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6 June 2006
After introductions, Karen introduced the session with some figures about current deals and noted that the number of deals appeared to be getting slightly smaller, but that their average value was increasing. Globally, in 2005, computer software supplies and services industry was the most popular area for M&A activity and in Europe, the five most sought-after industries for M&A were Miscellaneous Services, computer software supplies and services, wholesale distribution and real estate.
Largest deal in the US in 2005 was Proctor and Gamble’s acquisition of Gillette (nearly $58bn), while in Europe this honour went to Telefonica SA’s friendly tender offer to acquire O2 plc for 26.2bn Euros.
Having given some figures, she went on to give some “facts”, asking participants how true they thought they were. Chris Scott thought they might be made up by consultants to sell their services, a view with which there was some sympathy.
The next slide gave some alternative views, and Karen noted that success or failure was dependent on what the definition of success was and also what measurement was used. Chris Nutt agreed, suggesting that the purchase of Phoenix Insurance by Sun Alliance didn’t add value to the company but seemed more of a service to the industry. It was a careful, planned integration and went very well. In complete contrast, the merger of Royal Insurance and Sun Alliance, said Chris “decimated” the value of the organisation. The implementation was rushed, he said, and made the mistake of keeping two leaders – the CEO and deputy chairman who had opposing visions for the business.
Steve wondered if the value for companies would have declined if the organisations hadn’t merged…Chris Scott thought that M&A activity is undertaken for very different reasons, and said that GWR and Capital merged because they wanted to defend themselves against a key competitor, and also wanted first mover advantage.
Karen, coming back to the question of what defines success or failure, pointed out that if nothing else, the length of time in which analysts considered share price was very important. In a review of the research on M&A and how successful or otherwise it was Bruner considers that in general, M&A activity DOES create value and that its success is context driven – i.e. that M&A is local. He therefore considers that the utility of M&A research should lie in insights about local conditions.
He thinks that four “neighbourhoods” influence returns to shareholders - strategy; investment opportunity; deal design; and governance. The slide shows a few examples from each of the neighbourhoods.
Strategy - Focus Vs diversification
Bruner reports that the convention has been that acquiring companies in related fields is most likely to discover and enable exploitation of synergies and indicates that focusing gives better returns. On other hand, he notes, acquiring organisations which have different markets and different cash flows enables businesses to spread risk. In addition, studies have found that diversification pays in information-intensive industries but he concludes that “sticking to the knitting” is generally thought to be more profitable
Strategy - Strategic restructuring
In a related finding, Bruner reports that selling off underperforming businesses, again focusing the business activity of the organisation also provides positive shareholder returns.
Deal design - Merger of equals
Recent research (2002) indicates that where mergers combine partners of roughly equal influence without the payment of a premium by one party to another, value for shareholders is typically much smaller than those in other deals. In effect, CEOs trade power for premium – they negotiate control rights in the merged form in exchange for a lower premium for their shareholders. There was some discussion about how this may smooth the deal and result in faster postmerger integration, itself leading to better returns.
Governance - Managerial stakes
Hardly surprisingly, studies suggest that returns to buyer firm shareholders are associated with larger equity interests by managers and employees.
Governance - Friendly Vs hostile
The buyer’s approach to the target influenced by degree of entrenchment of target’s management – (mergers are friendly, negotiated, takeovers are offers made to target’s shareholders); several studies report larger returns for hostile approaches than for friendly, based on the principle that the target’s shareholders would be offered a better price in a hostile bid.
Bruner generated a set of general rules which may predict failure of M&As.
You step far away from what you know – this is about understanding your organisation’s core competency, which MAY be managing a portfolio of unrelated businesses. So it doesn’t necessarily rely on “just being in manufacturing”
At this point, Gary told the meeting about some disastrous attempts by utilities after deregulation to run double glazing and window companies (electricity companies) and domestic appliance retail outlets (gas and electricity companies).
Economic benefits are improbable – or not incremental; what counts for synergies within some buyer firms is a host of projects which would have been done eventually, without the acquisition. Or consideration of benefits which are improbable, but treated as likely – cross selling is one of these – it takes massive energy and effort to make two previously unrelated (and perhaps competitor) organisations sell in one another to customers.
