Shareholders Value Creation

How to create value for your organization? Why TSR (Total Shareholders Return) is the best metric for value creation? Why is it difficult to create sustainable value? How to build sustainable value creation strategy? Why CSR & brand value change not consider as a part of TSR? Why multiple compressions are so difficult to beat? Why investors & analyst discounts valuation multiple? How to transit majority investors without eroding TSR? How to create value in low growth economy? How to play your strategy with sustainable TSR matrix as per investors eye? Why investors communication is so important for value creation? Which strategy you should use for value creation? How to use value creation scenarios? Why cash strategy is so important in low growth economy?

If all these questions bother you before developing your company’s corporate strategy/value creation strategy then you must see New Year’s complimentary presentation

Shareholders Value Creation – “A handy e-book on how to create sustainable shareholders value”

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How Divestiture helps in restructuring corporate portfolio of business?

In order to achieve growth organizations give more importance to Merger & Acquisition. Merger & Acquisition plays pivotal role in organizations Corporate Strategy & maintaining portfolio of business to achieve high return on capital & growth. However situation arises once organization diversify itself into various businesses and its corporate portfolio becomes so huge that it is very difficult to maximize return on capital & take advantage of new growth opportunities.

Divestitures and carve-out plays a very important role in restructuring organizations corporate portfolio to maximize return & growth.

Normally organization doesn’t give as much importance to divestitures as to M & A however if Divestiture/Carve-out activity carried out timely & sequencely then it can provide huge benefit in terms of shareholders value, future growth and cash flow.

Why organizations do Divestiture

The reasons to divest a business are wide-ranging, from short-term cash generation to a desire to restructure the business portfolio by spinning off non-core or low-performing assets. And regardless of the driving force behind a divestiture, the overall objective of most companies is to get the best possible return—i.e., the highest price.

In order to get optimum return from divestiture organizations should do it in an accelerated time frame. Best practice is to make sure that to-be-divested units are configured for maximum appeal to potential buyer, and putting effective program management in place to manage the complexity of divestiture.

Divestiture Strategy

In order to develop its divestiture strategy, a company should comprehensively assess its corporate portfolio to identify opportunities for value creation. This entails four basic steps:

• Aligning assets with the business’ best opportunities
• Developing a timing and sequencing strategy for separation & divestiture  transaction
• Define boundaries of assets being considered for divestiture
• Packaging the divestiture assets for maximum value

Aligning assets with the business’ best opportunities

Organization should carefully study the overall business’ growth opportunities, and the capital required for each business in the portfolio to take advantage of those opportunities. This perspective then must be paired with an understanding of the potential value of each business to an external owner compared to its worth to the divesting company.

Timing & Sequencing Strategy

Parent company should determine the most advantageous timing  & sequencing strategy for the divestiture and its execution. In most instances, it is best to start with carving-out of a business unit before the sale process. Following are the benefits of carve-out.

     Transparency

Potential buyers require full transparency of an asset’s tangible and intangible value, contracts, service relationships and, of course, revenues and costs. Transparency will be easier to achieve if the divestiture target is a separate legal or organizational entity (which includes having its own accounting systems and boundaries).

      Avoid Uncovering Bad News

The second reason to begin the carve-out process early is that having a concrete and defined divestiture target helps to avoid uncovering any bad news during the sale process that would be an obstacle to negotiations with potential buyers. Furthermore, having already executed the carving out of the asset to be sold enables the selling company to quickly capitalize on emerging sales opportunities—such as a sudden recovery of M&A markets or the appearance of an unexpected potential buyer.

Define Boundaries of Divestiture Target

Once the timing and sequencing of the divestiture are determined, a company must carefully define the boundaries of the divestiture target, taking into consideration the strategic fit of the business unit as a whole and its constituent parts within the parent company. For example, one business function of a to-be-divested business unit might provide research services to the rest of the parent company, or possess valuable technical knowledge.

In addition, the future intended scope of the parent business after the divestiture should be considered to ensure potentially valuable assets are not jettisoned.

Packaging the divestiture assets for maximum value

The final step is to make the divestment target as attractive as possible to the most likely acquirers. Stopping at the prior step and focusing strictly on the to-be-divested business unit’s boundaries from an internal viewpoint likely would not result in the most attractive asset from a buyer’s perspective. For example, some investors desire complete, operationally functioning entities.

To facilitate a transaction the divesting company would need to provide a unit meeting that description from the buyer’s perspective and further adjust the boundaries of the to-be-divested organization if needed.

Divestiture Strategy Execution

Once it is clear which assets to divest and how it should be packaged, a number of best practices can help ensure successful execution.

Effective program management should be put in place to avoid underestimating the impact of divestiture on daily business.

Second, a company must plan for the future success of the divestiture target, and make sure accountability between the parent company and the to-be-divested organization is clearly defined.

Finally, it is vital for a divesting company to maintain an open dialogue and stay flexible as the transaction unfolds.

British Petroleum’s master carve-out & divestiture strategy

BP captured $9 billion in cash by divesting its petrochemicals units—up to $2 billion more than Wall Street analysts had expected. In crafting the divestiture program, BP’s corporate development experts defined the major steps needed to separate and sell the $25 billion-a year petrochemicals business. First, the unit was carved out as a standalone business under its own name—Innovene—so it could float on the New York Stock Exchange.

The carve-out, making Innovene the world’s fifth largest petrochemical and polymer company. BP’s dedicated corporate development team determined the key phases, major milestones, work streams and project teams needed to deliver the complex divestment. The whole process involved a detailed assessment of the path to a rapid separation, accelerating the process by two months and greatly enhancing BP’s chances of obtaining the best possible valuation in an IPO. As soon as Innovene was legally a separate entity, the priority turned to IPO preparation, developing the necessary sales presentations for the underwriters and preparing the flotation prospectus. Then the BP team made its move to woo potential buyers, which meant getting ready for the prospective acquirers’ due diligence procedures—a major work stream in it. The multiple options strategy paid off brilliantly, sparking a successful bid from specialty chemicals producer INEOS. The $9 billion deal represented one of the largest-ever leveraged buyouts and instantly made INEOS one of the world’s largest chemical companies. BP had completed a huge divestiture only a year after declaring its intent to sell.

It is generally easier to pursue divestiture in robust economy than during a downturn. Companies should use divestitures to enable much more substantial and long-lasting change. Success in the current economic environment can hinge on effective portfolio rebalancing and efficient divestiture execution. Companies that configure business units for maximum value, manage the complexity, ensure accountability and embrace flexibility throughout the divestiture process improve their likelihood of success. For many companies, there is no better time than the present to pursue divestitures to position themselves for high performance when economic conditions ultimately improve.

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How “FEEDBACK LOOP” affects Share Prices & Takeover Attempt?

Theory suggests that the marketplace imposes discipline on corporate managers. If top leadership performs poorly, the stock price suffers, things get worse and the company becomes a takeover target and executives loses their job. This phenomenon provides a strong incentive for corporate managers to perform well.

