Growth Strategies-II

UNIT 10 GROWTH STRATEGIES-II

Objectives
The Objectives of this unit are to:
l acquaint you with the various diversification strategies;
l explain the reasons for pursuing diversification strategies;
l explain the various routes to diversification;
l make clear the mechanics of M&A and the basic steps involved in M&A;
l explain the rationale behind M&A;
l identify the attributes of successful and effective acquisitions; and
l provide you with a brief overview of the M&A scenario in India.

Structure
10.1 Diversification
10.2 Related Diversification (Concentric Diversification)
10.3 Unrelated Diversification (Conglomerate Diversification)
10.4 Rationale for Diversification
10.5 Alternative Routes to Diversification
10.6 Mergers and Acquisitions (M&A)
10.7 Merger and Acquisition Strategy
10.8 Reasons for Failure of Merger and Acquisition
10.9 Steps in Merger and Acquisition Deals
10.10 Mergers and Acquisitions: The Indian Scenario
10.11 Summary
10.12 Key Words
10.13 Self-Assessment Questions
10.14 References and Further Readings

10.1 DIVERSIFICATION
Diversification involves moving into new lines of business. When an industry
consolidates and becomes mature, most of the firms in that industry would have
reached the limits of growth using vertical and horizontal growth strategies. If they
want to continue growing any further the only option available to them is
diversification by expanding their operations into a different industry. Diversification
strategies also apply to the more general case of spreading market risks: adding
products to the existing lines of business can be viewed as analogous to an investor
who invests in multiple stocks to “spread the risks”. Diversification into other lines of
business can especially make sense when the firm faces uncertain conditions in its core
product-market domain.

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Corporate Level While intensification limits the growth of the firm to the existing businesses of the
Strategy firm, diversification takes it beyond the confines of the current product-market domain
to uncharted and unfamiliar products- market territory. In other words, this strategy
steers the organization away from both its present products and its present market
simultaneously. Of the various routes to expansion, diversification is definitely the
most complex and risky route. Diversification approach to expansion is complex since
it seeks to enter new product lines, processes, services or markets which involve
different skills, processes and knowledge from those required for the current
bussiness. It is risky since it involves deviating from familiar territory: familiar
products and familiar markets.
Diversification of a firm can take the form of concentric and conglomerate
diversification. Concentric (Related) diversification is appropriate when a
firm has a strong competitive position but industry attractiveness is low.
Conglomerate (unrelated) diversification is an appropriate strategy when current
industry is unattractive and that the firm lacks exceptional and outstanding
capabilities or skills in related products or services. Generally, related diversification
strategies have been demonstrated to achieve higher value creation (profitability and
stock value) than unrelated diversification strategies (conglomerates).
The interpretation of this finding is that there must be some advantage achieved
through shared resources, experience, competencies, technologies, or other
value-creating factors. This is the so called synergy effect of diversification i.e.,
‘the whole is greater than the sum of its parts’. While it is difficult to predict
what is a “synergistic” match of a business to an existing corporate portfolio, the test
must be that the business creates new value when it is added to a corporation’s line of
existing businesses.

10.2 RELATED DIVERSIFICATION (CONCENTRIC

DIVERSIFICATION)
In this alternative, a company expands into a related industry, one having synergy with
the company’s existing lines of business, creating a situation in which the existing and
new lines of business share and gain special advantages from commonalities such as
technology, customers, distribution, location, product or manufacturing similarities,
and government access. In essence, in concentric diversification, the new industry is
related in some way to the current one. This is often an appropriate corporate strategy
when a company has a strong competitive position and distinctive competencies, but
its existing industry is not very attractive. Thus, a firm is said to have pursued
concentric diversification strategy when it enters into new product or service area
belonging to different industry category but the new product or service is similar to the
existing one with respect to technology or production or marketing channels or
customers. Such diversification may be possible in two ways: internal development
through product and market expansion utilizing the existing resources and
capabilities or through external acquisitions operating in the same market space.
Addition of lease financing activity in India is a case of market-related concentric
diversification. Another type of concentric diversification is technology related in
which the firm employs similar technology to manufacture new products.
Addition of tomato ketchup and sauce to the existing ‘Maggi’ brand processed items
of Food Specialities Ltd. is an instance of technological-related concentric
diversification.

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Growth Strategies-II
10.3 UNRELATED DIVERSIFICATION
(CONGLOMERATE DIVERSIFICATION)
Conglomerate diversification is a growth strategy in which a company seeks to grow
by adding entirely unrelated products and markets to its existing business. A company
that consists of a grouping of businesses from unrelated streams is called a
conglomerate. In conglomerate diversification, a firm generally introduces new
products using different technologies in new markets. A conglomerate consists of a
number of product divisions, which sell different products, principally to their own
markets rather than to each other. Conglomerates diversify their business risk through
profit gained from profit centers in various lines of business. However, some may
become so diversified and complicated that they are too difficult to manage efficiently.
However, since their huge popularity in the 1960s to 80s, many conglomerates have
reduced their business lines by restricting to a choice few. The reasons for considering
this alternative are primarily to seek more attractive opportunities for growth, spread
the risk across different industries, and/or to exit an existing line of business. Further,
this may be an appropriate strategy when, not only the present industry is unattractive,
but the company also lacks outstanding competencies that it could transfer to related
products or industries. However, since it is difficult to manage and excel in unrelated
business units, it is often difficult to realize the expected and anticipated results.
In India, a large number of companies diversified their operations following economic
liberalization. Gujarat Narmada Valley Fertilizers Ltd. has diversified from fertilizers
to personal transport, chemicals and electronic industries, while Arvind group,
hitherto confined to textiles, diversified into unrelated activities such as manufacturing
of agro- products, floriculture and export of fresh fruits. Likewise, BPL has decided
to venture into sectors like power generators, cement, steel and agricultural inputs in a
big way. Wipro is another company with wide ranging business interests
encompassing vegetable oils, computer hardware, and software, medical equipment,
hydraulic systems, consumer products, lighting, export of leather shoe nippers and has
recently entered into financial services (Refer to case study 1 in appendix-2).

