Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy

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Chapter 20 Acquisitions and restructuring 575

20.12 OTHER FORMS OF VALUE-CREATING

age of frequent pre-marital cohabitation, the bridal couple usually know one another better

than the merging companies do.

Mr Sirower rejects the view that the principal problem is ‘post-merger implementation’.

‘Many large acquisitions are dead on arrival, no matter how well they are managed after the

deal is done,’ he says. He asks why managers should pay a premium to make an acquisition

when their shareholders could invest in the target company themselves. How sure are man-

agers that they can extract cost savings or revenue improvements from their acquisition that

match the size of the takeover premium?

Perhaps it would help if senior managers abandoned the marriage metaphor in favour of the

story of the princess and the toad. Warren Buffett, the US investor, said nearly 20 years ago that

many acquisitive managers appeared to see themselves as princesses whose kisses could turn

toads into handsome princes. Investors, he observed, could always buy toads at the going price

for toads. ‘If investors instead bankroll princesses who wish to pay double for the right to kiss

the toad, those kisses better pack some real dynamite. We’ve observed many kisses, but very

few miracles. Many managerial princesses remain serenely confident about the future potency

of their kisses, even after their corporate backyards are knee-deep in unresponsive toads.’

Source:

Based on Michael Skapinker,

Financial Times,

12 April 2000.

and Securicor, its British competitor. In 2004, Group 4 Securicor, the new firm, reported

that its cost-cutting target was well ahead of schedule, and synergies greater than

expected due to strong and accelerating growth in demand for its services. However,

many others, are outright failures; and some, such as Morrisons’ purchase of Safeway,

are totally disastrous. Perhaps, at the time of the bid, the assessment of the bidding

management was correct, but they were caught out by changed circumstances. A more

likely explanation is that they were buoyed-up with excessive enthusiasm about the

bid. Although some bidders have the sense to walk away from a bid (e.g. Comcast’s

aborted bid for Disney in 2004), in too many cases, bidders delude themselves that the

proposed takeover is vital to the development of the group.

Referring to such cases, cynics use the term ‘winners’ curse’, for obvious reasons.

■ Stock market inefficiency

Does the stock market fail to assess the full value of a business, perhaps because it

belongs to a sector that is ‘out of favour’, or because the market adopts too short-term

a view of the prospects of the company?

Assessing the relative weights of these arguments is a major challenge for finance

and business researchers.

Corporate restructuring is an important vehicle by which managements can enhance

shareholder value by changing the ownership structure of the organisation. It involves

three key elements:

1 Concentration of equity ownership in the hands of managers or ‘inside’ investors

well-placed to monitor managers’ efforts.

2 Substitution of debt for equity

3 Redefinition of organisational boundaries through mergers, divestment, manage-

ment buy-outs, etc.

In the dynamic environment within which companies operate, financial man-

agers should be ever-alert to new and better ways of structuring and financing their

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576 Part V Strategic financial decisions

Corporate Business unit Asset

Diversification/demerger Acquisitions Pledging assets as security

Share issues Joint ventures Factoring debts

Share repurchase Management buy-outs Leasing and HP

Strategic alliances Sell-offs Sale and leaseback

Leveraged buy-outs Franchising Divestment

Liquidation Spin-offs

businesses. The value-creation process will involve the following:

■ Review the corporate financial structure from the shareholders’ viewpoint. Consider

whether changes in capital structure, business mix or ownership would enhance value.

■ Increase efficiency and reduce the after-tax cost of capital through the judicious use

of borrowing.

■ Improve operating cash flows through focusing on wealth-creating investment

opportunities (i.e. those having positive net present values), profit improvement

and overhead reduction programmes and divestiture.

■ Pursue financially-driven value creation using various new financing instruments

and arrangements (i.e. financial engineering).

■ Types of restructuring

Recent years have seen the development of new and elaborate methods of corporate

restructuring. Restructuring can occur at three different levels:

1 Corporate restructuring refers to changing the ownership structure of the parent com-

pany to enhance shareholder value. Such changes can arise through diversification,

forming strategic alliances, leveraged buy-outs and even liquidation.

2 Business restructuring considers changing the ownership structure at the strategic

business unit level. Examples include acquisitions, joint ventures, divestments and

management buy-outs.

3 Asset restructuring refers to changing the ownership of assets. This can be achieved

through sale and leaseback arrangements, offering assets as security, factoring debts

and asset disposals.

