Growth Through Acquisitions: A Fresh Look

The common wisdom on successful corporate acquisitions is short and simple: Make them small and make them synergistic. Yet companies that rely solely on this view risk missing an entire world of valuable strategic opportunities. Our yearlong research program has shown that companies can pursue a nonsynergistic strategy profitably. In fact, our research has uncovered a diverse group of organizations, including Thermo Electron Corporation, Sara Lee Corporation, and Clayton, Dubilier & Rice, that have grown dramatically and captured sustained returns of 18% to 35% per year by making nonsynergistic acquisitions.

Our 21 successful acquirers fell into two groups: diversified public corporate acquirers and financial buyers such as leveraged buyout firms. We chose to study LBO firms because, like the rest of the world, we were fascinated as we watched them outbid corporate buyers and then produce extraordinary returns without the benefit of synergies among their businesses. We compared the LBO firms’ practices with those of successful diversified corporate acquirers and were surprised to find that their operating principles were remarkably similar.

Yet many corporate strategists refuse to believe that they can be successful in pursuing nonsynergistic deals. In our view, their hesitancy results from fundamental misconceptions about the way today’s nonsynergistic acquirers operate. The first is that financial buyers rely on market timing to buy assets at a low price (turning around and selling them at a high price). In fact, we found that financial buyers actually pay substantial premiums above market price, just as other acquirers do.

The second misconception is that high financial leverage is used to discipline managers. In fact, financial buyers in our study, to avoid losing flexibility, make a conscious effort to prevent high leverage from controlling managers’ decision making about operations. Although many LBO firms start out with fairly high debt loads, they reduce their burden to relatively conventional levels (65% debt to total assets) within one to three years. Our findings are supported by the research of John Kitching, who studied 110 buyouts (“Early Returns on LBOs,” HBR November–December 1989). He found that by the second year after acquisition, debt repayment of the typical LBO exceeded repayment commitments by 600%.

Without a doubt, the 21 companies in our sample were very successful. Altogether they made 829 acquisitions. When asked whether they earned their cost of capital, 80% of the respondents (accounting for 611 acquisitions) said yes. Our sample of U.S. corporate acquirers averaged more than 18% per year in total return to shareholders over a ten-year period, and the financial acquirers averaged 35% per year by their own estimates.

Although the acquisitions of any given acquirer in our study were seemingly unrelated, successful acquirers picked a common theme and stuck to it. For example, we noted that Clayton, Dubilier & Rice—a financial buyer—was skilled at turnarounds, often shrinking the acquired company before growing it. (See W. Carl Kester and Timothy A. Luehrman, “Rehabilitating the Leveraged Buyout,” HBR May–June 1995.) Desai Capital Management, also an LBO firm, searched for growth opportunities in retail-related industries. Emerson Electric Company acquired companies with a core competence in component manufacturing, particularly those for which it could exploit cost-control capabilities. Sara Lee, which has acquired more than 60 different consumer-product companies—including Coach Leatherware Company, Playtex Apparel, and Champion Products Inc.—used branding and retailing as its common thread.

Making Acquisitions Work

But making this type of acquisition work is not easy. Our research has found that successful corporate and financial buyers use seven key operating principles. These principles affect almost every stage of the acquisition process, from the identification of candidates to postmerger management. They are:

• Insist on innovative operating strategies.

• Don’t do the deal if you can’t find the leader.

• Offer big incentives to top-level executives.

• Link compensation to changes in cash flow.

• Push the pace of change.

• Foster dynamic relationships among owners, managers, and the board.

• Hire the best acquirers.

Insist on innovative operating strategies.

Since the early 1980s, high-profile leveraged buyouts such as Duracell International, Uniroyal, and RJR Nabisco have attracted widespread attention. Much of the fanfare has focused on negotiation tactics, savvy financial structures, and prices. Little attention, however, has been given to the other 2,200-plus buyouts that have occurred in that time period and to the fundamental changes in operating practices that have generated positive returns for many of those companies.¹ Although many observers believe that LBO firms uncover hidden gems in the marketplace, more often they merely focus on improving operations.

Sunglass Hut International and Snapple Beverage Corporation, two acquisitions from our sample group, illustrate that the largest source of value creation in successful acquisitions comes from operating performance, not from financial leverage, market timing, or industry selection.² When Desai Capital acquired Sunglass Hut, it concentrated on growing revenues rapidly and created a new strategy to do so. Since the initial acquisition in 1988, Sunglass Hut has grown from 150 stores to more than 800 and has racked up an impressive 37% in annual returns by acquiring, in its turn, smaller stores and implementing a new store format. The company replaced clerks who knew little about sunglasses with trained customer-service specialists, introduced an extensive product assortment instead of relying on two or three popular lines, and instituted a low-price regional strategy. (See the chart “Sources of Value Creation in an Acquisition.”)

