Despite the ongoing climate of economic uncertainty, M&A activity has remained robust, but is becoming more and more complex by each passing day. Nevertheless businesses have been maintaining and acknowledging the fact that merger and acquisition remains the most important element in their growth strategy. However transactions are taking longer to conclude, which affects the growth of businesses and hence leaders are paying more attention and focusing on anticipating potential obstacles to the negotiation and valuation process, financing the deal etc and preparing for it beforehand.
Strategic rationale for any acquisition normally creates value typically by conforming to at least one of the following prototype: improving the performance of the target company, removing excess capacity from an industry, creating market access for products, acquiring skills or technologies more quickly or at lower cost than they could be built in-house, exploiting a business’s industry-specific scalability, and picking winners early and helping them develop their businesses.
How to improve the target company’s performance?
The most common value-creating acquisition strategies is to improve the performance of the target company. This means you radically try to reduce costs to improve margins and cash flows in the company you have acquired. Always remember that it is easier to improve the performance of a company with low margins and low returns on invested capital (ROIC) than that of a high-margin, high-ROIC company.
Remove excess capacity to consolidate your position in the industry
Normally the combination of higher production from existing capacity and new capacity from recent entrants often generates more supply than demand. It is in no one’s interest to shut a plant. Acquiring companies often find it easy to shut plants across the larger combined entity than to shut their least productive plants and end up with a smaller company.
Accelerate market access for the target company’s products
Most often, relatively small companies with innovative products find it difficult to reach the entire potential market for it’s products. But bigger companies who purchase these smaller companies use their own large-scale sales infrastructure to reach the markets faster and accelerate the sales of the smaller companies’ products.
Acquire skills or technologies faster or at lower cost than they can be built
To enhance their own products sometimes many big technology-based companies buy out other smaller companies that have the technologies they require. They do this because this helps them acquire the required technology more quickly rather than developing it themselves or to avoid royalty payments on patented technologies, and keep the technology away from competitors.
Exploit a business’s industry-specific scalability
Economies of scale are often the key source of value creation in M&A. While they can be, one has to be very careful in justifying an acquisition by economies of scale, especially for large acquisitions. That’s because large companies are often already operating at scale. If two large companies are already operating that way, combining them will not likely lead to lower unit costs. Economies of scale can be important sources of value in acquisitions when the unit of incremental capacity is large or when a larger company buys a subscale company.
Pick winners early and help them develop their businesses
This winning strategy involves making acquisitions early in the life cycle of a new industry or product line, long before most others recognize it’s potential. This acquisition strategy requires a disciplined approach by management in three dimensions. First, you must be willing to bet and make investments early, long before your competitors and the market see the industry’s or company’s potential. Second, you need to make multiple bets and to expect that some will fail. Third, you need the skills and patience to nurture the acquired businesses.
Synergy is one of the metrics that parties in an M&A deal use to justify the transaction cost. Usually the cost is calculated taking into account the expected benefits that will accrue to both the companies post acquisition. This is referred to as synergies and is classified as operating and financial synergies.
Operating Synergy: refers to the ability to increase the returns generated by assets and accelerate the growth which results in increased cash flows for the combined entity as they now eliminate duplicity of costs they incurred previously like distribution costs, administration costs, rental costs etc.
Financial Synergy: involves the improvement of the financial performance of the two firms when combined together. This includes increase in capacity to raise debts, lower cost of capital, improved cash flows, tax benefits, higher bargaining power, and capacity to negotiate lower cost of capital with financial institutions.
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