It is well understood that knowing your customers is the key to a successful product or service. Selling a business is no different. In fact, the first step in maximizing value is understanding what the buyer wants and needs, and how your company fits into the value chain of the buyer’s operations. But how do you get inside the buyer’s head? It’s helpful to remember that most of the time, long before a buyer approaches a potential target, there is a goal and a strategy about how to achieve that goal. While it may be next to impossible to get a buyer to fully disclose its ultimate objectives, an understanding of the focal strategies used in M&A can provide precious guidance. Used by corporations so well as by private equity firms, these strategies can be summarized as follows:
- Horizontal integration;
- Vertical integration;
- Conglomerate integration (also called diagonal integration).
Historically, these strategies, often applied in their pure form, have contributed to the formation of major corporations and reshaped entire sectors of the U.S. economy. Today, these fundamental strategies are more likely implemented in various combinations both by strategic acquirers or financial sponsors and result in the acquisition of big and small organizations alike. A good understanding of their underpinning can prove instrumental in interpreting the economic inventive and value drivers sought by the buyer.
A horizontal integration strategy seeks to combine businesses that operate in the same sector, in the same type of business or in the same stage of production. Some of the big name companies that successfully used horizontal integration in the past are Kodak, Standard Oil and DuPont. This type of integration helps organizations gain a larger share of the market and also eliminates competitors. However, the real advantage often lies in the ability to control prices and have access to new geographic markets. Other benefits include economies of scale and economies of scope. Economies of scale decrease the average cost per unit due to a larger scale of production of a single product so that the fixed costs can now be spread out to a larger number of units. For economies of scope, the average unit cost is lowered by sharing certain resources in the production, marketing or distribution of similar or complementary products. For instance, it is possible to sell different products by using the same sales force through the same distribution channels. The same know-how and technology used, for example, to produce PC monitors can also be used to make televisions. A good example of a company that more recently used this strategy to gain market share and build critical mass is Protection One, Inc. a leading home security companies in the U.S. During the 1990’s, Protection One, grew rapidly through bolt-on acquisitions of small privately held companies and even the purchase of customer accounts. (In the M&A lingo, bolt-on acquisitions are companies, products, assets or customer accounts that fit naturally within the buyer’s existing business lines.)
Vertical integration entails the combination of companies that operate in different stages of production. A typical example is offered by the oil and gas industry where exploration, production, refining and retail can be performed in principle by separate organizations that are not under a single, controlling ownership structure. Interestingly, most of the large public utility companies in the U.S. were created during the vertical integration wave between 1925 and 1929. The benefit to the buyers in this case may vary, but usually it centers on the advantage of having control over the target company. Some of the value-creation opportunities include:
- Tighter quality control;
- Elimination of transportation costs, since different stages of production can be combined in the same location;
- More efficient information flow and coordination of product planning, research and development or inventory management;
- Lower monitoring and transaction costs throughout the production process. These may include lower contracting, “haggling,” collection and negotiation costs;
- Lower business to business advertising costs, since the intermediary stages can be eliminated.
Typically, owning a supplier or a customer is considered to be a great way to add flexibility for the firm. This can prevent pressure on margins in the presence of challenging market conditions and even avoid distress during major economic downturns. Overall, the primary driver of vertical integration stems from the elimination of costly market exchanges and contracting activities among participants in the network of the supply chain. A good example of recent wave of vertical consolidation in North America is provided by the farming and food packaged industry. Today most food is produced not by family farmers but by a few of giant agribusinesses that have little resemblance to the traditional family farm. Consolidation was achieved through the acquisition of many small farms / companies that originally focused on a variety of different activities from breeding hens and hatcheries to operating feed mills and processing plants, and packaging and distribution.
Conglomerate acquisitions bring together various companies engaged in different and unrelated business activities. Typically, a conglomerate controls operations in different sectors, which require completely different skills in very specific functions (i.e. engineering, production, marketing, etc.). At first glance, no immediate synergistic advantages or other benefits to the acquirer would surface from such strategy, but a closer look reveals the opposite. Conglomerate integrations fall into two primary sub-categories and each can be extremely successful:
For these types of companies, the idea is that the managerial functions performed at the top of the organization are general enough that they can be transferred and applied to a variety of companies in different industries. General Electric Corporation, with its diversified business units and its ability to apply value-enhancing management techniques to newly acquired companies, is perhaps the typical example of a managerial conglomerate. In the 1990’s, GE became well known for implementing Total Quality Management, a management tool created by W. Edwards Deming, to improve quality and performance across all of its divisions.
It is usually more challenging to identify the potential economic advantages of a specific transaction when dealing with managerial conglomerates because much of that benefit is related to the talent of the buyer’s management team and the level of indivisibility of the managerial effort. At some point, we can expect that as the management team is spread too thin among different activities, efficiencies will start to decline. In these types of transactions, the value of control, rather than the value of synergies, most likely represents the premium paid by the buyer. The value of control resides in the benefit derived from changing the way a company is run. Note that the value of control is different from the value of synergy in that it is not predicated on the combination of two separate businesses, but only on replacing the target’s incumbent management team.
This term is used rather loosely, but essentially, financial conglomerates derive their appeal from their ability to establish discipline in the financial aspects of the corporation. Management engages in financial planning and analysis with the goal of lowering the cost of capital and increasing the cash flow of the companies under its control. Normally, actions to achieve such objectives include, among others, asset redeployment, tax burden reduction through relocation of certain operations in lower-tax jurisdictions, reduction of working capital, financial leverage and the optimization of operating leverage.
The traditional targets of conglomerates used to be larger and more diversified. Today, that the creativity of hundreds if not thousands of financial sponsors that acquire companies through Leveraged Buy-Outs have proven that also low middle market companies could become part of this acquisition strategy. Most financial sponsors often operate a very diverse portfolio of companies which allows them to extract financial efficiencies and leverage the expertise of the management team among different types of operations.
While the main strategies are quite straightforward and can be easy to identify, a live transaction is often characterized by various motives with the possibility of virtually infinite combinations. The primary goal of diversification, or financial synergies, might have secondary objectives such as achieving faster growth, tax savings, cost reduction, “cash slack” opportunities, etc.
Also, and maybe quite surprisingly, buyers often get caught up in M&A trends that influence their preference and behavior. Economic climates, market conditions and paradigm shifts created by a few large transactions in the market can change how buyers view M&A opportunities and strategy implementation. For example, easy access to credit can encourage financial buyers to pursue new transactions despite the low level of attractiveness of targets, while tight access to loans favors leading corporations with strong balance sheets and cash on hand, who then act as consolidators in their respective industries.
All in all, identifying the buyer’s strategy, even in its primary form, gives crucial insight and negotiating advantage. In particular, and as it transpires from the foregoing list of objectives, it becomes clear that certain inherent weaknesses of a target company have the potential to represent an alluring opportunity for the appetite of a particular buyer. This “low hanging fruit” can be transformed by the attentive seller and its advisors into concrete opportunities to maximize value.
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