Though some view large-scale acquisitions primarily as the province of adventurous conglomerates, in fact many old-line conservative giants are actively involved in such activities. General Electric, for instance, paid $2 billion in stock for Utah International, Exxon paid $1.2 billion in cash for Reliance Electric, and Allied Chemical and Kennecott Copper each paid more than $500 million for their respective acquisitions of Eltra and Carborundum.
When such corporate acquisitions succeed, it is often because the acquirers have a mechanism for identifying candidates that offer the greatest potential for creating value for the company’s shareholders. In a previous article, we pointed out that value is created when diversifying acquisitions lead to a free cash flow for the combined company (1) that is greater than could be realized from a portfolio investment in the two companies or (2) whose variability is smaller than it would be with a portfolio investment in the two companies.1
Effective systems for identifying and screening acquisitions have four important properties. First, they must provide means of evaluating a candidate’s potential for creating value for the acquirer’s shareholders. Second, they must be able to reflect the special needs of each company using the system. Relying on checklists or priorities with supposed universal applicability is the surest possible way of placing an entire acquisition program in jeopardy. Third, they must be easy to use—but not overly rigid. Since most structured frameworks of analysis run the risk of promoting mechanical solutions to complicated policy issues, formal screening and evaluation procedures must not be allowed to crowd out more informal, spontaneous contributions to the decision-making process.
Fourth, and perhaps most important, an effective acquisition screening system must serve as a mechanism for communicating corporate goals and personal knowledge among the parties involved. The analytic concepts and language inherent in such a system can significantly aid managers in implementing an acquisition program that is conceptually sound, internally consistent, and economically justifiable.
This article will focus on guidelines for screening acquisitions that diversify the acquirer’s operations. Our interest in such acquisitions is prompted by two considerations:
First, in today’s low-growth yet volatile environment, most companies with high-growth goals or an imbalanced portfolio of businesses find diversification necessary. Only a few companies have both the organizational and the technological traits for successful diversification through internal development, so acquisition becomes the only alternative.
Second, large companies seeking expansion opportunities often find significant antitrust barriers in their pursuit of those acquisition candidates that make the greatest strategic and business sense. These high-potential acquisitions are companies closely related to existing businesses. However, the company that reaches for the benefits of scale economies, production efficiencies, or market rationalizations will, in many cases, run afoul of antitrust legislation.
Related acquisitions that might be called “supplementary” involve entry into new product markets where a company can use its existing functional skills or resources. Such acquisitions are typically most valuable to companies with a strong competitive position and a desire to extend their corporate competence to new areas of opportunity. The base on which this form of diversifying acquisition is built can either be a proprietary functional skill, as is the case for many of the major pharmaceutical and chemical companies, or a more general corporate capability, such as Gillette showed in disposable consumer products or United Technologies in capital goods.
Related acquisitions that are “complementary” rather than supplementary involve adding functional skills or resources to the company’s existing distinctive competence while leaving its product-market commitment relatively unchanged. This type of acquisition is most valuable to companies in attractive industries whose competitive or strategic position could be strengthened by changing (or adding to) their value-added position in the commercial chain.
A classic example would be an original-equipment automotive parts manufacturer expanding into the distribution of replacement parts to secure a more stable, controllable market. Such a strategy often leads to a form of vertical integration as these new functional skills and/or resources are more closely linked to the diversifying company’s core businesses. The acquisitions of American Television and Communications by Time, Inc. or Cardiac Pacemakers by Eli Lilly represent this complementary type of strategy.
Unrelated acquisitions involve entry into businesses with product markets or key success factors unrelated to existing corporate activities. These unrelated businesses can be managed either actively or passively. In active management, the corporate office becomes heavily involved in evaluating the new division’s objectives and in establishing a highly competitive internal market for capital funds. Conglomerates such as Teledyne, Gulf & Western, and International Telephone and Telegraph typify companies pursuing this approach. In passive management, corporate headquarters usually limits its involvement to investment reviews, but there may be a centralized financing or banking function. The recent U.S. acquisitions by Thomas Tilling, Thyssen, and the Flick Group are all examples of this strategy. Diversified U.S. companies like U.S. Industries, IU International, and Alco Standard have historically followed this strategy, though recent economic events have forced the corporate office in each of these instances to take a more active management role.