The Snapple buyout, done by the well-known financial buyer Thomas H. Lee Company in 1992, provides another example of operating innovations. Shortly after the buyout, Snapple embarked on an ambitious growth strategy based on rapid geographic expansion and product-line extensions. Knowing that competitors would soon bring out their own natural teas and fruit juices, the company quickly built its production and distribution system. It established contractual relationships with bottling and distribution companies that had spare production capacity, thereby getting its product to market one year ahead of national competitors such as Fruitopia (from Coca-Cola Company’s Minute Maid division) and gaining a first-mover advantage.

As the Snapple example illustrates, innovative operating strategies allow acquirers to be successful in industries as notoriously competitive as the U.S. food and beverage industry. The lesson: Don’t look for growth only in high-growth industries.

Finding Nonsynergistic Acquirers

To find the most successful nonsynergistic acquirers, we screened all major companies making acquisitions over the past ten years—U.S. and U.K. public companies and known U.S. financial buyers. In selecting public corporations, we chose those that had acquired more than ten companies of size that were in more than four different major lines of business. Since some companies acquire a variety of businesses in order to vertically integrate, we saw them as one business and therefore eliminated them from our sample.

U.S. and U.K. Public Corporate Acquirers, 1985–1994 Sources: Annual reports, company interviews, Compustat, Securities Data Corporation.

Financial Buyers Sources: Asset Alternatives and Corporate Finance (Winter 1994).

For financial buyers, we chose firms that had disclosed investment funds of $250 million or more and that had raised at least two investment funds—an indicator of successful investment performance over time.

We then conducted detailed interviews with eight corporate acquirers and 13 financial buyers. The group of corporate acquirers in the study operated 50 different lines of business, outperformed the Standard & Poor 500 and Morgan Stanley Capital International (MSCI) indices by an average of almost 50%, and experienced compound annual revenue growth of 12% during the past ten years. The group of financial buyers in the study had reported capital of more than $16 billion and achieved estimated returns above 25% annually for their funds, with many producing returns exceeding 40%. If these financial buyers were viewed as corporate conglomerates, their 1994 revenues would place 45% of them in the Fortune 500.

Don’t do the deal if you can’t find the leader.

More than 65% of our respondents believe that managerial talent is the single most important instrument for creating value. Acquirers ensure that they have the right managers in three ways: They evaluate current executives; they look for managers within the organization who are not yet in leadership positions; they hire outside industry experts.

Nearly 85% of the responding acquirers in our interviews kept preacquisition managers in their positions. In other instances, successful acquirers have found leaders elsewhere in the company—leaders who had not yet had the chance to carry out their vision. Forstmann Little & Company discovered top leaders within middle management at General Instrument, and those individuals have gone on to create more than $3 billion in value over the past three years.

When successful acquirers look for outside industry experts, they tend to find outstanding performers at large corporations. For instance, Stephen Rabinowitz, who had an impressive track record as president of General Electric Lighting and later as vice president of AlliedSignal Braking Systems, was hired to turn General Cable Corporation around in 1994 after Wassall acquired it. Many potential buyers had looked at General Cable, a supplier of copper wire cables, but few knew how to make it profitable. In acquiring General Cable, Wassall was betting that the company could be turned around and that Rabinowitz was the man to do it. Within 18 months of the acquisition, the bet paid off: Rabinowitz had overhauled the company’s varied information systems, cut more than 30% of its product offerings, and dramatically reduced working capital.

However, when financial targets are not met, successful acquirers don’t hesitate to replace managers. Financial buyers show less patience than corporate acquirers. In 32% of the acquisitions by financial buyers in our study, one or more top-level managers were replaced within three years. In the corporate acquisitions, less than 10% of managers were replaced within three years. Why the difference between corporate and financial buyers? It may be attributable to the taller hurdles imposed by financial buyers or to corporate acquirers’ reluctance to displace managers and disrupt a company’s culture.

