunities. As Figure 1 illustrates, prepared companies have both these crucial links in place.

What's more, when unprepared companies trap themselves into reacting to deal pitches by Wall Streeters, they waste tremendous time and resources that could have been devoted to finding more suitable opportunities in the first place. That's because management must conduct extensive due diligence for all merger opportunities that present themselves, even though many should never have made it to the table. Careful due diligence may help avoid bad deals, but it doesn't help a company find the right ones.

Getting to 'always on'

It is no coincidence that the most successful acquirers are also the most disciplined. Before making a deal, experienced acquirers such as General Electric Co., IBM Corp., Wells Fargo & Co. and Siemens AG satisfy themselves that their strategic alternatives and acquisition opportunities have been carefully explored and their potential for creating value quantified. They understand which of their businesses should be developed organically, which should be sold and which would benefit from growth through acquisition. They are often the most credible buyers, able to pay the most, because they know what they are looking for and how they will integrate the acquired assets.

But very few companies fall into the category of GE and IBM regarding acquisition experience. For companies that want to become prepared before beginning or ramping up their acquisition strategy, they must see it as a transformation. Figure 2 shows characteristics of the change a company will undergo in this transformation.

Companies can take three steps to put this process in place: 1) aligning the top team around strategic priorities, 2) developing a master list of potential acquisitions and 3) strategic filtering and detailed profiling of a short watch list.

1. Aligning the top team on strategic priorities. Before considering any acquisition opportunity, senior management and boards of directors must agree on important strategic choices that set the direction of the businesses. These include realistic growth aspirations and the most profitable growth opportunities in light of how competition in the industry is evolving. Specifically, management must decide which customer segments -- and respective geographies -- they want to serve and how they intend to do so in ways competitors cannot easily replicate. This calls for assessing the company's competitive strengths and weaknesses as well as setting priorities for what capabilities will be required to win in their targeted segments. They must also understand investor expectations and review what they have led investors to believe. Major capital investments such as acquisitions often leave investors puzzled about what the company is trying to accomplish beyond merely getting bigger.

Most boards and management teams spend very little time discussing where they want their business to be over the long term. A common frustration among directors is that they spend too much time talking about current and recent past issues, a problem compounded by the procedural demands of the Sarbanes-Oxley legislation. These short-term issues are important, but they keep the board and management from setting a clear vision and strategy.

Without that vision, it's hard to answer the question of whether to achieve growth targets organically or through acquisition, or, most likely, a balance of the two. There is no substitute for regular discussions between the board and top management on this issue. This process helps identify the rationale for acquisitions and initial criteria for screening potential candidates. If an acquisition shows up out of the blue, then at least there will be a strategic context to decide whether it is worth any time to evaluate it. An examination of the successes and failures of past acquisitions gives an invaluable backdrop for discussing industry evolution and strategy adjustments to make for the future.

2. Developing a master list of opportunities. Casting a wide net, management should then generate a master list of acquisition opportunities in its core or adjacent industry spaces where it has decided it wants to grow and compete. The purpose is to leave no stone unturned. The goal is to know all relevant players so well that it's difficult for an outsider to bring an opportunity management has not considered.

The team that develops this list will need to use both bottom-up and top-down approaches and should be prepared for some labor-intensive information gathering. A top-down approach begins by identifying both industry and product-specific directories as well as government organizations if there is a regulatory element involved. Gathering lists of exhibitors at expos and trade shows also gives a broad view of which companies are in the marketplace. Cross-border searches often require substantial translation because not all lists will be available in English. A bottom-up approach requires a detailed understanding of the industry value chain. For example, medical information content is distributed through software providers whose software is purchased by hospitals. Finding out which medical content providers are carried by those software companies yields a list of relevant content providers. Of course, general Internet searches supplement all of this. Once all major players begin appearing on subsequent searches and few new businesses emerge, management can be confident of a solid initial list for which it will need to make strategic choices on how to proceed.

At this stage, only the most relevant information needs to be collected on these companies where possible -- size, geography, and whether public, private or subsidiary of a larger parent. As the process proceeds, more and more relevant information will be collected for those companies that remain under consideration.

3. Strategic filtering and selection of a watch list. Now, management must develop strategic filters of increasing detail to narrow the list of candidates. Executives often find this the most challenging part of the process because it involves implementing tough choices for what they need to compete and grow. Initial screens may be based on revenue and geography; subsequent deeper-dive screens might concern specific product lines, R&D and manufacturing capability, facility locations and management. Designing these filters forces executives to revisit and refine their strategic priorities. Additionally, the effort helps minimize the risk of doing the wrong deals by preventing unsuitable candidates from even being considered. Figure 3 illustrates a typical filtering process, in this case as a company competing in retail food might apply it.