The choice of a particular acquisition strategy largely depends on identifying the route that best uses the company’s existing asset base and special resources. When a company can export (or import) surplus functional skills and resources relevant to its industrial or commercial setting, it should consider related acquisitions as an attractive strategic option. On the other hand, a company that has a special capacity to (1) analyze the strategies and financial requirements of a wide range of businesses, (2) tolerate—and even encourage—a lack of uniformity in the organization’s structure, and (3) transfer surplus financial resources and general management skills among subsidiaries when necessary can exploit the potential benefits of unrelated acquisitions.
The decision to pursue a specific type of diversifying acquisition provides the context for drawing up precise guidelines. While every acquisition-minded company should undertake an audit of corporate strengths and weaknesses as well as an analysis of its risk-return profile and cash flow characteristics, the process of developing acquisition guidelines for related diversification should differ in focus and in content from what is used for unrelated diversification.
The most significant shareholder benefits from related acquisitions accrue when the special skills and industry knowledge of one merger partner can help improve the competitive position of the other. It is worth stressing again that not only must these special skills and resources exist in one of the two partners but they must also be transferable to the other. Thus, acquisition guidelines would describe those companies with functional skills and resources that would either add to or benefit from the company’s resource package.
Lest such identification appear too obvious or elementary, consider the dilemma that Ciba-Geigy Corporation faced in its 1974 acquisition of Airwick Industries. Ciba-Geigy’s products were almost entirely specialty chemicals and pharmaceuticals. Its corporate objectives were to continue to improve its long-term profits through new products derived from its extensive research program and from acquisitions in related fields. An attractive acquisition, according to Ciba-Geigy’s acquisition task force, should:
- Participate in growing markets.
- Have a proprietary position in its markets.
- Have operations likely to be favorably affected by Ciba-Geigy’s know-how in both research and development and the manufacture and marketing of complex synthetic organic chemicals.
- Be product rather than service oriented.
- Have sales of $50 million or more.
- Earn a good gross profit margin on sales.
- Have the potential for a return on investment of 10% or more.
- Be involved in such activities as specialty chemicals; proprietary pharmaceuticals; cosmetic and toiletry products; animal health products; proprietary household and garden products; medical supplies; products and services related to air, liquid, and solid waste treatment; or photochemicals and related products.
The search—a model of intelligent acquisition behavior—involved reviewing more than 18,000 companies in-house, along with an outside computer review. In addition, the company circulated the acquisition criteria among commercial and investment banking firms for their suggestions, and the task force worked with the company’s divisions to identify attractive candidates. All told, about 100 companies came through this screen and were scrutinized more closely. Among these was Airwick Industries.
Airwick had 1973 sales of $33.5 million, net earnings of $2.7 million, and a return on shareholders’ investment of 22.5%. The company’s principal products were air fresheners and a full line of sanitary maintenance items (such as disinfectants, cleansers, insecticides with odor-counteracting features, and some swimming pool products). Over the previous five years, the rapidly growing air freshener market had become extremely competitive. Bristol-Myers, American Home Products, and S.C. Johnson had all entered the market. While Airwick’s financial performance had been good, it was clearly facing financial pressures in meeting the marketing onslaught of these major consumer products companies.
After several weeks of extensive interviews and analysis, Ciba-Geigy’s task force concluded that Airwick was a sound company that had numerous potential synergies with Ciba-Geigy. The task force reported that acquisition of Airwick would be an attractive way of entering the household products business, if Ciba-Geigy had a strategic interest in this area. The tentativeness of this conclusion suggests that the acquisition guidelines failed to provide sufficient criteria for a final choice of the acquisition candidate.