You’re not creative in deal structuring – for example, mechanisms like earn-out incentives and tax shields (a strategy of reducing of income tax liabilities by taking allowable deductions from taxable income), are all associated with higher buyer returns.
You have poor checks, balances and incentives – this extends to the oversight of the firm and how you have delegated decision authority, but the key principle is that employees have some “skin in the game” – a shared interest.
Bruner has examined some examples of disasters and tried to identify common elements which can be transferred to M&A.
Complexity: rapid spread of problems, difficult to understand what’s going on
Tight coupling: no margin for error – and for disasters this could mean reduced safety systems, a lack of time and for business, it might mean a need to general returns quickly to satisfy the markets.
Management choices: create risk exposure or amplify it
Cognitive biases: which impair anticipation of, or response to, disaster. Karen said that in her review of some very famous disasters, cognitive biases were key factors – Pearl Harbour was undefended by US forces, for example, because no one thought it possible that a strike could come from Oahu, or that planes would be flying under radio silence. Other cognitive biases include groupthink (Janis) and the representativeness heuristic – where because two things look the same, they ARE the same.
Business not as usual: the trigger for the disaster. This, explained Karen, referred to any changes in the normal environment –
physical, manpower or competitive activity, for example.
Failure of the operational team: Inappropriate response by operational team.
Karen went on to describe two of the examples in Bruner’s theory.
Construction on the 40-story Hyatt Regency Hotel began in 1978, and the hotel opened in July 1980. One of the defining features of the hotel was its lobby, which featured a multi-storey atrium crossed by suspended concrete walkways on the 2nd, 3rd and 4th levels, with the 4th level walkway directly above the 2nd level walkway.
On July 17th, 1981, approximately 2,000 people had gathered in the atrium for a dance contest, including hundreds packed onto the walkways. Observers interviewed afterwards said that they saw the walkways “bouncing”. At approximately 7pm, two of the three walkways crashed onto the lobby, killing 114 people and injuring more than 200 others.
The accident investigation found that during installation, modifications were made to the way the supporting rods connected to the bridges. The original design by the architects called for three pairs of rods running from the second floor all the way to the ceiling. Havens, the company responsible for manufacturing the rods, objected to the original plan of the architects, since it required the whole of the rod below the fourth floor to be threaded in order to screw on the nuts to hold the 4th floor walkway in place. These threads would probably have been damaged when the structure for the 4th floor was hoisted into position.
Havens therefore proposed two separate sets of tie rods; one connecting the 4th floor walkway to the ceiling, and the other connecting the second floor walkway to the 4th floor walkway. In the original design, the beams of the 4th floor walkway only had to support the weight of the 4th floor walkway itself, with the weight of the 2nd floor walkway supported completely by the rods. In the revised design, however, the 4th floor beams were required to support both the 4th floor walkway and the 2nd floor walkway hanging from it. With the load on the 4th-floor beams doubled, Havens' proposed design was only 60% as strong as it should have been. In addition, ignoring the tenets of good structural design, no other load-bearing paths were proposed.
Another discovery of the investigation team was that during construction, workers installing the walkways complained that heavy wheelbarrow loads caused swaying and vibration in the walkways. Rather than investigating the structural weaknesses, project managers ordered workers to use other routes than the walkways.
Applying his theory, Bruner suggests the following elements contributed directly to the tragedy:
Complexity – the points of failure on the walkways were out of sight (that is, they were within the beams); in addition, if the 4th floor walkway fell, so would the 2nd floor walkway
Tight coupling – there were no secondary paths of load bearing, and no safety net
Management choices – construction altered from original stronger design to one which was 60% as strong, to simplify installation
Cognitive bias – here, management was too optimistic – believing in the integrity of the revised bridge design without adequate testing
Business not as usual – there was overcrowding; dancing on bridge added weight and vibration
Inappropriate response by operational team – managers on the building team ignored instability (vibrations) in bridge system in construction
The second case study Karen outlined was what has been described as the worst industrial disaster in history, Bhopal.
