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1-2.3: Acquisition Process
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From the course by University of Illinois at Urbana-Champaign
Corporate Strategy
309 ratings
University of Illinois at Urbana-Champaign
309 ratings
Course 6 of 7 in the Specialization Strategic Leadership and Management
From the lesson
Module 1: Vertical Integration and Diversification
This module focuses on corporate strategy with particular emphasis on vertical integration and diversification. It seeks to explain when vertical integration and diversification can create a competitive advantage.
Meet the Instructors
Joe MahoneyProfessor of Business Administration
University of Illinois, Urbana-Champaign College of Business Department of Business Administration
For this video, we're going to look at some of the reasons for
acquisitions and some of the problems in achieving them.
Once again, just like for vertical integration, like for
diversification, why do you do acquisitions?
It's the same answer over and over no matter what, why do you do strategy x?
It's always the same answer.
So, part of your education, then, is just getting these three categories, and
then everything else just becomes an application of that.
So, for any strategy, how does it increase revenue?
How does it decrease cost?
How does it reduce risk in ways that can't be replicated by a shareholder?
So, now, we've done vertical integration, we've done diversification, acquisition,
same thing.
So, the acquisition may increase market power, that will increase revenues.
You may overcame entry barriers.
It also can increase revenues.
You have cost of new product development, so
that the acquisition is cheaper than doing it yourself, that lowers your cost.
Increased speed to market, that can bring in revenue sooner,
that increases revenues.
Lower risk, straightforward,
lower risk compared to developing the new products yourself.
Increased diversification, which also may, as we just noted in our last video,
may either increase revenue, reduce risk, or potentially reduce cost.
All three of those categories are potentially involved in diversification.
And avoiding excessive competition, once again, that can lower cost.
Now, having that said that about bringing something within the organization and
acquiring, what are some of the problems?
Well, one of the problems is that when you bring in another organization.
They have a different culture that may be very different from the original,
acquiring company's culture, and they're kind of mixing the two together.
The other thing that often happens, empirically,
is a lot of the people from the acquired company leave the organization.
Because they think they're going to be disadvantaged in the pecking
order of the new organization, coming from the other organization.
And, in general, that may be the case.
And because of that, there's very high turnover of the management skill in
the acquired organization.
And if the purpose was to bring in those folks,
it has to be very carefully orchestrated to make sure that people feel
they're going to be empowered in the new organization.
Another problem is that there may be inadequate evaluation of the target, and
also that may mean you paid too much for the company.
Also, once you acquire the company,
it may put the acquiring firm in a higher debt ratio.
Which then makes the firm unable to do strategies that they would like to do
because they simply do not have the available financial resources, and
because of asymmetric information problems.
Even though they have good projects, they can't get the external capital
markets to support those ventures that they have.
The other idea is, of course,
they bring organizations together to achieve synergies.
Sometimes those synergies don't materialize, so
that you actually don't get reduced costs.
As a matter of fact, we also talked about influence cost.
So, the cost may actually go in the other direction and
your cost may actually go up.
Another is, we talked about last time, was too much diversification.
So, we talked about the growth rate, and
if you're diversifying to a certain point, fine.
But if you're growing too fast, diversifying too fast,
at some point your profitability on that y-axis starts to go down.
Also, managers may be overly focused on acquisitions.
And if they do that, their time and attention is on that and
not on the daily operations of the organization.
And then their performance in what they're doing may suffer,
because too much attention is on the next deal, rather than managing what you have.
And, finally, we talked about the bureaucratic cost of becoming
too large an organization.
And there, your cost structure, you may get increased cost there as well.
This slide here comes from empirical work, and
summary of empirical work, of hundreds and hundreds of studies on diversification.
And this is the summary slide of all of that empirical work.
So, the question is,
what are the characteristics that tend to lead to effective acquisition?
The first one that tends to have positive impacts,
is if you have complementary assets or resources.
So, for example, one company might be good at
developing products, but not have a very good distribution channel.
And another company may not have very good development of their products, but
may have a very strong distribution channel.
If they bring those two companies together,
then you have good products combined with good distribution of those products, and
those two things together are called complementary assets.
They reinforce each other and make each other more effective,
or another term would be, we had earlier, was synergy.