The levels of restructuring are summarised below:

Most of these devices have been covered elsewhere in this book. We devote the next

sections to a brief discussion of divestments and management buy-outs (MBOs),

which have so far received only passing mention.

Divestment

A divestment is the opposite of an investment or acquisition; it is the sale of part of a

company (e.g. assets, product lines, divisions, brands) to a third party. The heavy use

of divestment as a means of restructuring reflects the continuing efforts of corporate

management to adjust to changing economic and political environments.

One of the motives for acquisition, identified earlier, is the managerial belief that the

two businesses are worth more when combined than separate. A form of reverse syn-

ergy is a major reason for divestment: the two elements of an existing business are

worth more separated than combined. Whereas the arithmetic of synergy for acquisi-

tions argues that the arithmetic behind divestment, or reverse synergy,

argues that can be worth more than 4. In other words, part of the business can

be sold off at a greater value than its current worth to the company. The management

team may not relish the prospect of divesting itself of certain business activities, but it

is often necessary as the strategic focus changes.

5  1

2  2  5,

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Chapter 20 Acquisitions and restructuring 577

Self-assessment activity 20.7

Suggest reasons why a firm may choose to divest part of its business.

(Answer in Appendix A at the back of the book)

Two particular forms of divestment are sell-offs and spin-offs. Sell-offs involve sell-

ing part of a business to a third party, usually for cash. The most common reason for

sell-offs is to divest less profitable, non-core business units to ease cash flow problems.

In spin-offs, there is no change in ownership. A new company is created with assets

transferred to it, as in BT’s spin-off of MMO

in 2002, but the shareholders now have

holdings in two companies rather than one.

In theory, the value of the two companies should be no different from that of the sin-

gle company prior to spin-off. But numerous US studies suggest that spin-offs usual-

ly result in strong positive abnormal returns to shareholders. Why should this be so?

1 It enables investors to value the two parts of the business more easily. Poor-

performing business units are more exposed to the stock market, necessitating appro-

priate managerial action. For example, some high-street retailers have spun-off their

properties into separate companies, so that investors can judge performance on retail-

ing and property activities more easily.

2 The creation of a clearer management structure and strategic vision of the two com-

panies should result in greater efficiency and effectiveness.

3 Spin-offs reduce the likelihood of a predatory takeover bid where the bidder

recognises underperforming assets in a single company. They also make it easier

for the group to sell a clearly defined part of its business at a price better reflect-

ing its true worth.

Divestments enable companies to move their resources to higher-value investment

opportunities. They should be evaluated along exactly the same lines as investment

decisions, based on the net present value resulting from the divestment.

The motives for a demerger are broadly the same as for divestment discussed ear-

lier. However, with the current vogue to focus on core businesses, it is easy to forget

the drawbacks of demerger or divestment:

■ Loss of economies of scale where the demerged business shared certain activities,

including central overheads.

■ A smaller firm may find it harder to raise finance or may incur a higher cost of

capital.

■ Greater vulnerability to takeover, e.g. the acquisition of Innogy by RWE Ag.

Management buy-outs

Management buy-outs (MBOs) occur when the management of a company ‘buys out’

a distinct part of the business that the company is seeking to divest. MBOs usually arise

because a parent company decides to divest a subsidiary for strategic reasons. For

example, it may decide to exit a certain activity; to sell off an unwanted subsidiary

acquired by a takeover of the parent company; to improve the strategic fit of its various

business units; or simply to concentrate on its core activities. MBOs can also be pur-

chaser-driven, where the local management recognises that the business has greater

potential than the parent company management realises, or where the alternative is clo-

sure, with high redundancy and closure costs.

Once a company decides to divest itself of part of its activities, it will usually seek

to sell it as an ongoing business rather than selling assets separately. With an MBO, the

firm sells the operation to its managers, who put in some of their own capital and

obtain the remainder from venture capitalists.

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578 Part V Strategic financial decisions

The growth of MBO activity has been fuelled by venture capital firms enabling

managers to raise large sums of capital through borrowings (leveraged buy-outs), par-

ticularly mezzanine finance, a cross between debt and equity, offering lenders a high

coupon rate and, frequently, the right to convert to equity should the company achieve

a quotation. The Finance Act 1981 gave considerable help by allowing finance raised

to be secured on the acquired assets.

