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How good are Alliances as an Option to Acquisitions?

by Les Nemethy	CEO of Euro-Phoenix

Many investors often think that acquisition is the best or fastest way to achieve a strategic objective such as entering a particular market or acquiring a certain technology. 

An alliance, however, may be at least as good an option in certain circumstances (e.g. where a company lacks a budget for acquisitions).  Alliances are very common:  there are many tens of thousands of them negotiated every year, most of them across borders.

Types of Alliances

An alliance may be defined as a association among two or more parties which involves a sharing of resources and coordination among parties to achieve common objectives.

The three main types of alliance are contractual, cross-ownership or setting up a special purpose vehicle (SPV).

A contractual alliance is generally a pure commercial agreement that sets out the objectives, the resources contributed by each partner, the division of the spoils, as well as in many case the puts and calls, the representations and warranties, etc.

Cross-ownership may involve one party taking an ownership interest in the other, or parties taking an ownership interest in each other.  The relationship may be cemented through representation on the Board, or the contribution of capital.  Most alliances do not require cross-ownership.

Setting up an SPV (a company, a limited partnership, etc.) may be a good way to structure an alliance.  A Board of Directors provides a direct way of making decisions concerning the alliance.  A shareholders’ agreement may be used to regulate the corporate governance of the SPV.  The parties should also regulate who contributes what resources to the SPV, and how spoils are distributed.

The Rationale for an Alliance

Alliances have several advantages over acquisitions: 
· They are much faster to negotiate and implement than acquisitions.  They typically do not require due diligence of the acquired firm (although considerable research on the strategic or commercial opportunities available at hand is usually necessary).
· There is much less risk that the management of the alliance partner will depart (which often happens with acquisitions).  This generally means that there is a more committed team in place.
· There is no need for the huge investment that typically accompanies an acquisition.  If, for example, two alliance partners join forces to develop a certain product, technology, or geographic region, each alliance partner contributes thehuman, financial, or other resources necessary to achieve the joint objective.
a Elements of a successful alliance include the complementarity, compatibility and commitment of the alliance partners.

Drawbacks of an Alliance

Alliances are not appropriate in all circumstances, however.  They have a number of important drawbacks, which include:
· CEOs often like having resources under their direct command - but alliance partners do not respond well to commands.  They expect to be treated like partners.  Hence, achieving strategic objectives requires constant communication and effort put in to maintain the relationship.
· There is always a risk that the alliance partner will not hold their side of the bargain, which may jeopardize the efforts and investments of the partner that does hold their side of the bargain.  (This risk may generally be mitigated by good project management, for example using benchmarks for what objectives are to be achieved by certain dates), as well as including representations and warranties in the alliance agreement).
· One of the most surprising tendencies of alliances is for them to unravel once they have been successful.  While alliance partners may work together for many years to achieve their joint objectives, once these objectives have been achieved, and the venture has been declared a success, the partners have a tendency to go in different directions.  One may wish to sell, the other may wish to expand the scope of the venture (e.g. expand into additional countries or related ventures).  As a result, it is advisable to have good conflict resolution mechanisms built into the alliance agreement (e.g. mediation).

Most authorities on the subject estimate that only 40 to 50 per cent of alliances achieve their objectives in the long run.

Conclusions

Alliances are often not considered or given sufficient weight as a viable option for achieving corporate objectives.  While they are not appropriate in all circumstances, they are generally one of severable viable options.  Despite the relatively low track record of success for alliances, companies are facing increasing pressure to enter into  them as a means of bolstering competitiveness. Proceed carefully!

Les Nemethy is CEO of Euro-Phoenix Financial Advisors Ltd. (), a Central European corporate finance company focused on Mergers & Acquisitions.  He is the author of “Unlocking your Company’s Value”

Unlocking your company’s value

by Les Nemethy	CEO of Euro-Phoenix

This article is the thirtieth in the “Corporate Finance/M&A Corner” series.  To mark this occasion, I am pleased to announce the publication of a book entitled “Unlocking your Company’s Value: The Keys to a Successful Business Exit” (available at www.lesnemethy.com). The book has drawn considerably upon material used in these articles.

In the same way as planning a mountain climbing expedition, a company owner should plan not only for reaching the summit, but also for descent (which can be at least as treacherous).  In the corporate world, we should strategize not only on how to make our companies bigger and better but, from the beginning, also for eventual exit and succession.  

