M&A's Merganic Future

In the book Merge Ahead: Mastering The Five Enduring Trends Of Artful M&A, authors Gerold Adolph and Justin Pettit deduce that growing a successful company involves not just one, but three expertly developed and executed strategies—mergers and acquisitions, organic growth, and alliances—interwoven as one synchronized growth strategy. They coin the term “merganic” to describe this relationship.

Most companies use all of these growth levers at one time or another, but few companies consciously use them in ways that consistently reinforce and build on each other’s impact. The idea is to keep these three growth avenues continually active and to deploy them as appropriate to make the most of varying market conditions.

Any company with an effective growth strategy is in some stage of merger and acquisition preparation or action, is assessing and executing alliances, and is innovating and expanding its existing operations. The most critical element is to keep all three levers tightly intertwined. That’s what distinguishes an integrated growth strategy from simply having three different ways to pursue a similar outcome.

The following is an excerpt from this book.

The ever-increasing velocity of capital and information, and the impatience that it spawns. Deep-pocketed competition everywhere. Whipsaw periods of consolidation driven by a confusing stream of bubbles, waves, and bubbles on top of waves. And increasingly volatile global economic cycles. These trends and conditions have produced a highly uncertain business atmosphere in the short term and a challenging, hyperactive growth environment that will probably continue well into the 2010s. It will offer numerous M&A opportunities, some leading to higher ground and some leading to quicksand.

Despite these dynamics, succeeding in such an environment will still require profitable growth at a rate that exceeds the industry average in up cycles and overcomes the macroeconomic constraints in down cycles. But how can a company count on growing at such a rate?

The “merganic” approach is based on the observation that sustained growth is the result of the continuous acquisition of new capabilities, not the pursuit of transient market positions. There are only three ways to develop the capabilities necessary for profitable growth. Companies can make capabilities, developing them organically by building on their existing businesses. They can buy capabilities, purchasing them through M&A and combining them with their own existing assets and prowess to boost the top line. Or they can borrow capabilities, pursuing them through virtual scale by using alliances and partnerships.

Successful companies do not choose among making, buying and borrowing capabilities. They conduct all three activities using a coordinated road map, with the same people involved in planning all three, so that the activities are mutually reinforcing. This is the core of a merganic approach to growth.

The growth trinity

No single type of growth can drive above-average performance over the long term or buck the macroeconomic cycle when it turns down. The three routes to growth are interdependent and need to be considered together if they are to reinforce one another and buttress the firm’s overarching business theme.

To understand why this is so, consider each type of growth as a stand-alone approach. A company that relies solely on M&A for growth will tend to lose balance and bargaining power. When such companies seek complex acquisitions, beyond simple consolidations with other companies like themselves, they are more likely to define desirable targets in isolation from their overall growth strategies rather than in a holistic manner.

Furthermore, their eagerness to make deals, if only because they see M&A as the single easy path to growth, will inevitably lead the company to overpay for some marginal properties. When making deals is the sole focus of an expansion strategy (as with roll-ups), companies often do not, or cannot, take the time to integrate and build upon their acquisitions or develop internal capabilities; the next deal will soon be on its way.

The result is a trail of just barely knit together operations, neglected internal capabilities, and subpar organic growth. Finally, the investment community views such deals as a sign of poor strategy and frequently undervalues the transaction.

One might argue that if acquisitions are small, the repercussions of an ill-conceived or hurried execution are minimal. But there’s a catch in practice: most deals can’t be small when M&A is the sole source of growth. Rapid profitable growth is required, and if deals are the only vehicle for this, then some of them must be relatively large transactions that are capable of having a significant impact. This, in turn, greatly increases their complexity and worsens the odds of their success.

Citigroup followed a primarily deal-driven growth model from the late 1980s to the early 1990s, undertaking a decade-long blitzkrieg of acquisitions. The culmination of this rapid growth occurred on April 6, 1998, when the merger between Citicorp and Travelers Group was announced, creating a company with assets of almost $700 billion. A decade later, the leaders of Citigroup were still trying to fully rationalize the bank’s sprawling empire.

In 2003 and 2005 retrenching began, and parts of the Travelers Insurance business were spun off and sold. In January 2009, after drawing $45 billion in government loans, Citigroup posted a fourth-quarter loss of $8.29 billion—its fifth consecutive quarterly loss—and management announced it would split the company up, effectively dismantling its financial supermarket.