Recent downsizing due to falling sales had contributed to the decline of safety checking and a general lack of understanding about safety procedures. There was a general bleeding of knowledge about the plant with the downsizing and turnover. Commentators noted that the seepage of chemicals began just after a shift change and they were unfamiliar with the chain of events which led to the reaction.
The plant had been criticized in safety audits and had suffered from five reported major accidents at the plant between 1981 and 1984, but nothing had been done.
Three out of the four safety systems at the plant were inoperable – scrubber, flare system refrigeration system and water spray system. The first three systems had been shut down for maintenance, and the water spray did not reach the top of the 100 foot high vent tower from which the gas escaped during the accident. For unexplained reasons, more than optimal levels of MIC were being stored at the plant at the time of the accident.
To add to the ingredients to this tragedy, the workforce and general population were unaware of the toxic and dangerous nature of the chemicals with which they were dealing – as were the authorities. No action plans were established to cope with incidents, including proper information to hospitals and doctors on how to treat symptoms. In addition, although external alarm activated to warn residents of Bhopal, it was quickly switched off to avoid causing panic. The first information given to the authorities was false – that the gas wasn’t toxic. When given correct information about the toxicity of the gas, the authorities urged people to flee, causing them to come out of their homes and into contact with the gas, when staying indoors and breathing through a wet towel could have saved many.
Applying the theory to this incident:
Complexity – this was a complex chemical plant, with movement of toxic fluids and gases by remote control; shift change, new workers unclear about evolving conditions
Tight coupling – the plant was situated close to lots of people; maintenance problems and inoperable safety systems reduced the margin for error
Management choices – were to operate the plant with no safety systems and to pay little attention to problems with the safety systems despite the accidents and reports;
Cognitive bias – there was overconfidence in integrity of system designed in one part of the world and operated in a third world country where cultural and educational backgrounds are very different; there was acceptance of this incomplete knowledge as the norm
Business not as usual – temporary oversupply of MIC at the plant; leakage of water either by operator error or sabotage (Union Carbide always claimed the leak of water into the MIC tank was done by a disgruntled employee)
Inappropriate response by operational team – inattention to safety issues; failure to contain leak; failure to alert authorities and surrounding population; initial denial to authorities that gas was poisonous
Karen noted that human performance factors are the guts of every accident; but by declaring operators must have failed, it helps to avoid management culpability. Perrow suggests that “finding that faulty designs were responsible would entail enormous shutdown and retrofitting costs, finding that management responsible would threaten those in charge; but finding that operators were responsible preserves the system, with some soporific injunctions about better training.”
Moving on to apply Bruner’s views to a situation with arguably less tragic outcomes, Karen turned to the case study of Quaker’s acquisition of Snapple
Quaker was one of America’s oldest food enterprises. Starting in the breakfast cereal market, the company expanded and diversified, going into Europe in 1960s. CEO William Smithburg was appointed in 1979 and masterminded an aggressive programme to streamline production through supply chain management and renewed the company’s focus on customer satisfaction. Gatorade was acquired in 1983, and is widely considered as his greatest management triumph; in 1994, Gatorade dominated the segment with 85% market share.
Snapple started life as Unadulterated Food Products Inc. The company was founded by two window-cleaning brothers in law with the help of a health food store owner. It began distributing fruit juices, all-natural sodas and seltzers and fruit drinks to local health stores. It entered the developing iced team market with a “new age” tea in 1987 and attracted the attention of the Thomas H Lee Company who successfully proposed a leveraged buy-out and renamed the company “Snapple”.
Using third party endorsement from off-beat celebs like Howard Johnson, and Wendy Kaufman, an employee as the face of the advertising, Snapple created a quirky, individualist image which become cult-like. It also had an aggressive distribution strategy and an extensive and dependable network of independent co-packers and distributors to prepare, bottle, warehouse and sell its products. Snapple gave generous margins to distributors ($4 per case), who could also deliver other beverages at the same time, boosting their profitability. Snapple’s relaxed, respectful attitude to distributors and employees earned tremendous internal and operational loyalty.
