Mergers & Acquisitions – Growth Driver in Post-pandemic Era
“Covid-19 has disrupted global economy, slowed down investments and growth, and impacted merger and acquisitions (M&As). However, covid-19 has taught the importance of being resilient. With vaccines available now, humanity is at the cusp of a turnaround. Strengthening fundamentals with favourable government policies would drive a V-shaped economic recovery, thus increasing opportunities for growth multifold. Post-pandemic, new opportunities and challenges would compel managements to adopt M&A strategies to grow, and increase competitiveness. “Old is Gold” – time-tested traditional defensive and offensive strategies refined with new learnings during pandemic would drive M&As post-Covid. With support of highly disciplined and objective due diligence and water-tight legal documentation to mitigate risks, M&A strategies can help companies to succeed and create significant shareholder value over long-term. Read on to know more…”
I. Introduction
Globally, M&As have made their presence felt since 19th century. Over more than a century, M&A tides picked up during economic boom driven by technological innovations, deregulation, privatisation, political stability, favourable laws, etc. and receded during economic turmoil driven by wars, recession, market crash, oil crises, pandemic, etc. Each tide achieved different outcomes such as globalisation, consolidation, diversification, conglomerate building, takeovers, management buyouts, leveraged buyouts, etc.
Covid-19 has disrupted global economy. While traditional sectors such as manufacturing, logistics, hospitality, travel, real estate, etc. are bleeding; new-age technology driven sectors with focus on digital space have seen growth. GDP growth forecasts as per October-2020 IMF estimates are:
| Region | 2020 | 2021 | 2021-25 average |
|---|---|---|---|
| Global | 4.4% | 5.2% | 4.1% |
| India | 10.3% | 8.8% | 7.8% |
Covid-19 dramatically shifted investor’s outlook, most of whom took conservative wait and watch approach for their investment and growth strategies, impacting global M&A landscape. Certain exceptions, such as M&As in technology and retail sectors, have been a silver lining to this dark cloud providing optimism.
“Covid-19 dramatically shifted investor’s outlook, most of whom took conservative wait and watch approach for their investment and growth strategies, impacting global M&A landscape.”
With roll-out of vaccines, world is at the cusp of a turnaround. Economic recovery and M&As would drive each other. Let’s revisit some of the traditional M&A strategies and discuss their relevance in post-pandemic era to create shareholder value.
II. Alliance vs. Acquisition
Ultimate objective of each firm is growth in shareholder value. Both alliances and acquisitions drive growth. While viewed interchangeably, both are alternative strategies. It is important to ensure that firms do not acquire where they should collaborate or vice versa. Decision to ally vs. acquire depends on synergies, resources required and market conditions.
Alliances are less risky, co-operative and negotiated. Acquisitions are risky, competitive and at market price. There is no cookie-cutter approach to decide whether to ally or acquire. Managements err by force fitting the same strategy they once successfully implemented to all scenarios. Business development and M&A teams need to work together to adopt correct strategy every time.
“Both alliances and acquisitions drive growth. While viewed interchangeably, both are alternative strategies.”
Following are select few scenarios where alliance or acquisition may be adopted:
| Scenarios | Suggested Strategy | Example |
|---|---|---|
| Pooling of independent resources | Non-equity alliance |
|
| Sequencing interdependent resources | Equity alliance |
|
| Optimising value chain | Acquisition |
|
| Combining capacity | Acquisition |
|
| Eliminating redundant resources | Acquisition |
|
Clarity on when to use which strategy will help to succeed and increase shareholder value.
III. Traditional M&A strategies and their relevance in post-Covid era
Pre-Covid, over last decade, number of M&As rose globally. Some transactions created value while others eroded value. M&A activities have slowed during pandemic. Post-pandemic, new opportunities and challenges would compel managements to adopt following key M&A strategies for growth:
1. Industry consolidation
This has been one of the biggest drivers of M&A globally. Mature industries such as automotive, steel and petrochemicals suffer from overcapacity and related inefficiencies. Well-established industry leaders combine with less competitive players to regain competitive advantage through capacity rationalisation, market share gain, portfolio coherence, increased operational efficiency and enhanced innovation capabilities. To succeed, speed of integration and change management without bureaucracy is essential specially in case of merger of equals.
