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”

How strategic investors identify acquisition targets

by Les Nemethy	CEO of Euro-Phoenix

A strategic investor uses a very different process to identify acquisition targets than that used by financial investors. 

For a strategic investor, as the name implies, identifying an acquisition target must flow from the acquiring company’s strategy.

The worst methodology that a strategic investor might use to identify targets is to respond to the acquisition opportunities that it finds on an ad hoc basis.  This simply will not work for two major reasons:

· First, responding to opportunities on an ad hoc basis typically means that deep strategic thinking has been short-circuited.
· Second, if a strategic investor acquires a company that it came across merely on an ad hoc basis, how does it know that there were not better acquisition opportunities elsewhere in the market place?

It flows from the above thinking that a strategic investor, before embarking on an acquisition, should have a clear definition of its overall corporate strategy, and from such a corporate strategy should flow its acquisition strategy.  (Of course it is ideal to have these in writing: there is nothing that focuses the mind as much as putting something in writing, an approach which also helps to ensure that the different parts of the organization are also in consensus).

Some of the elements of an acquisition strategy might include definitions of the following:
· The rationale for the acquisition (e.g. vertical or horizontal integration, expanding into newer high-growth markets, acquiring technology or know-how, etc.);
· The precise profile of the target companies sought;
· The geographic range of possibilities;
· The financial criteria (revenues, profitability, etc.);
· The type of management or skills which may be required;
· The type of clientele which the target company should have;
· The valuation range in which such acquisitions may make sense.

A company may choose to create a strategy broader than an acquisition strategy, namely an M&A strategy. Such an approach would also cover the criteria which a company would set for divestiture of its subsidiaries.

Once the strategy has been defined, the acquiring company should engage in a systematic search for and assessment of all those companies that fulfil the criteria (as opposed to an ad hoc approach).  If there are a very large number of candidates, the list might be shortened by selecting only the most attractive ones.  

The most attractive ones might then be approached to ascertain whether they are willing to talk about a strategic partnership or acquisition, and with an eye to further fact-finding about the company.  It is often useful to use an independent third party intermediary for this approach, as it allows the approach to be anonymous, keeping the name of the acquiring party out of the market.

Failure to apply the above approach may result in a bidder finding itself among a herd of bidders in a frothy, overpriced market, competing for a target company that might not even be the best strategic fit.

Some of the more astute strategic investors have been monitoring their potential acquisition targets for many years, sometimes even decades, and are ready to make a move on short notice if the owner of a target company becomes willing to sell or if price expectations are reduced.  However, it is usually only a small percentage of potential target companies that a strategic investor is willing to acquire—the majority of potential targets quite often simply do not make the grade.

Central Europe is often an attractive area for acquisitions for global investors because most investors believe that Central Europe is on a convergence path with Western Europe, meaning that GDP per capita, incomes, consumption, etc. will catch up to Western European levels.  This is based on the belief that, “A rising tide raises all ships”.  Nevertheless, different countries move at different speeds at different points in time, depending on their political and socio-economic environments, and some companies are better acquisition candidates than others.  The importance of country and industry-specific knowledge at the local level cannot be over-emphasized.

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”

Effects of staff incentives on corporate value

by Les Nemethy   CEO of Euro-Phoenix

Les Nemethy from Euro-Phoenix writes in his blog for BBN that great care must be taken when designing a bonus system, so as to avoid the seemingly perverse effects that may actually destroy company value. 

On a trip to the US several years ago, the aircraft I was on pulled away from the gate on time. However, within a minute, the engines suddenly powered down.  We waited almost three hours on the tarmac, in the sweltering heat, without air conditioning, until the flight finally took off. The gentleman seated next to me explained what had just occurred: the airline staff’s bonus was based on the aircraft pulling away from the gate on time. They were not going to forego their bonus just because there was no available slot for taking off on the runway. With the best of intentions, the airline had actually created an incentive system which made passengers suffer. 

My point is that great care must be taken when designing a bonus system, so as to avoid the seemingly perverse effects that may actually destroy company value.  A well designed bonus system, one that creates genuine motivation for staff, is therefore a necessity for creating corporate value.

In different organizations, it is different combinations of the board, CEO, and senior officers who create the incentive system for all staff of the company.  Creating the right incentive system is one of the most important functions each group fulfils.  The following three considerations must be taken into account when designing any incentive system:

1. It must be motivating. 

There is no use in trying to motivate staff with equity if staff members have a short-term perspective, or are at a phase in life where they need cash to start a family or buy a first home.  As the saying goes, “happiness is getting what you want, and wanting what you get”.  It is therefore crucial for anyone designing a bonus plan to know the people involved quite well, to know what will really motivate them.  Very often it can be non-monetary factors such as recognition or a title.  In such cases, throwing money at trying to motivate people can actually be a complete waste.  Very often, there is a conflict between designing a system that is tailored to everyone’s individual needs, versus a “one size fits all” type of bonus system that has the advantage of being consistent, but may not take into account the preferences of a few individuals who are outliers.

2. Create the appropriate alignment of interests, particularly between senior management and shareholders. 

Generally speaking, equity, an option to obtain equity, or profit share may create the right kind of alignment.  However, it is extremely important to factor in the appropriate level of risk that may be taken by management—witness the undue risks taken by bank certain bank CEOs leading up to the financial crisis.  Another example: if you reward someone with a percentage of revenues, don’t be surprised if there is suddenly pressure on margins.  Are there checks and balances in the system?  Is the CEO allowed to make unfettered decisions about risk?  Is the person on a revenue-share bonus allowed to make decisions about margins?  If not, there is less of a problem.

3. Reward the types of behaviours you wish to encourage. 

 Is it top-line growth you wish to encourage?  Or is it frugality in terms of expenditure?  Is it the taking or avoidance of risks that you wish to encourage?  Is it team work or individual performance?  Make sure that your bonus scheme truly does create the desired behaviours, and that you are not creating undesired side effects (like cut-throat competition amongst your own staff) or inadvertently neglecting to encourage other behaviours that are equally important for the success of your firm (e.g. rewarding sales alone is unlikely to achieve the desired effects of quality, customer satisfaction, etc.)

A bonus system makes a statement about the values of a firm.  If you try to sell your firm or raise capital for your firm, investors will inevitably ask about what kind of incentive systems your firm has in place, and how well they are working.  Ultimately, you need a motivated team to build corporate value.  But there is no magic bullet, no ideal bonus system that works for all organizations.  The devil is, as so often, in the details.

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”