An MBO typically has three parties: the directors of the group looking to divest, the

management team looking to make the buy-out and the financial backers for the buy-

out team. A private company may agree to an MBO because the directors wish to retire

or because it needs cash for the remaining operations.

It is quite common for the new management team to obtain a better return on the

business than the old company. Reasons for this include:

■ the greater personal motivation of management

■ flexibility in decision-making

■ lower overheads

■ negotiating a favourable buy-out price.

Checklist for a successful buy-out

The venture capitalist will ask a number of penetrating questions in evaluating whether

the MBO is worth backing.

1 Has the management team got the right blend of skill, experience and commitment?

The financial backers may require changes in personnel, frequently the introduction

of a finance director.

2 What are the motives for the group selling and the management team buying? If

the business is currently a loss-maker, how will the new company turn it round? A

convincing business plan with detailed profit and cash flow projections will be

required.

3 Is it the assets or the shares of the company that are to be purchased?

4 Will assets require replacement? What are the investment and financing needs?

5 What is an appropriate price?

Buy-out failure is often the result of a wrongly priced bid, lack of expertise in key

areas, loss of key staff or lack of finance.

Once the financial backers are satisfied that the MBO is worth backing, a financial

package will be agreed. The management team will typically have a minority share-

holding, with the financial backers (often more than one) taking the majority stake.

While the venture capitalist company views the investment as long-term, it will look

for a potential exit route, frequently through a stock market flotation.

The management team will usually be expected to demonstrate commitment by

investing personal borrowings in the business. Redeemable convertible preference

shares often form part of the financial arrangements. These shares give voting rights

should the preference dividend fall into arrears and enable the holder to redeem

shares should the investment fail, or to convert to equity if the business performs well.

Venture capitalists make handsome returns from MBOs and similar deals – much

higher than the returns on the stock market investments. The question must be asked

as to whether large companies are acting in their shareholders’ best interests in per-

mitting buy-outs on such favourable terms. It is all very well to say that a particular

division is a non-core activity; but firms are constantly changing their definitions as to

what exactly is core. Restructuring, whether through MBOs or other forms, is waste-

ful and non-value-adding if the group selling the business could have achieved the

same efficiency and other gains as the new company.

Management buy-ins are the opposite of buy-outs. A group of business managers

with the necessary expertise and skills to run a particular type of business search for a

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Chapter 20 Acquisitions and restructuring 579

IPO revival helps buy-outs to four-year high

British buy-outs hit the highest

levels for four years in 2004,

helped by a record performance

in mid-market deals, according

to research to be released today.

KPMG, the professional

services firm, will say the

recovery in buy-outs was driv-

en by a revival in initial public

offering markets, strong activ-

ity in corporate mergers and

acquisitions and record-break-

ing levels of secondary buy-

outs, in which private equity

investors buy assets from

other private equity groups.

Those sources of demand led

to 145 buy-outs in 2004, with a

total value of the

highest value and the largest

number of deals since 2000.

Last year’s figures were 24 per

cent higher by value and 17

per cent higher by number of

deals compared with 2003.

The biggest deals included the

sales of the AA motoring

organisation and Saga, the

holiday and insurance group.

The strongest sector was the

larger mid-market, defined as

deals worth

which saw a record of

transactions. Deals in this seg-

ment included: Jimmy Choo,

the shoe maker, and Hobbs,

the high street fashion and

footwear group.

Charles Milner, head of cor-

porate finance at KPMG’s pri-

vate equity group, said: ‘In

2004 the market has been

characterised by strong com-

petition for the best deals, a

healthy degree of liquidity

realising value from portfolios

and continued interest in the

asset class from investors.’

He added that demand for

the best deals was ‘intense and

activity continues to be gov-

erned more by supply of quali-

ty opportunities than demand

from private equity investors’.

Activity was especially strong

in secondary buy-outs, support-

ed by strong appetite from

banks.

The research follows sepa-

rate concerns about a credit

bubble in parts of the private

equity sector. Multiples of debt

rose markedly over the year,

in some cases reaching six or

seven times earnings before

interest, tax, depreciation and

amortisation, KPMG said.

According to KPMG, the rate

of investment rose in the last

quarter of 2004, when 37 deals

worth in total were

completed.

