7. Growth Through Acquisition (Anslinger Copeland)

MERGERS AND ACQUISITIONS

GROWTH THROUGH ACQUISITIONS: A FRESH LOOK

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THE McKINSEY QUARTERLY 1996 NUMBER 2

LBOs outbid corporate buyers and then produce extraordinary returns. How do they do it? A .study of over 800 aciiui.sitions shatters some myths about the value of timing and leverage Don't do the deal if you can't find the leader

Patricia L. Anslinger • Thomas E. Copeland

HE CONVENTIONAL WISDOM on successful corporate acquisitions is short and simple: Make them small and make them synergistic. Yet companies that reiy solely on this view risk missing an entire world of valuable strategic opportunities. A year-long research program has shown that companies can pursue a nonsynergistic strategy profitably. In fact, research has uncovered a diverse group of organizations, including Thermo Electron Corporation, Sara Lee Corporation, and Clayton, Dubilier & Rice, that have grown dramatically and captured sustained returns of 18 to 35 percent per year by making nonsynergistic acquisitions.

T

The successful acquirers fell into two groups: diversified public corporate acquirers and financiai buyers such as leveraged buyout (LBO) firms. We chose to study LBO firms because, like the rest of the world, we were fascinated as we watched them outbid corporate buyers and then produce extraordinary returns without the benefit of synergies among their businesses. We compared the LBO firms' practices with those of successful diversified corporate acquirers and were surprised to find that their operating principles were remarkably similar. Puiriciti Anstin^LT is ii consuitunt and Tom Copclaiui is a principal in McKinsey's New York office. This article is reprinted by special permission from the January-February 1996 issue of the Hiirvard Bu.sine.\s Review. Copyright © 1996 The President and Fellows of Harvard College. All rights reserved.

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GROWTH THROUGH ACQUISITIONS: A FRESH LOOK.

Yet many corporate strategists refuse to believe that they can be successful in pursuing nonsynergistic deals. In our view, their hesitancy results from two fundamental misconceptions about the way today's nonsynergistic acquirers operate. The first is that financial buyers rely on market timing to buy assets at a low price (and then turn around and sell them at a high price). In fact, we found that financial buyers actually pay substantial premiums above market price, just as other acquirers do. The second misconception is that high financial leverage is used to discipline managers. In fact, lo avoid losing flexibility, the financial buyers in our study make a conscious effort to prevent high leverage from controlling managers' decision making about operations. Although many LBO firms start out with fairly high debt loads, they reduce their burden to relatively conventional levels (65 percent debt to total assets) within one to three years. Our findings are supported by the research of John Kitching, who studied !10 buyouts.'^ He found that by the second year after acquisition, debt repayment ofthe typical . * * * •. LBO exceeded repayment commitments Many corporate strategists . ^A^V . c * u \^u 4^ ,^u by 600 percent, reluse to beheve that they can ^ ^ be successful in pursuing .,,.^. ^ . . . ,, -.i • • • ^- , , Without a doubt, the 21 companies in our nonsynereistic deals , ^ i *i i sample were very successtul. Altogether, they made 829 acquisitions. When asked whether they earned their cost of capital. 80 percent of the respondents (accounting for 611 acquisitions) said yes. Our sample of US corporate acquirers averaged more than 18 percent per year in total return to shareholders over a ten-year period, while the financial acquirers averaged 35 percent per year by their own estimates. Although the acquisitions of any given acquirer in our study were seemingly unrelated, successful acquirers picked a common theme and stuck to it. We noted, for example, that Clayton, Dubilier & Rice - a financial buyer - was skilled at turnarounds, often shrinking the acquired company before growing it."^ Desai Capital Management, also an LBO firm, searched for growth opportunities in retail-related industries. Emerson Electric Company acquired companies with a core competence in component manufacturing, particularly those for which it could exploit cost-control capabilities. And Sara Lee, which has acquired more than 60 different consumer product companies including Coach Leatherwear Company. Playtex Apparel, and Champion International Corporation - used branding and retailing as its common thread. We would like to thank Bradley Boyer and Kristin Fink for their help in preparing ihis article. ••' "Early returns on LBOs," Harvard Business Review. November-December 1989. "i" See W Carl Kester and Timothy A. Luehrtnan, "Rehabilitating the leveraged buyout." Harvard Business Review. May June 1995.

