Lee Frederiksen — January 12, 2018 Mergers and acquisitions have become a popular business strategy for companies looking to expand into new markets or territories, gain a competitive edge, or acquire new technologies and skill sets. M&As are especially popular in the professional services space with the growing wave of retiring Baby Boomers and a rapidly changing economy and marketplace.
So what is the impact of all these mergers? More importantly, does an M&A make sense for your firm?
Here at Hinge, we’ve studied the factors that drive premium valuations and high growth and uncovered some facts that may surprise you.
Strategic M&A: Seeking a solution to a business problem
There are essentially two kinds of mergers and acquisitions: strategic and financial.
A financial merger or acquisition is pursued, as the name implies, for financial reasons—often to pick up some quick cash or as an investment. But I’m not really interested in financial M&As for this particular discussion.
Strategic mergers and acquisitions offer a solution to a different business problem. Perhaps the acquirer is looking to grab a new product line, add some additional facilities, enter a new market, or gain expertise and intellectual property. For professional services firms, a strategic M&A is often about gaining credibility, adding intellectual firepower or changing the balance of power in a particular market.
The bottom line is a strategic merger yields value for both the acquired and the acquiring firm. To reluctantly use a hackneyed phrase, it’s a “win-win” for both parties.
So what does a strategic merger look like? Here’s a good example:
A few years back we were researching firms that received unusually high valuations. One caught my attention. It was a smaller firm that specialized in top-secret work and had deep experience and contacts in one of the intelligence agencies. This firm was sold for an eye-popping 10-times revenue.
When we asked the acquiring firm about why they were willing to pay such sums, their reasons were perfectly clear.
The target firm offered must-have qualifications and contracts with a must-have client. To not have these capabilities would put the acquiring firm at a significant disadvantage when competing for upcoming work. In short, they believed the long-term value for the acquiring firm was much greater than the inflated purchase price.
That’s a strategic merger.
But when is it advantageous to proceed with an aggressive growth strategy of mergers and acquisitions, rather rely on disciplined organic growth?
When M&A Works as a Growth Strategy
Mergers and acquisitions make perfect sense in a variety of situations. For example, maybe an opportunity presents itself that requires fast, decisive action. Or maybe a competitive threat compels a defensive move to get bigger, faster.
Here are five situations in which mergers and acquisitions have proven useful as a growth strategy:
1 – Fills critical gaps in service offerings or client lists
When the marketplace changes in response to external events or new laws and regulations, it can create a gap in a firm’s critical offerings. It is a prime opportunity for a strategic merger.
After 9/11, the national security and defense industry lacked the relevant skills to match rapidly changing federal requirements. Companies quickly realized they would be sidelined without the skills and experience necessary to meet the new security demand. The firms with the requisite experience and relevant client lists suddenly found themselves strategically valuable and highly sought-after acquisition targets.
2 – Efficient way to acquire talent and intellectual property
Many industries are seeing an acute shortage of experienced professional staff. Cybersecurity, accounting, and engineering are just a few examples that immediately come to mind.
The reality is, intellectual property (IP) is the new currency of modern business. Once squirreled away and carefully guarded, IP is now actively bought and sold. For many companies, the acquisition of a firm and its IP is the quickest path to market dominance—or at least a roadblock to competitive incursions.
3 – Opportunity to leverage synergies
A strategic merger, if done as part of a thoughtful growth strategy, can result in synergies that offer real value for both the acquired and the acquiring.
There are two basic types of M&A-related synergies: cost and revenue.
Cost synergies are all about cutting costs by taking advantage of overlapping operations or resources and consolidating them in one entity. In a strategic M&A, a number of areas are suitable for cost-cutting, such as redundant facilities, workforces, or business units and areas of operation. But cost synergies can also result in an increase in buying and negotiating power thanks to the larger combined budget.
Revenue synergies alter the competitive balance of power and create opportunities to change market dynamics, sell more products, or raise prices. Companies can take advantage of revenue synergies and make more money in many ways, including the following:
- Reduce competition
- Open new territories
- Access new markets (through newly acquired expertise, products, services, or capacity)
- Expand the customer base for cross-selling opportunities
- Develop sales opportunities by marketing complementary products or services.
4 – Add a new business model
Many professional services firms are based on a billable-hours business model, but that is certainly not the only option. Some firms generate revenue as a fixed fee or through performance incentives. Others may employ subscription models (popular in the software industry).
Of course, the value of an effective M&A growth strategy is not just about how you are paid. A merger may also offer a new type of service, such as brokerage, insurance or money management. If you’re considering a new business model, the easiest way to develop and test it out is to acquire a firm that’s already using the model successfully. That way you avoid possible missteps from inexperience.