However in reality it is hard to find evidence that justify the theory that falling share prices do trigger takeover activity. But if the theory is false then it could be very difficult to maintain market discipline and managers may put their own interest ahead of the firms. So stock price & takeover trigger does exist but why is it so difficult to see. The reaon may be that another force is masking the effect.

The traditional view is that a firm’s low valuation relative to its peers suggests internal managerial problems. An acquirer can then take over the firm, correct its problems and earn a profit by restoring the firm’s value. Investors and firms that mount takeover attempts typically use factors like low price-to-earnings ratios to uncover troubled firms. Company managers strive to maintain high market valuation to prevent a hostile takeover. In this way, the marketplace supposedly imposes discipline on managers, prompting them to do the best they can.

However despite the above mentioned logic takeovers fail to systematically uncover a meaningful relationship between market valuations and takeover probabilities. This could be the problem of “feedback loop” that may be obscuring the view as investors anticipating a takeover, drive the stock price up offsetting the decline from the market’s perception of poor management.

How Takeover Attempt deterred?

Each firm sets a “potential” stock value by using other firms in the industry as a benchmark. That made it possible to determine whether the stock was trading at a discount attributable to poor management. Then they looked at movements of the firm’s share price and whether the company had been the target of a takeover attempt.

This allowed extricating the two forces: the “trigger effect” in which low price attracted takeover attempts, and the “anticipation effect” in which the market’s expectation of a takeover battle drove the price back up. Anticipation effect could be measured by looking at whether a firm’s shares traded above the discount that otherwise would be expected. As per analysts it basically happens more or less at the same time. That’s why it is so hard to disentangle it just by looking at the correlation between share price and takeover attempts.

As per analysts, normally on an average, a firm has a 6% chance of becoming a takeover target in any given year and a reasonable drop in price will increase the probability of takeover by about 7 percentage points on an average.

However the anticipation effect typically drives the price up, reducing the takeover prospect by 6 percentage points. The net result: A firm seen as poorly managed has a 7% chance of becoming a takeover target, rather than 6%.

An anticipation effect wipes out most of the trigger effect, stock price becomes a poor indicator of whether the market believes a firm has “agency problems”  i.e. it is poorly managed. While researchers typically use valuation measures as a proxy for management performance, a firm’s stock price may not reveal the full extent of its agency problems, as it may incorporate the expected correction of these problems. By breaking the correlation between market valuations and takeover activity into trigger and anticipation effects enables to ascertain the extent to which future expected takeovers are priced in. Directors who rely on share prices to assess the quality of their managers could be deceiving themselves.

Feedback Loop or the “anticipation effects” offsetting most of the trigger effect on share price — discourages takeovers. While managers clearly don’t like takeovers because they stand to lose their jobs, anyone who wants market forces to encourage the best possible management practices might find this findings disappointing. The feedback loop may both deter value-enhancing takeovers of firms that are already underperforming, and allow managers to shirk in the first place, since they are less fearful of disciplinary acquisitions.”

The “anticipation effect” may explain why acquiring firms find it far less profitable to take over publicly traded companies than private ones. There is no anticipation effect with private firms because their shares are not publicly traded. Why merger and acquisition activity tends to come in waves? “If a recent spate of mergers leads the market to predict future acquisitions, this [anticipation effect] causes valuations to rise … dissuading further acquisition attempts.

As per the research that’s why corporate managers often seem willing, even eager, to publicly complain that their firms may be takeover targets, even though that would seem to raise questions about their own management. These concerns inflate the price, which in turn deters the takeover from occurring. Industry practitioners suggest that this is an occasional practice among likely takeover targets.

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How to get maximum out of an Acquisition?

History shows that only 1/3rd of Merger & Acquisition were successful in the past. Why acquisition is not so successful? Why companies could not obtain maximum advantage of acquisition? As we see, after the downturn, M & A activity is going to be in great demand due to expanding market in emerging economy & consolidation activity in western economy in order to obtain economies of scale.

What shall an organization do before & after an acquisition so that they can get maximum advantage of acquisition?

A pivotal assumption of merger & acquisition is that acquisition will both preserve and create value during the integration process. If acquisition has to fuel future growth and to ensure that every deal captures and preserves optimum value, acquisitions must be managed like any other mission-critical function-with processes and platforms that span all stages of the deal lifecycle.

In order to get maximum advantage of acquisition M & A activity of organizations should be divided into 4 parts-

Corporate Activity
Pre-Deal Activity
Deal-In-Process Activity
Post-Deal Activity

Corporate Activity:

Formation of Internal M & A Department

When companies increase the number and pace of their acquisitions, the biggest practical challenge most of them face is getting not only the right people but also the right number of people involved in M&A. If they don’t, they may buy the wrong assets, under invest in appropriate ones, or manage their deals and integration efforts poorly. Organizations must invest to build their skills and capabilities before launching an aggressive M&A agenda. It can be achieved efficiently if organization shall have Internal M & A department fully dedicated to M & A activity.

For example, over the past six years, a leading global IT company acquired 50 software companies, nearly 20 percent of them market leaders in their segments. It executes many different types of deals to drive its software strategy, targeting companies in high-value, high-growth segments that would extend its current portfolio into new or related markets. They have achieved this by forming an internal global M & A team fully dedicated to M & A activity.

Align M & A activity to Organizations Corporate Strategy

One of the most often overlooked, though seemingly obvious, elements of an effective M & A program is ensuring that every deal supports the corporate strategy. Many companies are following M & A strategy where deals are only generally related to their strategic direction and the connections are neither specific nor quantifiable. Those who advocate a deal should explicitly show, through a few targeted M&A themes, how it advances the growth strategy. A specific deal should, for example, be linked to strategic goals, such as market share and the company’s ability to build a leading position. Bolder, clearer goals encourage companies to be truly proactive in sourcing deals and help to establish the scale, urgency, and valuation approach for growth platforms that require a number of them. Furthermore, many deals underperforms because executives take a one-size-fits-all approach to them—for example, by using the same process to integrate acquisitions for back-office cost synergies and acquisitions for sales force synergies. Certain deals, particularly those focused on raising revenues or building new capabilities, require fundamentally different approaches to sourcing, valuation, due diligence, and integration. It is therefore critical for managers not only to understand what types of deals they seek for shorter-term cost synergies or longer-term top-line synergies but also to assess candidly which types of deals they really know how to execute and whether a particular transaction goes against a company’s traditional norms or experience.

Building On lessons Learned

Like any other core business function, merger integration should be monitored and measured—and, of course, improved. This means building attainment of the required skills into human resource metrics and incentive systems. It also requires an honest assessment of current skills. Some successful acquirers have elevated the office of “integration manager” to a coveted position within the company so that up-and comers see the post as a senior management spot. Others use report cards to monitor the various elements of deal success, as well as the various performance indicators of the integration process: Was it on time and on budget? Were all synergies identified and achieved? One leading insurance company has established a systematic process for capturing lessons learned, holding monthly sessions for members of the integration teams to review the progress of all mergers, both completed and in progress. The company also makes the overall merger integration approach available to the organization as a whole on a database on the web.

