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    Bloomberg press   strategic due diligence Bloomberg press strategic due diligence Presentation Transcript

    • DD BkLT cvr2 9/12/02 1:51 PM Page 1 LOBAL, CROSS-BORDER DEALS often present G mouthwatering opportunities for expansion into new markets. However, these transactions also include STRATEGIC regulatory and legal issues, and must overcome complex cul- tural challenges to successfully integrate. Consider the merger between engineering giants Asea of Sweden and Brown Boveri of Switzerland. The merged organization, ABB, had to contend with strong national companies, Due Diligence governments, and striking unionized German workers, plus powerful and culturally different management. How can companies merging across borders, or acquiring abroad, foresee and account for risks associated with such issues? Bain & Company research finds the odds of success in M&A a dismal one-in-five. But the research also finds that deals beating these odds follow a pattern: They put strategic intent before due diligence and rigorous due diligence before committing to a purchase price. In successful deals, the com- mercial assessment calculates the cost of risks including local market peculiarities, differences in national and organiza- tional culture, likely competitor responses in all relevant geographies and businesses, and regulatory challenges. Truly strategic due diligence takes these elements and extrapolates GEOFF CULLINAN their impact on the merged companies’ business boundaries, TOM HOLLAND on integration objectives, and on ultimate returns to share- holders. Authors GEOFF CULLINAN AND TOM HOLLAND, of Bain’s worldwide corporate transactions practice, present a comprehensive tool kit for cutting through complexity in cross-border deals to identify core value and its potential. EXCERPTED FROM Due Diligence for Global Deal Making: The Definitive Guide to Cross-Border Mergers and Acquisitions, Joint Ventures, Financings, and Strategic Alliances EDITED BY Arthur H. Rosenbloom PUBLISHED BY
    • 1 Geoff Cullinan is a director in Bain & 2 Company’s London office, where he leads the 3 European private equity practice and the London 4 M&A practice. Mr. Cullinan has more than 5 twenty-five years of general management, strat- 6 egy consulting, and investor experience in a wide 7 range of industries, including consumer prod- 8 ucts, retail, automotive, chemicals, engineering, 9 and financial services. Prior to joining Bain, Mr. 10Cullinan was chief executive officer of Hamleys Plc, a retail business in 11the toys and games industry. Previous to this, Mr. Cullinan was the founder 12and managing director of OC&C Strategy Consultants and the head of the 13European consumer goods practice for Booz Allen & Hamilton Inc. He 14has a B.A. degree from the University of Essex and earned an M.B.A. with 15highest distinction from IMEDE, Lausanne. 16 17 18 19 Tom Holland is a director in Bain & 20 Company’s San Francisco office, where he heads 21 the global business consulting firm’s worldwide 22 private equity practice. For nearly twenty years, 23 Mr. Holland has worked with companies in 24 a variety of industries, including technology, 25 telecommunications, transportation, consumer 26 goods, and manufacturing. He has advised clients 27 on growth strategies, cost and asset restructuring, 28reengineering, and mergers and acquisitions. He has also helped clients 29facing major turnarounds or repositionings in turbulent industries, such as 30telecommunications, transportation, and aerospace. Prior to joining Bain, 31Mr. Holland held positions with Clorox and Bain Capital. He earned his 32M.B.A. with distinction from Stanford University and holds a B.S. degree 33in engineering from the University of California at Berkeley. 34 35 36
    • 12345678910111213141516171819202122232425 Copyright © 2002 by Arthur H. Rosenbloom. All rights reserved. Printed in the United States of America.26 Published by arrangement with Bloomberg Press, from Due Diligence for Global27 Deal Making: The Definitive Guide to Cross-Border Mergers and Acquisitions, Joint Ventures, Financings, and Strategic Alliances.282930 To order, call toll-free 800-869-1231. Please mention code: DILI. Discounts available for quantity purchases. Phone: 609-750-5070.313233 BLOOMBERG and BLOOMBERG PRESS are trademarks of Bloomberg L.P. All Rights Reserved. This publication contains the authors’ opinions and is designed to provide accurate and authoritative informa-34 tion. It is sold with the understanding that the authors, publisher, Bain & Company, and Bloomberg L.P. are35 not engaged in rendering legal, accounting, investment-planning, or other professional advice. The reader should seek the services of a qualified professional for such advice; the authors, publisher, Bain & Company,36 and Bloomberg L.P. cannot be held responsible for any loss incurred as a result of specific investments or planning decisions made by the reader.
    • 1 2 3 4 Strategic 5 6 7 Due Diligence 8 9 10 GEOFF CULLINAN 11 TO M H O L L A N D 12 13 Bain & Company 14 15 16 17V 18 ALUE CREATION, THE ULTIMATE AIM OF A MERGER, 19 acquisition, joint venture, or related type deal, is any- 20 thing but certain. One in five such deals falls through 21after it’s announced, due to either regulatory issues or a failure 22to resolve outstanding disagreements. Of those transactions that 23do close, one-half to three-quarters fail to create shareholder 24value (their earnings are less than their cost of capital), accord- 25ing to several studies by Harvard Business School and surveys 26of CFOs by Bain & Company. One of the main reasons is a 27failure to align strategic goals with the process of generating 28and executing transactions. 29 Cross-border transactions, involving companies based in 30different countries, often present mouthwatering opportuni- 31ties for expansion into new markets. However, these deals 32also include regulatory and legal issues and complex cultural 33considerations, such as the need to understand foreign mar- 34ket dynamics, employee work styles, and managerial bias to 35integrate the companies successfully afterward. The merger 36 3 3
    • S T R AT E G I C D U E D I L I G E N C E1 involving Swedish Asea and Swiss Brown Boveri Inc. was2 a classic multicultural merging of equals. Yet the complexity3 of integrating these companies into engineering giant Asea4 Brown Boveri (ABB) extended well beyond internal business5 issues. For instance, ABB had to contend with strong national6 companies, governments, and striking unionized German7 workers, plus powerful and culturally different management8 comprised of five nationalities on the eight-person executive9 committee and nineteen nationalities among the 170 head-10 office employees.11 Transactions that succeed—be they cross-border or within12 the same country—share a common element: The deals are13 closely aligned with the buyer’s strategic purpose.14 British American Tobacco (BAT), the world’s second-largest15 tobacco company, understood the importance of aligning transac-16 tions with strategy when it purchased Toronto-based Rothmans,17 Canada’s number-two tobacco company, in 1999. The acquisi-18 tion involved weathering three major antitrust inquiries and19 combining operations in more than seventy countries. Despite20 this complexity, integration was largely completed within a year.21 BAT Chairman Martin Broughton emphasizes, “You need abso-22 lute clarity … and you must stick to your strategy, or you’ll lose23 the troops.”24 To make sure two companies in a cross-border deal can25 achieve and maintain strategic alignment, you must conduct26 exhaustive strategic due diligence. Often called “commercial27 assessment” or “commercial review,” strategic due diligence28 begins with a company’s corporate, or strategic, planning.29 Hence, you must understand the strategic planning process to30 understand strategic due diligence.313233343536 4
    • R E V I E W I N G Y O U R S T R AT E G Y 1 2Strategy Precedes Due Diligence 3 4 5T RANSACTIONS SHOULD BE MADE ONLY WHEN THEY IMPROVE THE STRATEGIC POSITION OF THE INVESTOR’Sexisting business or add to its core competencies. To probe the 6 7 8logic of a transaction, ask the following five questions: 9 1 Strategy formulation: Is a transaction (acquisition, 10 joint venture, strategic alliance, minority interest stake) 11 required to fulfill corporate or business unit strategy? 12 2 Transaction target screen: Who is the best candi- 13 date based on attractiveness and availability? 14 3 Due diligence: Does this particular deal meet the 15 investor’s strategic objectives? 16 4 Target valuation: Can we do the deal at the right 17 price? 18 5 Integration: Can we execute our integration or 19 restructuring plans postdeal to extract the full value? 20 Before trying to incorporate a cross-border deal into your 21strategy, therefore, you first must have a solid understanding 22of your current strategic position. 23 24 25 Reviewing Your Strategy 26 27 28C ORPORATIONS VIEW STRATEGIC PLANNING ON TWO LEVELS: FROM A CORPORATE PERSPECTIVE AND FROMa business-unit level. Corporate strategy is about being in the 29 30 31right portfolio of businesses, whereas business-unit strategy 32is about making a particular business the best in its industry. 33Figure 1 illustrates this planning framework. 34 During strategic planning, assess the strategic position of the 35business unit that you suspect would most benefit from a trans- 36 5
    • S T R AT E G I C D U E D I L I G E N C E1 FIGURE 123 Strategic Planning Framework4 Corporate Strategy5 Corporate Capabilities6 Portfolio of Business Corporate Advantage78 Shareholder9 Value Business-Unit Strategy10 Costs11 Customers Competitive12 Competition Advantage Core Competencies131415 action involving external development through M&A, strategic16 alliance, or the like. Analyze the “four Cs”—costs, customers,17 competitors, and capabilities—to assess the full potential of a18 business.1920 Costs2122 FIRST, ANALYZE YOUR business unit’s strategic cost position23 relative to its competitors’, and identify opportunities for cost24 reduction. Address the following questions:25 Relative cost position. Do competitors have a cost advan-26 tage? Why are we (or they) performing above or below what27 we would expect, given our relative market position? What is28 our full potential cost position?29 Experience curve. To what extent is the business unit using30 its experience curve to drive down unit costs? Where are we31 versus competitors? What will prices be five years from now?32 Cost-sharing analysis. Is this business separate from33 another? How well can competitors in related businesses attack34 our business? Does the benefit of sharing costs with our other35 business units outweigh any lack of focus that sharing costs36 across multiple businesses would introduce? 6
