Lessons for smaller firms aspiring to buy larger companies

As Corus, Tata Steel Ltd’s ambitious overseas purchase, treads on a painful path to recovery and, with Novelis Inc., Aditya Birla Group’s similar overseas acquisition having already turned around, is there a lesson for smaller firms that aspire to buy larger companies?

We want more earnings capacity

Koushik Chatterjee, group executive director (finance and corporate), Tata Steel

Through the seven years since its $12 billion (around 72,850 crore today) acquisition of UK’s Corus when Tata Steel had to weather much criticism on an ill-timed and expensive buy, its finance head, Chatterjee, remained unflappable.

“At the time of Corus acquisition, the financing was done on a 50:50 debt to equity. In the first year post-acquisition, the Ebitda (earnings before interest, taxes, depreciation and amortization) level was about a billion pounds. Then there was the global financial crisis and the entire systemic liquidity dried up,” Chatterjee says. “Can a company be faulted for that?”

The global financial crisis killed 30% of the steel demand in Europe and pushed Corus to losses. The spread between raw material and steel prices crashed from €375-425 per tonne (around 30,375-34,425 today) to €175-190 per tonne (around 14,175-15,390 today) in the years since the acquisition. However, this year’s faint recovery and cost-cutting may give it a fillip.

“If we had not done anything, then about €200 (loss on spreads) multiplied by 14 million tonnes of steel would have resulted in about €2 billion-plus of losses at the Ebitda level,” Chatterjee points out. “Whereas last year we had about €400-500 million of Ebitda, which would mean that the company has done something to ensure that impact purely of the market has not only been negated fully, but has also been improved upon.”

“Debt is to be seen in the context of its earning capacity and our focus in Tata Steel group is to create more and more earnings capacity and earnings so that we can sustain the debt, repay the debt, take more debt and move forward,” he says. Adversity in the market was fought with counter-balancing internal initiatives on assets, productivity, product strategy, differentiation and market penetration, so now if the market improves “we would be more than ready to take the tailwind”, Chatterjee adds.

Post-merger integration is key

Raveendra Chittoor, assistant professor (strategy), ISB

Many firms from emerging economies have been becoming increasingly global in the last 10 years. The number of companies from emerging economies in the Fortune Global 500 list has gone up by nearly six times since the year 2000. The primary mode of internationalization employed by emerging market multinationals is overseas acquisitions, says Chittoor.

“Companies are leap-frogging by buying companies bigger than themselves and accelerating the process of growth. These acquisitions are aimed at not only gaining size, but also upgrading capabilities going up the value chain,” he adds.

In the case of Tata Steel, which was operating mostly in the lower end of the value chain, the Corus acquisition helped to move into higher value-added products and also become one of the top five steel companies in the world. Similarly, Hindalco Industries Ltd, which was a regional company in the aluminium primary metals space, has climbed up the value chain by buying Novelis.

Such acquisitions take time to realize. “Family businesses are in a better position to do this as they have longer-term perspective and can afford to take such long-term bets,” says Chittoor.

The biggest challenge lies in post-merger integration. When a small company acquires a large firm with a different set of capabilities, it is best to maintain and run it as a decentralized unit rather than integrating it completely—much like the way Tata Motors Ltd did with JaguarLand Rover, Tata Steel with Corus, and Hindalco with Novelis. It is only when the synergies are of a cost-saving type and there are no new capabilities to gain, does speedy and complete integration makes sense, says Chittoor.

Management should be proactive

Samir Bahl, head (investment banking), Anand Rathi

A normal acquisition comes with its own challenges, the major ones being integration of human capital and systems. Acquisition of a firm by a relatively smaller company is accompanied by an element of leverage, i.e., debt, which makes the usual challenges of integration even more acute, making the financial risk go up significantly, says Bahl.

“In most cases, costs are underestimated and revenue growth comes with a lag due to the leverage involved. The management should do its due diligence well and pay the right price for the deal,” he says.

Again, it is important for the management to make all difficult decisions related to work culture and human resources even before the acquisition is completed. It is crucial to stick with one work culture instead of trying and finding a mid-path. In most cases, acquisitions do not work out because of the poor integration of workforce, says Bahl.

“The acquirer should understand that the rules applying to a smaller firm may not apply to a bigger one,” he adds. Therefore, management of the merged entity should be decided logically. Usually, the acquirer considers its decisions best and final, which is not the case each time.

Similarly, integration of technology acquires a greater significance in the case of small firms buying larger ones. Delay in back-end integration may further hit revenues and escalate costs, adding on to the leverage involved.

“Management of the acquiring company in such cases should be extremely proactive and should ensure that the challenges are taken care of much before the acquisition is completed,” says Bahl.