Those reluctant to replace managers might take a lesson from Thomas H. Lee. The company engineered a management buyout of Diet Center in 1988. “We knew management was weak, but we thought we could fix it,” recounts former managing director Steven Segal, now managing director of J.W. Childs Associates. At the time of the Diet Center acquisition, Jenny Craig was predominantly an Australian food company and Nutri-System was just emerging from bankruptcy. Neither was a serious threat to Diet Center at first, but both became major competitors before long. When the competition got rough, Diet Center’s managers faltered.

Offer big incentives to top-level executives.

Finding and motivating the right managers is so important that many successful acquirers offer senior executives significant ownership stakes (usually 10% to 20%). If all goes as planned, those managers can become millionaires. Why offer such big carrots? B. Charles Ames, a Clayton, Dubilier & Rice partner, said it best, “Managers are more committed to doing the difficult work of restructuring, growing, and otherwise fixing an acquisition when some or all of their net worth is on the line.” Creating annual returns in excess of 35%, as these managers must, requires a great deal of commitment and effort.

Incentives are especially important when new managers are recruited into a company. In that case, substantial upside potential is often needed to woo outstanding executives away from comfortable and relatively low-risk jobs. Previous studies on buyouts have shown that CEOs of acquired companies typically hold 6.4% of their unit’s equity, whereas the average CEO of a public company might hold only .25%.³

In most of the cases we studied, executives are obliged to purchase enough stock so that their holdings constitute a large part of their net worth. These large holdings are often referred to as “pain equity”—a way to ensure that managers cannot afford to fail. If an executive is unable to buy the equity, acquirers may offer a discount or a loan.

A major controversy has erupted over whether public companies should follow these practices. Some argue that public companies cannot offer large ownership stakes to individual managers because shareholders monitor executive pay to ensure that it is “reasonable.” However, the best acquirers in our study, such as Thermo Electron Corporation, aren’t afraid to make top managers wealthy if their companies achieve outstanding returns. In fact, almost 60% of our corporate acquirers offer managers a chance to become much wealthier than their industry peers. Thermo Electron alone has created 40 millionaires. However, such acquirers are shrewd and give up only as much equity as required to lure the best talent.

Equity stakes are not the only motivating factor for managers, of course. Other forms of reward, such as public recognition and future advancement (within large corporate parents), are also needed to make the difficulties and uncertainty worthwhile to managers. Nonmonetary forms of compensation are particularly prevalent at public corporations, where executives with the best performance records are rewarded in a variety of ways.

Link compensation to changes in cash flow.

Besides issuing equity up front, successful acquirers motivate executives with carefully designed compensation schemes tied to changes in cash flow. Such incentive pay accomplishes two objectives. First, it’s a reward for current efforts—a symbol of recognition, a pat on the back. Second and more important, it provides a foundation—a common vocabulary—for communication between managers and owners so that managers will keep cash flow in mind when making daily operating decisions.

Many of the acquirers we studied pay managers a base salary set at roughly the average for the industry. However, they tie a substantial amount of total compensation to annual performance measures. They evaluate which measures are the most important drivers of operating cash flow and then set aggressive targets. Factors that affect current cash flow, such as inventory on hand, accounts receivable, and unit growth, are generally used along with variables that affect longer-term cash flows, such as return on new capital investment and gains in market share. These metrics are derived from overall business targets and are often incorporated into senior managers’ employment contracts, with explicit numerical targets set for each variable. Bonus payouts usually range from 50% to 100% or more of base salary. The size of the reward is correlated closely with the difficulty of achieving specific performance goals.

In 1993, when Kirkland Messina, a buyout firm in Los Angeles, acquired the Selmer Company, a maker of musical instruments, it knew it had to resolve a severe lack of communication among Selmer’s departments. It discovered, for example, that the sales force was not properly informing the manufacturing group of its inventory needs. The confusion caused the company to miss critical delivery dates on its highest-margin products: trumpets for professional musicians.

“The company was run in fiefdoms,” says CEO Dana Messina. Kirkland Messina changed all that: “We set up measures that forced partnering between functional areas. Sales managers have margin as well as revenue targets; manufacturing managers have customer-delivery as well as working-capital targets.” The result: Managers’ cash compensation has doubled, and cash flow has increased 50% in the two years since the acquisition.

Push the pace of change.