Pre-Deal Activity:

Target Identification

There are a number of different aspects to successful target identification. One important emerging need is to identify acquisitions in overseas markets. Acquirers must be able to assess the acquisition from the target’s point of view, as well as from their own. But understanding the regulatory and competitive environment in another country can be complex and time-consuming. Thorough due diligence, using local advisors, is critical to understanding the local market. It can identify challenges and ensure that they are properly reflected in synergy estimates and integration plans. Microsoft uses the enormous resources of its extended enterprise to identify potential acquisition targets. The business groups take the lead, looking within their own and related markets for opportunities. Ideas also come from venture capital relationships in both the United States and Europe, as well as through the company’s alliance and partner community. Acquirers must also be able to identify and capture new skills in the companies they buy. Cisco Systems—often known as the “acquirer of choice” by target companies—is an outstanding example of success in this regard. The maker of Internet networking equipment emphasizes that it acquires people and ideas, not just technologies. The leadership and talent of the acquired company must be committed to seeing the acquisition and the integration of the company work. It is not the first version of a product that becomes a billion dollar market, Cisco argues, but the subsequent versions. Cisco needs the acquired company’s talent to stay and build those next versions.

Synergy Identification

Executives at acquiring companies often fail to capture all the deal synergies they can because they define those synergies too narrowly. For example, they do not aggressively try to capture revenue synergies, even when they were used to justify the deal, because these synergies are considered harder to track. Business managers also do not want to have to achieve revenue growth rates that are over and above what they were already given as goals for their standalone business. On the other hand, some acquirers spend so much time running around after anything that was used in external communications to justify a deal that they don’t prioritize their efforts on the biggest and most accessible opportunities.

Example: Quaker Oats’ purchase of Snapple, the beverage maker, were using its R&D and marketing muscle to help Snapple rev up its fanciful flavors and visibility, Quaker spent far too much time trying to integrate Snapple’s distribution systems and channels with those of its Gatorade brand, with horrific results and huge losses of revenue and value in the Snapple business unit. To combat those tendencies, post-close integration priorities should precisely match the value and type of synergies that drove the deal in the first place.

This makes us to find out how to quantify synergy in terms of value.

“Synergies are the present value of net, additional cash flow that is generated by combination of two companies that could not have been generated by either company on its own.

Net means that the synergy calculation must take into consideration the cost to achieve the synergies and include any dis-synergies that the deal itself creates. Synergies must also create incremental cash flow. If the acquiring company could have captured the cash flow on its own, then they are not synergistic.”

Definition Example: A company trying to sell products into a country it does not currently serve. It could, perhaps, achieve such access on its own. But at what cost? How long would it take? Acquiring a target company that already has such access can be synergistic, as long as the criterion of net incremental cash flows is met. The synergy calculation would then take into consideration how much faster (and cheaper) such geographic access is to achieve.

Cisco’s acquisition of Linksys is a good example of capturing potential revenue synergies by accessing a new customer segment. Cisco knew that the retail market for wireless routers and associated products used in the home was growing many times faster than the corporate market that Cisco had traditionally served. The company knew that its in-house engineers could design products for this market. But Cisco also realized that it would take a year or two to design and test the products. That, combined with the fact that Cisco was not well known outside of the corporate space, led to the decision to buy Linksys, an established player with proven overseas sourcing and customer service capabilities. The resulting synergy would generate the incremental cash flow that would come from the acquisition contrasted with the cash flow that Cisco could have achieved on its own.

When done correctly, pre-deal synergy estimates should determine the total valuation and premium. By matching integration priorities to the necessary premium and deal rationale, the actual integration work will be correctly prioritized. A key element in synergy definition and measurement is the establishment of an appropriate baseline. Unless the acquirer and the integration teams know what they are comparing synergies against, it is impossible to determine if incremental cash flows are actually being identified and captured. The baseline is the starting point to measure value realized from the deal. Once established, the baseline becomes “non-negotiable”—everything needs to be measured against one common set of numbers. Key considerations for establishing a baseline include:

• A clear definition as to what is included versus excluded. Specifically, executives must firmly establish exactly what revenues and costs are included in the standalone cash flows of the two companies.

• A multi-year time horizon, since synergy capture will not occur in one year.

• Its clear acceptance by all parties. If the baseline is considered unfair, synergy estimates are likely to be sandbagged (it helps to use existing budget).

• Ensuring that savings or operating improvements that were already planned are included in the baseline so they are not counted as synergies later. The establishment of the baseline can be a time-consuming task, but it is critical.

Example: When Sony and Bertelsmann formed Sony BMG Music Entertainment, it was necessary to map financial and overhead spending for more than 60 geographies and businesses to identify baseline elements such as payroll expenses (one company classified them as HR expenses, the other as Finance), and differences in how corporate overheads were allocated to business units. Only when the baseline was agreed to by both parties (which took hundreds of meetings) was it possible to implement the bottom-up synergy targeting. Proper base lining helps avoid many common problems, such as counting as synergies the jobs that are eliminated in one department but transferred to other departments, or where the costs related to personnel reduction are incurred in multiple departments.

Cultural Assessment

A company must not only be able to determine if its own culture will mesh with that of the acquisition. The new, single culture must also serve strategic needs better than either of its predecessors. Hungarian oil company MOL, faced with entrenched national rivalries when it took over Slovakia’s formerly state-owned slovnaft, tackled the problem by recasting the merged entity as an international company and requiring all managers to learn English. Many acquirers confront similarly complex cultural issues. Cultural assessment can be daunting, especially because questions that can reveal key elements of an acquisition’s culture—relative intangibles like teamwork, competition, rewards and power—don’t usually appear on due diligence lists. In such cases, a systematic assessment can help.

Support from senior management

In many companies, senior managers are often too impressed by what appears to be a low price for a deal or the allure of a new product. They then fail to look beyond the financials or to provide support for integration. At companies that handle M&A more productively, the CEO and senior managers explicitly identify it as a pillar of the overall corporate strategy. At GE, for example, the CEO requires all business units to submit a review of each deal. In addition to the financial justification, the review must articulate a rationale that fits the story line of the entire organization and spell out the requirements for integration. A senior vice president then coaches the business unit through each phase of a stage gate process. Because the strict process preceding the close of the deal outlines what the company must do to integrate the acquisition, senior management’s involvement with it after the close is defined clearly.

The most common challenge executive faces in a deal are remaining involved with it and accountable for its success from inception through integration. They tend to focus on sourcing deals and ensuring that the terms are acceptable, quickly moving on to other things once the letter of intent is signed and leaving the integration work to anyone who happens to have the time. To improve the process and the outcome, executives must give more thought to the appointment of key operational players, such as the deal owner and the integration manager.

Appointment of Deal Owner

Deal owners are typically high-performing managers or executives accountable for specific acquisitions, beginning with the identification of a target and running through its eventual integration. The most successful acquirers appoint the deal owner very early in the process, often as a prerequisite for granting approval to negotiate with a target. This assignment, which may be full or part time, could go to someone from the business-development team or even a line organization, depending on the type of deal. For a large one regarded as a possible platform for a new business unit or geography, the right deal owner might be a vice president who can continue to lead the business once the acquisition is complete. For a smaller deal focused on acquiring a specific technology, the right person might be a director in the R&D function or someone from the business-development organization.