Mr Milner said: ‘The last

quarter of 2004 was strong

across the whole of the UK

buy-out market. Two deals

each over a billion pounds were

completed [the AA and Saga],

but there was also strong activ-

ity in the middle market.

‘There is no sign that this

level of activity will let up in

the new year.’

Source: Alexander Jolliffe, Financial Times,

4 January 2005.

£5.4 bn

£6.3 bn

£50 m–£250 m,

£19.4 bn,

business to acquire. The ideal candidate is a business, or part of a business, with strong

potential, but which has been underperforming or is in financial difficulty, perhaps

because of poor management. The new team rarely has the necessary capital to buy in

and often requires the backing of a venture capitalist.

Joint ventures and strategic alliances

Unlike mergers or acquisitions, joint ventures and other strategic alliances enable

both sides to retain their separate identities. They have been employed to good effect

to achieve a variety of objectives, but have become a particularly popular way of

developing new products and entering new markets, especially overseas. One of the

financial benefits is that the strength of two organisations coming together for some

specific strategic purpose can often lower capital costs associated with the new

investment.

There are two main types of joint venture. An industrial cooperation joint venture is

for a fixed period of time, where the responsibilities of each of the parties are clearly

defined. These are particularly popular in the emerging mixed economies of Central

and Eastern Europe. A joint-equity venture is where two companies make significant

investments in a long-term joint activity. These are more common as a means of invest-

ing in countries where foreign ownership is discouraged, such as in Japan and parts of

the Middle East.

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580 Part V Strategic financial decisions

A thirst for joint ventures

The drinks industry has witnessed a number of strategic alliances in recent years.

Unilever, the Anglo-Dutch group, formed a joint venture with PepsiCo, the US soft drinks

and snacks group, to sell canned ice tea. The attraction to Unilever was the opportunity to cre-

ate a new business, building on the complementary strengths of PepsiCo as an industry leader

and enabling it to enter the US market.

Scottish & Newcastle, a regional brewer, created a strategic alliance with Coors of the USA,

specifically to market and promote Coors’ Extra Gold premium lager in the UK. This joint ven-

ture offered Coors immediate, low-cost access to the UK market using a proven distribution

network. For Scottish & Newcastle, the licensing and distribution agreement added a further

brand to its range of premium lagers and a sharing of promotion costs.

Wessex Water, a UK privatised water company, entered a joint venture with Waste

Management from the USA. Their objectives were somewhat different. While the US firm

looked for access to a new geographical market, Wessex Water was looking to diversify from its

price-regulated water business.

Like any other investment, the potential partners need to assess the costs and ben-

efits of the joint venture and identify and manage the activities critical to success. One

problem can be the inability of the joint venture management team to make decisions

without the approval of parent companies. This can be overcome by structuring the

alliance with its own board of directors and financial reporting system.

How does restructuring enhance shareholder value? We suggest four ways in

which value can be created.

1 Business fit and focus

As we saw with divestments, a business unit may ‘fit’ one company better than anoth-

er. Management should review their strategic business units and ask whether they

operate best under the present ownership or whether they would create more value

under some other ownership through an external acquisition or management buy-out.

When unrelated activities have been divested, management has a much better focus on

its core businesses and can concentrate on pursuing wealth-creating investment oppor-

tunities and improving efficiencies.

2 Eliminate sub-standard investment

Managers commonly enter into investments that do not enhance shareholder value:

1 Heavy reliance on a single business may lead to diversification. Quite apart from

the additional overheads that may be created from diversification and the lack of

managerial expertise, such diversification may have no real benefit for sharehold-

ers. As we saw in Chapters 9 and 10, shareholders can often achieve the same, or

better, risk-reduction effects by creating diversified portfolios.

2 Pursuit of growth in sales and earnings brings power and, possibly, protection

from takeover, but does little for shareholders. Rather than pay out larger divi-

dends, management may be tempted to reinvest in projects or acquisitions that do

not add value.

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Chapter 20 Acquisitions and restructuring 581

3 While a strategic business unit may be profitable, it is often an amalgamation of

profitable and unprofitable projects, the former subsidising the latter. Restructuring

the business creates a leaner operation with no room for cross-subsidisation.

3 Judicious use of debt

Cautious managers argue that borrowing should be minimised, as it increases financial

risk and leaves little room for errors. Aggressive managers take a very different view.

