August 14, 2019
By Alex Brown, Deals Strategy Partner
Most companies want to grow, and they often choose to invest in organic growth such as developing new products or entering into new markets. When organic options are limited or when speed is a critical factor, an acquisition may be the only option. Deals can be tempting, and if the math makes sense and the company has cash or access to cash, they may be the right move.
Too often, though, companies adopt a reactive approach to deals: They pounce on an asset because it is in play and create a strategic rationale to justify a deal. For any deal, a company’s board of directors should assess the deal by stepping back and asking management key questions to ensure a deal is in the company’s long-term best interest:
- Does the deal align with the portfolio strategy of the company?
- Is the deal the best use of cash, or are there other uses that would create more value such as returning cash to shareholders via repurchase, dividends or de-leveraging?
- Is there a clear plan for synergy capture and risk management?
We’ll address each question in turn.
Before they consider any deal, directors should require that management articulate a clear portfolio strategy for the company – something many companies lack. A good portfolio strategy has the following elements:
- Clear statement of how each business fits with and is synergistic with the others in the portfolio
- A portfolio matrix with each business categorized (e.g., Grow, Maintain, Fix, Exit)
- A multi-year capital allocation plan by business and for the company overall, with the lion’s share of the capital focused on the Grow businesses – what we call platforms
- A clear articulation of the investments – both organic and inorganic – that support this pathway
The board should require that management provide regular updates on progress against the portfolio strategy, and how both acquisitions and divestitures clearly align with it. Further, the portfolio strategy should be communicated to investors so that as deals are announced the logic and the fit are obvious to the market.
As mentioned above, capital should be disproportionately allocated to the Grow businesses in the portfolio matrix, what we call growth platforms. For a business to be a growth platform it must satisfy two criteria:
- The markets that the business is in or can expand into have profit pools that are large enough and growing fast enough to support the company’s target financial and value trajectory.
- The business must possess or have access to (via organic or inorganic investments) differentiated capabilities: One to three things the business does better than the competition that enable it to win and capture the required share of the profit pool.
Companies typically have one or two growth platforms in their portfolio, though some companies don’t have any based on the definition above. Either the profit pool is too small to support their ambition, or they lack differentiated capabilities – they’re a parity or disadvantaged player.
Deals should focus on either creating or growing growth platforms or turning a Fix business – one that may produce solid returns but has more potential through repositioning – into a growth platform. While the latter is typically a transformative deal, most deals don’t have to be and shouldn’t be; they are inherently riskier and usually consume much more investment capacity. High performing companies often use a continuous flow of smaller, bolt-on acquisitions to grow and extend platforms. Further, as technology has become a critical lever for companies in almost every sector, joint ventures and alliances have become important tools for gaining access to new markets and capabilities.
The board should require that management articulate clearly how they intend to create and expand growth platforms, and how capital will be prioritized to that end.
Deals are expensive. Because acquisitions involve takeover premiums that have to be offset by synergy capture, they are the riskiest form of investment for companies. Therefore, directors should especially demand that management explain why a deal is the best use of cash.
Failed deals are a clarion call for investor unrest and activist involvement. Investors don’t like to have their money spent on risky investments unless those investments clearly support an articulated strategy as described above. Absent that clarity, investors would prefer that management pursue less risky organic investments, even if they will take a longer time to generate returns. Or they would prefer that management simply return the cash via share repurchase or increased dividends.
If an acquisition does align with strategy, then directors should press management for a clear understanding of the synergy capture plan and the risks to delivering it. Directors should require accountability: Which executive’s career is riding on ensuring the deal is executed properly and the synergies are delivered as planned?
For most companies, deals are necessary and, done well, an excellent way to create and preserve advantage in attractive markets. But they’re also risky, and directors have a fiduciary responsibility to ensure that management does deals that are aligned with a clear strategy and has plans to capture required synergies and manage attendant risks.
Learn more about Why boards should ensure their companies have a true deal strategy, part of the PwC series The board’s guide to deals.