Related diversification requires that new businesses or activities have a coherence or “fit” with the existing businesses of the acquirer. Achieving this fit involves exploring a range of possible choices. A quick review of Ciba-Geigy’s eight acquisition guidelines finds only two that express any notion of strategic fit (third and fourth). The company’s distinctive skills lay in its sophisticated research in organic chemicals and its technologically advanced production skills. Relative to many other companies, Ciba-Geigy did not require nor perhaps encourage an advanced marketing program.
If Ciba-Geigy’s objectives were to build on these skills and talents a strategy of related-supplementary diversification, attractive acquisition candidates would have similar critical success variables. Specifically, such businesses would:
1. Require high levels of chemically based research and development skills.
2. Manufacture products by chemical processes requiring a high degree of engineering or technical know-how.
3. Sell principal products on technically based performance specifications.
4. Not require heavy advertising or expensive distribution systems that would take resources away from the maintenance of distinctive R&D and manufacturing capabilities.
Ciba-Geigy would have steered away from businesses that were either marketing intensive or involved in the production of commodity chemicals, including many of those businesses it had targeted.
Alternatively, if Ciba-Geigy had wished to add important skills and resources in new functional activities—a related-complementary diversification strategy—attractive acquisition candidates would have experience in large-scale manufacturing, marketing, and distribution of chemically based products. They would be businesses:
1. Whose resource inputs could include Ciba-Geigy’s specialty chemicals.
2. Whose success depends highly on chemical usage or application.
3. Whose production and/or distribution involve chemically based products.
4. Whose key success factor is marketing oriented. This may include, but is not limited to, companies with extensive distribution systems, well-known brand names, and/or a tradition of customer acceptance.
These quite different sets of acquisition guidelines, though both seeking related diversification, help explain the task force’s dilemma with Airwick. Lacking precise diversification objectives and acquisition guidelines, the task force analyzed Airwick according to related-supplementary criteria, which required skills similar to those of Ciba-Geigy. However, Airwick’s key success factors were quite different from Ciba-Geigy’s, and Ciba-Geigy’s functional strengths were largely irrelevant to Airwick’s future. Naturally, the task force felt the need to hedge its recommendations until it had more meaningful acquisition guidelines for marketing-oriented companies.
The lesson of this case is simple but fundamental. Companies pursuing a strategy of growth into related fields must decide whether to expand existing skills and resources into new product markets or whether to add new functional skills and resources.
The principal benefits for companies pursuing unrelated acquisitions stem from improved corporate management of working capital, resource allocation, or capital financing and lead to a cash flow for the combined company that is either larger or less risky than its component parts. A company pursuing unrelated acquisitions can therefore usefully focus its acquisition criteria on the size and riskiness of a business’s cash flow and the compatibility of this cash flow pattern with its own cash flow profile. Once again, lest this appear too obvious, consider the uncertainty faced by General Cinema Corporation.
General Cinema, the nation’s largest operator of multiple-auditorium theater complexes and largest soft drink bottler, has compiled an enviable financial record. Both return on equity and earnings growth have exceeded 20% for the last decade. By the mid-1970s, the company had reduced the large amount of debt it had incurred while actively acquiring soft drink bottlers. It then began an acquisition search for a “third leg of the stool.”
General Cinema’s acquisition guidelines indicated a preference for well-run small to medium-sized companies ($5 million to $20 million in pretax earnings) whose consumer- or leisure-oriented products had unique characteristics that protected them against competition. Senior managers spoke of using the company’s competence in any new acquisition. All this suggests some very general related-diversification strategy.
General Cinema’s actions suggest, however, that this strategy was not followed. Its soft drink bottling business is not closely related to the multiple-auditorium theater business in either a product-market or a functional skill sense, nor were several of its previous diversification attempts, which involved bowling alleys, FM radio stations, and furniture retailing.