“When it comes to identifying opportunities, time is critical,” says Charlie Peters, vice president of development and technology at Emerson Electric. “Most of the actions required to create value are taken in the first two years after the deal is closed.” Both public and private acquirers agree that pushing the pace of change disciplines managers and sharpens priorities. It gives people in the organization a sense of urgency and a challenge. For example, Emerson acquired Fisher Controls International, a supplier of manufacturing process control equipment, in late 1992. Because of a series of operating changes—including plant consolidations, changes in procurement practices, inventory programs, and sales-force alignments—both profit and cash flows were able not only to meet aggressive two-year plans but also to exceed the original acquisition forecast. Emerson is not alone; Grand Metropolitan also makes change happen fast. After acquiring PET in February 1995, the company quickly moved to close plants, reduce costs at headquarters, and change brand strategy.

At WESCO, a buyout done by Clayton, Dubilier & Rice, operating income jumped from almost no profits to profits of roughly $55 million within two years. The previous owner, Westinghouse Electric Corporation, had sought to maximize profits by keeping manufacturing utilization high—a strategy that meant WESCO sometimes sold products at a loss. Following the acquisition, the new management team announced that the company was no longer in business to sell the maximum amount of product; it designed a new sales-incentive plan that rewarded the sales force for boosting gross margins instead of focusing on volume. Procurement and inventory control were improved by charging the branch managers 1% per month for inventory held less than two months and 2% for inventory held more than two months.

Foster dynamic relationships among owners, managers, and the board.

One critical difference between successful acquirers and most corporations is the level of interaction among managers, directors, and shareholders. Rather than erect a multi-tier, bureaucratic structure, successful acquirers create flat organizations. Sara Lee, for instance, employs a decentralized management structure that divides the corporation into discrete profit centers, each led by an executive with a high degree of authority and accountability for the performance of that business.

Other successful acquirers keep acquired businesses separate from other operating units, even if that policy precludes exploitation of potential synergies. They believe that giving acquired businesses a high degree of autonomy is essential.

The way Thermo Electron is organized illustrates the point. In the past ten years, Thermo Electron has acquired 30 companies in the environmental, energy, health care, and medical equipment industries. It owns between 50% and 80% of the stock of its operating units; the remainder is in the hands of the public. By structuring his company in this manner, CEO George Hatsopoulos has been able to offer a large and diverse group of managers equity stakes; yet he has maintained control by having key officers report to Thermo Electron and by having formal contractual agreements that specify operating policy. For example, each operating company is required to put its funds into a centralized cash-management system controlled by Thermo Electron, to follow internal control and accounting procedures, to submit annual and five-year plans, and to report to Thermo Electron’s senior executives about deviations from plan. In short, the operating units have the independence of public companies with the control and reporting relationships that are common in corporate subsidiaries.

More than 80% of the successful acquirers studied allow top-level managers to have the final say in all operational decisions as long as financial targets are met. The rest make major operational decisions jointly. Financial buyers in particular rarely override the decisions of upper management, in spite of having controlling equity positions. As a representative of one stated, “We have the same power as corporate parents, but we are less willing to use it.”

The best financial and corporate buyers often appoint a gatekeeper to be the interface between owner and operating unit manager. That individual becomes intimately involved in the acquired company’s operating decisions by acting as a sounding board for management, especially during the first 6 to 18 months after the acquisition. “We talk daily [with the CEO] for the first few months, until major change has happened; then we talk weekly,” says Thomas Weld, a managing director of Three Cities Research, a financial buyer.

Successful acquirers also carefully structure the boards of directors of acquired companies, limiting them to five to seven members. The boards typically consist of one to three managers from the acquired company, one or two industry experts, and two or three representatives from the ownership group. Financial buyers generally use outsiders on their boards to provide an independent point of view. In the case of corporate acquirers, however, industry experts are usually the CEOs of other operating units in related lines of business; owners are typically represented by the group head or holding company president. Both corporate and financial acquirers prefer a majority of seats on the board to be held by equity owners (managers and investors).

Hire the best acquirers.

One often overlooked aspect of acquisitions is selecting the deal makers. These individuals make judgments that are often critical to the success or failure of the transaction. Here the differences between financial buyers and corporate acquirers may lead to some differences in value creation.

Financial buyers hire highly skilled professionals with outstanding professional and educational credentials. In our sample of nine buyout firms and more than 100 professionals, 45% of professionals had previous experience making deals at either an investment bank or some other major investing firm. Another 35% had top-level operating or consulting experience. The educational background of investment professionals also suggests that they are drawn from an elite pool. More than 75% of associates and partners studied had advanced degrees in business or law, and more than 90% of those degrees came from high-ranked U.S. schools.

