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

The basic fundamentals for utility industry consolidation are strong. The industry is fragmented, notably in North America, but also in the UK, Australia, and Brazil, and cost pressures are escalating. These factors, coupled with limited alternative growth options, are increasing merger and acquisition (M&A) activity as an important industry top-line growth driver. However, significant uncertainties remain. Can consolidation, no matter how intuitively attractive, create sustainable long-term value? Or will it prove seductive but, ultimately, disappointing to shareholders, employees, customers, and management alike?

Value creation from an acquisition is not a given. The “first wave” of whole company mergers (1997-2004) produced mixed to disappointing results. In the majority of major acquisitions, positive value was not created in the first two years and was seen only after an average of four years. Systematic overestimation of strategic and operational synergies, particularly in the heat of “bidding wars,” led to excessive price premiums and elongated payback periods. To some extent, an acquisition entailed a “winner’s curse.”

As consolidation continues, and the target pool decreases, this will prove increasingly problematic for acquirers. Significant constraints (e.g., regulation, weak scale, labor, etc.) reduce an acquirer’s degrees of freedom and ability to actually drop value to the bottom-line. In particular, natural scale opportunities are limited, and most consolidated companies remain sub-scale post-merger.

This failure to realize estimated synergies is not simply a utility industry phenomenon. Globally, across all industries, 70 percent of mergers fail to achieve projected revenue synergies, with one quarter of deals falling more than 75 percent short. Performance on the operational side is better, but yet, one quarter of companies overestimate cost synergies by at least 25 percent. Failing to achieve revenue and cost synergies can lead, conservatively, to a 5 to 20 percent error in valuation. For example, in a deal like Exelon-PSEG, this error could translate into $0.6 to $2.4 billion in additional premium paid.

Our view is that significant value waits to be unlocked through the consolidation of the utility industry. However, conventional industry approaches to valuing and capturing merger benefits have been inadequate in our experience. In particular, utilities have been slow to move to single operating platforms and, outside of nuclear consolidation, to proactively establish and target specific performance advantages. In addition, cross-industry trends and competitors are raising the performance bar.

These trends are creating the impetus for new business/operating and cost/service level models. Operational excellence—powered by innovative operating models—will become the “price of entry” for successful consolidators. Leaders will be characterized by simplified, standardized, and extendable operating models and capabilities. They will possess improved operating performance, scale, differentiated leadership, governance, and performance management competencies, as well as a focused M&A team. They will leverage these capabilities to improve targeting and valuation and, ultimately, reduce the variability of benefit realization. A clear perspective on the value framework and a disciplined approach to M&A is vital.

The Value Realization Framework

Most utilities are relatively new to the competitive acquisition game. They typically have entered the acquisition arena without differentiated operating capabilities, and lack a detailed understanding of how costs and investments behave as you consolidate. During the pursuit, benefits look tempting and transition costs/issues appear manageable. Premiums paid creep upward, and a honeymoon ensues. Ultimately, however, deal economics erode as integration planning progresses. Early benefit potential proves to be over-estimated, and transitional/integration investments under-estimated in the face of labor constraints, cultural challenges, and IT investments.

More often than not, the two combining utilities only weakly integrate, with more aggressive consolidation and operational improvement deferred. Consequently, little changes day to day.

Rarely in the early stages is a visionary “master business architecture” developed that explicitly defines all aspects of the combined end model—at least in enough detail to provide a practical road map forward. In the end, the combined companies preserve distinct practices, policies, systems and cultures well after the merger is “concluded.”

Conceding these facts, can the level, and predictability, of operational synergies be improved? Experience in other industries suggests the answer is “yes.” Improving the capture of operating benefits as part of an acquisition strategy begins with a clear view of your competitive priorities, the sources and behaviors of value, and how they should be managed: for example, a clear understanding of fixed versus variable costs, step change investment points, and the degree of control and influence required operationally over an individual process to advance competitive differentiation. These factors should drive a master architecture of the high-performance acquisition business platform.

In our experience, we find three key process groups should be considered in defining this platform (see Figure 2):

• Core, less scaleable processes where operational excellence through process improvement is vital. These typically are mission-critical processes that require significant management control and are not highly scaleable.

• Non-core, more scaleable processes where third-party, or other virtual scale, models should be considered. These processes are mission support and often can be managed with well-defined service criteria. They typically are transactional processes with high volume scale and entail repeatable integration issues.

• Governance and control processes, which permeate all processes and heavily influence ultimate performance in a number of high-value areas. These include planning, performance management, and control/accountability processes.

