This guide explains some of the strategic rationale behind M&A deals. We look at why M&A is valuable, the difference between financial and strategic buyers, growth through strategic M&A transactions, and we overview some common acquisition strategies. Here are some key takeaways about M&A strategy:
The term “mergers and acquisitions” refers to the purchase and sale of a business or the consolidation of two or more business entities. In an M&A transaction, a company could acquire another business outright, two companies could merge together creating a new company, or a business could acquire some or all of another business’ assets.
When someone refers to M&A strategy, they’re referring to the underlying motivation for doing the deal. Companies form an acquisition strategy based on what they’re trying to achieve with the deal. Generally, the two major motivators for doing an M&A deal are to add value to the business, or to reduce the risk of competition.
This guide will explain some of the strategic rationale behind M&A deals.
To understand M&A strategy, we need to understand the difference between two types of buyers—financial and strategic buyers. Beyond turning a profit, financial and strategic buyers have different objectives for making acquisitions.
Strategic buyers are other businesses looking to make acquisitions to grow their business, reduce costs, or eliminate competition. Financial buyers are institutions (such as private equity firms) that are non-operators, looking to use financial leverage to make acquisitions and create value through equity rate of return.
A financial buyer is a type of buyer that’s interested in making an acquisition because of the return that can be made above and beyond the purchase price. Their primary focus is on the cash flow of the target business and on the potential exit strategy they can use to realize their return on investment.
The term financial buyer most often refers to a private equity company. Financial buyers use leverage to make acquisitions, meaning they borrow money from other investors and financial institutions to finance their acquisitions.
Financial buyers typically work on a five- to ten-year time frame—meaning they plan to exit the business in five to ten years. Various exit strategies could include taking the company public with an IPO, or an outright sale of the business or its assets.
Financial buyers look to improve the companies they purchase from a financial standpoint before they look to make changes to the management of the business. They typically look to generate more cash flow by boosting revenue with a capital investment, by cutting costs, or by achieving economies of scale through purchasing complimentary businesses.
Strategic buyers are primarily concerned with achieving synergies and how the target business could help them achieve their strategic goals. The main idea with strategic mergers and acquisitions is that the company would improve its core business by making this deal.
Financial buyers are typically non-operators, meaning they would prefer to make an acquisition and not need to get involved with the day-to-day of running the company. Because of this, financial buyers are typically long-term focused (five- to ten-year exit strategy) and aim to make a return on buying a well-run and well-managed business over time.
Financial buyers may be more concerned with the target company’s ability to generate quick cash flow than strategic buyers, who can often benefit greatly from strategic improvements. Part of this has to do with the fact that financial buyers typically use more leverage in a transaction than strategic buyers do. This cash flow is often required to offset a debt repayment structure.
Strategic buyers tend to be large companies that are well capitalized and able to look past immediate cash flow and instead focus on the possibilities for the growth of their core operations.
This section will look at the strategic benefits of M&A deals. To understand M&A strategy, you need to understand synergies. The basic premise of synergies is that two companies, when combined through a merger or through an outright acquisition, will be more valuable in combination than they would separately.
There are two different categories of financial synergies—cost savings and revenue enhancements. You can learn more about financial synergy here. Cost savings are financial synergies that occur when two companies merge, and the effect is lowering the costs of doing business through increased operating efficiencies. Examples of cost savings would be layoffs or a reduction in distribution costs as a result of the M&A deal. Revenue enhancements are financial synergies that result in the business’ ability to generate more cash flows through more effective use of assets. Examples of revenue enhancements resulting from M&A deals would be access to new markets, the opportunity to push price points, or to upsell newly acquired products to an existing customer base.
The basic idea is that after the merger or the acquisition, the resulting business will be better than it was before.
Strategic buyers are generally more interested in financial synergies than financial buyers are. Although this isn’t to say that financial buyers don’t benefit from financial synergies. Often financial buyers such as private equity companies will specialize in specific sectors or industries and, as a result, can benefit more from synergies than may be expected.
For strategic buyers, while the pursuit of synergies is important, there is more to the strategic rationale behind an M&A deal than synergies alone. There are two major acquisition strategies that strategic buyers often use when looking at M&A deals—vertical integration and horizontal integration.
Vertical integration is a business strategy where a company streamlines or expands its operations by taking ownership of more than one stage in its supply chain. Supply chains refer to the entire process of producing a product from sourcing the raw materials to produce the product to selling the end product to customers. Typical supply chains include the sourcing of raw materials, manufacturing, assembly, distribution, and retail selling of products or services. Vertical integration is often achieved through a merger with or an acquisition of a distributor, manufacturer, retailer, or production company.
Horizontal integration is a business strategy describing a merger with or an acquisition of a competing business. The primary motives for horizontal integration are to eliminate a competitor, increase revenue, and expand into new markets.
So, vertical integration is when a business does an M&A deal with another business in their supply chain (ie. Buying a manufacturing plant) and horizontal integration is when a business buys a competitor. Both of these strategies aim to increase the value of the business and/or to eliminate the risk of competition. Both vertical and horizontal mergers or acquisitions aim to create financial synergies (cost savings or revenue enhancements) through these acquisition strategies.
Generally, there are two growth strategies for an operating business—organic and inorganic growth.
Organic growth is growth to the core operations of the business. Organic growth comes mainly from getting new customers through marketing and selling, getting those customers to purchase more times, and getting them to spend more per transaction.
Inorganic growth, in contrast, is growth from M&A transactions rather than through scaling core operations of the business.
These concepts pertain more to strategic buyers than financial buyers because the core operations of a financial buyer are their M&A deals.
However, it’s worth noting that more mature companies (strategic buyers) can often see inorganic growth as a way to grow faster than they could organically. This happens when those companies grow over many years and manage to reach the limits of their total addressable markets.
Unlike small businesses that grow almost entirely organically, more mature companies start to see bigger gains from inorganic growth (M&A deals) than they do from growing their core operations further. Growing by 10 percent is comparatively easy for a small business as opposed to a business doing more than $1 billion in sales.
For more on these two different growth strategies, we’d recommend out guide: Organic vs Inorganic Growth. This guide also goes into detail about how there is an inverse relationship between how long a business has been around (financial track record) and its ability to get debt funding.
Most M&A deals involve some sort of financial leverage (using debt to help fund the transaction). More mature companies with strong financial track records will find it easier to get access to the debt required for M&A deals—making inorganic growth more feasible as a long-term strategy.