CORPORATEGROWTH:

Organic orAcquis i t ion,

What i s the BestApproach in Today’s

Market?

A Frost & Sullivan White Paper

Authors: Ken Herbert, Vice President &

Partner andClare Walker, Research Analyst

“Partnering with clients to create innovative growth strategies”

TABLE OF CONTENTS

01. INTRODUCTION 3

02. CURRENT M&A CLIMATE 4

03. KEY DRIVERS OF M&A ACTIVITY 6

Globalization 6

Corporate Growth and Expansion 7

Corporate Cash Balances 7

Private Equity Influence 7

Key Challenges to Organic Growth 8

04. KEY CHALLENGES TO A SUCCESSFUL M&A PROGRAM 10

Valuations 10

Lack of Targets 11

Competition from Financial Buyers (Private Equity) 11

Legal Issues 11

Shareholder Concerns 11

Market Reaction 11

Other: Integration Challenges 12

05. THE FROST & SULLIVAN APPROACH 13

Best Practices 13

The M&A Approach 13

Conclusion 16

06. FOR ADDITIONAL INFORMATION 17

TABLE OF CONTENTS

Frost & Sullivan

2

01. INTRODUCTION

The importance of growth in today’s market is as high as it has ever been. As firms lookat their growth strategy, they are faced with the question of whether to pursue a strategybased on acquisitions or organic growth. There are clear advantages and disadvantages toboth. The following presents a high-level look at a few of the key issues involved in thisdecision.

We have found that a combination of growth through both organic strategies andacquisitions is the best approach in today’s market for firms to achieve their growthobjectives. However, a systematic process for each approach is necessary to minimize riskand obtain success. It is interesting to note that many of the criteria needed for asuccessful growth strategy, whether through organic means or through acquisition, aresimilar. The table below highlights a few of the best practices we see in successful firms.

Frost & Sullivan

3

Organic

Advantages • Greater control • Less capital structure risk • Involves less uncertainty• Allows focus on core competencies• Greater investor transparency

Disadvantages • Takes time and long-term focus• More reliant on own capabilities

M&A

Advantages • Speed• Diversification/access to new product/service

line, intellectual property, and capabilities• Increase global reach and market share• Acquire talent and human resources• Game changing potential• Accelerate revenue growth value over long-term

Disadvantages • Integration issues• Increased potential to destroy shareholder

value over long-term

Focus on pipeline creation as well as execution

Clear goals and objectives

Systematic due diligence takes time and creativity

Effective understanding of strengths and weaknesses

Clear goals and objectivesPipeline measurement and growth budgets

Setting the right expectationsInternal communication

On-going processDisciplined capital allocation process

Proactive approach and opportunisticSuccessful firms have higher IRR hurdle rates

Acquisition Growth – IssuesOrganic Growth – Process

This paper provides on overview of the current mergers and acquisitions (M&A) climate,as well as a more detailed overview of the key issues driving both merger and organicgrowth strategies. As part of this analysis, we also conducted an extensive survey withover 200 corporate executives, the findings of which are presented here. Finally, weprovide an outline of the framework we use to implement a process by which firms areable to proactively manage their M&A efforts.

02. CURRENT M&A CLIMATE

Mergers and acquisitions are an integral part of business today. Both strategic purchasesand increasingly large and complex deals involving private equity and other financialbuyers have dominated the headlines over the past few years. It follows therefore thatbusiness leaders today want – and need – to examine the progress and the process ofsuch deals. Competition for targets is leading to heightened valuations, and, in somecases, rushed and ill-conceived deals. The reasons behind merging or acquiring, orconcentrating efforts on organic, incremental growth can vary and some may be industry-specific, but generally all businesses face similar challenges and market forces. Lessonshave been learned, but achieving the goals set at the outset of any deal in the long runrequires significant planning and effort.

The size and number of M&As have increased steadily since a boom in 2000 and low in2002 (see Chart 1). Over 12,000 deals were recorded in the U.S. in 2006 with a totalvalue of almost $1.2 trillion. A significant portion of this can be attributed to privateequity (PE) companies. For example, private equity driven deals have accounted for almost30% of the total M&A activity in the US, up from under 20% in 2002.