    • COMPETITORS Best demonstrated practices (BDPs). How low can we 1take our costs if we employ the best internal and external prac- 2tices? How low can competitors take costs? (Benchmarking is 3a related tool in this analysis.) 4 Product-line profitability/cost allocation/activity-based 5costing. Which products and customers really make the 6money? Which ones should we drop? 7 8Customers 9 10NEXT, TURN TO CUSTOMERS to identify revenue- and profit- 11maximizing strategies. 12 Market overview and map. What is the market size? Is it 13growing? How is it broken down by geography, products, and 14segments? What is each competitor’s market share? 15 Customer segmentation. Which parts of the market 16require different offerings? Are we fully penetrated in some 17segments and neglecting others? Can we adjust our offerings 18to grow sales or increase price realization? Which segments are 19financially attractive for us to invest in? 20 Distribution-channel analysis. What range of channels 21is possible for each product/service? Do some offer superior 22economics? Are we reaching our full potential in each? 23 Customer retention and loyalty. How can we identify the 24most profitable customers? How many more of them are there 25yet to reach? How do we increase our retention of our best 26customers? What is the profit impact of increasing retention 27by X percent? 28 Customer acquisition. How/where can we acquire profit- 29able customers? What will it cost? 30 31Competitors 32 33THIRD, INVESTIGATE OPPORTUNITIES to achieve differentia- 34tion and preempt competitor moves. 35 Competitive position overview. What is the business 36 7
    • S T R AT E G I C D U E D I L I G E N C E1 unit’s market share/revenue and profit by geography, product,2 and segment? What are its strengths, weaknesses, opportuni-3 ties, and threats (SWOT)?4 Profit pool analysis. Are we (or others) getting our fair (or5 better) share of the industry’s available profits? Where in the6 value chain is the profit concentrated? Can we move to capture7 more of it?8 Competitive dynamic. How will competitors act or react9 to external events? To our strategic actions (such as a merger10 or acquisition)?11 Relative performance. How do we and each competi-12 tor make the profits expected by the relative market share we13 have? Are we/they underperforming operationally? Is the busi-14 ness correctly defined?1516 Capabilities1718 THE FOURTH, and often overlooked, “C”—capabilities—con-19 siders strategies that best fit with the business unit’s core com-20 petencies.21 Core competencies. What special skills or technologies does22 the business unit have that create differentiable customer value?23 How can it leverage its core competencies? What investments in24 technology and people will help build unique capabilities?25 Make versus buy analysis. What products should the26 business unit make itself, and what products should it buy from27 another company?28 Organizational structure. What organizational structure29 will enable the business unit to implement its strategy most30 effectively? How can all other aspects of the organization be31 aligned with the strategy (such as compensation, incentives,32 promotion, information flow, authority, and autonomy)?3334 The business unit strategic planning process outlined above35 should precede and inform any transaction. Meanwhile, corporate-36 level strategic planning will help management distinguish the por- 8
    • C A PA B I L I T I E Stion of corporate growth that can be achieved organically from the 1areas where growth through acquisition makes sense. 2 Not all external growth strategies—that is, growth through 3acquisition—succeed. The misguided expansions of Gillette 4when it bought French pen maker Waterman and of Sears 5when it acquired Dean Witter illustrate the perils of making 6acquisitions based on a poorly thought through strategy. In the 7early 1980s Sears paid $6.7 billion for Dean Witter, based on 8the strategy of creating a one-stop financial supermarket for its 9department-store customer base. However, Sears soon found 10that there was limited cross-selling and cost-sharing potential 11between the two companies and that the capabilities required to 12operate a retail operation and financial services company were 13quite different. Sears refocused on its core retail operations by 14divesting Dean Witter just over a decade after the acquisition. 15 Strategic planning is obviously a crucial part of organic 16growth, but it is even more critical when undertaking exter- 17nal expansion, because strategic due diligence cannot occur 18unless a sound strategic plan is in place. Strategic planning 19is what you do to determine whether a transaction could help 20you achieve a goal. Strategic due diligence is what you do to 21determine whether a particular target could fulfill the strategic 22plan. For instance, as a part of its international expansion strat- 23egy, one of the world’s largest consumer goods manufacturers 24decided to develop its own distribution system in Turkey. The 25high profile of major competitors, as well as the global inef- 26fectiveness of the potential local partners, complicated the situ- 27ation. The company’s strategic planning, however, had focused 28on market sizing and retail models to estimate market potential 29and determine current demand. Market and competitor analysis 30had helped to estimate the scale of local opportunities in each 31region, as well as current regional distribution patterns and key 32distribution hubs. The analysis also defined hub distribution 33methods and how to capture market share. With all aspects 34of investigation pointing to an attractive strategic opportunity, 35the company had the basis from which to negotiate a major 36 9
    • S T R AT E G I C D U E D I L I G E N C E1 strategic alliance with the state monopoly to enter the market.2 Most of the strategic due diligence work had already been done3 in the strategic planning process.4 Objectives identified through strategic planning can—and5 should—inform the conduct of due diligence in both domestic6 and cross-border transactions.78910 Achieving Value11121314 A S PURCHASE MULTIPLES RISE, THE LEEWAY TO CRE- ATE VALUE TENDS TO DIMINISH. BUYERS HAVE A much smaller margin of error, because high multiples are justi-15 fiable only with high growth and correspondingly high investor16 internal rates of return. Whereas a buyer, as the more proactive17 party in any transaction, might be happy to pay a multiple of18 15 for a high-growth business, it won’t for a more mature19 business. Such deals require rigorous purchase decisions and20 extraordinarily tight portfolio management.21 Until 2000, an increasing amount of capital chasing a lim-22 ited number of deals led to higher purchase multiples. Figure 223 illustrates the economics of purchase multiples in transactions24 characterized by private equity investors, a small subset of the25 merger and acquisition universe.26 By 2000, multiples had leveled off, and what makes a deal27 at a given multiple attractive has evolved again. Consider28 the changes over time: During the 1980s, buyers made great29 returns because they put up to 90 percent debt on companies30 they bought. But there was little growth during this period, and31 little multiple expansion. In the 1990s, lenders’ reaction to the32 overleveraging of the 1980s as well as rising stock prices made33 deals for buyer’s equity more attractive and debt-driven finan-34 cial deals less popular. But there was to be another great call on35 debt: The 1990s’ rising tide of entrepreneurship culminating in36 an explosion of ventures in e-commerce led to greater amounts 10
    • A C H I E V I N G V A LU Eof capital, and hence competition for a limited number of deals. 1This led to the greatest multiple expansion (up to infinite) of all 2time. Figure 2 illustrates the pattern of an increasingly compet- 3itive environment. Multiples have since retrenched as investors 4realized that the growth aspirations of most dot-commers were 5unrealistic and the market for Internet stocks corrected. 6 Today, buyers should look to tried-and-true ways to enhance 7the value-creation potential of a transaction. Developing supe- 8rior strategies for growth, improving performance, and identi- 9fying excellent opportunities are ways that transcend market 10fluctuations. This approach consistently brings acquirers, joint 11venturers, and other investors to more rigorous purchase deci- 12sions and to better portfolio management through strategic 13insight and enhanced operating capabilities. Such strategies 14should be formulated before due diligence begins. The due 15diligence process should, among other things, map the extent 16to which the prospective transaction does or does not enhance 17value creation for the parties. 18 Strategic due diligence may appear to add extra layers of 19time and money to transactions, but it occurs along with other 20forensic, accounting, legal, environmental, and actuarial due 21diligence. Strategic due diligence, as a percent of equity, is 22relatively inexpensive, usually coming to tens of basis points 23on the equity and a small fraction of the enterprise value. And 24the investment pays off in spades. For instance, since 1996, 25Bain & Company has co-invested $60 million with its clients in 26seventy-two transactions in which Bain assisted with strategic 27due diligence. Of those, twenty-five transactions—about one- 28third of invested capital—have been realized or revalued, out- 29performing the market with a gross internal rate of return (IRR) 30of 67 percent. If Bain had invested that capital instead in the 31Standard and Poor’s 500 index (and borrowed half the invest- 32ment amount, as it did with its private equity investments), the 33firm would have realized a 20 percent return. 34 Compare these results with fifteen other private equity funds 35that invested $7.6 billion in 152 transactions that have been 36 11
    • S T R AT E G I C D U E D I L I G E N C E1 FIGURE 22 U.S. Private Equity Deals 1994–200034 LBO funds Venture funds Increasing Amount of5 Capital ’00 $155 B6 ’99 $88 B7 ’98 $80 B8 Total Dollars ’97 $50 B9 Raised ’96 $35 B10 ’95 $33 B11 $24 B ’9412 $0 $50 $100 $150 $2001314 Chasing Limited Number of Deals15 ’00 28316 ’99 35017 Number ’98 30618 of LBO/ ’97 275 Merchant19 ’96 277 Bank Deals20 ’95 24821 ’94 25522 0 100 200 300 40023 Means Higher24 Purchase Multiples25 ’00 726 ’99 8 ’98 827 Purchase ’97 728 Multiples ’96 729 ’95 630 ’94 531 0 1 2 3 4 5 6 7 832 Source: www.buyoutsnewsletter.com; www.ventureeconomics.com333435 realized or revalued; this cluster of transactions yielded a 5636 percent gross IRR. The bottom line? Buyout funds spend many 12
