Content M-5: Target selection

Question 1

Recap: When dealing with acquisitions and alliances, we seek to create fit and synergies between firms’ activities; the evaluation depends on the motive behind an alliance or acquisition. What are the type of synergies?

Answer 1

• Cost-reducing synergies
  > Economies of scale and scope
  > Subadditive
  > Examples: Consolidation, Combination
• Revenue-enhancing synergies
  > Superadditive
  > Examples: Customization, Connection

Question 2

Two methods to grow, internal and external. Examples?

Answer 2

• Organic: Using company’s own resources by:
  > Expanding
  > Rejuvenating (fresh perspective)
  > Diversifying
• Inorganic: Borrowing/buying resources through:
  > Mergers & Acquisitions
  > Alliances
  > Joint Ventures

Question 3

What is the diversification test, and the corresponding five step approach?

Answer 3

Diversification test: Vm(AB) - Cm(B) > V(A)

Approach:
1. Identify synergies to being in new + old business
2. Identify resource gaps
3. Identify best INORGANIC growth candidates who can fill the gap
4. Identify best mode for best INORGANIC growth candidates and estimate value.
5. Estimate ORGANIC growth value and compare.

Question 4

The reasons for mergers and acquisitions, and alliances, FAILING lie in two main areas

Answer 4

• Results
  > Bad financial results
  > No value creation; value destruction even
  > Unequal division across partners, or after merging.
• Process
  > Insufficient strategic, organizational and/or cultural fit
  > Lack of skills to arrive at a good deal and to manage conflict
  > Integration and management of process below par or incomplete
  > Bad planning

Question 5

Recap: Dynamic Relational View. Which components?

Answer 5

• Complementary resources (precedes other three)
• Relationship-specific assets
• Effective governance
• Knowledge sharing routines

Above four, contribute to relational rents.

Question 6

Recap: What is the five-step alliance process?

Answer 6

1. Business case & need
2. Partner selection
   > Partner search
   > Partner identification
   > Assessing fit
3. Negotiation & governance
   > Assessing value
   > Legal issues
   > Closing deal
4. Management
   > Knowledge transfer
   > Trust building
   > Conflict resolution
5. Assessment & evaluation

Question 7

Recap: What is the five-step acquisition process?

Answer 7

1. Business case & need
2. Due diligence & target selection
   > Analysis
   > Justification
3. Buying decision
   > Agreement
   > Announcement
4. Post-acquisition integration
   > Level of integration
   > Immediate PAI
5. Assessment & evaluation

Question 8

Kaul & WU (2016) Framework. What does it entail?
Has to do with the effect on the probability of target being acquired.

Answer 8

• Newness to acquirer of target market (i.e. relatedness) has negative effect on the probability of target being acquired.
• Strength of acquirer’s acquisitions capabilities have a positive effect as moderation on newness to acquirer of target market and manufacturing productivity of target.
• Manufacturing productivity of target (i.e. target’s capability strength) has negative effect on probability of target being acquired.

Central message:
- Acquirers seeking to create value by deploying their existing capabilities will prefer targets with weak capabilities in existing contexts
- Acquirers seeking to create value from acquirer new capabilities will prefer targets with strong capabilities in new (though related) contexts.
- Moreover, they expect that firms with weak acquisition capabilities will limit themselves to acquiring inferior targets in existing markets, and only those with strong acquisition capabilities will pursue targets with superior capabilities and in new markets.

Question 9

M&A: Different types with different aims. What are different M&A types? (5)

Answer 9

• Overcapacity: Aim to create more efficient operations, gain market share.
• Product/Market extension: Aim to extend a company’s product line.
• Geographical roll out: Aim to remain operating units to remain local while company expands geographically.
• Acquire R&D: Aims to supplement in house R&D to build position quickly.
• Industry convergence: Aim to combine resources form two industries whose boundaries are converging.

Question 10

Successful mergers and acquisitions are preceded by an extensive due diligence. What are the four categories for these extensive due diligence?

Answer 10

• Financial issues & investments
• Tax, legal & IT issues

Above-mentioned often being done at the beginning and often only areas, but… they’re conditions and DO NOT contribute to the creation of value.

• Organizational & employee capabilities
• Strategy & cultural fit

Above-mentioned often done much less extensively, but… are the only two that contribute to value creation, particularly strategy and culture.