Thus, in General Cinema’s case, the difference between the company’s espoused theory of diversification and its actual behavior is clear. Assuming, therefore, it had a realistic interest in unrelated diversification, what additional acquisition guidelines could usefully structure General Cinema’s search for an attractive unrelated acquisition candidate?
Turning first to General Cinema’s risk profile, one finds a high level of risk at the corporate level (its stock had a beta in excess of 1.8) but relatively low levels of risk at the operating subsidiary level. This divergence in risk levels was due to management’s policy of aggressive financial leverage with a debt-to-equity ratio (including capitalized leases) exceeding 3 to 1. By incurring high levels of financial leverage to increase its risk level, rather than assuming either operating or competitive risk, General Cinema was creating value for its shareholders.
A cash flow analysis of General Cinema’s product-market portfolio reinforces these conclusions. All of General Cinema’s divisions were classic cash cows—the largest competitors in mature, low-growth industries. In addition, the competitive positions of both the theater and bottling divisions were especially strong due to the franchise nature of both markets. Since both movie theaters and bottling operations are capital-intensive businesses, their cash flows, relative to many industries, were high. General Cinema’s cash flow strength was likely to increase as continued growth in revenues and financial leverage interacted to generate an increasing surplus of cash funds.
In short, General Cinema showed many of the characteristics of a well-managed, unrelated diversifier. In fact, the distinctive competence General Cinema’s senior managers often referred to consisted of well-developed planning and control skills in the corporate office, a key success variable for many such companies. Thus, additional acquisition guidelines for General Cinema, reflecting an unrelated-active strategy, could be as follows:
1. The acquisition candidate should be asset intensive. The assets could either be fixed, such as buildings and equipment, or intangible, such as trademarks, franchises, or goodwill. In either case, they should be well established with significant ongoing value in order to be “bankable.”
2. Since high levels of debt would be used, the acquisition’s assets should create high barriers to entry. This implies products relatively immune to technological obsolescence or markets not exposed to significant levels of internal competition or external pressure.
3. Since General Cinema’s surplus cash flow is increasing, an attractive acquisition should have significant growth potential over an extended period of time.
4. The acquisition candidate may have a low pretax return on invested capital (say 16%). However, total invested capital (debt, leases, and equity) should be at least three times the equity investment. Reflecting this (potential) leverage, the pretax return on equity should be high (at least 30%).
5. The requirements for relative immunity to market change and a high growth rate imply that the acquisition would be service oriented rather than technology based.
6. For senior managers to feel comfortable with the acquisition, they should market or distribute products or services to the consuming public.
7. Since General Cinema lacks surplus general managers, the acquisition should have good operating managers. Successful integration into General Cinema requires that the acquisition be adaptable to intensive planning and financial controls.
Most of the guidelines are as applicable to companies managing unrelated acquisitions passively as to companies operating actively. However, the criteria requiring integration into an intensive planning and financial control system and a corporate-managed resource allocation process embody those elements found in most actively managed portfolios of unrelated businesses.
The Ciba-Geigy and General Cinema cases clearly show how closely tied acquisition guidelines should be to overall corporate strategy. Effective acquisition guidelines must reflect carefully thought-out corporate objectives. In situations where the objectives (and especially diversification objectives) lack specificity or relevance, acquisition guidelines will be vague and have limited use in structuring a process for productive acquisition search and screening.
Screening the Candidates
Once an acquisition-minded company has established detailed and comprehensive guidelines, it can develop its own system for identifying promising candidates. This screening system should identify candidates with the greatest potential of creating value for the acquiring company’s shareholders.
As we said earlier, economic value is created only when diversifying acquisitions lead to a free cash flow for the combined company (1) that is greater than could be realized from a portfolio investment in the two companies or (2) whose variability is smaller than would occur from a portfolio investment in the two companies.
