Chapter 7 Merger and Acquisition Strategies LEARNING OBJECTIVES 1. Explain the popularity of merger and acquisition strategies in firms competing in the global economy. 2. Discuss reasons why firms use an acquisition strategy to achieve strategic competitiveness. 3. Describe seven problems that work against achieving success when using an acquisition strategy. 4. Name and describe the attributes of effective acquisitions. 5. Define the restructuring strategy and distinguish among its common forms. 6. Explain the short- and long-term outcomes of the different types of restructuring strategies. CHAPTER OUTLINE Opening Case: Strategic Mergers and Acquisition: Prominent Strategies for Forms Seeking to Enhance their Performance THE POPULARITY OF MERGER AND ACQUISITION STRATEGIES Mergers, Acquisitions, and Takeovers: What Are the Differences? REASONS FOR ACQUISITIONS Strategic Focus: A Merger of Equals: Making It Happen Isn’t Easy Increased Market Power Overcoming Entry Barriers Strategic Focus: Different Strategic Rationales Driving Cross-Border Acquisitions Cost of New Product Development and Increased Speed to Market Lower Risk Compared to Developing New Products Increased Diversification Reshaping the Firm’s Competitive Scope Learning and Developing New Capabilities PROBLEMS IN ACHIEVING ACQUISITION SUCCESS Integration Difficulties Inadequate Evaluation of Target Large or Extraordinary Debt Inability to Achieve Synergy Too Much Diversification Managers Overly Focused on Acquisitions Too Large EFFECTIVE ACQUISITIONS RESTRUCTURING Downsizing Downscoping Leveraged Buyouts Restructuring Outcomes SUMMARY KEY TERMS REVIEW QUESTIONS Mini-Case: Strategic Acquisitions and Accelerated Integration of Those Acquisitions are a Vital Capability of Cisco Systems MINDTAP RESOURCES LECTURE NOTES Chapter Introduction: With continued merger and acquisition activity, this chapter is very important. Much of the chapter’s material is summarized in Figure 7.1, which can be used to help students mentally organize what they learn in the chapter about mergers and acquisitions by examining reasons of acquisitions and problems in achieving success. OPENING CASE Mergers and Acquisition: Prominent Strategies for Forms Seeking to Enhance their Performance The Opening Case sets up the central theme for Chapter 7—merger and acquisition strategy. The influences on firms’ decisions to use merger and acquisition strategies are varied and interesting. The discussion of these influences in the Opening Case reinforces the discussion in the chapter about specific reasons firms choose to implement these strategies. The need to create value for stakeholders is a primary influence on firms’ decisions to engage in M&A activity. But companies interested in implementing merger and acquisition strategies sometimes face hurdles in their attempts to do so, including trade barriers and local public interest concerns. Teaching Note: There are several reasons corporations merge with or acquire other companies. However, the need to create value for stakeholders is a primary influence on firms’ decisions to engage in M&A activity in a slowing economy or weak R&D pipeline. To drive this point home, ask students why corporations don’t just develop internally the businesses/capabilities that it could obtain through acquisitions. Then, ask students why they think target firms might agree to be acquired. Students should realize that truly successful acquisitions provide benefits to both parties.
