Executing Transformative M&A to Change Business Models

Transformative M&A

It's always accompanied by a change in the business model or the governance of a company. There are many examples in the market. Take the automotive industry, which is under pressure to shift its business model to electric vehicles from conventional processes. In such cases, companies need to reinvent themselves or develop creative structures to sustain their business.

Governance

Imagine a company working in a very conventional business field and facing difficulties in gaining financing or new equity due to certain regulations introduced in the meantime. In the European Union, we introduced the so-called EU taxonomy a couple of years ago.

This defines certain business areas as carbon neutral or non-carbon neutral. The latter faces regulatory pressure, which influences the entire governance model of a company.

A story of a transformative deal

It's a very complex situation. When I was head of corporate development in M&A at a large German utility company, we faced serious financial crises due to several external shocks, particularly the German law of exiting coal-fired power production. 

As part of the restructuring and refinancing, the financing banks required the six public shareholders to sell 100% of their stake in the company. The problem was that it was a completely integrated group with high exposure to coal-burning power production, critical for securing the German power supply.

The group also had interesting businesses in renewable energy and service areas. Over time, increasingly strict ESG requirements, especially from investors and debt markets, made it difficult for a company with significant conventional power production to find investors or secure financing. 

We were trapped, unable to gain fresh capital to transform the business internally and struggling to find potential investors. Even if we found an investor, they would need deal financing, and banks were reluctant to finance such conventional assets.

ESG requirements had strong consequences, affecting financing and advisory services from investment banks and consultancies with internal policies restricting business with high CO2 footprint companies. 

We concluded that the only way to make the company viable was a complete separation of the group’s businesses. We introduced a conventional business arm and a green or growth arm, intending to sell the growth business, which attracted investment in green energy and energy transformation in Germany. The conventional arm would eventually be wound up using proceeds from the growth business.

We took the existing holding company, and transferred operations into two legally independent, 100% subsidiaries, creating a mega carve-out. The structure ensured no connection or contingent liabilities between the conventional and growth businesses, preparing the growth business for sale to infrastructure investors. The proceeds would pay off financing banks and finance the wind-up of the conventional arm.

However, some stakeholders, including shareholders and employee representatives, opposed this plan. They preferred to sell the group as a whole to maintain its size and strength and avoid winding up a business with over 80 years of history in Germany.

The separation of that group into two independent subgroups helped establish a financing enabler. The conventional business was able to finance itself due to its ongoing cash flow, while the growth business could stand alone and secure financing.

The decision to split the company was clear and supported by every stakeholder. The challenge was determining the transaction perimeter, specifically what to sell and to whom.

The established structure ensured the growth business could always gain financing. However, the conventional business, although cash positive, needed a solution to be managed separately. The overarching holding company served as the transaction vehicle. The standalone separation of the growth business helped convince investment committees to consider the transaction.

Investment committees faced the dilemma of handling the attractive growth business alongside the conventional, "dying" business model. To address this, we developed a clear decommissioning and net-zero strategy, including steps to transition power plants to new technologies or other uses. 

Another enabling tool we developed was a legal optional solution called "shareholding as a service." This model allowed any investor, after closing the transaction, to transfer the coal business into a trustee solution, so the investor would not have the conventional business on their books, and a third party would manage the windup of the business.

 When it comes to managing the asset, there was participation in the wind-up proceeds, defining how many years the conventional business would need to run. The operational cash flow could keep the company running and surpluses would be placed in an escrow account.

Additionally, certain subsidiaries in the group could be sold over time, with proceeds, net of decommissioning and personnel costs, clearly projected.

There was a mechanism to determine how much of the remaining cash would go to the service provider, typically a legal service group or lawyer managing the wind-up.

There was definite an increase in valuation. Valuing each part of the group separately would have resulted in a more favorable valuation for the growth business due to its clear going concern perspective, high exposure to new technologies, and favorable business environment. 

The conventional business, with a limited active period and identified cash proceeds, also comes with additional costs like decommissioning big power plants, which is not cheap. This affects its valuation compared to a business with a clear way forward and a better focus.

Employee unions

Germany has a strong culture of unions and employee representation. Their primary interest is to secure the best outcomes for employees in every transaction and business decision. The major motivation is to avoid layoffs and relocations, and unions in Germany typically have a strong voice and entrepreneurial background. 

In many companies, especially in the supervisory board, there is an equal representation of employee and capital sides, with 50% employee representatives and 50% from the capital side. To gain approval for fundamental business decisions, it's crucial to have the support of the employee representatives to ensure mutual understanding and cooperation.

Massive lay offs are definitely not the case from a strategic point of view. Sometimes synergies involve certain personnel decisions, but especially in a big corporate setting, employees are key assets. They possess the knowledge and history of the company's culture.

Typically, synergy cases involve more administrative functions. Due to natural fluctuation and aging within the workforce, it's not essential to lay off employees during transactions.

Supervisory board

You have to have several discussions with them, offer compromises, and negotiate a way forward that respects both sides' motivations. You must keep in mind the best interests of the employees from their work council's point of view while explaining why certain measures or structural changes are necessary to prevent harm to the company. 

They need to understand the financing and restrictions associated with certain business models. While their focus on employee well-being is crucial, especially in countries with strong union cultures, it's essential that these movements do not harm everyone involved, necessitating a compromise.