We have identified eight principal ways in which one or both of these conditions can be met through diversifying acquisitions as well as several additional ways that are not, strictly speaking, due to diversification.2 Each involves the way in which the two companies’ resource structures can be successfully integrated to form a more efficient business unit.
The following list briefly outlines those economic, strategic, and managerial variables that have the greatest potential impact on value creation. These variables can be divided into two broad categories—those dealing with the candidate’s risk-return profile and those dealing with the candidate’s integration potential.
Return characteristics principally concern the size and timing of an acquisition’s prospective cash flows. While such characteristics are often thought of as company specific, many industries show readily identifiable cash flow patterns over their business cycles and/or their life cycles:
Size and period of cash flow.
These variables focus on the pattern of free cash flows into and out of the acquisition over time. Generally, a period of investment (negative cash flow) during industry growth is followed by a period of return (positive cash flow) during maturity. A specific acquisition’s cash flow pattern will reflect its capital intensity, profitability, growth rate, and stage of maturity.
Noncapitalized strategic investments.
These are investments in assets that are not reflected on the company’s balance sheet but are nevertheless important to its competitive success. Such assets as R&D skills, production technology, and market power (through advertising or distribution presence) are typically highly illiquid but are often the most effective competitive weapons and market entry barriers a company has.
Returns due to unique characteristics.
Returns from the intangible assets developed through “strategic expenses” are often high, since along with specialized management skills they usually represent a company’s distinctive competence. Alternatively, high returns may reflect entrepreneurial talents or access to one-of-a-kind sources of supply. Care should be given to distinguishing between company characteristics that can be developed and unique characteristics such as entrepreneurial talent, government franchises, or access to low-cost natural resources.
Liquidity primarily depends on the marketability of the investment’s underlying assets. Generally, the less risky an asset and the higher its collateral value, the easier it is to convert into cash. Highly liquid assets seldom provide distinct competitive advantages, however, or yield high rates of return.
Every return (or cash flow) has some level of risk; normally, the greater the potential returns, the greater the risks. A critical part of management’s job is to control these risks so that the risk-return tradeoff becomes more attractive than otherwise.
Vulnerability to exogenous changes in supply or demand.
These risks arise from exposure to changes outside the company’s control or, alternatively, the inability of managers to influence their business environment. The risks faced by a company depend on how critical a specific environmental factor is to the company, how readily available substitutes are, and how specialized the company’s internal resources are. The greater the company’s ability to lay off or pass on these environmental risks in the marketplace, the more stable its cash flow and the lower its risk.
Ease of market entry and exit.
Generally, the easier market entry or exit is, the more likely it is that industry rates of return will be driven toward normal or risk-adjusted levels. Entry-exit barriers can include capital requirements, specialized skills and resources, market presence, and government licenses or permits. Michael E. Porter described how knowledge about and use of entry and exit barriers can be critical in corporate strategy and competitive rivalry.3
Excess productive capacity.
The risk of excess capacity is directly linked to market growth and the nature of capital investment to meet that growth. If it is most efficient to add new productive capacity in large increments of fixed investment (with corresponding sunk costs) and if these assets are long-lived (or with similar technological efficiencies), significant incentives to maintain volume through price cutting will exist whenever one competitor’s relative demand falls off. Where market demand is relatively price inelastic, everyone in the industry will suffer revenue losses and reduced profitability.
Gross margin stability.
This is closely related to production capacity risks and the ease of market entry and exit. Gross margins are good indicators of profitability and the availability of cash flow to support the development of more competitive technological, marketing, or administrative systems. The stability of gross margins also indicates the relative attractiveness of increasing operating leverage by substituting capital investment (with its fixed costs) for variable costs in the production process.
