Investment Entry through Acquisition

Many investment proposals are proposals to acquire a foreign company rather than start a new foreign venture. Although the steps outlined in Figure 13 apply to acquisition entry as well as new-venture entry, acquisi­tions have special features that deserve some additional comment.

An investor may acquire a foreign company for any of several reasons or mix of reasons: product diversification, geographical diversification, the acquisition of specific assets (management, technology, distribution chan-nels, workers, and others), the sourcing of raw materials or other products for sale outside the host country, or financial (portfolio) diversification. The resulting acquisition may be classified as horizontal (the product lines and markets of the acquired and acquiring firms are similar), vertical (the ac­quired firm becomes a supplier or customer of the acquiring firm), concen­tric (the acquired firm has the same market but different technology or the same technology but different market), and conglomerate (the acquired firm is in a different industry from that of the acquiring firm).

We are concerned here only with horizontal acquisitions by investors whose primary purpose is to enter a foreign target market. In this context, acquisition is a form of investment entry—an alternative to investment entry through a new venture.

1. Possible Advantages and Disadvantages of Acquisition Entry

Compared to new-venture entry, acquisition entry offers several possible advantages. They are possible rather than certain because the success of an acquisition depends critically on the selection of the acquired company. A poor selection—for whatever reason—can turn any advantage into a disad­vantage for the unwary firm.

The most probable advantage of acquisition entry is a faster start in exploiting the foreign target market, because the investor gets a going enterprise with existing products and markets. In contrast, it could take three to five years for an investor to achieve the same degree of exploitation if he were to start from scratch. For the same reason, acquisition entry promises a shorter payback period by creating immediate income for the investor. But even this advantage can prove illusory in specific instances. The acquisition process can easily take a year or more, and the post­acquisition process of fitting the acquired company to the operations and policies of the investor can constrain performance and earnings. Acquisition entry substitutes the problem of transferring ownership and control for the problem of starting a new venture. Which problem is more severe depends on the circumstances.

Another possible advantage of acquisition entry is that it may provide a resource that is scarce in the target country and is not available on the open market. Usually this resource is a human skill, notably of a managerial or technical nature. Difficulties in staffing a new venture, therefore, favor acquisition entry. It has been said that an acquisition is fundamentally an acquisition of the people in the acquired company. But this advantage can be dissipated if the staff subsequently leaves the acquired company.

A third possible advantage is the acquisition of new product lines. But once again, this advantage can turn into a disadvantage if the investor has no experience in the new product lines. If acquisition is used as an entry mode, it is vital that the acquired company have a product line that is similar to, or compatible with, the investor’s. Otherwise, the acquired com­pany will fail to provide a vehicle for a transfer of the investor’s knowledge and skills needed to exploit the target market. Indeed, a new problem is created: managing at a distance a foreign enterprise whose product line and market are strange to the investor. Insofar as foreign acquisition is con­ceived as an entry mode, its basic purpose is geographical diversification, not product diversification.

Apart from advantages that can become disadvantages, acquisition en­try may have distinctive drawbacks. Locating and evaluating acquisition candidates can be extraordinarily difficult. In some countries where good candidates do not exist, the investor may end up with a poor prospect in the expectation of improving its performance or else turn to new-venture entry. Even when an apparently good candidate is identified, secrecy, differ­ent accounting standards, false or deceptive financial records, and the con­cealment of problems can all pose obstacles to an objective evaluation of the candidate. Other possible drawbacks include antiquated plant and other facilities that will require substantial new investment to bring them up to standard, and poor geographical location in the target country.

Finally, acquisition entry may be disadvantageous because of host and home government policies. In general, host governments view the acquisi­tion of local companies by foreign investors in a less favorable (or more unfavorable) light than new ventures started by foreign investors. This is true even for industrial countries, such as Canada, Australia, Japan, and France. The belief is widespread in host countries that acquisitions do not make much economic contribution and certainly not enough to offset the undesirable displacement of local ownership with foreign ownership. Thus negotiations are apt to be more arduous than for new ventures, and the risk of official rejection is higher. Acquisition entry may also be disapproved in some industrial host countries on antitrust grounds. Moreover, the U.S. investor needs to consider the application of U.S. antitrust policy to a foreign acquisition.