1 Explain the popularity of acquisition strategies in firms competing in the global economy.
In the latter half of the 20th century, acquisition became a prominent strategy used by major corporations to achieve growth and meet competitive challenges. Even smaller and more focused firms began employing acquisition strategies to grow and enter new markets. However, acquisition strategies are not without problems; a number of acquisitions fail. Thus, the chapter focuses on how acquisitions can be used to produce value for the firm’s stakeholders. THE POPULARITY OF MERGER AND ACQUISITION STRATEGIES Acquisitions have been a popular strategy among US firms for many years. Some believe that this strategy played a central role in the restructuring of US businesses during the 1980s, 1990s, and into the 21st century. Increasingly, acquisition strategies are becoming more popular with firms in other nations (e.g., those of Europe). In fact, about 40 to 45 percent of the acquisitions in recent years have been made across country borders (i.e., where a firm headquartered in one country acquires a firm headquartered in another country). Merger and acquisition trends: • There were five waves of mergers and acquisitions in the 20th century, the last two in the 1980s and 1990s. • There were 55,000 acquisitions valued at $1.3 trillion in the 1980s. • Acquisitions in the 1990s exceeded $11 trillion in value. • World economies (especially the US economy) slowed in the new millennium, reducing M&As completed. • Mergers and acquisitions peaked in 2000 at about $3.4 billion and fell to about $1.75 billion in 2001. • The global volume of announced acquisition agreements was up 41 percent from 2003 to $1.95 trillion for 2004, the highest level since 2000, and the pace in 2005 was significantly above the level of 2004. • Although the frequency of acquisitions has slowed, their number remains high. • In the latest acquisition boom between 1998 and 2000, acquiring firm shareholders experienced significant losses relative to the losses in all of the 1980s. A firm may make an acquisition to do the following: • Increase its market power because of a competitive threat • Enter a new market because of an available opportunity • Spread the risk due to the uncertain environment • Shift its core business into more favorable markets (e.g., because of industry or regulatory changes) Evidence suggests that at least for acquiring firms, acquisition strategies may not result in desirable outcomes. Studies have found that shareholders of acquired firms often earn above-average returns from an acquisition, whereas shareholders of acquiring firms are less likely to do so. In approximately two-thirds of all acquisitions, the acquiring firm’s stock price falls immediately after the intended transaction is announced, indicating investors’ skepticism about the likelihood that the acquirer will be able to achieve the synergies required to justify the premium. Mergers, Acquisitions, and Takeovers: What Are the Differences? Before starting the discussion of the reasons for acquisitions, problems related to acquisitions, and long-term performance, three terms should be defined because they will be used throughout this chapter and Chapter 10. A merger is a transaction where two firms agree to integrate their operations on a relatively co-equal basis because they have resources and capabilities that together may create a stronger competitive advantage. An acquisition is a transaction where one firm buys a controlling or 100 percent interest in another firm with the intent of making the acquired firm a subsidiary business within its portfolio. Whereas most mergers represent friendly agreements between the two firms, acquisitions sometimes can be classified as unfriendly takeovers. A takeover is an acquisition—and normally not a merger—where the target firm did not solicit the bid of the acquiring firm and often resists the acquisition (a hostile takeover).
2 Discuss reasons why firms use an acquisition strategy to achieve strategic competitiveness.
REASONS FOR ACQUISITIONS The main strategic reasons for acquisition are detailed one at a time in the text after the Strategic Focus article. Teaching Note: You may find it helpful to refer students to Figure 7.1, which lists the reasons for acquisitions. STRATEGIC FOCUS A Merger of Equals: Making It Happen Isn’t Easy! Lafarge is French-based successful global company specializing in cement, construction aggregates and concrete. Holcim is a materials company in Switzerland. The orchestrated a merger of equals in 2014. The firms believed that they could achieve $1.5 billion in annual cost savings as a result of integrating their operations. After passing regulatory hurdles in the companies where they do business, the deal almost fell through concerning the valuations of the companies. Teaching Note: Discuss with students the potential hurdles to successful mergers of equals. What obstacles do companies face prior to completing the deal? Now that the deal is signed, what does the future hold for the new combined firm? Review the obstacles to integration and the pitfalls associated with merger and acquisition strategies. Increased Market Power As discussed in Chapter 6, a primary reason for acquisitions is that they enable firms to gain greater market power. Acquisitions to meet a market power objective generally involve buying a supplier, a competitor, a distributor, or a business in a highly related industry. Though a number of firms may feel that they have an internal core competence, they may be unable to exploit their resources and capabilities because of a lack of size. Horizontal Acquisitions When a competitor in the same industry is acquired, a firm has engaged in a horizontal acquisition. Horizontal acquisitions increase a firm’s market power by exploiting cost-based and revenue-based synergies. Research suggests that horizontal acquisitions of firms with similar characteristics result in higher performance than when firms with dissimilar characteristics combine their operations. Examples of important similar characteristics include strategy, managerial styles, and resource allocation patterns. Horizontal acquisitions are often most effective when the acquiring firm integrates the acquired firm’s assets