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Diversification: is it a worthwhile risk for companies to take?

CEOs can undermine the potential issues with diversification but it pays off for the prepared

Should a business stick to its knitting or should it look to diversify through acquisition?

Should a business stick to its knitting or should it look to diversify through acquisition?

 

Should a business stick to its knitting or should it look to diversify through acquisition? As always, context is important and it depends.

“If you can diversify into a new space that relies on the same key skills and competencies used in your own space, then it can make sense in a field similar or adjacent to your own but not exactly the same,” says Eamonn Hayes, managing director of Capnua, a corporate finance firm. 

Preparation is key

Just make sure it’s a good use of resources. “The scarcest resource in large or medium corporates is probably spare management. You’re not going to use your valuable management resource for a small opportunity, or to grow something from scratch. You’re much better applying that resource at scale,” says Hayes.

Do your homework. “Diversification through acquisitions is attractive for companies as it allows them to reach scale quickly when expanding into a new product line or geography, and contrasts favourably with the time and cost involved in pursuing organic growth opportunities,” says Maura McLaughlin, partner of M&A development at Arthur Cox, a legal firm based in Dublin.

“However, it is critical to review diversification opportunities carefully so that the acquirer really understands how the target will enable the entity to succeed in new or complementary areas. Buyers frequently underestimate the potential cultural issues in these transactions, and the compliance and managerial issues raised where a target operates in an unfamiliar area or distant geography.”

Integration planning should begin well in advance of completion

The very factors that make a target attractive – such as innovative processes, an entrepreneurial mindset or access to new markets – can make it difficult to integrate the businesses and maximise shareholder value postcompletion. “We have seen this frequently where a traditional business acquires a new technology,” she says.

“Acquirers who can harness the innovation to create value in their existing business or to create a complementary product or service succeed, while those who are pursuing diversification for its own sake rather than as part of a well-considered long-term strategy can find it an expensive and frustrating experience.”

Integration planning should begin well in advance of completion, subject to anti-trust concerns. Buyers should also evaluate the merit of proceeding initially by way of a partial stake in the target, so that they can reduce the downside risk where they have full control, but not yet full understanding of that business, McLaughlin suggests.

Technology

Access to technology was identified by Pinsent Masons, an international law firm with an office in Dublin, in their recent Pacesetter’s study of fast growing European companies, as a key driver of M&A and as a route to securing access both to fast growth markets, and critically to the tools and talent required to deliver future success.

Right now there is a trend for infrastructure contractors to acquire technology companies to enable the delivery of “Smart City” solutions, and automotive manufacturers acquiring software houses to advance the progress of autonomous vehicles, points out Dennis Agnew, corporate partner in Pinsent Mason.

While the benefits of such diversification are clear,they come at a cost as the risks are substantial. “Operating synergies may be less than can be achieved in horizontal consolidation. At worst key talent can exit and the whole process can be a considerable drain on management time. Navigating the rapid pace of technological change also represents a substantial hurdle. Future gazing is an imprecise art.”

Right now there is a trend for infrastructure contractors to acquire technology companies to enable the delivery of “Smart City” solutions. Photograph: iStock
Right now there is a trend for infrastructure contractors to acquire technology companies to enable the delivery of “Smart City” solutions. Photograph: iStock

Shareholders also need to take note. From a shareholder’s perspective studies have shown that diversifying or conglomerate-type deals fail for the bidding company as they reduce returns. “I’d be asking, why is my manger buying outside of his or her comfort zone?” cautions Ronan Powell, professor of Corporate Finance at the UCD Graduate School of Business.Typically the target does well and “they get the takeover premium”.

“Obviously managers are evaluating strategic options all the time but if I was a shareholder and they started to do a lot of deals unrelated to the core business, I’d be concerned,” says Powell.

“If the CEO is up front and communicates directly about the need for divestments and investments, maybe then I’d be more comfortable. My problem is where there are a lot of overconfident CEOs starting to buy in industries they know very little about.”