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M&A Value Creation: Combating the "Winner's Curse"

Significant value waits to be unlocked through consolidation, but conventional approaches have been inadequate.

Fortnightly Magazine - October 2006

as opposed to traditional entitlement cultures, and will have the knowledge and training processes in place to accelerate performance improvement in acquired companies.

For utilities, our experience suggests process improvements typically account for 60 to 75 percent of aggregate operating synergies. Capturing process-driven benefits expediently requires establishing operational excellence before pursuing a merger. Process simplicity and standard-integration strategies facilitate the realization of process benefits. The dependence on process benefits, however, implies the need for greater operational due diligence and pre-close planning to ensure that a performance advantage actually exists.

Capturing scale, on the other hand, is less controllable. Capturing scale requires a wide variable cost base to spread fixed costs, and an easily extendable platform. Where it exists, however, scale typically behaves in a step-wise fashion, with incremental “step” investments required to extend capacity at relatively short increments:

• Large IT step investments typically are required at 1 to 1.5 million customer increments, e.g., bill processing;

• These require attention to where on the step scale function (between incremental investment points) the combined companies are likely to lie;

• Most combinations remain sub-scale on a cross-industry basis—opportunities to leverage third-parties to achieve virtual scale through variable pricing arrangements should be considered; and

• “Global” scale should be leveraged, where available, but is not substantively different from “regional” scale—it’s the absolute size that counts and potential delivery options that matter.

Creating as wide of a performance advantage as possible is vital. A historical review of operational synergies actually captured in utility combinations suggests average cost improvement typically is from 7 to 11 percent of total O&M and capital spend. This suggests a low performance differential between the acquirer and acquired. The acquirer is not bringing any decided operational advantage to the combination and is unlikely to capture significant, sustainable synergies without a major change effort during merger integration or soon thereafter.

Consequently, premiums have declined into the 15 to 18 percentage range consistent with this historical performance. An advantaged operator can achieve 2 to 4 times the benefits of a peer operator in the same acquisition. Our experience suggests that utilities with higher operational and capital efficiencies experience significantly higher cost improvements from mergers. A large driver of increased benefit capture is reducing future infrastructure improvement costs. On average, the costs to integrate key IT applications on a scaleable platform are one-third of what it is without the platform. For example, the costs of upgrading/replacing a CIS system might range from $50 million to $100 million and take 24 to 36 months to implement. Having a scaleable option in place would reduce those costs to $15 million to $30 million and implementation time to 12 to 24 months. Moreover, replicable acquisition platforms, standardized and operationally efficient, can yield 10 to 20 percent faster implementations at greater scale and reduce future integration costs by 50 to 60 percent.

Attention to the acquisition business platform—particularly as a prerequisite to making a major acquisition—improves target selection, due diligence, binding offer pricing, and ultimately, synergy capture and long-term integration. In particular, high-impact operational platforms improve valuations