M&A Blog #03 – types of acquirers and the ways they create acquisition value
Fans of HGTV home flipping shows recognized that, in addition to people who buy properties to live in, there are people who buy homes to be fixed and flipped – that is to be sold to another buyer later. This is exactly the same in the world of M&A. There are acquirers who buy companies to be hold for an indefinite period of time (corporate strategic acquirers) and acquirers who buy companies to be “fixed and flipped” (financial buyers from the private equity (PE) world). We will go through each type in this post along with the ways these acquirers create value from their acquisitions. Given my work history as a corporate acquirer, we will focus more on the corporate strategic acquirer type.
A corporate strategic acquirer is an operating company that combines some portion of its current operations with that of the target’s operations. Examples are Coca Cola, Google (also known as Alphabet Holding), Sony Corporation, Facebook, Comcast, and more. This type of acquirer typically looks for healthy targets that can supplement the acquirer’s current operations, typically in the same industry (be that a competitor or a value chain partner). Strategic acquisition transaction volumes vary with market cycles, debt availability, and economic conditions – typically makes up 80% to 90% of annual transaction volume. For a corporate strategic acquirer, value creation comes from personnel reductions, leveraging supplier and distribution channels, and cross-selling products. Because these acquirers benefit from combination synergies, they are often able to pay more in a prospective acquisition than their PE counterparts.
However, because corporate strategic acquirers have synergies to realize, their due diligence period is typically longer than those of PEs (in non-auction transactions). A target company looking for a quick exit should bear that in mind when dealing with corporate acquirers. We will discuss due diligence in detail in several future post in this series. Further, even though a corporate strategic buyer can pay more than PEs for a target, a savvy corporate buyer would want to conserve as much of those synergy cash for itself. Buying right (the right target, at the right price and terms) increases the chance that the acquisition would be successful in overcoming surprises that the corporate buyer will face in the post-acquisition integration phase (there will always be surprises, regardless of how much due diligence was put in). Buying right also increases the chance of turning a good ROI for shareholders (remember our discussion in the last post of a successful acquisition yielding a return higher than investors’ required return).
When Wells Fargo acquired Wachovia in 2008, the two banks were in the same business (retail and commercial banking, mortgage lending, and investment banking). The acquisition gave Wells Fargo increased scale and scope, expanded market presence in US east and southeastern coasts, as well as cost-cutting synergies in the areas of management, marketing, and product development. Wells Fargo went on to become the highest earnings bank in the country in early 2014. Its executives and industry analysts credited some of that result to the purchase of Wachovia, per Wall Street Journal (January 2014).
We’ll shift gears a bit now and discuss the financial buyers from the private equity (PE) world. These buyers typically don’t have operating companies to combine with the target. They create value through a revised capital structure and modified management’s incentives. We will discuss capital structure in great details in the next two blogs. For now, know that for PE buyers, value comes from:
Using a higher level of debt (which is less expensive than equity) to increase returns. Compare to corporation’s average level of debt of 1.5x EBITDA, a PE portfolio company typically carries 3.5x or higher.
Reduction of capital investment made through greater investment discipline, faster analyses, reduction of asset base (inventory, leasing vs. buying), and negotiating more favorable terms with suppliers (to stretch accounts payable).
Modified management’s incentives; where management carries 5% to 15% of the portfolio company’s equity and is extremely motivated to create shareholder value. Combine with the high debt capital structure, these incentives can translate into significant equity returns to management.
PE seeks returns superior to the public market (stocks and bonds) through alternative investment strategies. If the public market yields an 8% to 10% returns to shareholders, PE has to achieve roughly 5% more, mainly due to the loss of liquidity during the duration of the investment (typically 10 years for the pool, 5-7 years per portfolio company). Typical PE firms include those who engaged in leveraged buyouts (LBOs), equity recapitalizations, going-private transactions, PIPES (private investments in public equities), and minority (less than 20% ownership) preferred investments. It is worth noting that PE often doesn’t invest its own money. As a professional money manager, PE invests funds from its limited partners (LPs). Typical LPs include insurance companies, endowments, pension funds, and high net worth individuals (or their family offices).
When the PE firm Bain Capital acquired Sealy Mattress for $791 million in 1997, it invested only $140 million of its own fund and leverage the balance on Sealy’s balance sheet. Bain proceeded with closing manufacturing facilities, reducing manufacturing overhead and headcount, and pushing for new product development. The new lower-cost, lower-quality, one-sided mattress was the product that came from this acquisition. It increased sales for Bain while reducing mattress life for customers. At the end of its investment period in 2004, Bain sold Sealy to Kohlberg Kravis Roberts & Co (another PE company) in a deal valued at $1.5 billion (more than double the 1997 purchase price), netting Bain a significant return on its investment.
A list of M&A value-creation drivers is listed below – courtesy of Professor Thomas Harvey at Penn State University:
One other reason for acquisitions, which may or may not create value is acquihire: when companies acquire targets just to get the target employees. Click here for more on the topic.
Though they often compete in acquisitions, there is one primary goal that unites corporate strategic and PE acquirers: creating value for their investors. Each has its own investment thesis and end goals, however, as a group, they tend to focus on several key actions to increase returns:
Reduce costs: eliminating duplicate facilities and staff, consolidating production and warehouses, bulk-buying from suppliers, and achieve lower unit costs and economies of scale.
Increase revenue: M&A deals tend to generate a list of new customers and a list of new products for both the acquirer and the target. By cross-selling products to each other’s customers, M&A deals increase sales leads. It is worth nothing though that revenue synergy is slower and harder to realize that cost reduction synergies; mainly because customer adoption is not within the acquirer’s control and is typically longer and lower than expected (if it happens at all).
Geographic expansion: certain types of businesses, such as a wholesaler distributor, building supply companies, or concrete providers, are typically limited by their geographies. The heavy or large products restraint the ability of these businesses to sell to a widely dispersed customer based (contrast this with Amazon, who sells online to a very wide geography). M&A deals allow these companies to expand its service and customer coverage area. When InBev (maker of Stella Artois, Bass, and Brahma beers) acquired Anheuser-Busch (maker of Budweiser and Michelob beers) in a 2008 hostile takeover, the combined company created one of the largest beer distribution channels across the globe – significantly creating greater scale and purchasing power for its owners.
Determining a target’s potential value and related synergies directly impact how aggressively a buyer should bid on an acquisition. An acquirer should always price the value of a target based on the latter’s standalone value. Synergies are challenging to estimate and realize, revenue synergies more so than cost synergies, and should always be conserved for the acquirer’s shareholders (as opposed to the target’s shareholders). An M&A deal should avoid baking synergies into the acquisition price because you will end up paying too much for a target – minimizing the returns for your own shareholders. In some cases, these transferences of value have caused zero or negative returns (i.e. failed M&A deals). We will discuss how synergies are valued and incorporated into M&A evaluations when we discuss valuation and accretion/dilution later in this series of blog posts.
