Grooming up for Sale

Preempting hostile takeovers
Companies that stick to valuation basics can capture any value that would make them attractive for takeover bids.
Jenny Askfelt Ruud, Johan Näs, and Vincenzo Tortorici

(McKinsey Quarterly) The market for corporate control is undergoing a fundamental change: it is not only growing—M&A activity reached record levels in 2006, peaking at nearly $4 trillion globally—but also getting more aggressive. Last year more than 100 hostile transactions, valued at over $520 billion, were announced around the world (Exhibit 1). That’s three times the previous record, in 1999, according to data from Dealogic.

This activity is driven in part by a host of new players—including private-equity firms, hedge funds, and activist shareholders—that seem more and more willing to put companies in play at a moment’s notice. Further complicating the landscape, notably in Europe, is a recent flood of value-creating cross-border opportunities that have appeared as traditional barriers to hostile pursuits erode.

Amid this frenzy, many managers wonder uneasily how vulnerable their companies might be to takeover and contemplate fixes to ward off unwanted attention. Especially when they are under attack, their first reaction may not be the one that would create the most value: they often take last-minute defensive action to resist hostile bids at all costs. Typically, such responses aim only to protect a company’s independence, whether or not it’s in the best interests of shareholders.

In our experience, the best approach both to serve shareholders and to position companies for long-term strategic independence is to think and act preemptively. Even in today’s intense M&A market, companies can proactively assess the “extractable” value that an alternative owner might see and then move to capture it themselves. Much of this approach is simply good housekeeping: sticking to the basics of corporate strategy and rigorously implementing value-creating measures that the best managers have been executing all along. In this way, a company has the best opportunity to capture the value of strategic, operational, financial, and portfolio moves that might otherwise make it an enticing target for an acquisition or hostile takeover by value-hungry predators. Managers who neglect these basics for too long—often as a consequence of noneconomic constraints perceived as unbeatable—not only destroy value by failing to implement sound management practices but may also be hard pressed to explain why a company wouldn’t be better off with new owners.
Yet, incumbent managers enjoy a natural advantage over any potential acquirer because they have superior information about their companies’ operations and overall status. So in theory, they should be able to capture at least as much value as any hostile predator envisions if they can preempt whatever value creation measures a predator may plan and execute them with rigor. By tackling these opportunities well in advance of a possible takeover bid, managers will generate the greatest possible value for current shareholders, even if a hostile bidder never materializes. They will also improve their companies’ positions in the market for corporate control and help prevent the accompanying trauma of a hostile takeover. The value created from such an aggressive stand-alone strategy should be substantial and may therefore induce potential buyers to look elsewhere for “buy-low” opportunities.

A few enduring conceptual frameworks offer managers a structure for diagnosing the vulnerability of their companies to takeover, identifying where outsiders may see pockets of value waiting to be captured, and planning a path forward (Exhibit 2). Many companies have significant untapped potential to create value by improving their operations, restructuring their portfolios, managing their balance sheets, and improving their governance. Management can also take measures to ensure that current market valuations reflect current strategy and performance, as well as improvements over time.

Operational improvements. Companies with untapped operational potential—even solid but average performers—make interesting restructuring candidates, particularly for their leading industry peers and for active-ownership companies that could readily improve their performance. Management should conduct pragmatic, objective private equity-like due diligence to identify ambitious—yet achievable—performance targets for all levers that could create operational value. Companies must identify and act on such opportunities as quickly as possible—for example, by developing a stronger performance culture through renewed incentives, implementing lean processes, or moving or outsourcing production.

Portfolio restructuring. A company with a significant part of its capital in businesses that could be worth more or grow faster under alternative owners will inevitably attract interest—even if those businesses are profitable to the current owners. The lower the value to acquirers and the greater the potential synergies with other players, the more enticing they become.2 Companies can dampen that interest by evaluating the business logic, future strategy, and “M&A tradability” of their own current portfolio and by looking for opportunities to improve its composition. Companies can, for instance, sell noncore assets and commit the proceeds either to high-growth, high-return businesses or to additional shareholder dividends. In one recent example, a large European telecommunications company divested noncore assets worth 15 to 20 percent of its total corporate value to rid itself of businesses and projects that made it an attractive candidate to predators eyeing its valuation if it were broken up.

Balance sheet management. An underperforming financial structure will leave any company vulnerable to acquisition, though of all levers this is one of the fastest (and often least contentious) to pull. Indeed, the fact that appropriate measures can be taken so quickly acts as a powerful enticement to outside investors—particularly private-equity firms. Extraordinary long-term cash balances, high working-capital levels, and underleveraged balance sheets all attract outside attention, for good as well as not-so-good reasons. Management should analyze the company’s balance sheet to identify any pockets of excess capital that can be released (for example, in the form of extra dividends to shareholders) while retaining sufficient cash for productive future growth. The impact of increased leverage will be seen not only in a company’s immediate financial results but also in stronger performance incentives, such as a cash flow orientation among managers and a renewed sense of urgency.

Better governance. Strong or weak governance weighs on all the measures already mentioned. Perceptions of weak governance or a management group whose interests aren’t aligned with those of the shareholders can make a company vulnerable to attack from both external suitors and its own shareholders. For example, once shareholder activists and hedge funds acquired significant control of the Stockholm-based insurance group Skandia, they were able to use their position to exercise material influence over the board’s composition and agenda. Special events, such as option program scandals and turbulent changes in management and the board, made Skandia vulnerable. When governance is an issue, remedies include aligning the interests of top managers with those of the shareholders, increasing the transparency of governance, and making targeted changes in the board of directors and the management team to align the company’s core competencies with its current challenges and, more generally, with global best practices. Installing best-practice performance-management and incentive structures and linking potential upside and downside effects to corporate performance (similar to what private-equity firms implement for their portfolio companies) signal management’s commitment to increasing shareholder value.

Addressing perceptions. As managers implement these strategies, it will be crucial to eliminate any gaps in perception between a company’s market value and its potential value after the improvements it undertakes; companies trading at low multiples compared with their industry counterparts attract extra attention. Differences in perceptions develop when investors don’t see or understand how a company is going about creating value or when they lack confidence in management’s ability to deliver it. To address the former problem, executives should ensure that the company has the best possible investor communications, issues candid earnings guidance, liaises routinely with its more professional shareholders, and manages expectations adroitly. To a limited extent, companies can also proactively manage the composition of their investor base by targeting strategic long-term investors to create stability during periods of transformation. This approach may force a company to rebuild its credibility through more aggressive steps, such as replacing senior management or recruiting new board members.

Each of these measures helps companies anticipate and manage the forces that make them most vulnerable, including consolidation and M&A frenzy in their industries, the value that other owners might hope to extract, and still more powerful enablers, such as internal conflicts, failed attempts at hostile takeovers, risk or accounting issues, and bad press.

Do preemptive measures to unlock a company’s full value guarantee its long-term strategic independence? They don’t—and shouldn’t. In some cases, alternative owners may have intrinsic, unique sources of value creation that stand-alone companies can’t match. In others, aggressive players may be deliberately willing to overpay in their quest for size and for leadership in an industry segment. The rational choice for shareholders is then to capture the highest net present value by selling out and pursuing other investments. In daily M&A activity, value creation isn’t always the key driver for acquisitions. But one thing is certain: when a company captures all available pockets of value and systematically closes gaps (that is, opportunities for predators), it will fetch a much higher price if it should ultimately be acquired—and its shareholders should be happy.