Article

Back to the Future: The reemergence of Strategic M&A

GE wrestled Honeywell from the arms of United Technologies in October, while AOL and Time Warner hope to seal their merger deal this month.

Di Orit Gadiesh and Charles Ormiston

First published on dicembre 15, 2000
Tempo di lettura min.


GE wrestled Honeywell from the arms of United Technologies in October, while AOL and Time Warner hope to seal their merger deal this month. Both events underscore an important shift: old-fashioned mergers and acquisitions may have surpassed "the Internet" on CEOs' agendas. Indeed, The Street.com's Internet Sector Index has fallen 35% since September and fully 59% since its peak in March. Meanwhile, the total market cap of the top ten M&A deals closed this year has already reached $650 billion, way ahead of last year's top ten completed deals of $445 billion. M&A, clearly, has resurged. Moreover, $600 billion in top 10 new deals announced so far this year include prominent plays at industry redefinition, like GE's and AOL's, showing M&A has reemerged as a master tool of strategy. The early history of M&A includes the bold creation of dominant manufacturers like US Steel, General Motors and DuPont in the early 1900s. However, its more recent history includes a corporate craze for diversification in the ’60s and ’70s, and leveraged buyouts fueled by high risk, high yield debt in the ’80s. More often than not, LBO transactions, like Kohlberg Kravis' infamous takeover of RJR Nabisco, amounted to corporate restructuring and financial engineering, or what in best cases might be called "active investing." They rarely altered the nature of competition in their industries. Shift to Strategy So what's different today? In the late ’90s we've seen both an increase in M&A and a fundamental shift in its motivation. None of the largest acquisitions announced worldwide last year—and since completed—were merely about swapping assets. All had a stated strategic rationale. Some were conceived to improve competitive positioning, as in Pfizer's takeover of pharmaceuticals competitor Warner-Lambert. Others let acquirers push into adjacent businesses. Witness cable network powerhouse Viacom's acquisition of broadcast network mainstay CBS. This has allowed Viacom to deploy CBS' assets to promote its cable offerings, and vice-versa. Still other mergers were geared to redefine a business model, for instance new media force AOL's deal with old media empire Time Warner announced January 2000. Yet, succeeding at M&A has never been easy. Several well-structured studies calculate 50%-to-75% of acquisitions actually destroy shareholder value instead of achieving cost and/or revenue benefits. There are five root causes of failure: Poor strategic rationale, or a poor understanding of the strategic levers Overpayment for the acquisition, based on overestimated value Inadequate integration planning and execution A void in executive leadership A severe cultural mismatch Of the five, getting strategic rationale right is fundamental. Being clear on the nature of strategic levers is critical both for pre- and post-merger activities. Indeed, failure to do so can trigger the four other causes of failure. The following rationale lie on a continuum from somewhat strategic to highly so. Five Key Rationale 1.Growing Scale: A first, and common, rationale is to grow scale, which does not mean simply getting big. Rather, success requires gaining scale in specific elements of your business and using these to become more competitive overall. For instance, if materials cost is a significant driver of profit, then purchasing scale will be key. If customer acquisition is more important, then channel scale will be critical. Getting scale-based initiatives right requires the correct business definition and the correct market definition. This can be tricky since, over time, the definition of scale in an industry can change dramatically. For example, the merger of Pfizer and Warner-Lambert, and pending merger of SmithKline Beecham (SKB) and Glaxo Wellcome respond to a sea-change in the economics of pharmaceuticals. For decades, pharmaceuticals were a national or regional business. Regulatory processes were unique to each geography, and barriers existed that made cross-border drug introduction difficult. Distribution and regulatory costs needed to be spread over the maximum proportion of local markets. Today, many of those barriers have diminished, while the costs per successful drug development have risen exponentially. Jan Leschly, recently retired CEO of SKB, put it directly in the June 2000 Harvard Business Review, "What really drives revenues in the drug business is R&D." R&D can and should be spread across the entire global market: leveraging R&D to more geographies, more products and more types of disease. 2.Building Adjacencies: A second strategic rationale for M&A is expansion to adjacent businesses, as in the Viacom example. This can mean expanding business to new geographies, new products, higher growth markets, or new customers. But most importantly, the additions should be highly related to your existing business. Chris Zook, in his forthcoming book Profit from the Core: Growth Strategy in an Era of Turbulence, provides empirical evidence that expanding to highly related businesses through acquisitions drove some of the most dramatic stories of sustained, profitable growth in the ’90s—Emerson, GE, Enron, Schwab and Reuters, to name a few. Travelers Insurance Group acquisition of Citicorp bank, gave the two companies a complete range of financial services products to cross-sell to their combined customers. 3.Broadening Scope: Scope is closely related to adjacency expansion, but instead of just buying a related business, you undertake serial acquisitions that substitute for a new-business-development or technology R&D function. This serial/scope acquisition model has been successfully applied to a number of industries such as computer software (e.g. Computer Associates); financial services (e.g. GE Capital); Internet hardware (e.g. Cisco) and chip manufacturing (e.g. Intel). For these firms, major, ongoing investment to scan for new product concepts or technologies is a structural part of their growth strategy. For most of these firms, organic development would be too expensive, too slow and/or dilute focus on their existing businesses. 4.Redefining Business: Fourthly, M&A can be deployed strategically to redefine a business. This is the right strategic rationale when an organization's capabilities and resources grow stale very suddenly, through, for example, a major technological change. In such cases, a firm cannot quickly refresh its technology or knowledge by making internal investments and incremental adjustments. Nortel, in this situation, transformed its business model through a series of acquisitions. Since January 1998, the company has acquired 21 businesses, including Cisco competitor Bay Networks, to refocus from supplying switches for traditional voice communication networks to supplying technology for the Internet. It deployed M&A strategically to make what CEO John Roth calls Nortel's "right angle turn." 5.Redefining Industry: Sometimes a bold, strategic acquisition can redefine an entire industry, changing the boundaries of competition and forcing business competitors to re-evaluate their business models. For example, the AOL/Time Warner merger could potentially rewrite the rules for communication and entertainment. Beyond creating new distribution channels for content, and new content for the Internet, the merger could allow the new company to choose to take profit in either content or distribution, depending on customers' preferences. No other traditional content or distribution competitors have this choice. Similarly, several analysts believe GE's acquisition of Honeywell will fundamentally alter relationships in the aircraft industry, between operators, maintenance providers, leasing companies, manufacturers, and parts suppliers. In the words of an analyst, anonymously quoted in The New York Times: "I think GE just bought Boeing, and Boeing doesn't know it yet." Foundation for Success A clear, strategic rationale for an acquisition is critical, but not enough to guarantee a successful deal and merger integration. The rationale helps to identify the right target and set boundaries for negotiations, but the hard work remains of bringing two companies together effectively. Nonetheless, the "why" informs the "how." The right strategic rationale will inform preparation and valuation of the merger, and the leadership and communication style to adopt and plan for the post-merger integration, including cultural integration. In short it will be your master tool for capturing the value that spurred your acquisition. Bain Book Profit from the Core Learn more about how companies can return to growth in turbulent times.