Chart 1: Historical M&A Activity

Source: Mergerstat

Frost & Sullivan

4

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

*

Num

ber o

f Dea

ls

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

Valu

e in

$B

illio

ns

# deals $ in billions

In order to further illustrate the current thinking of corporate executives regarding M&Aactivity and gain insight across industries, Frost & Sullivan conducted a brief survey amongNorth American corporate executives to gauge their feelings about growth strategy,among other things. Perhaps indicative of the larger sentiment, executives at many of ourclient companies are divided about the best way to achieve their strategic goals – throughorganic growth, or merger and/or acquisition (see Chart 2). Size and reach of a companyare some of the variables used in evaluating what strategy is best, and while deals in thisarena might not reach RJR-Nabisco- or Time-Warner-AOL-like proportions, there is roomand opportunity for PE and larger corporations looking to make strategic moves.

Chart 2

Source: Frost & Sullivan

Indeed, one of the overwhelming reasons why executives might not look to M&A to growtheir company is because of the risks involved. Risks exist at every level – huge capitalresources are used, leadership is tested, complex technology and systems requireintegration, and of course people need to be introduced and then work together to makeplanned synergies flourish.

Organic growth is known to take longer, though it is historically more sustainable. Manyexecutives agree it is a question of time – short-term gains and speed-to-market arementioned again and again as an advantage of M&A, “but what about the long-termconsequences?” A company must have a plan and comprehensive process in place toincrease assurances that a merger or acquisition is successful in the long run.

Moreover, many companies are being priced out of acquiring companies in their industryby high valuations and intense competition from the private equity industry. While severalsurvey respondents felt that many deals were overvalued – partly due to the PE influence– most of them went on to highlight that given the strategic aspirations of the acquirers,they made the right move by buying aggressively. Often, companies have little choice but

Frost & Sullivan

5

Which do you see as the better approach to meeting

your growth objectives?

Organic Growth, 42.3%

Merger or Acquisition, 51.5%

Both, 6.1%

to pay more than the real value in this highly competitive environment, and then hope –and plan – to achieve value realization.

Emerging and thriving industries such as information technology enabled services,telecommunications, pharmaceuticals and biotechnology are expected to see the mostM&A activity in the coming years. PE deals will continue, but the level of activity willdepend on the amount of liquidity available to finance deals and the availability of targetsthat offer sufficient potential relative to price.

Further discussion is included on the best practices identified by working with clientsacross industries and taking stock of how directors and managers feel about the currentclimate from within. In addition, Frost & Sullivan has created an approach built upon bestpractices from the industry to support an M&A process.

03. KEY DRIVERS OF M&A ACTIVITY

The number one reason for a firm to acquire is to grow their top-line and get highervaluations as a result. And, overall, other main drivers are consistent across industries.

Following are a few of the key drivers for M&A activity:

• Globalization/geographical expansion• Corporate growth and expansion/diversification• Product/service line acquisitions (horizontal and vertical)• Access to improved technology or other• Intellectual property acquisitions • Corporate cash balances• Private equity influence• Corporate divestitures• Public to private transactions• Private company buyouts/management buyouts• Defensive deals• Tax strategy

Globalization

While the majority of mergers and acquisitions take place within the same country andeven region (approximately 30%), they can be a key part of a company’s globalizationstrategy. There are significant gains to be made by expanding across borders, foremostbeing access to large and perhaps untapped markets. Having people on the ground in acountry where there is potential to increase the size and scope of your business aroundthe world is crucial. Most of the considerations in conducting mergers or acquisitionsacross country borders will be the same as, or similar to, those conducted continentally.However, additional challenges present themselves, including, most significantly, cultural

Frost & Sullivan

6

issues or conflicts and meeting international regulatory compliance requirements. Peopleliving and working in different countries react to the same situations or events in verydifferent manners. While all workplaces and companies have their own unique culturewhich needs to be integrated post-deal, local cultures across the globe can be even moredifficult to navigate.

