Chapter 3: Alliances, Divestures, Leverage Buy-outs

Alliances Introduction Joint partnership, strategic alliances and tie-ups are fast becoming easy and viable means of achieving growth. Amidst the wave of consolidations and mergers that is already active around the globe, todays CEOs are now focusing on articulating processes and attitude to successfully manage such partnerships and alliances. A strategic alliance is a cooperative arrangement between two or more organizations designed to achieve a shared strategic goal. There are two general types of alliances: Equity-based and non-equity based. Equity-based alliances include minority stock investments, joint ventures, and at the extreme end, majority investments. Non-equity alliances essentially are structured on the basis of contractual arrangement that specifies the responsibilities of each party, the mode of operation of the alliance, and the considerations involved in expansion or termination. Alliances or joint ventures are based on risk-sharing principle. It entails companies to have or build capabilities to manage alliances, thereby making it part of growth strategy. Drivers for Alliances and JVs Expansions of scale and scope by competitors. Return on investment (ROI) for alliances have been higher than ROI of individual companies entering into alliances. Mergers and acquisitions are usually time consuming and costly. If they fail, the acquirer bears the brunt of the failure. Globalization and liberalization process Outsourcing boom

1. Strategic alliances usually take forms of cross-selling agreements, and patent-licensing deals. Alliances are particularly crucial to IT based businesses that are in a hurry to access or leverage content, customers, or technology, as well as to all businesses that need to mitigate risk while pursuing growth options. 2. Additionally, alliances are better received than mergers and acquisitions in fast-moving, highly uncertain industries like electronics, mass media, and software. They are also the preferred choice for companies trying to build new businesses, enter new geographies, or access new distribution channels. Contractual alliances, being simple and flexible, are better received by the market than more complicated equity joint ventures. And, finally, when it comes to alliances, it turns out that polygamy pays: multi-partner alliances and consortia tend to be quite well received. 3. Since alliances provide a highly tailored way to access capabilities such as specific products or technologies, many deals are small relative to the parents overall business and may not provoke much movement in share prices. For one thing, big deals attract more scrutiny from the market.

Alliances for growth

Alliances for growth can involve new capabilities, new channels, and new geographies. New capabilities- Building new businesses would entail building / creating a host of new capabilities- products, customer relationships, technologies, and so on. Few organizations, especially those launching e-businesses, can develop these capabilities internally with sufficient speed. Alliances give companies a way to leverage their existing skills while they quickly and flexibly access the capabilities of others. In addition, alliances often involve less capital commitment and risk than do acquisitionsa big advantage in areas in which a companys management capabilities are unproved. New channels: Alliances should be looked at as a strategic alternative for companies seeking to expand sales through new distribution channels. Especially in mature businesses, customer acquisition costs can be much lower for alliances than for go-it-alone strategies. New geographies: Companies have used alliances successfully to enter new geographies. Corning, for instance, has used alliances very effectively to enter new geographic markets and achieve a range of other objectives. When the company teamed up with Asahi Glass and Samsung in December 1996 to build a Mexican factory that manufactures glass funnels and panels for color-TV tubes, the announcement was accompanied by a significant share price increase for Corning, which owns 40% of the venture.

Networks and consortium

Multi-partner alliances can give their participants targeted access to specific assets and resources of the partners. By contrast, M&A can be highly impractical when three or more partners wish to combine some of their assets; if a two-way merger is costly and disruptive, a three-way merger is more so. And even if the expected benefits of the merger or acquisition are very large, they may be weak and pale in comparison with the transaction costs of the deal itself. Many of the most successful business builders also use alliances to position themselves at the center of a network in which they can leverage intangible capital without owning many expensive assets. Nokias market capitalization, for example, has grown by USD 253 billion over the past five years. The company has leveraged a broad range of alliances to access manufacturing capacity, to conduct joint R&D, and to make products available to large numbers of customers rapidly. Nokia has joint ventures with Capitel Group in China and Gradiente in Brazil, participates in technology alliances such as Bluetooth and Symbian, and reaches customers through strategic supply arrangements with AT&T, NTT DoCoMo, and Sprint. The announcement of these alliances generally produced a favorable market reception.