10. 4 RATIONALE FOR DIVERSIFICATION

Under strict assumptions of an efficient market theory, there is no convincing rationale
for one company to acquire another, especially less efficient or unrelated businesses.
Since the markets are imperfect and do not follow the norms of efficient market
theory, companies do diversify for several reasons given below:
Economies of Scale and Scope (Synergy): The merger of two companies producing
similar products should allow the combined firms to pool resources and attain lower
operating costs. By making optimal use of existing marketing, investment, operating
and managerial facilities of the two combining firms and eliminating redundant and
overlapping activities, the combined entity can lower the operating costs and increase
operational efficiency. The saving may come from reduced overheads or the ability to
spread a larger amount of production over lower (consolidated) fixed costs. There may
also be differential management capabilities: an efficiently managed firm may acquire
a less efficient firm with the intent of bringing better management to the business.
Efficiencies can also be gained through pooled financial resources or simply through
pooled risk.
Widen Market Base and Enhance Market Power: Large number of collaborations
and acquisitions are aimed at expanding the market for the firm’s products. For
instance, HCL and Hewlett Packard Ltd., Tata-IBM, Ranbaxy Laboratories and Eli
Lilly Company, Hindustan Motors and General Motors and Tata Tea and Tetley of
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Corporate Level USA, entered into tie-up arrangements mainly to exploit the market opportunities.
Strategy Mergers and acquisitions can increase a firm’s market share when both firms are in
the same business. But, market share does not necessarily translate to higher profits or
greater value for owners unless the merger substantially reduces the inter-firm rivalry
in the industry.
Profit Stability: Acquisition of new business can reduce variations in corporate
profits by expanding the company’s lines of business. This typically occurs when the
core business depends on sales that are seasonal or cyclical. A large number of
organizations pursue diversification strategy just to avoid instability in sales and
profits which can result from events such as cyclical and seasonal shifts in demand,
changes in the life cycles and other destabilizing forces in the micro, meso and macro
environment.
Improve Financial Performance: Large firms generate cash that can be invested in
other ventures. The firm acts as a banker of an internal capital market. The core
business sustains itself on its moneymaking ventures, and uses this cash flow to create
new ventures that generate additional profits. A firm may also be tempted to exploit
diversification opportunities because it has liquid resources far in excess of the total
expansion needs. Sometimes a company may seek a merger with another organization
with the intention of tiding over its financial problems.
Growth: Diversification is basically a way to grow. Indeed, managers often cite
growth as the principle reason for diversification. The most important factor that
motivates management to diversify is to achieve higher growth rate than which is
possible with intensification strategy. If the management feels that the existing
products and markets do not have the potential to deliver expected growth, the only
alternative they have is to diversify into new territories. Unlike organic growth, which
is slow, an acquisition or merger (inorganic) can deliver the results rather quickly
since resources, skills, other factors essential for faster growth are immediately
available.
Counter Competitive Threats: Organizations are driven at times towards external
diversification through merger by competitive pressures. Such a strategic move is
expected to counter the competitive threats by reducing the intensity of competition.
Access to Latest Technology: Many Indian firms enter into strategic alliances with
foreign firms to gain access to the latest technologies without spending huge amount
of money on R&D. For instance, Johnson and Nicholson India Ltd., a leading
domestic paint manufacturer, has strengthened its position in the Indian market and
also diversified into industrial electronics along with its German partner, Carl Schevek
AG of Germany.
Regulatory Factors: A large number of organizations have diversified their
operations geographically to exploit opportunities in different regions and countries
and also to take advantage of the incentives being offered by the various governments
to attract investment. Many companies enter other countries to avoid restrictions
placed by the regulators in their host country.

Activity 1
Compare and contrast the strategies of Bajaj group and TVS group. Are they
following concentric or conglomerate diversification?
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Growth Strategies-II
10.5 ALTERNATIVE ROUTES TO DIVERSIFICATION
Once a firm opts for diversification, it must select one of the options discussed below.
There are three broad ways to implement diversification strategies:

Mergers and Acquisitions

A merger is a legal transaction in which two or more organizations combine
operations through an exchange of stock. In a merger only one organization
entity will eventually remain. An acquisition is a purchase of one organization by
another. In recent years, there were quite a few acquisitions in which the target firms
resisted the take-over bids. These acquisitions are referred to as hostile takeovers. It
is natural for the target organization’s management to try to defend against the
takeover. Although they are used synonymously, there is a slight distinction between
the terms ‘merger’ and ‘acquisition’. This will be discussed more in detail in the
later sections.

Strategic Partnering
Strategic partnering occurs when two or more organizations establish a relationship
that combines their resources, capabilities, and core competencies to achieve some
business objective. The three major types of strategic partnerships: joint ventures,
long-term partnerships, and strategic alliances are discussed below:
Joint Ventures: In a joint venture, two or more organizations form a separate,
independent organization for strategic purposes. Such partnerships are usually focused
on accomplishing a specific market objective. They may last from a few months to a
few years and often involve a cross-border relationship. One firm may purchase a
percentage of the stock in the other partner, but not a controlling share. The joint
ventures between various Indian and foreign companies such Hindustan Motors and
General Motors, Hero Cycles with Honda Motor Company, Wipro and General
Electric, etc are examples of such strategic partnering.
Long-Term Contracts: In this arrangement, two or more organizations enter a legal
contract for a specific business purpose. Long-term contracts are common between a
buyer and a supplier. Many strategists consider them more flexible and less inhibiting
than vertical integration. It is usually easier to end an unsatisfactory long-term
contract than to end a joint venture. A good example is the change in supplier
relationships that Chrysler’s management undertook after 1989, when it launched the
LH project to create a new generation of cars. Supplier relationships are critical at
Chrysler since outsourced components constitute about 70 percent of Chrysler’s cars,
compared to about 50 percent for GM and Ford. Japanese automakers also enter into
such arrangements with their vendors frequently.
Strategic Alliances: In a strategic alliance, two or more organizations share
resources, capabilities, or distinctive competencies to pursue some business purpose.
Strategic alliances often transcend the narrower focus and shorter duration of joint
ventures. These alliances may be aimed at world market dominance within a product
category. While the partners cooperate within the boundaries of the alliance
relationship, they often compete fiercely in other parts of their businesses.

