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Profit from global capital flows

By Peter S. Cohan and Srinivasa Rangan

Executive Summary
Cutting costs can save only so much money before investors want to see revenue growth. Using global capital flows and a solid methodology, managers of industries can increase revenues by merging with or acquiring companies in rapidly growing markets. Just be sure to take account of the targeted market’s entrepreneurial ecosystem.

Managers face significant challenges these days. Economic growth is slow, but investors want to buy stock in companies that boost profit growth. If that growth does not come from rising revenues, managers respond by cutting costs. And those cost cuts have yielded record profit margins – expected to rise to a record high 8.9 percent in 2010, according to the New York Times. Now sitting on $1.84 trillion in cash, according to the Federal Reserve – up 26 percent from 2009 – these companies would seem to be in the catbird seat.

But they’re not. How so? Companies have achieved all the profit growth they can expect based on cutting costs. To sustain future profit growth, they’ll need to boost revenues as well. The good news is that if they can achieve that revenue growth, their record profit margins will bring bounteous profit growth.

But how to achieve that revenue growth is now the $64,000 question. One answer could be to use their hoards of cash alongside the torrents of global capital flows to make acquisitions that will enable these companies to profit by applying their skills in more rapidly growing markets.

New research offers a way to think about tapping the accumulated capital to fuel growth. Tracing the flow of capital around the world has led to the conclusion that countries can boost their share of capital by changing the conditions that attract it. For example, between 2009 and 2011, foreign direct investment is expected to rise 50 percent, from $1.2 trillion to $1.8 trillion, according to the United Nations Conference on Trade and Development, while private capital flows to emerging markets are anticipated to grow 41 percent, from $531 billion to $746 billion, according to the Institute for International Finance. What is more, an increasing number of countries have come to recognize what they need to do to attract capital.

Transparent and efficient financial markets, reliable and effective corporate governance systems, human capital development systems that promote skills needed to boost growth, and clear and supportive intellectual property protection laws constitute the four elements of a high quality entrepreneurial ecosystem (EE) that attracts capital.

This EE framework, shown in Figure 1, can help managers of industries face difficult questions:

  1. Should they preserve the corporate strategies that got their companies to their current position?
  2. Do those strategies represent a core rigidity that makes their companies unable to adapt to change and thus vulnerable to upstart competitors?
  3. If so, do acquisitions represent a profitable means of reviving a moribund company’s growth?

In some cases global acquisitions can represent a logical way to extend a firm’s corporate strategy. Deals that make the most strategic sense target large, rapidly growing markets and assemble a set of capabilities that enables the combined company to take significant share in those growing markets. Such deals likely will pay off for managers by reviving a stagnant company. Wal-Mart’s latest move to buy the South African retailer Massmart is one such bold step that may end up giving the giant U.S. retailer a huge leg up in several African countries even as it faces stagnant growth and intense competition in its home country.

In other cases, acquisitions are a mistake because the availability of private equity and bank debt enables deals that otherwise would not make strategic sense. Deals that are driven primarily by the availability of capital to finance them, rather than a sound strategic logic, tend to fall apart rather quickly once the appetite for such financing switches off. Such failed deals should be a cautionary tale. Their key lesson is that managers must separate the investment and the financing decisions. If the availability of financing causes managers to seek investments that make little economic sense, the managers will regret it later.

In general, managers make their companies vulnerable if they do not remain keenly attuned to changes in their competitive environment. A manager’s willingness to break out of the bubble separates her from those who would rather bask in past successes than continue to push the company forward. The globalization of entrepreneurship represents a threat to companies that refuse to pay attention to how this force can upend their business. Yet for managers willing to tap its power, the globalization of entrepreneurship can revive a moribund company in a mature industry.

Managers in established industries should use a formal methodology to figure out how to use acquisitions in growth markets to revive a company. As explored below, such a methodology can help managers willing to follow the steps as a way to inject entrepreneurial energy in a corporate gas tank operating at too low an octane level.

Haier and Whirlpool

One established industry that was affected by global capital flows and the evolving entrepreneurial ecosystem in China and the U.S. is the appliance industry. The industry was growing slowly, and several potential acquirers decided to focus on Maytag, an industry leader. Maytag had suffered because it had not adapted well to the growing power of mass merchandisers in the distribution of home appliances and the rising market share of lower cost competitors, specifically those based in Asia, that made and sold appliances at much lower costs and prices.

Maytag’s failure to adapt put it in play for various industry participants. Thanks to the global availability of capital, these players included industrial acquirers and private equity firms. In the case of Maytag, the private equity firms were major players. One such firm, Ripplewood Holdings, made a bid for Maytag, as did China-based Haier Group, which was joined by two private equity firms – Bain Capital and Blackstone Capital Partners.