Appointment of Integration Manager

Normally, integration managers are not sufficiently involved early in the deal process. Moreover, many of them are chosen for their skills as process managers, not as general managers who can make decisions, work with people throughout the organization, and manage complicated situations independently.

Integration managers should involve as soon as the target has been identified but before the evaluation or negotiations begin. They should drive the end-to-end merger-management process to assure that the strategic rationale of a deal informs the due diligence as well as the planning and implementation of the integration effort. During IBM’s acquisition of Micromuse, for example, a vice president–level executive was chosen to take responsibility for integration. This executive was brought into the process well before due diligence and remains involved almost two years after the deal closed. IBM managers attribute its strong performance to the focused leadership of the integration executive.

Deal-In-Process Activity:

Stringent Stage Gate Process

A company that transacts large numbers of deals must take a clearly defined stage gate approach to making and managing decisions. Many organizations have poorly defined processes or are plagued with choke points, and either fault can make good targets walk away or turn to competitive bids. Even closed deals can get off to a bad start if a target’s management team assumes that a sloppy M&A process shows what life would be like under the acquirer.

An effective stage gate system involves three separate phases of review and evaluation. At the strategy approval stage, the business-development team (which includes one or two members from both the business unit and corporate development) evaluates targets outside-in to assess whether they could help the company grow, how much they are worth, and their attractiveness as compared with other targets. Even at this point, the team should discuss key due diligence objectives and integration issues. A subset of the team then drives the process and assigns key roles, including that of the deal owner. The crucial decision at this point is whether a target is compatible with the corporate strategy, has strong support from the acquiring company, and can be integrated into it.

At the approval-to-negotiate stage, the team decides on a price range that will allow the company to maintain pricing discipline. The results of preliminary due diligence (including the limited exchange of data and early management discussions with the target) are critical here, as are integration issues that have been reviewed, at least to some extent, by the corporate functions. A vision for incorporating the target into the acquirer’s business plan, a clear operating program, and an understanding of the acquisition’s key synergies are important as well, no matter what the size or type of deal. At the end of this stage, the team should have produced a nonbinding term sheet or letter of intent and a roadmap for negotiations, confirmatory due diligence, and process to close.

The board of directors must endorse the definitive agreement in the deal approval stage. It should resemble the approval-to-negotiate stage if the process has been executed well; the focus ought to be on answering key questions rather than raising new strategic issues, debating valuations, or looking ahead to integration and discussing how to estimate the deal’s execution risk.

Each stage should be tailored to the type of deal at hand. Small R&D deals don’t have to pass through a detailed board approval process but may instead be authorized at the business or product unit level. Large deals that require significant regulatory scrutiny must certainly meet detailed approval criteria before moving forward. Determining in advance what types of deals a company intends to pursue and how to manage them will allow it to articulate the trade-offs and greatly increase its ability to handle a larger number of deals with less time and effort.

As companies adapt to a faster-paced, more complicated era of M&A deal making, they must fortify themselves with a menu of process and organizational skills to accommodate the variety of deals available to them.

Post-Deal Activity (Capture Synergy):

Fast-Pace Synergy Capture

The synergy capture effort should be “front loaded” so that the emphasis is to go after the biggest synergies as soon as possible.

Opportunities for synergies tend to be time-sensitive. Successful acquirers tend to capture 70-75 percent of synergies in the first year after the deal. The reason is that it is very difficult for any acquirer to stay focused on execution for more than 18-24 months—it becomes too easy to revert back to the status quo, the next acquisition or the new big program that comes along. In fact, very few companies achieve significant synergies in cases where they have waited more than three years to finish capturing benefits. To quickly identify the highest value synergies, best-practice acquirers often prioritize synergy opportunities by assessing them along three dimensions: size, time to implement, and difficulty of capture. They then work on how to make the biggest opportunities easier to implement in less time.

Example: When a major specialty chemicals company began to plan its acquisition of a large global rival, it focused ruthlessly on planning and achieving the major source of synergies-savings from procurement of direct materials. That singular focus led the client to exceed its publicly stated cost synergy target of $200 million by more than 40 percent-a quarter ahead of schedule.

Adequate Incentive program

Incentives play an important part in achieving many other corporate goals (not the least of which is hitting profit targets). So why should things be any different for achieving synergies? Yet many companies do not specifically tie synergy targets to incentive systems. Incentive programs should be explicit and timely; they should create meaningful rewards which are directly tied to synergy goals.

Example: After Cadbury Schweppes purchased candy and gum maker Adams, the external rallying cry was “Beat Wrigley!” Internally, it was “Beat the Model!” Personal financial incentives were tied to the performance of each functional and regional team against the integration model.

Involvement of Right People

Company must appropriately match people with the skills needed in a given position, so they must get the right people doing the right things in relation to capturing synergies.

Example: In a large merger of wireless providers, core finance staff was tied up preparing the integration plans for their own department. The merger integration team saw that these people were needed to craft a synergy management process for the whole company. Finance resources were therefore shifted to roles that supported the overall merger integration process

Cultural & System Synergy

Some cultures are just not adept at achieving synergies. Achieving synergies requires some degree of “measurement culture” where the idea of tracking a success and tying it to a financial metric is a way of life.

Example: A merger of Medicare Advantage providers was predicated on achieving scale economies and sharing operational best practices to fuel continued rapid growth. But without formal budgeting and KPI processes, the NewCo could not agree to how many cost synergies could be harvested without sacrificing growth. As a result, synergies were not captured, operational dis-synergies began to show up in the absence of clear integration action, and the NewCo quickly faced a major slowdown in growth—with big profitability problems.

Adopting Correct Process

Companies must use a rigorous, holistic process to capture synergies. Such a process includes detailed tracking mechanisms, linking synergy targets to ongoing budgets and financial plans, and a system to quickly determine if synergy capture is on schedule (and fix it if it is not).

Example: When Rogers Communications was merging with Microcell, clear synergy guidelines were established before the integration teams kicked off. Rogers Wireless’ Senior Leadership Team initiated the process by outlining the requirements by quarter for creating true deal value. They then articulated what those requirements meant for each team. Teams were then asked to identify one or two “quick win” synergy opportunities (those that would be realized in the first quarter after close) and to map out the synergy realization for each quarter afterwards. The synergy goals were 50 percent higher than what was promised to the Street, and they created tremendous pressure and focus on realization. As a result of this rigorous process, Rogers was able to achieve the target operating cost target synergies of $100 million earlier than anticipated. This contributed to the overall success of the integration of Microcell and positioning Rogers to be the largest wireless provider in Canada.

Conclusion:

Major hurdle of any acquisition to achieve maximum out of acquisition or to create great synergy with the merged entity can’t be magically materialized. Synergy by its actual definition means possibility not certainties.

However lots of acquirers think that by describing certain possibility, the synergies will appear once the deal is close- as if to talk about them is some how enough to make them come to pass. In practice, it takes works and commitment to identify maximum value from synergies. They must be rigorously targeted, pursued and tracked by the right people, the right system and the right process at the right time. Only then do synergy opportunity becomes real benefits- and only then can deals be truly successful.