    • A C H I E V I N G V A LU Etimes more on due diligence than their corporate counterparts, hand they reap on average much higher returns. Given theirlack of specific industry experience by which to test a target’sprojections, they build their own models and carefully evaluatethe downside. They attach a price tag to risk and achieve a highlevel of confidence in the acquisition’s value to them. What canwe learn from buyout funds? A small buyout group that had rolled up a U.S. construc-tion equipment manufacturer into a new company approacheda major private equity firm offering to sell the new companybefore it did an initial public offering (IPO). The private equityfirm conducted a strategic review of the target company andtested the owners’ forecast of 20 percent revenue growth. Theteam interviewed hundreds of end users, rental-fleet managers,and competitors to understand market trends. It also analyzedpurchasing patterns for other types of heavy equipment tounderstand the effect of economic cycles on demand. Two major flaws emerged in the owners’ projections for thetarget company. First, a projected year-long recession in theconstruction industry during the next five years would resultin sell-offs by rental fleets. As a result, increased sales of usedequipment would depress new-equipment sales and prices foran estimated three-year period. Second, the owners had fore-cast that the U.S. market would grow to match European pen-etration levels—an assumption that turned out to be wrong, asstrategic due diligence uncovered. The equity firm discoveredthat lower equipment-ownership levels in the United Stateswere the result of a highly efficient, mature rental market,suggesting that organic growth in this sector would be severelylimited. This situation contrasted with the absence of a rentalmarket in Europe, which drove much higher equipment salesthere. As a result of this strategic due diligence, the private-equitygroup decided not to pursue the deal. The small buyout firmwent ahead with its IPO. The company’s share price stagnatednear the IPO level for two and a half years. After earnings per 13
    • S T R AT E G I C D U E D I L I G E N C E1 share dropped 66 percent in one year, a strategic buyer acquired2 the company for a pittance.3 Investors must recognize that economic cycles happen in dif-4 ferent countries and in different industries at different times. For5 instance, it’s important for a Canadian investor to have a handle6 on when the Italian construction industry might take a downturn7 if it seeks to do an Italian construction industry transaction.891011 Factoring in Cross-Border1213 Complexities14151617 T HE CROSS-BORDER DEAL ADDS AN EXTRA LAYER OF COMPLEXITY: LACK OF FAMILIARITY WITH FOREIGN markets. A complex combination of legal, economic, and cul-18 tural factors drives potential market penetration levels for any19 product by country. It would be naïve to assume, for example,20 that just because the United States has 99 percent penetration21 of Internet applications, the same potential exists in France. Yet22 it’s harder in cross-border deals to peel away such assumptions23 and grasp different market dynamics to understand the true24 potential value of a cross-border deal.25 Such complexity existed when a U.S. health and fitness club26 sought to roll out its concept in Europe. Although the U.S.27 company was unfamiliar with European markets, strategic due28 diligence helped it assess the attractiveness of the markets and29 ease of entry into key European countries. Extensive research30 and interviews quantified size, growth, demographics, and31 spending trends in each market. Further efforts assessed the32 level of consolidation within each country, rental/property33 costs, the cost of leisure-sector assets, the number of large34 operators, and the number of available targets.35 Strategic planning showed that the European market had36 high growth prospects, that supply was fragmented, and that 14
    • ACTIVE INVESTINGthe players were local or regional. Part of the strategic due 1diligence thus focused on identifying and assessing potential 2targets to create a pan-European club. Face-to-face interviews 3with leading targets in priority markets determined the avail- 4ability of each target, its level of fit with the buyer, and the 5economics of club operations in each country. 6 After the benefits of a number of targets were identified and 7quantified, it became clear that the U.S. company could also 8improve the target’s postdeal profitability by applying its best 9practices (better operating systems and more effective market- 10ing) from the U.S. market to existing European players. Note, 11however (as many have failed to), that for industry investors, 12the driver of successful expansion is strategic fit. Deals justifi- 13able only because they appear capable of generating operating 14efficiencies should be viewed warily. 15 16 17 18 Identifying Your 19 Strategic Rationale 20 21 22A S WE HAVE MADE CLEAR, THE CHANCES FOR TRANS- ACTIONAL SUCCESS DRAMATICALLY IMPROVE WHENthe target’s business is aligned with the buyer’s strategic 23 24 25goals. Discussed below are five principal strategic rationales 26for transactions: active investing, scale, adjacency, scope, and 27transformation. Each rationale should be evaluated as part of 28the corporate strategic planning process and the results used as 29guidelines to determine the attractiveness of a target. 30 31Active Investing 32 33LEVERAGED BUYOUT COMPANIES and private equity firms 34engage in “active investing.” Unless the private equity investor 35has previously invested in a company in the industry, this form 36 15
    • S T R AT E G I C D U E D I L I G E N C E1 of investing involves acquiring a company and running it more2 efficiently and profitably as a stand-alone firm, with no opera-3 tional integration. Typically, these transactions improve perfor-4 mance through financial engineering, incentive compensation,5 management changes, and stripping out costs. Private equity6 player Bain Capital’s purchase in 1990 and restructuring of7 Gartner Group illustrates the power of “squeezing the lemon.”8 With its operations fine-tuned, Gartner became a premier9 broker of computer-industry information. According to Chris10 Zook’s Profit from the Core: Growth Strategy in an Era of11 Turbulence, (Harvard Business School Press, 2001), Gartner12 expanded its margins from 10 percent to 30 percent before13 Bain Capital resold Gartner to Dun & Bradstreet in 1993.14 Active investing can, and often does, add value; however, it is15 truly the domain of leveraged buyout and private equity firms.16 For strategic investors, a more persuasive fit is needed.1718 Scale1920 THE MOST COMMON strategic rationale is to expand scale.21 Scale doesn’t mean simply getting big. The goal is to use scale22 in specific elements of a business to become more competitive.23 For instance, if materials costs are a significant profit driver,24 reducing costs through volume discounts will be a useful25 consequence of scale. If customer acquisition is critical, chan-26 nel scale (domination of a distribution channel to gain both27 distribution power and cost reduction via bulk shipping or28 fleet maintenance) will be critical. Getting scale-based initia-29 tives right requires the correct business and market definition.30 Setting initiatives can be tricky because, over time, the defini-31 tion of scale in an industry can change dramatically.32 For example, the mergers of Pfizer and Warner-Lambert33 and of SmithKline Beecham (SKB) and Glaxo Wellcome were34 responses to a sea change in the internationalization of the35 pharmaceutical industry. For decades, pharmaceuticals were36 national or regional businesses. Regulatory processes were 16
    • SCOPEunique to each country, and such barriers made drug introduc- 1tion to foreign markets difficult. Distribution and regulatory 2costs needed to be spread over as many local markets as pos- 3sible. Today, many of those barriers have been lowered, while 4drug-development costs have risen dramatically. Jan Leschly, 5retired CEO of SKB, said it directly in the May–June 2000 6Harvard Business Review: “What really drives revenues in 7the drug business is R&D.” Research and development can and 8should be spread across the entire global market, leveraging 9drug discovery and commercialization to more countries, more 10products, and more diseases. 11 12Adjacency 13 14ANOTHER STRATEGIC RATIONALE prompting transactions is 15expansion into highly related, or adjacent, businesses. This ratio- 16nale can mean expanding a business to new locations, develop- 17ing new products in existing markets, or providing products or 18services addressed to higher growth markets or to new custom- 19ers. Experience has shown that the additions should be closely 20related to the investor’s existing business. In Zook’s Profit from 21the Core, he and coauthor James Allen provide empirical evi- 22dence that acquisitions of closely related businesses drove some 23of the most dramatic stories of sustained, profitable growth 24in the 1990s: Emerson, GE, Charles Schwab, and Reuters, to 25name a few. Travelers Insurance’s acquisition of Citicorp gave 26the merged companies, renamed Citigroup, a complete range of 27financial services products to cross-sell to their combined cus- 28tomers across a broad range of global markets. 29 30Scope 31 32BROADENING A COMPANY’S SCOPE is closely related to 33adjacency expansion, but instead of simply buying a related 34business, the serial investor is engaged in buying expertise to 35accelerate or substitute for existing new business development 36 17
    • S T R AT E G I C D U E D I L I G E N C E1 or R&D. This serial transaction model has been successfully2 employed in a number of industries, such as financial services3 (for example, GE Capital), Internet hardware (Cisco), and chip4 manufacturing (Intel). For these firms and companies like5 them, organic development is often too expensive, too slow, or6 too diluting of their focus on existing businesses.78 Transformation910 COMPANIES CAN USE external expansion to redefine a busi-11 ness. This is an appropriate strategy when an organization’s12 capabilities and resources very suddenly grow stale, for exam-13 ple, due to a major technological change. In such instances,14 a firm cannot quickly shore up its technology or knowledge15 by making internal investments and incremental adjust-16 ments. When telecommunications equipment provider Nortel17 Networks embarked on a strategic shift toward becoming a18 provider of Internet infrastructure, it transformed its business19 model through a series of acquisitions. From January 199720 through the end of 2001, the company made nineteen major21 acquisitions, including Bay Networks, a competitor of market22 leader Cisco Systems. The mergers refocused Nortel from sup-23 plying switches for traditional voice communication networks24 to supplying technology for the Internet as well. It undertook25 mergers and acquisitions strategically to make what then CEO26 John Roth called Nortel’s “right-angle turn.” Hard hit in the27 2001 technology downturn, Nortel Networks nonetheless28 became and remains Cisco’s closest rival.29 Sometimes a bold strategic acquisition can redefine an entire30 industry, changing the boundaries of competition and forcing31 rivals to reevaluate their business models. This is the highest32 risk rationale. In the early 1900s such mergers created the likes33 of General Motors and DuPont, and their marks on respective34 industry competition have endured. More recently, the AOL/Time35 Warner merger has tried to rewrite the rules for communication36 and entertainment. But the new model remains unproven. 18