Example: Bayer acquired Monsanto in 2018 for USD 66bn at a premium of ~45% to trading share price. Bayer felt the compulsion to acquire Monsanto, despite high premium, to ensure continued dominance post two large consolidations in global agriculture market in 2015-2017: (a) ChemChina acquired Syngenta for ~USD 43bn and (b) ~USD 130bn merger of Dow Chemical with Dupont. Bayer-Monsanto became a global behemoth with integrated agriculture business, widened product portfolio and strong R&D capabilities enabling it to control the global food value chain in terms of pesticides to be used and seeds to be planted.
Some companies use consolidation cum restructuring to create coherent portfolios.
Example: Dow Chemicals and Dupont’s merger of equals created a global leader in chemicals sector. Both companies first merged their businesses and realised synergies then over 18-24 months restructured in to three businesses: agriculture, material science and specialty products.
Pandemic has led to significant demand destruction and inefficiencies across sectors. While demand would return gradually, there are opportunities across sectors to consolidate through M&A and gain competitiveness. Therefore, post-Covid, consolidation will continue to be one of the biggest drivers of M&A.
2. Diversification
This strategy entails extension of company’s product line or market reach. These are win-win propositions. Acquirer gets entry into new product line or new geography with local management. Target gets access to capital, branding, marketing capabilities, modern technology and knowhow to compete rivals. Success depends on the ability to grow on each other’s strengths, market leadership and best practices.
Example: Fuels and advanced mobility joint venture between RIL and BP plc enabled BP to enter India to tap large consumer market. Joint venture will leverage joint branding, RIL’s pan-India leadership and millions of consumers, and BP’s global experience in high-quality differentiated fuels and advanced mobility solutions.
Example: Some international accounting firms entered India through acquisition of local firms. They acquired local management and talent and local firms benefitted from global brand name and knowhow.
Several manufacturers are planning to fully or partially shift from China to India. M&A with Indian entities would enable global players to quickly enter India and shift supply-chains without causing severe disruptions to their global operations.
“Well-established industry leaders combine with less competitive players to regain competitive advantage through capacity rationalisation, market share gain, portfolio coherence, increased operational efficiency and enhanced innovation capabilities.”
3. Divestment
This strategy involves monetising non-core underperforming assets. This helps sellers to strengthen balance sheet, increase focus on reshaping and strengthening core businesses to increase competitive advantage and unlock shareholder value. It is important to identify correct assets based on strategic unfit, find a suitable buyer through a well-run process and move swiftly to maximise value and avoid stress sale, overcome resistance from stakeholders and minimise opportunity costs.
Example: Jack Welch aggressively divested 117 business units accounting for 20% of GE’s assets during his first four years as CEO. Proceeds were deployed to revitalise GE’s core businesses and increase competitiveness over long-term. He viewed holding on to losing businesses as threat to GE’s existence.
Ongoing economic stress would create several divestment opportunities including assets which rarely go on the block. Using this strategy proactively rather than reactively would help firms to quickly exit unjustifiable businesses, be future proof and protect shareholder value.
4. Ensuring survival
At times M&As do not generate economic returns but are necessary to ensure survival. Survival may be at stake due to changes in technology, changes in consumer preferences, changes in laws, improvement in efficiency and effectiveness of competitors, losing market share, etc. In order to gain competitive parity and advantage and ensure continued survival in the fast-evolving market, an entity may engage in M&A.
Example: Facebook acquired WhatsApp for USD 16bn to stay relevant in the social media space. Walmart acquired Flipkart for USD 16bn to achieve competitive parity, specially in e-commerce, with Amazon globally. In both cases acquirers have not reaped returns but deals ensured their global relevance and survival.
Covid-19 has affected several large players across sectors. To ensure continued survival, large players with strong balance sheets would be scouting for stressed targets with strong fundamentals to regain market share and competitiveness.
5. Industry convergence
This strategy involves evolution of new industry and business model which generates synergies by combining resources from existing industries whose boundaries are disappearing. Historically, this strategy has not been very prevalent. Given the recent focus to create digital platforms by combining several existing sectors such as telecom, technology, media, finance, retail, education, entertainment, etc., this strategy has already gained importance globally. As per NASSCOM, technology spending during pandemic has significantly increased with 30% jump in digital transformation deals and 80% jump in cloud spending.