Despite the figures showing that the Snapple had the highest growth rate of all beverages companies in July 1994, there were some issues. Firstly the industry was maturing – Coca-Cola a formed joint venture with Nestea (Nestle) and Pepsico with Lipton and smaller competitors included Arizona Iced Tea, Nantucket Nectars, and Mystic.
Many distributors in the summer and fall of 1994 had large product inventory because of the cooler than expected summer and Snapple’s inability to react quickly to changing market conditions.
In addition, there were significant cultural differences between Snapple and Quaker.
Steve said he thought that certainly on the face of it, the reasons for the acquisition of Snapple by Quaker were all sound. There was a general agreement that hindsight was a wonderful thing….
The cereals and pet food markets were mature markets and Quaker was looking for growth and positioning in new areas.
Quaker also believed it could repeat its success with Gatorade (which increased sales from $100m to $1.3bn in ten years) – the two brands shared some characteristics – rapid growth, dominant position in a niche market. Quaker thought it could leverage Snapple and Gatorade into a superior combined offer, despite the differences in the organisations.
Finally, Quaker thought it could extract value by running Snapple more efficiently – by changing the supply chain. The independents Snapple used to distribute its products had exclusive rights in their regions and were adept at getting product into restaurants, delis etc, but inefficient in servicing the highest-volume channel, the supermarkets. Quaker was good at servicing the supermarkets and proposed to take high volume outlets from the independents and give them Gatorade to distribute to convenience stores and mom and pop outlets in return.
Snapple used independents who manufactured finished product under licence, but offered little flexibility in terms of delivery – it took three weeks to complete an order. Quaker planned to switch manufacturing to company-owned plants.
Finally, Snapple offered 55 flavours, not all of which had strong support; by reducing the range to the top 40 flavours, Quaker would save money on brand management, manufacturing, and distribution.
– There was a general feeling around the room that the price was a little high – which perhaps sharpened the feelings of the markets about the deal.
To streamline operations for greater efficiencies got off to a bad start when Quaker had to buy many of the bottlers and took a $30m restructuring charge. However, the real challenge lay in integrating the distribution systems and this took so much management time and energy, that the marketing plan was delayed.
However, even when it was instigated, it was anti-brand – Wendy, the Snapple Lady went, and was replaced by a big corporate campaign which alienated Snapple’s core customers. Between summer 1995 and October 1996, Quaker revised earnings for Snapple downwards five times, and alarmed by this, Standard and Poor reduced Quaker’s credit rating from A- to BBB+. While the direct link cannot be made, some commentators view the mismanagement of Snapple as leading to the acquisition of Quaker by Pepsico in 2000.
Looking at the application of Bruner’s idea to this M&A example, Karen did point out that obviously, he had chosen case studies that supported his theory, but that we had taken a case study which he had NOT chosen to see if it played out there too – of which more later.
When considering the failings of the operating team, it appeared it was unable to realise the potential of the brand – not simply misunderstanding the consumers, but also the culture of the company.
However, Bruner believes that the key issues about the acquisition were down to management choices in that they made two errors about strategic reaction. Quaker’s plans for Snapple embraced two “bets” about the reaction of others. The strategic plan assumed the distributors would swap the supermarket distribution rights of Snapple (at $4 margin per case) for the right to distribute Gatorade, at $1-2 margin per case. Not only did this slice through the margin, but the opportunity for volume. In addition, Quaker anticipated an easier exit from the co-packer contracts.
The second bet was an assumption that competitors would not encroach further on the niche market.
The group thought that to some extent, views about the market were always formed some months before the acquisition takes place, and as a consequence, all
M&As carry risk to some extent. Chris Scott mentioned that the discussion between GWR and Capital started about eight months before the merger happened and in the meantime, there was an industry slump in advertising revenues.
Gary then went on to describe the acquisition of Chiron by Bayer Diagnostics, where he was involved on the European side of the integration. At the time, most of Bayer was managed on a matrix basis, with individual business group heads (for example pharma, Polymers, etc) reporting to a country MD, with a dotted line to the MDs of the business groups. Bayer was beginning to make changes to this, downgrading the country MDs and changing the business group MDs to regional MDs.
