Innovation-driven acquisitions

November 2022  |  COVER STORY | MERGERS & ACQUISITIONS

Financier Worldwide Magazine

November 2022 Issue

While there are many reasons for a company to pursue a deal, one driving force over the last decade or so has been innovation. More companies are turning to innovation to drive growth and deliver value.

Growing a business organically – by improving products or services, and identifying new markets, for example – may provide more control and predictability, but it tends to be a slower process compared to expanding through acquisitions or strategic partnerships.

On the other hand, to achieve success through M&A, companies need to strike the right deals and mitigate potential risks. Indeed, various studies suggest somewhere between 70 to 90 percent of acquisitions fail to deliver the anticipated results. But done properly, acquisitions can provide an effective way to access innovation.

Research and development

Innovating is not cheap. It requires considerable time, energy and capital, and carries a high risk of failure. While research and development (R&D) may eventually yield critical technology to develop new products, services and business models, it can also have a negative return on investment (ROI) and dissatisfy stakeholders if results are mediocre.

In 2019 alone, organisations around the world spent $2.3 trillion on R&D – the equivalent of roughly 2 percent of global GDP – about half of which came from industry and the remainder from governments and academic institutions, according to McKinsey. Further, annual investment into R&D has been growing at approximately 4 percent per year over the past decade to 2020.

As such, acquiring existing innovations can be a more appealing option. Buying a target could allow a company to benefit immediately from a proven innovation, to direct their resources into other avenues, and to minimise the risks of a costly R&D campaign. Ready-made, established products and services can be a financial and reputational boon for acquirers. Access to new capabilities, R&D and technical talent are cited among the biggest drivers of M&A deals.

In terms of talent, diversity and inclusion (D&I) also has a role to play – diverse companies have 19 percent higher revenue from innovations than non-diverse organisations, and display better financial performance overall, according to the Harvard Business Review.

Well-funded start-ups rapidly develop innovations that may threaten to disrupt established business models or steer industry growth into new areas. These companies are increasingly targeted by acquirers. Companies have invested significantly in R&D-focused dealmaking – around £92bn between 2017 and 2019, according to Deloitte.

Technology acquisition and R&D are two crucial indicators of digital innovation in modern businesses – but many organisations lack an R&D strategy which has the clarity, agility and conviction to achieve set goals. There are, of course, many reasons why a company’s R&D aspirations fail.

Some large companies have abandoned centralised R&D teams and instead farm the responsibility for innovation out to other, more disparate teams. These teams may comprise less capable individuals with little R&D experience. An absence of constructive criticism and the inability to exchange ideas with colleagues can obstruct an R&D pipeline.

Inexperience with R&D processes at a managerial level may also cause problems. Under pressure in today’s highly competitive market, management may push engineers and scientists to produce results quickly. But working to constrained timelines can be hugely detrimental to the process, impacting product quality, frustrating employees and creating bad management practices.

As a result, companies can be motivated to instead seek innovation externally, through M&A.

Technology driving deals

A great deal of merger activity takes place in high-tech, innovative industries. Technological developments have been causing waves, with innovative start-ups disrupting traditional products, markets and industry incumbents. Shifts in technology, consumer behaviour and convergence across sectors have forced companies to take the necessary steps to stay competitive in their markets.

In recent years, there has been a sharp increase in transactions pursued with the primary purpose of acquiring capabilities or technologies across key disruptive innovation categories, such as FinTech, artificial intelligence (AI) and robotics, among others, according to Deloitte. There is rising demand for innovations associated with the internet of things (IoT), AI, electric vehicles and sustainable, fuel-efficient technologies. The coronavirus (COVID-19) pandemic also propelled innovation and business transformation.

According to GlobalData, in 2021 the total value of global tech deals had reached almost $3 trillion by Q3, largely due to activity in the technology, media and telecommunications (TMT) sector. Standout deals included Intuit’s acquisition of Mailchimp for $12bn and Square offering $29bn for Afterpay.

2022 has also seen a string of announced $1bn-plus tech transactions, such as Broadcom’s $61bn cash and stock offer for VMware, Kaseya’s purchase of Datto for $6.2bn, HP’s $3.3bn deal to acquire Poly, and MD’s $1.98bn deal for Pensando.

Going forward, the TMT sector is expected to see continued high deal volume, driven by digital adoption of additional technology in global markets since the outbreak of the pandemic. Cash-rich private equity (PE) funds are likely to be at the forefront of this push, investing in tech companies or acquiring divested, non-core tech assets. Global PE M&A activity reached record levels in 2021, according to Refinitiv, accounting for 27 percent of all global M&A value and 9 percent of volume – with 470 PE investments worth a combined $225.7bn in the technology sector alone.

In the US, according to PwC, investors are expected to focus on three core areas. First, cutting-edge companies which are emerging to serve customised needs across key verticals such as HealthTech, PropTech, FinTech, e-commerce and AutoTech. Second, companies providing horizontal software capabilities to improve the consumer experience. Lastly, software that enables compliance with emerging environmental requirements.

One potential headwind, however, is greater regulatory oversight of deals by antitrust authorities. Dealmakers will face scrutiny over transactions that may be anticompetitive or pose a threat to national security. In the US, the Federal Trade Commission (FTC) and the Department of Justice (DOJ) Antitrust Division have announced plans to overhaul merger review processes, which would in turn impact tech sector deals. And the US is not alone in such endeavours.

According to Baker McKenzie, regulation of foreign investment in the TMT space is being driven largely by rising national protectionism and widening national security concerns, including economic security. “This trend reflects the growing importance of technology and data to the global economy as well as the resultant vulnerabilities that may exist. COVID-19 has also galvanized the regulation of foreign investment as governments seek to protect strategic assets that may have become more exposed to acquisition. Cross-border tech M&A transactions are thus becoming more complex, especially where multiple jurisdictions are involved,” notes Baker McKenzie.