Example: Over last 5 years Jio has converged from a pure play telecom operator to a technology enable digital services company. Driven by this convergence, backed by strong business model, growth plans and relevance in post-pandemic economy, Jio completed one of its kind fund raise of USD 20bn, despite economic downturn, from strategic investors such as Facebook and Google, and several global marquee financial investors who have similar focus.
6. Deploying free cash flows
Several firms which generate high cash flows have two alternatives: (a) to distribute dividend or buyback shares, (b) to reinvest in opportunities which would generate high returns for shareholders. In the latter, entities deploy M&A strategy to continue to create shareholder value.
Example: In 2017-2018, LVMH deployed its free cash to acquire Christian Dior’s Couture Brand and Belmond. These acquisitions coupled with stabilisation of previous acquisitions of Hermes, Bulgari and Loro Piana during 2010-2016 led to almost tripling of LVMH’s share price in last four years.
7. Agency problems
Management compensation is linked to entity’s growth and performance. At times, in order to increase compensation, management uses M&A to show growth despite no expected returns or synergies. Pandemic has taught importance of efficient use of resources. Therefore, shareholders should identify and block such management motives to avoid value erosion.
8. Management hubris
At times, out of experience or arrogance and over-confidence, bidding entity’s management believes that they can manage the target assets more efficiently. Therefore, investors should correctly assess management’s capabilities to manage the target assets before approving the M&A to ensure that the investment and monetary discipline achieved during pandemic is not lost.
While all M&As aim to create shareholder value, they represent different strategies. Post-Covid, objective evaluation of transaction rationale would be increasingly important to ensure continued focus on larger strategic goals and investors do not lose value due to loss of competitiveness or reckless management decisions.
IV. Importance of Due Diligence (“DD”)
Deal making is glamorous and exciting. While M&A team’s role is to successfully complete a transaction, it is equally responsible to suggest a no-go to management in case the proposed deal does not fit overall strategy. Initial high-level discussions in buyside M&As focus largely on financial models, valuations and publicity. However, the secret success mantra is a thorough high-quality objective DD deep diving into details to evaluate the following:
“Deal making is glamorous and exciting. While M&A team’s role is to successfully complete a transaction, it is equally responsible to suggest a no-go to management in case the proposed deal does not fit overall strategy.”
- What are we buying? – assets, technology, customers, employees, capacity, supply-chain, new products, etc.
- Synergies – quantum, time and cost to integrate, realisation probabilities, etc.
- Intrinsic value – determine target’s standalone valuation on as-in basis excluding synergies using methods such as discounted cash flow, trading comparables, transaction comparables, etc.
- Risks and liabilities – litigations, regulatory non-compliances, undisclosed liabilities, contingent liabilities, unfunded employee benefits, charges on assets, etc.
- Price cap – maximum price beyond which one would walk away from the deal.
A high-quality objective DD involves testing strategic rationale, SWOT analysis, evaluating entire business case, and identifying unrealistic assumptions and flaws in logic. Some organisations err in considering DD as hypothesis testing paper exercise and end up losing shareholder value. DD is a science as well as an art – combines backward looking findings with forward looking strategy.
Pandemic has disrupted businesses across sectors. Therefore, post-pandemic, highly disciplined DD would be significantly important to equip management with effective tools to make right go-no-go decisions to create or safeguard shareholder value.
V. Risk mitigation through legal documentation
Once decided to go ahead with the transaction, legal documentation is critical to complete the deal. Several transaction issues such as bridging valuation gap, post-closing price adjustments, regulatory compliances, integration plans, governance mechanism, reserved matters, financing mechanism, distribution policy, material adverse event, exit rights, deadlock and dispute resolution mechanisms, warranties and indemnities, etc. get resolved only at documentation stage.
“Several transaction issues such as bridging valuation gap, post-closing price adjustments, regulatory compliances, integration plans, governance mechanism, reserved matters, financing mechanism, distribution policy, material adverse event, exit rights, deadlock and dispute resolution mechanisms, warranties and indemnities, etc. get resolved only at documentation stage.”
