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Why acquisitions are good for business

Wednesday, July 12, 2017 - 06:00
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Acquisitions get a bad rap. Acquisitions are described as risky. Acquiring companies are portrayed as evil raiders and titans. Tales of high stake chest thumping negotiations between power brokers fill our conversations. Stories of lay-offs, firings, law suits and forced relocations ensue. But even with all of the negative, I know that acquisitions are good for business.

Acquisitions are misunderstood

One of my favorite pastimes is to read about the great deals of our times. Carl Icahn’s hostile takeover of TWA. KKR’s acquisition of RJ Reynolds. Ron Perelman’s takeover of Revlon, and many others.

These types of high profile deals are indeed often dominated by larger than life raiders, huge egos, and lay-offs and forced liquidations of once prized corporate assets. But these types of deals represent a small minority of acquisitions. And the rationale for these types of deals are often very different compared to that of a typical privately held company.

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Improved cost structure

Acquisitions are good if you want to improve the cost structure of your business. One of the primary benefits of engaging in an acquisition based growth strategy is an improved cost structure. The improved cost structure arises as a result of building economies of scale, leveraging purchasing power, improving efficiencies and other business performance, or simply rationalizing underutilized business assets. These cost synergies are often the cornerstone of the investment thesis and considered the most “likely” of benefits to be realized by the acquiring company. But beware, simply because cost synergies have been identified does not imply they are guaranteed to materialize. Some deals may actually have negative synergies, depending on the industry as well as the specifics of the individual companies involved in the transaction.

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Increased cash flows

Acquisitions are good if you want to increase your cash flow. A strong allure of pursuing acquisitions is simply to build a larger empire. And while the desire to grow large for the sake of empire building is a not a recommended business strategy, the ability to sustainably grow cash flows in a systematic way very much is. Acquisitions allow a company to leverage both cost and revenue synergies, leading to increased cash flow. When negotiated and structured appropriately, acquisitions can provide a positive stream of cash flows day one, something brownfield and greenfield investments are unable to provide.

Greater diversification, decreased risk

Portfolio Theory (i.e. diversification) effectively states that a diversified portfolio of stocks lowers risk while increasing return when appropriately diversified (and yes, I’m massively simplifying into one sentence one of the most influential concepts in finance over the last century). A business can diversify in a similar way. Acquisitions are good for diversification. An acquisition based growth strategy provides diversification benefits to the business, lowering non-systemic risk while increasing returns.

Higher valuation

Acquisitions are good if you want to increase the value of your business. Aquisitions provide a proven way to increase the relative valuation of your business. Growth through acquisitions provides a company a way to not only grow cash flow, which results in a higher valuation, but to also increase the multiple on which these cash flows are valued. While there are a lot of factors that influence valuation and multiples, the simple fact remains that, all else equal, a larger company will command a larger multiple than a smaller company. Put differently, a company with $10 million in EBITDA will have a higher multiple than a company with $1 million in EBITDA. These are just a few of the reasons why acquisitions are good for business.

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