Strategic Rationale for Alliances and Joint Ventures 1. First, when parent companies want to stay involved in a business but need to gain scale to compete, they may unite business units into a joint venture; Sony and Ericsson, for example, combined their mobile-handset units to take on Nokia and Motorola. Joint ventures face many of the same integration challenges found in large-scale mergers, and the partners must cope with the added problems of shared ownership. 2. Companies should also consider joint ventures and non-equity alliances to share risks and costs when entering new markets or think about investing in next-generation research or manufacturing. For example, many chemical and petrochemical companies have created joint ventures to share the costs of major new plants and to develop novel technologies. Union Carbide and AlliedSignal, for instance, combined their skills more than 15 years ago to launch UOP, a joint venture that develops process technology for the oil-refining, petrochemical, and gas-processing industries. It has since grown to become the worlds largest process-licensing organization, with reported annual revenues of more than USD 800 million. 3. When technology players reach for scope to provide integrated solutions, these companies will structure alliances with complementary businesses, as happened with pharma and biotechnology as well as with banking and insurance companies. Indeed, as the volumes of data generated by biotech research have created a need for specialized hardware and software, IBM has developed a portfolio of bioinformatics alliances with companies including Monsanto and Applied Biosystems. Limitations of JVs 1. Joint ventures usually take longer to get going than do contractual alliances. A joint venture is a completely new company, separate from either of the partners and often owning assets contributed by them. It thus requires complex governance structures and a significant commitment of senior managements time. 2. Furthermore, joint ventures may not last forever. So while a joint venture might be the right answer in certain cases, companies considering one should first explore simpler deal structures that capture most of the value at lower cost and with less complexity. 3. Joint ventures may complicate or disturb the parent companys future strategic options Therefore, if management wants to proceed with a joint venture, or an alliance or even an M&A the announcement should articulate with absolute clarity how the deal fits into the companys overall strategy. It should also spell out the benefits for the company and its partners, the effects on current partners, and the strategic options that management expects the alliance to create in the future. Too many managers approach deals with an acquisition mind-set. They should instead be open to alliances, taking to heart the evidence that big ones can really move the market.

Case Study: American Online To see how important alliances have become in technology-driven industries and how profoundly alliances can contribute to a companys market value, you need only look at America Online. After fewer than 15 years of existence, AOL has a market value of well over USD 100 billion (USD 121.5 billion on August 1, 2000). This startling record of success is attributable, in large part, to AOLs web of alliances and partnerships, which have helped it become the worlds largest provider of on-line services. Through a portfolio of partners, AOL gains access to products, content, technology, and global customersassets that create a network of increasing returns and help explain the companys prodigious market cap. Each new alliance for content makes AOL more attractive to subscribers, and this in turn attracts more advertisers and content partners. AOLs deals have often moved its share. In 1997, for example, AOL formed an innovative alliance with Tel-Save to market long-distance service to AOLs customers. The alliance was received positively by the market. Likewise, in October 1997, long before AOL acquired Netscape Communications, the two companies announced an alliance to launch a co-branded instant-messaging service. The service notifies users when other registered Instant Messenger users are also on-line. The price of AOL stock jumped by more than 9 percent when this technology-related alliance was announced. AOL has expanded into both Latin America and Europe through joint ventures. In Latin America, the company entered into a partnership with the Cisneros Group. In Europe, a joint venture with Bertelsmann also created significant abnormal value when it was announced. Source: www.mckinseyquarterly.com Mergers versus Alliances 1. In many situations, mergers and acquisitions are the only options for maintaining competitiveness. Shareholder demand, for instance, often mandates spinning off noncore divisions, and then quickly acquiring new and strategically complementary resources to maximize achievement of core objectives. 2. In addition, rapid consolidation in vertical industries such as high technology, financial services, and telecommunications means companies must initiate mergers among equals or buyouts of smaller firms simply to survive. De-regulation of certain industries may also be responsible for driving strategic consolidation through acquisitionsensuring the increased size, diversity of resources, and broader industry playing field that facilitate international leadership. The rapid internationalization of business has also been a strong influence on merger activity. 3. Typically in all M&A transactions, the window of opportunity is so narrow that it is impossible to negotiate a merger or acquisition in a timely manner. In this case, a strategic alliance, which can be quickly formed and disbanded if necessary, is particularly well suited. 4. Strategic alliance enables companies to rapidly enter profitable segments and high growth markets a quick infusion of talent, manufacturing capabilities, or additional distribution channels. 5. Faced with increased earnings pressure, companies also view strategic alliances as a means for leveraging non-core resources rather than spinning them off. Finally, strategic

