This is “The Board’s Involvement in Strategy: Special Situations”, section 7.3 from the book Governing Corporations (v. 1.0).
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Two dimensions of strategy formulation merit special attention because they require substantial board involvement and typically are subject to detailed scrutiny by investors and other stakeholders—crafting a capital structure for the corporation and dealing with a takeover, merger, or acquisition proposal.
Deciding on an appropriate capital structure is a strategic board responsibility. Businesses adopt various capital structures to meet both internal needs for capital and external requirements for returns on shareholders investments. A company’s capitalization shapes its balance sheet and is constructed from three sources of capital:
In deciding on a company’s financial structure, management often seeks to minimize the cost of capital, whereas investors look for the greatest possible return. While these desires can conflict, they are not necessarily incompatible, especially with equity investors. This is because the cost of capital can be kept low and the opportunity for return on common stockholders’ equity enhanced through what is called “leverageA high percentage of debt relative to common equity.”—creating a high percentage of debt relative to common equity. Doing so, however, increases risk. This is the inescapable trade-off both management and investors must factor into their respective decisions.
The leverage provided by debt financing is further enhanced because the interest that corporations pay is a tax-deductible expense, whereas dividends to both preferred and common stockholders must be paid with after-tax dollars. Thus, it is argued, the lower net cost of bond interest helps accrue more value for the common.
Higher debt levels increase a firm’s fixed costs that must be paid in good times and bad, and can severely limit a company’s flexibility. Specifically, as leverage is increased, (a) the risk of bankruptcy grows; (b) access to the capital markets, especially during times of tight credit, may diminish; (c) management will need to spend more time on finances and raising additional capital at the expense of focusing on operations; and (d) the cost of any additional debt or preferred stock capital the company may have to raise increases.
Because of its tax advantages and stability relative to equity capital (common stock), some finance experts have argued that higher proportions of debt capital may be advantageous to corporations. Their advice is not always heeded, however. Although periodically companies use debt to buy back common shares, a practice that can improve stock performance, most large companies rely heavily on equity financing.
Companies tend to use debt under certain circumstances more than others. For example, the decision whether or not to use debt is often related to the nature and risks of the cash flows associated with the capital investment. When diversifying into new lines of business, companies that are moving into related fields tend to use equity capital and those entering unrelated fields tend to use debt. Ownership structure is another factor. Firms with a high degree of management ownership, for example, are less likely to carry high levels of debt, as are corporations with significant institutional ownership.
In earlier days, a debt-free structure was often considered a sign of strength, and companies that were able to finance their growth with an all-common capitalization prided themselves on their “clean” balance sheet.
The advent of leveraged buyouts (LBOs)Acquisitions of other companies with a large amount of borrowed monies. Typically, the assets of both the acquired company and the company doing the acquiring are used as collateral in the purchasing. of the 1980s brought a new twist to the capitalization issue. Because of their low degree of leverage, large corporations with conservative, low-debt capitalizations became vulnerable to capture. Corporate raiders with limited financial resources were successful in raising huge amounts of noninvestment grade (“junk”) debt to finance the deals. The captured companies often would then be dismembered and stripped of cash holdings so the raiders could pay down their borrowings. In effect, the prey’s own assets were used to pay for its capture. As a takeover defense, potential targets began to assume heavy debt themselves, often to finance an internal buyout by its own management.
By purposely leveraging their prey so highly (at times with current income insufficient to meet current interest requirements) that the company could not continue to conduct business as usual, raiders forced cuts in low-return growth avenues and the sale of those divisions, which are more valuable outside the firm. In the process, a significant amount of intrinsic firm value was distributed to stockholders—especially those who had bought in for just that purpose—at the expense of other stakeholders and the company’s long-term needs. They justified their actions by stating that managers who operated with low leverage were either inept or feathering their own nest, or both.
Takeovers, mergers, and acquisitions are an integral part of corporate strategy and not only provide important external growth opportunities for companies but also involve considerable risks for the firm and its shareholders. A mergerThe joining of two companies to form one company. signifies that two companies have joined to form one company. An acquisitionThe purchase of one company by another. occurs when one firm buys another. To outsiders, the difference might seem small and related less to ownership control than to financing. However, the critical difference is often in management control. In acquisitions, the management team of the buyer tends to dominate decision making in the combined company.This section is based on de Kluyver and Pearce (2008), chap. 9; and Rérolle and Vermeire (2005, April 29).
The advantages of buying an existing player can be compelling. An acquisition can quickly position a firm in a new business or market. It also eliminates a potential competitor and therefore does not contribute to the development of excess capacity.
Acquisitions, however, are also generally expensive. Premiums of 30% or more than the current value of the stock are not uncommon. This means that, although sellers often pocket handsome profits, acquiring companies frequently lose shareholder value. The process by which merger and acquisition decisions are made contributes to this problem. In theory, acquisitions are part of a corporate growth strategy based on the explicit identification of the most suitable players in the most attractive industries as targets to be purchased. Acquisition strategies should also specify a comprehensive framework for the due diligence assessments of targets, plans for integrating acquired companies into the corporate portfolio, and a careful determination of “how much is too much” to pay.
In practice, the acquisition process is far more complex. Once the board has approved plans to expand into new businesses or markets, or once a potential target company has been identified, the time to act is typically short. The ensuing pressures to “do a deal” are intense. These pressures emanate from senior executives, directors, and investment bankers who stand to gain from any deals, shareholder groups, and competitors bidding against the firm. The environment can become frenzied. Valuations tend to rise as corporations become overconfident in their ability to add value to the target company and as expectations regarding synergies reach new heights. Due diligence is conducted more quickly than is desirable and tends to be confined to financial considerations. Integration planning takes a backseat. Differences in corporate cultures are discounted. In this climate, even the best designed strategies can fail to produce a successful outcome, as many companies and their shareholders have learned.