Corporate Growth and Expansion

A commonly cited reason for M&A is access to new markets, as with globalization, or newcustomers. In addition, resources such as talent and intellectual property including ideas,patents, equipment, and technology. While achieving market leadership remains a toppriority for the acquirers, access to best-in-class technologies and the business imperativeto achieve critical scale were also felt to be key drivers of these acquisitions. They arenecessary elements for achieving market share and leadership.

Innovation in this day and age is difficult to pursue purely within a company’s walls. Often,supplements from the outside are needed whether operational or financial. M&A providesinstant access to new resources to mine. Costs may end up going down as well – therelative proportion of expensive areas such as research and development will decrease asthe company expands.

Corporate Cash Balances

Over the past five years, corporate cash balances have reached all-time highs. This has ledto a substantial increase in share buybacks. Moreover, the increased cash available to firmshas had implications for the cost of capital requirements, potentially lowering thenecessary hurdles, which in turn makes some acquisitions appear attractive.

Private Equity Influence

Private equity firms have emerged in the last several years as one of the key drivers ofthe global M&A arena. These firms have the ability to offer flexible financial arrangementsas well as expertise in enhancing the corporate development, and motivation and capacityto improve the business. The PE approach can be used to teach other strategic buyers tolook at a target from a different perspective – Will the target be able to meetexpectations? How will it make money?, etc. Viewing a target objectively is key to futuresuccess.

The PE industry raised a record $459 billion in 2006. The recent PE influence is illustratedin Chart 3, which shows that the three largest deals have been made in the last 15months. This increased competition – and perhaps fear for some that if they do notmerge there is a greater possibility of being taken over – can in turn spur strategicmergers. PE obviously has a significant amount of capital available, but finding somethingto buy will be more and more difficult in the coming years as both credit conditionscontinue to tighten and valuations move up.

Frost & Sullivan

7

Chart 3

Source: Dealogic

Key Challenges to Organic Growth

Organic growth is incremental; it takes time to develop the internal resources necessaryto build a bigger and better business. And this – its inherent slowness – is also its biggestcriticism. As part of our recent research, when asked to identify their key challenges toorganic growth, the lack of talent was the primary reason cited. It follows, therefore, thatit is one of the drivers behind making an acquisition. Many small or mid-size companiesfeel that they do not have the right people trained in certain areas, or enough people totake on certain kinds of projects. This lack of resources is followed closely by shareholderdemand for near-term impact, cost of capital, and ideas, in terms of the barriers tosuccessful organic growth. Material costs and political barriers are also challenges, butless so, and are really considerations in any critical business decision.

Chart 4 shows the executives’ view on the key challenges to using organic growth as astrategy.

8

Frost & Sullivan

Chart 4

Source: Frost & Sullivan

Other received a significant number of responses. We therefore further broke down theseother challenges since they relate to several industries (see Chart 5).

External forces include market conditions, competition, and regulations. Complexities inthe markets can be difficult to navigate – particularly if there are not enough staffmembers or resources internally to perform research, etc. Competition makes slowgrowth challenging – companies believe they are likely to fall behind if they don’t acquireto gain market share.

Internal forces include leadership hesitation and, again, limited resources, whetherfinancial, human, or technical.

Chart 5

Source: Frost & SullivanFrost & Sullivan

9

Key Challenges to an Organic Growth Strategy

Talent, 26.9%

Shareholder demand for near-term impact,

21.5%Cost of Capital,

15.4%

Ideas, 10.4%

Material Costs, 5.8%

Political, 5.4%

Other, 14.6%

Organic Growth: Other Restraining Forces

External51.4%

Internal48.6%

It is our experience that firms do not lack for ideas when it comes to organic growth.The problem is in selecting the right ideas, and executing on them. Successful firms havetraditionally applied a very high cost of capital, forcing a high degree of discipline on theirevaluation process. Moreover, successful firms have a very clear process in place foranalyzing and evaluating ideas, and to ensure that they have the necessary time andresources to be successful. However, they also will pull the plug quickly if an initiative isnot going as planned.

04. KEY CHALLENGES TO A SUCCESSFUL M&A PROGRAM

The following highlights the key challenges firms face in pursuing a successful M&Aprogram. Keep in mind, in our view, M&A are not a strategy in and of themselves, but atool to be used in a successful growth strategy.