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GROWTH THROUGH ACQUISITIONS: A FRESH LOOK

Making acquisitions work But making this type of acquisition work is not easy. Our research found that successful corporate and financial buyers adopt seven key operating principles. These principles affect almost every stage ofthe acquisition process, from the identification of candidates to postmerger management. They are: • • • • • • •

Insist on innovative operating strategies. Don't do the deal if you can't find the leader. Offer big incentives to top-level executives. Link compensation to changes in cashflow. Push the pace of change. Foster dynamic relationships among owners, managers, and the board. Hire the best acquirers.

Insist on innovative operating strategies. Since the early 1980s, highprofile leveraged buyouts such as Duracell International. Uniroyal, and RJR Nabisco have attracted widespread attention. Much ofthe fanfare has focused on negotiation tactics, savvy financial structures, and prices. Little attention, however, has been given to the other 2,200-plus buyouts that occurred during that period, and to the fundamental changes in operating practices that have generated positive returns for many of those companies.''^ Although many observers believe that LBO firms uncover hidden gems in the marketplace, more often they merely focus on improving operations. Sunglass Hut International and Snapple Beverage Corporation, two acquisitions from our sample group, illustrate that the largest source of value creation in successful acquisitions comes from operating performance, not from financial leverage, market timing, or industry selection.' When Desai Capital acquired Sunglass Hut, it concentrated on growing revenues rapidly, creating a new strategy in order to do so. Since the initial acquisition in 1988, Sunglass Hut has grown from 150 stores to more than 800 and has racked up an impressive 37 percent in annual returns by acquiring smaller stores, in its turn, and implementing a new store format. The company replaced clerks who knew little about sunglasses with trained customer service specialists, introduced an extensive product assortment instead of relying on two or three popular lines, and instituted a low-price regional strategy (see exhibit). •^ William F. Long and David J. Ravenscraft, "Decade of debt: Lessons from LBOs in the 1980s." The Oeal Deiade: What takeovers and leveraged hiiyouls mean for cnrporate governanee. ed. Margaret M. Blair. Brookings Institution. Washington. DC, 1993. ' Various acaJemic studies of LBOs support our findings Ihal sucuessful diverse acquirers are able lo create value mainly by improving operations, See Steven Kaplan. "The effects of management buyouts on operating perfonnance and value." Journal of Financial Eeonomics. 24, 1989. p. 217.

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The Snapple buyout, executed by thefinancialbuyer Example: Sunglass Hut International Thomas H. Lee Company Total company value (S million) in 1992, provides another Acquisition plus net example of operating innopresent value of •^ 4 2 subsequent investments vations. Shortly after the Normal gain from the buyout, Snapple embarked 55 market (Jan 88-Jan 94) ^ 4% ' on an ambitious growth industry gain over market 11% 25 strategy based on rapid Financial leverage 5% 12 geographic expansion and product line extensions. Operating improvements 60% 140 Knowing that competitors Entity value (Jan 94) 274 would soon bring out their Source: Private files: Compjstat. McKinsey analysis own natural teas and fruit juices, the company quickly built its production and distribution system. It established contractual relationships with bottling and distribution companies that had spare production capacity, thereby getting its product to market a year ahead of national competitors such as Fruitopia (from Coca-Cola Company's Minute Maid division) and gaining afirst-moveradvantage.

Sources of value creation in an acquisition

As the Snapple example illustrates, innovative operating strategies allow acquirers to be successful in industries as notoriously competitive as the US food and beverage industry. The lesson: Don't look for growth only in high-growth industries. Don't do the deal if you can't find the leader. More than 65 percent of our respondents believe that managerial talent is the single most important instrument for creating value. Acquirers ensure that they have the right managers in three ways: they evaluate current executives; they look for managers within the organization who are not yet in leadership positions; and they hire outside industry experts. Nearly 85 percent ofthe acquirers we interviewed kept preacquisition managers in their positions. In other instances, successful acquirers found leaders elsewhere in the company - leaders who had not yet had the chance to implement their vision. Forstmann Little & Company discovered top leaders within middle management at General Instrument, and those individuals have gone on to create more than S3 billion in value over the past three years. When successful acquirers look for outside industry experts, they tend to find outstanding performers at large corporations. For instance, Stephen Rabinowitz, who had an impressive track record as president of General Electric Lighting and later as vice-president of AlliedSignal Braking Systems, was hired to turn General Cable Corporation around in 1994 after

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GROWTH THROUGH ACQUISITIONS: A FRESH LOOK

