A Framework For Optimising M&A Value

In the M&A arena, who wins, who loses, and why? Any company contemplating an acquisition must familiarise itself with the simple facts that external growth in an extremely competitive marketplace, and the probability of increasing shareholder wealth via such growth, is low. Two broad types of research provide this warning. Academic studies have, typically, looked at the ex ante market reaction to the announcement of a merger, taking into account not only expected costs and benefits of the deal, but also the market's expectation that the deal will actually be consummated. The other approach is ex post, looking at the success or failure of merger programmes after their completion. The bad news for potential acquirers is that neither approach provides grounds for an optimistic forecast. Therefore, M&A programmes must be carefully conceived and executed.

Tom Copeland, Tim Koller, & Jack Murrin, Valuation

External growth through M&A is not only difficult, but rarely value-creating. Many acquisitions fail due to over-anticipated potential synergies, large premiums, different and opposing cultures, mixed and confusing goals et al. There is an acute need for a holistic analysis of the M&A process, which links strategy to the value drivers, in order to optimise the potential gains. What follows is a simple framework-call it the Value-Strategy Chain-for mapping specific strategies, or motivations for M&A, onto the value drivers that they directly impact. Moreover, since companies must be able to prioritise between available strategies, so as to be better able to spot targets, a system for determining appropriate value drivers, ranking them using industry percentiles-call it the Strategy Star-has been utilised.

• The Value-Strategy Chain framework is a simple model for identifying strategies that will improve the net gains from M&A. It links strategies to the elements of valuation, or value drivers. The implementation of these strategies will improve the performance of specific value drivers by enhancing the efficiency of the merged company. To optimise synergies in M&A, companies might have to target more than one value driver, thereby implementing overlapping strategies.
• The Strategic Star benchmarks the relative position of each of these value drivers against industry standards. This helps prioritise the value drivers that the acquisition should target.

Using these two constructs in tandem will allow the company to better understand its competitive position and improve the decision-making process. In the model used here, six broad generic value drivers, derived from the first principals of valuation, have been identified. These value drivers are, in turn, linked to certain strategic decisions that management can focus on.

Identifying The M&A value drivers

To optimise the value gain, it is obvious that the synergy should be maximised while the premium is minimised. Thus:

Value Created Through M&A = Increase In Synergy minus
Decrease In Premium

Increasing Synergy. Synergies are possible from the efficiency gains that the post-acquisition entity can tap. These gains accrue due to improvements in management, financials, operations, and risk-control, as well from a reduction in some inefficiencies. If these synergies are to be exploited, the value of the combination must exceed the sum of its parts.

Added Synergy = Value Of The Combination minus Sum Of The Parts

Just how can the value of the combination be maximised?

Value Of Combination = Discounted Cash-Flows Of Combination = (Revenues minus Costs) / Risks

Amounting as it does to the post-M&A DCFs, this value can be enhanced by either increasing the revenues of the combined company, and/or reducing costs or the volatility of earnings.

Decreasing the Premium. The other manner of increasing the net gain from M&A is to pay a lower price for the prey. The bidder should attempt to check for market imperfections in valuing the target company by indexing the price for its shares against those of the rest of the industry.

Against this backdrop, to optimise value-creation through M&A, the acquirer must identify the relevant value drivers. This approach will lead it to identify a particular class of M&A, and further to specific management strategies. This analysis will establish whether the acquirer possesses the requisite capabilities.

Optimising Revenue Gains

The value driver. Managerial synergy targets total revenue gains and can be measured by jumps in marketshare. Typically, this can be achieved through horizontal or related conglomerate mergers.

The strategy. Managerial skills are an input in the production process, much as capital and other forms of labour. These skills can range from company-specific to industry-specific to generic management. The argument for taking over another company is the belief that some of these skills and resources are transferable. Therefore, a company with strong and transferable managerial skills will be able to take over one with inefficient or bad management, and improve efficiency by replacing existing management. When M&A targets larger total revenues-and not cost-cutting-for value-creation, this motivation provides the necessary efficiency to tackle horizontal or related mergers. If such synergies exist, the marketshare of the combination will definitely be more than the sum of its parts.

The problems. Although many M&As are executed with these motives, managerial synergies often remain elusive. There are several reasons for this:
It is very difficult for companies to accurately identify their relative managerial ability. This makes it difficult for them to determine whether their skills are indeed better than those of the companies they wish to improve.
There exists very little evidence of managerial synergy since transfer of skills are difficult unless it is in the same, or a related, industry. Besides, inefficient management practices are often embedded in the culture of the target organisation and aren't easy to root out.

M&A isn't necessarily the only route for shareholders to replace inefficient managements.

Using increased marketshare as a value driver has its problems when the post-M&A company may be looking to divest overlapping, or poorly-marketed, products. In this case, although marketshares will suffer, profitability will increase. So, the acquirer must either apply the marketshare argument only to the segments it continues to occupy, or shift its focus to gauging the benefits of repairing the poor diversification strategies of the target company.

Boosting Marginal Revenue Through Financial Synergy

The value driver. An increase in revenue per unit, or the marginal price, of the company's products is possible when M&A leads the acquirer to redirect its cash to industries more attractive than the one it was in before the acquisition. Return on Investment (ROI) improves when marginal revenue rises, so long as costs and investments remain unchanged. The primary motive for these acquisitions is channelling cash from unattractive industries to more attractive industries.

The strategy. Empirical evidence suggests that in most cases of conglomerate mergers, capital expenditure is the only function that is brought under the supervision of the new management. This is probably because companies believe in their ability to induce financial synergy through M&A, which will decrease the cost of capital. This is due to a combination of two reasons:

• Cash-Flow/Investment Opportunities (Strategic Realignment). When companies feel that there are few investment opportunities, either within themselves or in the same industry, they look to redeploy their capital in a more attractive industry. This logic is similar to the bcg Product Matrix, which recommends that companies milk their cash-cows to fund the question-marks in the hope that they become stars. Thus, the company turns itself into a miniature capital market, allocating cash from low-growth areas to fields of higher return.
• Tax Savings. Tax laws distinguish between internally- and externally-generated funds, offering tax-benefits to acquiring companies. To exploit these benefits, companies might opt not to return money to shareholders and, instead, acquire other companies. Acquisition can also help utilise unused tax-credits.

The problems. Many pure conglomerate mergers can be explained by the desire to improve the rate of ROI. But several roadblocks remain:

• There is little economic logic to the belief that post-acquisition (read: larger) companies are able to borrow more cheaply. For, there is no net reduction in the risk from a situation where these companies remain separate but guarantee the debt.
• The notion that the diversified predator can generate larger returns-through increased earnings and capital appreciation-for its shareholders than non-diversified predators is a misconception. On the contrary, there is more uncertainty about the size and variability of future cash-flows as overall risk for diversified companies is higher.
• Individual shareholders are as capable of investing in attractive sectors as companies. Thus, M&A may not be the only means for creating value for them.

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