Chart 6 shows the executives’ view on the key barriers to M&A as a strategy.

Chart 6

Source: Frost & Sullivan

Valuations

Valuations were cited by over 36% of the respondents, but all of these barriers areentwined. The competition from buyers increases the valuations – the law of supply anddemand at work. The high valuations that owners have witnessed lately have heightenedexpectations. Overstated valuations of companies have priced smaller strategic buyers outand opened the door for financial buyers. However, it is important to note that at large,the S&P 500 is trading now at about 17 times the past 12 months earnings. This valuationis at the lower end of where the market has traded over the past 20 years. However, this

10

Frost & Sullivan

Key Barriers to a Successful M&A Strategy

Valuations, 36.1%

Lack of Targets, 16.2%Competition from Financial Buyers (Private Equity),

12.0%

Legal Issues, 9.1%

Shareholder Concerns, 7.5%

Market Reaction, 5.0%

Other, 14.1%

is relative, and it is clear that many potential buyers today perceive valuations asprohibitive to pursuing deals.

Lack of Targets

Because of the increasing activity over the last decade, there is a lack of available andproper/feasible/sensible targets for many buyers. This reflects the increased scrutiny firmsfeel are placed on deals today, as well as the spike in activity from private equity firmsover the past five years.

Competition from Financial Buyers (Private Equity)

Private equity has come on strong in the last year in particular. A financial buy is done fordifferent reasons than a strategic one, but the main driver is always a return oninvestment. And though Frost & Sullivan expects the influence of private equity to havepeaked, easing valuations and market pressure, they should not be counted outconsidering the substantial capital overhang with private equity firms.

Legal Issues

The size of the merger or acquisition can bring different levels of legal issues. In additionto ensuring federal anti-trust laws are observed in a merger with a competitor, statereviews are required. In the age of Sarbanes-Oxley, shareholder activism, and greater dealscrutiny, legal issues and consequences are clearly top-of-mind for many potential buyers.

Tax consequences can also arise depending on the structure of the deal – for both buyerand seller. Legal issues may be an obstacle in joining companies – though it is possiblethat an acquisition can reduce taxes.

Shareholder Concerns

Shareholders may express concerns before heading into purchasing transactions becauseof potential loss of value of their holdings. These shareholders have cause; it’s beendemonstrated over the years that mergers can destroy shareholders’ value in a companyover time. Therefore, if the majority of shareholders do not want to go forth withacquisitions it will hold the company back. It is clear that many firms are slowly movingout of the investor-imposed “penalty box” after many of the excessive deals of the 1995-2000 period, but shareholder concerns remain.

Market Reaction

These deals can be kept secret for some time before being made public. The reason forthis and the cause for concern usually stems from the potentially negative reactions fromemployees, suppliers, bankers, customers and other stakeholders. If a negative reaction

11

Frost & Sullivan

occurs to an announcement, the possibility exists that the merger will never close. Doesthe market know more than you do? A negative reaction can taint and challenge a deal inthe works. If the market reacts positively then value creation is anticipated.

Other: Integration Challenges

Chart 7

Source: Frost & Sullivan

Poorly managed integration of systems and people can negatively impact the corebusiness. Infighting and politics can run rampant, and cultural issues can be severe.Therefore, the correct organizational and cultural fit is crucial. A clear objective that iscommunicated clearly to employees is necessary.

After integration challenges, the other challenges mentioned include:

• A lack of both financial and human resources; • Hesitance of potential buyer and the subsequent missing of a market

opportunity; • Regulatory hurdles such as corporate governance and, in cross-borders

situations, meeting international regulatory requirements;• Market risk and uncertainty is one factor that cannot be controlled, but can be

planned for; and• Concerns about control over the process, which can lead to leadership

hesitance.