    • T R A N S F O R M AT I O N Managers overseeing transactions face different problems 1based on the strategic rationale of the deal. Thus, financial and 2scale deals, which often attempt to squeeze more efficiency out 3of targets, differ from deals attempting to enhance the scope 4of new technologies or products. “If you acquire a company 5because your industry has excess capacity, you have to figure 6out quickly which plants to close and which people to lay 7off,” writes Joseph L. Bower, a professor at Harvard Business 8School, in the March 2001 issue of the Harvard Business 9Review. “If, on the other hand, you acquire a company because 10it is developing a hot new technology, your challenge is to hold 11on to the acquisition’s best engineers.” 12 Dynamic companies treat strategic planning as a work in 13progress, not a one-time event. In response to a company’s 14ever-evolving strategic focus, the company may approach 15future transactions based on different strategic rationales. The 16London-based Grand Met is a classic example. It completed a 17successful hostile buyout of Pillsbury, owner of Burger King, 18in early 1989 for $5.7 billion. Grand Met’s adjacency-focused 19strategy was to become the world leader in food, drink, and 20retailing, based on the premise that it could capitalize on 21synergies among these sectors. In 1997 Grand Met merged 22with Guinness. The combined entity, now known as Diageo, 23realized that projected operating synergies between food and 24drink products might have been overrated and decided to focus 25primarily on drinks. Diageo has since begun divesting its food 26holdings and targeting liquor and beverage acquisitions to fur- 27ther increase its scale in that area, exemplified by its purchase 28of a piece of Seagram, and divestiture of Pillsbury. 29 Even a single acquisition may provide more than one stra- 30tegic benefit. For instance, when a private equity firm married 31an Italian vending machine company with a similar one in 32Scandinavia, it derived benefits by combining production and 33purchasing (to maximize scale) as well as by implementing one 34company’s best-management practices in the other (to broaden 35scope by acquisition of management expertise). 36 19
    • S T R AT E G I C D U E D I L I G E N C E1 FIGURE 323 Strategic Rationales for Top Ten Acquisitions4 Less strategic More strategic5 $80 B $600 B6 100%7 Business Redefinition8 80% Adjacency9 Financial Engineering10 60% Scale1112 40%13 Diversification14 20% Industry Redefiniton15 Adjacency16 0%17 1988 2000 Note: Dollar figures are nominal181920 It should come as no surprise, then, that the popularity of21 different types of deals shifts over time. As Figure 3 illustrates,22 the share of financial engineering and diversification deals in23 the top ten mergers by price tag has shrunk in recent years,24 while transactions based on scale and industry redefinition25 have ballooned.26 In 1988 fewer than 20 percent of the top ten mergers by price27 tag reported were highly strategic. This was the era of LBO28 takeovers such as RJR Nabisco/KKR and Federated/Campeau.29 In 2000, the era of transformational mergers such as AOL/Time30 Warner and scale mergers like Glaxo Wellcome/SKB, all of the31 top ten mergers were strategic. (Acquisitions in 2000 include32 “announced” deals, such as the GE/Honeywell merger, which33 subsequently fell through for antitrust reasons.) While deal34 volume declined in 2001, deal rationales remained highly35 strategic.36 20
    • MARKET DEFINITION 1 2 3 Undertaking Thorough 4 5 Due Diligence 6 7O NCE YOUR STRATEGIC PLANNING PRODUCES A SOUND RATIONALE FOR PURSUING A CROSS-BORDER DEAL,you must undertake a thorough commercial review of each 8 9 10target you identify. The commercial review, or strategic due 11diligence, process identifies the drivers of earnings to establish 12whether the target is a good investment. The rigorous analysis 13evaluates the stand-alone cash flow value of a deal. It addresses 14the four key aspects of business attractiveness: 15 1 Market analysis 16 2 Competitive positioning 17 3 Customer evaluation 18 4 Company analysis 19 20 As discussed previously, however, good strategic transac- 21tions add significantly to the combined entity’s value over and 22above the target’s stand-alone value. Due diligence also helps 23uncover prospects for making operating improvements and 24assesses the potential for market redefinition. 25 Figure 4 shows the analytical activities that underlie each of 26the four key steps in commercial review. 27 28Market Definition 29 30IN MARKET DEFINITION, you first identify the target’s industry 31and the stages of the value chain in which the target operates. 32Second, you determine whether the target’s products fit into one 33business or whether they should be treated as distinct product 34categories. Third, it’s necessary to establish whether the size of 35the market should be seen as local, regional, or global. 36 21
    • S T R AT E G I C D U E D I L I G E N C E1 FIGURE 423 Critical Due Diligence Activities4 Market Competitive Customer Company5 Output Analysis Positioning Evaluation Analysis6 Market Definition/Sizing 78 Industry Dynamics   9 Industry Trends 1011 Competitor Market Map  12 Competitor Dynamics/Profit 1314 Competitor Benchmarking  15 Customer Analysis  1617 Impact of Input Costs 18 Cost Reduction Opportunities 1920 Internal BDP Opportunities 21 Growth Opportunities  22232425 Industry Dynamics and Trends2627 ONE MUST ALWAYS be aware of industry dynamics and28 trends. Investors often define a target’s business synergies by29 the extent to which the target company shares production costs30 and customers with the acquirer. They inquire whether the31 target’s products are sold to the same customers and whether32 the production and distribution processes share costs. Cross-33 border issues add another dimension to the analysis. Principal34 geographic concerns include whether customers are local,35 regional, or global and whether they can be shared across36 specific geographies. For example, can producing globally 22
    • INDUSTRY DYNAMICS AND TRENDSunearth cost advantages? Is the product cheap to transport, and 1are there significant economies of scale across regions? The 2matrix in Figure 5 illustrates these issues. 3 In the following example, a potential acquirer investigated 4a global building-materials firm as a target. As part of strate- 5gic due diligence, it assessed whether it should consider the 6European market as a single market or as a number of sepa- 7rate markets. This business definition not only established the 8target’s relative market position in Europe but also formed the 9basis of an investigation into potential cross-border synergies 10that would result from an acquisition. 11 Upon investigation, the acquirer discovered that customers 12and distribution channels in the European countries were very 13different, and it needed to view these factors, and hence its 14business units, separately. On the other hand, as transportation 15was a small proportion of total costs, the European market 16 17 FIGURE 5 18 19 Business Definition Matrix 20 High 21 One business with potential for One business 22 differentiation or niche position 23 24 Separate businesses with 25 potential for cost leadership 26 Cost 27 Sharing Separate businesses Separate One 28 businesses business 29 with with 30 potential for potential for 31 bundling substitution 32 33 Low 34 Low Customer Sharing High 35 36 23
    • S T R AT E G I C D U E D I L I G E N C E1 offered opportunities for significant cost sharing among both2 the acquirer’s and the target’s business units. This market defi-3 nition suggested that the acquirer should view the competitive4 landscape at a country level, but view production, and hence5 synergies, at a pan-European level. On a pan-European basis,6 the target, the number-one player, appeared to have a market7 share of only about 20 percent in a highly fragmented market.8 When viewed at a country level, however, the target was clearly9 a dominant player, with market share of 50 to 80 percent in10 most of its markets.11 Market due diligence also requires determining trends in how12 the market behaves. The forces that affect industry dynamics13 include the following:14 q competition (pricing, tactics, consolidation, orderly15 behavior);16 q distribution channels (direct versus brokers/third par-17 ties); and18 q fundamental shifts (new technologies, replacement/19 substitution).2021 Competitor Market Map2223 A MARKET MAP of competitors helps determine the size24 of each market segment; which segments are attainable (for25 example, government contracting may be off-limits to foreign26 firms); and the market share of companies within each sector.27 In addition, market maps can be broken down by distribution28 channel and customer type to establish the target’s advantage29 within each subsector of the market. This breakdown can help30 identify specific threats that other players may pose that are not31 captured in a less differentiated overview of the market.3233343536 24
    • COMPETITOR BENCHMARKING 1Competitor Dynamics 2 3COMPETITOR DYNAMICS INVOLVE evaluating whether industry 4rivalry is passive or aggressive, understanding competitors’ 5strategies, and determining the basis of each player’s strategy, 6including the following factors: 7 q value proposition (price, service, breadth of offering, 8 quality); 9 q strategic initiatives (channel/product focus, growth ini- 10 tiatives); and 11 q strengths and weaknesses (level of proprietary 12 processes, level of vertical integration, structural 13 advantages/disadvantages). 14 15 In the example of the building-products manufacturer described 16earlier, other competitors had gradually eroded its U.K. market 17by targeting specific distribution channels. To identify the cause 18of this market share decline, the company constructed a market 19map, segment by segment, which uncovered an aggressive com- 20petitor. This competitor had built a strong position targeting the 21market’s specification channel and whose competitive advantage 22hinged on its focus on the top 100 architects/specifiers. Due dili- 23gence enabled the company to identify the reason for its loss of 24market share, and, through interviews with leading specifiers, 25develop defensive solutions that allowed the company to stem 26further volume losses. 27 28Competitor Benchmarking 29 30YOU CAN DETERMINE the target’s position versus its com- 31petitors by comparing its cost of goods, operating costs, and 32returns on assets and capital against the industry’s best compa- 33nies. Benchmarking is often based on a combination of infor- 34mation a competitor publishes—such as annual reports, press 35releases, and price lists—and interviews or site visits to discuss 36 25