with its own assets, but only after evaluating and divesting excess capacity and assets that do not complement the newly combined firm’s core competencies. Vertical Acquisitions A vertical acquisition has occurred when a firm acquires a supplier or distributor that is positioned either backward or forward in the firm’s cost/activity/value chain. Related Acquisitions When a target firm in a highly related industry is acquired, the firm has made a related acquisition. Teaching Note: Remind students that, as discussed in Chapter 6, during the 1960s and 1970s, both horizontal and related acquisitions were discouraged as they were regularly challenged by agencies of the federal government. The ability of firms to make horizontal acquisitions increased in the 1980s because of changes in the interpretation and enforcement of antitrust laws and regulations by the courts and the Justice Department. It is important to note that acquisitions intended to increase market power are subject to regulatory review, as well as analysis by financial markets. Overcoming Entry Barriers As discussed in Chapter 2, barriers to entry represent factors associated with the market and/or firms operating in the market that make it more expensive and difficult for new firms to enter the market. It may be difficult to enter a market dominated by large, established competitors. As noted in Chapter 2, such markets may require: • Investments in large-scale manufacturing facilities that enable the firm to achieve economies of scale so that it can offer competitive prices • Significant expenditures in advertising and promotion to overcome brand loyalty toward existing products • Establishing or breaking into existing distribution channels so that goods are convenient to customers When barriers to entry are present, the firm’s best choice may be to acquire a firm already having a presence in the industry or market. In fact, the higher the barriers to entry into an attractive market or industry, the more likely it is that firms interested in entering will follow acquisition strategies. Entry barriers that firms face when trying to enter international markets are often great. Commonly, acquisitions are used to overcome entry barriers in international markets. It is important to compete successfully in these markets since global markets are growing faster than domestic markets. Also, five of the emerging markets (China, India, Brazil, Mexico, and Indonesia) are among the fastest growing economies in the world. STRATEGIC FOCUS Different Strategic Rationales Driving Cross-Border Acquisitions The decision to acquire a company should be carefully identified, examined, and agreed upon by key decision-makers throughout the firm prior to finalizing an acquisition decision. The most successful acquisitions, including cross-border ones, are products of a rational decision-making process that is grounded in careful analysis of a pro-posed transaction with its strategic rationale as a guiding force. The strategic rationale sometimes results in firms deciding to acquire ownership percentages of target firms to see if a full acquisition is warranted at a later date. This seems to be the situation with Alibaba Group Holding Ltd., the Chinese-based company that is the world’s largest e-commerce platform. With the strategic rationale of “becoming more global” as a driver, the firm is acquiring parts of firms outside its home market, including its 9 percent purchase of U.S. online retailer Zulily, Inc. and its investments in mobile messaging app-maker Tango, also a U.S. firm. Teaching Note: Students may be surprised that cross-border acquisitions of the type described in the Strategic Focus are taking place. The more accepted scenario is one in which developed market acquirers purchase firms in emerging markets. Though emerging market acquirers may have the resources and opportunity to engage in cross-border acquisitions of developed market companies, capabilities to manage/integrate the acquired firms is another issue. Ask students to identify the skill sets/capabilities that emerging market acquirers should possess to ensure that their developed market acquisitions perform at acceptable levels. Cross-Border Acquisitions Acquisitions between companies with headquarters in different countries are called cross-border acquisitions. Teaching Note: Chapter 9 examines cross-border alliances and the justification for their use. Cross-border acquisitions and cross-border alliances are alternatives firms consider while pursuing strategic competitiveness. Compared to a cross-border alliance, a firm has more control over its international operations through a cross-border acquisition. Historically, US firms have been the most active acquirers of companies outside their domestic market. However, in the global economy, companies throughout the world are choosing this strategic option with increasing frequency. In recent years, cross-border acquisitions have represented as much as 40 percent of the total number of acquisitions made annually. Some trends in cross-border acquisitions: • Because of relaxed regulations, the amount of cross-border activity among nations within the European community also continues to increase. • Many large European corporations have approached the limits of growth within their domestic markets and thus seek growth in other markets. • Many European and US firms participated in cross-border acquisitions across Asian countries that experienced a financial crisis due to significant currency devaluations in 1997, and this facilitated the survival and restructuring of many large Asian companies such that these economies recovered more quickly than they would have otherwise. Acquisitions represent a viable strategy for firms that wish to enter international markets because: • This may be the fastest way to enter new markets • They provide more control over foreign operations than do strategic alliances with a foreign partner Cost of New Product Development and Increased Speed to Market Acquisitions also may represent an attractive alternative to developing new products internally due to the cost and time required to start a new venture and achieve a positive return. Also of concern to firms’ managers is achieving adequate returns from the