Biggest challenges in transformative M&A

The biggest challenge was bringing all stakeholders behind the concept. Achieving a mutual understanding and agreement on how to execute the transaction was crucial.

In a multi-stakeholder environment, you deal with numerous parties, including shareholders, employee representatives, politicians (since energy companies in Germany have high political exposure), financing banks, customers, and suppliers.

Introducing the concept to all these stakeholders required challenging discussions and numerous long meetings, particularly for the responsible CFO at the time. The strategy involved individually educating each stakeholder with the same message but tailored to their background and concerns. 

For instance, financing banks understand deal perimeters and due diligence, while politicians need different explanations. Ensuring transparency and maintaining consistent communication was one of the key challenges.

Success metrics

You can look at this from two perspectives. One is the process view, focusing on checklist criteria such as allocating employees to companies A and B, transferring contracts, handling licenses, and separating data files. You need to audit the financials and address the mechanics of the deal, defining metrics around these tasks. This involves creating an inventory of all company assets and determining how to manage each category.

On the other hand, there are the soft measures, particularly related to company culture and employees. Imagine an 80-year-old traditional German energy company always integrated into one operational holding, now facing a completely new governance and business model, dividing into two different worlds.

This complex change process affects employees, as they must adapt to two companies with different business approaches.

The conventional business focused on power production for German society, while the new business involves building renewable energy assets, providing energy services, and integrating energy solutions.

This requires a different market approach, handling customers, generating leads, applying for projects, and constantly engaging with potential clients. Employees must learn to work in this new environment, facing new challenges, which brings significant changes in governance.

Internal rate of return

In the end, every transaction can be simplified by looking at the numbers. In this specific case, the shareholders of the company were municipalities with certain financial criteria they wanted to achieve. The sale of the group was also a requirement from financing banks as part of the restructuring. The shareholders had to sell, regardless of the price, though they aimed to sell at the highest value.

Despite disruptions in the energy markets over recent years, the deal turned out well for everyone involved, with no complaints. A key part of the pitch was presenting a clear financial case for why the transaction made sense.

Future of transformative M&A

In the end, it is my deep conviction that large transformative M&A will dominate future deals, especially in energy-intensive industries like chemical, automotive, and steel. These industries face challenges that require them to rethink and reinvent their business models.

We see traditional industries needing transformative M&A to adapt. For example, industrial companies are transforming broad product portfolios into focused entities within specific industries or sectors.

Once acquisitions are identified that help transform the company, you can align your portfolio accordingly, divesting businesses that are no longer core. However, starting with selling can be risky if you don't have an acquisition target, as it might weaken the group and make it a target for acquisition. Strategic framework and assessment are crucial.

Alternatively, an incremental approach can transform through a series of acquisitions, focusing on customer shifts or industry changes. The advantage of a big transformative acquisition is timing, especially if there is pressure on the business model. If there's no immediate pressure, a case-by-case approach may be better, though it takes more time and faces risks like unavailability of targets.

Good preparation is key, whether for buying or selling. On the buy side, understanding potential targets through research and knowing the industry well helps mitigate risks. On the sell side, transparent documentation and addressing business weaknesses provide comfort to potential investors during due diligence.

Complexities of deals in Germany

In certain industries, particularly those driven by IP or innovation, you may face over-engineering when competing with companies from different cultures. The German M&A environment is characterized by a very risk-averse atmosphere. However, those involved in M&A in Germany have intrinsic motivation to overcome risks and find solutions.

One reason deals take so long in Germany is the governance structure of German companies. You must align every stakeholder behind a deal, starting within the company, then moving up to the executive board, and finally to the supervisory board.

Some companies can make decisions quickly, but others have a formal process requiring documents to be prepared and submitted weeks in advance, making the process complicated and time-consuming.

Transforming business models

We are considering connecting our machineries to our own cloud, offering a service portfolio through a subscription business model. This is something we in the technology and industrial engineering sectors are exploring. For instance, automotive suppliers, including Porsche, are considering subscription models for their cars. Instead of configuring a car with specific features at purchase, everything is included, and customers can subscribe to features on a monthly basis.

For example, you could opt for the entertainment system for an additional charge one month and cancel it the next. This model raises questions about profitability, as it requires significant investment in the cars. If some customers are not interested in extras and only want to drive from point A to point B, it remains to be seen how profitable this approach can be. Nonetheless, it is a model that is being considered.

Promoting change as a shareholder

In the end, you must understand the industry and the regulatory framework and pressures associated with it. For example, in the chemical industry, chemical parks have extensive infrastructure, including energy production, water and wastewater treatment, and waste treatment. These sites are very energy-intensive and have a significant CO2 footprint.

With the net zero ambition that nearly everyone is considering, you must decide whether to invest capital in transforming your chemical production site into a green one, which requires significant capital expenditure. Alternatively, you might invest in growing your business by entering new markets and technologies. If the latter is preferred, you can engage in transformative M&A by selling your chemical park site to an infrastructure investor who will handle the transformation. You would pay rent to use the site, avoiding large local infrastructure investments and freeing up capital for other purposes.

It's always a strategic decision on which path to take. In the worst case, if no investment is made, the site might be closed down, and operations relocated to another country, a scenario sometimes seen in Germany.