To be sure, many financial firms were caught in the global credit crisis. But Citigroup was supposed to be different: it had been organized around the idea that M&A would provide the size, diversity, and coordination needed to insulate the company from the froth of economic upheaval. Instead, a too-wide strategic focus and an inability to efficiently transform deals into organic growth left it highly vulnerable in a crisis environment. This is a common long-term predicament for companies that rely solely upon mergers and acquisitions for growth.

Organic growth’s shortcomings

But organic growth alone is no panacea either. Like M&A, organic growth—through the introduction of new products, expansion within current markets, or direct entry into new markets—by itself is not sufficient over the long term. There are two main reasons for this: the maturation of industries and the relativity of growth.

When an industry first emerges or when it undergoes a major shift that fundamentally expands its markets, high levels of organic growth are possible. For instance, where an expanding market is driving growth and a company can out-innovate or out-market its competition, other forms of growth may not be necessary at all. But sooner or later, these windows of opportunity will close.

These days, the velocity trend is causing them to close faster than ever, as more and more competitors converge on the same set of opportunities, and the leaders’ time-to-market advantages erode. Even in some new markets and new technologies, the rising complexity of offerings, or the rapid response of competitors, is driving companies to undertake M&A rather than attempt to go it alone.

Monsanto and DuPont, for example, acquired seed and other companies during the 1990s to capture the full value of their innovations in agricultural biotechnology and to provide some defense against imitators. Moreover, as industries mature, it becomes harder and harder for companies to maintain a substantial edge, and their performance trends back to the median, which is not enough to satisfy the demand for superior performance.

In short, organic growth tends to run out of gas as industries mature. At this point, well-conceived and well-executed mergers and acquisitions become necessary, along with the willingness to tap the virtual scale of alliances.

The second reason why organic growth alone tends not to be sustainable is because a company’s performance is meaningful only relative to that of its competitors; performance is not absolute. A company can have a high organic growth rate, but still fall behind relative to its industry, especially when its competitors pursue growth through M&A and alliances.

The relative performance rates of companies are manifest in stock market valuations. This is why investment markets often factor in expectations of returns that for most industries would not be reasonable from organic growth alone. When this happens, the company must look beyond organic growth to acquisitions or alliances because staying the course of organic growth is tantamount to falling behind.

Alliances alone

The third growth strategy, virtual scale, might seem at first blush to be an ideal compromise. It provides growth potential at much less expense than either going it alone or pursuing premium-laden acquisitions. By combining their assets and complementing one another’s capabilities, companies can expand their operations faster and maintain more flexibility than with an outright purchase. Joint ventures and the other forms of collaborative deals that provide virtual scale can enhance the clout of all the companies involved.

But in reality, as with M&A and organic growth, pursuing virtual scale as a dedicated growth strategy is untenable. Although alliances and partnerships have their place, any experienced executive knows that they are often difficult to negotiate, manage and sustain as the parent companies’ motivations evolve. Multiplying the work involved in one agreement by the number of alliances required to create sustained growth would result in a highly complex web of relationships.

It also requires that revenues be split among the principals. Furthermore, to be a desirable partner, a company must be able to contribute either tangible assets and capabilities or an entrée to markets and infrastructure. That means real-world know-how and hard assets—which can be built only through organic growth or acquisitions.

The credit card giant Visa Inc., now a public company, was founded as a vehicle for virtual scale, a cooperative that eventually included more than 21,000 banks and enabled each of them to extend payment and credit services to their customers across a global processing network. This virtual scale relationship was mutually beneficial and spurred tremendous growth in many banks. But it did not, by any stretch, excuse any of the banks from developing their core capabilities further, or from growing through appropriate acquisitions.

Finally, if a company were to lose its ability to pursue other means of growth, it would become dependent on its alliances; it would devolve to a subordinate role, akin to that of a captive supplier or customer. It would no longer be a true partner, and before long, most likely, either it would have to give up some of its margins and profits to the other partners, or it would be replaced.

Gerald Adolph is a senior partner with Booz & Co. He leads the firm’s work for mergers and restructuring clients. Justin Pettit is a partner specializing in corporate finance and shareholder value. This excerpt from Merge Ahead is used with permission of The McGraw-Hill Companies Inc.