Mergers and “Value Creation” - Basing the Core Strategy Process on “Values”

Introduction

We often come across in business newspapers about Merger and Acquisition (M&A) activities. These two terms refer to two entities coming to terms and becoming one. The motivation, process of due diligence, post-activity integration handling may have a lot in common, but the management students need to have clarity between M&A. A merger is a clear case of two entities coming together and becoming a single entity. It is a more holistic process, the consent of both the entities is there, in terms of assets, turnovers, and market shares, these two may be closer in comparison. The motive for this ‘coming together’ may be due to acquiring better size, getting guarded from a third common enemy, gaining economies of scale, consolidating on complementary investments, and achieving respectable market share in the industry context. Any or more than one of the above may be the motivation for the Merger.

For the above, regulatory clearances may be required, at the same time some of the regulatory activities may also trigger such merger thoughts in two open-minded companies. On the other hand, though many of the above may be true in terms of process, the intent of one dominant player may be to “acquire” the smaller player in the industry, again to consolidate the assets, expertise, skills, manpower, market share etc. The “target” may or may not be willing to be “sold off” is the critical difference, and also the dominant role of the bigger of the two companies. Often the acquired company loses its identity and gets subsumed under the larger umbrella. Demerger is the reverse of merger wherein larger entity gets split/broken into smaller segments. “Value unlocking” is the often-stated motivation.

The business context   

Often companies after taking off from the startup stage of survival and initial growth start looking for consolidation. Of the dominant variables for management intervention viz. (i) topline, (ii) recent period topline growth, (iii) market share, (iv) EBITDA which indicates core operational profitability (agnostic of capital structure etc.), (v) overall bottomline, and (vi) cashflow situation, the company should stand in good stead. These metrics are seen on two planes; one is absolute, and the other is relative. Basics, as indicated above, have to improve over a period of time is the expectation. At the same time in terms of industry average and also the average of top five firms of the industry, how one’s parameters are is one question that is often asked. It is akin to comparing the stock price of a company with the overall index and with the performance of peers from the narrower industry segment to which the company belongs.

Often said statement is “topline is only a vanity, profit is sanity, whereas cash is reality”. Growth, market share, projected profitability may appear important, but the reality lies in having proper cashflow. Without cash or cash equivalents that can be converted into cash quickly, often the unstoppable “outgo” commitments can’t be respected without defaulting. How do we do the entire cycle profitably and “cash smoothly” is the challenge. This approach may not be followed by modern startups with “grow fast with huge losses to get acquired” approach.

The two usecases

“COM” is the company present in the industry “IND” and with decent values for above six metrics. The organic growth path that was followed so far has not yielded much results is the understanding at the management level. They wanted to grow fast and acquire greater market share that may lead to better bargaining power and respectability in the market. Larger volumes also means better discounts that can be acquired on the raw materials and logistics side. Thus, economies of scale benefits beckon such. The management might spot another player in the IND called “PANY” that may be of comparable size and with attractive above metrics as discussed above. Thus, the management of these two entities come together to “discuss” directly or through “appointed consultants for the process”. Final and finer details may be worked out, and modalities and pace agreed upon. Then, on a fine day the merger gets announced and the effective date gets notified after the regulatory nods. Thus, from COM and PANY, the new merged entity “COMPANY” comes into existence. The consolidation of the market side and organization side shall take some time and can be amicably resolved as the process happened with “consent” of both parties. Post-merger integration often is a smooth one though a huge exercise.

One the other hand, in the same IND if the entity COM would like to acquire a smaller company “com”, with or without the consent of “com”, then acquisition takes place. The process will be smooth if the “com” agrees to be swallowed by “COM”. Then, friendly acquistion is the result. Else, hostile takeover is the result. Many damaging instances can happen when hostile process unleashed. Some of these are, the unwilling small entity shall create obstacles in the path or make itself unattractive or burdensome to be had in the COM portfolio, if COM pushes ahead with the process against “com” interest. A sort of non-cooperation gets exhibited throughout the process, and even after the event. The post-acquisition integration shall be messy and costly, if the smaller entity did not agree to it. Otherwise, with willing owners of the smaller entity “com” submitting before the larger entity of “COM”, the result shall be a larger combined entity which will still be called “COM”.

The “Value”

We saw the very motivation behind the merger or acquisition. Two possibilities are friendly or hostile. Consolidated entity shall have better topline, higher market share, better negotiation and bargaining power in the industry, greater visibility, better placed for taking on any over-seas player venturing into the domestic market or even a large new entrant from the domestic industry itself. Such willing acquisitions happened in soft drinks industry when larger players ventured into Indian market. Similar, willing mergers happened in the telecom market when a large conglomerate made its intent clear that it was entering the sector. Cement industry saw huge round of consolidation in Indian market, both mergers and acquisitions happening, some on friendly terms, and others on not-so friendly. This can be a detailed case study.

The “Value” as was aimed was realized or not is a matter of deeper subject of study. Stock price-based studies are common. The steady value that got realized after the “event” has to be compared in an “imponderable” situation of “what would have happened to each of these two”, if the event had not happened. Thus, the combined Value “V” that got generated now compared to the prior period, whether is comparable or not to the “sum of individuals Values V1 and V2” that would have been garnered by COM and PANY combination or COM and com combination. If the V is larger than sum of V1 and V2, then it is said that there is a “synergy” that came into existence or got created. Else the event resulted in “value destruction”. In such cases, the synergy created is negative. Hard to accept but often this may be the situation in many instances. The reason could be not basing the “Value creation” on the foundation of “Values”.

Basing the Core Strategy Process on “Values” framework

All negotiations in the process happen based on how much is one valued. Whether all cash or stock-swap ratio uses the information from valuation exercise. The valuation of the entities has to happen on the “Values” foundation is the starting point. The disclosures of assets happens in a flaunting manner but the future/current liabilities including the possible losses / penalties / charges to be paid from court cases etc. are not disclosed fully. Additionally, people are not often treated fairly.

Additionally, either case of M&A results in larger teams for combined entity and “double CXO” positions. For instance, one have to deal with two CFOs, or two CMOs, or two CTOs. One of these has to subsume and agree to be part of the team playing the perceived second fiddle. Many ambitious professionals might press the “Exit” button at this stage. The valuable resources, especially with significant residency period and familiar with the prevailing context, if choose to do abrupt quitting, this affects post-event integration and also synergy creation. Thus, people have to be dealt with “Values”. Similarly, other stakeholders like long term suppliers to the smaller firm also need to be dealt with “Values”. They have to be brought around the table and made to see the value that still exists for them. These vendors have been part of the value creation and important members of eco-system and can’t be left in the lurch.

Transparency, trust, and truthful conduct become the three “T”s that shall ensure the success of the “Value creation” process. A simple example to appreciate the importance of the above is compensation to the employees in the combined entity. The structures, paying out of the incentives, and long-term retention attractions might have been different in each of the companies that have now become a single entity. How does one honour the earlier commitments? How does one have these “common” for the combined entity. These might appear simple questions but touch the deeper ethical depths. How things are handled in terms of transparency and truthful conduct shall develop long term trust. Long term survival and value creation get promised through the “Values” based approach and frameworks. Rest shall be a smoother execution.