alliances allow companies to enter into trial marriages before making the substantial commitment of resources that mergers and acquisitions entail. 6. The forms such alliances take are virtually unlimited, but they include joint marketing arrangements, shared research and development, collaboration on product design, technology licensing, and outsourcing of virtually all types.

Precautions while entering into JVs/ Alliances The potential for such risk requires following rules of the road when structuring each partnership. There are both legal and strategic routes for getting the most out of every alliance while minimizing their hazards. Among steps companies should take to tap into these alliances are the following: Due diligence Due diligence is important both for assessing the potential contribution of new partners, and for evaluating companies that have worked with yours in the past, but through markedly different arrangements.. Be specific. It becomes very important that companies have clearly defined objectives, performance benchmarks, and specific timelines for key milestones, for the joint venture companies. This needs to be distinctly articulated / defined and measured accordingly. Shared values Even if their companies are markedly different, alliance partners must share basic values if their initiatives are to succeed. For example, a large public company that wants to accelerate research and development may find a good partner in a growing and innovative engineering firmbut only if that firm also values the strict financial controls that are important to the larger company. Work toward dedicated arrangements. Avoid staffing alliances with managers and employees who serve two masters with substantial and often conflicting demands. For example, if one partners incentives relate entirely to sales, but the others relate to new product development, those working on the alliance, and thus influenced by both incentive plans, will lack clear direction. You must create consistent incentives for success that tap into the staffs inherent motivations. And you should also put your most goal-oriented in-house staff in charge of managing the alliance. Move toward permanent knowledge transfer. Whenever possible, rotate large numbers of in-house employees through an alliance as a training tool. Without violating terms that delineate ownership of intellectual property, take advantage of cross-training opportunities. Allow for continual change While formulating alliances, there should be enough scope for experimentation and pullback due to adverse market conditions and finally should provide for dissolution, if these alliances are hampering financial performance. Possible conclusion- Alliances / joint venture agreement should specifically provide for a clear exit strategy. Companies might find alliances as a route towards solo strategy of operations; in such cases, companies may question the partner`s commitment towards the JV and need to be able to regain 100% control. JVs / alliances entered into by companies should not allow either parties to share assets that could be used for other party`s growth. Reconsider acquisitions. Typically, alliance-related contracts anticipate that one company may seek to acquire the other if the arrangement shows this scenario. Taking a long-term view of the alliance encourages a highly collaborative and trusting relationship early ona precursor to a successful corporate marriage.

DIVESTURES

Introduction The economic slowdown has increased pressure on companies to revisit their operational strategies and their business portfolio to determine if divestitures are viable options to resolve most critical business issues. This has created a buyer's market rich with investment opportunities. Though recent trends point toward stabilization, overall M&A activity has declined significantly domestically and abroad since the second half of 2007. Many corporate buyers continue to face a challenging economic environment. At the same time, financial buyers face much tighter lending restrictions, making it difficult for them to offer acceptable (if any) pricing for deals. These factors, combined with the weak performance of a target business and sellers heightened need to divest quickly to generate cash, have caused a dramatic change in market dynamics. As a result, deal multiples only the better businesses are coming to market, and significant gaps continue to arise between what buyers are willing to pay and what sellers are expecting to receive for a target business. When sellers dont present a consistent and compelling business case, the bids they receive for a business are likely to be well below expectations, reflecting the issues that potential buyers claim will affect market value and future earnings. This is exaggerated in todays uncertain market, where even the perception of unmeasured risk can derail a deal, require sellers to pursue alternative buyers, increase the time to close, and reduce the price paid to the seller. Not only does this create delay in the receipt of critical sale proceeds, as time elapses and target management focuses on the deal rather than business needs, other impacts also surface: Employee turnover increases and productivity declines as staff members speculate about their future, weigh their options, and potentially leave the company for other opportunities. Critical investments and new products are often put on hold. Competitors use the opportunity to attack the target on its most vulnerable points, raising doubts among key customers, and making it harder to attract new business. Four Guiding Principles of Successful Divestures Most successful sellers in todays market use a thorough divestiture process that follows the four guiding principles of successful divestitures: planning for all aspects of the divestiture process, presenting financial information tailored to the deal, preparing thoroughly, and positioning for the exit and execution.

