STRATEGIC

DEVELOPMENT:
DIRECTIONS AND
MECHANISMS
After studying this chapter, students should
be able to:
 describe the general directions of business growth
define and distinguish between internal and external business growth;
describe the various types of merger and acquisition;
explain the motivations behind mergers and acquisitions and the reasons why they succeed or
fail;
describe what a strategic alliance is and why organizations enter into them;
explain what is meant by a disposal and describe why organizations pursue this pathway;
understand the regulatory and legal frameworks that influence business growth.
Directions of growth
Generic directions and mechanisms
◦ Growth can be within the same industry or in a different industry
◦ The former is typically referred to as related whereas the latter is unrelated, but
these characterizations are often less than useful because the division of
growth directions into only two types is an oversimplification.
Unrelated development
◦ Unrelated developments (which are usually classified as diversification in the Ansoff matrix)
is those in which a different industry is entered – can be classified according to how different
the ‘new’ industry’s activities are compared to the existing one.
◦ If it is possible to exploit existing competences in the new industry, the chances of success are
increased (such as with similarities in technology, marketing, design concept or similar). We
can refer to this type of unrelated development as concentric.
◦ however, the new industry entered does not enable any existing competences to be leveraged
and/or there are no common links between new and existing, the risk is higher. This is referred
to as a conglomerate development.
Related development
◦ Most growth and development, however, occurs within the areas in which a business is most
acquainted – its micro or near environment.
◦ Within this setting, growth can occur in two ways:
I. vertically growth
• Vertical growth is development of a business into a different stage of the supply chain of which it
is a part.
• Backward vertical development is movement towards a supplier of resources used by the business.
This might be an attempt to secure supply of a key resource or to gain a cost advantage over
competitors by ‘locking in’ a supplier.
• Forward vertical development is growth towards the next stage in the supply chain by gaining an
interest in a buyer of the company’s outputs.
II. Horizontal development
• Is a move resulting in higher market share within the same markets
• The acquisition of, or merger with, a competitor would be one way of achieving this, for
example.
• The strategic logic behind horizontal development is typically to gain leverage or market
power over suppliers or buyers. Higher volume generally confers greater scale economies in
purchasing whereas larger product market share confers greater pricing power over customers.
 Organic (internal) growth
◦ Organic growth is the most straightforward mechanism of business growth. Most
companies have used internal growth as their main method of growth at some time, and
so its ‘popularity’ is obvious.
◦ Internal growth is expansion by means of the reinvestment of previous years’ profits and
loan capital in the same business that generated the profits. This results in increased
capacity, increased employment and, ultimately, increased turnover.
◦ Advantages – lower risk, within existing area of expertise, avoids high exposure to costs
of alternative growth mechanisms (e.g. by debt servicing).
◦ Disadvantages – slower than external growth, little scope for diversification, relies upon
the skills of existing management in the business.
 External mechanisms of growth:
Mergers & Acquisition (M&As)
Merger
• In a merger the shareholders of the organizations come together, normally
willingly, to share the resources of the enlarged (merged) organization, with
shareholders from both sides of the merger becoming shareholders in the
new organization.
 External mechanisms of growth:
Acquisition
• An acquisition is a joining of unequal partners, with one organization
buying and subsuming the other party. In such a transaction the shareholders
of the target organization (the smaller one) cease to be owners of the
enlarged organization unless payment to the shareholders is paid partly in
shares in the acquiring company. The shares in the smaller company are
bought by the larger.
 Explanations and motivations for M&As
There are a number of potential reasons for pursuing an external growth strategy;
• to increase market share in order to increase pricing power in an industry;
• to enter a new market, possibly to offset the effects of decline in current markets or to
broaden market portfolio;
• to reduce competition, possibly by purchasing a competitor;
• to gain control of valuable brand names or pieces of intellectual property such as patents;
• to gain preferential access to distribution channels (to gain resource inputs on preferential
terms or to secure important supplies) by purchasing a supplier;
• to broaden product range in order to exploit more market opportunities and to spread risk ;
◦ to develop new products for the market faster than internal R&D could do;
◦ to gain access to new production or information technologies in order to reduce
costs, increase quality or increase product differentiation;
◦ to gain economies of scale, such as by increasing purchasing power so that inputs
can be purchased at lower unit cost;
◦ to make productive use of spare or under-used resources, such as finance that is
sitting on deposit in a bank;
◦ to ‘asset strip’ – the practice of breaking up an acquired company and recovering
more than the price paid by selling the parts separately;
◦ to enhance corporate reputation (appropriate if the existing company name has been
associated with an alleged misdemeanour).