As a recent case study of Haier asserts, on June 21, 2005, Haier bid $1.3 billion to acquire Maytag, a move that industry analysts suggested was driven by its goal of gaining direct entry into the premium segment of the U.S. household appliances market. A mere six days later, Haier tapped those global pools of capital to raise its bid by assuming $975 million in Maytag debt with the help of Bain Capital and Blackstone.

Alas, Haier’s dreams of owning Maytag fell apart when it announced on July 20, 2005, according to China Daily, that it would drop out of the bidding due to the challenges of integrating the business that it discovered in its due diligence process, along with its fear of a political backlash in the United States against a Chinese company buying this American appliance icon. This left two bidders – New York private equity firm Ripplewood Holdings and larger appliance maker Whirlpool.

In May 2005, the Ripplewood group submitted a bid to buy Maytag for $1.1 billion, or $14 a share. In June, Haier launched its $16 a share bid as discussed above. Then on July 18, 2005, Whirlpool launched a surprise offer for Maytag of $1.36 billion, or $17 a share, according to the New York Times. Whirlpool said it would pay at least 50 percent in cash and the balance in shares. Whirlpool's offer valued Maytag at 35 times expected 2005 earnings of 49 cents a share.

On Aug. 22, 2005, Whirlpool won by agreeing to pay $2.7 billion in cash and stock for Maytag. According to MarketWatch, the parties signed a definitive merger agreement, with Whirlpool paying Maytag shareholders “$10.50 in cash and between 0.1144 and 0.1398 of a share of Whirlpool stock for each share held. The deal equaled about $21 a share, with Whirlpool also assuming $977 million in Maytag debt.”

This minicase illustrates three important ways that these developments can influence managers who want to take advantage of global capital flows and EEs:

  1. Haier tapped global capital to make its bid. Without help from Bain Capital and Blackstone, Haier would not have felt comfortable raising its bid by offering to buy Maytag’s debt. This suggests an opportunity for managers to use global capital flows to ease access into foreign markets.
  2. Whirlpool raised its bid to keep Maytag away from Haier. Without Haier’s access to these private capital pools, Whirlpool likely would have stayed out of the bidding or would have at least made a lower offer – just slightly higher than what Ripplewood offered. But the combination of Haier’s higher offer and the competitive threat that Whirlpool perceived from Haier demonstrates how global capital flows can be a threat to some industry participants and a help to others.
  3. Haier withdrew its bid due to perceived U.S. barriers to Chinese capital. One of the major reasons that Haier decided not to raise its bid had to do with the EE challenges in the U.S. Specifically, Haier’s due diligence revealed challenges in managing Maytag’s U.S. operations – suggesting gaps between Haier’s approach to managing human capital and that of Maytag. Moreover, after the uproar over a bid by a Chinese oil company to acquire a U.S. one, Haier decided to back off rather than try to overcome that barrier.

Methodology for managers

Managers can take advantage of the growth opportunities while shunning the risks of global acquisitions as illustrated in the Haier case by using a method that helps them identify the most attractive countries in which to invest, ending with a reshaped company that grows faster than it did before. This methodology is built on the assumption that there may be meaningful differences between the entrepreneurial ecosystem in which the acquirer operates and that of its target. More specifically, this methodology is intended to help acquiring managers think through whether the differences between their EE and that of their target company represent a threat or an opportunity. Managers should capture the opportunities – in the target’s financial markets, corporate governance, human capital and intellectual property regime – and protect themselves against the threats in the target’s EE.

What follows is a six-step methodology that will help managers exploit the opportunities of global mergers and acquisitions to revive a moribund company in an existing industry.

Step 1: Pinpoint large countries growing fast with industries in which your company competes. Managers in existing industries have an opportunity to scan the world and look for other countries in which they might want to offer their products. The most attractive countries likely will be ones that have a large number of potential customers with rapidly growing demand. The reason such countries are attractive is that an existing company that has reached significant scale can grow only in a way that is meaningful to investors if that growth springs from big, growing markets.

To find such markets, managers may seek to focus on developing countries with large populations where there is demonstrably rapid growth in demand for their products. It is worth noting that unless the manager’s company can satisfy that demand better than competitors already do, then the investment it might make in trying to take a share of that market likely will be wasted. To avoid that fate, managers ought to conduct research into the specific criteria that channels and end-users apply to competing suppliers to assess which one to pick. Such analysis can help managers assess their odds of winning a share of that country’s markets.

