In the last six decades, many researchers have attempted to identify the key variables leading to successful company acquisitions. These studies have not always been definitive or quantifiable. The reason is connected to the challenge of simplifying an acquisition into a mathematical framework. Instead, businesses find success in the complexity of big dreams.
Long before they were considered an alternative for enhancing or diversifying a portfolio of returns, acquisitions played a strategic role in railroad expansion, oil field development and empire building. The great leaders in history and industry alike have made acquisitions a part of a grander strategic vision, not simply a scheme for growth.
Part of the misconception about the proper role of acquisitions is due to the conglomeration of corporate America and rise of private equity (PE) firms. Both of these trends took root post-World War II, but were glamorized in the 1980s with the successful diversification of General Electric and high-profile LBOs such as KKR & Company’s (formerly known as Kohlberg Kravis Roberts & Co.) hostile takeover of RJR Nabisco. Starting in 2003 with a low-interest environment, we began to see what has been termed the Golden Age of Private Equity, and PE deals were yielding returns that were triple the S&P.1 Over time, acquisitions became an alluring way for businesses to experience exciting and rapid growth. Even smaller businesses in diverse industries became comfortable with the tactic.
In reality, outside the world of private equity, business acquisitions rarely yield a positive return on equity. Most studies have the success rate pegged between 10% and 30%.2 The reason private equity firms can yield such high returns, especially in a low-interest-rate environment, is because they leverage the firm with maximum debt. Similar to real estate deals, PE firms experience ROE magnification as debt increases. Of course, in the E&C industries, high leverage is less practical because of variability of cash flows and bonding requirements. Likewise, from a company perspective, diversification is rarely a strong argument for making an acquisition. Professor Damodaran at the Stern School of Business at NYU, for instance, found that the values of conglomerates were discounted approximately 10% compared to the sum of the individual company values.3 The value of diversifying risk by consolidating unrelated businesses is offset by increasing complexity and administrative burden.
For superior profitability and long-term growth, the best motivation for purchasing another company is to make a strategic vision possible. Instead of having an “acquisition strategy” consisting of shallow or vague statements, such as scale realization or diversification, develop a complete company strategy, of which acquisitions play a part. This subtle difference in thinking can, at minimum, keep your business on track. Ideally, it could mean a game-changing acquisition.
WHAT IS A STRATEGIC DIRECTION?
In order to plan acquisitions in the proper context, it helps to reinforce what it means to have a strategic direction. It starts with a simply stated goal or a vision, such as “to win in X industry by 20xx.” From there, pivotal points on how to win are identified (i.e., best-in-class service or perfect safety records). The complexity lies in the countless details, activities and responses that allow you to achieve the pivotal points and eventually accomplish the vision. In other words, strategy is the road map for winning before the game is ever played. In the game of football, the coach does not say that his strategy is to win. Before the game, the coaches definitely have the goal of winning, but, not stopping there, they identify the pivotal points required to win the game, given the opponent’s strengths and weaknesses. Finally, they design the plays and practice scenarios tailored for those pivotal points. The strategy is all the above. With that in mind, think of an acquisition as one of the plays that could be called during the game. It could be a play that is called frequently or only sparingly. Perhaps it is very risky, such as a fake punt on fourth down, or maybe it is your bread-and-butter play. But no matter the scenario, it should fit with your overall strategy to win the game.
Consider Chicago Bridge & Iron’s (CB&I) recent acquisitions of Lummus Global and Shaw Group. CB&I is an excellent example of a company with a strategic focus. It has responded to emerging trends and has transformed through organic growth and acquisition from an oil and gas storage company into one of the world’s largest energy infrastructure companies. In order to make this transformation, two pivotal points of emphasis were required. First, in today’s rapidly evolving energy markets, CB&I had to be a leader in emerging process technologies. Second, in order to secure the world’s largest projects, it had to compete effectively for government services. In 2007, with the acquisition of Lummus Global, CB&I not only acquired a large portfolio of process technologies, but also solidified its position as a global player. In 2013 nuclear and government contracts were CB&I’s target in its acquisition of Shaw Group. Today those acquisitions have been deemed a strategic success, positioning CB&I to compete for the world’s largest projects. At first, however, analysts were bearish on the deal, not seeing the value.4 Such is usually the case with strategic moves — outsiders may not see the logic.
