Creating value from mergers, acquisitions and alliances

Mergers, acquisitions and alliances—collectively M&A—are long-established routes for changing corporate scope, capability and competitive position.

When to use it

• Use this assessment for every proposed merger, acquisition or alliance, from initial rationale through valuation and integration planning.

Origins

This six-task assessment synthesises corporate finance, strategy, due diligence and integration practice rather than reproducing one named model. Its economic test is conventional but demanding: the acquirer creates value only when realisable synergy exceeds the control premium plus transaction, integration and risk costs. Successive merger waves gradually brought rationale, target selection, diligence, valuation and execution into one connected process.

What it is

“Eat or be eaten” captures the pressure behind many deals, but pressure is not a rationale.

Underperforming companies can become targets; acquirers can also destroy value by acting defensively or impulsively.

Survival of the combined entity is an inadequate success measure. The relevant test is incremental shareholder value.

At minimum, the value of AB after the transaction should exceed the pre-deal standalone values of A and B together.

Research conducted since well before the author began M&A work in the mid-1980s repeatedly finds that a majority of transactions destroy rather than enhance shareholder value.

Overpayment for control is the immediate cause. It commonly arises because:

Managers become committed to completion—through strategic conviction, competition or empire building—and allow negotiation momentum to override price discipline.

Pre-deal strategic analysis is too shallow.

Due diligence leaves material uncertainty unresolved.

Integration cost, difficulty and delay are underestimated.

The underlying acquisition logic can be stated plainly. If A buys B for a strategic reason:

Combining A and B should create cost savings, revenue gains or capital efficiencies.

Those synergies should make AB worth more than A and B separately.

B’s shareholders will normally demand a premium over the pre-bid standalone value to surrender control.

A’s shareholders gain only when synergy value exceeds that premium and all additional deal costs.

The core analytical challenge is therefore to estimate realisable net synergy without deal enthusiasm contaminating the assumptions.

How to use it

Complete six connected tasks:

Confirm the strategic rationale.

Select the right target.

Assess the risks.

Value both standalone entities.

Value net synergies.

Confirm that value remains after premium and risk.

Each task should have an evidence owner and a documented walk-away condition.

Confirm the strategic rationale

An unexpected target can tempt the team to begin diligence before establishing why ownership is strategically useful.

Resist that sequence. Deals consume scarce leadership and specialist capacity, so a company cannot pursue half a dozen seriously at once.

Define the rationale first, then compare the opportunity with other targets and non-acquisition routes.

Address three questions:

Which strategic objective must be achieved?

Is acquisition the best route?

Which strengths can the acquirer transfer without weakening the existing business?

Common objectives include:

Entering new markets or products.

Obtaining skills or technologies.

Creating scale or scope economies.

Diversifying risk.

Reducing competition, subject to competition law.

State whether the motive is offensive, defensive or mixed and how the deal changes the competitive position.

Compare four routes—organic development, acquisition, merger and alliance—on speed, investment, control and integration. Ownership is justified only if its benefits exceed the alternatives.

The strategic rationale for acquisition

Inventory transferable strengths and constraining weaknesses before estimating synergy. Candidates may include R&D, operating efficiency, marketing, distribution and financial control.

Nestlé’s application of marketing and distribution strength to Rowntree’s product range is a classic example. Kraft offered a similar, more controversial rationale for acquiring Cadbury in 2010.

Select the right target

Use four steps:

Define strategic-fit criteria.

Separate mandatory criteria from preferences.

Screen every candidate consistently.

Rank those that pass.

Do not collapse these stages.

Divide fit into hard and soft criteria so culture and behaviour are not ignored.

Hard criteria include size, product–market scope, technology, competitive capability and financial standing.

Tie every criterion to the rationale. A skills acquisition requires strength in the desired capability; a complementary combination may favour weakness where the acquirer is strong; scale economics require a defensible position in important segments.

Soft criteria include customer and employee orientation and attitudes towards innovation or cost control.

Greater cultural distance normally increases integration difficulty. Where business philosophies differ, reduce expected synergy and increase cost, time and retention assumptions rather than merely noting the gap.

Treat essential conditions as screening criteria and eliminate any target that fails one. Use desirable attributes only to rank the survivors.

This two-stage design prevents a high aggregate score from hiding failure on a non-negotiable condition. A candidate that passes every screen and ranks reasonably is safer than one that excels overall but fails a critical requirement.

Screening acquisition candidates for fit

Weighting should reflect deal form. Shared philosophy may be helpful in an outright acquisition but essential in an alliance that requires continuing joint control.

Apply the same evidence standard to the entire candidate universe. Remove failures without allowing familiarity or deal excitement to create exceptions.

The example ranks four passing candidates—A, B, C and D—against weighted criteria.

Ranking acquisition candidates for fit and availability: an example

Availability X Y YY Y

First assign relative weights; the illustration gives cultural fit substantial importance.

Then score each candidate, with B emerging as the strongest fit.