Question 11

Cultural fit. The concept of cultural (or organizational) fit is much more fuzzy, but in general we should look at two categories, which are:

Answer 11

• Organizational culture
  > HR practices and reward systems
  > Values
  > Organizational structure and decision-making
  > Objectives
• National culture
  > collectivism vs. individualism
  > low vs. high power distance
  > masculinity vs. femininity
  > low vs. high uncertainty avoidance

Culture generally viewed as an obstacle to acquisition success. But, it’s a double edged sword! Cultural distance does impede integration processes as it influences understandability, communication, and employee retention, but at the same time some diversity may also trigger learning.

Question 12

A Map of Synergies (Framework). Is a continuum, depends on which two dimensions?

Answer 12

• Probability of success (high vs low)
• Time frame (short vs long)

Look up this framework.
Essentials: Those close to the center (high probability of success, short time frame) tend to be cost-saving synergies. Those on the outside are revenue-generating synergies, which require a lot of time and management and are less likely to succeed. In determining your walk-away price, your discount factor for synergies should rise as you move away fromt he center.

Question 13

It is impossible to determine whether the target should be complementary or similar and what will constitute strategic fit without understanding of the motive of an acquisition. As such, it’s also difficult to define strategic fit - because, “it depends”, on the motive.
Just like internal synergy creation: Assessing similarity of resources is done with purpose in mind.

Answer 13

True!

Question 14

Target selection, which five questions?

Answer 14

1. Why are we really buying? (motivation to acquire)
2. What are we really buying?
   > Assess the following elements for fit: Customers, competition, cost economics, capabilities.
3. What is the level and the context of the target’s capabilities?
   > Level: how much stronger or weaker are the capabilities as compared to the ones of the acquirer.
   > Context (product market, geographical market, technology field etc.): how relevant/new are the capabilities for the acquirer?
4. Where are the synergies - and the skeletons?
   > Assess expected type of synergies and costs associated with achieving them.
   > Take into account negative synergies!
5. What is the target stand alone value and our walk-away price?

Question 15

Many firms have made many acquisitions have have produced little value. Due diligence too often becomes an exercise in verifying the target’s financial statements rather than conducting a fair analysis of the deal’s strategic logic and the acquirer’s ability to realize value from it. Why is that?

Answer 15

• Managers seldom kill potential acquisitions, even when the deals are deeply flawed.
• Many due diligence processes fail to uncover major problems.
• Firms routinely overestimate the synergies available from their acquisitions.

Question 16

Successful acquirers view due diligence as much more than an exercise in verifying data. What do they do?

Answer 16

• Go through the numbers deeply and thoroughly
• Put the broader strategic rationale for the acquisition under the microscope
• Look at the business in its entirety, probing for strengths and weaknesses and searching for unreliable assumptions and other flaws in logic.
• Take a highly disciplined and objective approach
• They are prepared to walk away from a deal, even in the very late stages of negotiations.

Question 17

All successful acquirers build their due diligence process as an investigation into which four basic questions?

Answer 17

1. What are we really acquiring?
2. What is the target’s stand-alone value?
3. Where are the synergies - and the skeletons?
4. What’s our walk-away price?

Question 18

Related to: “What are we really buying?”
When senior executives begin to look at an acquisition, they quickly develop a mental image of the target firm, which shapes the entire deal-making process. An effective due diligence process challenges this mental image. Acquirer must build its own proprietary, bottom-up view of the target and its industry. What is this called?

Answer 18

Strategic due diligence

Question 19

Related to: “What are we really buying?”
Strategic due diligence entails gather information about the so-called “4Cs of competition”. What are those 4 Cs?

Answer 19

• Customers
• Competitors
• Costs
• Capabilities

Question 20

Related to: “What are we really buying?”
Effective acquirers systematically test a deal’s strategic logic by organizing their investigations around the four Cs of competition. What are the four steps?

Answer 20

• Get to know the customers: draw a map. Compare target’s customer segments with those of tis competitors.
• Check out the competition: examine target’s industry presence
• Verify cost of economics: Assess whether the benefits of sharing costs with other BUs will outweigh the lack of focus that sharing costs across multiple businesses might introduce (use benchmarking)
• Take stock of capabilities: You’re not just buying a balance sheet, but also capabilities (e.g. management expertise). Involves looking at which organizational structures will enable the firm to implement its strategy most effectively.