Most studies carried out in this area show that the probability of a major acquisition or merger failing (as measured in terms of financial return) is greater than the probability of success. Empirically, the probability of failure increases with the size and complexity of the merger and with the degree of unfamiliarity with the target business. They also show that the buyer often pays too much for the target company because it is overoptimistic in terms of its ability to (a) do better than the existing management, (b) implement the synergies identified, and (c) integrate the target within its own company in a timely manner.
The application of new international accounting standards (and, more particularly, International Accounting Standard (IAS) 36 on impairment of assets) forces companies to examine the value of their assets, especially that of their intangible assets, on a recurring basis. As a result, each overpaid acquisition will inevitably result in impairment of goodwill, and, sooner or later, the board and management will have to publicly admit that their decision has destroyed shareholder value. This new regulation alone is a powerful reason for boards to go beyond merely approving major transactions and become much more actively involved in merger and acquisition (M&A ) activity than in the past.
The very nature of the M&A process makes the board’s involvement a particularly sensitive issue, however. An acquisition frequently results from a long, confidential negotiation process, often involving extremely technical issues, and its outcome is largely uncertain. These factors lead management to present the board with only summary and high-level information on the opportunity and to wait for the outcome of the process before organizing in-depth discussions with the board.
This is unfortunate because M&A activity represents a unique opportunity for a board to add value. Outside directors may have unique experience with the M&A process, particular intermediaries, or with all too often overlooked merger integration challenges. At the very least, the outside view offered by the board at an early stage may counterbalance the optimism of the executives driving the deal or the partiality of numerous experts pushing for its completion, resulting in a more “realistic” attitude to the opportunity.
Rérolle and Vermeire (2005) identify a number of useful best practices to assist boards in M&A planning and execution:
Validate the strategic benefits of the transaction. Every major acquisition must take place within an established strategic framework. Many mistakes are attributable to acquisitions that are justified only after the fact as a “strategic fit.” At a minimum, the board should ask how the opportunity came about—whether it is something the company’s management has been working on for some time, whether it concerns a business activity or market with which the company is familiar, and whether it represents geographical or other diversification.
Also, rarely can an acquisition be justified solely on the grounds of the savings it will generate because they are often illusionary. It must either meet a need that has been clearly defined up front and which the company cannot meet using its own resources, or it must enhance the company’s competitive position. In order to create value, the acquisition must make it possible to build a genuine competitive advantage or to decisively prolong an existing competitive advantage. The directors’ role is to test the solidity of this premise.
Verify that the price paid is reasonable. Ultimately, analyzing an opportunity culminates in a valuation. Such a valuation should reflect a realistic assessment of (a) the intrinsic value of the target in accordance with a number of different scenarios, (b) the value of expected synergies (and the cost of implementing them), (c) the positive and negative impacts of the transaction on the value of the purchaser’s company (e.g., management will have to devote considerable time to integrating the target, which may have an adverse impact on the purchaser’s business activities), and (d) the price that management offers to pay and the terms and conditions of payment.
Furthermore, when a proposed acquisition is of particular significance in light of the company’s size and when there is a possibility of a conflict of interest or a challenge by the minority shareholders concerning the price paid, it is advisable to have a fairness opinion drawn up by an independent expert.Usually, such opinions are prepared by the company’s financial advisers or other consultants hired by management (who naturally hope to gain repeat business). The board must ensure that this expert appraisal is carried out in a truly independent manner. The board must therefore verify the independence and skills of the expert(s), and, when the report is submitted, it must ensure that the work was carried out properly, in accordance with the professional standards in force. This assumes that at least one member of the board has adequate, relevant experience or that the board is assisted by another expert to help it in this task of supervision.
Ensure that a comprehensive due diligence process has been carried out. Due diligence is of critical importance as it enables the purchaser to verify the integrity of the seller’s financial statements, representations, and warranties, and to identify potential problems.
The due diligence must be based on broad (but relevant) objectives concerning the integration of the target. All too often, due diligence is mainly based on legal and accounting criteria, whereas the company needs to identify all the areas of major risk and, in particular, current and future operating risks, or others that may constitute an obstacle to effective integration. A comprehensive due diligence process covers items, such as an analysis of the target’s competitive advantages and their durability, the identification of key people (in particular those that the company may rely on for the purposes of integration), and the measurement of the stability of the most significant customer relations and the long-term prospects of formal or informal alliances.
Approve a specific integration plan. Experience has shown that integrating the target is the most complex part of the M&A process. In spite of a broad consensus on this point, this difficulty remains largely underestimated. The board can play an important role in alleviating this major problem by asking management to provide it with an integration planThe process of uniting or blending either a merged or an acquired company into another. prior to concluding the transaction. In particular, this plan needs to include (a) a timetable for the integration program, (b) an identification of the main initiatives undertaken by management to recover a significant portion of the control premium paid, (c) an assessment of the human resources and expertise to be earmarked for the integration process, and (d) a detailed business plan showing all the costs and benefits associated with integration.
During mergers and acquisitions, boards tend to focus on the strategic, financial, and governance aspects of a transaction. They often neglect one of the greatest sources of value in many M&A transactions: the talent of the management team in the target company. Exercising due diligence about talent is as important as paying close attention to the balance sheet, cash flow, and expected synergies of a deal. By asking management a series of questions about human capital in a merger or acquisition, boards can contribute to a smoother transition to a single company, a better merging of cultures, the loss of fewer “A” players, and a stronger talent bench for the merged company—all of which should ultimately create more value from the deal.