1. Plan for all aspects of the divestiture process

Clarity regarding the scope, goals, and objectives of the transaction: A seller needs to clearly outline the parameters surrounding the assets to be disposed. This includes determining what is included and excluded within the scope of the transaction, the expectations about structure, and issues related to employees. Many transactions may begin with far too much ambiguity, which can be leveraged by buyers to their advantage later in the process.

Developing a divestiture project plan The critical step to a successful divestiture is to create a managed divestiture project plan with a clearly defined team that has sound project management experience, including a well laid out transaction timeline for all functions and responsibilities. At this stage it's important to avoid oversimplifying the plan. Having a realistic view about the demands on and capabilities of the internal team, as well as the scope and objectives of the transaction, is the most critical thing. Determining the implications of whats left behind Divestitures often result in unexpected stranded costs being left behind with the seller. These indirectly may erode the value received from the transaction, if there is no clear strategy with the company with regard to assets / businesses left behind. These decisions may relate to restructuring, merger, or expansion that the company might be thinking of.

2. Present financial information tailored for the deal

Evaluate information requirements- Sellers should carefully consider what information will be needed by potential buyers, what information is available, and how to best present it. While generally accepted accounting principles (GAAP) financial statements and deal-basis financial statements often vary significantly, both can be important to many buyers. Sellers may lose value by presenting only GAAP financial statements, but they may be unable to complete a transaction by presenting only deal-basis financial statements. Presentation of both sets of financial statements may be preferred; if so, it's important to bridge the differences between the two. Multiple sets of data that cannot be reconciled or bridged can erode buyer confidence. Describe the business in a clear and cohesive manner Avoiding inconsistencies in the data provided to buyers, and communicating credible, supportable forecasts, are critical to accelerating the divestiture process. This will include that the data provided for offering memorandums, management presentations, is complete, accurate and consistent prior to delivering them to buyers.

3. Preparation
Identifying operational issues and opportunities Many divestiture target businesses, particularly in a challenging economic environment, are performing below management expectations. Under these circumstances, it's important to fully review operations prior to putting the business up for sale. This enables the seller to identify and address crucial issues prior to any presentation to potential buyers: non-recurring costs impacting earnings, working capital investment, delayed capital expenditure (CAPEX) spending, plant efficiency, excess back-office costs, and restructuring options. This process is referred to as preparatory or sell-side due diligence; which is a vital aspect of divesting in todays market. Early issue identification and its intended resolution can help neutralize the issue as a negotiating point. Validate forecast assumptions Testing or validating the business unit's forecast assumptions is a significant focus of buyer due diligence. Consequently, sellers in the preparation stage of a transaction should be sure to: analyze forecast assumptions with a degree of skepticism, anticipate buyer concerns and areas of focus for the assumptions included in the forecast, and prepare adequate support for those assumptions (e.g., historical performance versus forecast and third party forecast assumptions)