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How to do successful spin-off of a large organization?

Why Organization does spin-off? Normally a giant organization spin-off their underperformed business in a separate company in order to reduce burden on parent company by way of eliminating underperformed business from the Balance Sheet.

It is always good for an organization to hive off underperformed business to enhance their fund raising capacity and simultaneously increases company’s market value.

However there are instances where large organizations hive off their business as it becomes very difficult to generate maximum return from each business due to uniqueness of each business and their growth depends upon industry cycle and economic environment of that particular industry.

We have lot of example where hive off business in a growing industry has provided exceptional growth which was not possible in a consolidated mode. Hive off provides an opportunity and focus that makes an optimum utilization of fund.

I would like to share a successful spin-off example of Tyco International. Chris Coughlin, CFO and Ed Breen, CEO of Tyco International were responsible for company’s turnaround from scandal-scarred history under former CEO to a company with moderate growth and strong capital structure.

In 2006 the board has decided to spin off Tyco’s health care business (now Covidien) as well electronic business into a separate company. Today original Tyco International is of $ 20 billion company half of its original size.

Spin off of Tyco International in 3 separate units required stiff challenge and lot of strategic thinking.

How the Process Started:

In 2005 business of Tyco International was thriving and debts were at an adequate level. At that time top management decided how to grow value of corporation over next 5-10 years. Discussion with investors makes them realize that investors are more keen about long-term capital structure of the company and diverse portfolio that would make earnings go up or down in a particular period.

Health care division of Tyco requires huge capital structure due its nature of business, so it requires flexibility in accessing capital market to raise fund for new technologies. Contribution of revenue from health care business was only a quarter of total revenue. It becomes necessary to make health care business an A-rated kind of company as other business division didn’t require such a huge capital structure.

So it was decided to grow health care business in a separate company as it may be better off on its own. In addition to being a large group, with about $10 billion in annual revenues, it was well organized, it had integrated many of its acquired businesses, and it had a seasoned management team. And once they reached that conclusion with the health care business then they started to look at the rest of the portfolio. Given the shareholder base it was concluded that it is probably made sense to pull apart the electronics business as well, enabling that business to invest more effectively during the down cycle, which might be more difficult as a part of a multi-industry player. This affected the emergence of Tyco international, Tyco Health Care (Now Covidien) & Tyco Electronics.

How Board was Convinced:

Boards were quite happy with achievement of new CEO & CFO the way they bring company out of crisis and they had great pride in the organization. They understood the need to look at the company’s portfolio and the process was put together to consider the proposal in greater detail. After some lively discussions, the board agreed that that strategy made sense and at the end they were convinced.

How Investors were Convinced:

Initially there was skepticism. Some investors felt that they had built this great company, it is doing very well, the stock is also performing very well, so why pull it apart when the profits were growing and cash flow was strong?

There was concern and confusion about how long the process would take, and some didn’t fully appreciate the complexities of a spin-off on this scale but once the proposal was produced in front of investors and when they saw the filings that were required—which were just massive—and the SEC review process, people started to understand how truly complex it was and ultimately everyone agreed for spin off.

Normally companies do equity carve-out first to create a stock that traded before doing the final spin-out however Tyco being a large organization requires an appropriate capital structure in place. It needs to be ensure that the Tyco, which was actually the smallest piece in terms of profitability, didn’t need additional cash. They had very solid cash-generating businesses and it can put together a capital structure and a debt structure that are appropriate. They didn’t think that they needed to establish a market by putting out 15 percent or 20 percent in advance. They can set up the appropriate capital structures that would best support the three companies without having to move a lot of money around. So after looking at a number of alternatives the Management decided a straight dividend of shares.

Management:

The most challenging part of spin off was to get the management teams in place and transferring the technical knowledge from some of the corporate functions that resided at the Tyco headquarters to the two new businesses. So they set up a formal mechanism to manage the whole transition process and held reviews every month with each function.

One of the nice things about this separation is that it provided some enormous opportunities for present employee. They had built some real strength in some of the functions, so as the company separated and needed, say, treasurers for all three companies, they were able to fill those positions internally. The CFO for electronics, for instance, came from inside that organization, a new CEO was appointed from another Tyco business. In health care they had an experienced team in place that pretty much remained in tact. There were other opportunities for people to move up many other functions including tax, treasury, and legal.

Recruitment of Board Members:

It was easier than expected. Typically, recruiting 1 board member can be a challenge, but how do you find 20? They went through a very rigorous process to identify skill sets that needed on each of the boards; it also decided to have non-executive chairmen at the two new companies because neither CEO had led a public company before. Given the scale of these companies and the market-leading positions they have, it surprised that the process actually attracted very many qualified people. But not having to go on to an existing board where people might have been working together for years and not having to worry about fitting in, that ended up being a real plus.

Interestingly, one of the decisions of the existing Tyco board was not to split itself up—which is different from what’s happened in a number of other major spin-offs. What drove that decision was that the board came in together shortly after the previous board had stepped down. They saw the advantage of a new full team building a strong working relationship. So although you might ask if it wouldn’t be better to have some of the board that was experienced in overseeing some of the businesses but they felt that the best approach was to attract completely new members.

CFO in a Strategic Role:

The way the world is today, it can’t be imagine that the CFO not playing a strategic role, particularly in a business as large and diverse as Tyco group. A critical part of the strategy is allocating capital across the businesses—where are they going to invest, what are they going to do with the cash flow between acquisitions and with their dividend policies, and so on. With the capital markets being what they are and with investor expectations of CEOs as well as CFOs, these two positions have to be very closely linked. The more complex the business models more the CFO’s plays strategic role. To do that, you have to have extremely strong technical finance functions behind you. At Tyco they would have never execute this kind of a transaction, nor could they have spent the time that needed on both the strategy and managing the overall separation process if they hadn’t had world-class experts in the controller, treasurer, and tax roles.

After Spin off:

Now after the spin off each of the three companies is moving aggressively toward changing their portfolios. It was indicated at the time they separated that all three companies still had to make changes to their portfolios that include making strategic acquisitions as well as divesting certain businesses.

Additionally, each company are more nimble now, as separate companies with their own management teams, M&A groups, tax groups, accounting groups, and so on. And with all the complexity of going through such transactions it can actually do more in a shorter period of time. For example, the health care business has already announced that they’re getting out of their retail business; Tyco International is exiting its infrastructure services business, Earth Tech, and Tyco Electronics has announced that it’s getting out of its power systems business.

Allocation of capital has become much more defined and much more focused, so we see more transactions in each of the three companies in bringing businesses and technologies in, as well as divestitures.

Conclusion:

If you’re buying small companies and add management expertise and processes and competencies that smaller companies don’t have that is one thing. But when they become $10 billion-plus organizations with tens of thousands of employees around the world you have to honestly look at what value is created by adding to a corporation. It’s very difficult to manage a broad base of businesses—such as heavy manufacturing, service businesses, and technology-driven companies—in a single portfolio, and to argue that that’s the right way to do it for a long period of time becomes more and more difficult. The world obviously changes and it’s incumbent on management to continue to take a very hard look at its portfolio of businesses, the value that’s being added, and whether they are truly better off being a part of the same large company.

