M&A: Integrating your Acquisition

The two biggest value creators in the acquisition process are strategy and integration. In spite of this, it seems like the majority of management out there still regards integration as something of a fuzzy process: a process dominated by soft skills and textbook management theory. Take it from an M&A practitioner: I have seen millions of dollars of value destroyed by poorly executed integrations.

Much of the prevailing thinking around the integration process goes that it’s driven by size; that is to say, the size of the acquisition is directly correlated to how much time and energy should go into the integration. Sure, there’s a certain logic you can fit around this. If nothing else, when you spend more on something, you’re more inclined to want it to work well. But if you’re undertaking the acquisition at all, you should want it to work well.

The thinking around size and integrations is flawed, however. There’s a fare more sophisticated way to think of integrations that focuses on extracting value from the acquired company, whatever its size. It goes back to the strategy of both the firms and how the strategy of the target firm fits with that of the acquiring firm. Integrations should be determined not by the size of the target firm’s operations but rather based on what they were purchased for.

So, let’s take the case of a transport logistics firm taking over a rival. Imagine that the two firms operate in similar geographies but the acquirer’s customer value proposition is to be the best-in-class (i.e., the best customer service, the fastest deliveries, etc.). And say that the target firm’s proposition is to be the cheapest in the business. How do you integrate it? Well, really, you don’t want to integrate it. You keep it in the company’s family but you can’t integrate it fully without damaging its business model – what made it attractive in the first place.

This is not to say that the acquisition wasn’t a good management decision. In fact, given the different models of the two firms, it could turn out to be very interesting – perhaps a way for the acquiring firm of diversifying when there’s a downturn and clients turn towards cheaper services. But the key with such acquisitions, as the chart above outlines, is to keep them separate and feed them well (i.e., provide them with good personnel and resources).

You can’t impose a new business model on the acquired firm, when its existing business model was what drove value in the deal in the first place. Why would American Airlines take over Southwest and turn it into a luxury airline service? Examples of this are everywhere. It’s most common among companies who are placed in different segments of the market (discounters and luxury) but it can be found just about everywhere the key reason for an acquisition isn’t the target firm’s resources.

Now let’s suppose that the same transport logistics firm is taking over its main rival – they’re similar in every respect, save for a few minor differences. This company has logistics warehouse facilities in cities the acquirer still hasn’t got a presence in yet (resources) as well as a much newer fleet of fuel-efficient vehicles (resources). These resources are quite easily integrated – and in fact, they should be integrated. Unlike the previous acquisition example, you don’t have to change the customer value proposition, its profit formulas or its key processes to make the integration work. You just fold it in.

This theory has been built on practice and stands up against every case study on integration that we've come across. For example, more often that not, academic case studies on integration talk about the importance of culture - that's absolutely true and follows what has just been discussed. Dividing integrations into "big" and "small" is naive practice and only serves to destroy value. By fully understanding what needs to be integrated before the process even starts, the company maximizes the opportunity to create value from the acquisition.

M&A: Determining price and structure

Pricing a company for an acquisition isn’t quite as simple as just carrying out a traditional Discounted Cash Flow analysis. Let me use a sporting analogy, which may make some sense. Sometimes a team seems to pay what is far in excess the market value for a player from another team. And onlookers says something along the lines of, “he was only worth half that.”  But if he’s the player that makes that team complete and the team goes on to win the championship, then clearly, they didn’t overpay.

It’s not entirely different when valuing an acquisition. For example, some of the prevailing thinking among companies right now is that “we will not pay more than the market price for that company.”  It’s understandable in some ways: as soon as a CEO pays over the market price for an acquisition, someone in the financial press is going to mutter “management hubris.”  But what’s important in pricing an acquisition is its value to the buyer and not the value which the market says. That is a conceptual difference where the sophisticated buyers in corporate acquisitions are making a difference.

So let’s say the market is telling a company that a firm should trade at six times it normalized EBITDA and instead, they pay seven to eight times; does it mean they’ve overpaid? Of course, we can’t rule out the possibility that they did.  But if the target company is special to them, meaning that it’s a good strategic fit (just like the seemingly overpriced player that fills the position in the sports analogy), frankly they haven’t overpaid. This is the kind of wisdom that should drive an acquiring firm’s maximum value before entering negotiations.