Debt provides a powerful incentive to improve performance and minimise errors.

The consequences of management’s successes and mistakes are magnified through

gearing, leaving little room for error. Managerial mediocrity is no longer acceptable.

Cash flow – not profit – becomes the all-important yardstick, for it is cash flow that

must be generated to service the debt and meet repayment schedules. In this respect,

incurring debt obligations may provide an important signal to the market concerning

the resolve of the management team.

Furthermore, debt is a cheaper source of finance because interest is tax-deductible,

while dividends on equity are not. Restructuring the Balance Sheet by substituting

debt for equity, within acceptable gearing limits, creates a tax shield and increases the

company’s market value.

4 Incentives

Raising debt to realise equity can be a powerful incentive to both shareholders and

managers. Equity is concentrated in the hands of fewer shareholders, providing a

greater incentive to monitor managerial actions. This often leads to the creation of man-

agerial incentives to enhance shareholder value, through executive share options or

profit-sharing schemes. Remuneration packages may increase profit-related pay at the

expense of salaries and wages. This will also benefit loan stock holders, who have pri-

ority ahead of profit-sharing, but after employees’ wages and salaries.

A 3-eyed venture capitalist

3i is way out in front as the UK’s leading venture capital investment company, accounting

for about one-fith of total UK venture capital investment. Its roots go back to 1929, when a

report under the chairmanship of Lord Macmillan identified the ‘Macmillan gap’ – a shortage

in the financing of small and medium-sized companies. Little was done, however, until 1945,

when the Industrial and Commercial Finance Corporation, backed by the Bank of England, was

created to bridge this gap. In 1973, it united with the Finance Corporation for Industry to

form Investors in Industry, which later became simply 3i. It was floated on the stock market in

1994 in a £1.6 billion flotation, making it a FTSE Top 100 company. At March 2005, its market

value was £4.25 billion.

During its long history, spanning some 60 years, it has provided more than £12 billion ven-

ture capital to over 12,000 small and medium-sized businesses, helping to bridge the finance

gap experienced by small companies. Its biggest profit on a deal came from its investment in

Caledonian Airways, which, when it was eventually acquired by British Airways, netted £100

million. But venture capital is a risky business, and 3i has had its share of failures, the largest

of which was its investment in Isosceles, the company set up to mount a contested £2.4 bil-

lion management buy-in of the Gateway supermarket chain. The deal backfired, leaving 3i

with £83 million debt and equity to write off. Many well-known businesses, like Waterstones,

Geest and Laura Ashley, have benefited from its financial backing.

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582 Part V Strategic financial decisions

SUMMARY

We have explored various motives for merger and takeover activity, and have argued

the importance of a coherently-structured strategic approach to acquisitions, including

planned integration that emphasises human and organisational factors. Finally, we

briefly discussed other forms of corporate restructuring.

Key points

■ The decision to acquire another company is an investment decision and requires

evaluation on similar criteria to the purchase of other assets.

■ Added complications are the resistance of incumbent managers to hostile bids and

the presence of long-term strategic factors.

■ The takeovers most likely to succeed are those approached with a strategic focus,

incorporating detailed analysis of the objectives of the takeover, the possible alter-

natives and how the acquired company can be integrated into the new parent.

■ If the takeover mechanism works well, it is an effective and valuable way of clear-

ing out managerial dead wood.

■ Many takeovers appear to be launched for ‘managerial’ motives, such as personal

and financial aggrandisement.

■ The main reasons for failure of takeovers are poor motivation and evaluation,

excessive outlays (often with borrowed capital) and poorly planned and executed

integration.

■ The complexity of takeover integration is related to the motive for the takeover

itself, ranging from cash generation, requiring only a loose control over operations,

to economies of scale, requiring highly detailed integration.

■ The impact of mergers can be studied by comparing the financial characteristics of

merger-active and merger-inactive firms to assess any performance differentials,

but this approach suffers from many problems.

■ The main alternative is a capital market-based approach to assess how the market

judges a merger in terms of share price movements.

■ The available evidence suggests that the bulk of the gains from mergers accrue to

shareholders of acquired companies, although some evidence suggests that share-

holders of acquirers can also share in the benefits, presumably if the takeover is

well-considered.

■ Corporate restructuring enhances shareholder value through (i) improving the

business fit and focus, (ii) judicious use of debt and (iii) providing incentives for

management.