10.6 MERGERS AND ACQUISITIONS (M&A)

Mergers and acquisitions and corporate restructuring—or M&A for short—are a big
part of the corporate finance. One plus one makes three: this equation is the special
alchemy of a merger or acquisition. The key principle behind buying a company is to
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Corporate Level create shareholder value over and above that of the sum of the two companies. Two
Strategy companies together are more valuable than two separate companies—at least, that’s
the reasoning behind M&A. This idea is particularly attractive to companies when
times are tough. Strong companies will act to buy other companies to create a more
competitive, cost-efficient company. The companies will come together hoping to gain
a greater market share or achieve greater efficiency. Because of these potential
benefits, target companies will often agree to be purchased when they know they
cannot survive alone.
A corporate merger is essentially a combination of the assets and liabilities of two
firms to form a single business entity. Although they are used synonymously, there is a
slight distinction between the terms ‘merger’ and ‘acquisition’. Strictly speaking, only
a corporate combination in which one of the companies survives as a legal entity is
called a merger. In a merger of firms that are approximate equals, there is often an
exchange of stock in which one firm issues new shares to the shareholders of the other
firm at a certain ratio. In other words, a merger happens when two firms, often about
the same size, agree to unite as a new single company rather than remain as separate
units. This kind of action is more precisely referred to as a “merger of equals.” Both
companies’ stocks are surrendered, and new company stock is issued in its place.
When a company takes over another to become the new owner of the target company,
the purchase is called an acquisition. From the legal angle, the ‘target company’
ceases to exist and the buyer “gulps down” the business and stock of the buyer
continues to be traded.
In summary, “acquisition” is generally used when a larger firm absorbs a smaller firm
and “merger” is used when the combination is portrayed to be between equals. For
the sake of discussion, the firm whose shares continue to exist (possibly under a
different company name) will be referred to as the acquiring firm and the firm’s whose
shares are being replaced by the acquiring firm will be referred to as the target firm.
However, a merger of equals doesn’t happen very often in practice. Frequently, a
company buying another allows the acquired firm to proclaim that it is a merger of
equals, even though it is technically an acquisition. This is done to overcome some
legal restrictions on acquisitions.
Synergy is the main reason cited for many M&As. Synergy takes the form of
revenue enhancement and cost savings. By merging, the companies hope to
benefit through staff reductions, economies of scale, acquisition of technology,
improved market reach and industry visibility. Having said that, achieving synergy is
easier said than done-synergy is not routinely realized once two companies merge.
Obviously, when two businesses are combined, it should results in improved
economies of scale, but sometimes it works in reverse. In many cases, one and one add
up to less than two.
Excluding any synergies resulting from the merger, the total post-merger value of the
two firms is equal to the pre-merger value, if the ‘synergistic values’ of the merger
activity are not measured. However, the post-merger value of each individual firm is
likely to be different from the pre-merger value because the exchange ration of the
shares will not exactly reflect the firms’ values compared to each other. The exchange
ration is distorted because the target firm’s shareholders are paid a premium for their
shares. Synergy takes the form of revenue enhancement and cost savings. When two
companies in the same industry merge, the revenue will decline to the extent that the
businesses overlap. Hence, for the merger to make sense for the acquiring firm’s
shareholders, the synergies resulting from the merger must be more than the value lost
initially.

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Different forms of Mergers Growth Strategies-II

There are a whole host of different mergers depending on the relationship between the
two companies that are merging. These are:
l Horizontal Merger: Merger of two companies that are in direct competition in
the same product categories and markets.
l Vertical Merger: Merger of two companies which are in different stages of the
supply chain. This is also referred to as vertical integration. A company taking
over its supplier’s firm or a company taking control of its distribution by
acquiring the business of its distributors or channel partners are examples of this
type of merger.
l Market-extension Merger: Merger of two companies that sell the same
products in different markets.
l Product-extension Merger: Merger of two companies selling different but
related products in the same market.
l Conglomeration: Merger of two companies that have no common business
areas.

Activity 2
Scan The Economic Times, Business Line, Business Standard or any other business
daily for news on mergers. Classify the mergers you have come across during your
search into various types discussed.
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From the finance standpoint, there are three types of mergers: pooling of interests,
purchase mergers and consolidation mergers. Each has certain implications for the
companies and investors involved:
Pooling of Interests: A pooling of interests is generally accomplished by a common
stock swap at a specified ratio. This is sometimes called a tax-free merger. Such
mergers are only allowed if they meet certain legal requirements. A pooling of
interests is generally accomplished by a common stock swap at a specified ratio.
Pooling of interests is less common than purchase acquisitions.
Purchase Mergers: As the name suggests, this kind of merger occurs when one
company purchases another one. The purchase is made by cash or through the issue of
some kind of debt investment, and the sale is taxable. Acquiring companies often
prefer this type of merger because it can provide them with a tax benefit. Acquired
assets can be “written up” to the actual purchase price, and the difference between
book value and purchase price of the assets can depreciate annually, reducing taxes
payable by the acquiring company. Purchase acquisitions involve one company
purchasing the common stock or assets of another company. In a purchase
acquisition, one company decides to acquire another, and offers to purchase the
acquisition target’s stock at a given price in cash, securities or both. This offer is
called a tender offer because the acquiring company offers to pay a certain price if the
target’s shareholders will surrender or tender their shares of stock. Typically, this
tender offer is higher than the stock’s current price to encourage the shareholders to
tender the stock. The difference between the share price and the tender price is called
the acquisition premium. These premiums can sometimes be quite high.
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Corporate Level Consolidation Mergers: In a consolidation, the existing companies are dissolved, a
Strategy new company is formed to combine the assets of the combining companies and the
stock of the consolidated company is issued to the shareholders of both companies.
The tax terms are the same as those of a purchase merger. The Exxon merger with
Mobil Oil Company is technically a consolidation.