capital invested to develop and commercialize new products—an estimated 88 percent of innovations fail to achieve adequate returns. Perhaps contributing to these less-than-desirable rates of return is the successful imitation of approximately 60 percent of innovations within four years after the patents are obtained. Because of outcomes such as these, managers often perceive internal product development as a high-risk activity. Internal development of new products is often perceived by managers to be costly and to represent high risk investments of firm resources. Although sometimes costly, it may be in the firm’s best interest to acquire an existing business because: • The acquired firm has established sales volume and customer base, thus yielding predictable returns. • The acquiring firm gains immediate market access. In addition to representing attractive prices, large pharmaceutical firms have used acquisitions to supplement products in the pipeline with projects from undervalued biotechnology companies; thus, this is one way to appropriate new products. Lower Risk Compared to Developing New Products As discussed earlier, internal product development processes can be risky, in that entering a market and earning an acceptable return on investment requires significant resources and time. All the same, acquisition outcomes can be estimated easily and accurately (as compared to the outcomes of an internal product development process), causing managers to view acquisitions as carrying lowering risk. Teaching Note: Not long ago, P&G acquired premium dog and cat food manufacturer Iams Co. to support the launch of its pet products into supermarket chains and mass merchandisers such as Walmart. Having assessed the potential of Iams in the marketplace, P&G managers were confident they would achieve positive results through their strategy; thus, they may have considered entry into the premium pet-food market through acquisition to be less risky than entering the market via internal product development. Because acquisitions recently have become such a common means of avoiding risky internal ventures, they could become a substitute for innovation, which has a serious downside (e.g., the decline of Cisco systems). Teaching Note: Although they often enable firms to offset the risk of internal ventures and of developing new products, acquisitions are not without risks of their own. Acquisition-related risks are discussed later in this chapter. Increased Diversification It should be easier for firms to develop new products and/or new ventures within their current markets because of market-related knowledge, but firms that desire to enter new markets may find that current product-market knowledge and skills are not transferable to the new target market. Acquisitions also may have gained in popularity as a related or horizontal diversification strategy (enabling rapid moves into related markets or to expand market power) and as an unrelated diversification strategy because of the changes in regulatory interpretation and enforcement of antitrust laws discussed in Chapter 6. Using acquisitions to diversify a firm is the quickest and often the easiest way to change its portfolio of businesses—e.g., Goodrich evolved from a tire maker to a top-tier aerospace supplier through 40+ acquisitions. Firms must be careful when making acquisitions to diversify their product lines because horizontal and related acquisitions tend to contribute more to strategic competitiveness, and thus they are more successful than diversifying acquisitions. Teaching Note: Remember, related diversification seeks lower costs through economies of scope, synergy, and resource sharing, whereas unrelated diversification hopes to realize financial economies and better internal resource allocation among diverse businesses. Reshaping the Firm’s Competitive Scope To reduce intense rivalry’s negative effect on financial performance, a firm may use acquisitions as a way to restrict its dependence on a single or a few products or markets. Teaching Note: The following are examples of auto manufacturers that have gone through acquisitions to reduce dependence of too few businesses: • General Motors acquired Electronic Data Systems and Hughes Aerospace to lessen its dependence on the domestic automobile market (where its market share had declined from approximately 50 percent in 1980 to less than 30 percent 10 years later) and escape intense competition with Japanese automakers. However, GM later sold these businesses to focus its efforts on its core automobile business. • DaimlerChrysler considered expanding into financial and computer services, aftermarket sales, and electronics and satellite systems to pursue more desirable operating margins in areas that are more attractive than are alliances or acquisitions in car manufacturing. • Ford management considered making the company the world’s leading consumer services business that specializes in the automotive sector by tapping all sectors in after-sales markets, including repairs, replacement parts, and product servicing. To evaluate its success in reshaping the firm’s competitive scope through diversification, Ford would measure its performance against world-class consumer firms, regardless of industry (i.e., rather than using the traditional yardsticks of rival automakers). Learning and Developing New Capabilities Some acquisitions are made to gain capabilities that the firm does not possess—e.g., acquisitions used to acquire a special technological capability. Acquiring other firms with skills and capabilities that differ from its own helps the acquiring firm learn new knowledge and remain agile, but firms are better able to learn these capabilities if they share some similar properties with the firm’s current capabilities. One of Cisco System’s primary goals in its early acquisitions was to gain access to capabilities that it did not currently possess through its commitment to learning. The firm developed an intricate process to quickly integrate the acquired firms and their capabilities (knowledge) after an acquisition is completed. Figure Note: Figure 7.1 presents the reasons for making acquisitions and the problems encountered. A comment that problems are discussed in ensuing sections is appropriate.
