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Deal or no deal

Deal or no deal

You've got your eye on a new acquisition, but is it really worth it? Having the right business model is key to success.


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Nostalgia is a seductive liar

Nostalgia is a seductive liar. It would be understandable if many veteran executives in the consumer goods industry indulged in misty-eyed reverie about the good old days, when double-digit growth was the norm, channels to market were straightforward and consumers were slavishly loyal.

In truth, business life was never that simple or rosy – there were still recessions, wars, corporate failures – but the memories contain some truth. In the heyday of the big multinational manufacturers and retailers, as Mark Belford, Co-Head, Consumer & Retail Banking at KPMG Corporate Finance in the US, puts it, “It was possible to succeed with what I call an inertia-based enterprise. If you had the products, distribution and marketing, the business would almost look after itself.”

Life – especially if you run a global brand – just isn’t that simple any more. Take growth, for example. Liz Claydon, Head of Consumer & Retail for KPMG in the UK, says: “Companies are finding organic growth harder to come by. Our barometer of leading consumer packaged goods companies shows that the median compound annual organic growth rate decreased from 4.2 percent in 2015 to 3.4 percent in 2016. Companies can grow faster – the top performer has enjoyed a median organic growth of 7.7 percent over the past six years – but it is becoming difficult to grow the business by launching a new product or taking an existing product into new markets where competition from local brands is intensifying.”

On top of that, the business is having to cope with changing customer preferences, digital technology and disruptive innovators, many of which are funded by private equity investors or venture capitalists for whom the potential rewards justify the risks. The spectacular success of Dollar Shave Club, the subscription model grooming company, began when a group of venture capitalists decided to put money into several start-ups that would disrupt Procter & Gamble’s business. They didn’t all work but five years after Dollar Shave’s launch in 2011, the company was acquired by Unilever, for US$1bn, according to media coverage. That, as Belford says, is the kind of return that will encourage investors to make similar bets.

In response to such radical and rapid change, the major players are looking to simplify their model – in KPMG’s barometer, the companies that generated most organic growth often focused on a single market and a single brand. That means rationalizing their portfolios – which is why we have seen, for example, Unilever putting its spreads business up for auction – but also strengthening them in the right areas – which is why Unilever has also acquired fast growing South Korean skincare brand Carver Korea for US$2.7bn.

Time for a good deal

There are, according to Mark Harrison, Deal Advisory Partner at KPMG in China, good reasons why acquisitions seem particularly attractive now. Interest rates are at historic lows, many companies have large cash reserves and many global groups recognize that the right acquisition can help accelerate change. The global volatility in the sector is also driven by businesses in emerging, relatively high-growth economies looking for new markets, know-how and technology.

The Western perception is that corporate China’s appetite for foreign acquisitions has diminished as companies heed recent government warnings about the need to invest in their domestic market, yet Harrison says this is an over-simplification. “If you want to acquire companies with technology to assure the food supply, or invest in infrastructure projects in Bangladesh, allied to the One Belt One Road project, this is clearly now supported by government policy. However, non-core investments not aligned with government policy such as a football club or real estate will likely be more challenging.” Food and drink remains of strategic importance to China – if it can improve the safety and image of its brands, domestic players could increase their market share – so Harrison expects its companies still to be in the market for the right acquisition.

The difficult bit is making sure you have the right deal. The crux of the problem, as Clayton M. Christensen, the world’s most influential innovation guru noted in his Harvard Business Review article The Big Idea: The New M&A Playbook, is that: “Many executives fail to distinguish between deals that might improve current operations and those that could dramatically transform the company’s growth prospects. As a result, companies too often pay the wrong price and integrate the acquisition the wrong way.”

The right business model is key

As Belford says, the easiest way to build a rationale for an acquisition is to calculate the impact on unit cost. Yet that means that, in effect, there is a confirmation bias in favor of acquisitions that improve performance. The trouble is, CEOs often overestimate the gains to be made from such deals, pay too much and fail to integrate the target properly. Even if an acquisition is well integrated, Christensen argues, it rarely changes the company’s trajectory because investors anticipate – and discount – such improvements as soon as a deal is announced. This matters because, as Alfred Rappaport and Michael Mauboussin noted in their 2003 book Expectations Investing, “it is not earnings growth per se that determine growth in a company’s share price – it’s growth relative to investors’ expectations.”

This is especially true today when, as Belford says, the relationship between shareholder and corporate leadership is more volatile than ever. There are, he says, about 10 activist investors who can create anxiety in North American boardrooms. In October 2017, billionaire hedge fund manager Nelson Peltz narrowly lost his expensive campaign to win a place on the board of Procter & Gamble and challenge the company’s current business model.

Christensen argues that business models are at the heart of why some acquisitions work and others don’t. It’s hard to integrate a business if you don’t understand it and he says that four elements of every acquisition’s business model are critical:

  • The customer value proposition. Whether the offering helps customers do a vital job more effectively, conveniently or affordably than the alternatives.
  • The profit formula. How the revenue model and cost structure ensure that the company generates profit and the cash to sustain operations. 
  • The resources. Employees, customers, technology, suppliers, products, facilities and cash – companies use to deliver the customer value proposition.
  • The processes. Manufacturing, R&D, budgeting, sales and marketing. Plugging resources into the existing business is, usually, not that difficult.

Integrating the other elements is trickier. As Claydon says, “Many of the big brands are acquiring disruptive start-ups, often through their own venture capital arms. They recognize that their operating models and processes can be too bureaucratic and that they need the agility and speed of a start-up. The challenge then is to remember why they are buying the company – keep the talent with the right incentives, and try to retain what made the customer value proposition so distinctive.”

Given that the world’s companies spent, the Sunday Times estimates, US$4.4tn on acquisitions in 2015, it may sound absurd to suggest that all these issues are not thoroughly thought through. Yet many clearly are not. “You can’t think about post-acquisition execution too early – or too deeply. These deals generate a momentum of their own but sometimes soon after the deal is done, companies realize they may have limited experience with what they’ve just bought,” says Harrison.

Sometimes, Belford says, deals can go awry because companies drill down too hard on the numbers. “Don’t get me wrong,” he says, “there is no point in paying too much but often companies don’t proceed because they don’t factor in the intangibles. There is a ‘soft power’ aspect to every acquisition. Will the target company make you look cool and help you appeal to a new audience? Will it lead to you working with innovative suppliers? How committed are their customers – if they’re fiercely loyal does that make the target more valuable?”

Such questions are particularly critical when assessing the worth of a disruptive start-up. Typically, as Christensen notes, these find a niche because their product is simpler and more affordable than existing offerings. Envisaging how effectively they will move to higher-performance, higher- margin products is difficult, so many investment analysts play it safe and underestimate growth. This makes the deal look riskier to an acquisitive CEO who might pull back from the kind of target that could – if it achieves what Claydon calls premiumization – change the company’s trajectory.

Every day the wrong businesses are bought for the wrong purpose at the wrong price. Yet this needn’t be the case. Acquirers who do their due diligence thoroughly increase their chances of success. Belford also says that companies need to be realistic about their own culture. “One piece of advice I always give to companies is ‘Know thyself’. Don’t buy an innovative new start-up if you’re going to micromanage it and destroy its entrepreneurial vigor. Or buy something so complex that you don’t have the time to integrate it effectively.”

This is the question, Claydon says, every acquisitive CEO must ask themselves, is it faster, more economical and more effective to buy something that you could, given enough time and money, make yourself? For an increasing number of consumer goods companies, seeking to create or defend value in a hyper-competitive marketplace, the answer to that is likely to be ‘yes’.

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