Squeezing value from mergers and acquisitions

The ASX today took a heavy hit, with all sectors (apart from gold) bleeding red. The poor showing, prompted by fears over Europe and the Australian economy, follows on from a 7.3% fall in the S&P/ASX200 index in May.

The floundering sharemarket is, in part, fuelling mergers and acquisitions. Negotiations are ongoing between the ASX and share registry Link Market Services, while commodities titan Glencore is seeking to acquire both grain company Viterra and iron miner Xstratam.

So, are mergers and acquisition a good strategy for growth during times of stock market instability?

Studies show that most acquisitions (70%) do not generate profit or value for the acquiring company, says Nigel Garrow, a lecturer in management (finance) at the Macquarie Graduate School of Management.

That leaves 30% who succeed. LeadingCompany tried to find out why.

The problems

Acquisitions create a number of managerial challenges for the acquiring company.

Kwanghui Lim, an associate professor of strategic management at the Melbourne Business School, has (along with INSEAD’s Rahul Kapoor) researched the effect of acquisition on the innovativeness of the acquired firm.

“We did that because a lot of times when you ask why companies are doing acquisitions, they’ll say it’s because they want the inventions and inventors associated with another company,” Lim says.

But when these innovative firms are bought out, they typically become less innovative. “Over time, they end up converging to level off productivity of the acquiring firm.”

Another reason why companies do not get the expected value out of their acquisitions is because they don’t think carefully about how the acquired business fits into their own.

“If you buy a firm that has very similar skill sets, that’s no good. You’re paying for very little that you don’t already have,” Lim says.

“Likewise if you buy a firm that’s very different, that’s also no good. You end up buying a firm that has knowledge that you’re going to struggle to use within your own context. It’s like adopting an alien child. It’s too hard.”

Lim gives the example of online video-calling company Skype, which in 2005 was bought by online retailer eBay for $2.6 billion. The intention was to use Skype’s video-calling facilities in eBay, so people could speak to and see the people they were buying and selling to. This didn’t make much sense, and the acquisition was a disaster. “Skype stopped innovating, and became very dysfunctional,” Lim says. Eventually, eBay sold off Skype at a loss.

Acquisitions can also destroy value by alienating the target company’s people. “When we interview managers, we share stories at a people level,” Lim says. “When you buy a firm, it doesn’t just affect things like productivity, but also intangible things like mood, sentiment, motivation.”

In the process of an acquisition, people can become alienated, and their careers can be sidelined. This can lead them to lose interest or get frustrated. “People can also feel like they’ve been sold out by management. Or they might no longer find the company is the right fit for them, given its changing culture and processes.”

The solutions

Even before anyone acquires anything, it’s easy to predict which companies are well placed to make money off acquisitions, Garrow says.

Firms who have had steady leadership and solid returns over a number of years tend to be the ones who gain shareholder value following an acquisition.

Garrow has conducted research that found that when a company has had the same chief executive and chair for five years or more, the acquisitions they conduct are far more likely to be successful.

“This boils down to their experience, their knowledge of the business, and the degree of stability in terms of strategy,” Garrow explains.

This principle repeats itself in business profitability. “Companies who do successful acquisitions tend to have good performance in the three years leading up to an acquisition. Whereas companies who make weak acquisitions tend to have a spike in performance. So you want to look at your continuity.”

Cisco shows the way

For companies that do fit those criteria, there are a number of strategies they can use to improve their chances of making money.

For one, they need to carefully plan around the process.

An example of a company that did this successfully is Cisco. From 1993, the technology communications company set itself the task of acquiring 75 other companies over the course of seven years. At their peak, these acquisitions represented 50% of Cisco’s revenue.

“The first and perhaps most important principle of a scalable and repeatable M&A is that an acquisition is not an event but a process,” writes Mike Volpi, who joined Cisco as a senior executive during this period.

The company developed and applied strategies it believed were crucial to its successful acquisition strategy. These included:

• Paying careful attention to synergies.
• Buying market leaders.
• Keeping principle objectives consistent.
• Not kidding themselves about their probability of success

Volpi writes that successful acquisitions strategies have to be developed by a company, and not just recommended by consultants and applied by management.

“Prior experience undeniably helps, but since a company – and its DNA – are highly organic, an outsider will have difficulty engaging with the various parts of the organisation. It is critical to develop a company-wide process over a series of transactions rather than relying on hired help.”

Preserving innovation, rewarding success

Lim offers some other solutions to try and preserve the innovative culture at a lot of small companies after they’re bought by a bigger one.

One of the key determinants of acquisition success is the degree to which the acquired firm is integrated.

“If you buy a firm and leave it independent, it has a better chance of doing well than if you bring it in, break it apart and assimilate it into the larger company.”

Another lesson is to make sure you know how to use and engage the knowledge of the acquired firm. This is where eBay got it wrong. Skype was eventually bought by Microsoft, a much more logical fit: the leading video-calling software is a useful addition to the dominant operating systems engineered by Microsoft.

Another strategy is simply to reward successful acquisitions, says Garrow.

He says that firms that align their corporate governance practises with their acquisitions strategy can achieve better success.

“What I tend to find is that the acquiring firm’s chief executive tends to do quite well in terms of remuneration when they make the acquisition,” Garrow says. “But there’s a good case to say the remuneration increases should be in line with post-acquisition performance.”

Companies can also reward post-acquisition success in the staff of the company they’ve acquired, says Lim.

“Don’t pay them all at once. Stagger the rewards in a way that rewards future action. You want a structure where innovative people have an incentive to continue to work hard.”

This shouldn’t just be done monetarily. Lim says the leaders of acquisition targets need to be given work that excites them, and encouragement to continue building within a new organisation. This can help slow or prevent the productivity convergence that happens when innovative firms are acquired by larger ones.

Ultimately, acquisitions can be successful, but leading companies know it takes time, effort and the appropriate structures to pull them off.

“Too many managers… think of acquisitions a magic bullet,” Lim says. “They think ‘we don’t know this market so we’ll buy a firm that does’.”

“But there’s no free lunch.”

For more on the subject

• A Cisco executive explains their winning M&A strategy
• A metastudy of the academic research