Acquisitions
As stated earlier, an acquisition is only slightly different from a merger. Like mergers,
acquisitions are actions through which companies seek economies of scale,
efficiencies, and enhanced market visibility. Unlike all mergers, all acquisitions
involve one firm purchasing another—there is no exchanging of stock or consolidating
as a new company. In an acquisition, a company can buy another company with cash,
stock, or a combination of the two. In smaller deals, it is common for one company to
acquire all the assets of another company. Another type of acquisition is a reverse
merger, a deal that enables a private company to get publicly listed in a relatively
short time period. A reverse merger occurs when a private company that has strong
prospects and is eager to raise finance buys a publicly listed shell company, usually
one with no business and limited assets. The private company reverse merges into the
public company and together they become an entirely new public corporation with
tradable shares. Regardless of the type of combination, all mergers and acquisitions
have one thing in common: they are all meant to create synergy and the success of a
merger or acquisition hinges on how well this synergy is achieved. (Refer to case
study-2 in Appendix-2).

10.7 MERGER AND ACQUISITION STRATEGY

There are a number of reasons that mergers and acquisitions take place. These issues
generally relate to business concerns such as competition, efficiency, marketing,
product, resource and tax issues. They can also occur because of some very personal
reasons such as retirement and family concerns. Some people are of the opinion that
mergers and acquisitions also occur because of corporate greed to acquire everything.
Various reasons for M&A include:
Reduce Competition: One major reason for companies to combine is to eliminate
competition. Acquiring a competitor is an excellent way to improve a firm’s position
in the marketplace. It reduces competition and allows the acquiring firm to use the
target firm’s resources and expertise. However, combining for this purpose is as such
not legal and under the Antitrust Acts it is considered a predatory practice. Therefore,
whenever a merger is proposed, firms make an effort to explain that the merger is not
anti-competitive and is being done solely to better serve the consumer. Even if the
merger is not for the stated purpose of eliminating competition, regulatory agencies
may conclude that a merger is anti-competitive. However, there are a number of
acceptable reasons for combining firms.
Cost Efficiency: Due to technology and market conditions, firms may benefit from
economies of scale. The general assumption is that larger firms are more cost-
effective than are smaller firms. It is, however, not always cost effective to grow.
Inspite of the stated reason that merging will improve cost efficiency, larger companies
are not necessarily more efficient than smaller companies. Further, some large firms
exhibit diseconomies of scale, which means that the average cost per unit increases, as
total assets grow too large. Some industry analysts even suggest that the top
management go in for mergers to increase its own prestige. Certainly, managing a big
company is more prestigious than managing a small company.
Avoid Being a Takeover Target: This is another reason that companies merge. If a
34 firm has a large quantity of liquid assets, it becomes an attractive takeover target
because the acquiring firm can use the liquid assets to expand the business, pay off Growth Strategies-II
shareholders, etc. If the targeted firm invests existing funds in a takeover, it has the
effect of discouraging other firms from targeting it because it is now larger in size, and
will, therefore, require a larger tender offer. Thus, the company has found a use for
its excess liquid assets, and made itself more difficult to acquire. Often firms will
state that acquiring a company is the best investment the company can find for its
excess cash. This is the reason given for many conglomerate mergers.
Improve Earnings and Reduce Sales Variability: Improving earnings and sales
stability can reduce corporate risk. If a firm has earnings or sales instability, merging
with another company may reduce or eliminate this provided the latter company is
more stable. If companies are approximately the same size and have approximately
the same revenues, then by merging, they can eliminate the seasonal instability. This
is, however, not a very inefficient way of eliminating instability in strict economic
terms.
Market and Product Line Issues: Often mergers occur simply because one firm is in
a market that the other company wants to enter. All of the target firm’s experience
and resources are readily available of immediate use. This is a very common reason
for acquisitions. Whatever may be the explanation offered for acquisition, the
dominant reason for a merger is always quick market entry or expansion . Product line
issues also exert powerful influence in merger decisions. A firm may wish to expand,
balance, fill out or diversify its product lines. For example, acquisition of Modern
Foods by Hindustan Lever Limited is primarily related product line.
Acquire Resources: Firms wish to purchase the resources of other firms or to
combine the resources of the two firms. These may be tangible resources such as
plant and equipment, or they may be intangible resources such as trade secrets,
patents, copyrights, leases, management and technical skills of target company’s
employees, etc. This only proves that the reasons for mergers and acquisitions are
quite similar to the reasons for buying any asset: to purchase an asset for its utility.
Synergy: Synergy popularly stated, as “two plus two equals five,” is similar to the
concept of economies of scope. Economies of scope would occur if two companies
combine and the combined company was more cost efficient at both activities because
each requires the same resources and competencies. Although synergy is often cited
as the reason for conglomerate mergers, cost efficiencies due to synergy are difficult to
document.
Tax Savings: Although tax savings is not a primary motive for a combination, it can
certainly “sweeten” the deal. When a purchase of either the assets or common stock
of a company takes place, the tender offer less the stock’s purchase price represents a
gain to the target company’s shareholders. Consequently, the target firm’s
shareholders will usually gain tax benefits. However, the acquiring company may
reap tax savings depending on the market value of the target company’s assets when
compared to the purchase price. Also, depending on the method of corporate
combination, further tax savings may accrue to the owners of the target company.
Cashing Out: For a family-owned business, when the owners wish to retire, or
otherwise leave the business and the next generation is uninterested in the business, the
owners may decide to sell to another firm. For purposes of retirement or cashing out,
if the deal is structured correctly, there can be significant tax savings.
To summarize, firms take the M&A route to seize the opportunities for growth,
accelerate the growth of the firm, access capital and brands, gain complementary
strengths, acquire new customers, expand into new product- market domains, widen
their portfolios and become a one-stop-shop or end-to end solution provider of
products and services.
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Corporate Level
Strategy 10.8 REASONS FOR FAILURE OF MERGER AND