3 Describe seven problems that work against developing a competitive advantage using an acquisition strategy.
PROBLEMS IN ACHIEVING ACQUISITION SUCCESS Research suggests that perhaps 20 percent of all mergers and acquisitions are successful, approximately 60 percent produce disappointing results, and the last 20 percent are clear failures. Successful acquisitions generally involve a well-conceived strategy in selecting the target, the avoidance of paying too high a premium, and employing an effective integration process. A number of problems accompany an acquisition strategy. Acquisition-related problems shown in Figure 7.1 that are discussed in this section are: • Difficulties integrating the two firms after the acquisition is completed • Paying too much for the target (acquired) firm or inappropriately or inadequately evaluating the target • The cost of financing the acquisition, related to large or extraordinary debt • Overestimating the potential for gains from capabilities and/or synergy • Excessive or too much diversification • Management being preoccupied or overly focused on acquisitions • The combined firm becoming too large Integration Difficulties Integration problems or difficulties that firms often encounter can take many forms. Among them are: • Melding disparate corporate cultures • Linking different financial and control systems • Building effective working relationships (especially when management styles differ) • Problems related to differing status of acquired and acquiring firms’ executives The importance of integration success should not be underestimated. Without successful integration, a firm achieves financial diversification, but little else. Consider these points. • The post-acquisition integration phase may be the single most important determinant of shareholder value creation (or value destruction) in mergers and acquisitions. • Managers should understand the large number of activities associated with integration processes. Teaching Note: Several years ago, Intel acquired Digital Equipment’s semiconductors division. On the day Intel began to integrate the acquired division into its operations, six thousand deliverables were to be completed by hundreds of employees working in dozens of countries. FIGURE 7.1 Reasons for Acquisitions and Problems in Achieving Success Seven reasons for acquisitions are presented in the left column whereas seven problems in achieving acquisition success are presented in the right hand bubble-column of Figure 7.1. To summarize, the seven reasons that firms (and managers) implement acquisition strategies are to: • Increase market power • Overcome entry barriers • Reduce the cost of new product development and increase speed to market • Lower risk compared to developing new products • Increase diversification • Avoid excessive competition • Learn and develop new capabilities The seven reasons for poor performance of acquisitions or problems faced in attempts to achieve success are: • Integration difficulties • Inadequate evaluation of target • Large or extraordinary debt • Inability to achieve synergy • Too much diversification • Managers overly focused on acquisitions • Too large Note: Problems encountered as firms try to successfully achieve their objectives and create value from acquisitions are discussed in detail in the next sections of this chapter. It is important to maintain the human capital of the target firm after the acquisition to preserve the organization’s knowledge. Turnover of key personnel from the acquired firm can have a negative effect on the performance of the merged firm. Teaching Note: The following are examples of firms and the steps they took to preserve human capital through the acquisition process. • When AllliedSignal acquired Honeywell, the firm set an aggressive timetable to merge their operations into a $24 billion industrial powerhouse in six months, despite the great diversification involved. This required a team to develop and implement the integration. • Rapid integration is one of the guidelines that DaimlerChrysler uses for successful firm integration in a global merger or acquisition. Managers are encouraged to deal with unpopular issues immediately and honestly so employees will be able to anticipate the effects the integration is likely to have on them. • Cisco Systems is quick to integrate acquisitions with its existing operations. Focusing on small companies with products and services related closely to its own, some believe that the day after Cisco acquires a firm, employees in that company feel as though they have been working for Cisco for decades. Inadequate Evaluation of Target Due diligence is a process through which a firm evaluates a target firm for acquisition. In an effective due-diligence process hundreds of items are examined in areas as diverse as the financing for the intended transaction, differences in cultures between the acquiring and target firm, tax consequences of the transaction, and actions that would be necessary to successfully meld the two workforces. Due diligence is commonly performed by investment bankers, accountants, lawyers, and management consultants specializing in that activity, although firms actively pursuing acquisitions may form their own internal due-diligence team. Teaching Note: For the reasons below, firms often pay too much for acquired businesses: • Acquiring firms may not thoroughly analyze the target firm, failing to develop adequate knowledge of its true market value. • Managers’ overconfidence may cloud the judgment of acquiring firm managers. • Shareholders (owners) of the target must be enticed to sell their stock, and this usually requires that acquiring firms pay a premium over the current stock price. • In some instances, two or more firms may be interested in acquiring the same target firm. When this happens, a bidding war often ensues and extraordinarily high premiums may be required to purchase the target firm. Teaching Note: Some acquirers overpaying for target firms include the following: • British retailer Marks & Spencer paid $750 million for Brooks Brothers of the United States, but the acquisition was still unsuccessful after more than ten years of integration. • Sony paid a 28 percent premium for CBS Records and a 60 percent premium for Columbia Pictures. • Bridgestone paid a 60 percent premium for Firestone, and its winning bid was 38 percent higher than a competing bid from Pirelli. • National City Corporation agreed to acquire First of America for a price that was 3.8 times book value and 22.9 times First’s estimated 1998 earnings—National City’s stock fell 5.9 percent. • First Union Corp. paid 5.3 times book value when it acquired CoreStates Financial Corp. • Federated paid $10 per share for Broadway Department Stores when Broadway’s stock was selling for $2 per share, a 400 percent premium in a transaction valued at $1.6 billion to acquire Broadway’s prime West Coast real estate locations. Firms sometimes allow themselves to enter a “bidding war” for a target even though they realize their current