ACQUIRE TO WIN TOMORROW
While all companies, public and private, face certain pressures from stakeholders to make short-term gains, acquisitions are moves best made with the future in mind. Of course, it would be unreasonable to say that any business leader failed to consider the future before making a deal. Yet, the high level of emotions associated with deal fever has been known to cause tunnel vision in some instances. In other cases, the shortsightedness of middle managers or outside stakeholders has been known to pressure executives to make decisions incongruent with or counterproductive to the firm’s overall strategic direction. By looking for success at some point post-integration, executives can have a better view of the acquisition. Now that does not suggest short-term economics should be ignored. But giving more weight to the long-term case will inform a more thorough and thoughtful due diligence process.
Consider the case of Caterpillar’s misinformed acquisition of China’s Siwei in 2012. It was not from lack of strategy that caused Caterpillar CEO Douglas Oberhelman to announce to shareholders the year prior, “We are stepping it up big-time and putting our money where our mouths are. We’re going to play offense, and we’re going to win. We will win in China.”5 The Caterpillar CEO was facing significant pressure to show traction in the world’s largest coal market — China. In June 2012 Caterpillar paid approximately $700 million for Siwei, a fast-growing and profitable seller of mine-safety equipment, and its parent company, ERA Mining Machinery. With the acquisition, Caterpillar was supposed to gain a foothold in China’s mining industry.
That is until Caterpillar announced in January that it would be writing down $580 million from the purchase due to alleged accounting fraud. The stated value of the firm ended up being a complete mirage. While it seems to be inappropriate to argue malfeasance against Caterpillar executives, at a minimum they made a huge misstep under the influence of deal fever. They wanted to make it work and were even neglectful of early warning signs. According to Forbes, Siwei was running low on cash and had a mountain of bills, and Caterpillar made early loans to the company before the deal even closed. Missing from the decision were basic strategic questions such as, “Who are the managers running the acquired company?” “How do the firm’s values fit with our values?” “What are the value drivers for this firm, and do they complement or enhance our own value proposition?” Complete answers to these questions should have easily revealed the fraud that was hidden in piles of financial reports. Leaders do not need auditors as much as they need an understanding of strategic congruency.
One of the primary benefits of having a properly considered corporate strategy is to stay ahead of competitive and industry changes that tend to depress profits. Twenty years ago we may not have had to worry much about change in the engineering and construction industries, but today our industry is evolving. Competitors are becoming larger, technology is becoming more sophisticated, consulting/design and CM firms are becoming more integrated, etc. In this sort of dynamic environment, acquisitions can be a particularly effective means for keeping up with trends and changing the game. Organic growth can be slow and expensive. While of course riskier, acquisitions can be quick and decisive.
One domestic producer of cement in Mexico, with aspirations to become a global leader in the industry, was able to pursue acquisitions in 1992 that kept it on pace to meet its goal, despite unfavorable industry forces. CEMEX, faced with competitive pressure in Mexico from Swiss giant Holderbank (now Holcim) and unfavorable tariffs in the U.S., decided to make a big move into the Spanish cement market through the acquisition of two firms totaling 28% market share.6
As a competitive response, it was a success. It gained access to an important European market dominated by Holcim, of which CEMEX had the cultural and language advantage. From an operational perspective, CEMEX also adopted best practices from the more efficient Spanish firms. For instance, the use of petroleum coke as a fuel source in Spain was exceedingly more productive; so within two years, CEMEX adopted the practice at its Mexico operations.7 As a result, CEMEX was able to improve its competitiveness by adopting the Spanish efficiencies. Beyond that, Spain, at the time an investment grade company, also provided CEMEX access to cheaper capital that could be used to fund further acquisitions. And acquire it did. In 15 years, CEMEX went from near stagnation to become one of the world’s largest providers of construction materials. It did so from a shrewd awareness of the environment it operated in and a complete
understanding of the innovative value it could derive from acquired firms. Its approach commendably became known as the “CEMEX Way.”