 Potential problems with M&As:
why do they sometimes go wrong
I. The main failure factors
There are a number of reasons why integrations do not work. We can summarize these ‘failure factors’
under six headings;
i. lack of research into the circumstances of the target company (and hence incomplete knowledge);
failure in this regard can result in some nasty surprises after the integration;
ii. cultural incompatibility between the two parties;
iii. lack of communication within and between the two parties;
iv. loss of key personnel in the target company after the integration;
v. paying too much for the acquired company and hence over-exposing the acquiring company to
financial risk;
vi. assuming that growth in a target company’s market will continue indefinitely – market trends can fall
as well as rise.
II. Government policy and integrations
◦ Government policy on mergers may have contributed to some integration failures.
◦ Corporate growth can be restricted by government (which in the UK is represented
by the Competition Commission), as companies are only allowed to establish a
certain market share.
◦ Being prevented from expanding in a related area may force some companies to
take the more risky route of diversification (acquiring a company making different
products in different markets).
Success factors for M&As
I. success depends upon the identification of a suitable ‘target’ candidate with whom to merge or
acquire. The emphasis on the word suitable is expanded upon below.
II. a preparation for an approach should involve a detailed evaluation of the target company’s
competitive position. This would typically comprise a survey of its profitability, its market
share, its product portfolio, its competitiveness in resource markets and so on.
III. consideration should be given to the compatibility of the two companies’ management styles
and culture. Because integrations often involve the merging of the two boards of directors, it is
usually important that the directors from the two companies are able to work together.
Success factors for M&As
IV. if the target company has key personnel (say a key manager or a distinctive research
capability resident within a number of uniquely qualified scientists), then measures should be
taken to ensure that these key people are retained after the integration. This can often be
achieved by holding contractual talks with such people before the integration goes ahead.

V. the initiating company should ensure that the price paid for the target (or the valuation of its
shares) is realistic. A key calculation of any investment is the return made on it; this is usually
measured as the profit before interest and tax divided by the price paid for it. It follows that the
return on investment (as a percentage) will depend upon the price paid for the target company
◦ Porter (1987) identified three criteria for success in mergers and acquisitions which
are;
i. ‘Attractiveness’ describes the likelihood of making above average profits in the
target company’s industry or industry segment
ii. The ‘cost of entry’ describes the overall cost of the merger or acquisition and
includes the major capital sum (for the target’s shares) plus additional and
sometimes hidden costs such as payments to advisors (e.g. merchant banks and
legal people) and the indirect or invisible costs such as management time and
integration costs
iii. Competitive advantage’ asks whether synergistic gains actually exist between the
two companies.
Strategic alliances
◦ The term strategic alliance is used to describe a range of collaborative
arrangements between two or more organizations.
◦ These agreements can vary from a very formalized agreement, which could see
the creation of a new jointly owned limited company, to an informal
arrangement for a short-term project
Types of strategic alliance
I. Focused and complex alliances
• Focused alliances are those that tend to focus on collaboration at one or possibly two stages of the value chain.
They may, for example, purchase as one in order to exert greater buying power on a supplier. Others may
collaborate on product distribution or on technology.
• More complex alliances are those that involve cooperation over a wide range of activities on the value chain. For
example ,the relationship that existed between 1979 and 1994 between Honda from Japan and the British Rover
Group was a complex alliance. Although the two companies remained legally separate, they cooperated in all of
the primary value-adding activities, including product design.
II. Consortia
◦ The term consortium is often used when referring to an alliance that involves more than two
organizations.
◦ Consortia are often created for time-limited projects such as civil engineering or construction
developments.
The form of alliance chosen by the parties will
depend upon several factors.
i. The complexity of the alliance will depend upon the objectives that the two parties are pursuing
ii. Alliance partners tend to seek cooperation on the minimum number of areas that are needed in
order to avoid over-exposure to the risk of one of the parties leaving abruptly or ‘finding out too
much’.
iii. The selection of partners for a consortium will depend upon matching the resource and skill
requirement of the project with those organizations that are willing to contribute to the effort.
iv. Organizations with previous experience of projects of the type proposed will obviously be
among the most in demand as consortium participants
Motivations for forming strategic alliances
I. International competitive pressures
• As organizations seek out new markets for their products, many recognize that they have skills or knowledge
deficiencies where an in depth knowledge of a foreign market is required.
• The need to develop local knowledge is increased if overseas production (with an overseas alliance partner) is
being considered to meet market demands. While local knowledge can be hired (say through a local importing
agent), it is often quicker and more reliable to seek assistance from an already established producing organization
of the host country
II. Capital pooling
• The high capital requirements of many projects, in terms of both set-up costs, ongoing running cost and delays in
profit generation, together with high levels of risk generally generated by such delays are reasons for considering
the use of alliances.