    • S T R AT E G I C D U E D I L I G E N C E1 data that are not publicly available. The ability to benchmark2 competitors also depends on geography: In certain countries,3 for example, privately owned companies must file detailed4 financials, but in other countries they may release only very5 limited figures. Benchmarking helps the acquirer identify areas6 of potential improvement for the target.7 During customer interviews the building-products company8 learned that certain foreign competitors were able to sell simi-9 lar products at 20 to 30 percent lower prices than its potential10 target and still achieve typical industry margins. Self-evidently,11 the competition had lower operating costs than the target’s. But12 which costs? Because many of the competitors were privately13 owned, the acquirer could not obtain detailed financials to14 define their components of cost. However, through interviews15 with raw material suppliers, the acquirer established that raw16 materials costs (approximately 70 percent of costs) were prob-17 ably similar to the target’s given the similar scale of competi-18 tors. On further analysis, the acquirer discovered that competi-19 tors used the same machines as the target, thus leading to the20 conclusion that the competitors’ cost advantage lay outside the21 manufacturing process.22 The acquirer looked hard at selling, general, and adminis-23 trative (SG&A) costs and concluded that the target’s problem24 lay in maintaining a similar level of sales expenditure per each25 U.K. customer regardless of profitability. This analysis identi-26 fied a problem—and suggested a solution. Through profitabil-27 ity analyses, the acquirer could reduce the target’s number of28 unprofitable customers and introduce a new pricing structure29 to weed out cherry-pickers. The target would thereby enjoy30 margins comparable to those of its competitors, who targeted31 only customers from whom they could obtain respectable32 margins. As the acquirer found, analyzing customer segments33 often helps pinpoint profit-enhancing opportunities.343536 26
    • CUSTOMER ANALYSIS, INPUT COSTS, AND PRICE EL ASTICITY 1Customer Analysis, Input Costs, and 2Price Elasticity 3 4ASSESS THE TARGET’S RELATIONSHIP with its customers 5and measure how price affects demand—in other words, the 6company’s price elasticity. Increases in input costs can have 7a major impact on a firm’s cash flow that cannot be passed 8on to the customers without reducing sales. To assess cus- 9tomer price elasticity, establish the historical impact of price 10changes on key inputs by investigating their relationship to 11margins. Cross–border price elasticity issues are important 12to understand—especially the local industry norms for 13price and cost adjustments based on raw materials price 14increases. 15 For example, in a recent transaction, a company selling 16consumable products to heavy industries faced a surge in 17the price of a critical raw material at the same time that the 18underlying markets were declining for the first time in years. 19From customer and management interviews it soon became 20clear that in the United States there was a tacit understanding 21that these costs temporarily could be passed on to customers. 22European customers, however, were far less likely to be so 23accommodating. The quid pro quo in the United States was 24that in periods of weaker input prices, such customers would 25receive price cuts, whereas European customers exerted far 26less pressure on their suppliers in such situations. 27 Due diligence not only evaluates the potential for cost 28reductions, it also establishes the likely timing of when (if 29at all) such savings might be achievable and how customers 30will react to the prices costs dictate. To attain the right pic- 31ture of price elasticity companies need to benchmark costs 32internally, across the target’s plants or units, and thought- 33fully evaluate the benefits of achieving best demonstrated 34practices (BDPs) throughout the acquired or merged com- 35pany and its offerings. 36 27
    • S T R AT E G I C D U E D I L I G E N C E12 Growth Opportunities34 THE LAST PART OF cross-border strategic due diligence focuses5 on the target’s growth opportunities, often the greatest generator6 of value. Determining these opportunities is one of the hardest7 aspects of due diligence to execute. Eager to maximize price and8 terms, target management too often makes “hockey stick”–shaped9 profit projections that greatly exceed the company’s historical10 performance. Many targets project growth from regions where11 they only recently have established a presence. For example, a12 small U.K.-based supplier to the leading electronics companies13 realized that to serve the global market, it had to establish new14 operations in Mexico, Central Europe, and China in addition to15 its existing plants in the United Kingdom and the United States.16 The supplier, which we’ll call TechCo, accomplished this expan-17 sion quickly through a series of acquisitions and joint ventures, at18 the same time executing a management buyout.19 The revenue from the first of TechCo’s acquisitions increased20 TechCo’s apparent growth rates and raised expectations, which21 were raised further due to a bidding war between potential22 investors in the management buyout. Two years after manage-23 ment bought TechCo, its revenue had turned flat, and the com-24 pany was struggling to maintain its debt repayment schedule, a25 problem exacerbated by the declining high-tech markets. The26 cause of TechCo’s poor performance was that both the manage-27 ment team and the investors had underestimated the complexity28 of globalizing operations as well as the regional market share29 required to compete effectively in different markets.30 Hindsight is a marvelous thing, but it seems clear that more31 effective strategic due diligence would have questioned TechCo’s32 ability to match its customers’ fast growth rates by understand-33 ing the source of that growth and the operational complexity of34 transforming a regional firm into a global leader. Better due dili-35 gence could have thrown cold water on the red-hot projections.36 A target’s future cash flows must be established based on 28
    • C R O S S - B O R D E R C O M P L I C AT I O N Srealistic assumptions and converted into a more concrete value 1through the use of discounted cash flow and comparative com- 2pany analysis. In this regard, number crunching based on unre- 3alistic assumptions is a recipe for disaster. Consider the case of a 4leading LBO firm contemplating a $400 million acquisition of a 5major value-added reseller of personal computers and network- 6ing products. At a four-times-earnings multiple, the deal looked 7great. Management projected future growth from increased 8hardware sales and a significant expansion of its service busi- 9ness, which it planned to enhance by introducing higher-margin 10services like systems integration and outsourcing. 11 There was only one problem: The target’s five-year revenue 12and profitability forecast was hopelessly unrealistic. A more 13penetrating analysis revealed that the economics of direct 14versus value-added PC sales favored the direct-sales channel, 15a sure sign that the target’s hardware business was about to 16decline. Second, interviews showed that few large customers 17perceived value-added resellers to be capable of delivering a 18full range of services. The target’s existing customers had no 19intention of extending the range of services they bought, giving 20the target no prospect of generating sufficient incremental mar- 21gin to offset the decline in hardware sales. In fact, the survival 22of the whole value-added reselling sector was under serious 23threat. The LBO firm walked away from the deal. 24 The next year, the value of the target’s public competitors 25declined more than 5 percent. Another purchaser eventually bought 26the target company for $100 million, a 75 percent drop in value. 27 28 29 Cross-Border Complications 30 31 32B LAISE PASCAL SAID, “THERE ARE TRUTHS ON THIS SIDE OF THE PYRENEES WHICH ARE FALSE ON THEother.” And Duncan Angwin, from Warwick Business School 33 34 35in Coventry, England, asserts that we can today replace 36 29
    • S T R AT E G I C D U E D I L I G E N C E1 “Pyrenees” with any national border to better understand the2 complexities of cross-border transactions. As Figure 6 shows,3 these fall into three categories: peculiarities of local markets,4 cultural differences, and regulatory and legal issues. These fac-5 tors affect the firm’s stand-alone value and become increasing-6 ly important when evaluating the strategic rationale of a deal.7 Peculiarities of local markets. A variety of factors, from8 climate to the dominance of local players, drive customer9 trends in a market. One classic example may be the popularity10 of sport utility vehicles (SUVs) in the U.S. automobile market,11 compared with a much lower penetration of such vehicles in12 Europe. There are many reasons why this is true, not the least of13 which is substantially lower fuel prices in the United States.14 Cultural differences. Different styles of doing business15 often make a market for the same product vary from country16 to country. Also, cultural peculiarities often dictate the organi-17 zational structure of the target company (such as hierarchical18 organizational structures in Japan).19 Some cultural differences can be overcome; others cannot.20 Due diligence can determine the extent to which change can21 or cannot occur smoothly within a firm or market, a theme22 discussed at length in Due Diligence for Global Deal Making2324 FIGURE 62526 Cross-Border Complexities27 Peculiarities Cultural Regulatory/28 of Local Markets Differences Legal Issues29 •Different sales •Ways of doing business •Labor laws30 channels •Organizational •Tax implications31 •Different structures •Antitrust laws32 purchasing •Local politics •Financial/33 patterns operational34 reporting35 requirements36 30
