FINANCIAL TIMES MASTERING STRATEGY The Complete MBA Companion in Strategy Horizontal acquisitions: the benefits and risk to long-term performance by Laurence Capron orizontal mergers and acquisitions - that is to say, those acquisitions that involve companies operating in the same industry - are generally explained in one of two ways. Neo-classical economists and strategy scholars argue that M&A helps businesses improve their competitive position by exploiting synergies, for example through asset rationalization or the transfer of specific competences. The other main “school” (rooted in the industrial organization economy) views M&A as a means for companies merely to increase market power and capture higher profits at the consumer’s expense. Empire building, oversized egos, overconfidence, faddishness, and other emotional and political factors drive mergers too. But the purpose of this article - based on research into more than 250 companies in Europe and North America - is to explore the conditions under which horizontal acquisitions can result in greater efficiency and long-term performance. This subject has gained more attention in the wake of studies by academics and consulting firms suggesting that 50 to 70 percent of H 197 acquisitions end in failure. It has also been shown that stockholders of bidding companies gain little or nothing from the announcement of an acquisition, presumably because the market is skeptical of the ability of managers to recoup the control premium and post-merger integration costs. It is true that acquirers are often overoptimistic about the scale of potential synergies, but the poor averages mask the fact that some businesses do manage to enhance performance and more than offset the implementation cost. Cost and revenue synergies Two types of synergy need to be distinguished: cost based and revenue based. Cost-based synergies generally receive more attention since horizontal acquisitions are typically seen as a mechanism to reduce costs by acquiring overlapping businesses. Traditionally, such acquisitions have been considered an effective means of achieving economies of scale in manufacturing, as well as in R&D, administrative, logistics, and sales functions. For example, in a mature industry characterized by severe cost-reduction pressure, product standardization, and high advertising expenditures, an acquisition makes it possible to increase volume and standardization, and to spread fixed costs without adding substantial capacity to the industry. Revenue-based synergy can be exploited if merging businesses develop new competences that allow them to command a price premium through higher innovation capabilities (product innovation, time-to-market, etc.) or to boost sales volume through increased market coverage (geographic market and product line extension). An acquisition can be an effective means of getting access to skills or competences that are difficult or time consuming to develop in-house or that are not easily tradable through a market transaction. Successful technology acquisitions, indeed, can require command of the culture and processes behind that technology. An acquisition is a way of buying technical competences along with the corporate context, people, and mindset that have fostered their development. For example, UK-based Getty Images, a provider of stock photos and film footage with 25 brick-and-mortar stores worldwide, wanted to make a quick technical and cultural transition to e-commerce. Thus in 1998, it acquired Seattle-based PhotoDisc, a distributor of royalty-free photos over the internet, which provided both technical expertise and a digital culture that Getty Images worked to infuse in to its other brands. Although these two paths toward value creation have been identified as reasons behind the current wave of acquisitions, few empirical studies have investigated the extent to which merging companies exploit economies of scale and leverage their competences after acquisition. Empirical setting Method To investigate post-acquisition consolidation practices (asset rationalization and competence transfer), we used data obtained through a large-scale international survey in Europe and North America. For this study, we identified more than 2,000 companies in the manufacturing sector that had acquired competing companies between 1988 and 1992. The 1988-92 period was chosen to exclude both recent deals where consolidation had not yet taken place and earlier acquisitions whose principal Horizontal acquisitions: the benefits and risk to long-term performance actors might have moved on. The companies represent a wide range of industries mainly in the UK, France, Germany, and the US. The data are gathered from the responses of managers at 253 horizontally merged companies: 70 percent were cross-border, 30 percent domestic. Particularly well represented were chemicals (15 percent), foods (15 percent), and pharmaceuticals (12 percent). Pm-acquisition features Our data showed that acquisitions, in general, are undertaken by strong companies that target other strong companies. The acquirers’ performance was in 58 percent of cases superior to and in 31 percent at least equivalent to the industry average. More than two-thirds of target businesses also performed as well as or better than their sector average, even if on the whole they were weaker in this area than their wouldbe parents. The same picture emerged when managers were asked about preacquisition resources. The targets were particularly strong vis-à-vis the competition in commercial and technical areas like R&D and manufacturing. The operational, managerial, and financial resources of the target businesses before acquisition, however, were significantly more limited than those of the acquirer. Acquisition motives Acquisitions were seen by sample respondents as an effective way