Merger & Acquisition (M&A) activity: The song is ended?

And the melody is becoming fainter and fainter! The surge in M&A activity came to an abrupt halt in July last year, largely as a result of the sub-prime crisis and the lack of confidence in financial markets that it engendered. The slow-down in activity has continued into the first quarter of 2008, with announced deals of approximately $750bn being 25% down on the same period in 2007. Even Microsoft’s attempt to gain control of Yahoo, in a deal that would have been worth $47bn, has been called off and Microsoft has backed off with its tail between its legs.

M&A activity is a reflection of business confidence, and that confidence took a body blow during the sub-prime crisis. Sources of finance available to fuel deal-making suddenly dried up, which had a major impact on the ability of private equity (PE) funds to close deals. Given that PE accounted for nearly 25% of global activity at the peak of the boom, the impact on global M&A activity was palpable.

Conditions are no different in South Africa, with the atmosphere being more about deals that haven’t come to fruition than those that have. The largest of these was the cancellation of Royal Bafokeng’s intention to acquire a controlling stake in Mutual & Federal. This deal was announced in 2007 at a likely cost of R8bn. In addition, listed property group SA Reit recently pulled out of a deal that would have seen it acquire the property interests of Super Group for a figure approaching R1bn. This announcement came soon after SA Corporate Real Estate Fund announced the cancellation of its potential BEE deal with Wipken Trust due to price weakness.

In addition to the impact of global factors, local business confidence has been further dented by rising inflation (some of it imported through oil prices at record levels and still rising), rising interest rates and the electricity crisis (if one is still allowed to use that word in this country!). The rise in interest rates could have a worrying impact on a number of  BEE deals that have already been consummated, in that many of these deals take the form of options on future growth, where the growth needs to surpass a hurdle rate based on borrowing rates before value created is shared with the BEE partners. As interest rates rise it is likely that more and more of these deals will move out of the money, which is not in the best interests of the country.

But if there is a glimmer of optimism in an otherwise gloomy scenario, it is that it appears that developed and developing markets have uncoupled, such that it may no longer be true that when the USA and Europe sneeze, the rest of the world catches a cold. Statistics on cross-border deal-making show that more and more deals are being concluded between companies in emerging markets, and that this is extending to conglomerates from emerging markets doing deals in developed markets. The recent tussle between Tata and Mahindra to gain control of Jaguar and Land Rover in the UK was evidence of this trend. As it happens the battle was won by Tata, but the real significance is that this transaction represents something of a reversal of the norm. Historically funds were expected to flow from developed to developing economies.

The increasing trend in South-South (between developing economies) investment played out in South Africa in 2007 in the form of Industrial & Commercial Bank of China’s acquisition of a 20% interest in Standard Bank and ongoing interest by Oger, the Turkish telecoms company, in Telkom. At the time of writing MTN had just announced that it was in talks with Bharti Airtel of India, with a view to Bharti making an offer for MTN. In the outward direction, Naspers in particular has been active in investments in Brazil, Russia and India.

What to do while the band takes a break

The slowdown in M&A activity presents a number of opportunities, such as:
- Reviewing the effectiveness of your M&A strategy
- Considering divestitures as part of that strategy
- Looking for bargains
These are considered below.
M&A Strategy

Bain & Co., the international consultancy, conducted a review of 250 CEOs a few years back and found to their astonishment that 40% of the CEOs interviewed did not operate according to an investment thesis that they could articulate. And 50% of those that did have an investment thesis found after three years that their thesis was incorrect. The implication is that formulating an effective growth strategy is not a once-off exercise, but one that needs to be revisited on a regular basis. The hurly-burly of boom times does not always lend itself to quiet reflection, but the relative calm at the moment could be a good time to sit back and regain some perspective.

Questions that your growth strategy should answer include:
- In what areas of the business should we grow organically, and in what areas do we need to grow by acquisition?
Areas of the business requiring radical change, dramatic leaps in terms of market share or the acquisition of scare skills might be the best candidates for growth by acquisition. Organic growth should be given serious consideration in other areas.
- Is deal-making a core skill of the business, based on a track record of success, or do we need to either beef up in-house skills or hire consultants to help?
The companies that achieve the best results through acquisitions are the ones that undertake smaller acquisitions on a regular basis, rather than one big one. They are thus able to move up the experience curve. Without this experience, it would be better to look for help.
- Do we understand the value proposition we are looking for in acquisitions, and can we express that proposition in terms that can be monitored post the event?
Making acquisitions for ‘strategic’ reasons that cannot be quantified can be a value trap. At the minimum, a scenario analysis should be used to justify the acquisition in financial terms.
- Do we have the processes in place to ensure that we get the deal we want?
Clearly defined financial objectives help in this regard, but in-house disciplines in relation to negotiations (such as clearly-defined levels of authority) are needed to ensure that you don’t pay too much for the company.
- Do we know how we are going to integrate acquisitions into our existing operations? If a dominant culture is one of your key strategic assets, then you will need to plan how this culture will be imparted to the target, and indeed how to capture the good points of the target’s culture into your own. And of course there are a myriad other logistical and human challenges that need to be addressed. Planning the integration should start long before the ink on the purchase agreement is dry.
- Do we have a communication plan to keep our stakeholders in the loop when an acquisition is being/has been made?
Skilled acquirers understand the need to communicate in order to allay the fears that naturally arise in times of change. If need be, even communicate that there is nothing to communicate about.

Consider divestitures

In boom times it is natural to think of acquisitions, but divestitures are equally important to consider. Warren Buffet’s annual report to the shareholders of Berkshire Hathaway is always amusing as well as wise. In the February 2008 version he refers to the words of a Country & Western song which go “I’ve never been to bed with an ugly woman, but I’ve sure woken up with a few”. Should the heady atmosphere of the boom have played havoc with your better judgment, this is the time to take stock and to refine your portfolio. Again, the key question to answer is whether your company is the best owner for a particular business. If not, then value could be created by divesting.

But to realise that value requires careful planning. Conducting due diligence on the asset to be sold will help to prevent unpleasant surprises surfacing during negotiations with potential buyers. If a carve-out is involved, you will need to pay careful attention to drawing up a set of stand-alone financials that will achieve credibility with potential buyers. The tax implications of such a sale will also need to be managed carefully.

While not being glamorous – “No one ever got famous for a successful divestiture” – this may be your best strategic option.

Look for bargains

There is an irony that financial buyers are able to create more value from their acquisitions than trade buyers. The irony lies in the fact that this is so despite the fact that financial buyers do not have access to the synergies that potentially accrue to trade buyers, such as greater buying power, ability to rationalise overheads and economies of scale. Financial buyers rely on the effectiveness of their management processes and strategy-setting to create additional value. In the recent past this has allowed them to out-price trade buyers in the market, but with sources of funding having dried up, this dynamic has changed. In a time when companies may be rationalising their portfolios, there could be bargains to be had.

Conclusion
M&A activity moves in cycles, and there’s no doubt that we are in a downturn at this time. The only questions now are how deep it will be and for how long will it last. But while the prospect of a downturn is alarming at first, it also brings opportunities to revisit your strategy, to review your investment portfolio, divesting where appropriate, and to invest selectively. And then of course to sit back and hum softly to yourself, until the music starts again.