Plan for key terms in the purchase agreement Typical areas of negotiation include purchase price adjustment mechanisms (e.g., working capital, indebtedness, and restricted/trapped cash); representations and warranties; indemnities; and transaction scope (included or excluded assets). Proactive sellers take the lead in drawing up key contractual terms, including the rules for presenting financial information and nature of post-closing adjustment mechanisms in areas like working capital, net assets), as well as what accounting policies and GAAP deviations may need to be disclosed. 4. Position for the exit Managing the process Sellers that actively manage the transaction process experience fewer delays and retain more value than those that allow potential buyers to dictate the process and timeline. Careful planning, presentation, and preparation will allow the seller to provide all buyers with the same information and answers they require, promoting a much smoother transaction process. Drafting of transition service agreements Moving from signing to close is critical, and explicit plans for vital transitioning services, systems, supply agreements, and back-office operations to the divested business often drive this outcome. Too often, such arrangements are mere afterthoughts that lead to value deterioration, closing delays, or difficulties for both parties. Leveraged Buyouts (LBO) A leveraged buyout is the acquisition of the existing private or public stock or a company by a group of equity sponsors that typically is financed with debt and equity, and uses the cash flows of the target company to repay the debt. The equity sponsors may include the management team or the company. The assets of the company are pledged as collateral behind the assumed debt in the transaction. A typical leveraged buyout involves the acquisition of a public company in an under-appreciated sector or where the stock is unattractive compared to its peers. The aim is to reinvigorate the management team, pay down the acquisition debt using the company's cash flows, and then sell or make the company public again at a later date at a higher valuation. It is important to recognize that the appropriate transaction structure will vary from company to company and between industries. Factors such as the outlook for the companys industry and the economy as a whole, seasonality, growth rates, market swings and sustainability of operating margins should all be considered when determining the optimal debt capacity for a potential LBO target.

Attributes of attractive buyout candidates: For a company to be acquired on a leveraged basis, it must have a number of positive characteristics as mentioned below: a) Stable Cash Flows. The greater the stability and predictability of cash flows, the less risk there is in the transaction. Lenders will look to the stability of cash flows to determine how much they will lend to the company. Historical measures of cash flows may indicate likely future stability; however. It is important to evaluate the future cash flows in the context of the leveraged buyout. And evaluate the companys overall financial performance and ability to generate cash with a significantly altered capital structure. Increased leverage may have an impact on the

ability of the company to invest in capital and working assets and consequently, the future financial and operating profile of the firm may change. b) Strong Management Team. While stable cash flows are a pre-requisite for a successful leveraged buyout. They cannot be relied upon as the sole basis on which to proceed. The quality of the management team is equally as important the equity sponsor and lenders will want to have comfort that the management team has been in place for an extended period and that the management team has the requisite experience to manage the company under a leveraged scenario. c) Undervalued Assets. An attractive buyout candidate may be a company that has undervalued assets or businesses that can be divested so help reduce leverage once the transaction has closed. While lenders may not depend on asset sales to repay debt, they can be an effective means to quickly reducing the leverage of a buyout d) Strong Balance Sheet. An equity sponsor will look for in evaluating a buyouts candidate are (i) the company's ability to reduce costs and (at) the targets existing capital structure. The greater the ability to reduce expenses and lower the leverage, greater is the opportunity to realize value in the leveraged buyout. Pros and Cons of LBO There are a number of advantages to the use of leverage in acquisitions. Large interest and principal payments can force management to improve performance and operating efficiency. This discipline of debt can force management to focus on certain initiatives such as divesting non-core businesses, downsizing, cost cutting or investing in technological upgrades that might otherwise be postponed or rejected outright. In this manner, the use of debt serves not just as a financing technique, but also as a tool to force changes in managerial behavior. Interest payments on debt are tax deductible, while dividend payments on equity are not Private equity firms typically invest alongside management, encouraging (if not requiring) top executives to commit a significant portion of their personal net worth to the deal. By requiring the targets management team to invest in the acquisition, the private equity firm guarantees that managements incentives will be aligned with their own. The most obvious risk associated with a leveraged buyout is that of financial distress. Unforeseen events such as recession, litigation, or changes in the regulatory environment can lead to difficulties meeting scheduled interest payments, technical default (the violation of the terms of a debt covenant) or outright liquidation can create trouble for acquiring company. The value that a financial buyer hopes to extract from an LBO is closely tied to financial performance, growth prospects and proper management of investments in working capital and capital expenditures. Weak management at the target company can also pose threats to the ultimate success of an LBO.

In addition, an increase in fixed costs from higher interest payments can reduce a leveraged firms ability to weather downturns in the business cycle. Finally, in troubled situations, management teams of highly levered firms can be distracted by dealing with lenders concerned about the companys ability to service debt.

Review Questions 1. What is Leveraged Buyout and what are key drivers for LBO to be successful? 2. What are the advantages and disadvantages of an LBO? 3. What strategic rationale drives alliances and joint ventures? How do they compare against mergers and acquisitions? 4. Explain the key guiding principles while carrying out a divesture process.