Question 21

Related to: “What’s the target’s stand-alone value”?
What should be rigorously analyzed, and why?

Answer 21

The target’s books! To verify reported numbers. Firms can use a wide range of accounting tricks to buff their numbers.

Question 22

Related to: “What’s the target’s stand-alone value?”
Firms can use a wide range of accounting tricks to buff their numbers. What are some examples of such tricks?

Answer 22

• Stuffing distribution channels to inflate sales projections
• Using overoptimistic projections to inflate the expected ROI
• Disguising the head count of cost centers by decentralizing functions so you never see the full picture.
• Treating recurring items as extraordinary costs (get them off the balance sheet)
• Exaggerating a website’s potential for being an effective, cheap sales channel.
• Underfunding capital expenditure or sales, general and administrative costs in the periods leading up to a sale to make cash flows look better.
• Encouraging the sales force to boost sales while hiding costs.

Only way to uncover these tricks is to send a due diligence team into the field!

Question 23

Related to: “Where are the synergies - and the skeletons?”
Why are synergies estimates often untrustworthy?

Answer 23

Managers routinely overestimate the value of cost and revenue synergies and underestimate the difficulty of achieving them.

Question 24

Related to: “Where are the synergies - and the skeletons?”
The map of synergies distinguishes five categories of synergies based on two dimensions. What are these two dimensions and what are the categories?

Answer 24

Dimensions:
- Probability of success (high vs low)
- Time frame (short vs long)

Results in:
- Eliminating duplicate functions, business activities, and costs -> easiest to achieve.
- Savings realized from cutting shares operations costs (e.g. distribution and sales)
- Savings from facilities rationalization. Typically more difficult to achieve as they can involve significant personnel and regulatory issues.
- Most elusive revenue synergies, staring with sales of existing products through new channels.
- Selling new products through new channels.

Each circle/category offers large rewards, but the farther out the savings or revenues lie, the more difficult they become to achieve and the longer it will take.

Question 25

What is routinely overlooked in due diligence?

Answer 25

Negative synergies

Question 26

Related to: “What’s our walk-away price?”
What is a walk away price?

Answer 26

The maximum price you’re willing to pay when the final price negotiation is conducted.

Question 27

What does the capabilities-based perspective on acquisitions entail?

Answer 27

Viewing acquisitions as a means for firms to access and deploy capabilities and resources, especially those whose services cannot be directly transacted through the factor market. –> Requires the firm to take ownership of the asset in order to make use of it.

Question 28

When are targets with weak capabilities in existing context preferred?

Answer 28

When acquirers are seeking to create value by deploying their existing capabilities.

Question 29

When are targets with strong capabilities in new (though related) context preferred?

Answer 29

When acquirers are seeking to benefit from the acquisitions of new capabilities.

Question 30

There are two distinct sources of value from acquisitions. What are these sources and what do they entail?

Answer 30

1. Capability deployment: acquisitions may be a means for a firm to deploy their exiting resources and capabilities, creating value by improving the performance of the acquired firm. Target is preferred with weak capabilities for greater improvement potential, and also operating in the same/similar context so that acquirer’s capabilities are relevant.
2. Acquisition of new capabilities: Acquisitions may be means for firms to acquire new resources and capabilities, allowing them to bridge capability gaps and enter new markets. Target is preferred with strong and distinctive capabilities to maximize value creation. Different context preferred because they want to acquire capabilities that they don’t already possess.

Question 31

Capability deployment and acquisition of new capabilities are two sources of value from acquisitions. Which one is more likely to be pursued? Why?

Answer 31

Capability deployment, because it will face lower ex ante information costs and lower ex post integration costs than capability acquiring acquisitions.

Question 32

Firms have little to gain form acquiring capabilities that are either extremely similar (and therefore redundant) or completely unrelated (and therefore irrelevant).

Answer 32

True!

Question 33

Acquisitions are associated with several costs. Which are these (2) and what do they entail?

