Deals that expand the sectors in which a company competes — as opposed to helping it scale up its existing business — will lead merger and acquisition (M&A) activity this year, because the dynamic that drove growth of these deals in the last two years is still in place.
Fully 60% of M&A deals of $1 billion or more last year were these so-called scope deals, according to a survey by Bain & Company, an increase from 50% in 2018 and 40% five years ago.
The deals are attractive because they’re a way for companies to become part of the technology upheaval that's rewriting industries.
"We live in a world of business model disruption catalyzed by technological progress and the emergence of digital native competitors," Bain said in its Corporate M&A Report 2020.
But the track record of companies that use mergers and acquisitions to move into new areas is spotty at best — these deals can be tricky to get right. Although most executives surveyed by Bain said the scope deals they’ve been involved in worked out well, the research on how well these deals fare is mixed.
A report released by Willis Towers Watson last year found a far shakier track record for these deals compared to acquisitions that help companies scale up in industries they’re already in.
"Shareholders tend to be happier with deals within core competencies as opposed to expanding beyond them," David Hunt, senior director of global services and solutions at Willis Towers Watson, told CFO Dive.
Look for strategic adjacencies
The best way to make these deals pan out is to pick companies that expand your scope but nevertheless remain close to your core competencies, according to Ken Stillwell, CFO of cloud business software company Pegasystems.
On an M&A panel last year at the MIT Sloan CFO Summit in Boston, Stillwell said executives are smart to skate to where the puck is heading rather than where it already is, but you want to avoid skating too far out into areas you know little about. A better move is to identify areas that are strategically adjacent to your core competencies and buy those companies.
"What are adjacencies on the edge where you get some leverage and your story still holds together?" Stillwell said.
Investors on the hunt
Regardless of how far out from your core competencies you plan to expand, you can expect heated competition from private equity and venture capital funds on the hunt for the next disruptive technologies.
Although M&A activity as a whole is expected to be down this year, the deals that get done are expected to involve the same technology disrupters that make attractive targets in scope acquisitions.
In a survey on their 2020 investment plans, 54% of executives in private equity and 51% in venture capital say they’re targeting companies operating in artificial intelligence, robotics, the Internet of Things, extended reality and 5G.
"Competition over deals continues to be intense," Scott Hendon, national leader of private equity for BDO, which conducted the survey, told CFO Dive. "While tech can be expensive, some areas … provide attractive and steady revenue streams."
More prosaic areas of business — media, real estate, retail and consumer products — are not high on investors’ target lists, the BDO findings show. That’s especially the case if economic growth eases and even dips into a downturn, as many executives expect.
In the BDO survey, 72% of executives in private equity and 56% in venture capital say they expect to see a recession within two years, and in findings by Deloitte, released in mid-January, 97% of CFOs said the economy will hit a downturn before the end of the year.
Sanford ("Sandy") Cockrell, Deloitte’s CFO practice leader that oversaw the CFO survey, said most executives are already in a defensive posture, which means their focus is on cost-cutting, not acquisitions.
"2020 budgets were constructed with the view that we were going to have a downturn,” Cockrell told CFO Dive, "so companies across the board were already building into their budgets either no increases in spending or were looking for certain targets for the business to find some savings."
In a 2020 look-ahead, consulting firm Baker McKenzie predicted global M&A to drop 25% this year, from $2.8 trillion to $2.1 trillion. The deals that get done will largely involve acquisition of disrupters. "Across all sectors," the report said, "companies will seek to acquire advanced digital capabilities that they cannot replicate in-house."
In other words, scope acquisitions. Companies will continue to take a chance on expanding their reach outside of their areas or core competency.
Bottom line: Expect fewer mergers and acquisitions this year, but most of them will be taking companies into new directions rather than helping companies scale up in their existing areas of competency. The BDO report predicts more activity in the latter part of the year.
"Continued interest in the tech sector from strategic and financial buyers alike and the proven value of M&A as a vehicle for growth could bode well for a rally in the second half of this year," the report said.