    • K E Y F A C T O R S I N E V A LU AT I N G S T R AT E G I C R AT I O N A L E S(Bloomberg Press, 2002). For our purposes here, it is sufficient 1to point out that in assessing whether a target is likely to sat- 2isfy corporate strategy, cultural compatibility issues should be 3considered. 4 Regulatory issues. The high-profile attempted takeover of 5Honeywell by GE illustrates the complexities arising from regu- 6latory differences across regions. As it was a U.S.-to-U.S. take- 7over, GE appeared convinced that once the U.S. Department of 8Justice approved the $41 billion proposed merger, the deal was 9as good as done. The European Commission, however, had a 10different opinion, and the combined companies’ sales in Europe 11gave the EC jurisdiction. Legal considerations of this sort are 12further highlighted elsewhere in Due Diligence for Global 13Deal Making, but a rigorous corporate strategic planning pro- 14cess should anticipate such issues early on. 15 16 17 18 Key Factors in Evaluating 19 Strategic Rationales 20 21 22S TRATEGIC RATIONALES LIE ON A CONTINUUM, FROM DEALS THAT PLAY BY THE HISTORICAL RULES OFmerger transactions and valuation (like any classic LBO sce- 23 24 25nario) to those that stretch the rules (like the Travelers-Citicorp 26merger that aimed at scale benefits, adjacency expansion, and 27product scope all at once) to those that transform these rules 28(like the AOL/Time Warner deal, which sought to redefine 29the media industry). With more complex rationales—such as 30business or industry redefinition—more work is required to 31determine the right price. Figure 7 illustrates the value con- 32siderations for each type of deal. These considerations include 33stand-alone cash flow, cost of integration, economies of scale 34to be achieved, revenue and customer synergies, and value of 35the option to compete in new businesses. 36 31
    • S T R AT E G I C D U E D I L I G E N C E1 FIGURE 72 Strategic Rationales34 Play by the rules Transform the rules56 Redefining Active Adjacency Business Redefining7 Value Consideration Investing Scale Expansion Scope Models Industries89 Stand-alone cash flow      1011 Cost of integration     1213 Scale economies     1415 Revenue and    16 customer synergies1718 Value of options  192021 Although due diligence is most commonly associated with22 a target’s stand-alone cash value, it also provides the insights23 to understand the potential synergies and scale benefits that24 may be fundamental to the strategic rationale. Without in-depth25 strategic due diligence, a thoughtful acquirer will find it dif-26 ficult to determine whether its vision of redefining an industry27 can become a reality. Extensive due diligence should therefore28 form the basis of any investigation into a transaction’s desir-29 ability and real value.30 By definition, a deal will take place if the buyer prices the target31 at an equal or higher value than the target values itself. To get a32 return on a transaction, the buyer must believe either that the target33 is undervalued or that more effective management or strategic fit34 will increase its value—or that of the combined entity. To avoid the35 pitfall of buyer hubris that has caused untold numbers of deals to36 fail, the buyer must rigorously test whether it can realistically trim 32
    • DUE DILIGENCE FOR SCALE-DRIVEN TRANSACTIONScosts and enhance revenue sufficiently to make the deal worthwhile. 1In more strategic investing, the buyer must test its potential to add 2value to the stand-alone company and the ability to translate per- 3ceived strategic advantages into profit. The primary role of strategic 4due diligence is to test whether and how quickly these opportuni- 5ties can become bottom-line realities and what price, therefore, is 6justified. 7 8 9 10 Due Diligence for 11 Scale-Driven Transactions 12 13 14A FTER DISCOUNTING FUTURE CASH FLOWS TO DETER- MINE NET PRESENT VALUE OF A STAND-ALONEbusiness, a buyer in a scale-driven transaction needs to 15 16 17value the benefits of combining the target’s operations with 18its own. Failure to do so is likely to doom a deal. In cross- 19border due diligence, use the framework described above 20to test whether the benefits of scale are easy to translate 21across borders. It’s important to check your assumptions— 22especially the ones that drive the biggest benefits—by doing 23the following: 24 q Define similarities/differences 25 q Identify overlap of shared customers, costs, and com- 26 petitors 27 q Quantify level of expected scale economies, such as 28 improved plant utilization and sales force 29 q Calculate the cost of achieving such economies 30 q Estimate the experience curve (the rate of decrease in 31 product cost per unit based on combined volumes pro- 32 duced by the merged companies) 33 34 One U.S. specialty retailer attempted to grow throughout 35Europe by expanding its existing format into European markets 36 33
    • S T R AT E G I C D U E D I L I G E N C E1 to obtain a competitive edge through superior purchasing scale2 and a retail concept proven in the United States. But the ambi-3 tious rollout flopped, because the company did not properly4 recognize the differences in markets from country to country. A5 more thorough due diligence effort would have spotted compe-6 tition from high–end department stores in the United Kingdom,7 small-shop retailers in Germany, and established “hypermar-8 kets” in France. The U.S. retailer soon found that it could not9 exploit its big-box format, so successful on its home turf. The10 out-of-town specialty retail concept was relatively unfamiliar to11 European consumers and failed to catch on.12 The economics were also different in Europe. For instance,13 U.K. property costs are relatively high compared with U.S.14 costs. Large out-of-town locations were difficult to find and15 required high traffic to generate profit. The U.S. retailer quickly16 tried to adapt by changing its product portfolio to rival local com-17 petition and meet local consumer tastes, a strategy that failed to18 realize the hoped-for synergies, like common purchasing, that19 had driven its original case for expansion.20 Careful strategic due diligence could have informed the U.S.21 company, before it rolled out its big-box format into Europe,22 whether market differences were consistent with its concept.23 The company’s failure to test the assumptions behind its origi-24 nal investment thesis prevented it from understanding the local25 consumer, store economics, and competition.26 Deals based on scale benefits must explicitly identify and27 quantify expected economies. The first step is to determine28 which aspects of scale really count—in other words, what29 allows the company to take advantage of merging revenue and30 earnings streams? Different businesses achieve the benefits of31 scale differently. Some, such as automotive companies, gain32 it from global scale, while supermarkets gain it from regional33 or local scale. Others, like medical product manufacturers, get34 it from scale within a distribution channel. In sectors such as35 cosmetics, profitability is only partly linked to scale because36 branding has a stronger impact on margins. 34
    • DUE DILIGENCE FOR SCALE-DRIVEN TRANSACTIONS To achieve scale benefits, the merged businesses must be hsimilar enough to share some costs. In 1995, Rexam’s new chiefexecutive, Rolf Börjesson, envisioned transforming the U.K.company from a conglomerate of unrelated, cyclical, low-value-added businesses into the world’s leading consumer packagingproducer, through acquisitions. The first transaction closed in1999, when Rexam purchased Sweden’s PLM, Europe’s largestbeverage-can manufacturer. PLM provided opportunities forcost reduction through shared European manufacturing facili-ties. In 2000, Rexam boldly purchased American National Can(ANC), making Rexam the world’s largest can maker. WhenRexam acquired ANC, Börjesson focused his due diligenceon making certain that ANC’s processes were similar and thatthe two companies could share customers. The scale achievedthrough the ANC acquisition brought further cost savings andsuperior U.S. process technology to Europe while opening upthe U.S. market for Rexam. To become an international leader in the industry, Börjessonhas planned to create a packaging conglomerate of sufficientscale to attract investors’ attention. Börjesson and his team arebuilding a position from which Rexam can trade business unitswith other companies to pursue the most efficient global mixof packaging operations and businesses. Börjesson knew he would have a hard time convincingthe market he could overcome the significant challengesthese deals created. Part of Rexam’s due diligence there-fore included significant postmerger integration planning toconsider the likely difficulties that combining the operationswould generate. Differences in management and manufactur-ing style in Europe and America combined to make unlikelyan easy cross-border integration of eleven major companysites. Another issue was the ongoing investigation from theEuropean Union’s monopolies commission, which constantlychanged the playing field. Börjesson and his team developeda plan to integrate the companies quickly and establish a uni-form strategy to avoid uncertainty during the transition. He also 35
    • S T R AT E G I C D U E D I L I G E N C E1 immediately rebranded the company and put in place a senior2 management team to provide clear direction to all members of3 the organization.4 To earn early shareholder support, Börjesson focused on5 making a success of each acquisition rather than trumpeting6 Rexam’s long-term strategy. “Give them some detail before7 the deal, and lots after,” he says. He picked acquisitions he8 believed could produce results quickly. “I ask, ‘Can we have all9 the savings on the bottom line in three years?’ ”10 After an acquirer understands how to capitalize on scale, it11 needs to predict the financial impact of combining the compa-12 nies to understand the premium the acquirer would be willing13 to pay. For instance, the Rexam synergies from two acquisi-14 tions were estimated at $49 million to $56 million. At a 10.7 to15 10.8 multiple, the capitalized value of these synergies reached16 $530 million to $600 million. By the end of 2001, Rexam had17 already captured $46 million in savings, or 82 percent of its18 high-end goal.19 Over time, as a company produces a certain product, the20 average unit cost usually falls because the company gets better21 and better at producing it, resulting in lowered prices to cus-22 tomers because of those productivity gains. This relationship is23 captured by industry-experience curves.24 Companies use experience curves to develop pricing strate-25 gies, improve performance, and assess commercial prospects.26 In due diligence, a company calculates its own and the target’s27 cost-experience curve and projects an experience curve for28 the combined entity. For each function the acquirer must ask29 the following: Where can I save on head count? How many30 employees should be offered severance or redeployed? Which31 plants, distribution centers, or stores can be closed, and which32 activities can be moved to more efficient locations? What con-33 tracts can be renegotiated at advantageous rates? What savings34 will these changes yield, net of lost sales, closure, and sever-35 ance costs?36 Further questions relate to the balance sheet: What capital 36