The diagnostics business had two technologies; one was focused on laboratories, where huge complicated (and very expensive) machines processed thousands of different tests very quickly; the other was self-testing, which encompassed the diabetes market. They were very different markets, with different customers who had very different priorities.
From 1993-1998, IVD worldwide company revenues hovered around $18bn with increases or decreases of only 1-2% per year. In such a stagnant market, the response of the top ten companies was consolidation. The potential returns from the market were excellent – it was predicted that the market share of the top ten companies would grow from 60-65% in late 1990s to 85-90% in the 2000s.
Turning to reasons for the acquisition, Bayer Diagnostics’ rationale appeared to be sound. Gary explained that Bayer had a lot of cash on its balance sheet, and was being pressured by investors to buy something and Steve made the comment that he was surprised that Bayer had pressure from Germany. Gary pointed out that Bayer was also listed on the NYSE.
Prime among the reasons to acquire Chiron was that Bayer Diagnostics needed the technology to get into NAD (nucleic acid diagnostics) which was considered to be the next big thing in the industry – although Gary pointed out that it hadn’t happened yet.
In effect, what happened on the completion of the deal was that Bayer Diagnostics bought sales which went onto the balance sheet and it also bought market share and it looked, as Gary commented, a good outcome. However, many of the Chiron employees left (perhaps down to the difference between the cultures?) and therefore Bayer Diagnostics did not acquire the depth of expertise it had originally considered it was buying. In addition, the intellectual property that the company had bought in the shape of the NAD technology was not as valuable as was originally thought – because the idea hasn’t caught the imagination of customers yet.
The outcome of the sale had some immediate teething problems in the light of issues with the diagnostic unit produced by Chiron, which Gary said had a significant impact on the reputation of Bayer Diagnostics. This was combined with a general drop in sales worldwide and four years after the acquisition sales for Bayer Diagnostics had only increased to $1.8bn from $1.7bn.
Working in the Diagnostics business in Europe, Gary said that Europe formed the management team and partly because they wanted to do it so quickly, they didn’t get clarity or consensus on what the regional structure was there to do. So it was only a couple of years later that the organisation started to look for synergies, by which time much of the advantage was gone.
In addition, in Gary’s view, management was concentrating too much on the lab business to the detriment of the self testing business – they produced roughly the same level of profit but the self-testing business did so with approximately 500 people whereas the lab business needed a staff of 4,000. This led to a number of missed opportunities for the self-testing business.
When looking at the application of the idea to this case study, Gary felt that not only was the technology and its sale complex, but also the whole of Bayer, where the failure of one drug, Lipobay, tipped the whole corporation into crisis, not just the pharmaceutical business.
The meeting discussed whether this acquisition was a success or failure. Gary thought that the purchase hadn’t been a disaster, but that getting value out of it had been significantly slower than was hoped – and in fact, the market is still waiting for NAD testing to become popular. If NAD does become the next best thing in the marketplace, Bayer Diagnostics may finally reap the rewards of the technology it bought ten years ago – although, as Gary added later, there is no guarantee that Bayer Diagnostics is still at the forefront of the technology.
At the end of the meeting, the group discussed whether the Bruner typology was helpful in planning for M&A. Chris noted that there were some elements of the market that you couldn’t legislate for – for example, the failure of the market in the Bayer case and the decline of advertising revenue in the merger of GWR and Capital Radio.
Karen asked if the group felt that the role of the advisors should include market scanning and although the group thought that it should, they also acknowledged that advisors generally were concerned in making the deal work, regardless of the performance of the company/companies afterwards. It was pointed out that advisors get paid only if the deal came off.
Chris Nutt noted that some of the problems which arose might have been identified in due diligence – but Steve thought that not all due diligence was done to the same level.
It seemed to Karen that the cultural aspects of deals seemed to be hugely important and yet still, cultural due diligence is done only as the exception, rather than the rule.
Gary thought that Bruner’s typology was quite useful, but too complicated. He thought that there was very little discernable difference between “complexity” and “tight coupling” and thought that what might be more helpful are just four areas of importance. These were strategy and planning, execution (which is where many of the M&As we looked at fell down), some sort of market scanning which he termed environment/business and finally, the cognitive bias, which he considered might well also be complacency.