Majority of 2011 M&A Deals Stand to Backfire Unless Merger Strategies Center on Building Capabilities – Not Diversification, According to Booz & Company Quantitative Research

A capabilities-driven M&A strategy is one of the surest ways to make the most of the money, energy and time that global companies are expected to devote to deal making this year, according to Booz & Company Partners Gerald Adolph and Paul Leinwand.

New York (March 30, 2011) With trillions of dollars in cash on their balance sheets, many of the world’s largest companies will make significant acquisitions during the balance of 2011. Experts are predicting vigorous global M&A activity, with the dollar volume of deals increasing by more than a third from last year, nearly matching the biggest year ever, 2006.

But money and opportunity are only a small part of a winning M&A strategy. According to Booz & Company research among hundreds of deals across multiple sectors, including healthcare, utilities and consumer staples, the most successful M&A strategies are geared toward leveraging the distinctive capabilities of one, or both, companies; they’re not geared primarily for diversification. In all three sectors analyzed, the results were the same: Deals done to add capabilities had significantly more winners than losers (ranging from 38% to three times more winners than losers, depending on the sector).

Deals done for the purpose of diversification, however, were more likely to fail than to succeed (up to 40% more losers than winners, depending on the sector).

The data make it clear that a capabilities-driven M&A strategy is one of the surest ways to make the most of the money, energy and time that global companies are expected to devote to deal making this year, according to Booz & Company Partners Gerald Adolph and Paul Leinwand. Leinwand is co-author of the recent The Essential Advantage: How to Win with a Capabilities-Driven Strategy (Harvard Business Review Press, December 2010), and Adolph is co-author of Merge Ahead: Mastering the Five Enduring Trends of Masterful M&A (McGraw-Hill, Spring 2009).

Why Capabilities-Driven M&A Works

“It’s no surprise that M&A strategies with a capabilities lens outperform others: In today’s competitive marketplace, companies that have a winning set of capabilities create significantly more value than their peers and M&A is one vehicle for making sure that you have the right capabilities and right portfolio that leverages what you’re great at,” said Adolph.

“Winning companies align their strategic direction to the capabilities that make them unique. They make hard choices about differentiation and stick to them. They understand that differentiating capabilities are more valuable than assets like facilities, equipment, and even brands. They apply a capabilities lens to all their acquisitions: they only consider those targets that strengthen their own capabilities system or that bring along a market that can benefit from what they do particularly well,” Leinwand said.

Amazon.com: A Master of Capabilities-Driven M&A

Adolph and Leinwand believe that Amazon.com has demonstrated a highly successful capabilities-driven approach to M&A. In its first 15 years as an e-commerce pioneer, instead of buying assets (like catalogues, customer lists, and warehouses), Amazon has systematically sought deals that bring it either complementary capabilities that fit its existing capabilities system, new arenas in which to use its capabilities more effectively, or both. Among Amazon’s capabilities-driven deals…

  • Audible.com, a producer of audio books, helped Amazon create a digital audio-reading feature for the Kindle.
  • Joyo, the number one online bookstore in China, helped them build capabilities for logistics, distribution, and processing payments in China.
  • Dpreview, digital photography review site, gave Amazon the capabilities in managing user-generated commentary, making Amazon the world’s richest forum of user-generated commentary on phones, PDAs, and computer-based devices.
  • Zappos, the online shoe and apparel store, gave Amazon direct in-person customer support capabilities, which complemented Amazon’s automated capabilities.

“Every benefit of an acquisition, from new products, to new markets, to cost cutting is an outgrowth of a successful capabilities strategy. Executives considering M&A should therefore be looking to acquire capabilities that support their existing strategy,” Leinwand said.

Added Adolph, “A merger or acquisition should not be its own strategic exercise that distracts from the current strategy, or dilutes existing capabilities that provide valuable competitive advantage.”

Rules of the Road: Five Recommendations for Capabilities-Driven M&A

Adolph and Leinwand put forth five key rules that they believe will enhance the M&A strategy of any company by making it more capabilities-driven:

  1. Conduct capabilities due diligence: Stress tests have to go beyond financial and legal due diligence and beyond the typical aspirational strategies. They have to look at the capabilities of the combined entity: Will the combined capabilities system strengthen the company’s competitive advantage and produce an enduring, attractive economic return?
  2. Cut smart, integrate better: Capabilities are less visible than assets e.g., plants, customer lists, patents, etc. but they are more important. After a deal, however, capabilities can come under pressure due to cost and headcount reductions. Therefore, companies should identify key capabilities (e.g., people, processes, activities, systems) in advance, make plans to migrate and invest in those, while other parts of the business can be de-emphasized, closed, or sold.
  3. Structure for maximum effectiveness: Think through the best way to leverage capabilities in the post-integration company. For example, when Mars acquired the William Wrigley Jr. Company in 2008, it not only left the Wrigley Company as a stand-alone business, Mars transferred its own non-chocolate brands, such as Starburst and Skittles, to Wrigley’s portfolio. This provided the real underlying value in the acquisition: to create a new division for non-chocolate brands, and establish a better platform for growth as a purveyor of innovative, flavor-driven impulse purchases.
  4. Preserve knowledge: When negotiating a deal, executives may not know which people and processes to focus attention on, and which can be let go. Smart companies therefore must take steps to retain the people and capabilities that prompted them to make the deal in the first place. When P&G bought and relocated Tambrands (the makers of Tampax) in 1997, it knew that many executives would not make the move. So P&G interviewed many of the Tambrands veterans and created a knowledge database searchable with fuzzy logic.
  5. Make M&A a core capability: For some companies, proficiency in acquisition and integration is part of their distinctive capabilities system. At others (such as Amazon), it’s an important “table-stakes” function. In either case, the way in which M&A is conducted can dramatically reinforce a company’s focus and competitive advantage, especially if these practices are repeated, time after time, until they become second nature.

The authors maintain that a full range of M&A questions, challenges and imperatives are best addressed and viewed through a capabilities lens. These include…

  • Determining the main M&A trends in a wide range of industries, e.g., consumer packaged goods, financial services, healthcare, and technology.
  • Understanding why acquiring for the core of the business is the most effective M&A strategy.
  • Avoiding mistakes when using M&A to move into adjacent markets.
  • Averting pitfalls when using M&A to expand a company’s geographic footprint.

To learn more about The Essential Advantage and Capabilities-Driven Strategy, visit www.theessentialadvantage.com.

About Booz & Company’s M&A Research
Booz & Company identified and evaluated 630 M&A deals in the healthcare, utilities and consumer staples industries over a 10+ year period to assess performance one and two years after the deal announcement. The firm then classified the rationale of each transaction as either capability building (acquiring companies because they bring a needed new or better capability to support a primary way to play), diversification (deals done to allow the acquiring company to enter a new sector or industry), or scale and consolidation (purchasing other companies with the same basic types of product lines and capabilities). The authors calculated acquirers’ excess returns versus the return of the S&P 500 Sector Index and compared winners vs. losers.