Archive for April, 2011|Monthly archive page

Problems in M&A: Are you bidding too low?

Today’s slow growth, low interest rate environment is ripe for increased M&A activity.  Even companies like Dell and P&G who historically pursued organic growth strategies have come to the realization that achieving historical returns requires a smart M&A strategy.   Yet, this is easier said than done.  One of the biggest challenges from the acquirer’s perspective is what to bid for the target company or part of its assets without over or under bidding.

A recent edition of Knowledge@Wharton a Wharton School of Business publication, discusses an important yet often ignored deal killer, namely that of the “false negative” valuation.  These are deals that get away but shouldn’t as a result of the target being under-valued due to out dated methodologies. According to the authors, the true value of a target company can be determined only if the buyer looks beyond current core operations to include future growth potential.  A better valuation approach should embolden reticent buyers without ratcheting up incentives to over-optimistic acquirers.

Most acquirer’s experience False Negatives due to a systematic bias in their valuation methodology.  This bias is in the form of organizational and shareholder pressure to accelerate deal pay back and to discount value creation (i.e. cash flows) that is tied to future time horizons. This inclination towards conservative, short-term based valuations is understandable.  However, it often results in companies systematically missing out on strategic opportunities to competitors who are more capable of managing the uncertainty associated with future.

To overcome this bias, the authors have developed a new method to M&A value determination that avoids both false positives (over paying) and false negatives. This approach combines McKinsey’s Three Horizons strategic planning model with a new process for analyzing value, called Opportunity Engineering.  At the core of the methodology is how companies determine the target’s value and cash flows over 3 time horizons:

Horizon 1 includes the existing core operations of a firm that produce the cash flow needed to sustain the business, to meet investor expectations and to invest in future growth.  Horizon 2 represents operations that are generating small, albeit fast-growing revenue streams that could become high-revenue core operations in the next 2-3 years.  Horizon 3 opportunities embody new products, services, and capabilities that extend beyond the core business.  H3 opportunities show compelling, long term potential but carry a high degree of uncertainty and risk.

The methodology to determine the full value of a potential acquisition is straightforward.  First, the acquirer should analyze the target firm’s cash flows and assets and assign them to the relevant horizons of their strategic plan.  Secondly, the acquirer will drill deep to understand how these assets add value today and in the future. Simply put, the more horizons that a target hits, the more valuable it becomes, since it not only increases current value but also carries the potential for future organic growth.

Finally, the acquirer would supplement their traditional net present value (NPV) analysis with a new valuation methodology called Opportunity Value (OV).  OV attempts to calculate the potential returns of an acquisition by estimating the positive cash flows of hidden or uncertain assets in future horizons. In essence, OV is providing a positive view of uncertainty.  As such, OV is complementary with NPV, which treats uncertainty negatively.  When used together, these tools provide an all-encompassing but not inflated valuation.

In my experience, the majority of deal makers rarely consider anything beyond the H1 value of a target when arriving at a bid price, although some managers will intuitively take future potential into account.

Not surprisingly, the greatest potential growth is found in the areas with the highest levels of uncertainty. Acquirers would be prudent to use tools that systematically identifies elusive but potentially rich medium to long term returns found in the target firm and then factor them into their bid prices.

For more information on our services and work, please visit the Quanta Consulting Inc. web site.

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Using IT to drive Insurer growth

Despite an improving economic climate, Canadian insurers continue to face considerable challenges including growing price competition, rising distribution & delivery costs and increasing competition from banks.  At the same time, consumers – particularly younger, more educated and more affluent ones – are rapidly turning to online tools to purchase and service products.

Emerging technologies offer Insurers the potential to increase market penetration, grow share of wallet and reduce sales, marketing and support costs.  However, Canadian firms are appreciably behind when it comes to using IT to drive revenues and bolster customer service.  There are understandable reasons for this conservatism.  As an industry built on trust developed through personal connections, Insurers are hesitant to adopt arm’s-length ways of developing relationships.  Moreover, with up to 20% of its operating budget spent on technology and its supporting services, Insurers tend to frame IT as an expensive cost center prone to high-priced cost overruns not as a strategic business driver.

Yet, many global insurances companies are using new web and mobile technologies to drive revenues and outflank competition.  In particular, four areas offer rich rewards for those company’s that can truly understand their customer’s needs, make IT a strategic imperative and execute with excellence.