The best and the brightest don’t come cheap. Starting compensation for associates can be greater than $100,000 per year and can grow to more than $500,000 within five years. The opportunity for associates to influence the actions of managers at acquired companies also gives them a powerful non-monetary motivator: a strong sense of impact. At a more senior level, the financial rewards are huge. Partners at successful firms usually earn in excess of $1 million per year from a combination of management fees, incentive (“override”) payments from realized investments, as well as capital appreciation of stock.

Corporate acquirers pursue a different strategy for building their acquisition teams. Unlike financial buyers, they tend to hire people with less deal-making experience, preferring to develop their own talent. Corporate investment professionals generally possess fewer advanced degrees and come from less prestigious schools. They are paid significantly less than their counterparts at financial firms. Unlike financial buyers, where both senior and junior staff evaluate the desirability of an acquisition, corporate buyers typically have senior executives make those decisions. Staff associates are limited to structuring the deal, negotiating it, and working out legal and accounting issues. The prospect of fast-track promotion serves as the key motivator for corporate investment professionals, rather than the decision-making autonomy and financial rewards offered by financial buyers. Do corporate acquirers lose anything by not hiring the same type of people as financial buyers do? Although this hypothesis cannot be tested directly, our analysis of the two groups’ respective acquisition processes and returns suggests that they do.

How to Do It

Many companies today find themselves with a surplus of cash and a shortage of places to use it profitably. In the past five years, more than 1,300 companies have collectively stashed $150 billion in their coffers.

We believe that most companies can benefit from the nonsynergistic approach to acquisitions we have described. However, cash-rich companies should consider carefully the magnitude of change that will be required. Taking into account their company’s skills, organizational structure, and corporate culture, they should do one of the following to implement the strategy.

Evolve in-house capabilities.

This approach is most suited to those companies that already have the right frame of mind—those that are entrepreneurial and growth oriented and that already follow many of our key operating principles. Most likely such companies are currently running highly autonomous operating units, sometimes with separate legal structures, albeit with close ties to the parent corporation. Here most changes will be evolutionary rather than revolutionary and will be geared to bringing acquisition and management techniques in line with best practices.

Companies thinking of developing in-house acquisition capabilities will need to screen potential acquisitions, structure sophisticated deals, and monitor portfolio companies effectively. In addition, they will need to develop individualized performance-based evaluation and compensation systems. Specifically, we recommend that headquarters allow each subsidiary to pursue its own long-range strategy, have a separate management compensation plan, and pursue acquisitions in its main line of business. Nonsynergistic acquisitions and spin-offs, however, should be managed by the parent company, as should selection and removal of high-level subsidiary managers.

Establish a separate subsidiary.

Where a company’s business system and culture are likely to reject nonconforming additions, we recommend creating an acquisition group outside the core organization. Many multibusiness or single operating companies, especially those that are highly centralized or have strong corporate cultures, would find this approach the most appropriate for them. Companies that wish to copy the operating practices of successful acquirers must be confident that they have or can find the skills necessary to run an independent acquisition program within the guidelines suggested here. At various times, some public companies, including General Electric Company and Hanson Trust, have set up or spun off operations to allow for the autonomy and flexibility needed to invest in businesses outside their core businesses. At Chemical Bank, Chemical Venture Partners was established as an autonomously managed partnership, yet the bank is the only limited partner and the employees are Chemical Bank employees.

Outsource.

A company without an experienced team of advisers can hire outside assistance. However, the advisers’ interests must align with the company’s. If a company uses investment bankers, for example, it must realize that the way deal fees are structured makes completing a transaction the highest priority of such advisers. The risk: overpayment on price, hurried due diligence, overly simplistic contracts, and little premerger planning.

Another option exists for those whose corporate climate is suited to partnerships. A company wishing to make nonsynergistic acquisitions can benefit from a partnership with a financial buyer experienced in nonsynergistic deals. For example, Oak Industries, a manufacturer of consumer components, formed a successful partnership with Bain Capital in 1992 to acquire Gilbert Engineering, a specialty-connector manufacturer for cable television.

Any CEO who wants to implement our guidelines in his or her own company must ask, Am I confident that I can buy into new businesses and generate maximum returns from my investment dollars? Ultimately, for a company to become a successful acquirer, executives must think in ways that are unorthodox and uncomfortable to them. Each of the successful acquirers in our study made purchases where others failed to discern a path to success. Yet the acquirers in our survey did succeed in exporting their knowledge to new businesses. Thus, interpreted properly, “Stick to your knitting” does not mean a company should stay in its core business. It really means a company should grow within its field of knowledge. Our sample of acquirers did just that.