Certain issues have upfront monetary bearing for both parties. They deploy following key measures to mitigate economic risks:
1. Earnouts:
Total consideration may be split in to two parts: (a) Upfront consideration, (b) Earnouts, i.e., deferred / contingent consideration. Payment of earnouts is dependent on achieving certain milestones related to growth, earnings, synergies, approvals, etc. to be achieved over a definite period. Larger the valuation gap or uncertainties, higher the earnout component. Earnouts motivate target’s management to deliver promised results and ensure efficient handover to acquirer.
Example: In 2019, Saudi Aramco announced purchase of 70% stake in SABIC from PIF for ~USD 69bn. Initial consideration structure was heavy on earnout due to high growth and synergy estimates. Later, crude prices and petrochemicals margins fell and increased uncertainties. To manage cashflow risks, save costs and access debt market, parties agreed to further increase the earnout component.
| Evolution of earnout structure | Upfront (%) | Earnout (%) |
|---|---|---|
| Initial agreement in March-2019 | 50% | 50% up to December-2021 |
| Amendment 1 in October-2019 | 36% | 64% up to September-2025 |
| Amendment 2 in June-2020 | ~10% | ~90% up to April-2028 |
While agreeing terms of earnout, it is important that long-term performance is not compromised to achieve short-term results.
2. Warranties, indemnities and holdback:
Buyers ask for several warranties from sellers to hold them accountable for the disclosures during DD. In case of breach of warranties, sellers are liable to indemnify buyers subject to a de-minimis, basket and cap over a definite period. Buyers aim to include higher indemnities and sellers aim to minimise the same through warranties. Creating a balance through negotiations is a science as well as an art. To ensure that sellers fulfil their indemnity obligations in case of any warranty breaches, buyers may holdback part consideration to adjust the indemnities at the end of the period.
Post-pandemic, buyers would seek Covid-19 specific warranties and higher indemnities to cover the risks of business continuity, operations, and financial performance due to impact of pandemic. Sellers may mitigate this risk by availing Warranty and Indemnity Insurance.
3. Material adverse event (“MAE”):
MAE provides parties with walk away rights in certain events which lead to a material change after signing. Such events include insolvency, changes in laws / industry / business / assets, etc. Materiality of change and its long-term impact are important to trigger this.
Post-pandemic, buyers would insist on including Covid-19 linked events such as next wave of virus spread, supply-chain interruptions, industry-wide disruptions, etc. Sellers would insist on including only specific and quantifiable events. Tough negotiations would be required to create a balance and ensure that neither party walks away from the transaction at the last minute without penalty.
Covid-19 has only increased the M&A risks. Therefore, importance of risk mitigation through water-tight legal documentation has significantly increased for both parties to successfully complete the transaction. Otherwise, the parties would walk away from the deal even if positive synergies are expected.
VI. Conclusion
Covid-19 has taught importance of being resilient to manage continuity, learn and emerge stronger, and prepare for new normal. To counter economic downturn due to Covid-19, globally governments have introduced several positive fiscal, monetary and financial policy initiatives. Several Indian government initiatives such as “Make in India”, “Aatmanirbhar Bharat”, changes in FDI and other laws and tax concessions have increased the ease of doing business in India. India has become a hot destination for global investments attracting FDI inflows of ~USD 40bn during April-September 2020, despite slowdown due to Covid-19 restrictions.
With V-shaped economic recovery and strengthened fundamentals, M&A transactions would increase multifold. “Old is Gold”. M&A principles have been well established over several decades. They have stood the test of time and only evolved and refined during downcycles. Post-pandemic, a combination of above discussed time-tested traditional and new defensive and offensive strategies would drive M&As to seize the opportunities to create shareholder value and overcome challenges to establish new economic order.
References
- Harvard Business Review – March 2001, May 2002, April 2004, July-August 2004
- Gaining and Sustaining Competitive Advantage, Fourth edition
- Media release and public filings of RIL and Saudi Aramco
- International Monetary Fund, World Economic Outlook Database, October 2020
- FDI Statistics updated up to September 2020 by DIPP