McKinsey consultants, Tim Koller, Marc Goedhart and David Wessels, in their book Valuation: Measuring and Managing the Value of Companies (Wiley, 2010) argue the strategic rationale for a successful acquisition conforms to five archetypes.
If an acquisition does not fit one of these five archetypes “it is unlikely to create value.”
Each archetype provides a specific rationale for proceeding with an acquisition.
Archetype 1: Improve the target companies performance
For example, you buy a company, reduce costs, improve revenues, margins and cashflows.
Archetype 2: Consolidate to remove excess capacity from an industry
In a number of industries, capacity exceeds demand. It can make sense after an acquisition to shut down the least productive plants in a combined entity.
Archetype 3: Accelerate market access for the target’s (or buyer’s products)
Large companies with global sales forces can purchase small companies and use their marketing and sales grunt to extract value out of the acquisition.
Archetype 4: Get skills faster or at a lower costs that they can be built.
Between 1993-2001, Cisco purchased 71 companies to become a key player in internet technologies.
Archetype 5: Pick winners early and help them to develop their business.
Here a company makes an acquisition early in the lifecycle of a new industry before others recognise the industry is about to take off.
If these are the five archetypes of successful value creation through acquisition Koller et al argue there are a number of usually less successful, often value destroying strategies. These include:
The Rollout Strategy: Consolidating lots of small companies in highly fragmented companies. Rollout works when businesses can achieve big cost savings or much larger revenues than individual businesses can.
Rollouts are difficult to successfully execute because they invite copycats driving up prices for smaller companies across the industry.
Consolidating to improve competitive behaviour: It’s not uncommon in highly competitive industries for companies to try to reduce price competition by buying up competitors. The authors notes that unless the industry consolidates to just three or four companies pricing behaviour doesn’t change.
Entering into a transformational merger: Transformational mergers capture cost synergies and create a more innovative whole - by creating cultural and business synergies.
Transformational mergers are rare because the timing, the circumstance and the management team all read to be aligned. Execution requires a higher level of management skill.
Buy cheap: Finally, you can create value by buying cheap - that is buy a company below its intrinsic value.
In the authors’ experience however such opportunities are rare and relatively small.
They are more likely to exist in cyclical industries where you can make money by buying at the bottom of a cycle and selling at the top.
It is however much more common for buyers to pay a premium over the current market value.
By highlighting the five types of acquisition strategies that have created value for acquirers in the past, the authors have made it more likely that smart acquirers - will target acquisitions that will create value.
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