Compare that result with availability. Here the choice lies between preferred candidate B and more available candidate D, supporting initial conversations with both.

Apply the same process to an unsolicited approach; availability does not make candidate C strategically suitable.

Assess the risks

No substitute exists for disciplined due diligence. Deals that succeed without it do so despite unmanaged uncertainty, not because diligence was unnecessary.

Financial diligence tests the accounts; legal diligence identifies claims and obligations; environmental diligence tests regulatory exposure. Extend the scope to tax, operations, technology, people and other material risks.

Strategic diligence—an area in which the author has specialised since the mid-1980s—addresses the central question of value creation or destruction.

Estimate market growth, competitive effects on price, relative positioning, post-merger responses and the impact of target initiatives for every material segment or business unit. Strategic due diligence and the market contextual plan review provides the detailed approach.

Score each risk and opportunity by probability and value impact using The suns & clouds chart.

Build the material items into cash-flow scenarios. Probability-weighted outcomes from Expected value and sensitivity analysis support a risk-adjusted standalone value.

Value the standalone entities

Value the target before synergy. Discounted cash flow (DCF) is the primary method, although inexperienced users face the pitfalls noted in The tipping point (Gladwell). Triangulate with three simpler approaches:

Net asset value: historical book value rather than market value, often materially low.

Comparable trading multiples: sales, EBITDA, EBIT or P/E ratios from listed peers, each tied to a company and period that may not represent sustainable performance.

Comparable transaction multiples: sales or earnings ratios from similar recent deals, influenced by the trading conditions and acquisition appetite at their historical dates.

Use all three to establish a plausible range, ideally within +/- 15 per cent of its centre. Then build a DCF from information in the confidential memorandum and data room. Forecast revenue, direct and preferably variable overhead cost by major segment; add indirect cost, fixed-capital expenditure and working capital; then discount the cash flows. Test reasonable operating assumptions and discount rates and reconcile the resulting NPV with the valuation range.

The result supplies consistent cash flows for sensitivity testing in Task 5. Estimates will remain uncertain but should be explicit and usable.

Repeat the standalone valuation for the acquirer, or at least the units that will interact with the target, using the same discount rate.

Value the synergies

Identify each synergy operationally before assigning it value.

Identify the synergies

Group synergies into three categories:

Revenue enhancement.

Operating-cost savings.

Capital-cost savings.

Revenue gains may come from:

The target selling the acquirer’s offer to its customers.

The acquirer selling the target’s offer to its customers.

Jointly creating a new offer for both customer groups.

Combined capability increasing share of wallet or opening new customers.

Less customers lost because they prefer an independent supplier.

Operating savings often underpin the case and may include:

Lower material and component prices from purchasing scale.

Lower outsourced-service cost, including IT and payroll.

Production economies of scale.

Economies of scope.

Removal of duplicated sales, marketing and administrative overhead.

Consolidation of land, buildings, factories, offices, plant and equipment.

Capital savings arise when existing target capacity avoids new investment. A competitor’s spare factory, IT infrastructure or head-office space may support growth more cheaply than construction.

Value the net synergies

Add each synergy to the standalone DCF through explicit timing, volume, price, margin, investment and ownership assumptions. For product X, estimate annual incremental sales to the target’s customers.

The resulting increase in target NPV is that synergy’s gross value.

Repeat for product Y.

For product Z sold to the acquirer’s customers, measure the increase against the acquirer’s standalone NPV.

Value every revenue and cost synergy separately to prevent overlap and expose dependencies.

Sum the items, then apply two cautions:

Deal momentum encourages overstatement. Apply a 50 per cent probability to revenue synergy R, producing 0.5R through Expected value and sensitivity analysis. Apply a 80 per cent probability to more controllable cost savings C, producing 0.8C.

Deduct transaction and integration costs, including redundancy and early lease termination.

The remainder is the base estimate of net synergy value.

Ensure added value

Bring together:

The target’s standalone value.

Expected net synergy value.

The risk-and-opportunity assessment.

Acquisition premia often fall in the 30–40 per cent range. If the likely premium is at that level and base synergy is less than 40 per cent of standalone target value, walk away.

A higher synergy estimate still requires risk adjustment. Walk away when a credible downside can materially reduce target value, synergy or both.

More than half of acquisitions destroy value, commonly because the buyer overpays.

Keep the walk-away price independent of negotiation momentum.

Top practical tip

Define the rationale and screening criteria before engaging a target. The right target at a disciplined price is more important than completing a deal.

Top pitfall

Treat every merger, acquisition and alliance as capable of destroying value. Do not count synergy twice, ignore integration cost or let the desire to win determine the price.

Further reading

• Sirower, M.L. (nineteen ninety-seven). The Synergy Trap: How Companies Lose the Acquisition Game. Free Press.
• Haspeslagh, P.C. and Jemison, D.B. (nineteen ninety-one). Managing Acquisitions: Creating Value Through Corporate Renewal. Free Press.