So, if you bring those resources together,
you may be be able to effectively increase revenues and decrease costs.
A second is, in general, friendly acquisitions do better than hostile.
Because, as we mentioned before,
even in a friendly acquisition, the people who were acquired are a little bit
concerned that they are going to be left out of the new organization.
You can be almost assured that in a hostile acquisition they're going to
be left out.
And so, therefore,
it is not going to be very good harmony of the two organizations.
A lot of adjustment costs, and often the adjustment costs outweigh the benefits.
Much more likely to get the benefits that way and the cost when you have friendly
acquisitions that are negotiated between the parties rather than hostile takeovers.
Another is, was there a careful selection process, and
also in terms of the prices paid?
I mean, the most fundamental thing of all what makes a good acquisition, well,
depends on the price you pay.
People talk about lots of other characteristics, but
the price is a really important one.
And then, finally, the last one was connected to the previous slide about when
we had the discussion about debt.
So, those companies that, when they acquire another company, but
they still don't have a really prohibitively high debt to equity ratio,
they have the flexibility when new profitable opportunities come along.
They're still financially positioned to be able to act
upon those opportunities because they haven't overburdened themselves with debt.
So they, or another way to phrase it,
as on the slide there at the bottom left, maintain the financial slack.
A very famous book in finance called A Random Walk Down Wall Street.
It's called a random walk because if we look at the stock price of any company
right now, what's the price of the company going to be one minute from now?
Well, in general, that's called a stochastic process or
a random process, or sometimes called, I think the story about where did
random walk came from is if a person is drunk or inebriated.
And they're walking down the street and they're walking like this.
And because they're so unstable, their next step is maybe random.
And that's why it's called the random walk.
So, it's kind of getting inside the,,
if it's very difficult to predict what the stock price is going to be moving forward.
So, in our course,
we're focusing on this idea of trying to gain a sustainable competitive advantage.
Well, this brings us into the idea of an efficient market.
And an efficient market is,
if an industry is generally known to be highly profitable, there will be many
firms bidding on the assets already in the market that are already in that market.
So, generally, the discounted value of the future cash flows,
that is NPV, will be impounded in the price that the acquirer pays.
So, in other words, suppose you think
here at Illinois we might be interested in the Chicago Bulls as a basketball team.
We might say that's a great monopoly market and
they've got a tremendous cash flow.
I want to buy that organization and make money.
Well, the seller's going to look at the future cash flow projected
of that organization, discounting it back to the present.
And an efficient market is going to predict that the price they sell it for
is equal to that future discounted cash flow.
So, when you buy that organization of the Chicago Bulls,
the expectation in an efficient market is your NPV will be zero.
That is, you'll get a competitive rate of return on investment.
What it's really saying, it's hard to get sustainable competitive advantage, or
positive NPV, by just going out and buying it.
Because the sellers, if they are smart, they'll be selling it at a price
that kind of captures all of the value for themselves.
Not easy to just buy your way into profitability.
And the situation may be even worse than the efficient market, and
this is called the winner's curse.
So, the idea is that the most optimistic bidder usually
overestimates the true value of the firm.
And this one's really an incredible example.
Quaker Oats, in late 1994, purchased Snapple Beverage Company for $1.7 billion.
Many analysts at the time calculated that they overpaid by about 1 billion.
So, even if they had just consulted analysts in the market,
they would've gotten this input from a lot of different people,
that they're overpaying by a billion.
And then, later on, or three years later,
it actually is revealed that the analysts were correct.
Quaker Oats sold Snapple for $300 million.
So there, getting the winning bid doesn't mean you win.
You may actually be losing because you paid too much.
So, in general, this is the idea, then, of asymmetric information.
And if you're playing a game of bidding with other people,
suppose I am bidding against Warren Buffett.
I don't think I want to play that game too much because Warren Buffett has so
much more information than I do.
So, when I go and try to acquire something, I may be prone to the winner's
curse, while Warren Buffett, having more information, much less so.
So, as we just mentioned, Quaker Oats overpaid for Snapple by over $1 billion.
In terms of some of the categories that we've discussed in this video,
what are some possible reasons to explain why such an over-evaluation may occur?
