Lesson for M&A: If You Want to Grow, Don't Expand

For companies that want to succeed at M&A, here’s a critical lesson to take to heart: If you want to grow, don’t expand.
Mergers and acquisitions are likely to fail if companies follow a standard, popular approach, using M&A to expand into hot new areas in an attempt to jump-start growth. 
Whenever leaders focus on financial considerations and ignore—or misjudge—the fit between the companies’ capabilities, failure is almost certain. M&A efforts are most likely to succeed when they are based on, or are designed to strengthen, the capabilities in which a company is already strong. 
The best use of M&A is to enhance or better leverage the key capabilities that set a company apart from its competitors and enable it to win.
Those are the central findings of Booz & Company’s research into M&A. The shows that deals that either enhance or leverage a company’s distinctive capabilities produce a compound annual growth rate (CAGR) that averages 12 percentage points more in annual total shareholder return (TSR) than deals in the same industry and region where the fit between the companies is limited.
In the eight years of the study—which include the 2008 financial crisis—deals that leveraged key capabilities produced an average annual TSR 3.9 percentage points above the market index, and deals that enhanced key capabilities outperformed the market by an average of 0.4 percentage points per year. By contrast, deals that had a limited fit—in which companies did not seek to improve upon or apply their capabilities system in any major way—underperformed the market index by an average of 9.1 percentage points.
"The research shows that deals made to enhance or leverage the key, differentiating things that companies do exceptionally well consistently outperform deals based on traditional definitions of overlap or adjacency,” says Gerald Adolph, a Booz & Company senior partner and a coauthor of the study. Adolph leads the firm’s mergers and restructuring practice.
"We call this the ‘capabilities premium in M&A,’” Adolph said. “Capabilities are—and need to be—the basis for inorganic growth. And the premium is huge: let’s just consider a hypothetical market growth of 5 percent. In this case, deals with capabilities fit would generate 8 percent annual returns, whereas deals with limited capabilities fit would actually come in at negative 4 percent TSR per year."
According to Adolph, capabilities need to be strictly defined and clearly understood. 
“When we talk about the capabilities that matter in M&A, we are referring to the key strengths and differentiators, such as tailored innovation, unique distribution, superior marketing, and unparalleled customer intelligence, that support a company’s strategy and enable it to deliver on its promise to customers. We don’t mean the basic ‘keep the lights on’ functions or the competitive necessities that every player in an industry needs to have. Key capabilities are the few differentiating strengths that drive a company’s identity and success." 
Leaders, board members, and investment bankers need to look beyond financial questions when contemplating a deal and also ask themselves:
  • What is unique about the target’s capabilities? How does the target create value?
  • How does its capabilities system differ from our own?
  • If we are buying a company for its product and service portfolio, are we sure those products and services will thrive within our capabilities systems?
  • If we are buying a company for its capabilities, can we integrate them with our own?
  • How will the new company generate value out of its evolving capabilities system?
  • What is the risk that the capabilities won’t fit?
  • Which assets (facilities, processes, suppliers, and employees) do we need to bring on board to support the combined capabilities?
"To determine whether the other company’s capabilities fit, you need to understand your own," Adolph said. "And your due diligence needs to go beyond legal and financial issues to also test technology, organisation, and culture fit."