    • D U E D I L I G E N C E F O R A D J A C E N C Y- D R I V E N T R A N S A C T I O N Sequipment or property can the combined company sell as con-solidation progresses? Can inventory reduction free up cash?Will scale-related revenue benefits result from a broadenedproduct mix or a more effective advertising budget? A cash-flow model, constructed from answers to these questions, willmore reliably predict value than industry acquisition multiplesor comparisons with top-performing companies. If the duediligence of a transaction aimed to produce cost efficienciessuggests that such savings will be modest, the acquirer mightwell ask whether this is a deal worth doing. Due Diligence for Adjacency-Driven TransactionsA TRANSACTION PROVIDES THE MAXIMUM COST SAV- INGS WHEN THE TARGET’S PRODUCTS AND SERVICESare similar to those of the acquirer. Incremental revenue fromsuch a transaction, which aims to make one plus one equalmore than two, is more elusive to obtain than many peoplethink. Due diligence uses the tools of market definition andcustomer evaluation to test whether such benefits will occur ifa deal goes through. To help sales grow from existing customers and products,a company usually needs to change its customers’ behaviors.This is no simple task. For example, additional revenue maydepend on cross-selling new products or persuading consum-ers to buy bundles of goods or higher-priced brands and ser-vices. These objectives are tough to achieve at a time whensales forces, brands, and pricing also may be changing. Thekey to correctly valuing incremental revenue involves rigor-ously testing whether the new entity’s combined offeringswould hold more appeal for customers than separate, stand-alone offerings. Test adjacency by asking the following: 37
    • S T R AT E G I C D U E D I L I G E N C E1 Cross-selling2 q Which customers purchase each product?3 q Do they purchase products in a bundle?4 q What are customers’ buying criteria?56 Cost of achieving benefits of adjacency7 q How much will it cost to retrain the sales force?8 q How much must we invest in information technology?910 The adjacency expansion of the U.K.-based bookseller11 W. H. Smith illustrates these perils. Facing competition in its12 core markets, the distributor and retailer (with approximately13 1,000 stores, including traveler, convenience, music, and book14 stores, and $3.5 billion in sales) decided to launch a do-it-yourself15 chain; add new product lines such as toys, typewriters, and gifts,16 as well as music through its bookstores; and look for interna-17 tional growth opportunities. One part of this strategy involved18 buying a United States–based music retailer, The Wall. After19 losing $310 million in 1996, W. H. Smith decided to refocus20 on its core business. Among the many reasons for this return21 to its core business was W. H. Smith’s inability to effectively22 cross-sell some of the new product lines.23 A recent acquisition by a leading private equity group in24 Europe illustrates the many benefits of creating a pan-European25 player in markets that were once dominated by large, nationally26 focused enterprises. As in many European industries, multiple27 regional players dominated the coffee vending machine mar-28 ket, which presented extremely attractive opportunities for con-29 solidation. Recognizing this opportunity, a private equity firm30 acquired the number-two European competitor and then sought31 to buy the number-one player to create a strong European posi-32 tion. The strategic rationale of the deal was to provide buyers a33 one-stop shop for coffee vending needs.34 The rationale presumed that combining the highly comple-35 mentary products of the two companies would provide sig-36 nificant cross-selling opportunities to a customer base seeking 38
    • DUE DILIGENCE FOR SCOPE-DRIVEN TRANSACTIONSto consolidate suppliers. Furthermore, consolidation within 1the vending services industry would provide the opportunity 2for common platforms and standards. These platforms would 3reduce the service costs for customers and create large savings 4opportunities in production for the manufacturers. Such benefits 5would accrue in addition to the significant cost savings available 6through sales of redundant plants and overhead consolidation. 7 The due diligence focused on the benefits of cross-selling and 8the ability to consolidate operations and achieve cost savings. 9There were concerns that instead of cross-buying benefits, exist- 10ing customers might reduce their combined purchases and shift 11some volume to other suppliers in an effort to maintain multiple 12sources. However, extensive customer interviews demonstrated 13that the combined company not only would retain its volumes 14but also would grow them due to the products’ complementary 15features, thereby proving the original thesis. A detailed review 16of SG&A and production also conclusively demonstrated the 17opportunities for significant consolidation. 18 19 20 21 Due Diligence for 22 Scope-Driven Transactions 23 24 25T RANSACTIONS CAN ALLOW COMPANIES TO ADD NEW CAPABILITIES OR SCOPE. SOME COMPANIES, MOSTnotably fast-growing technology outfits like Cisco, Microsoft, 26 27 28and Intel, have used acquisitions as a principal source of 29growth. They target companies with capabilities that would be 30too expensive to replicate, too slow to develop internally, or 31too diluting of managers’ focus on their existing businesses. To 32quantify the expected profit implications from the additional 33scope, the potential buyer must do the following: 34 q Identify capabilities sought 35 q Compare the value of revenue enhancement and cost 36 39
    • S T R AT E G I C D U E D I L I G E N C E1 savings to costs and benefits of organic growth2 q Determine whether the employees and company can suc-3 cessfully be integrated4 q Calculate the cost of integration, including the cost of5 retaining key employees.67 For these transactions, the potential for cost savings or revenue8 growth is an important factor in the valuation, but the make-or-9 break issue is whether a target has high-quality employees who10 can be integrated into the buyer’s organization.11 Transactions based on scope often are more complex than other12 strategic deals. A scope-based acquisition requires something13 more than simply extending the acquirer’s core competencies.14 For example, an industrial conglomerate that produced15 automobile and aerospace parts considered buying an indus-16 trial hydraulics manufacturer to widen the scope of its product17 offerings. Management wanted to use the target employees’18 skills to enter the lucrative aerohydraulics market. The acquirer19 interviewed major customers, technical engineers, and industry20 experts during the due diligence process. The investigation deter-21 mined that the skills needed to produce aerohydraulic parts were22 very different from those needed to produce industrial hydraulic23 components. In this case, the commercial review found that the24 strategic rationale of the acquisition, namely scope, was flawed,25 and so prevented a potentially costly mistake.26272829 Due Diligence for3031 Transformation-Driven Transactions32333435 E CONOMIC, TECHNOLOGY, OR INDUSTRY CHANGES MAY REQUIRE A COMPANY TO ALTER ITS BUSINESS fundamentally. Transactions based on changing the combined36 entity’s business are often based on a vision that’s difficult to 40
    • DUE DILIGENCE FOR TRANSFORMATION-DRIVEN TRANSACTIONSquantify. As a result, they are risky and hard to justify. Here, due 1diligence is essential to establish the risks of trying to redefine the 2industry. The key tools applied for this type of commercial review 3are customer and competitor interviews to carefully test whether 4a new business model can be applied to the market in question. In 5implementing these tools, companies must do the following: 6 q Focus on possible outcomes (scenario analysis) 7 q Test customer acceptance and cost and revenue synergies 8 for each scenario to develop probable outcomes 9 q Determine market size, expected growth, competitive 10 position, and customer acceptance of new markets 11 12 A clear example cited earlier of an attempt to redefine an 13industry comes from one of the highest-profile mergers of recent 14years, the AOL/Time Warner merger. AOL/Time Warner aimed 15to take a lead in redefining the way people buy media offerings. 16The company made a bold, long-term strategic move that, as was 17noted, has yet to prove itself but has certainly shaken up the music 18industry. 19 In transformation transactions, executives are wise to address 20soft issues, such as corporate culture, head-on. A Bain & Company 21study of twenty-one high-performance business turnarounds 22shows that a fact-based approach to solving soft issues works 23for businesses driving transformational change. The study found 24three constants of corporate transformation that yielded high 25returns: The most successful transformers focused on results, not 26the process of change; they replaced key senior executives, not 27departments wholesale; and they implemented multiple moves 28quickly and simultaneously. 29 In business, as in life, the personalities of the people involved 30are critical for success. The due diligence process must include 31an evaluation of the capabilities of current management. If the 32acquirer deems them unlikely to expand the company to achieve 33the necessary returns, it may need to replace them, or coach 34them. The potential acquirer may rather drop the deal entirely or 35approach it differently. 36 41
    • S T R AT E G I C D U E D I L I G E N C E1234 Assessing Your Findings5678 C ROSS-BORDER ISSUES OFTEN COMPLICATE THE DUE DILIGENCE PROCESS, REDUCING THE POTENTIAL TO realize the value sought. Many cross-border peculiarities,9 such as market dynamics, local competitors, and local con-10 sumer tastes, are as straightforward to quantify as they are11 in a domestic deal. However, the risk of cultural differences12 between two firms can affect the value. Although it is diffi-13 cult to accurately quantify such risks, acquirers must evaluate14 them. Nonquantifiable barriers associated with a deal represent15 an execution risk that acquirers must consider and mitigate16 through an effective implementation plan.17 From a cross-border perspective, therefore, the probability18 that a deal will succeed depends primarily on two factors: the19 quantifiable value of the deal and the level of cultural barriers20 or execution risk. Figure 8 shows how these factors affect the21 likelihood of any particular deal succeeding.22 A deal with high quantifiable value and few cultural barriers23 will have the highest chance of success. Conversely, a deal that24 is likely to generate little value and has many cultural barriers25 is very likely to fail. Generally, acquirers prefer transactions26 that fall into the “high value/low barriers” segment. If there is27 a clear strategic rationale to the deal, there may be little alter-28 native to selecting a target that will involve significant cross-29 border issues. A clear example of such a deal was the attempted30 GE takeover of Honeywell. It would be naïve to assume that31 Jack Welch was unaware of the potential European opposition32 to the deal. However, the enormous strategic benefits of the33 deal made it a risk worth taking. As he took ownership of the34 merger process, he said, “My neck is on the line.”35 Significant cross-border issues should not deter buyers from36 considering a merger or acquisition. A private equity firm that 42