GE wrestled Honeywell from the arms of United Technologies in October, while AOL and Time Warner hope to seal their merger deal this month. Both events underscore an important shift: old-fashioned mergers and acquisitions may have surpassed "the Internet" on CEOs' agendas.

Indeed, The Street.com's Internet Sector Index has fallen 35% since September and fully 59% since its peak in March. Meanwhile, the total market cap of the top ten M&A deals closed this year has already reached $650 billion, way ahead of last year's top ten completed deals of $445 billion. M&A, clearly, has resurged. Moreover, $600 billion in top 10 new deals announced so far this year include prominent plays at industry redefinition, like GE's and AOL's, showing M&A has reemerged as a master tool of strategy.

The early history of M&A includes the bold creation of dominant manufacturers like US Steel, General Motors and DuPont in the early 1900s. However, its more recent history includes a corporate craze for diversification in the ’60s and ’70s, and leveraged buyouts fueled by high risk, high yield debt in the ’80s. More often than not, LBO transactions, like Kohlberg Kravis' infamous takeover of RJR Nabisco, amounted to corporate restructuring and financial engineering, or what in best cases might be called "active investing." They rarely altered the nature of competition in their industries.

Shift to Strategy

So what's different today? In the late ’90s we've seen both an increase in M&A and a fundamental shift in its motivation. None of the largest acquisitions announced worldwide last year—and since completed—were merely about swapping assets. All had a stated strategic rationale. Some were conceived to improve competitive positioning, as in Pfizer's takeover of pharmaceuticals competitor Warner-Lambert. Others let acquirers push into adjacent businesses. Witness cable network powerhouse Viacom's acquisition of broadcast network mainstay CBS. This has allowed Viacom to deploy CBS' assets to promote its cable offerings, and vice-versa. Still other mergers were geared to redefine a business model, for instance new media force AOL's deal with old media empire Time Warner announced January 2000.