Later in this screening process, as more detailed profiles have been completed on remaining candidates, the ease or difficulty of post-merger integration becomes a more important part of the discussion. Then, potential transition risks such as culture clashes, labor contracts, distribution gaps and management depth can be identified to differentiate deals and identify those opportunities most likely to realize value. It is virtually impossible to conduct a sophisticated financial analysis of synergy potential -- including probability estimates and timing of expected synergies -- without evaluating integration risks. Prepared acquirers begin these considerations during the screening process. Different transactions will have different integration issues that directly affect due diligence and valuation, and, ultimately, whether a candidate should remain under consideration.

The product of this exercise is a short "watch list" of the most promising acquisition candidates with detailed profiles of each candidate. This watch list can also be grouped by transaction strategy -- for example, a larger platform deal followed by smaller tuck-ins on the list, or just the opposite. At times, the process will require significant discussion and heated debate, but there is no substitute for guiding what the company is searching for and what is competitively meaningful. In the end, management will have a much better view of its competitive landscape and the true priorities of its businesses. As an IBM senior corporate development executive told me, "The more you look, the more you find; the more you look, the more you learn; the more you look, the more you test your strategies."

Moreover, this process will assist management in developing and communicating sensible, credible acquisition stories to the board, investors and employees. At GE, acquisition selection is done by the same division managers who will later be responsible for implementing the deal and whose compensation is linked to its performance. Since the division managers used pre-approved filters to screen for possible deals, directors are more likely to approve a deal once it reaches them. An informed board can assess whether a deal has emerged logically from an agreed-on strategy or whether it is an opportunistic event.

Reaping the benefits

When this process works properly, a banker is unlikely to ever bring management a significant transaction the company has not already considered. And management can quickly determine why a company that is available for sale is not on its watch list. This process is expensive and time-consuming; the largest companies may have dozens of people supporting it throughout the business units. But failing to use some version of this process is even more costly -- and virtually guarantees that any deals the company does will not be strategic.

Management teams that go through the process I have outlined do not have to be active acquirers. They can afford to be patient -- they have well-developed alternatives. They can negotiate with multiple parties on their watch list and seek the best values. After the stock market implosion in 2000, these companies were in an excellent position to shop for valuable deals.

Routinely revisiting this process will enable management to track what deals competitors have done and better consider the signals competitors are sending about their own growth objectives and how they intend to compete. Because they have a clear watch list of competitively important companies, management will also know those deals competitors might do or attempt to do that will, in fact, require an immediate response.

Becoming a prepared acquirer requires effort at multiple levels of an organization -- but the effort is sure to help the people working at each level meet their responsibilities more successfully. Most important, an aligned, "always on" management team is the lifeblood of a successful corporate development process, one that will give investors strong reasons to buy shares on deal announcements and will grow shareholder returns over the long run. Directors who insist that a documented strategic M&A process be in place well before any opportunities are presented to them can avoid merely being the last hurdle on the CEO's path to announcing a major transaction -- and can thereby shoulder their fiduciary duties far more credibly. The business and corporate development executives who devise and implement the M&A process can be satisfied that any deals they do will be much more likely to succeed. Shareholders, meanwhile, can be glad their company has gotten a lot smarter about how to move ahead in a competitive and fast-changing world.

The reactor era

In an interview appearing in Business Week magazine of Sept. 17, 2001, Carly Fiorina, former CEO of Hewlett-Packard Co., reflected the "reactor" mentality when she tried to explain the nearly 20% drop in the price of HP shares on Sept. 3, 2001, the day HP announced its acquisition of Compaq Computer Corp.: "You don't make this kind of move and judge its success," she said, "by the short-term stock price."

The research indicates otherwise. I examined more than 1,000 deals valued at $500 million or more announced between July 1, 1995, and Aug. 31, 2001. I first excluded those deals where the acquirer's share price could not be tracked on a major U.S. stock exchange. Then, using the rationale that a deal had to be material, I excluded those deals in which the value of the seller was less than 15% that of the acquirer. Last, deals were culled in which the acquirer announced another significant acquisition within a year. That left a sample of 302 deals for which the average acquirer market capitalization was $14.2 billion and average seller market capitalization (5 days before announcement) was $5.5 billion. The average market capitalization of sellers relative to their acquirer was nearly 50% -- so these were very significant deals.