Wassail acquired it. Many potential buyers had looked at General Cable, a supplier of copper wire cables, but few knew how to make it profitable. In acquiring General Cable, Wassail was betting that the company conid be turned around and that Rabinowitz was the man to do it. Within 18 months of the acquisition, the bet paid off: Rabinowitz had overhauled the company's various information systems, cut more than 30 percent of its produet offerings, and dramatically reduced working capital. However, when financial targets are not met, successful acquirers don't hesitate to replace managers. Financial buyers show less patience than corporate acquirers. In 32 percent ofthe acquisitions by financial buyers in our study, one or more top-level managers were replaced within three years. In the corporate acquisitions, thefigurewas less than 10 percent. Why the difference? It may be attributable to the taller hurdles imposed by financial buyers, or to corporate acquirers' reluctance to displace managers and disrupt a company's culture. Those reluctant to replace managers might take a lesson from Thomas H. Lee. The company engineered a management buyout of Diet Center in 1988. "We knew management was weak, but we thought we couldfixit," recounts former managing director Steven Segal, now managing director of J.W. Childs Associates. At the time of the Diet Center aequisition, Jenny Craig was predominantly an Australian food eompany and Nutri-System was just emerging from bankruptcy. Neither was a serious threat to Diet Center at first, but both became major rivals before long. When the competition got rough, Diet Center's managers faltered. Offer big incentives to top-level executives. Finding and motivating the right managers is so important that many successful aequirers offer senior executives substantial ownership stakes (usually 10 to 20 percent). If all goes as planned, those managers ean become millionaires. Why offer such big carrots? B. Charles Ames, a Clayton, Dubilier & Riee partner, said it best: "Managers are more committed to doing the difficult work of restructuring, growing, and otherwise fixing an acquisition when some or all of their net worth is on the line." Creating annual returns in excess of 35 percent, as these managers must, requires a great deal of commitment and effort. Incentives are especially important when new managers are recruited into a eompany. Substantial upside potential is often needed to woo outstanding exeeutives away from comfortable and relatively low-risk jobs. Previous studies on buyouts have shown that CEOs of acquired companies typically hold 6.4 percent of their unit's equity, whereas the average CEO of a public company might hold only 0.25 pereent.'' '•'• Mictiaei C. Jensen. "Eelipse of the public eorporation," Harvard Business Review, Scplcmbcr October 1989. p. 61.

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FINDING NONSYNERGISTIC ACQUIRERS To find the most successful nonsynergistic acquirers, we screened all major companies making acquisitions over the past ten years: US and UK public companies and known US financial buyers. In selecting public corporations, we chose those that had acquired more than ten companies of size that were in more than four different major lines of business. Since some companies acquire a variety of businesses in order to vertically integrate, we saw them as one business and therefore eliminated them from our sample. For financial buyers, we chose firms that had disclosed investment funds of $250 million or more and that had raised at least

two investment funds - an indicator of successful investment performance over time. We then conducted detailed interviews with eight corporate acquirers and 13 financial buyers. The group of corporate acquirers in the study operated 50 different lines of business, outperformed the Standard & Poor 500 and Morgan Stanley Capital International (MSCI) indices by an average of almost 50 percent, and experienced compound annua! revenue growth of 12 percent during the past ten years. The group of financial buyers studied had reported capital of more than $16 billion and

US and UK public corporate acquirers. 1985-94 Companies

1994 sales

Annualized

S million

return Percent

Index; S&P 500

Number of acauisition5 and divestitures

Degree of diversification

16

14.3

Berkshire Hathaway

3,847.5

32.0

26

Phelps Dodge Corporation

3,289.0

29.7

10+

15,536.0

23.7

85

9

1,585.3

22.4

30

12

Sara Lee Corporation Thermo Electron Corporation Illinois Tool Works

4

3,461.3

21.8

10

5

23,512.2

20.4

95+

8

AIco Standard Corporation

7,992.5

18.3

62

9

Air Products and Chemicals

3,485.3

17.2

10

5

59,316.0 3,085.3

17.2

24

14.3

76 11

Emerson Electric Company*

8,607.2

13.9

40

4

Harcourt General Index: MSCI (UK)

3,208.5

13.1 5.4

10

4 5

Canagra

General Electric Company Dover Corporation

Wassal

5

1,022.0

14.4

11

BAT Industries

28,169.3

14.1

10

7

Hanson Trust

16,899.7

9.8

31

20

Grand Metropolitan

11,740.3

7.6

47

* Although they did not exceed the total return of theSSP 5D0 Indei over the ten-year time frame, these companies experienced periods of exceMence between 1980 and 199