Like the construction materials market, the rest of the industry is facing pressure to commoditize in order to stay competitive. Two generic strategies helpful to consider in this context are a low-cost strategy and a differentiation strategy.8 If these two strategies are thought of as requiring a trade-off between competing on cost and competing on value at, then choosing one would require commitment from all of the firm’s activities, especially acquisitions.
Suppose that a general contractor, building in the Class-B, midrise office market, had the strategy of winning contracts primarily on some combination of differentiating value-added activities (i.e., innovative technology, reliability, on time delivery, etc.) and not always on lowest price. Suppose further that this general contractor was sitting on excess cash and was looking to make an acquisition to move into the Class-A space. As is usually the case in real life, it did not have a whole menu of companies to select from — only two. Candidate A was a no-frills but fast-growth contractor that had built a handful of Class-A shells in various markets. It also owned a proprietary project manager training program that gave it best-in-class efficiencies. Candidate B was a smaller and younger but profitable, interior design-build firm, which had won awards in the past year for its high-profile completion of a Fortune 500 headquarters. It also was in the first phases of adopting BIM technology and had strong relationships with the two of the city’s most reputable owners. Equalizing for price, both companies appear to be very promising as acquisitions. Both are potential game-changers for our fictional GC.
In this highly stylized example, our GC can choose candidate A and be on the path of fast growth but also price compression and commoditization. Or the contractor could choose candidate B, a slower-growth and riskier option, with much higher profitability and unique value propositions. Based on previous experience and differentiation-based strategy, this contractor should likely pick candidate B. Another contractor with a low-cost history may do very well in picking candidate A. Of course, in practice, strategies are usually more complex than this. However, it is important for a business executive always to be mindful of how he or she is positioning the company in the market. As a natural extension, all of the firms’ activities should be consistent with that positioning. Game-changing acquisitions should not be about changing strategy or focus. They are about directing your business to uncharted areas of value creation.
Developing a corporate strategy and choosing complementary acquisitions is only part of the equation. Strategy realization is only achieved upon successful integration, which is hard work requiring attention to many details. The costs of integration are high, and something as simple as personality conflicts could lead to failure. As FMI has found in previous research, successful integrators are common in that they have had great sensitivity toward the people involved in both sides.9 It is hard to imagine anything energizing and unifying two separate groups of employees more than convergence around a consistent and clearly communicated vision of how to win in the marketplace.
Scott Ihle is a research associate with FMI Corporation. He may be reached at 919.785.9263 or via email at email@example.com.
1 Krantz, Matt. Private equity firms spin off cash. USA Today, March 16, 2006.
2 Christensen, Clayton, Richard Alton, Curtis Rising and Andrew Waldck. The Big Idea: The New M&A Playbook. Harvard Business Review, March 2011.
3 Damodaran, Aswath. The Value of Transparency and the Cost of Complexity. 2006.
4 Boone, Timothy. CB&I completes Shaw acquisition. The Advocate. February 21, 2013.
5 Montlake, Simon. Cat Scammed: How a U.S. company blew half a billion dollars in China. Forbes. March 4, 2013.
6 Lessard, Donald and Cate Reavis. CEMEX: Globalization the “CEMEX Way.” MIT Sloan Management. March 5, 2009.
8 Porter, Michael. Harvard Business School.
9 Davis, Hunt. After the sale: Acquisitions and the art of integration. FMI. 2010.