This depends on market share position, vulnerability to external forces in the marketplace, and position vis-à-vis suppliers and purchasers. Substantial evidence shows that in many industries companies with high market share have higher cash flows and higher returns on investment than those with low market share. If, however, a high market share position requires large investments in relatively specialized assets (fixed or intangible), these companies may also be highly vulnerable to major changes in the marketplace. Such external market risks include technological obsolescence, swift changes in consumption patterns, and new distribution or marketing systems accompanying changing demographics or technology. Finally, shifts in the bargaining strengths, or competitive positions, of suppliers or purchasers may substantially alter the costs or benefits of internal market share positions.
The increasing legislation concerning social issues and the public welfare has altered the costs and rates of returns of many companies. Driving forces behind this legislation include environmental concerns, consumer protectionism, and employee safety and benefits.
Many companies have discovered that political and environmental risks may be significantly greater than the strategic, competitive, or technological risks faced in day-to-day business. The Mideast crisis and the continued turbulence in much of the Third World are only the most obvious instances. Unstable economic and monetary policy in the United States and trade policy in Japan are other, equally important, facets. Failure to assess and manage these risks correctly may render an otherwise successful corporate strategy irrelevant.
Each of these risk measures reflects one particular aspect of an asset’s or a company’s risk profile. How managers handle these risks as well as the inherent economic characteristics of the asset can be summarized through the following two capital market risk measures:
- Financial risk. This refers to the burden of fixed contractual payments incurred to own an asset. The greater this fixed burden (usually through debt or lease payments), the greater the financial risk. Skilled managers often use financial risk as an integral part of corporate strategy.
- Systematic and unsystematic risk. These measure the volatility (or the riskiness) of the returns of an asset or a business relative to the returns of all other assets in the marketplace. Systematic or market-related risk, which is most relevant to equity investors because it directly influences market value, reflects a company’s inherent cash flow volatility and financial risk relative to the volatility of the economy in general. Unsystematic risk measures the risk specific to a particular company or asset. It can be reduced or eliminated by investors through portfolio diversification.
The second set of criteria a diversifying company should consider in developing its screening program concerns the acquisition’s potential for successful integration. Such criteria are often much more important for a related diversifier than for an unrelated diversifier. In fact, a related diversifier may well focus most of its efforts in this area, since its corporate strategy and business commitments will render many risk-return criteria meaningless. Nevertheless, issues of organizational compatibility and the availability of general management skills are critical to the success of all diversifying companies:
Supplementary skills and resources.
These criteria principally reflect a related-supplementary diversification strategy. Consequently, they focus on a company’s ability to transfer and effectively use the skills and resources of one partner to the competitive advantage of the other. Generally, the potential benefits of this type of merger increase as the shared skills and resources constitute an increasingly larger element in the cost of doing business.
Complementary skills and resources.
These criteria reflect a related-complementary diversification strategy. They focus on improving the competitive position of the business by adding new functional skills and resources to the existing resource base.
Financial fit-risk pooling benefits.
These criteria are more important in unrelated than in related diversification. They focus on developing an internal capital market that is more efficient than the external capital marketplace. These benefits can arise out of improved working capital (cash) management, improved investment management (cross-subsidization), improved resource allocation, or more aggressive financial leverage.
Availability of general management skills.
Talented general managers are essential whenever value creation depends on the revitalization of underused assets. A surplus of general management resources in either partner must always be considered an extremely positive feature.
As any experienced diversifier will know, this is a critical issue. All of the previous criteria identify the potential for value creation, which can be realized only by an organization that can effectively exploit this potential and thereby create a more competitive enterprise.
Meeting Individual Corporate Needs
An acquisition screening system should reflect a company’s specific objectives. For example, a currently cash-rich company expecting to face substantial capital investment demands in five years might articulate its size and period of investment criteria as: “The most favorable investment pattern (purchase price plus subsequent infusion of funds into the acquisition) is a maximum of $100 million over the next three-year period. The acquired company should become financially self-sufficient by the end of the third year and generate surplus cash flow by the fifth year.”