for an acquirer to grow into new markets and to access complementary products, brands, and skills. Revenue-based synergies seem to drive many acquisitions. For example, 52 percent of the respondents recognized access to new brands or products as an important driver of the acquisition. The search for economies of scale seemed less important; 35 percent felt that this was a significant factor in functional areas (R&D, logistics, administrative). One-fifth of respondents also identified a defensive motive, namely pre-empting the target at the expense of a competitor, underlining the truth that strategic motives can be intertwined with tactical ones. Post-acquisition behavior Asset rationalization Figure 1 shows the extent to which the merging company’s assets (facilities and staff) in R&D, manufacturing, logistics, sales, and administration were significantly rationalized (divested) after acquisition. Irrespective of function, significant rationalization measures affect only a small percentage of merged companies, suggesting that the search for cost-cutting and downsizing gains motivates only a limited number of horizontal acquisitions. This interpretation is consistent with the pre-acquisition objectives ranked by managers. Furthermore, post-acquisition asset rationalization affects the acquiring and target businesses asymmetrically: the target’s assets are three to five times more likely to be divested than the acquirer’s assets. For example, 24 percent of the targets underwent rationalization of manufacturing assets that affected at least 30 percent of their staff or units, while only 7 percent of the acquiring companies faced an identical experience. Similarly, 26 percent of the targets underwent a rationalization of administrative services that affected at least 30 percent of staff or units, while only 5 percent of the acquirers underwent such rationalization. Manufacturing and administrative functions tend to be the most affected by postacquisition asset divestiture, as their divestiture presents a lower risk of damaging innovative capabilities, commercial presence, or image. The asymmetric rationalization of assets supports previous research findings of economic and behavioral motivations. From an economic standpoint, acquirers in the same industry as the target can recognize target inefficiencies due to their experience in managing similar lines of business. From a behavioral standpoint, acquiring managers are often more confident of their own capabilities than those of the target. Moreover, it is politically easier for the acquirer to impose divestiture measures on the target than on its own businesses. Transfer of competences Figure 2 shows the extent of competence transfer both to and from the target within nine competence categories. competences, either from acquirer to target or target to acquirer. Acquirers transfer their competences into the target’s businesses, or tap new competences from the target. This transfer occurs in technical (product innovation, manufacturing), commercial (sales networks, brand, marketing expertise), and operational areas (supplier relationship and logistics expertise). For example, 43 percent of respondents recognized that the acquirer’s network was used to a great extent to distribute the target’s products, and 35 percent of the respondents reported that the target’s sales network was used to distribute the acquirer’s products. Although respondents ranked access to the target’s competences as a more important motive than the transfer of their competences to the target, in reality the acquirer is more inclined to transfer its own competences than to use the target’s competences. There may be several reasons for this: the need for the acquirer’s competences to support the target’s rationalization process; a stronger knowledge and control of the acquirer’s competence transfer; difficulties in gaining access to the target’s competences due to information asymmetry; the departure of key target people and other target disruptions; damaged competences in the post-acquisition process. In sum, it seems that time, trust, credibility, and process skills are needed to gain valuable competences from the target. Only a few businesses, such as NationsBank (now merged with BankAmerica) or Cisco Systems, the US-based market leader in data networking, have developed the sophisticated post-acquisition management processes to retain and leverage the target’s skills and people. Drivers of performance Figure 3 shows acquisition performance as assessed by respondents. Respondents were asked to assess the extent to which the acquisition improved the performance of both the target and the acquirer, using four performance measures: general performance; cost savings (cost-based synergies); innovation capabilities (revenuebased synergies); market coverage (revenue-based synergies). More than half the respondents assessed the acquisition as either unsuccessful or moderately successful. Only 49 percent of respondents considered the acquisition as highly successful - consistent with those studies mentioned earlier suggesting that 50 to 70 percent of acquisitions fail to deliver expected benefits. In our research this result is even more striking as we focus on horizontal acquisitions, or those that should have higher potential for exploiting synergies due to business relatedness. This result suggests that, among horizontal acquisitions, there is a huge variation in acquisition performance. For example, 56 percent of respondents recognized that the acquisition increased the combined market share of the merging companies. However, 41 percent reported that the acquisition did not help in developing additional market share. Similarly, 53 percent of respondents recognized that the acquisition improved combined profitability, while 47 percent reported that the acquisition