ACQUISITION
The record of M&As world over has not been impressive. Advocates of M&As argue
that they boost revenues to justify the price premium. The notion of synergy, ‘1+1 =
3’, sounds great, but the assumptions behind this notion are too simplistic. In real life
things are not that simple and rosy. Past trends show that roughly two thirds of all big
mergers have not produced the desired results. Rationale behind mergers can be
flawed and efficiencies from economies of scale may prove elusive. Moreover, the
problems associated with trying to make merged entities work cannot be overcome
easily. Reasons supporting the use of diversification have been explained in the
previous section. The potential pitfalls of this strategy are explained in this section.
The conclusion that one may draw from this discussion will be that “successful
diversification would involve a well thought strategy in selecting a target, avoiding
over-paying, creating value in the integration process.”
The potential pitfalls that a firm is likely to encounter during diversification include:
Integration Difficulties: Integrating two companies following mergers and acquisition
can be quite difficult. Issues such as melding two disparate corporate cultures, linking
different financial and control systems, building effective financial and control
systems, building effective working relationships, etc., will come to the fore and they
have to be contend with.
Faulty Assumptions: A booming stock market encourages mergers, which can spell
danger. Deals done with highly rated stock as currency appear easy and cheap, but
underlying assumptions behind such deals is seriously flawed. Many top managers try
to imitate others in attempting mergers, which can be disastrous for the company.
Mergers are quite often more to do with personal glory than business growth. The
executive ego plays a major in M&A decisions, which is fuelled further by bankers,
lawyers and other advisers who stand to gain from the fat fees they collect from their
clients engaged in mergers. Most CEOs and top executives also get a big bonus for
merger deals, no matter what happens to the share price later.
Mergers are also driven by fear psychosis: fear of globalization, rapid technological
developments, or a quickly changing economic scenario that increases uncertainty can
all create a strong stimulus for defensive mergers. Sometimes the management feels
that they have no choice but to acquire a raider before being acquired. The idea is that
only big players will survive in a competitive world.
Failure to carry out effective due-diligence: The failure to complete due-diligence
often results in the acquiring firm paying excessive premiums. Due diligence involves
a thorough review by the acquirer of a target company’s internal books and
operations. Transactions are often made contingent upon the resolution of the due
diligence process. An effective due-diligence process examines a large number of
items in areas as diverse as those of financing the intended transaction, differences in
cultures between the two firms, tax concessions of the transaction, etc.
Inordinate increase in debt: To finance acquisitions, some companies significantly
raise their levels of debt. This is likely to increase the likelihood of bankruptcy leading
to downgrading of firm’s credit rating. Debt also precludes investment in areas that
contribute to a firm’s success such as R&D, human resources development and
marketing.
Too much diversification: The merger route can lead to strategic competitiveness and
above-average returns. On the flip-side, firm’s may lose their competitive edge due to
over diversification. The threshold level at which this happens varies across
36 companies, the reason being that different companies have different capabilities and
resources that are required to make the mergers work. Crossing these threshold limits Growth Strategies-II
can result in overstretching these capabilities and resources leading to deteriorating
performance. Evidence also suggests that a large size creates efficiencies in various
organizational functions when the firm is not too large. In other words, at some level
the costs required to manage the larger firm exceed the benefits of efficiency created
by economies of scale.
Problems in making M&A work: Mergers can distract them from their core
business, spelling doom for the company. The chances for success are further
hampered if the corporate cultures of the companies are very different. When a
company is acquired, the decision is typically based on product or market synergies,
but cultural differences are often ignored. It’s a mistake to assume that these issues are
easily overcome. A McKinsey study on mergers concludes that companies often focus
too narrowly on cutting costs following mergers, without paying attention to revenues
and profits. The exclusive cost-cutting focus can divert attention from the day-to-day
business and poor customer service. This is the main reason for the failure of mergers
to create value for shareholders.
However, not all mergers fail. Size and global reach can be advantageous and tough
managers can often squeeze greater efficiency out of poorly run acquired companies.
The success of mergers, however, depends on how realistic the managers are and how
well they can integrate the two companies without losing sight of their existing
businesses. Though the acquisition strategies do not consistently produce the desired
results, some studies suggest certain decisions and actions that firms may follow
which can increase the probability of success. The attributes leading to successful
acquisition suggested by various studies are that the:
l Acquired firm has assets or resources that are complimentary to the acquiring
firm’s core business.
l Acquisition is friendly.
l Acquiring firm selects target firms and conducts negotiation carefully and
methodically.
l Acquiring firm has adequate cash and fovourable debt position.
l Merged firms maintains low to moderate debt position.
l Acquiring firm has experience with change and is flexible and adaptable.
l Acquiring firm maintains sustained and consistent emphasis on R&D and
innovation

10. 9 STEPS IN MERGER AND ACQUISITION DEALS

A firm that intends to take over another one must determine whether the purchase will
be beneficial to the firm. To do so, it must evaluate the real worth of being acquired.
Logically speaking, both sides of an M&A deal will have different ideas about the
worth of a target company: the seller will tend to value the company as high as
possible, while the buyer will try to get the lowest price possible. There are, however,
many ways to assess the value of companies. The most common method is to look at
comparable companies in an industry, but a variety of other methods and tools are
used to value a target company. A few of them are listed below.

1) Comparative Ratios
The following are two examples of the many comparative measures on which
acquirers may base their offers:

37
Corporate Level P/E (price-to-earnings) Ratio: With the use of this ratio, an acquirer makes an offer
Strategy as a multiple of the earnings the target company is producing. Looking at the P/E for
all the stocks within the same industry group will give the acquirer good guidance for
what the target’s P/E multiple should be.
EV/Sales (price-to-sales) Ratio: With this ratio, the acquiring company makes an
offer as a multiple of the revenues, again, while being aware of the P/S ratio of other
companies in the industry.