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What is Enterprise Value? How to calculate it?

Every now and then people get confuse about Enterprise Value. Some feels that it is a market capitalization value which is used when buying and selling a company. Today most of the M & A activity happens around Enterprise Value. So it is necessary that we should fully understand what actually is enterprise value and how it affects company’s buying behavior.

Enterprise value is a measure of the actual economic value of a company at any given moment. Enterprise value measures what it would actually cost to purchase the entire company. Many investors use the current value of all of a company’s outstanding shares as its economic value. Known as market capitalization, the current market value of all of a company’s shares is equal to the current number of outstanding shares multiplied by the current share price:

Market Capitalization = Number of Shares Out * Current Share Price

You can find the current share price almost anywhere, thanks to the wonder of 15-minute delayed and real-time quotes. Shares outstanding can be a little trickier, but it can find with the latest quarterly earnings press release or SEC filing. Although the number appears in the quote feeds of a number of data providers, it often lags the latest reported quarter by a couple of weeks and seldom takes into account in timely fashion the shares issued to acquire another company.

Now, if market capitalization is the value of all of the outstanding shares, why use enterprise value at all? I mean, enterprise value only appears in a few business school textbooks that focus on cash-flow valuations. The rest of the investment media uses market capitalization.

Although market capitalization is the key component of the actual economic value of a company, it is hardly the only one. Using only market capitalization to value companies is kind of like using the down payment on a house as a proxy for how much a house is worth. The larger the mortgage on the house is, the more wrong you end up being. When a company carries long-term debt, which is essentially what a mortgage is, the company has pledged its own assets to borrow money. If someone were to acquire that company, she would also acquire responsibility for that debt. Much like the person who “assumes” a mortgage of $50,000 after paying $20,000 in equity for a home, a company that pays $20 million for the stock of a company with $50 million in debt has really paid $70 million for the entire company.

The simple fact is that debt matters. Now, many companies have an inconsequential amount of debt; however, there are plenty where the amount of debt that the company has is quite consequential. A controversial, Nobel Prize winning economic theory called M&M (after two professors named Modigliani and Miller) proposed that the effective capital structure of a company was the market value of its equity plus its debt. The controversial part was when they went on to say that there is no optimum capital structure, meaning that every dollar of debt a company carried consumed a potential dollar of equity. Put another way, a company’s value was a given. Whether it chose to recognize that value all in debt or equity was the company’s choice — there was no capital structure that resulted in a higher valuation without increasing earnings somehow.

Another very important factor to consider when analyzing a company is what it has in the bank. If a company has a hoard of cash or significant equity stakes in other publicly traded businesses, these are pretty easy to value and are obviously sources of liquidity for the company. Going back to our home example, say you bought a home for $70,000 — $20,000 in cash and $50,000 in debt after assuming the mortgage. When you walked in the house, you found $20,000 in cash left by the previous owner. After putting this $20,000 in the bank, your effective purchase price becomes $50,000. Although you paid out $20,000 to the owner, you got it right back.

Because of the rather complicated rules of acquisition and corporate ownership, this somewhat ludicrous example happens all of the time in the business world. If a company has $20 million in cash in the bank, it is not like the outgoing Chairman can put it in his pocket as he leaves. That money belongs to the company — and those who own the company. If someone is buying the company, that money really belongs to him or her. No one else can take it. As a result, when the old owners are paid off they are paid off with cash from the new owners — leaving any cash in the company behind for the new owners to keep. Given that equity stakes in other publicly traded companies are really just as good as cash — heck, maybe even better — it makes sense to count this as part of the cash hoard for the purposes of determining what the actual economic price of a company is.

Given all of this, you can see that the real, economic purchase price of a company at any given moment is the value of the stock (the market capitalization), plus the debt that the company has taken on, minus any cash or investments it has on the books. This is what we call enterprise value. We use this instead of market capitalization because it is the actual economic purchase price of a company at any given moment. Enterprise value reflects the actual purchase price anyone acquiring a company would have to pay.

Enterprise Value = Market Capitalization + Long-term Debt – Cash & Investments

Why go to all of this trouble when some people argue that the value of the stock has already been adjusted for the debt and cash a company has? Because no matter how much the actual price of the stock changes, the debt and the cash do not go away. An acquirer still has to take on the debt and still gets to put the cash in the bank whether the company’s stock is worth $1 billion or one dollar. Debt and cash are economic realities and must be factored into the purchase price an acquirer pays for a company. Enterprise value is not a valuation, meaning the theoretical price at which a company should trade, but a value, meaning the current, real price as definite as if stuck on with a pricing gun.

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Who is ths best owner of a business?

Frankly, we never know who the very best owner of a business might be; we can only know who is probably the better owner among competing alternatives. A better owner could be a larger company, a private-equity firm, a sovereign-wealth fund, or a family. It could also be an independent public company listed on a stock exchange, a mutual (owned by its customers), or even a government- or employee-owned entity. Being better owners, each of these types of companies may add value to a business in a number of ways.

Better ownership is not permanent or static but rather can change over the life cycle of a business. Too many companies don’t recognize that even if their own distinctive capabilities remain the same, the needs of a business naturally change as it matures and the industry in which it competes changes as per time.

A company’s business founders are its first best owners. Their entrepreneurial drive, passion, and commitment to the business are necessary to get the company off the ground. As it grows and requires larger investments, a better owner may be a venture capital firm that specializes in helping company to grow by providing capital, improving governance, and enlisting professional managers to handle the complexities and risks of scaling up an organization. Eventually, the venture capital firm may need to take the company public, selling shares to a range of investors to finance further growth. As the public company grows, it might find that it can no longer compete with larger corporations because, say, it needs global distribution capabilities far beyond what it can build in a reasonable amount of time. It may thus sell itself to a larger company that’s the better owner because of an existing global distribution network, thereby becoming a product line within a division of the larger company.

As the division’s market matures, the larger company may decide to focus on faster-growing businesses. In this case, it might sell its division to a private-equity firm—a better owner if the firm can eliminate corporate overhead that’s inconsistent with the business’s slower growth and thereby leave the division with a leaner cost structure. Once the restructuring is done, the private-equity firm can sell the division to yet another better owner: a large company that specializes in running slow-growth brands.

The best-owner life cycle makes that executives must continually seek out new acquisitions for which their companies could be the best owner while at the same time divesting businesses for which they no longer are. Since the best owner for businesses constantly changes, any corporation, large or small, should acquire and dispose of them regularly.

For acquisitions, applying the best-owner principle often leads acquirers toward targets very different from those that traditional target-screening approaches might uncover. Traditional ones often focus on targets that perform well financially and are somehow related to the acquirer’s business lines. But through the best-owner lens, such characteristics might have little or no importance. It might be better, for instance, to seek out a financially weak company that has great potential for improvement, especially if the acquirer has proven performance-improvement expertise. Or it might be better to focus attention on tangible opportunities to cut costs or on the existence of common customers than on vague notions such as how related the target may be to the acquirer.