The market price suggested for the firm or something just below it is a good opening gambit when entering negotiations. It establishes trust between your firm and the target, in that it’s a serious offer, while still giving you flexibility to move the price upward if negotiations lead that way. Keep in mind that the maximum price you establish before negotiations constitute a limit and not a target. Another consideration is the bigger the difference between the market price and your maximum value, the more likely it is that you’ve found a really good target. It’s important to stress here that I would never advocate paying over the value of what a company is worth. What I am saying is that a company’s value essentially depends on the acquirer.

This is why the best valuations aren’t quite as simple as estimating the cash flow of the acquired firm; there are lots of specifics to each valuation: are you acquiring access to new markets which will increase the revenue for your existing products? Are there synergies present in the deal which will allow you to significantly cut back on operating costs?  Does the acquisition of the firm provide you with a patent that advance the technology your firm possesses? These are just some of the potential questions that affect the pricing of the value of the target to a firm, but each firm will be asking different questions.

Valuations are underpinned by the structure of the deal. What we’re seeing for in the market at the moment is a 60/40 breakdown of cash and equity but just as with value, this depends on the situation. The old saying, “you name the price and I’ll name the structure,” comes into play. Therefore, in addition to entering negotiations with a negotiation opening price and a ceiling price for the target, you’ve got to keep in mind what concessions you’re willing to give up for the structure: are you happy to provide promissory notes or warrants? How much equity are you willing to give up? How much debt should you take on?

What I hope I have shown here is that reaching the best possible pricing and structure of a deal is an intricate process. It’s different every time – acquiring managers are sometimes surprised at what the target firm’s management value highly and vice versa. Above all, I hope to have shown that by setting parameters for pricing and structure before entering negotiations, acquiring firms give themselves the best opportunity for maximizing the deal.

M&A: Finding Good Acquisition Targets

The acquisition process is nothing without good targets. These targets generally don’t just appear on the horizon - Management has to be proactive in searching them out and creating a long list or database. The companies in this database can come from tip-offs from people you know, small companies you heard about or just old fashioned research. But as is often the case, a pro-active approach here is far more effective than a passive one: the best acquisition opportunities often aren’t immediately obvious. And managers of potential acquisitions won’t come knocking on your door asking you to buy their company.

Some of the companies we’re in touch with keep an active database of over fifty companies that might become acquisitions at some stage. Fifty companies isn’t even that excessive a number. Keeping a list of this size is good practice for any management looking to partake in M&A: The best acquisitions are often opportunistic. But opportunistic shouldn’t be confused with catch as catch can: Preparing a long list of potential targets allows firms to be opportunistic – to be ready for good acquisitions as opportunities present themselves.

What I mean by that is that there’s no wrong time to make an acquisition. If a target firm provides a compelling answer to why the company would want to acquire it, any time there’s an opportunity to buy that target, the company should be doing everything in its power to acquire it. There just isn’t a bad time to acquire a firm which is a good strategic fit. Body Shop, a cosmetics retailer coined a phrase, “extinct is forever” and the same could be said for missing out on a target which is a good strategic fit. Once the opportunity to purchase that company has passed, the chances are, it’s not going to arise again.

“Why?”

Why is the over-riding question here. If management can’t answer this question when looking at targets, the likelihood is that it’s not a good target for the company. At some point during the search for companies or even during the negotiation process, the CEO is going to ask “why are we doing this?” In the most simplistic terms, management will know they’ve found a good company when the answer to this question is compelling – essentially, an acquisition that meets the strategic objectives of the acquiring business. The companies in your database should answer the question why for you as soon as you see their name on that list.

Once your database has reached a good size, you’ll begin to apply filters – it’s highly unlikely you’ll approach every one of those firms. These filters should be driven by an M&A framework, which I plan to discuss in a later article. The framework is driven by your firm’s strategy and how the target you’re looking at fits in with that strategy. There are broad ‘dos’ and ‘don’ts’ here, such as not betting your firm on any acquisition and avoiding acquisitions which have the potential to detrimentally affect the reputation value of your company. But the framework I will discuss addresses these issues.

Finally, I’m often approached about the statistic which says that around 70% of acquisitions fail. This is based on academic studies which have been carried out to look at the share price of acquiring firms in the days after an M&A deal has been completed. If the stock prices of the acquiring firm goes up, the deal ‘created value;’ if not, ‘value was destroyed.’ Is this really how we should be assessing the value of M&A? Of course not – it misses so much of the value which is inherent in the deal and the strategy behind it. By identifying a target that’s a good strategic fit for your firm, there’s no reason the acquisition cannot be a long-term success.