The value that corporate owners create is never in the abstract or according to their own tastes; it must be created with a view to what investors are likely to value.  A homeowner might think that he or she is improving the value of a house by adding a swimming pool, but it is actually a fact that they will almost never recover the incremental value of that swimming pool when selling the house.  Similarly, every decision made by shareholders during the course of building a company will either add to or detract from the future saleability of a company—such decisions are seldom neutral.  What I am driving at is that building a company and selling a company are not two separate acts but part of a single continuum.   From the beginning, value will be optimized if one builds a company with at least one eye on how investors are likely to perceive its value. 

It is unfortunate that the word “exit” has something of a negative connotation in Central Europe.  Often it is associated with failure, with giving up.  Yet it is interesting how in some cultures, exit is associated with success—particularly the Latin cultures.  (In Spanish, “exito” means success, or in Italian “riuscire” (to succeed) comes from the word “uscire” (exit)). 

Getting into a war (think of Afghanistan or Iraq) is easy—it is the exit that is the trick, and the event which will ultimately decide whether the intervention was successful or not. Similarly, it is difficult to judge the ownership of a company as a success or failure until after it has been sold. One explanation for the success of private equity investors is that they generally have an exit strategy even before they invest in a particular company.

Of course, buying shares is easy; it’s selling at a profit (the exit) that is the challenge.  As Henry Kravis, the American financier, once said:  “Don’t congratulate us when we buy a company.  Any fool can buy a company.  Congratulate us when we sell it and when we’ve done something with it and created real value.”  The book covers many ways to create value, ranging from corporate governance to risk management.   

“Unlocking your Company’s Value” deals with two major subjects:  Business Exit Planning (a subject that has been popular in North America for one or two decades, but is only now starting to become known in Central Europe), and how to manage a transaction (e.g. raising capital, finding a strategic partner, selling a minority or majority interest).  The subjects are dealt with not from the perspective of a corporate finance professional, but so as to outline what business owners should know about these two subjects in order to unlock the theoretical and illiquid value of his or her business.  I have done my best to distil the thousands of conversations I’ve had with business owners over the past 25 years into one easy-to-understand book and I hope you will find it useful.  

Les Nemethy is CEO of Euro-Phoenix Financial Advisors Ltd. (), a Central European corporate finance company focused on Mergers & Acquisitions.  He is the author of “Unlocking your Company’s Value

How a private equity investor chooses acquisition targets

by Les Nemethy	CEO of Euro-Phoenix

Private equity investors typically have a charter which sets out well-defined parameters for investments to be made by the fund, including:

· Nature of investments.  Some funds like high growth companies, other prefer investments with stable cash flow or dividends.  Still others prefer turn-around situations.
· Geographic scope. many Central European funds restrict themselves to EU member states, the bolder ones will venture in to former Yugoslavia or Turkey;
· Preferred sectors.  Some funds are generalist funds that will look at just about any sector, others focus on one particular sector, such as transportation, infrastructure, telecommunications, etc.
· Investment size.  Most funds will specify a minimum or maximum investment size (e.g. EUR 5 to 25 million).
· Ownership interest.  Some funds insist on control, others will take minority interests.
· Fresh equity.  Many financial investors are not willing to buy out shareholders, they only want to inject fresh equity into a company (e.g. to fund growth).  Others will consider a combination of fresh equity and buying out existing shareholders.  Buyout funds will want to buy 100% of a company.

It is therefore important to find a good match between private equity fund and the company.  It is likely a waste of time to enter into discussions with a fund if the applicant company does not fit the fund’s criteria; investing in such a company would put fund management into breach vis-a-vis its own investors.  Business owners should therefore do a little homework before approaching funds—the investment criteria are usually on the fund’s website.

The average private equity fund in Central Europe will typically screen a few hundred investment cases every year.  Not more than a few will actually become the object of an investment.    The vast majority of private equity funds typically have an investment committee that makes all the investment decisions, and a local person (who may or may not be a member of the investment committee), who basically becomes the protagonist of the investment to be made in a particular company, at the level of the committee.  Hence the owner of a business must first convince the protagonist of his investment case.  The owner of a business seldom, if ever, communicates directly with other members of the investment committee. 

Hence the written information prepared by the company, most notably the Information Memorandum prepared by the company, particularly its Executive Summary, may become an important indirect communication tool with the investment committee.

A financial investor will usually subject a company to an initial due diligence, using its own internal staff, before obtaining a green light from the investment committee to proceed with a full due diligence of the firm, using external advisors (at a minimum lawyers, possibly financial advisors, auditors, tax advisors, technical experts, etc.) 