By composing such statements, a company can tailor generic guidelines often found in acquisition screening grids to its own unique needs. Where guidelines or screening criteria are complex or especially important to the acquiring company, any particular measure may require more than one statement. Similarly, the desired characteristics of industries and companies may be expressed in either positive or negative terms depending on the acquiring company’s resources and objectives.
Developing these criteria should involve all members of the group or task force responsible for formulating and implementing the acquisition program. Each should generate descriptive statements based on his or her understanding of the company’s objectives and needs. Subsequent discussions among these persons can then lead to a single set of generally accepted and explicit screening criteria.
Once formal statements or criteria have been developed, it is sometimes useful to establish weightings or scoring ranges for each measure. These scoring ranges will reflect the importance of each item to the acquiring company.4 Specific designation of the value of each measure forces managers to discuss the entire acquisition in terms of corporate objectives, resources, and skills.
Such a discussion also ensures internal consistency of the program. Wide discrepancies may signal that managers differ in their perceptions of the company’s objectives, strategy, or distinctive competence or, alternatively, that they have either overlooked or understood only implicitly key elements in the diversification strategy.
As the acquisition task force screens industries, industry subgroups, and individual companies, the process will typically be iterative, reducing the potential acquisition universe to a smaller and smaller size. Industry subgroups (companies sharing the same key success factor or similar products and/or markets) will replace industries, and companies will replace industry subgroups until a limited set of candidates exists.
At each step in the screening process, the managers involved should individually evaluate the potential candidates and then meet to analyze their evaluations and discuss any major differences. Managers should ask: Do the results make intuitive sense? Why is there such a wide (or narrow) spread in the point scores? Has some critical element been overlooked?
As the screening process develops, company strategists should modify both the explicit screening criteria and their scoring ranges as new information about the potential acquisition and/or the environment emerge. Some diversifiers may also be useful to make the statements more detailed as the screening process narrows attention to fewer candidates or to eliminate certain criteria altogether. Generally, the need to revise statements will be less for related diversifiers than for unrelated diversifiers, since the former typically have a smaller universe of candidates to choose from. Clear communication of objectives and differences of opinion is particularly important since, once an acquisition decision has been made, a company can reverse itself only with very high financial and organizational costs.
This procedure should stimulate the flow of information and judgments among those responsible for the acquisition program and lead to a questioning of assumptions, provide a critical analysis of differences of opinion, and improve the consistency between corporate objectives and resources. Just as the capital budget or the operating budget can be used as a communications tool, so too can the acquisition screening grid serve an important communications function.
Potential for Value Creation
The last step in the screening process is determination of the candidate’s potential for value creation for the shareholders of the acquiring company. This potential should then be compared to the cost of the acquisition as well as to the company’s other investment opportunities (including the repurchase of its own stock).
In many ways, this procedure is similar to capital budgeting exercises that use the notion of net present value or discounted cash flow, but the analysis of a potential acquisition is significantly more complex than most capital budgeting decisions. Whereas the typical investment project involves assets with risks reasonably similar to those already in the company’s portfolio and under the control of familiar managers, this is not the case with many acquisition candidates. Not only may the acquired asset’s risks be different but the managers of an acquired company are often of unknown quality. Even where some familiarity exists, the managers’ attitudes and motivation can change radically after the acquisition is consummated.
Another significant difference between an acquisition and the typical investment project is that the capital marketplace acts as a pricing mechanism to equate the value of a company with its risk-return characteristics. A lucky acquirer may well find a bargain or, more precisely, a company whose intrinsic value is greater than its market value plus the transaction costs necessary to acquire it.
Much more likely, however, is the case where an acquisition candidate is not undervalued relative to its existing level of cash flow and risk but rather is underusing its asset base. In this case, the acquirer will have to make extensive changes in the acquired company’s management and/or use of assets for the acquisition to be economically justifiable. These changes will result typically in a company whose risk and expected cash flow are vastly different from what they previously were. Historic measures of this asset’s performance may well be useless in the evaluation of future prospects.