Answer 33

• Ex ante information costs: associated with the difficulty of identifying and evaluating a potential target. Costs will increase with the distance between the contexts of the 2 firms and reduce with the buyer’s acquisitions capabilities.
• Ex post costs of integration challenges: costs resulting fromt he challenges associated with integrating the operations of 2 distinct firm. Integration costs first decrease and then increase with target capability, being the lowest when target capabilities are at the same level as those of the acquirer.

Question 34

Conclusion of a paper:
- Acquirers pursue weak targets in existing markets (consistent with capability deployment) but are relatively more willing to acquire superior targets when entering new markets (consistent with capability acquisition).
- These preferences are moderated by the buyer’s acquisitions capabilities: firms that have weak acquisitions capabilities generally limit themselves to buying inferior targets in existing markets. Firms with strong acquisitions capabilities pursue a broader range of targets and are relatively more willing to enter new markets and acquire superior targets.

Answer 34

True!

Question 35

When does an acquisition occur?

Answer 35

When one firm buys another firm or a business of that other firm.

Question 36

When does a merger exist?

Answer 36

A merger occurs when a new firm is formed and the acquirer and target firms are dissolved.

Question 37

What are the stages in an M&A process?

Answer 37

1. Target selection
2. Valuation & negotiation
3. Due diligence
4. Implementation
5. Evaluation

Question 38

Should, ideally, the valuation & negotiation as well as post-merger integration activities depend on each other?

Answer 38

Yes! The valuation must take into account the anticipated PMI challenges and the PMI activities must be mindful of the value drivers in the evaluation.

Question 39

How is a valuation different from the process of deciding what to pay for the target?

Answer 39

A valuation helps to set the upper and lower bounds on what the acquirer should be willing to pay.

Question 40

In a valuation, the lower and upper bounds on what the acquirer should be willing to pay are determined. What do these two entail?

Answer 40

• Lower bound = determined by the standalone value of the target firm (0 synergies and ignoring costs of integration that are synergy independent). Offer below this value should be rejected unless a bargain is spotted.
• Upper bound = synergistic value (standalone value + value of synergies with the acquirer).

Area between lower bound and upper bound is the bargaining zone! Within a point of agreement is hoped to be found.

Question 41

Integration costs can be separated into which two categories?

Answer 41

• Synergy dependent integration costs: depend on the kind of synergies being extracted; may be thought of as a variable tax that eats into the value of the synergy.
• Synergy independent integration costs: doesn’t depend on the type or value of the synergy being extracted through integration but instead depends on the scale and age of the target firm. Larger and older firms will require greater integration efforts to be compatible.

Question 42

There are several known challenges to post-merger integration (PMI). Which are these?

Answer 42

• Complexity
• Limited information: many decisions that are premises int he PMI planning phase are made without accurate information.
• Functioning while integrating: keeping the businesses running as usual while negotiating in a complex integration process.
• Uncertainty and change: PMI implies uncertainty and change for employees -> lower productivity.
• Cultural differences: acquirer and target typically differ not only in their formal structures but also in their organizational or national cultures. This can create conflict.

Question 43

In PMI, two consequences need to be balanced when deciding on organizational integration levels. Which are these?

Answer 43

• The need for collaboration
• The need for minimizing disruption

Question 44

We can think about PMI decision regarding the combined organizational structure in terms of two sequential choices. What are these?

Answer 44

1. Grouping choices (the boxes in an organizational chart)
   > 0: Autonomy: both units exists, but operated completely independent; report to same CEO.
   > 1: Peer: the units work together as peers
   > 2: Report: 1 unit (typically target firm) report to the other (often the acquirer)
   > 3: Absorption: 1 unit is completely absorbed by the other.
2. Linking choices (the lines in the organizational chart)
   > Incentives
   » 0: reward on individual unit performance
   » 3: reward on combined unit performance
   > Information channels
   » 0: no information flows between target and acquirer unit
   » 3: extensive information flows
   > Standardization of work procedures
   » 0: Both units use own processes and procedures
   » 3: Switch to common processes and procedures

These grouping and linking choices are often complements! The value of choosing low looking choices is enhanced when a low score is chosen on grouping choices.

Question 45

Key principle CH11: In every acquisition, each pair of organizational units from the acquirer and target could have a different optimal level of integration between them.

Generally, lower levels of integration (low scores on grouping and linking choices) are sufficient for low modification and dissimilar resources.

Answer 45

True!