A strategic investor uses a very different process to identify acquisition targets than that used by financial investors (the subject of my next column). For a strategic investor, as the name implies, identifying an acquisition target must flow from the acquiring company’s strategy.

The worst methodology that a strategic investor might use to identify targets is to respond to the acquisition opportunities that it finds on an ad hoc basis. This simply will not work for two major reasons:

• First, responding to opportunities on an ad hoc basis typically means that deep strategic thinking has been short-circuited.
• Second, if a strategic investor acquires a company that it came across merely on an ad hoc basis, how does it know that there were not better acquisition opportunities elsewhere in the marketplace?

It follows from the above thinking that a strategic investor, before embarking on an acquisition, should have a clear definition of its overall corporate strategy, and from such a corporate strategy should flow its acquisition strategy. (Of course it is ideal to have these in writing: there is nothing that focuses the mind as much as putting something in writing, an approach which also helps to ensure that the different parts of the organization are also in consensus).

Some of the elements of an acquisition strategy might include definitions of the following:

• The rationale for the acquisition (e.g. vertical or horizontal integration, expanding into newer high-growth markets, acquiring technology or know-how, etc.)
• The precise profile of the target companies sought
• The geographic range of possibilities
• The financial criteria (revenues, profitability, etc.)
• The type of management or skills which may be required
• The type of clientele which the target company should have
• The valuation range in which such acquisitions may make sense

A company may choose to create a strategy broader than an acquisition strategy, namely an M&A strategy. Such an approach would also cover the criteria which a company would set for divestiture of its subsidiaries.

Once the strategy has been defined, the acquiring company should engage in a systematic search for and assessment of all those companies that fulfill the criteria (as opposed to an ad hoc approach). If there are a very large number of candidates, the list might be shortened by selecting only the most attractive ones. The most attractive ones might then be approached to ascertain whether they are willing to talk about a strategic partnership or acquisition, and with an eye to further fact-finding about the company. It is often useful to use an independent third party intermediary for this approach, as it allows the approach to be anonymous, keeping the name of the acquiring party out of the market.

Failure to apply the above approach may result in a bidder finding itself among a herd of bidders in a frothy, overpriced market, competing for a target company that might not even be the best strategic fit.

Some of the more astute strategic investors have been monitoring their potential acquisition targets for many years, sometimes even decades, and are ready to make a move on short notice if the owner of a target company becomes willing to sell or if price expectations are reduced. However, it is usually only a small percentage of potential target companies that a strategic investor is willing to acquire – the majority of potential targets quite often simply do not make the grade.

Central Europe is often an attractive area for acquisitions for global investors because most investors believe that Central Europe is on a convergence path with Western Europe, meaning that GDP per capita, incomes, consumption, etc, will catch up to Western European levels. This is based on the belief that, “A rising tide raises all ships.”

Nevertheless, different countries move at different speeds at different points in time, depending on their political and socio-economic environments, and some companies are better acquisition candidates than others. The importance of country and industry-specific knowledge at the local level cannot be over-emphasized.

Owners and managers of businesses always have the option of financing a business by way of either debt or equity. For any business, there is usually an optimal debt to equity ratio that best fulfils the objectives of owners and managers and which depends on a number of factors.

There are numerous advantages to financing via debt. Debt has the advantage of generally being tax deductible (although tax regimes in some countries do set a limit on the amount of debt which is deductible), and debt financing has the advantage of avoiding dilution of equity ownership. The cost of debt financing is therefore lower than the cost of equity.

However the big disadvantage of debt financing is that it increases the level of risk in the corporation (i.e. there is a higher risk of default). Moreover, as the level of debt increases in a company, the cost of such debt also tends to increase so as to compensate for the additional risk.

There are also a number of cyclical factors that may have an impact on the debt to equity ratio. The expected debt to equity ratio varies depending on whether markets are bullish or bearish, whether the economic sector to which a company belongs is more sunrise or sunset, or indeed whether a company is in an early development phase or at maturity.

During the last economic boom, most business owners would have preferred a higher mix of debt to equity as debt was readily available, interest rates were lower, companies had more accurate earnings forecasts, and earnings tended to rise over time. Expansion could be financed via debt, while existing equity owners remained in control and interest was tax deductible.

However, during the current recession, earnings are much more difficult to predict (companies often have trouble forecasting the coming quarter, let alone for the year) and debt is less readily available as a result of the much more conservative lending policies the banks are adopting. While interest rates such as Euribor, Libor, etc. have decreased by several percentage points, the spreads over Euribor or Libor have generally increased by anywhere from 100 to 400 basis points for most companies, meaning that the real cost of debt financing (after adjustment for inflation) has generally increased.

The word ‘deleveraging’ often arises during the current recession. The dynamics described above often force companies to substitute equity for debt. However, equity has also become more difficult and costly to source compared to 18 months ago. Despite this, beefing up the balance sheet with a healthy dose of equity is an option that the majority of business owners and managers should be considering today.

In addition to the option of equity injection, hybrid instruments (which contain features of both debt and equity) may also strengthen a company’s financial position. Two common hybrid instruments are preferred shares (which have an obligation to pay a certain dividend rate) and convertible debt (where the lender may be willing to accept a lower interest rate in exchange for having the option to convert the debt into equity at a later date). Hybrid instruments typically have a level of risk that is higher than debt but lower than equity, and therefore the cost of financing also lies somewhere between the cost of debt and the cost of equity. (Hybrid instruments will be the subject of subsequent columns).

A strong balance sheet can be even more of a source of strength and competitiveness in a recession than during a boom. It is no accident that even strong banks such as HSBC are raising equity, not because they are undercapitalized, but to take advantage of opportunities in the marketplace. Equity may also be viewed as a financial cushion, something that could help companies weather a deepening recession in the event that the much-touted recovery does not occur as soon as expected.