Why Scope deals have outnumbered Scale deals in M&A deal activity recently?

Introduction

  1. Due to lower cost of capital, higher cash reserves available with corporates and booming stock market, M&A activity are increasing rapidly.M&A activity essentially mirrors a company’s growth strategy and are undertaken to achieve it’s tactical and strategic priorities.
  2. The strategic rationale to acquire a company has changed in past few years.Previously, companies were acquired to archive scale and market leadership.These deals are termed as Scale deals and these deals happen within the same industry and mostly among competitors. These deals focused on reducing costs by eliminating duplicate functions, processes and systems, leverage each other fixed assets to increase utilization and to increase their purchasing power due to the combined scale.The logic of a scale acquisition is that the combined cost per unit of a product/service of the combined entity would reduce with increase in production.These deals are not restricted to only among large companies but also in mid size companies.Many mid size companies combine together to form a bigger entity which can compete with larger players.In IT industry acquisitions like IGate – Patni are instances where two mid tier companies combined together to compete against larger IT service providers. Scale acquisitions primarily focus on cost synergies to improve productivity and efficiency though there have been instance where there have been revenue synergies due to cross selling opportunities.
  3. Due to digital disruption, most of the current business models of the legacy companies in each industry are no longer relevant to the growth.Hence there is a need for many legacy companies to revamp and align their current business model to align to the market growth.Hence, scale acquisitions are no longer relevant among legacy companies to drive market share or growth.At the most scale acquisitions can help to protect the market share or in some case additional cost savings that can be realized by the scale acquisition can be invested in scope acquisitions.
  4. Hence in order for companies to be relevant and align their value proposition according to the current market demand, companies are required to reevaluate their services portfolio to check if their service offerings satisfy the current market/customer demand.Post this analysis, the company needs to decide if it can build any of the service offerings that it is either missing or currently weak in, either organically or thru acquisitions. Such acquisitions where companies acquire targets to increase their market share/revenues come under scope deals.Hence scope deals focus more on increasing the top line growth and hence the deal rationale revolves around revenue synergies.
  5. The rationale for scope deals for the acquirer could be to strengthen the existing service offerings, add a new product/service line, expand to new markets or gain entry to new markets.In some cases it could also be get access to a technology capability- like in a digital deal where acquisitions happen to acquire the IP or technology like Machine Learning, Cloud computing, AI and IoT.Most of the deals currently happening in the market primarily in the technology, Healthcare sector are scope deals.For instance IBM decision to acquire Redhat for $34billion to leverage open source framework of Redhat to provide hybrid/multi cloud services comes under the Scope deal.Scope deals also happen in adjacent industry.Due to digital disruption, more industry convergence deals are happening, primarily in Telecom and Media like AT&T acquisition of Time Warner.

Valuation in Scope deals against Scale deals

  1. After the deal rationale is finalized and the acquirer decides to either go for Scale/Scope deals, the next step would be to value the deal.Generally Scope deals are priced higher than Scale deals and are valued at premium.The reason for the high premium is because, the upside potential for an acquirer to realise higher growth and market share is higher in Scope deal against a Scale deal.With a scale deal, the benefits of the acquisition would generally be one time cost synergies of consolidating duplicate functions and increasing efficiency.In Scope deals, especially for capability driven deals, the acquirer can upsell/cross sell and bundle the combined service offerings to increase wallet and market share.For market expansion deals, the acquirer can gain entry to new markets, get access to new client roster and also access to the high quality skills of target.All these things if leveraged correctly could position the acquirer as a market leader regionally or functionally or in a particular domain.Hence the combined service offerings along with access to new customers and to new markets could give the acquirer a high competitive advantage in its industry.

Due Diligence – Scale vs Scope Deals

  1. The Due Diligence process would vary when the acquisition is a Scale or Scope deal.As scale deals generally happen within the same industry, the acquirer has a very good idea about the industry, its market potential/growth and an indication of how the proposed acquisition can alter the competitive landscape.Hence most of the due diligence is focused on confirming the target business data on Financials, IT and Customer contracts.More importance would be given to cost synergies and total cost savings that can be realized by consolidating IT systems, back office functions and supplier relationships. The operating model of the combined entity would not change post acquisition.
  2. In a scope deal, the due diligence strategy would be different.The acquirer needs to assess how the target can be a strategic fit for the future growth.The acquirer in most cases may not have expertise on the target business or its market and hence would depend totally on the target management to drive synergies and value creation post acquisition. The acquirer also needs to check how it can add to the future growth of target business either by providing capital or giving access to its customers/markets for selling the target services.The target operating model to be followed by the combined entity post acquisition needs to be identified and would be derived from the deal rationale.As the target and acquirer mostly operate on different business segments, the culture and way of working of both entities will differ and hence due diligence needs to be done on the cultural fitment and ensure that the combined operations does not affect the target Working culture and it’s way of Working.This shall reduce any attrition post acquisition.

Integration- Scale vs Scope deals

  1. Integration planning for a scale deal is relatively simple as the target business in almost all cases are completely integrated with acquirer business.The integration planning needs to purely focus on realizing cost synergies immediately as well as deciding on the target systems and employee management.In most cases, the acquirer decides to identify the systems, processes and supplier relationships that shall be operative post acquisition. In some cases, the acquirer can choose the best of breed approach for retaining IT systems and processes.The HR integration would primarily focus on the resources that needs to be retained and the roles that are redundant as a result of the acquisition.
  2. In a scale acquisition, the target management does not continue post acquisition. In case of scope acquisition, the acquirer does not have expertise on the target business and would require the founders expertise to run the entity.So the acquirer would want remain the founders to continue post acquisition to support them on Integration so that synergies can be realized out of the acquisition.
  3. In a scope deal, the integration planning is complex and would determine the value creation of the acquisition.Once the target operating model is identified, based on the Organization structure, Governance process and target culture / way of working, the Integration plan would decide on the degree of integration and to what extent the target business can function independently. It is not advisable for the target to be completely independent from the acquirer because the acquirer would not be able to leverage the combined synergies of both the entities.In addition, the acquirer would also want to leverage knowledge/expertise of the target business by enabling Knowledge sharing/ transfer sessions for its employees. It is also important that the target follows the corporate governance and basic ideology of the acquirer. In all cases, back office functions like HR, Finance and IT functions are integrated in order for the acquirer to track the synergies and value creation as the result of the acquisition. Sales/GTM integration also is important so that the combined Salesforce can work together to achieve targets thru cross-selling / bundled service offerings of the combined entity.The acquirer needs to be careful not to disrupt any of the target process that can destroy value.For instance, the target may have an entrepreneurial culture against a acquirer’s bureaucratic culture.Hence by imposing the acquirer bureaucratic process on target employees would affect their morale and would result in their exit. The talent management/hiring practice needs to be carefully evaluated by the acquirer and best practices followed by the target can be adopted.

Conclusion

  1. The strategic rationale to Integration strategy would differ for a Scale deal and Scope deal.
  2. The scale deal is relatively simple to execute and focus on cost synergies.The scope deal are challenging and for the scope deal to be successful, the acquirer needs to be seasoned and experienced.
  3. The acquirer needs to have a repeatable M&A process and should have built a capability along with best resources in its team to be successful in these acquisitions.
  4. Scope deals has a potential to give high upside revenues and market share growth compared to a scale deal.Facebook acquisition of Instagram is a classic instance of Scope deal that gave high growth to Facebook and brought high market share.
  5. In order to successfully navigate the current business uncertainty and the business model disruption due to digital, companies need have a repeatable M&A capability to identify targets that have potential to increase market share and integrate it quickly in order to realize the synergies.


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