To measure performance, I calculated total shareholder return (stock price appreciation plus dividends) to the acquirer at the announcement of the deal (one week before to one week after) and one year later. While one year may seem a short period in which to judge success or failure, the first year is critical in delivering performance promises because it signals the credibility of those promises. Moreover, research increasingly shows that initial market reactions are an accurate predictor of the acquirer's operating performance over subsequent years.

I examined not only absolute return, but also a relative total shareholder return, or RTSR, relative to both the broader market (S&P 500) and the acquirer's industry peers within the S&P 500. The key results for the sample of 302 deals using RTSR to industry peers -- very similar to the S&P 500 benchmark results -- are as follows:

1. On average, acquirers underperform their industry peers. Average returns to acquirers around deal announcement were -4.1%, with 64% of deals viewed poorly, and 36 % viewed positively by the market -- a familiar result. One year later, average returns were still -4.3%, and 61% of acquirers lagged their industry peers.

2. Initial reactions are persistent and indicative of future returns. One year later, the portfolio of deals that began poorly (-9.2%) maintained almost the same negative return (-9%). The portfolio of deals that began positively (5.7%) maintained a strong positive return (4.9%). A closer look shows that 67% of the initially negative deals were still negative and 50% of the positives were still positive a year after announcement. So while a positive start is no guarantee of future success, if companies do not deliver on promises, a negative start is very tough to reverse -- and even tougher for negative deals using stock as currency. Three out of four stock deals that were initially negative were still negative a year later.

3. Delivering results after a good start pays off big. Deals that began in the right direction -- and actually delivered -- dramatically outperform deals that begin poorly. In the year following announcement, acquirers whose deals were met initially with a negative investor reaction, and continued to be perceived negatively, posted an average return of -24.9%; whereas acquirers whose deals initially received, and continued to receive a favorable response, returned an average of 33.1% -- a difference of 58 percentage points!

4. Price matters. The average premium paid for targets across the whole sample was nearly 36% with an average premium of 38.4% paid by the initially negative group and 30.7% by the positive group. One year later, virtually the same finding was intact. Those buyers that were ahead of their peers one year after announcement (regardless of the initial reaction) paid an average premium of 31%; those buyers lagging their peers paid premiums of 39%. Most striking, the average premium paid by the persistent negative performers was 40.5% whereas the persistent positive performers paid an average premium of only 25.8%.

5. Cash deals outperform stock deals. Cash deals, while less common (12% of all deals), markedly outperformed stock swaps. At announcement, the returns relative to peers of cash deals beat all-stock deals by 4% (-1.0% versus -5%). One year later, the gap widened to 8.3%: Cash deals beat their peers by 0.3% while stock deals lagged their peers by -8.0%. This finding reaffirms the widely reported result on the underperformance of stock deals. Further, poorly received stock deals were the most persistent performers with 73% of them still negative a year later (having a -26.8% return).

6. Sellers are the biggest beneficiaries of M&A transactions. While buyers lost on average, shareholders of selling companies earned an average 20% return from the week before the deals to the week after.

7. M&A transactions create value at the macroeconomic level. That is, mergers create value for the economy. While the shareholders of buyers most often lose value, the shareholders of sellers most often gain value. In the aggregate, there is value creation of 1% at announcement when looking at the combined market cap changes of both buyer and seller. In my sample, stock deals had negative combined value creation of -0.5% while cash deals yielded a positive return of nearly 7%.

Exhibit A illustrates the general pattern of returns to acquirers during the most recent merger boom. These important findings are not accidental. Investor reactions are powerful forecasts based on previous expectations and the new information given by the company about the economic wisdom of the transaction. Acquirers that truly deliver or show evidence of their ability to honor their promises do extremely well over time; acquirers that deliver on the negative expectations do poorly.

It is interesting to note that initial market reactions of both the persistent positive and persistent negative portfolios (5.6% and -10.3%, respectively) were later discovered to have been nearly the same as the overall initial positive and negative portfolios. The subsequent performance of the persistent performers is largely a function of acquirers confirming the initial perceptions of investors. Mark Sirower

Mark L. Sirower leads the M&A strategy practice at PricewaterhouseCoopers LLP in New York. He is a visiting professor at New York University's Stern School of Business and author of "The Synergy Trap: How Companies Lose the Acquisition Game" (Free Press, 1997, 2000).

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