bids exceed the parameters identified through due diligence. Large or Extraordinary Debt In addition to overpaying for targets, many acquirers must finance acquisitions with relatively high-cost debt. In the 1980s, investment bankers developed a new financing instrument for acquisitions, the junk bond. Junk bonds represented a new financing option in which risky investments were financed with money (debt) that provided a high return to lenders (bond holders). Junk bonds offer relatively high rates, some as high as 18 to 20 percent during the 1980s. Teaching Note: Junk bonds are considered by many to be a new financing option, not because they are new, but because they represented the first instances in which non-investment grade (below a B rating) securities were used to raise funds by companies whose securities were normally rated as investment grade. Teaching Note: A number of well-known and well-respected finance scholars argue in favor of firms utilizing significantly high levels of leverage because debt discourages managers from misusing funds (for example, by making bad investments) because debt (and interest) repayment eliminates the firm’s “free cash flow.” Inability to Achieve Synergy Acquiring firms also face the challenge of correctly identifying and valuing any synergies that are expected to be realized from the acquisition. This is a significant problem because to justify the premium price paid for target firms, managers may overestimate both the benefits and value of synergy. To achieve a sustained competitive advantage through an acquisition, acquirers must realize private synergies and core competencies that cannot easily be imitated by competitors. Private synergy refers to the benefit from merging the acquiring and target firms that is due to the unique assets that are complementary between the two firms and not available to other potential bidders for that target firm. Teaching Note: As pointed out earlier, the average return to acquiring firm shareholders is near zero, and many of these lead to negative returns for acquiring firm shareholders. Firms experience transaction costs when using acquisition strategies to create synergy. Direct costs include legal fees and charges from investment bankers. Managerial time to evaluate target firms and then to complete negotiations and the loss of key managers and employees post-acquisition are indirect costs. Too Much Diversification In general, firms using related diversification strategies outperform those using unrelated diversification strategies. However, conglomerates (i.e., those pursuing unrelated diversification) can also be successful. In the drive to diversify the firm’s product line, many firms over-diversified during the 60s, 70s, and 80s. As detailed in Chapter 6, information processing requirements are greater for a related diversified firm (compared to its unrelated counterparts) due to its need to effectively and efficiently coordinate the linkages and interdependencies on which value-creation through activity sharing depends. In addition to increased information processing requirements and managerial expertise, over-diversification may result in poor performance when top-level managers emphasize financial controls over strategic controls. Teaching Note: Controls are discussed in more detail in Chapters 11 and 12. Financial controls may be emphasized when managers feel that they do not have sufficient expertise or knowledge of the firm’s various businesses. When this happens, top-level managers are not able to adequately evaluate the strategies and strategic actions taken by division or business unit managers. As a result, • When they lack a rich understanding of business units’ strategies and objectives, top-level managers tend to emphasize the financial outcomes of strategic actions rather than the appropriateness of the strategy itself. • This forces division or business unit managers to become short-term performance-oriented. • The problem is more serious when manager compensation is tied to short-term financial outcomes. • Long-term, risky investments (such as R&D) may be reduced to boost short-term returns. • In the final analysis, long-term performance deteriorates. Teaching Note: The experiences of many firms indicate that over-diversification may lead to ineffective management, primarily because of the increased size and complexity of the firm. As a result of ineffective management, the firm and some of its businesses may be unable to maintain their strategic competitiveness. This results in poor performance. As noted earlier in this chapter, acquisitions can have a number of negative effects. They may result in greater levels of diversification (in products, markets, and/or industries), absorb extensive managerial time and energy, require large amounts of debt, and create larger organizations. As a result, acquisitions can have a negative impact on investments in research and development and thus on innovation. Reducing the emphasis on R&D and on innovation may result in the firm losing its strategic competitiveness unless the firm operates in mature industries in which innovation is not required to maintain competitiveness. Managers Overly Focused on Acquisitions If firms follow active acquisition strategies, the acquisition process generally requires significant amounts of managerial time and energy. For the acquiring firm this takes the form of: • Searching for viable candidates • Completing effective due diligence • Preparing for negotiations with the target firm • Managing the integration process post-acquisition The desire to merge is like an addiction in many companies: Doing deals is much more fun and interesting than fixing fundamental business problems. Due diligence and negotiating with the target often include numerous meetings between representatives of the acquirer and target, as well as meetings with investment bankers, analysts, attorneys, and in some cases, regulatory agencies. As a result, top-level managers of acquiring firms often pay little attention to long-term, strategic matters because of time (and energy) constraints. Too Large Firms can reach economies of scale by growing. But after a certain size is achieved, size can become a disadvantage as firms reach a point where they suffer from what is called “diseconomies of scale.” This implies that problems related to excess growth may be similar to those that accompany over-diversification. Other actions taken to enable more effective management of increased firm size include increasing or establishing bureaucratic controls, represented by formalized supervisory and behavioral controls such as rules and policies designed to ensure consistency across different units’ decisions and actions. On the surface (or in theory), bureaucratic controls may be beneficial to large organizations. However, they may produce overly rigid and standardized behavior among managers. The reduced managerial (and firm) flexibility can result in reduced levels of innovation and less creative (and less timely) decision making.
