Growth is an imperative for corporations. Growth provides corporations with expanding opportunities enabling them to attract the best executives or motivating workers. Growth is also a means for maintaining or enhancing a firm’s relative competitive position. Avoidance of growth in a market where incumbent rivals are relentlessly seeking to increase their market shares can result in a serious loss of market position with the attendant adverse impacts on profitability that can jeopardize long-term survival.
Since growth ultimately must come from markets currently served or new markets to be served, growth by acquisition is the strategy of entry into new product markets by purchasing the common shares or assets of a business or businesses already established in these markets. From the vantage point of the acquiring company, management goals are often stated as rectifying some “problem” or “deficiency”:
• countering a substantial decline in the company’s overall earnings growth;
• utilizing existing excess capacity;
• dealing effectively with a vertical competitive threat.
However, the overriding objective of an acquiring company is taken to be profitable growth by acquisition. That is, an acquisition opportunity will be undertaken only if it is value creating; it must enhance the “market value” of its presently outstanding common shares. Acquisitions are typically associated with the p ayment of a significant control premium by an acquiring company when it purchases the shares of an acquired company or acquiree. The control premium is the amount by which the offer price per share of the acquiree exceeds its pre-acquisition share price, expressed as a percentage. Over the period 1976-90 premiums in large US industrial acquisitions have averaged around 50 percent and ranged up to 185 percent.
Three Conditions for Profitable Growth by Acquisition
For an acquisition to create value for an acquirer, three conditions have to be met. First, there must be an improvement in the acquiree’s financial performance over time sufficiently large to fully recapture the offer premium. Alberts and Varaiya (1989) develop a model in which required improvements in the acquiree’s financial performance are characterized as a combination of required improvements in expected future economic profitability (the difference between expected future return on equity and cost of equity capital) and earnings growth rate to fully recapture the offer premium. Second, there must be a sustainable improvement in the acquiree’s operating performance sufficiently large that will in turn generate the improvement in sustainable financial performance necessary to recapture the offer premium and thus make the acquisition profitable. To achieve this improvement in operating performance the acquiree must offer the acquiring company some combination of five significant bargain opportunities (Alberts, 1974):
1. Position bargain: management can enhance the acquiree’s financial performance by further differentiation of its product or service offering (by enhancing existing attributes and/or adding new ones), further increasing its relative efficiency (by lowering raw material costs by purchasing from acquirer at a lower cost than the acquiree has been paying), or both.
2. Expansion bargain: management can profitably extend the sales of the acquiree’s products into geographical markets not presently served by it (perhaps because of capital constraints).
3. Synergy bargain: management can integrate the acquiree’s positioning strategies with those of one or more of the acquiree’s other units, and by doing so could bring about further differentiation of the acquiree’s offering, a fu rther increase in the acquiree’s efficiency, or both.
4. Leverage bargain: management can, on de termining that the acquiree uses significantly less leverage (the ratio of permanent debt to i nvested capital) than incumbent rivals, match these rivals’ leverage ratios so that the acquiree’s economic profitability can be increased, given the other drivers of economic profitability.
5. Tax bargain: management can elect to finance the acquisition in a way that allows the acquiree under the current US tax code to allocate some portion of the offer premium to step up the depreciation bases of some of its assets and thereby increase its tax depreciation and decrease its tax liabilities relative to what they would be for acquiree standing alone.
The third condition for a value-creating acquisition is that management performance in implementing the acquisition will be effective enough to bring about the required improvements in operating performance. At a minimum this requires that the management cadre that will oversee the acquiree have sufficient knowledge to identify the bargain sources of premium recapture. Additionally, the acquiree’s organizational structure must be designed to balance its need for autonomy with the imperative of coordinating the acquiree’s decisions with those of other business units of the a cquiring company (Hill, 1994). Finally, the acquiree’s management processes (for example, performance evaluation systems) must be integrated with those of the acquiring company .
Evidence on Acquisition Profitability
There are four sets of available data to assess the profitability performance of acquisitions: (1) benchmark data which compares the economic profitability and earnings growth improvements necessary for value creation with the levels of such improvements actually observed (Alberts and Varaiya, 1989); (2) company performance data which compares company profitability before and after acquisition (Meeks, 1977; Mueller, 1980; Ravenscraft and Scherer, 1987); (3) case study data (Porter, 1987; Copeland et al., 1990); and (4) event study data that compares the short- and long-run changes in the common stock returns (adjusted for market-wide movements) of acquirers before and after acquisition (Jarrell et al., 1988; Agrawal et al., 1992). The thrust of these four sets of data is that the acquirer should not expect the acquisition to be value creating if it pays the magnitude of the offer premium that other companies have paid on average for their acquirees; in fact the acquirer should expect the acquisition to be significantly value destroying.
However, the historical record on acquisition profitability in conjunction with the three conditions for profitable growth by acquisition does indeed identify for acquiring company management two critical requirements for value-creating growth by acquisition: (1) acquire the right unit in the right market or markets in which entry is sought and effectively implement the acquisition so that the expected financial performance improvements will be realized; and (2) avoid the payment of the typical observed offer premium, but limit it to a fraction of the performance improvement that careful analysis indicates is expected to be generated.