The specific mechanics of net present value (or the discounted cash flow valuation process) appear in almost any financial handbook and are in the repertoire of most investment bankers or management consultants.5 For discounted cash flow to be useful in acquisition analysis, it should be readily adaptable in the following three areas:
1. Developing detailed cash flow projections (including additional capital investments) over the acquired company’s period of ownership.
2. Establishing relevant rates of return for the acquired company (and its constituent parts) based on its prospective risk characteristics and its capital structure.
3. Performing sensitivity analyses under the various economic, operating, and financial scenarios likely to be faced.
While this approach seems straightforward and objective, it is in practice much more complex and intuitive. Wherever operating, financial, or strategic changes are to be made in the acquired company’s businesses, simple extrapolation or projection of current performance is, at best, risky. Similarly, if integration with the acquirer is to occur, as in related diversification, managers must evaluate changes in the cash flows and risk levels of both acquirer and acquired. Virtually every attempt to achieve one of the several potential benefits of diversification will lead to subtle yet important changes in the combined company’s cash flow and risk characteristics. Careful use and a thorough understanding of the valuation process are of paramount importance, for slight errors in estimating these cash flows or risk levels can lead to valuation prices that differ by 30% or 40%.
Nevertheless, a careful application of the method we have outlined will force a company to be as concrete as possible in its assessment of future risks and returns. No one formula or method, least of all a simplified discounted cash flow analysis, should be expected to reveal by itself the best option or decision. The worth of any screening and evaluation system will vary according to both the quality of information used and the ability of managers to use this tool without crowding out important intuitive judgments about the compatibility of corporate cultures, the quality of an acquisition candidate’s management, and the long-term strength of a candidate’s competitive position.
The room for error in making these judgments is considerable. The anticipated benefits of an acquisition are often greater than those finally realized. Reaping benefits that stem from operating synergies requires considerable time and management effort. The knowledge of which benefits are achievable and at what costs comes from both prior experience and a strong sense of administrative feasibility. These personal characteristics of decision makers, along with the ability to value future returns accurately, lie at the base of a successful acquisition screening system.
Preparing the Ground
Executives often ask why they should have elaborate acquisition guidelines when such decisions must often be made without sufficient time for detailed, comprehensive analysis or when candidates best suited to their company’s needs are not available. To summarize, formal acquisition guidelines can help companies prepare themselves for swift action in three ways:
First, working through a formal process in periods of relative calm tends to reinforce a broad understanding among executives of the company’s objectives. Given the complexities of organizational life in the modern corporation, this benefit is not trivial.
Second, experience with a structured process, such as articulating acquisition guidelines or writing specific screening criteria, leads to widely shared assumptions about the company’s strengths and weaknesses and its special needs and to a general agreement on what is most important for future profitability and corporate development.
Third, working within a formal system develops a common language or set of concepts relevant to the acquisition decision. This language system and the analytic framework it represents serve to ensure that key decision makers follow similar logic when acquisition opportunities suddenly appear and quick decisions are necessary.
The issue concerning the availability of acquisition candidates is often overemphasized. Most companies, especially those that are publicly owned, are available at a price. In the capital markets, where there is a continual auction of corporate securities, companies change hands every day. The real question is not whether attractive candidates are available but whether the company’s potential to create value for the acquirer’s shareholders is sufficient to justify the purchase price.
McKinsey Award Winners 1980
1 See our article, “Diversification via Acquisition: Creating Value,” HBR July–August 1978, p. 166.
2. See our book, Diversification Through Acquisition: Strategies for Creating Economic Value (New York: Free Press, 1979).
3. Michael E. Porter, “How Competitive Forces Shape Strategy,” HBR March–April 1979, p. 137.
4. See our book, Diversification Through Acquisition, p. 194, for a detailed explanation of how to develop a weighting system.
5. For a good summary of this valuation process, see Alfred Rappaport, “Strategic Analysis for More Profitable Acquisitions,” HBR July–August 1979, p. 99.