So what does a private equity firm look for in its investment choices:

· A solid business opportunity that reflects its acquisition criteria (e.g. growth, size, geographic parameters, etc.);
· Exit strategy—who are the likely buyers for the company?  What are the chances for a successful exit?
· A strong management team, who is prepared to stay until the exit of the fund.  (An owner-manager who is cashing out is often too high a risk for the private equity investor—please see my earlier article on the “One Man Show”, available at www.europhoenix.com/library);
· Strong corporate governance—good decision structures, reporting systems, and strong documentation.  Private equity investors seek management teams that are highly motivated, are prepared to agree to ambitious, and are prepared to work extraordinarily hard to achieve significant financial gains.  Conversely, if results are not forthcoming, managers that own shares may find their ownership diluted.
· Manageable risks.  No actual, pending or potential litigation, or the potential for surprises on the downside;

After the due diligence, the investment committee  (or at least certain members) will usually review the due diligence report of lawyers and other advisors, and the proposed Sale and Purchase agreement.

Sometimes private equity firms will purchase what they call “bolt on” investments.  Bolt on investments are do not typically need to satisfy all of the investment criteria (e.g. they may be smaller than usual, or management of a bolt-on investment may choose to exit), as the acquired bolt-on company would be purchased to create synergies with one of their existing portfolio companies.

Private equity firms have taken an ever larger share of the M&A market in Central Europe.  They are an important potential source of financing for mid-sized firms that must not be neglected.

Les Nemethy is CEO of Euro-Phoenix Financial Advisors Ltd. (), a Central European corporate finance company focused on Mergers & Acquisitions.  He is the author of “Unlocking your Company’s Value”

The importance of corporate strategy

by Les Nemethy			CEO of Euro-Phoenix

Companies are typically valued based on projected future cash flow or various multiples (e.g. of revenues, cash flow, etc.).  However, at some point in virtually every transaction, an investor will inevitably ask the seller for a written copy of the company’s strategy.  It is surprising how often the answer is that no such strategy document exists.  Does this matter?  I would argue most emphatically that, in most cases, the answer is “yes”. 

This article deals with three issues: (a) why is a written strategy important?  (b) what kind of issues should a strategy document address?  and (c) who should prepare the strategy document?

(a) Why is a written strategy important?

If you are thinking of carrying out an equity transaction, most investors will ask for a written strategy for the simple reason that a written strategy is an indication that there is not just an implicit framework in the owner or CEO’s head, but a coherent strategy that represents a consensus within the management team that has been communicated broadly.  Even worse, the lack of a written strategy may indicate that the firm has no strategy, or that it is “half-baked”.  If the company does not have a good strategy, there is a high probability that cash flows cannot be sustained or grown, and possibly also that the company is a “one man show” (for more on this, please refer to my earlier article on the “One Man Show” which can be found at www.europhoenix.com/node/480).  Putting a strategy in writing, and debating the subject among the management team, tends to sharpen minds.  A written strategy should be an evolving document, evolving as management thinking advances on the subject.

(b) What kind of issues should a strategy document address? 

Strategic thinking has evolved considerably over the years and, for an excellent book on the subject, I recommend The Lords of Strategy by Walter Kiechel.  There is not simply one monolithic method of formulating and carrying out a strategy.  However, in my opinion, investors will typically look for a strategy document that addresses the following issues:
· What is the vision and mission of the company?
· How does the company define its service/product/value proposition?
· How does the company define its market(s)?  (Geographically, in terms of customers, etc.)
· What makes the company unique?  Why would clients buy from the company  as opposed to a competitor?
· What are the barriers to entry for competitors?
· What are the strategic goals for the company (e.g. what position is it aiming to reach within its core market(s))?  Where would the company like to be in three to five years time?

Of course, once a company gives a strategy document to a potential investor, the investor will look for a business plan that is consistent with the strategy, and a management team that has the competencies and capabilities to implement the strategy.

(c) Who should prepare the strategy document?

From an investor’s perspective, it is best if management itself prepares the strategy document rather than farming it out to an advisory firm.  Or if outside advisors are used, managers should not be “hands off”, but use outside advisors as complementary to their own involvement.  Most investors find it important that management be capable of strategic thinking. 

In short, when preparing a company for a transaction, the objective is to show value in the company beyond its tangible assets.  The lack of a (good) written strategy will potentially increase the level of risk for an investor (increasing the discount rate in a Discounted Cash Flow valuation) and decrease the applicable multiples in a comparables valuation.  A written strategy, and then a credible plan for the execution of that strategy, form the cornerstone of a company’s value beyond the bricks and mortar.

Les Nemethy is CEO of Euro-Phoenix Financial Advisors Ltd. (), a Central European corporate finance company focused on Mergers & Acquisitions.  He is the author of “Unlocking your Company’s Value”, available at