1.  Establish new sales channels

New wireless platforms like the iPhone, iPad and BlackBerry enable Insurers to reach customers more effectively and efficiently.  In one case, South African Metropolitan Life is piloting a new short-term life insurance product, Cover2Go, which allows new customers to purchase a contract by simply by sending an SMS.

2.  Leverage Social Networking

Popular sites such as Facebook and LinkedIn offer tremendous potential to build brand communities, enhance the customer experience and engage a national workforce. In one example, State Farm is using Facebook as a national training platform.  Approximately 17,000 agents have mobilized into groups of “friends” to discuss new products and exchange best practices around customer service and claims processing.

Some Insurers have invited customers into their product development process. Allstate has set up social-network forums to facilitate interactions among motorcycle customers and enthusiasts. The forums solicit customer feedback and use it to inspire new products and services.

3.  Develop custom products

Forward-thinking insurance firms are using powerful data analytics capabilities to identify unexploited customer segments and then target them with tailored, “mass customized” products.  One large Insurer I know is combining sophisticated “rules-based” algorithms with high performance computing to enable product designers to adapt policies both to customers’ preferences and to specific market regulations.

In another case, some auto insurers are using IT to develop dynamic coverage models based on driving patterns and behavior. One leading carrier in the United States, for example, uses GPS technology to monitor drivers and then apply discounts to policies as a reward for safe driving.

4.  Streamline customer service

Even with extensive IT, insurance remains a labour intensive and complex business.  However, a growing number of firms are using off-the-shelf technology to streamline customer service. For example, AXA and Zurich Insurance have location-based iPhone applications that enable customers to use their phones to record damaged areas and then to send the accident photos to reporting centers to expedite claims handling.

In the future…

Social networking has the potential to reorder the traditional Insurance business model. With its ability to mobilize people quickly, sites like Facebook could quickly spawn large affinity groups which can negotiate preferential insurance rates much like Groupon has been offering since 2008.

To use IT as a growth driver, executives need to look beyond their industry in order to identify promising business opportunities that are enabled by new technologies and business models.

For more information on our services and work please visit the Quanta Consulting Inc. web site.

Failing Smart Drives Innovation

When it comes to launching innovative products or programs, failure is one word few executives want to be associated with.  But in reality, failure can be a significant catalyst for innovation.  The key lies in how the organization treats the failure and then learns from it.  Benefiting from failure is more than a cliché; there is solid academic thinking and corporate experience that backs it up.

Baba Shiv, a Professor at the Stanford Graduate School of Business, conducted research at how people deal with failure.  According to Shiv, all organizations consist of two types of people.  The type 1 mindset is fearful of making mistakes and is risk-averse.  They associate failure with shame and pain. Most individuals within corporations display type 1 thinking. In a firm dominated by type 1 personalities, innovation is generally nothing more than incremental change. Conversely, the type 2 mindset is fearful of missing out on opportunities. For them, failure is not viewed as bad; it can actually be helpful. From so-called “failures” emerge those “aha!” moments of insight that propels forward the innovative process and leads to breakthrough change.  

Outside of overhauling the employee base, how can companies make the shift towards a type 2 mindset?

Use rapid prototyping

One approach to overcoming risk-averse behaviors is to engage teams in rapid prototyping – a process whereby brainstormed ideas are quickly developed into a physical model or a mock-up of a solution. Moving rapidly from concept to something more concrete allows individuals to visualize the outcome of their ideas as well as more richly engage customers or other parts of organization.  Since few prototypes end up as the final solution, rapid prototyping teaches that failure is actually a vital part of the process and not a negative outcome. This rethink helps the brain associate “failure” with more positive emotions and propels forward the course of innovation.

Rapid prototyping is a powerful tool but it has its challenges.  For example, individuals may become wedded to certain prototypes and be reluctant to jettison them.  Moreover, working through multiple iterations can end up being an exhaustive practice.

Provide a license to fail

Companies like P&G, 3M and Google expect and often want poor concepts to fail as quickly as possible. Their management systems are designed to filter out poor or unrealistic ideas while providing additional resources to support higher potential concepts.   These firms also create an innovation culture based on trust, open communication and critical thinking.  They do not penalize failure but expects individuals and the firm to learn from it.  Understanding that breakthroughs are often unexpected, environments like this allow and incentivize scientists and line of business managers to reset their assumptions around the concept or technology, either reframing its appeal or helping it be leveraged to other solutions. 