    • ASSESSING YOUR FINDINGS 1 FIGURE 8 2 Cross-Border Success Matrix 3 4 High Can we execute? High chance of success 5 6 7 8 9 Quantifiable 10 value of 11 deal 12 13 14 Is the deal an efficient 15 Low chance of success allocation of resources? 16 Low 17 High Risk of cultural barriers/differences Low 18 19 20owned a U.K./U.S. industrial products manufacturer was con- 21sidering an acquisition of a U.K./E.U. company. Significant 22cross-border issues included the cultural differences between 23the entrepreneurial U.S. management team and the European 24division management team; fundamental differences in market 25dynamics (for example, distributor-based sales in the United 26States versus direct sales in Europe); and different capabilities 27and sector strengths. The strategic benefits included synergies 28in the U.K. operations, product portfolio enhancement, regional 29branding, scale benefits through purchasing/production ratio- 30nalization, and internal benchmarking. These issues placed the 31deal in the “high value/high risk” box. The buyer did not walk 32away. By addressing the risks, it was confident it would real- 33ize synergies. For instance, the parties addressed and resolved 34branding issues and established the future strategy of the firm. 35 Figure 8 also underscores the possibility that a deal with 36 43
    • S T R AT E G I C D U E D I L I G E N C E1 very few cross-border complications can still fail to add much2 value to the acquirer. Companies that either are more risk3 averse or have a portfolio gap may still be willing to undertake4 such deals. They accept a lower return in exchange for the5 reduced risk that the relatively straightforward deal offers. Of6 course, the price of a deal is likely to take this into account, so7 the returns may be no easier to achieve.8 Creating value through M&A transactions has always been9 an uncertain business. Information that increases the level of10 confidence in value creation is extremely valuable. The added11 complexities of cross-border deals accentuate the need for a12 comprehensive strategic due diligence driven by the acquirer’s13 need to understand the key issues that could affect the specific14 deal. A comprehensive review in the context of the acquirer’s15 corporate strategy helps it understand the stand-alone value of16 the deal, the potential for improvements through active invest-17 ing, and the potential to add value through strategic rationales18 unique to the acquirer.192021222324 The authors would like to acknowledge the support of Bain25 colleagues John Billowits, Katie Smith Milway, Robin Stopford,26 and Christian Strobel in preparing this text.27282930313233343536 44
    • CHECKLIST 1 2 Cross-Border Strategic Due Diligence 3 4EVERY TRANSACTION IS UNIQUE and requires a custom- 5ized approach. However, the following questions provide a 6guide to the types of issues generally encountered. Questions 7in bold refer to those specific to cross-border deals. 8 9GENERAL 101. Market Analysis 11 q What is the target’s key market (market definition)? 12 q What are the underlying trends in the target’s market? 13 q How will these trends affect the growth and profitability of 14 that market? 152. Competitive Position 16 q Which competitors participate in the target’s market? 17 q What is the target’s size and growth relative to the competi- 18 tors in the market? 19 q How has the competition developed over time? 20 q How do the competitive dynamics vary by distribution channel? 213. Customer Evaluation 22 q Who are the target’s customers? 23 q What are the key trends in the customers’ markets? 24 q What are the key criteria for gaining and retaining new 25 customers? 26 q How does the target meet the customer retention criteria? 27 q How profitable are the different customer segments? 284. Cost Evaluation 29 q What is your cost position relative to the target’s? 30 q Who are your least profitable customers, and how much are 31 they costing you? 32 q How much further can competitors drive down costs? 33 q What costs can you truly share with your target? 34 q How much further can you drive down costs on your own? 35 As a merged entity? 36 45
    • S T R AT E G I C D U E D I L I G E N C E1 5. Company Analysis2 q How does the target’s profitability compare to the profit-3 ability of its competitors?4 q How sensitive are the target’s margins to input costs?56 ACTIVE INVESTING (What is the firm’s full potential?)7 1. Market Analysis8 q Are there any opportunities for the target to influence the9 market structure?10 2. Competitive Position11 q Are there any opportunities to increase the target’s market12 share?13 q Are there any threats to the target’s position?14 3. Customer Evaluation15 q Is there an opportunity to weed out unprofitable cus-16 tomers?17 q Is there an opportunity to trade up customers to higher-18 value-added products/services?19 4. Company Analysis20 q Are there any opportunities to improve profitability (cost21 reduction opportunities, revenue enhancement)?22 q Can you achieve these improvements (timing to full poten-23 tial)?2425 STRATEGIC RATIONALE26 q What are the expected costs of integrating the two firms?27 q Do the quantifiable strategic benefits associated with the28 acquisition outweigh the costs?29 1. Scale30 q Does the target participate in the same market as you?31 q How will the transaction improve the competitive position of32 the combined entities in the related markets?33 q What are the potential scale economies of the transaction?34 q What are the specific cost-reduction opportunities, and how35 quickly can they be achieved?36 q Do you share customers/customer types with the target? 46
    • S T R AT E G I C R AT I O N A L E q What are the similarities/differences of the markets in 1 the different countries? 2 q Are competitors local, regional, or global? 3 q Are scale economies relevant on a local, regional, or 4 global basis? 5 q Is there customer sharing between countries? 62. Adjacency 7 q Is the transaction highly related to your corporate strategy? 8 q How large is the potential to cross-sell the target’s products 9 with yours? 10 q How similar are the buying criteria for the two products? 11 q Which roles will overlap in the combined companies? 12 q What is the potential for cost savings in the combined 13 companies? 14 q Are opportunities for cross-selling transferable across 15 borders? 163. Scope 17 q Does the target possess the capabilities you seek? 18 q Will the new capabilities significantly improve your prof- 19 itability? 20 q How does the cost of acquiring the capabilities from the 21 target compare to the cost of building them internally? 22 q Can the capabilities be retained postacquisition? 23 q Are the capabilities transferable across borders? 244. Transformation 25 q What is the underlying potential for transforming the 26 industry? Will customers accept the transformation of the 27 industry? 28 q How will the integration of the target aid the transformation 29 of the industry? 30 q How will the transformed industry benefit the combined 31 companies? 32 q Are the benefits of the transformation local, regional, or 33 global? 34 35 36 47
    • 12 Bain’s business is helping make3 companies more valuable.45678 F OUNDED IN 1973 ON THE PRINCIPLE THAT CONSULTANTS MUST MEASURE THEIR SUCCESS IN TERMS OF THEIR clients’ financial results, Bain works with top management teams9 to beat their competitors and generate substantial, lasting finan-10 cial impact. Our clients have historically outperformed the stock11 market by 3:1.1213 Who we work with1415 Our clients are typically bold, ambitious business leaders.16 They have the talent, the will, and the open-mindedness required17 to succeed. They are not satisfied with the status quo.1819 What we do2021 We help companies find where to make their money, make more22 of it faster, and sustain its growth longer. We help management23 make the big decisions: on strategy, operations, technology,24 mergers and acquisitions, and organization. Where appropriate,25 we work with them to make it happen.2627 How we do it2829 We realize that helping an organization change requires more30 than just a recommendation. So we try to put ourselves in our31 clients shoes and focus on practical actions.3233343536 Visit www.bain.com for more information.
    • DD BkLT cvr2 9/12/02 1:51 PM Page 1 LOBAL, CROSS-BORDER DEALS often present G mouthwatering opportunities for expansion into new markets. However, these transactions also include STRATEGIC regulatory and legal issues, and must overcome complex cul- tural challenges to successfully integrate. Consider the merger between engineering giants Asea of Sweden and Brown Boveri of Switzerland. The merged organization, ABB, had to contend with strong national companies, Due Diligence governments, and striking unionized German workers, plus powerful and culturally different management. How can companies merging across borders, or acquiring abroad, foresee and account for risks associated with such issues? Bain & Company research finds the odds of success in M&A a dismal one-in-five. But the research also finds that deals beating these odds follow a pattern: They put strategic intent before due diligence and rigorous due diligence before committing to a purchase price. In successful deals, the com- mercial assessment calculates the cost of risks including local market peculiarities, differences in national and organiza- tional culture, likely competitor responses in all relevant geographies and businesses, and regulatory challenges. Truly strategic due diligence takes these elements and extrapolates GEOFF CULLINAN their impact on the merged companies’ business boundaries, TOM HOLLAND on integration objectives, and on ultimate returns to share- holders. Authors GEOFF CULLINAN AND TOM HOLLAND, of Bain’s worldwide corporate transactions practice, present a comprehensive tool kit for cutting through complexity in cross-border deals to identify core value and its potential. EXCERPTED FROM Due Diligence for Global Deal Making: The Definitive Guide to Cross-Border Mergers and Acquisitions, Joint Ventures, Financings, and Strategic Alliances EDITED BY Arthur H. Rosenbloom PUBLISHED BY