2) Replacement Cost
In a few cases, acquisitions are based on the cost of replacing the target company. The
value of a company is simply assessed based on the sum of all its equipment and
staffing costs without considering the intangible aspects such as goodwill,
management skills, etc. The acquiring company can literally order the target to sell at
that price, or it will create a competitor for the same cost. This method of establishing
a price certainly wouldn’t make much sense in a service industry where the key
assets—people and ideas—are hard to value and develop.

3) Discounted Cash Flow

An important valuation tool in M&A, the discounted cash flow analysis, determines a
company’s current value according to its estimated future cash flows. Future cash
flows are discounted to a present value using the company’s weighted average cost of
capital. Though this method is a little difficult to use, very few tools can rival this
valuation method.

4) Synergy
Quite often, acquiring companies pay a substantial premium on the stock value of the
companies they acquire. The justification for this is the synergy factor: a merger
benefits shareholders when a company’s post-merger share price increases by the
value of potential synergy. For buyers, the premium represents part of the post-merger
synergy they expect can be achieved. The following equation solves for the minimum
required synergy and offers a good way to think about synergy and how to determine
if a deal makes sense. In other words, the success of a merger is measured by whether
the value of the buyer is enhanced by the action. The equation:
(Pre-merger value of both firms + synergies)
—————————————————— = Pre-merger stock price
Post-merger number of shares
Here the pre-merger stock price refers to the price of the acquiring firm. Increase in
the value of the acquiring firm is a test of success of the merger. However, the
practical aspects of mergers often prevent the anticipated benefits from being fully
realized and the expected synergy quite often falls short of expectations.
Some more criteria to consider for valuation include:
l A reasonable purchase price - A small premium of, say, 10% above the market
price is reasonable.
l Cash transactions- Companies that pay in cash tend to be more careful when
calculating bids, and valuations come closer to target. When stock is used for
acquisition, discipline can be a casualty.
l Sensible appetite – An acquirer should target a company that is smaller and in a
business that the acquirer knows intimately. Synergy is hard to create from
disparate and unrelated businesses. And, sadly, companies have a bad habit of
biting off more than they can chew in mergers.

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The Basics Steps in Mergers and Acquisitions Growth Strategies-II

1) Initial Offer by the Intending Buyer

When a company decides to go for a merger or an acquisition, it starts with a tender
offer. Working with financial advisors and investment bankers, the acquiring company
will arrive at an overall price that it’s willing to pay for its target in cash, shares, or
both. The tender offer is then frequently advertised in the business press, stating the
offer price and the deadline by which the shareholders in the target company must
accept (or reject) it.

2) Response from Target Company

Once the tender offer has been made, the target company can do one of the several
things listed below:
Accept the Terms of the Offer: If the target firm’s management and shareholders are
happy with the terms of the transaction, they can go ahead with the deal.
Attempt to Negotiate: The tender offer price may not be high enough for the target
company’s shareholders to accept, or the specific terms of the deal may not be
attractive. If target firm is not satisfied with the terms laid out in the tender offer, the
target’s management may try to work out more agreeable terms. Naturally, highly
sought-after target companies that are the object of several bidders will have greater
latitude for negotiation. Therefore, managers have more negotiating power if they can
show that they are crucial to the merger’s future success.
Execute a Poison pill or some other Hostile Takeover Defense: A target company
can trigger a poison pill scheme when a hostile suitor acquires a predetermined
percentage of company stock. To execute its defense, the target company grants all
shareholders—except the acquirer—options to buy additional stock at a hefty
discount. This dilutes the acquirer’s share and stops its control of the company. It can
also call in government regulators to initiate an antitrust suit.
Find a White Knight: As an alternative, the target company’s management may seek
out a friendly potential acquirer, or white knight. If a white knight is found, it will
offer an equal or higher price for the shares than the hostile bidder.