There is some evidence that U.S. managers are more inclined to make quick, arbitrary decisions on foreign acquisitions than on investments in new foreign plants. Certainly, many U.S. manufacturers have become un­happy with foreign acquisitions. Some years back, while interviewing the top managers of a billion-dollar corporation, I discovered that all eight of the corporation’s European acquisitions were in deep trouble, even though they were located in different countries and had dissimilar product lines. The explanation for this unfortunate situation was that the former chair­man of the board had picked up the European companies on trips to Europe entirely on his own, without any prior investigations or consulta­tions with his staff. Surely, the chairman was unlucky, but no manager can reasonably expect to do much better with purely subjective decisions.

2. The Need for an Acquisition Strategy

Managers should recognize that foreign acquisition is a high-risk entry mode that needs an acquisition strategy to guide decisions. These decisions ought to be made in the context of a company’s entry planning system (the elements of which are identified in Figure 1). Acquisition investments should be evaluated by checkpoints used for an investment entry decision, as shown in Figure 13. An acquisition strategy specifies objectives (ranked by importance); the desired features of an acquisition candidate (such as size, product line, sales and profit potentials, quality of management, tech­nological sophistication, manufacturing and other facilities, distribution channels, and so on), which constitute the acquisition profile; and guide­lines for pricing, financing, and assimilating the acquisition.

The acquisition profile guides the search for candidates and their subse­quent screening to identify the most attractive candidates. The profile should include the same factors used by the investor to assess the profitabil­ity of any investment entry project in the target country (see the project profitability checklist). Armed with the profile, managers can start the search for candidates. Search information may come from several sources: the press, trade journals, business contacts, company directories (such as Moody’s in the United States), special industry surveys, annual reports, bankers, consultants, brokers, agents, distributors, and others. After succes­sive screenings have narrowed the choice to a single candidate, it is neces­sary to investigate all aspects of that candidate’s business to answer the following questions: (1) How well does the candidate fulfill our entry strategy requirements for the target country/market? (2) How well does the candidate fit the product line, technology, markets, management style, and other features of our company? (3) What can we expect to achieve with ownership of the candidate that we could not achieve with a new-venture investment? (4) What is the dollar value of the candidate to our company?

Full answers to these questions will require personal visits to the candi­date. It is desirable to establish friendly personal contact with the candidate prior to any negotiations, but full access to the candidate’s records and facilities may not be possible until both sides sit down to negotiate. Often, a third party (such as a banker or broker) can facilitate the collection of information as well as negotiations.

Financial analysis of an acquisition investment is much like that of any investment entry project. To estimate the value of an acquisition candidate, it is recommended that managers undertake a discounted cash flow analysis along the lines discussed earlier in the chapter. The projected cash flows express what the investing company expects to achieve over, say, the next five years if the candidate were to come under its management control. Perceived opportunities to cut costs or increase sales of the candidate are, therefore, brought into the cash flow projections. Similarly, they would include any additional investment needed to attain planned performance. In brief, cash flow analysis should answer the question: What net cash flows will be contributed to the investing company by the acquisition candidate under the investor’s control over the planning period?

Capitalization of expected cash flows (adjusted for risk) at the investing company’s hurdle rate gives managers a value estimate of the candidate. Valuation methods that rely exclusively on the candidate’s past perform­ance (book value of assets, past earnings, and so on) should be avoided, because the candidate’s future prospects under the investor’s management may be very different from its past performance. The capitalization of expected cash flows should be regarded as the investor’s ceiling price in negotiations with the candidate.¹⁸ Of course, managers will try to acquire the candidate at a lower price, and they may succeed if the owner discounts future earnings more heavily than the investing company, a not uncommon situation with individual and family owners.

Careful negotiations are time-consuming, but managers should guard against overeagerness to reach final agreement. Acquiring a company in a week’s visit to the target country is an almost certain road to later disap­pointment. But handled right with the right candidate, negotiations can bring the investor a going enterprise that will stand a good chance of achieving his objectives at an acceptable profit.

Source: Root Franklin R. (1998), Entry Strategies for International Markets, Jossey-Bass; 2nd edition.