Institute Desperation

A powerful yet reluctantly deployed strategy towards institutionalizing type 2 thinking is to implant a sense of “desperation.” The two most common ways to trigger desperation is by cutting resources or reducing lead times.  When an atmosphere of desperation is created, individuals are forced to be more innovative to achieve their goals.  In other words, necessity becomes the mother of invention. In one example, Anheuser-Busch InBev successfully uses desperation by reducing advertising budgets to drive media effectiveness and efficiency. Following a period of desperation, the team is spurred to look at new, less expensive ways of communicating its message. 

In most companies, managers use strategies that are opposite to desperation, such as inspiration, incentives and incubators, to stimulate innovation. Conceptually, this approach makes sense but it often doesn’t work in practice. While innovation is often stimulated, its path usually ends at the desk of a risk-averse type 1 manager. Furthermore, fostering desperation can be a risky endeavor.  Individuals may never come up with the desired solution or results.  As well, a sense of scarcity can incite internal strife.

It is time organizations relooked at their approach to innovation. The sooner firms realize that failure is not bad, the quicker they will be on their way to breakthrough innovation.

For more information on our services and work, please visit the Quanta Consulting Inc. web site.

The trouble with employee financial incentives

In the current economic climate, many companies are pulling out all stops to improve employee performance particularly for jobs with top and bottom line responsibility such as sales reps, investment bankers and plant managers.  Conventional wisdom (supported by extensive research) says that pay-for-performance incentives in the form of bonuses and commissions are an excellent tool to motivate desired behavior. Interestingly, a recent article published in Knowledge@Wharton, a Wharton School of Business publication, highlights research that shows the opposite; namely, that using financial incentives carry significant costs as well.

The article’s authors, Adam Grant and Jitendra Singh, demonstrate that financial incentive schemes can trigger unintended and counter-productive behaviors that lead to poor organizational dynamics.  The article lists three major concerns:

1.  Unethical actions

In one example, the vegetable brand Green Giant had a problem with insect parts ending up being packaged in its frozen pees. To correct this, management created an incentive plan that rewarded employees for finding contaminants in the products.  Unfortunately, some employees took this as an opportunity to cheat by planting insect parts in the packages in order to collect the bonus.  Clearly, incentives by themselves do not ensure that employees will pursue the the most ethical or moral path to earn them. 

Furthermore, the employees most motivated by incentives could also be most likely to act unethically.  Studies by Wharton management professor Maurice Schweitzer and colleagues showed that individuals most inspired by goal achievement are also more likely to engage in unethical actions such as cheating or overstating their performance.

2.  Pay inequality

By it’s very nature, financial incentives magnify real and perceived pay inequality.  Numerous studies have shown that people judge the fairness of their pay not in absolute terms, but rather in terms of how it compares with the pay earned by peers. As a result, pay inequality can lead to workplace strife when overlooked employees begin to feel jealousy, disappointment and resentment towards high performers.  The result is usually higher employee turnover, reduced collaboration and lower organizational productivity.

A wealth of research underscores the negative implications of pay inequality. In one interesting case, Notre Dame researcher Matt Bloom found that major league baseball teams with larger gaps between the highest-paid and lowest-paid players lose more games, score fewer runs and give up more runs than teams with more equitable pay distributions.

3.  Lower intrinsic motivation

Financial incentives can result in worse, rather than better, performance by diminishing intrinsic behavioral drivers like having pride in ones work or enjoying challenges.  Studies out of the University of Rochester has shown that rewards often undermine a person’s intrinsic motivation to work on interesting or challenging tasks – especially when the rewards are announced in advance or delivered in a controlling manner.  For the employee, what may be seen as fun and rewarding initially can soon be viewed as stressful and less interesting when performance begins to be rewarded.

As a consultant, I have witnessed the aforementioned issues as byproducts of successful pay-for-performance in sectors as diverse as Retail, IT and Manufacturing.  My key takeaway is not that pay for performance strategies should not be tried or do not work.  They do – assuming factors like quality, service and pricing are competititive.  Rather, the lesson is that managers need to design and deploy incentive programs carefully with an eye towards the full organizational impact.

For more information on our services and work, please visit the Quanta Consulting Inc. web site.