4 Name and describe the attributes of effective acquisitions.
EFFECTIVE ACQUISITIONS Research has identified attributes that appear to be associated consistently with successful acquisitions: • When a firm’s assets are complementary (highly related) with the acquired firm’s assets and create synergy and, in turn, unique capabilities, core competencies, and strategic competitiveness • When targets were selected and “groomed” through earlier working relationships (e.g., strategic alliances) • When the acquisition is friendly, thereby reducing animosity and turnover of key employees • When the acquiring firm has conducted due diligence • When management is focused on research and development • When acquiring and target firms are flexible/adaptable (e.g., from executive experience with acquisitions) • When integration quickly produces the desired synergy in the newly created firm, allowing the acquiring firm to keep valuable human resources in the acquired firm from leaving Table Note: The attributes or characteristics of successful acquisitions and their results are summarized in Table 7.1. TABLE 7.1 Attributes of Successful Acquisitions Successful acquisitions generally are characterized by the following attributes and results: • Target and acquirer having complementary assets and/or resources that result in a high probability of achieving synergy and gaining competitive advantage • Making friendly acquisitions to facilitate integration speed and effectiveness and reducing any acquisition premium • Effective due diligence - target selection and negotiation processes that result in the selection of targets having resources and assets that are complementary to the acquiring firm’s core business, thus avoiding overpayment • Maintaining financial slack to make acquisition financing less costly and easier to obtain • Maintaining a low to moderate debt position, which lowers costs and avoids the trade-offs of high debt and lowers the risk of failure • Possessing flexibility and skills to adapt to change to facilitate integration speed and achievement of synergy • Continuing to invest in R&D and emphasizing innovation to maintain competitive advantage Note: The table also lists seven “results” of successful acquisitions. Teaching Note: One way to teach the finer points of the M&A process is to see its parallels with marriage and courtship. Though the source is rather dated now, Jemison & Sitkin (1986, Academy of Management Review) offered an interesting analysis based on this framework. Their points are too extensive to comment on here, but reference to their writings is helpful.
5 Define the restructuring strategy and distinguish among its common forms.
RESTRUCTURING Restructuring refers to changes in the composition of a firm’s set of businesses and/or financial structure. From the 1970s into the 2000s, divesting businesses from company portfolios and downsizing accounted for a large percentage of firms’ restructuring strategies. Restructuring is a global phenomenon. During this period, restructuring can take several forms: • Downsizing, primarily to reduce costs by laying off employees or eliminating operating units • Downscoping to reduce the level of firm unrelatedness • Leveraged buyouts to restructure the firm’s assets by taking it private Sometimes firms use a restructuring strategy because of changes in their external and internal environments. For example, opportunities sometimes surface in the external environment that are particularly attractive to the diversified firm in light of its core competencies. In such cases, restructuring may be appropriate. Downsizing Once thought to be an indicator of organizational decline, downsizing is now recognized as a legitimate restructuring strategy and has been one of the most common restructuring strategies adopted by US firms. Downsizing represents a reduction in the number of employees, and sometimes in the number of operating units, but may or may not represent a change in the composition of the businesses in the firm’s portfolio. Historically, divesting businesses from company portfolios and downsizing have accounted for a large percentage of firms’ restructuring strategies. Commonly, firms focus on fewer products and markets following restructuring. Firms use downsizing as a restructuring strategy for different reasons. The most frequently cited reason is that the firm expects improved profitability from cost reductions and more efficient operations. Downscoping Compared to downsizing, downscoping has a more positive effect on firm performance. Downscoping refers to the divestiture, spin-off, or other means of eliminating businesses that are unrelated to the firm’s core business. In other words, downscoping refocuses the firm on its core businesses. Whereas downscoping often includes downsizing, the former is targeted so that the firm does not lose key employees from core businesses (because such losses can lead to the loss of core competencies). As indicated by the discussion of over-diversification earlier in the chapter, reducing the diversity of businesses in the portfolio enables top-level managers to manage the firm more effectively because: • The firm is less diversified as a result of downscoping • Top-level managers can better understand the core and related businesses Note: Indicate to students that the requirements and characteristics of strategic leadership by a firm’s