Step 2: Identify risks and opportunities in the country’s regulations regarding foreign ownership and other corporate governance matters, its capital markets, its human capital and its intellectual property regime. However, if managers see an opportunity in meeting customer needs better than the competition, they should consider next whether the country’s entrepreneurial ecosystem is at odds with their own. Such differences do not necessarily mean that the managers should not seek to enter that new market. However, managers will find themselves at a disadvantage if they do not explore those differences early in the process of considering a new country in which to expand.

To that end, managers should conduct research into the details of the EE of the country where they perceive growth opportunity. Such research should seek to answer questions such as the following:

  • Are the country’s financial markets deep enough to be a good source of capital for the business, or will capital need to come from other countries?
  • Does the country have a sufficiently rigorous set of corporate governance principles and enforcement mechanisms to protect their investment?
  • Does the country have limits to how much of its companies can be in the hands of foreign investors?
  • Can the country’s human capital enable them to achieve their growth objectives? If so, what is the best way to manage that human capital?
  • Does the country protect intellectual property, or would managers be better off assuming that the country will permit its companies to steal their intellectual property?

Based on the responses to such questions, managers can decide whether a country’s entrepreneurial ecosystem presents more opportunities than threats. And they can consider how they might protect themselves against those threats while taking advantage of its opportunities.

Step 3: Identify companies in those countries/industries that could be acquisition candidates. Having settled on a particular country in which to invest, managers may wish to consider whether they should seek to take market share through a de novo venture, partnership or acquisition. Acquisition is a common mode of entry – particularly for managers of companies in existing industries.

The primary reason acquisitions are popular among managers is that the other options generally take more time to generate sufficient revenues and profits to get the attention of investors. To develop a list of potential acquisition candidates, managers should seek out lists of companies in their industry in those countries ranked by market share. Managers should collect more data on each of these companies about their management teams, financial performance and prospects, current products, research and development projects and key capabilities.

Step 4: Rank the companies based on their fit with your company’s skills and the potential for an attractive investment return. Such data can help managers as they decide which of those companies they should approach first, and which they should shun. Before making an approach to one or more of these companies, managers should consider these questions:

  • Will the target company combined with their company be better able to take market share in that new country?
  • Will the cash flows from the combined company exceed the target’s purchase price?
  • Will they be able to integrate the target effectively after the deal closes?

Managers should rank the potential candidates based on how they stack up on the answers to these questions.

Step 5: Complete the acquisition and integration of the company that best fits these criteria. The next step is to execute. In general, this involves a huge amount of management effort, in conjunction with advisers, capital providers, target company management and regulators, to complete all the tasks from contacting the target company to completing the integration of the target into the acquiring company. As noted above, execution is fraught with landmines – including satisfying the needs of regulators and working effectively with the target company’s managers so they’ll be on board with the idea of joining the acquiring company’s management team.

Step 6: Set performance milestones and manage the company to achieve them. Once the deal has been concluded, managers need to get down to the brass tacks of running the business. This means

  • Setting performance goals for the combined company
  • Putting in place managers who will be held accountable for achieving these goals
  • Formulating the strategy that will enable the combined company to win in the marketplace
  • Getting the resources – in capital, technology and people – to implement the strategy
  • Making adjustments based on whether the strategy works or falls short

Conclusion

Revenue growth is a powerful imperative for managers in existing industries. Due to the rising tide of global capital flows, acquisitions are a means of achieving such growth. But these acquisitions are fraught with both opportunity and risk. The entrepreneurial ecosystem and the methodology outlined here can be a useful guide for managers to think of ways to capture the benefits of global acquisitions while skirting the shoals of their risks.

Peter Cohan is a columnist for AOL DailyFinance. He is president of Peter S. Cohan & Associates, a management consulting and venture capital firm. The Achiever Newsletter ranked his eighth book, You Can't Order Change: Lessons from Jim McNerney’s Turnaround at Boeing, as the No. 1 business book of 2009. He is the author or co-author of nine books, including his latest, Capital Rising. He teaches business strategy to undergraduate and M.B.A. students at Babson College and has taught at Stanford, MIT, Columbia and the University of Hong Kong. He holds a B.S. in electrical engineering from Swarthmore College, did graduate work in computer science at MIT and earned an M.B.A. from The Wharton School at the University of Pennsylvania.

Srinivasa Rangan is associate professor of strategy and international business at Babson College and has received several teaching awards. Among his teaching, research and consulting interests are global strategies of firms and forging and managing of strategic alliances. He is the co-author of Capital Rising and the best-seller Strategic Alliances: An Entrepreneurial Approach to Globalization. Rangan has graduate degrees from the London School of Economics and IMD in Lausanne, Switzerland, and his doctoral degree is from the Harvard Business School.

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