3) Closing the Deal

Finally, once the target company agrees to the tender offer and regulatory
requirements are met, the merger deal will be executed by means of some transaction.
In a merger in which one company buys another, the acquirer will pay for the target
company’s shares with cash, stock, or both. A cash-for-stock transaction is fairly
straightforward: target-company shareholders receive a cash payment for each share
purchased. This transaction is treated as a taxable sale of the shares of the target
company. If the transaction is made with stock instead of cash, then it’s not taxable.
There is simply an exchange of share certificates. The desire to steer clear of the
taxman explains why so many M&A deals are carried out as cash-for-stock
transactions.
When a company is purchased with stock, new shares from the acquirer’s stock are
issued directly to the target company’s shareholders, or the new shares are sent to a
broker who manages them for target-company shareholders. Only when the
shareholders of the target company sell their new shares are they taxed. When the deal
is closed, investors usually receive a new stock in their portfolio—the acquiring
company’s expanded stock. Sometimes investors will get new stock identifying a new
corporate entity that is created by the M&A deal.
39
Corporate Level
Strategy 10.10 MERGERS AND ACQUISITIONS: THE INDIAN
SCENARIO
M&A activity had a slow take-off in India. Traditionally, Indian promoters have been
very reluctant to sell out their businesses since it was synonymous with failure and
was never viewed as a sensible move. This scenario changed dramatically in the 90s
with the Tatas selling TOMCO and Lakme. Suddenly selling out had become a
sensible option. The second major reason for the slow take-off of M&A activity was
due to the fact that even while the companies continued to decline, the banks and
financial institutions, normally the biggest stakeholders in most Indian companies
were reluctant to change the managements. Fortunately this situation has changed for
the better. Worried about the spectre burgeoning NPAs, these institutions are now
willing to force the promoters to sell out. The FIs and banks are flushed with funds
and they are willing to assist big companies in acquiring new companies.
Indian cement industry was trendsetter in M&A in India. The cement industry was
ripe for consolidation in many ways. The industry comprised of four or five dominant
players in addition to a number of small players having economically viable
capacities, but with very small market shares. Rapid expansion by the bigger players
in a capital-intensive industry meant that these small players would naturally be
marginalized. Moreover, the excess capacity due to rapid expansion of big players
meant that the smaller players would lose money. This situation naturally spurred the
merger activity in the cement industry.
The past few years have been record years for M&A globally with mega deals
dwarfing the previous records. M&A has also become a buzzword among Indian
companies as well. HDFC-Times Bank, Gujarat Ambuja-DLF and ICICI Bank-
Centurion Bank mergers have all been in the news recently for this reason. The merger
wave in the country was catalyzed by economic liberalization in 1991. M&A activity
is on the rise and the Indian industry has witnessed a spate of mergers and acquisitions
in the past few years. Mergers and acquisitions are here to stay and more are expected
to follow in the near future.
Mergers and acquisitions in India, just as in other parts of the world, are primarily
aimed at expanding a company’s business and profits. Acquisitions bring in more
customers and business, which in turn brings in more money for the companies thus
helping in its overall expansion and growth. More and more companies are, therefore,
moving towards acquisitions for a fast-paced growth. Consolidation has become a
compelling necessity to counter the effects of increasing globalization of businesses,
declining tariff barriers, price decontrols and to please the ever demanding and
discerning customers. And these pressures are expected to intensify and relentlessly
batter every business in the future. The M&A activity is helping the companies
restructure, gain market share or access to markets, rationalize costs and acquire
brands to counter these threats. The shareholders of many companies are also
supporting these moves and sharp increase in share prices is an indication of this
support.
Since size and focus are factors that matter for surviving the onslaught of
competition, mergers and acquisitions have emerged as key growth drivers of Indian
business. Tax benefits were the sole reason to justify mergers in the past but for many
Indian promoters, that is no longer an incentive. Indian companies have taken to
M&A many reasons. Experts feel that Indian companies look at M&As due to the size
factor, the niche factor or for expanding their market reach. They are also of the
opinion that acquisitions help in the inorganic (and quicker) growth of the business of
a company. Besides these factors, the pricing pressures and consolidation of
global companies by building offshore capabilities have made M&A relevant for
40
Indian enterprises.
Many Indian companies have also followed the M&A route to grow in size by adding Growth Strategies-II
manpower and to facilitate overall expansion by moving into new market space.
Another reason behind M&A has been to gain new customers. For instance, vMoksha,
an IT firm, saw a rise in the number of its customers due to acquisitions as it
expanded considerably in the US market and leveraged on the existing customer base.
Similarly, Mphasis added new customers in the Japanese and Chinese markets after
the acquisition of Navion. The need for skill enhancement seems to be another major
reason for companies to merge and make new acquisitions. The Polaris-OrbiTech
merger helped in combining skill sets of both companies, which consequently led to
growth and expansion of the merged entity. Likewise, Wipro acquired GE Medical
Systems Information Techno-logy (India) to leverage its expertise in the health science
domain. (Refer to case study-3 in Appendix-2).

10.11 SUMMARY
Diversification involves moving into new lines of business. Of the various routes to
expansion, diversification is definitely the most complex and risky route.
Diversification of a firm can take the form of concentric and conglomerate
diversification. A firm is said to pursue concentric diversification strategy when it
enters into new product or service areas belonging to different industry category but
the new product or service is similar to the existing one in many respects.
The two major routes to diversification are mergers and acquisitions and strategic
partnering. One plus one makes three: this equation is the special alchemy of a merger
or acquisition. Although they are used synonymously, there is a slight distinction
between the terms ‘merger’ and ‘acquisition’. The term acquisition is generally used
when a larger firm absorbs a smaller firm and merger is used when the combination is
portrayed to be between equals.
Firms take the M&A route mainly to seize the opportunities for growth, accelerate the
growth of the firm, access capital and brands, gain complementary strengths, acquire
new customers, expand into new product-market domains, wident their portfolios and
become a one-stop-shop or end-to-end solution provider of products and services. The
three basic steps in the merger process are—offer by the acquiring firm, response by
the target firm and closing the deal.
M and A activity had a slow take-off in India. However, M&A has become a
buzzword among Indian companies after the economic liberalization in 1991. M&A
activity is on the rise and the Indian industry has witnessed a spate of mergers and
acquisitions in the past few years.

10.12 KEY WORDS

Acquisitions: A company taking over controlling interest in another company.
Concentric Diversification: A firm is said to have pursued concentric diversification
strategy when it enters into new product or service area belonging to different industry
but the new product or service is similar to the existing one with respect to technology
or production or marketing channels or customers.
Conglomerate Diversification: Conglomerate diversification is a growth strategy in
which a company seeks to grow by adding entirely unrelated products and markets to
its existing business.
Diversification: Diversification involves moving into new lines of business.
Joint Ventures: Two or more organizations form a separate, independent organization
for strategic purposes. 41
Corporate Level Mergers: The conpination of two or more companies.
Strategy
Strategic Alliances: Two or more organizations share resources, capabilities, or
distinctive competencies to pursue some business purpose.
Strategic Partnering: Two or more organizations establish a relationship that
combines their resources, capabilities, and core competencies to achieve some
business objective.

10.13 SELF-ASSESSMENT QUESTIONS

1) What is meant by diversification? What are the pros and cons of a diversification
strategy?
2) Explain the mechanics of mergers and acquisitions. What motivates the top
management to go in for M&A?
3) What are the pitfalls that a management should take into consideration while
going for M&A?
4) Explain the basic steps involved in the M&A process.
5) Scan the business newspapers in the past few months and explain the M&A
trends in Indian business scenario and list out the various reasons why Indian
companies plan to follow M&A strategy.

10.14 REFERENCES AND FURTHER READINGS

Hitt, Michael A. Ireland, Duane R. and Hoskisson, Robert E. (2001). Strategic
management: competitiveness and globalization, 4th ed., Thomson Learning.
Srivastava, R.M. (1999). Management Policy and Strategic management (concepts,
skills and practice), 1st ed., Himalaya Publishing House.
Ramaswamy, V.S. and Namakumari, S. (1999). Strategic Planning: Formulation of
corporate strategy (Texts and Cases)-The Indian context, 1st ed., Macmillan India
Limited.