either did not improve, or even damaged, the profitability of the merging businesses. From a cost-based synergy standpoint, acquisitions improved the cost position of the merging companies in fewer than half the cases. But from a capability and revenue-based synergies standpoint they provided key benefits, especially in market coverage. Acquisitions were reported to improve R&D capabilities in 49 percent of the cases, product quality in 47 percent of the cases, and time to market in 47 percent of the cases. More importantly, 64 percent of respondents acknowledged that acquisitions broadened their product line, while 70 percent reported that they increased market coverage. Performance implications Several implications can be drawn from the above results. Lesson 1. Managers should pay more attention to competence transfer and exploitation of revenue-based synergies. Furthermore, rationalization measures send a clear signal to the market that the post-acquisition integration process is under way. However, the research shows that revenue-based synergies, which rest on a longer process of sharing or transferring competences into a new organizational context, also account for a significant part of acquisition performance. Lesson 2. Rationalizing assets through an acquisition does not automatically lead to cost savings. There is some evidence that the acquirer is generally more effective in rationalizing its own assets than those of the target. Interestingly, although acquisitions are rarely followed by a rationalization of the acquirer’s assets, such a rationalization increases efficiency. This phenomenon may reflect several factors. It may be that the acquirer already understands and controls its own assets, while obtaining information on the target’s assets is contingent on the willingness of the target’s people to collaborate and share information. As a result, the acquirer may lack insight into the target’s assets and force a rationalization that is not accepted by the target’s people. Or it may be that the decision to divest acquirer assets is motivated by a strong economic rationale, while HorLzonMI acquis/tions: the benefits aod risk to lonp-term performance both economic and political motives may drive the divestiture of the target’s assets (which would also explain why the target is three to five times more likely to be downsized than the acquirer). Lesson 3. Excessive rationalization of the target’s assets may damage the innovation and market capabilities of the merging businesses. As the target bears the brunt of rationalization measures, there is a risk of destroying valuable existing competences or impeding the development of new competences if the target is deprived of the organizational slack necessary to innovate and explore new markets. The negative impact of excessive rationalization can be seen in mergers like those between Quaker Oats, the US cereals and sport drinks business, and Snapple, a US soft drinks company, or of two US banks, First Interstate/Wells Fargo. The acquisition of FI by Wells Fargo in 1996 led to a significant loss of FI clients. Wells Fargo chose to close FI’s branch network (considered to be an overlap) and 75 percent of the top 500 FI executives left. In this example, not only were cost savings less than expected, but revenues declined as Wells Fargo tried to replace FI’s “relational banking” with its own “transaction banking,” switching FI clients from traditional branches to smaller mechanized branches in supermarkets. As a result, a significant proportion of FI clients moved to local competitors. FI was sold to Minneapolis-based Norwest in 1998. Lesson 4. Cost savings can be achieved through transfer of competences, particularly to the target. Thus, asset divestiture per se may not be the most effective way of reducing costs; transfer of competences can reduce costs by changing the way the target operates its businesses. Lesson 5. Competence transfer both to and from targets improves the innovation and market capabilities of the merging businesses. Thus, acquisition can be an effective means to leverage competences. The data indicate that the flow and effectiveness of competence transfer is bidirectional, suggesting that both target and acquirer competences can be exploited. For example, the merger of Nortel with Bay Networks in 1998 allows Nortel to share with Bay its competences in circuit technology, and gain access to the internet protocol (IP) technologies, routing technologies, and ins and outs of running IP networks that Bay possesses. Lesson 6. The transfer of the target’s competences into the acquirer’s businesses is more challenging and less predictable than that of the acquirer’s competences into the target’s businesses. 203 Summary Two types of synergy - cost and revenue based - are typically used to justify takeovers. But to what extent do merging companies exploit economies of scale and leverage their competences after acquisition? In this article - based on a major study of more than 250 merged businesses - Laurence Capron compares pre-acquisition motives and post-acquisition behavior. Among the conclusions, she finds that cost cutting and asset downsizing may not be the most effective ways to increase performance; that managers need to understand the risks of damaging the takeover target: and that they should pay more attention to transferring competences and exploiting revenue synergies. Suggested further reading Capron, L. (1999) “The long-term performance of horizontal acquisitions,” Strategic Management Journal, 20 (11, Nov.): 987-1018. Capron, L. and Hulland, J. (1999) “Redeployment of brands, sales forces, and general marketing expertise following horizontal acquisitions: a resource-based view,” Journal of Marketing, 63 (April): 41-54. Haspeslagh, P. and Jemison, D. (1991) Managing Acquisitions, New York: The Free Press.