Trends in Successful Acquisitions
We have found that the most successful corporate acquirers have mastered what we call a capabilities-driven approach to inorganic growth. That is to say, they understand the differentiated capabilities system of their businesses, the key strengths that combine processes, tools, knowledge, skills, and organization in a way competitors can’t match. This understanding gives their deals both higher success rates and market-beating financial returns.
Focusing on targets that leverage one’s key capabilities provides the greatest chance of M&A success…deals that leveraged the buyer’s key capabilities or helped it acquire new ones produced significantly better results, on average, than local stock market indexes in the two years following the deal.
companies may not always describe their M&A activities using capabilities terminology, but their transactions nonetheless reflect a calculated awareness of what they already do — or could do — extraordinarily well.
In our schema of M&A, deals fall into three categories: leverage, enhancement, and limited fit. Leverage deals are situations in which acquirers buy companies that they know or believe will be a good fit for their current capabilities system
Enhancement deals are designed to bring the acquirer capabilities it doesn’t yet have and that will allow it to intensify its own capabilities system.
Limited-fit deals occur when the acquirer largely ignores capabilities; the transaction doesn’t improve upon or apply the acquiring company’s capabilities system in any major way.
Enhancement deals are inherently more complex than leverage deals. But when they work, they can have outsized returns for the acquirer..Indeed, information technology was a sector in which enhancement deals led to even higher returns than leverage deals over the period of our study…Enhancement deals, which companies make to acquire a capability that allows them to augment their system of capabilities, are especially common in industries facing major technological or regulatory shifts.
Capabilities-driven companies know how to alternate between leverage and enhancement deals to achieve their growth objectives…Success relies less on quickly identifying and capturing synergies, and more on taking the time to find ways to manage cultural differences, retain essential people, and help those people’s ideas take root in the broader organization.
The Multiple Discount
Why don’t enhancement deals perform as well as leverage deals? From a TSR perspective, the biggest difference (two years after a deal’s close) is the price-to-earnings multiple of the acquirer. Strategy&’s study shows that doing deals takes a toll on multiples generally, but the negative impact is greater when the acquirer is taking on new capabilities. The downward multiple adjustment may reflect the fact that these deals are more complex and difficult to carry off successfully. In any event, the difference suggests that those doing enhancement deals should be vigilant not only in integrating their new pieces but also in making sure that everyone — including the investment community — understands the end goal.
By their nature, leverage deals make the most sense where companies that already have advantaged capabilities can integrate products and services into their sophisticated, well-functioning systems.
Theoretically, we don’t have many positive things to say about deals that don’t begin with a capabilities rationale. The evidence suggests these deals usually lead to negative returns
Limited-fit deals can work when they have a lot of consolidative potential — that is, when there is overlap between the acquirer and the target, and a chance to drive synergies in areas such as procurement, or to remove a significant amount of cost.
Besides sharpening the vision of prospective buyers, a capabilities lens can help a company figure out what doesn’t fit — and what it should therefore divest. The theory behind capabilities-driven divesting is simple: Get rid of the assets that don’t mesh with what you do best. These assets, which may be profitable, still distract companies from getting the most out of their capabilities systems. Ultimately, the assets that are clearly a good fit for the capabilities you have should get more funding so they can reach their potential.
General Electric’s announcement early in 2015 that it would sell off GE Capital, its long-standing finance unit, reflects what is essentially a capabilities-driven approach to divesting. In GE’s case, that doesn’t mean that it lacks the capabilities necessary for success in the areas of lending and credit. Rather, it means that maintaining these capabilities in light of intensifying regulatory scrutiny takes focus away from its core engineering-based capabilities. And in fact, every company’s thinking about which of its capabilities are indispensable, and which aren’t, should evolve in response to market changes and should be reflected in its M&A strategy.
Operational improvements. firms frequently create value by taking out costs through targeted programs, focusing on workforce realignment, procurement, sourcing, and other areas. A capabilities-driven approach can enhance value by revealing which capabilities are affected by cost programs, and by taking pains to ensure that core strengths are not diluted. Understanding capabilities can help ensure that only the fat, not the muscle, gets cut. At the same time, companies can build on distinctive capabilities to accelerate top-line growth in areas such as improving R&D and innovation and sales-force effectiveness.
Market-driven growth. firms create value by investing in businesses that are riding industry growth waves, or investing in situations where market disruptions are creating growth opportunities. In such scenarios, there is the potential for all assets to be lifted by a rising tide. But those that are focused on strengthening their capabilities systems will create more value than others. The capabilities approach helps to drive greater performance by identifying and focusing on these assets.
Market-driven growth. PE firms create value by investing in businesses that are riding industry growth waves, or investing in situations where market disruptions are creating growth opportunities. In such scenarios, there is the potential for all assets to be lifted by a rising tide. But those that are focused on strengthening their capabilities systems will create more value than others. The capabilities approach helps to drive greater performance by identifying and focusing on these assets.
Financial restructuring. PE firms create value by persuading lenders to renegotiate interest rates and/or exercise forbearance to enable the implementation of operational improvements. The capabilities approach enhances value by designing the debt restructuring around the company’s capabilities system, as well as by adding credibility to the turnaround plan by showing how the company’s capabilities will provide its “right to win” in its markets.