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Appendix-2 Growth Strategies-II

Case Study-1
Aditya V Birla Group: A Case of a Highly Diversified Group
The Aditya V Birla group is one of the fastest growing industrial houses in the
country. Grasim, a group company, was incorporated as Gwalior Rayon Silk
Manufacturing (Weaving) Co Ltd in 1947. It started as a textile manufacturing mill
and integrated backward in 1954, to produce VSF (Viscose Staple Fiber) used in
textiles. It expanded its capacity further through backward integration into
manufacture of rayon grade wood pulp, caustic soda and manufacturing equipment to
become a low cost producer. Grasim diversified into cement when industry was
decontrolled. It also diversified into production of sponge iron in 1993. Grasim has
presence in exports and computer software as well. It holds significant equity in
several other Birla group companies.
The manufacturing facilities of Grasim are spread all across the country. Grasim’s
sponge iron plant is located at Raigarh near Mumbai, while its cement plants are
located at Jawad, Shambhupura in Rajasthan and Raipur in MP. The VSF plants are
located at Mavoor and Harihar in Karnataka and Nagda in MP and it has recently set
up a new VSF plant at Surat, Gujarat. It has pulping facilities at Nagda, Harihar and
Mavoor. Grasim’s textile mills are located at Gwalior and Bhiwani near Delhi.
The Aditya Birla Group’s strategy has been to diversify into capital-intensive
businesses and become a cost-leader by leveraging on its various strengths. Apart
from Grasim, major companies in the group include Hindalco Industries Ltd
(aluminium), Indian Rayon (Cement, VFY, carbon black, insulators etc), Indo-Gulf
Fertilizer (Fertilizer - Urea), Tanfac Industries (Chemicals for aluminum), Bihar
Caustic & Chemicals Ltd (Caustic Soda/ chlorine), Hindustan Gas Industries (gas
producer), Birla Growth Fund (financial services), Mangalore Refinery (oil refinery).
Grasim holds a 58.6% stake in Kerala Spinners Ltd, which manufactures synthetic/
blended yarn. Grasim’s fully owned subsidiaries, Sun God Trading and Investments
Ltd and Samruddhi Swastik Trading and Investments Ltd, are into asset based
financing. The group also owns several companies in Thailand, Indonesia and
Malaysia manufacturing textiles, synthetic/ acrylic yarn, rayon, carbon black and
other chemicals.

Case Study-2
Ispat International: Building a Muscle of Steel
Steel magnate Lakhmi N. Mittal’s Ispat International announced the acquisition of
LNM Holdings and a merger with the US based International Steel Group Inc (ISG)
in a deal worth $ 17.8 billion to form the world’s largest steel firm, Mittal Steel Co.
Mittal Steel, with operations in 14 countries in Europe, Africa, Asia and the United
States and 165,000 employees will have pro forma revenues of $30 billion in 2004
and an annual production capacity of 70 million tones, according to a statement from
Ispat International. The Netherlands-based Ispat International, 77-percent owned by
Mr.Mittal, will issue 525 million new shares, valued at $ 13.3 billion to the
shareholder of LNM Holdings. The Mittal Steel Co. will then pay $42 a share in cash
and stock-or about $4.5 billion- depending on Mr.Mittal’s share price, to the ISG
shareholders.
These transactions dramatically change the landscape of the global steel industry.
The coming together of Ispat International, LNM Holdings and ISG, one of the largest
steel producers in America, will create global powerhouse. This combination also 43
Corporate Level provides Mittal Steel with a more significant presence in important industrialized
Strategy economies such as those in North America and Europe and in economies that are
expected to experience above average in steel consumption, including Asia and Africa.
According to Mr.Aditya Mittal, President and CEO of the new combined entity, Mittal
Steel will be a leader not only in terms of its global reach and operational excellence
but also among the most profitable steel producers in the world. LNM Holdings
earned $ 9.9 billion revenue and had an operating income of $3.2 billion in the first
nine months of 2004, and was also one of the largest steel companies. (Source: The
Hindu, October 26, 2004)

Case Study-3
Nicholas Piramal India Ltd: Profiting from M and A
Nicholas Piramal India Ltd (NPIL), best known for its growth by mergers and
acquisitions, is among the top ten companies in the domestic formulations market with
a major presence in anti-bacterial, CNS & CVS-Diabetic. NPIL has expanded
aggressively after the Nicholas group took over Nicholas Laboratories in 1986. The
turnover and net profit have grown at a healthy compounded annual growth (CAGR)
of 33% and 45% respectively in the past decade. With more than a dozen joint
ventures with pharmaceutical companies in different healthcare segments, NPIL has
mastered the art of forging JVs and running them successfully.
Prices of over 60% of the drugs and formulations are controlled by the government
through DPCO in the Rs130 billion Indian pharmaceutical market. In the domestic
bulk drugs market, low entry barriers have resulted in overcapacity and price wars.
Major domestic players are, therefore, focusing on formulations, where brand image
and distribution network act as entry barriers. They are increasing their overseas
marketing and manufacturing network to enhance their exports (under patent drugs to
third world countries and generics to developed nations). In anticipation of WTO
regime, multinational corporations are strengthening their operations in India by
setting up 100% subsidiaries or through marketing tie-ups with major domestic
players. The big local players are also strengthening their operations through brand
acquisitions, co-marketing and contract manufacturing tie-ups with MNCs.
Following this trend, NPIL is focusing on strengthening its R&D to gear up for the
patents regime. The company’s R&D facility with more than 100 scientists (acquired
from Hoechst Marion in 1999, renamed as Quest science Institute) is one of the best
R&D centers in India. NPIL has hived off its Falconnage (glass) and bulk drug
division into separate entities to improve efficiencies. It is working on seven new
chemical entities (NCE). The first one, an anti-malarial drug, is already
commercialized. NPIL has set a growth target of more than 30% through aggressive
product launches as well as mergers and acquisitions of brands and companies in the
therapeutic segment of anti-bacterial, CVS-diabetes, Nutrition and GI tract and
Central Nervous System (CNS).

44