Keeping the best-owner principle front and center can also help with negotiations for an acquisition by keeping managers focused on what the target is worth specifically to their own company—as well as to other bidders. Many managers err in M&A by estimating only an acquisition’s value to their own company. Because they are unaware of the target’s value to other potential better owners—or how high those other owners might be willing to bid—they get lulled into conducting negotiations right up to their breakeven point. Of course the closer they get to it, the less value the deal would create for their own shareholders. Instead of asking how much they can pay, they should be asking what’s the least they need to pay to win the deal and create the most value.

Consider the example of an Asian company that was bidding against a private-equity firm to purchase a European contract pharmaceutical manufacturer. The Asian company estimated the target’s value to itself and also to the private-equity firm, which could add value by reducing overhead costs and attracting customers that hadn’t used the target’s services because it was owned by a competitor. The Asian company estimated that the contract company was worth $96 million to the private-equity firm.

The Asian company could make the same overhead cost reductions and add similar customers—but on top of this, it could move some of the manufacturing to its lower-cost plants. As a result, the target’s value to the Asian company was $120 million, making it the best owner and enabling it to pay a higher price than the private-equity firm would, while still allowing it to capture significant value. As a side note, the value of the target to its European parent was only $80 million.

Knowing the relative values, the Asian company could afford to bid, say, $100 million, pushing out the private-equity firm and gaining $20 million in potential value creation. The Asian company could further increase its share of the value to be captured, by announcing plans to enter the business even without making the acquisition. If the seller and the private-equity firm were convinced, they would have to reduce their estimates of the target’s value, and the Asian company could reduce its bid, capturing more value still.

For divestitures, including both sales and spin-offs, the best-owner principle allows managers to examine how the needs of the businesses they own may have evolved in different directions. For example, most pharmaceutical companies grew up as parts of diversified chemical companies because the basic manufacturing and research requirements were the same. But as the two industries specialized, their research, manufacturing, and commercial requirements diverged so much that they became distant cousins rather than sisters.

Today, running a profitable commodity chemical company demands scale, operating efficiency, and the ability to manage costs and capital expenditures. But creating value in a pharmaceutical company requires a deep R&D pipeline and large local sales forces, as well as specialized expertise in areas such as the regulatory-approval process and dealing with large public and private purchasers. While having both kinds of businesses under one owner made complete sense 50 years ago, it no longer does. That is why nearly all former chemical and pharmaceutical combines have split up over the past three decades; Zeneca, for example, separated from ICI in 1993, and Clariant and Sandoz parted ways in 1995.

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How to maintain maximum return on Portfolio of Business?

One of the most challenging task a top executive of a business faces is to maintain & grow portfolio of business that provides maximum returns to an organization.

In today’s environment companies that actively mange their portfolio of business are finding that the traditional method of balancing portfolio like invest free cash flows in more attractive businesses, preferably with synergies to existing ones, and look to build a strong position—often creates little value. Given the breadth and pace of today’s global markets, companies must constantly compete for acquisitions across the world and pay a hefty premium for highly attractive businesses. Often, merely reinvesting free cash flows makes little difference to the portfolio’s value.

In order to take decision beyond the conventional model of portfolio management, today’s business mangers take ad-hoc decisions and act more on gut feeling rather than on actual data. Portfolio strategy, at its core, is about being or becoming the natural owner of businesses and balancing investment opportunities against the supply of capital, given the predicted returns of current and potential investments.

What’s natural owner of business & how to become the natural owner of your business?

Companies can be natural owner of business in several ways depending on how they add value to a business-

Operational synergies, for instance, may let them use the same technology, produce in the same plants, or distribute to the same channels where business systems overlap. In specific situations, such as emerging markets, natural ownership can include superior access to capital and talent—one of the reasons emerging markets still have conglomerates with a broader business mix than in more developed markets.

A company that isn’t the natural owner of a certain type of business can decide to become one by building a large enough position and striving for distinctive performance in key areas. When many universal banks acquired investment banks in the 1990s, they worked to become natural owners in a very attractive business segment. Many failed, but some of the most successful global banks built their position in this way.

Corporate skills also can be a source of natural ownership. The skills of any company are the product of its culture and history. Certain oil companies know how to foster operational excellence in refining; these companies have repeatedly created significant value by acquiring refining assets from other oil companies and improving their performance.

Measuring natural ownership isn’t straightforward but does provide an important point of comparison among portfolio options.

The best test for natural ownership is whether a different owner would ascribe a higher value to a business. Measuring this point is difficult and subjective, but business managers can do so for an existing business by valuing their plans assuming realistic performance levels and then comparing this value with the price the business would command if it were sold, using either private equity-style valuation models or recent M&A multiples. For M&A opportunities, managers can compare the price they could rationally offer with the likely bids of others—keeping in mind that other offers aren’t always rational.

Portfolio Balancing Opportunity with Capital

Even if a company is the most natural owner of all its businesses, merely investing free cash flows in the most attractive ones may not be the best approach for generating maximum returns. Companies must consider that almost all businesses can be bought or sold and that capital can be raised or returned to shareholders. Therefore, managers must constantly examine a company’s entire portfolio of businesses and opportunities as if they were planning to reinvest all its capital.

The notion of capital balance starts with the mix of investments in new and existing businesses—the mix that creates the most value. More often than not, the amount of capital a company has for investment doesn’t equal the amount of capital required by all of its opportunities. Companies with more investment opportunities than capital, such as a fast-growing technology company with interesting intellectual property, tend to look for more capital. These companies will be more aggressive on divestments, impose higher hurdle rates on investments, and ponder raising more capital through additional debt or equity issues. Companies with more capital than investment opportunities, such as a successful company in a mature market, tend to accept lower returns from new opportunities, are more reluctant to divest, and look for ways to return cash to shareholders via buybacks and dividends.

Calculating capital balance requires a clear understanding of the current portfolio, investment and divestment opportunities, and available capital and financing.

In analyzing the capital balance, business managers should distinguish among three types of capital decisions:

Capital deployed in existing businesses

Almost all businesses require a certain rate of reinvestment—for example, to develop new products or keep production facilities up to date. While the current rate of reinvestment may create the most value for a mature business, a higher rate may be necessary to gain market share or expand into new markets.

Capital deployed in larger investment opportunities

Big opportunities include completely new investments, such as an acquisition or a market entry, and dramatic shifts in current businesses. An example of a dramatic shift could be a decision to transform a company from a technology provider into a service provider that owns and operates its technology.

Capital gained by exiting existing businesses

Exiting some businesses, such as those that have scarce assets—say, mobile-phone businesses in markets with a limited number of licenses—often brings a company a premium above the current value. In other businesses, an exit won’t necessarily generate a price that reflects the business’s true economic stand-alone value; in many transactions potential buyers discount the price they’re willing to pay by assuming a worst-case economic scenario. Certain businesses are too interlinked with other operations or the corporate identity for divestment to be practical. Some involve government or other stakeholders that put a sale beyond a company’s control.

In all situations business managers who understand the elements of capital balance can make better-informed decisions. These managers have to arrive at a number of judgments on the relative merits of investments and divestments, such as trade-offs between strategic fit and short-term value creation and whether to modify hurdle rates.