The M&A value framework implies a fundamental change in how a company views its operating model—less emphasis on customization and unique requirements, and more emphasis on a simpler framework, often breaking traditional paradigms. It implies that successful utility consolidators will bring superior and transferable processes and capabilities, as well as flexible, extendable, next-generation technology in high-impact areas, with strong management teams and corporate performance processes. Leaders will have highly competent corporate centers possessing strategic planning and M&A capabilities. They will have well-defined governance processes and will develop talent that can be infused into acquired companies. They will be well down the road on developing performance, 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 by reducing pricing uncertainty. A 1 to 3 percent reduction in the value paid for an acquisition is not unreasonable, representing from $10 million to $30 million per billion dollars of enterprise value.

All Processes Are Not the Same

Two factors drive the realization of operating synergies in a merger. The first is absolute value creation potential. The second is the ability to transfer superior operating performance to a target company rapidly and efficiently. Each process has different cost, performance, and skill characteristics—and hence, differing operational improvement and transfer behaviors. In our experience, procurement and IT capital spend are the highest priority areas to capture meaningful near-term cost synergies. This is then followed by overhead consolidation, which, while typically easy to transfer in concept, represents smaller dollars and often gets compromised by internal political issues or significant severance costs.

Generation operation also is an area with significant potential. A superior operator can bring meaningful enhancement to fuel procurement, non-fuel O&M, and capital investment. Critical to success, however, is a leadership bench to infuse in the acquired company and a technical platform, particularly work management, to improve work scheduling and prioritization. Nuclear consolidation strategies have demonstrated this potential.

Field operations and asset management—involving the core T&D business—are the two high-potential value areas most difficult to unlock. Improving T&D performance, excluding union constraints, typically requires a strong work management and scheduling platform, as well as significant cultural and performance management changes. Improved T&D productivity is driven not only by technology and process changes but also by migrating to an accountable performance culture with in-the-field supervisors, improved work force planning, and targeted performance incentives. Asset management can be improved in the short term through attention to capital prioritization, but long-term improvement requires information platforms that, while recognizing significant activity in this area, typically are inadequate today for most utilities.

Driving the Acquisition Platform

Having a good understanding of value sources and a well-defined acquisition business model is not enough to ensure success. Merger companies still have to turn the plan into reality. Acquisition leaders across all industries possess two critical capabilities. The first is a designated, experienced M&A organization. The second is an execution playbook that translates the theory into tactical guidelines and practices that move from target selection through transition and stabilization to full integration.

Several dynamics must be in place within the acquiring company for an internal M&A team to flourish. The first is building a dedicated team within corporate strategy with strong integration with the finance organization. The team should be flexible and easily ramped up and down, with a core team and an extended deal team identified and trained. The core team should blend internal and external expertise, have permanent operational expertise, and be strongly integrated with the finance department. The inside/outside team requires veterans of the acquiring company who are experienced with both the strategic and operational challenges that confront the business and outsiders (both external hires and third parties) who have seen similar challenges under different scenarios. Ideally, the staff would offer perspectives from past deals or have operational experience working on integration matters in specific functional areas. They should be able to adapt this experience to the value drivers of a particular deal.

The M&A playbook includes customized integration methodologies, performance metrics, tools, and templates that are tailored to the acquiring company’s needs, and can be applied in a manner consistent with the value drivers of a particular deal. A key component of the playbook is a diagnostic tool, giving the acquiring company vital leading indicators that signal a deal’s complexity before entering the due diligence phase. While the diagnostic should not be seen as replacing due diligence, its purpose is to provide an important barometer of potential downstream integration challenges when there is still time to influence the terms and conditions or, if warranted, walk away from a deal. The diagnostic tool typically includes a series of a function-specific decision-tree analyses designed to zero in on the ramifications of most likely trouble spots in the integration effort.

Most important, the playbook enables executives to maintain focus and keep their eye on the “value ball.” By building a repeatable and scaleable process tailored to a company’s needs, the executive team is led through the steps and questions that help it to focus only on those activities and functions that drive value realization, while postponing others. Finally, an M&A playbook is a living set of documents and methodologies. It is important that with each successive analysis or integration, the lessons learned from previous initiatives are incorporated.

Do you build and buy? Buy and transform? Or buy and simply combine and hold, transforming much later? Our view is that because of the reliance on operational synergies to drive value, utility acquirers should focus on selective transformation before an acquisition and consider change programs in high-impact functions as part of merger integration. Assuming an organization has about a 24-month window for accepting major change, taking measured risks, and selectively transforming as part of the merger integration process, while seemingly aggressive, can pay big rewards and put the newly merged utility on the path to high performance. However, do not try to change everything. Rather, focus on high-impact areas that will be competitive differentiators for the combined company.

We recognize the challenges of pursuing change programs both before, and as part of, acquisitions. In the end, current performance levels and acquisitive aspirations will affect platform priorities and design. In addition, the possibility of acquiring superior operating platforms is a consideration. The right path forward—the right balance of business transformation and M&A—requires a deep understanding of change readiness and the capabilities required to support the company’s competitive strategy. The time to consider these issues is before the acquisition, not during integration.