Yet, succeeding at M&A has never been easy. Several well-structured studies calculate 50%-to-75% of acquisitions actually destroy shareholder value instead of achieving cost and/or revenue benefits. There are five root causes of failure:

Poor strategic rationale, or a poor understanding of the strategic levers
Overpayment for the acquisition, based on overestimated value
Inadequate integration planning and execution
A void in executive leadership
A severe cultural mismatch

Of the five, getting strategic rationale right is fundamental. Being clear on the nature of strategic levers is critical both for pre- and post-merger activities. Indeed, failure to do so can trigger the four other causes of failure. The following rationale lie on a continuum from somewhat strategic to highly so.

Five Key Rationale

1.Growing Scale: A first, and common, rationale is to grow scale, which does not mean simply getting big. Rather, success requires gaining scale in specific elements of your business and using these to become more competitive overall. For instance, if materials cost is a significant driver of profit, then purchasing scale will be key. If customer acquisition is more important, then channel scale will be critical. Getting scale-based initiatives right requires the correct business definition and the correct market definition. This can be tricky since, over time, the definition of scale in an industry can change dramatically.

For example, the merger of Pfizer and Warner-Lambert, and pending merger of SmithKline Beecham (SKB) and Glaxo Wellcome respond to a sea-change in the economics of pharmaceuticals. For decades, pharmaceuticals were a national or regional business. Regulatory processes were unique to each geography, and barriers existed that made cross-border drug introduction difficult. Distribution and regulatory costs needed to be spread over the maximum proportion of local markets. Today, many of those barriers have diminished, while the costs per successful drug development have risen exponentially. Jan Leschly, recently retired CEO of SKB, put it directly in the June 2000 Harvard Business Review, "What really drives revenues in the drug business is R&D." R&D can and should be spread across the entire global market: leveraging R&D to more geographies, more products and more types of disease.

2.Building Adjacencies: A second strategic rationale for M&A is expansion to adjacent businesses, as in the Viacom example. This can mean expanding business to new geographies, new products, higher growth markets, or new customers. But most importantly, the additions should be highly related to your existing business. Chris Zook, in his forthcoming book Profit from the Core: Growth Strategy in an Era of Turbulence, provides empirical evidence that expanding to highly related businesses through acquisitions drove some of the most dramatic stories of sustained, profitable growth in the ’90s—Emerson, GE, Enron, Schwab and Reuters, to name a few. Travelers Insurance Group acquisition of Citicorp bank, gave the two companies a complete range of financial services products to cross-sell to their combined customers.

3.Broadening Scope: Scope is closely related to adjacency expansion, but instead of just buying a related business, you undertake serial acquisitions that substitute for a new-business-development or technology R&D function. This serial/scope acquisition model has been successfully applied to a number of industries such as computer software (e.g. Computer Associates); financial services (e.g. GE Capital); Internet hardware (e.g. Cisco) and chip manufacturing (e.g. Intel). For these firms, major, ongoing investment to scan for new product concepts or technologies is a structural part of their growth strategy. For most of these firms, organic development would be too expensive, too slow and/or dilute focus on their existing businesses.

4.Redefining Business: Fourthly, M&A can be deployed strategically to redefine a business. This is the right strategic rationale when an organization's capabilities and resources grow stale very suddenly, through, for example, a major technological change. In such cases, a firm cannot quickly refresh its technology or knowledge by making internal investments and incremental adjustments. Nortel, in this situation, transformed its business model through a series of acquisitions. Since January 1998, the company has acquired 21 businesses, including Cisco competitor Bay Networks, to refocus from supplying switches for traditional voice communication networks to supplying technology for the Internet. It deployed M&A strategically to make what CEO John Roth calls Nortel's "right angle turn."

5.Redefining Industry: Sometimes a bold, strategic acquisition can redefine an entire industry, changing the boundaries of competition and forcing business competitors to re-evaluate their business models. For example, the AOL/Time Warner merger could potentially rewrite the rules for communication and entertainment. Beyond creating new distribution channels for content, and new content for the Internet, the merger could allow the new company to choose to take profit in either content or distribution, depending on customers' preferences. No other traditional content or distribution competitors have this choice. Similarly, several analysts believe GE's acquisition of Honeywell will fundamentally alter relationships in the aircraft industry, between operators, maintenance providers, leasing companies, manufacturers, and parts suppliers. In the words of an analyst, anonymously quoted in The New York Times: "I think GE just bought Boeing, and Boeing doesn't know it yet."

Foundation for Success
A clear, strategic rationale for an acquisition is critical, but not enough to guarantee a successful deal and merger integration. The rationale helps to identify the right target and set boundaries for negotiations, but the hard work remains of bringing two companies together effectively. Nonetheless, the "why" informs the "how." The right strategic rationale will inform preparation and valuation of the merger, and the leadership and communication style to adopt and plan for the post-merger integration, including cultural integration. In short it will be your master tool for capturing the value that spurred your acquisition.