• The desire to gain economies of scale in areas such as research and development and the desire to secure access to
markets are other reasons why companies choose alliances.
 Successful alliances
◦ The success of an alliance is attributed to a number of factors,
i. complementary skills and capabilities of the partners;
ii. the degree of overlap between the parties’ markets be kept to a minimum;
iii. a high level of autonomy, with strong leadership and commitment from the parent
organizations (if appropriate);
iv. the need to build up trust and not to depend solely on the contractual framework of the
relationship;
v. recognizing that the two partners may have different cultures.
 Disposals
◦ We should not assume that business strategies are always designed to cause
business growth. There are times when organizations may wish to become
smaller.
◦ As with growth strategy, size reduction can be achieved by organic reduction (by
winding down production of a product area), by divestment (the opposite of
acquisition) or by demerger (the opposite of merger).
◦ Demergers and divestments (which together are referred to as disposals) involve
taking part of a company and selling it off as a ‘selfcontained’unit with its own
management, structure and employees in place. The unit may then be sold on to a
single buyer (for whom it will be an acquisition) or it may be floated on the stock
market as a public limited company.
 Reasons for disposal
◦ There are a number of reasons why a company may elect to dispose of a part of
its structure;
i. under-performance of the part in question (e.g. poor profitability), possibly due
to negative synergy;
ii. a change in the strategic focus of the organization in which the candidate for
disposal is no longer required;
iii. the medium- to long-term prospects for the disposal candidate are poor;
iv. the disposal candidate is an unwanted acquisition (or an unwanted subsidiary of
an acquired company that is otherwise wanted);
 Reasons for disposal
◦ the need to raise capital from the disposal to reinvest in core areas or to increase liquidity in
the selling company;
◦ the belief that the disposal candidate would be more productive if it were removed from the
seller’s structure;
◦ in some circumstances, disposal may be used as a tactic to deflect a hostile takeover bid,
particularly if the predatory company is primarily interested in acquiring the company to gain
control over the disposal candidate;
◦ as part of a programme of ‘asset stripping’ – the process of breaking a company up into its
parts and selling them off for a sum greater than that paid for the whole.
 Shareholders and disposals
◦ The most common method of corporate disposal is a ‘private’ transaction between two companies,
which is intended to be of benefit to both parties. The seller gains the funds from the transaction and
is able to focus on its core areas. The buyer gains the product and market presence of the disposal
which, in turn, will be to its strategic advantage
◦ Disposals are designed to create synergy to the shareholders in the same way as integrations. We
should not lose sight of the fact that business organizations are owned by shareholders and it is the
role of company directors (as the shareholders’ agents) to act in such a way that shareholder wealth
is maximized. If this can be achieved by breaking a part of the company off, then this option will be
pursued
 Other methods of disposal
I. Equity carve-outs
◦ Equity carve-outs are similar to demergers insofar as the spin-off company is
floated on the stock exchange.
◦ However, in this form of disposal, the selling company retains a shareholding in the
disposal, with the balance of shares being offered to the stock market. In this
respect, equity carve-outs can be seen as a semi-disposal: part of the disposal is
kept, but not as a wholly owned subsidiary.
 Other methods of disposal
II. Management buy-outs
• A management buy-out (MBO) is said to have occurred when a company
which a parent company wishes to dispose of is sold to its current
management.
• MBOs are often a mutually satisfactory outcome when the disposal candidate
is unwanted by its parent but when it has the possibility of being run
successfully when the existing management have the requisite commitment
and skills.
◦ The advantages of MBOs can be summarized as follows:
i. The selling parent successfully disposes of its non-core business and receives a
suitable price for it which it can then reinvest in its main areas of activity.
ii. The divested organization benefits from committed managers (who become its
owners). When the management team finds itself personally in debt as a result
of the buyout (having had to find the money for the purchase), their motivation
and commitment tends to be maximized. In some MBOs, some of the capital
for the purchase is provided by venture capital companies.
iii. If part of the MBO capital is met by the company’s existing employees, the
organization benefits from the commitment of people who have part-ownership,
and who therefore share in the company’s success through dividends on shares
and through growth in the share price.
The regulatory framework of external growth
The purpose of regulation
• Most governments have taken the view that there is some need to put in place a regulatory framework for
external business growth because of the implications for competition in markets
• Governments are usually keen to encourage business activity in their countries because of their beneficial
effects upon employment, tax revenues, exports and standard of living.
National and supranational regulators
I. European Union regulation
II. The Office of Fair Trading
III.The Competition Commission