Not all firms that make acquisitions have acquisition strategies, and not all firms that have acquisition strategies stick with them. In this section, we consider a number of different motives for acquisitions and suggest that a coherent acquisition strategy has to be based on one or another of these motives.
Firms that are undervalued by financial markets can be targeted for acquisition by those who recognize this mispricing. The acquirer can then gain the difference between the value and the purchase price as surplus. For this strategy to work, however, three basic components need to come together.
- A capacity to find firms that trade at less than their true value: This capacity would require either access to better information than is available to other investors in the market, or better analytical tools than those used by other market participants.
- Access to the funds that will be needed to complete the acquisition: Knowing a firm is undervalued does not necessarily imply having capital easily available to carry out the acquisition. Access to capital depends upon the size of the acquirer — large firms will have more access to capital markets and internal funds than smaller firms or individuals — and upon the acquirer’s track record — a history of success at identifying and acquiring under valued firms will make subsequent acquisitions easier.
- Skill in execution: If the acquirer, in the process of the acquisition drives the stock price up to and beyond the estimated value, there will be no value gain from the acquisition. To illustrate, assume that the estimated value for a firm is $100 million and that the current market price is $75 million. In acquiring this firm, the acquirer will have to pay a premium. If that premium exceeds 33% of the market price, the price exceeds the estimated value, and the acquisition will not create any value for the acquirer.
While the strategy of buying under valued firms has a great deal of intuitive appeal, it is daunting, especially when acquiring publicly traded firms in reasonably efficient markets, where the premiums paid on market prices can very quickly eliminate the valuation surplus. The odds are better in less efficient markets or when acquiring private businesses.
Acquire poorly managed firms and change management: Some firms are not managed optimally and others often believe they can run them better than the current managers. Acquiring poorly managed firms and removing incumbent management, or at least changing existing management policy or practices, should make these firms more valuable, allowing the acquirer to claim the increase in value. This value increase is often termed the value of control.
Prerequisites for Success
While this corporate control story can be used to justify large premiums over the market price, the potential for its success rests on the following.
- The poor performance of the firm being acquired should be attributable to the incumbent management of the firm, rather than to market or industry factors that are not under management control.
- The acquisition has to be followed by a change in management practices, and the change has to increase value. Actions that enhance value increase cash flows from existing assets, increase expected growth rates, increase the length of the growth period, or reduce the cost of capital.
- The market price of the acquisition should reflect the status quo, i.e, the current management of the firm and their poor business practices. If the market price already has the control premium built into it, there is little potential for the acquirer to earn the premium. In the last two decades, corporate control has been increasingly cited as a reason for hostile acquisitions.