5 – Save time and long learning curves
Much like adding a new business model, a strategic M&A may help you save considerable time an expense in your growth strategy.
Let’s say you’re considering a new service for your business. Your firm is fully capable of developing and delivering that service on its own, but it will take more time, money and resources than you’re willing to devote. It might be easier and more cost-effective to simply acquire the capability.
Not only is this a practical and smart shortcut to the sought-after service and expertise, you also acquire a built-in customer base and target audience. Bingo!
When M&A Falters as a Growth Strategy
But not everyone succeeds when mergers and acquisitions are part of the overall growth strategy. Sometimes a solid strategy is derailed by problems in implementation or flaws in the logic or reasoning behind the strategy.
Let’s explore how an M&A growth strategy can go wrong:
1 – Cultural clash
Different firms have different cultures. No surprise there. But the difference in cultures can be problematic. According to research conducted by Bain & Co., a clash of cultures can be the biggest reason mergers fail.
You can guard against this by being clear about the culture you want and using all tools at your disposal to ensure you achieve it. For example, education, the right incentives, and a focus on your employee brand are most helpful when looking at a possible merging of corporate cultures.
2 – Loss of differentiation
Avoid mergers when the features—and benefits—that make one firm valuable are not relevant to the other brand. Rather than add critical assets, capabilities or value, the acquired or merged firm dilutes the brand and competitive advantage.
A merger should be the result of carefully researched brand analysis. It should NOT be an ego-driven trophy deal.
3 – A major distraction
Mergers and post-merger integrations are resource-intensive activities that usually involve some of the most senior people in the firm. If they are not prepared for it, they can easily be distracted by other critical, but less urgent activities.
The potential for distraction is greatest—and most profound—after the deal is done and the focus moves to integration. If senior management gets too distracted, and you risk having the merger flounder as well as damaging the underlying business.
4 – Marketplace confusion
Let’s say Firm A, a highly respected accounting firm that specializes in manufacturing, acquires Firm B, a cybersecurity firm with specializes in helping retailers. The acquisition seems very strategic. Seeing an opportunity, the combined firm, A+B Associates, tries to add retail to their specialization. The result is a confused marketplace.
Does A+B still specialize in manufacturing? Are they no longer an accounting firm?
The confusion can be even worse if the only rationale for the merger is growth for growth’s sake. The whole confusing mess could be avoided with a solid, research-based plan to position the merged brand and help current and potential customers understand the rationale and benefits of the merger.
5 – Loss of brand strength
If the marketplace is confused, the strength of your brand will suffer. After all, brand strength is the product of a simple equation:
Reputation x Visibility = Brand Strength
Where reputation is what you’re known for and visibility is how widely you are known for it. Understanding this equation can help you avoid the perils of diminished brand strength.
An ill-timed merger can quickly diminish the strength of both the acquiring and acquired brands. Here’s an all-too-typical example:
Brand M, which has considerable visibility in the Midwest, wants to expand into the Southeast. To accomplish this, Brand M acquires Brand S, a southeastern-based firm. But there is a problem. The Midwestern brand is unknown in the southeast, so its overall brand strength is actually diminished by the acquisition. And, when the southeastern firm adopts the brand identity of Brand M, its brand strength is also diminished. Everybody loses.
So how do you overcome this problem? Sometimes a gradual transition to a new brand is the right answer. Other times a concerted focus on building the visibility of the new brand in the market where it’s less known is the key.
Watch out for situations where you must change both the focus of the reputation and increase visibility. These are the most challenging mergers.
Developing Your High Growth Strategy
Achieving high growth starts with a true understanding of the marketplace as it really exists and how your firm is actually perceived (not as you’d like it to be perceived). Do your research and understand fully what each firm—the acquired as well as the acquiring—bring to the equation.
In the end, a successful high-growth strategy will include the following elements:
It is forward-looking—A good strategy is not just a response to what has been. It’s about what can be achieved. Where do you really want your firm to go? How will you get there? What needs to happen to do it?
It doesn’t require complete consensus—If absolutely everyone thinks it’s a great plan, then you’re not taking appropriate risks.
It does require buy-in—Senior management must be onboard and embrace what needs to be done. Without management buy-in, any strategy is doomed to failure. But don’t forget your employees. Workers at all levels should be enthusiastic about what the firm is gaining and where it’s heading.
It focuses on implementation—High growth requires careful implementation of every aspect of a business strategy and plan. Follow through with implementation.
If M&A is a part of your growth strategy, focus on the emerging culture and brand and carefully shape the new firm. And consider carefully how the merged firm will generate organic growth.
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