Technology companies have been busy participants in the M&A market for many years. Microsoft, for example, has made at least 225 acquisitions since the early 1990s, including large, high-profile deals for innovative, emerging companies such as Skype and LinkedIn. Elsewhere, business software provider Salesforce operates an active venture fund that focuses on reinforcing the company’s capabilities in enterprise technology, having invested in numerous start-ups including Snowflake and Zoom.

Often the most innovative companies are themselves serial acquirers. Microsoft, Apple, Alphabet and Amazon, for example, frequently use M&A to add to their product lines and service offerings. These innovation-driven acquisitions are often pursued to complement organic growth, as in-house innovation alone may be unable to keep pace with technology breakthroughs, new ideas and shifts in consumer demand. Companies may lack specific technology required to complete their offerings, and pursue deals to fill the gaps.

Another industry that thrives on innovation-driven acquisitions is life sciences. Biotech and pharmaceutical companies use acquisitions to expand their product pipelines and access new drugs and therapeutics – sometimes in areas where they do not currently develop them, sometimes to augment their existing offerings.

Corporate venturing

Corporate venture capital (CVC) has become a fundamental feature of innovation strategy, providing companies with a conduit to the external innovation ecosystem. It can seed an M&A pipeline, help to acquire talent or accelerate growth into adjacent markets or sectors. Corporate venturing is more interested in strategic investments to access external innovation, with financial returns often a secondary factor.

According to Deloitte, it is no longer just technology companies driving the innovation space; rather, companies across a wide gamut of sectors have launched venture funds, with the express aim of, in addition to financial returns, gaining invaluable access to new technologies, business models and talent, all of which are central to driving growth through innovation.

CVC funds are exploring areas such as co-investing with adjacent sector companies in order to pool resources and create attractive consumer and market offerings, particularly in investment hotspots such as the US, Israel, the UK, France, Germany, India, China and Japan.

2021 was a significant year for CVC, which recorded around 52 percent growth in deal count year on year. Going forward, with corporate innovation becoming increasingly reliant on start-up investments, CVC activity is likely to remain popular. Even non-cash returns, including access to market data and knowledge, should keep start-up investment attractive to corporates.

However, there are headwinds in the CVC space. According to KPMG, during Q2 2022, CVC investment in the Americas dropped from the high levels seen over the prior five quarters. The decline likely reflects a combination of factors, such as corporates focusing on their core operations in light of current uncertainties, pulling back funding to their VC arms, and reducing investments in start-ups that are not seen as strategic priorities. That said, heading into 2023, KPMG expects corporates to focus predominantly on making strategic venture capital investments aimed at complementing their core businesses.

Though investment activity still remained elevated compared to historic levels, CBInsights reported the biggest percentage declines in deals and dollars in over a decade in the CVC space. In the second quarter of 2022, global funding with CVC participation fell 32 percent quarter-over-quarter to $26.6bn, while volume dropped 18 percent to 1148 deals. Coinbase Ventures and Google Ventures were the most active CVCs in Q2 2022, although both slowed their dealmaking compared to Q1.

Intellectual property in M&A

Intellectual property (IP) is, of course, a key component of innovation-focused dealmaking. In recent decades, there has been a remarkable shift in the contribution to overall business value from tangible to intangible assets. Increasingly, IP is a key differentiator between rivals. For savvy acquirers, IP can add value, provide competitive advantages, unlock technology transfer, diversify products and accelerate growth.

In recent years, the focus on IP in M&A has improved markedly. Buyers are better at valuing and evaluating the underlying IP assets of target companies. To fully benefit, acquirers must first identify the ultimate goal of a potential innovation-driven acquisition. Is it to enter a new market, to gain access to new resources, to lower costs, to build a premium product, or perhaps some other objective?

Whatever the aim, executing an IP deal can be complex. IP ownership issues, for example, need to be understood and properly managed to ensure ultimate control of IP. Accordingly, the due diligence phase of the deal is critical, allowing buyers to identify sources of IP risk and prepare steps to remedy those issues. Acquirers also need clear sight of any potential disputes that could have a financial impact post-close, such as IP claims that may erode the value of the acquisition.

Integrating innovation targets

Once the transaction is completed – if not before – the focus on post-deal integration of the innovation target should be made a priority. Integration R&D activities can expose the business to significant risks, making it more difficult than some other aspects of the integration process. Achieving a successful integration requires a holistic approach. Companies should appoint a leader with the right skills to manage the integration process and realise the full value of the transaction.

A decision will need to be made about the extent of autonomy the acquired company is given to continue its work, supported by a larger company with deeper pockets. The acquirer will have to consider the right approach for them – from keeping the new team separate, to partial integration, to full integration. New organisational structures, including governance, common product development processes and project models, as well as transparent metrics, should be put into place to drive innovation power.  

High demand

Given the increasing cost of R&D, more companies are looking to acquire innovative businesses to gain access to new products and services, so the emergence of new, disruptive technology will remain an important trend to watch.

A major area of focus for acquirers will be environmental, social and governance (ESG). On the environmental side, commitments to reduce carbon emissions and transition to greener energy sources will fuel M&A opportunities for new technologies and products. With regulators, investors and customers among the stakeholder groups demanding that companies give more consideration to ESG, the focus on ESG innovations will only intensify.

Across the spectrum of sectors and industries, acquirers are sure to keep innovation in high demand.

© Financier Worldwide

BY

Richard Summerfield