Deciding to Acquire: Deal Rationales

Introduction
Last time we reviewed some basic strategy frameworks, and stated that the best M&A deals are those that address challenges identified via strategic analysis.  This post expands on that point, with a discussion of the “why” of M&A deals.
 
Deal Rationales
Every successful deal starts with the identification of the deal rationale, or the “why” of the deal.  This rationale should drive all subsequent decisions regarding the best approach to the transaction.  While there are numerous non-operational deal rationales- i.e. acquiring a company to change its capital structure and thus benefit from some financial arbitrage- most acquisitions are done to improve results of operations.  As such, it is critical to identify what type of acquisition will best address the acquirer’s operational gaps. This is where the strategic analysis comes in:

• What risks is the business facing, and will acquisition activity amplify those risks?
• Can we raise prices? 
• How much additional TAM is available, and how much of that can we realistically capture if we proceed with a deal?
• Are we better off selling more to existing customers, or expanding our portfolio?
  
• What are our competitors, suppliers, customers up to, and how shall we respond?

Before we get into the discussion of basic operational deal rationales, I am inserting a disclaimer.  I make some generalizations below, and have simplified some concepts to make them more easily digestible.  Nevertheless, I think the main points hold water, so I will ask all my banker and consultant friends to be indulgent.
 

Rational #1: Economies of scale
Acquiring an overlapping company to:

1. Acquire revenue accretion
2. Eliminate duplicate administrative costs
3. Enjoy greater pricing leverage
4. Enjoy greater purchasing leverage
5. Increase capacity

Real-world example: Miller-Coors

Rationale #2: Economies of scope- geographic
Acquiring a complementary company to gain access and expertise in geographies not previously served.
Real-world example: Yahoo!- Alibaba

Rationale #3: Economies of scope-market offers
Acquiring a complementary company to:

1. Add new products and/or create combined product offers
2. Gain access to customer base for cross-selling

Real-world example: Symantec-LifeLock

Rationale #4: Vertical Integration
Acquiring a company above or below in the value chain:

1. Acquire a supplier to ensure adequate supply of inputs and control over costs
2. Acquire a customer to realize additional margin, and/or control points of distribution

Real-world example: Comcast- Universal

Rationale #5: Defense
Acquiring either a complementary or overlapping company to:

1. Prevent competitors from acquiring highly prized assets
2. Respond to a competitor’s growth in scope or scale
3. Prevent value erosion, i.e. acquiring a new market entrant to control the timing and distribution of their disrupting product while legacy offers complete their value cycle

Real-world example: PepsiCo- Quaker

Rationale #6: Innovation
Acquiring a complementary company to:

1. Purchase research and development (often the case with serial acquirers in technology and pharmaceuticals)
2. Gain access to the company’s proven talent, so as to benefit from their future creative efforts

Real-world example: Warner Bros.- Shed Media

Note that it is common for a deal to provide multiple synergy benefits; however, there will still be a primary value driver that ultimately defines the rationale of the deal.  For example, when PepsiCo acquired Quaker, the primary value driver was the addition of the Gatorade brand sports drink, so as to compete with Coca-Cola’s Powerade product.  Naturally, there was enough overlap that PepsiCo could also benefit from more scale in the purchase of ingredients, from the elimination of duplications in distribution, etc.  These were real, albeit ancillary, synergy benefits.  The actual deal rationale was defense, i.e. the matching of a competitor’s offer in a highly rivalrous industry.

Determining Which Type of Deal to Pursue

Overlapping deals
Overlapping deals address various elasticity constraints.  That is a nerdy way of say that overlapping deals are appropriate for acquirers that need to:

1. Raise prices, but cannot due to a lack of market leverage or declining demand
2. Lower prices to discourage new entrants and/or substitutes, to address falling demand, or to compete in a rivalrous industry, but cannot due to margin constraints
3. Reduce the costs of inputs, but cannot due to a lack of market leverage or constrictions in supply (usually accompanies #2 above)
4. Produce more in the face of sticky prices with high demand, but cannot due to a lack of capacity

Overlapping deals provide scale and market leverage.  Extra-accretive revenue synergies will be realized if the deal allows an increase in pricing; however, the primary value driver of an overlapping deal is most often cost synergies.  This means that substantial integration activities are likely to be required to realize the projected synergies, and corresponding costs to achieve must therefore be considered in the deal valuations.

Complementary deals
Complementary deals add products, geographies, innovation, and/or expertise.  If cost synergies exist, often they are ancillary benefits.  The primary value driver will usually be extra-accretive revenue synergies.  Synergy realization risk is higher in a complementary deal than an overlapping deal, and we will discuss the reasons for this in more detail in future posts.  For now, just understand that careful attention will need to be paid to diligence, valuation, and integration, in order to ensure synergy realization on complementary deals.

Vertical deals
The objective of a vertical deal is to eliminate a “middleman” and thereby realize either:

• Cost synergies (acquiring a supplier) or
• Revenue synergies (acquiring a B2B customer)

The reality is often neither are realized, and again we will discuss the reasons and provide examples in future posts.  Vertical transactions will, in most cases, also require that the acquirer perform substantial integration activities if extra-accretive synergies are anticipated.
 
Conclusion
Hopefully this discussion of deal rationales illustrates why it was critical to begin the process with a good understanding of our strategic foundation.  We’ll continue to expand on this in future posts, and I’ll throw in some fun, real-world examples that should provide even more insight on how these basics come into play.
 
I look forward to hearing your thoughts,
K