So, please reflect on this question and post your response in the discussions for
this video.
Thank you.
To finish up with this video, we can ask the question,
under what scenarios can the bidder do well?
The first one is luck, that even if you're the highest bidder of many different
bidders, the actual value may be greater, but I wouldn't count on that.
For example, suppose you take just a normal distribution.
A normal distribution occurs when you have 30 people or more voting.
You get this kind of distribution.
And you're way out there on the tail of the distribution.
That is, you're bidding the highest.
The probability that if you don't have any more information than anyone else,
the probability that the value is actually greater than your bid is less than 5%.
So, 95% is going to be,
the other 29 bids are going to be correct that you've overpaid for that.
You may get lucky, and 5% of the time you may be right and the other 29 are wrong.
Matter of fact, another interesting question to ask is, whatever you bid
on a company, suppose there were, instead of 30 bidders, there were 60 bidders?
Should you bid higher or lower than your bid with 30 people,
or 29 others competing with?
Now you're competing with 59 others.
Interestingly enough, the answer is you should actually bid less.
And the reason is the following logic.
What's worse than being the highest bidder of 30 bidders?
Well, the answer is, in this example of being the highest bidder of 60 bidders.
because now you're banking on you being right and the other,
not 29 being wrong, but now 59 being wrong.
So, your chances now of luckily getting the highest bid to be correct
has gone from 5% to 1% or less than 1%.
So, and that brings us into this idea,
once again as we had in the previous slide, of the winners curse.
The second way you'd come out ahead is if you had asymmetric information.
That was my Warren Buffett example.
So, just take an example here.
Here's a $5 bill.
We can bid right now.
We can have everyone watching this video bid on this $5 bill.
What's the winning bid going to be?
What's the efficient market?
Expectation of the winning bid on this $5 bill.
Well, this is common knowledge of a common value.
So, the efficient market means that the winning bid will be 4.99 or $5.
That is, you can't purchase this asset and make money.
You're going to get a competitive rate of return on your investment.
But now let's play the game where I took a random bill out of my pocket,
a $1 bill, $5 bill, $10 bill.
And then, let's have us all bid on that.
Well, let's have one person, Warren Buffett, who actually gets to see every
time what the bill is, and then we play a bidding game with Warren Buffet.
That's not going to be a very fun game to play because the rest of us are going to
be prone to having the winner's curse problem,
while the person with the asymmetric information will always come out ahead.
Finally, the last category is, how can you overcome the efficient market?
And within our strategy class,
we've been emphasizing this idea of asset specificity.
Let's take a non-asset specificity case.
Let's say there's nine rolling mills, and there's one blast furnace.
The rolling mill companies want to buy the blast furnace, and you have nine or
ten different companies bidding.
Well, suppose that blast furnace is worth to each of those companies $10 million.
Well, it's just like bidding for that $5 bill.
You have a competitive bidding by all these companies.
And when they bid, they're just going to keep bidding up until the value that they
actually provide to the blast furnace is equal to the amount
in which the blast furnace owner appropriates all the gains.
And the winning bid in the efficient market hypothesis is that the winning bid
of the rolling mill will be an NPV of zero.
But now, let's flip it around to be not competitive bidding.
But suppose we have one blast furnace company and one rolling mill company.
And suppose,
now, let's say that the value of combining these assets together is 10 million.
Well, now you don't have efficient markets.
You don't have competitive bidding.
Now, you have specific assets.
And there, the expectation is that the bidding company will come ahead.
So, the specific, so, this is what I said if there's one blast furnace,
one rolling mill, on your slide there, you see the concept co-specialized asset.
That's what co-specialized asset means, one buyer one seller.
And in that particular case, the buyer can come out ahead.
So, the buyer may get, matter of fact, if you share it equally,
the buyer can get 5 million and the seller can get 5 million.
So, to sum up the slide then, how do you come out ahead when you're bidding?
Luck, but don't count on it.
Second, to have asymmetric information.
And third, is if you're a buyer who has a unique asset or
some kind of asset specificity.
In that situation, you can overcome the efficient market hypothesis in finance and
you can potentially come out ahead.
That's it for this video, and hope to catch you in our next video soon.
Take care, bye.
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