Firms are struggling with macro headwinds, regulatory and industry changes that have structurally changed their value proposition. They face continued slow growth, margin pressure and higher expenses. Many firms are unable to earn sufficient returns to cover their cost of equity. Consequently, their valuation multiples are under pressure. Understandably, they are searching to diversify revenue sources to reduce vulnerability to a prolonged downturn affecting their profitability. A quick way of achieving this goal is thru acquisitions to gain access to new markets.
Unfortunately, this quest gives rise to increased strategic risk. Strategic risk concerns a firm’s long-term ability to survive due to the incompatibility of its strategy and resources with industry changes. There are numerous examples of near fatal unnoticed strategic risk. A recent one was Hewlett Packard, which was reviewed in my December 12, 2012 post. Some firms, including HP, don't seem to consider risk as an input into strategy. Rather, it becomes an unintended consequence because it is not reflected in the income statement. Furthermore, the strategies of these firms appear inflexible, designed to work only in one state of the world. When that state changed they were unable to adjust.
Strategic risk is likely to increase as a slow recovery continues and firms intensify their search for growth. Some may even be tempted to gamble for redemption by expanding into areas in which they lack the skills to manage. The basic problem is that management target's return-not risk. The traditional response to a challenged core business is to take more risk in pursuit of nominal income return. Return, however, is where the risk is located. This leads to a vicious circle of herding into current popular areas that are already occupied by well entrenched competitors. A predictable erosion of margin follows leading to an escalation of commitment. A framework is needed to manage the risk profile inherent in strategy and business model changes consistent with an organization’s risk tolerance and capital structure. The Board of Directors need to set the strategic direction and risk tolerance and then monitor management to ensure they follow the Board’s wishes.
A key component of this framework is to improve the profitability of legacy business lines. Otherwise, resource demands will expose the firm to new risks the firm will be unable to manage. You cannot transform fast enough to offset the continued deterioration of your historic core business units. This would involve shrinking these business units to a defensible core based on the firm’s identifiable competitive advantages.
Evaluating new strategic acquisitions starts with the review of the new markets the firm seeks to enter. The firm must have real identifiable competitive advantages to succeed against the expected competitor response. If you cannot beat them then why join them? A realistic risk assessment is also required of the risks the firm is willing and able to accept in the pursuit of its strategic initiatives. Next, a capital plan is needed to raise the capital to fund the new risk exposure and consistent with credit rating goals. The firm also must ensure that it has the necessary skills to manage the risks involved. Finally, capital must be allocated to business units based on risk and strategic considerations.
Acquisitions are a means of implementing strategy. They are not strategy itself. You have to get the strategy right before acquiring. This demands active Board involvement. They need to balance the need for management experimentation, grounded in facts against delusional adventures. They must pay particular attention to large scale transformational acquisitions not based on identifiable competitive advantages. Such actions usually contain hidden exposures to remote risk. Equally important is not to force a change if you lack the ability or resources to implement it successfully. Instead consider accepting low growth, manage the business for cash and return the excess capital generated to shareholders. Not everyone can or should transform and grow. Everyone must, however, adapt to the changed economic and industry environment. Just like with love-you have to stop looking for growth in all the wrong places.
J
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