top management team are discussed more fully in Chapter 12. Teaching Note: There are many examples of downscoping strategies. Two of these with which students are likely to be familiar are the following: • General Motors’ successful spin-off of EDS • PepsiCo’s spin-off of its fast-food businesses (Taco Bell, Pizza Hut, KFC) US firms use downscoping as a restructuring strategy more frequently than do European companies. However, there has also been an increase in downscoping by Asian and Latin American firms as they adopt Western business practices. Teaching Note: Research has shown that refocusing is not usually successful unless the firm has adequate resources to have the flexibility to formulate the necessary strategies to compete effectively. Leveraged Buyouts A leveraged buyout (LBO) refers to a restructuring action whereby the management of the firm and/or an external party buys all of the assets of the business, largely financed with debt, and thus takes the firm private. Often, LBOs are used as a restructuring strategy to correct for managerial mistakes or because managers are making decisions that primarily serve their personal interests rather than those of shareholders. In other words, a firm is purchased by a few (new) owners using a significant amount of debt (in a highly leveraged transaction) and the firm’s stock is no longer traded publicly. In general, the new owners restructure the private firm by selling a significant number of assets (businesses) both to downscope the firm and to reduce the level of debt (and significant debt costs) used to finance the acquisition. A primary intent of the new owners is to improve the firm’s efficiency. This enables them to sell the firm (outright to another owner or by a public stock underwriting), thus capturing the value created through the restructuring. It is not uncommon for those buying a firm through an LBO to restructure the firm to the point that it can be sold at a profit within a five- to eight-year period. There are three types of leveraged buyouts: management buyouts (MBO), employee buyouts (EBO), and whole-firm buyouts where another firm takes the firm private (LBO). Research has shown that management buyouts can also lead to greater entrepreneurial activity and growth.
6 Explain the short- and long-term outcomes of the different types of restructuring strategies.
Restructuring Outcomes Downsizing often does not lead to higher firm performance; in fact, research has shown that downsizing contributed to lower returns for both US and Japanese firms. The stock markets in the firms’ respective nations evaluated downsizing negatively. Investors concluded that downsizing would have a negative effect on companies’ ability to achieve strategic competitiveness in the long term. Investors also seem to assume that downsizing occurs as a consequence of other problems in a company. Teaching Note: In free-market based societies, downsizing has generated a host of entrepreneurial opportunities for individuals to operate their own businesses. In fact, as discussed in Chapter 13, start-up ventures in the United States are growing at three times the rate of the national economy. Downsizing tends to result in a loss of human capital in the long term. Losing employees with many years of experience with the firm represents a major loss of knowledge. As noted in Chapter 3, knowledge is vital to competitive success in the global economy. Thus, in general, research evidence and corporate experience suggest that downsizing may be of more tactical (or short-term) value than strategic (or long-term) value. Downscoping generally leads to more positive outcomes in both the short and the long term than does downsizing or engaging in a leveraged buyout (see Figure 7.2). Downscoping’s desirable long-term outcome of higher performance is a product of reduced debt costs and the emphasis on strategic controls derived from concentrating on the firm’s core businesses. In so doing, the refocused firm should be able to increase its ability to compete. Although whole-firm LBOs have been hailed as a significant innovation in the financial restructuring of firms, there can be negative trade-offs. • The resulting large debt increases the financial risk of the firm • The intent of the owners to increase the efficiency of the bought-out firm and then sell it within five to eight years can create a short-term and risk-averse managerial focus • These firms may fail to invest adequately in R&D or take other major actions designed to maintain or improve the company’s core competence. Figure Note: Restructuring alternatives—downscoping, downsizing, and leveraged buyouts—and short- and long-term outcomes are summarized in Figure 7.3. FIGURE 7.3 Restructuring and Outcomes As illustrated in Figure 7.3, • Downsizing reduces labor costs, but the long-term results are a loss of human capital and lower performance. • Downscoping reduces debt costs and emphasizes strategic controls, which result in higher performance. • Leveraged Buyouts provide an emphasis on strategic controls but increases debt costs; the long-term outcome is an increase in performance, but also greater firm risk. Instructor Manual for Strategic Management: Concepts and Cases: Competitiveness and Globalization Michael A. Hitt, R. Duane Ireland, Robert E. Hoskisson 9781305502147, 9780357033838
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