One niche services company had calculated its current capital balance realized that it could create further value in its core business but would be better off diversifying into adjacent businesses with a superior long-term outlook and uncorrelated risks.

Assessing Future Investment Returns

To allocate capital among various opportunities, management has to understand the future economic returns that potential investments will generate, but assessing future returns is a very challenging task. Many management teams still focus on accounting returns, such as profits on book capital, ignoring the fact that the market value of an existing business is higher than the book value if its returns are above the cost of capital (and lower if its returns are below the cost of capital). Likewise, the value of new businesses must account for any goodwill paid to acquire them. Management often compare the book returns of existing businesses with the net value creation from new ones; the result is an unfortunate bias toward keeping lackluster businesses and shying away from new opportunities that require the payment of goodwill or entry costs.

For Example any new deal’s value creation depends on the potential synergies (cost, capital, revenue, and growth) it produces and the extent to which the premium paid cancels out those gains. Synergies, of course, must be rigorously quantified. The likelihood of actually realizing forecast synergies also needs to be assessed, along with such offsetting factors as lost revenue. The projected value created must then be weighed against any premium paid over the target’s intrinsic value rather than against the current share price, which often reflects takeover speculation.

Calculating the net returns of a portfolio of investments can be complex, as actual returns may differ markedly from accounting ones. The most accurate approach is to decompose net returns into the underlying future returns of the business, minus entry costs and plus synergies gain. Management can estimate this value by using simple proxies; for example, they can usually derive a good estimate of future returns from long-term returns on invested capital, which are surprisingly stable in many industries. Note that long-term growth heavily influences future returns; at typical levels of profitability, growth at twice the rate of GDP generates returns that are two to three times higher than growth at GDP.

The main reason many companies fail to create value when they change their corporate portfolios is that managers have misjudged the exit or entry costs, such as acquisition goodwill or start-up losses. Again, managers should consider external proxies. In the case of acquisitions, executives know the premiums paid for past transactions, and premiums for new businesses can be justified by synergies even if they are assessed only approximately. In the case of a divestment, a substantial loss of value can result from the loss of synergies, and while few companies bother to quantify the synergies among existing businesses, that oversight can lead to unpleasant surprises at the moment of a divestment. When a large financial institution tried to divest its asset-management business, it found that more than a third of its value depended on captive business, which buyers would exclude from a stand-alone valuation. As a consequence, the company had to grant extensive guarantees in order to sell.

One proxy for future returns that is often used—but should not be—is short-term growth in earnings per share. This approach does not adequately account for the amount of capital needed to acquire or maintain an investment, so it tends to favor acquisitions even if they will destroy value.

A practical approach should be to calculate the net return, typically over the next five to ten years, from all portfolio moves under consideration: keeping a business, investing in step changes or new businesses, or selling businesses. Managers should always calculate returns relative to the current value of a business, existing or new. Coincidentally, this metric resembles the approach taken by private-equity firms. It lets managers easily link the results of portfolio strategy to a business’s medium-term targets for growth and returns. In that sense, only investments that give a company some form of advantage sufficient to pay back the costs of entry and exit are likely to generate sufficient returns on capital. Here, the connection to natural ownership becomes clear: the ideal investment is one where natural ownership leads to superior net returns. The ideal portfolio is one with enough such investments to deploy all the available capital at rates clearly above the cost of capital.

Given the complexity of portfolio decisions, how should managers go about defining a portfolio strategy? Here are four useful hints-

Understand the context and objectives

Approaches to portfolio strategy can vary considerably, depending on the context. One company may want to determine which businesses it can divest with minimal loss of value and strategic coherence. Another might want to assess the range of investment options for cash flows generated by its current, maturing businesses.

Manage Decision Issues

Operational managers do not have the best position for making portfolio decisions: they are often inclined to favor the businesses they are currently responsible for, so they are reluctant to recommend reallocating capital to new opportunities. To overcome such decision issues, a company should charge people who are independent of the operating businesses—typically, the board, advised by the CEO and the CFO— with the responsibility for making all final portfolio decisions.

Do Rigorous Analysis

Any rational portfolio decision depends on a true understanding of a business’s performance and upside. Management often claims they have all the data, although those data are purely internally focused. To analyze a portfolio, a functional team, led by the CFO, should rigorously and quantitatively benchmark the returns and growth of individual businesses as compared with those of their peers. The team also needs to challenge internal plans by comparing them with the historical performance of the business or that of peers.

Maintain Capital Discipline

Even the best portfolio strategy cannot adequately account for all future developments. Investors do not expect a company to predict the future, but they do expect it to show discipline once projected returns do not materialize.

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How Merger & Acquisition is different in downturn as compare to in rising Market?

M&A is a dominant force in industries consolidation. It has become increasing global rather than dominated by a few countries with little linkage among them. In 2000 and 2001, the United States, Europe, and Asia accounted for approximately 60, 30, and 10 percent of deal volumes by target, respectively. From 2005 to 2008, the distribution was much more balanced, at approximately 40, 40, and 20 percent. Cross-border M&A activity grew from 23 percent of the total in 2000 to 29 percent in 2006 and 41 percent 2007, falling back to 35 percent in 2008. Emerging markets, particularly in Asia, played an important role in this transformation; China and India together represented some 12 percent of all cross-border deals in 2008.

How M & A is different in downturn as compare to in rising market?

Although we see little change in the themes driving the M&A market, the way companies think about the execution of deals has already changed visibly. M&A in a rising market with easy access to capital is very different from acquisitions in a downturn, when opportunities arise and decisions must be made very quickly.

The key differences fall in three specific areas.

SPEED

The interval between the announcement and the closing of deals valued above $1 billion has fallen dramatically, from about 130 days (1995–2007) to about 60 in 2008. Companies have already started to realize that if they want to close successfully in turbulent markets, they must undertake fast, targeted due diligence on the main issues and then use representative and warranties more extensively to address minor ones.

MANAGING STAKEHOLDERS

In a downturn market, a company can’t start to negotiate deals without knowing for sure whether it will have the necessary support at the end: there is no longer much time to build an internal consensus among the board, nor can executives assume that shareholders will extend the benefit of any doubts. In particular, a company must actively establish realistic expectations for growth and profitability. Coming out of the past rising market, many board members and shareholders will have unrealistic ones—the downturn is not yet reflected in future earnings estimates, and this problem will have to be managed to frame external growth moves correctly. It is likely that we will see a greater proportion of deals financed by equity, due to the economic uncertainties: this will make solid investor and board support even more important.

OPPORTUNITY SCANNING

The best opportunities in a downturn are often good pieces of a distressed portfolio forced into a fire sale. Success in this environment will depend on choosing the right targets to stalk: these will be very different from the sorts of deals business-development teams have considered during the rising market in a last few years. In the downturn it is necessary to put aside conventional thinking about M&A and take a fresh look at the industry: do not assume that any company will simply be “not for sale” over the next few years. Which companies will experience difficulty? Which parts of which businesses would tempt you? How can you put together creative deals that will snare them?

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