12

Frost & Sullivan

M&A: Other Restraining Forces

Risk/market uncertainty, 6.3%

Regulatory hurdles, 6.3%

Buyer hesitance, 15.6%

Lack of resources (financial, human),

15.6%

Concerns about controlling process,

6.3%

Integration challenges, 50.0%

05. THE FROST & SULLIVAN APPROACH

Best Practices

A company should have an overall strategy for growth. Organic growth and M&A arepieces of it, and can exist together to improve revenues and synergies. Organic growthsupplemented with targeted acquisitions with specific gains such as technology orchannels is part of the strategy – M&A is a tool. A company must differentiate itself in themarketplace, either with product or a service, and the success of any merger oracquisition can depend on better marketing and salesmanship. In fact, we feel that acombined approach, one that incorporates both an opportunistic and proactive M&Astrategy as well as organic initiatives, is the best solution for a firm to meet their long-term growth objectives.

The M&A Approach

Through experience in partnering with industry clients and performing our client survey,Frost & Sullivan has identified best practices for putting a comprehensive M&A process inplace for clients. A successful program has the following elements:

• A clear understanding of goals to be achieved through M&A• Established team, budget and ownership within the organization• Proactive and opportunistic• Comprehensive understanding of best practices for each step in the process

A successful firm has a strong and vibrant pipeline of potential deals and opportunities atall times. The firms that have been known to be successful in both identifying and gettingthe most value from deals, such as ITW, Berkshire Hathaway, GE, to name a few, do notlet the bankers or the market drive their deal activity.

We have found the following approach to be both successful and robust enough for bothsmall and large firms alike. It should be noted that many private equity firms offer someof the best practices in creating and managing a deal pipeline, and should be studied bycorporate buyers for ideas.

As part of an on-going process, we suggest firms follow this path in executing its M&Aapproach:

1. Sector or trend overview – Where do we want to look to do deals?2. Target-specific analysis – What are the opportunities within the above that

meet our criteria?3. Transaction due diligence – What are the company-specific issues we need to

address?4. Post-deal integration and strategy – How do we make this work?

13

Frost & Sullivan

Sector or Trend Overview

This represents one of the most important aspects in the process. At the early stage,firms need to be very clear on their expectations and goals. In addition, they need to beprecise about what makes the most sense strategically, for them to focus in on for thelong term. A few of the important questions to be looked at early on include thefollowing:

• What are the sectors that are most attractive to a specific company based on their requirements or expectations for growth through acquisitions or mergers?

• What are the industry segments, geographic regions, market sectors, that best match with the requirements of the buyer?

• Overlayered with the market, what sectors or market offer the best opportunity for an accretive and strategically successful acquisition?

Target-Specific Analysis

Once segments are identified, develop a screening process designed to identify specifictargets. At this point, questions regarding deal size, company-specific attributes, andother factors need to be addressed. A firm must be able to provide an explicit answer tothe “if the ideal opportunity walked through the door, what would it look like” question.It is at this point that the following items are explored in greater detail:

Transaction Due Diligence

Depending on the transaction, this is the step that involves all of the company-specificdue diligence issues. In addition to the market-focused items listed below, this is when allof the critical legal, financial, technical, cultural, and other issues need to be addressed.The timeframes here are often limited for competitive reasons, so having an experienceddeal team and the necessary resources are critical for the successful execution at thisstage. A few of the key market-related issues to be explored include the following:

• Does the company represent a viable investment opportunity?• Is the industry attractive? • Is the business strategy appropriate? • Are revenues reasonable and sustainable? • Is the technical plan appropriate?• Are operating and capital expenses budgets adequate?• Are the organization and competencies in place?

14

Frost & Sullivan

• SWOT analysis• Financial benchmarking• Management profiles • Sales and margin analysis• Product positioning and placement

• Product and service mix• Justification for attractiveness• Customer concentration• Analysis of growth prospects and outlook• Technical analysis

Post-Deal Integration and Strategy

A common grievance about M&A is that the people doing the actual deal become toofocused on just doing the deal. Meanwhile, other areas tend to be overlooked, such asgetting the upfront strategy and integration right. The goals and objectives for the mergeror acquisition need to be formulated and then made well-known among all stakeholders.They also need to be kept in mind throughout the process in order to continue to movetowards them and maintain a timeline.

“Start your integration planning before you even get a term sheet” – this is an explicitexample of what was repeated throughout the survey. Part of this is being crystal clearfrom the very outset of the strategic and financial goals for the merger or acquisitiontarget. Differences in culture need to be addressed right from the design stage if it is tosucceed. If the merger or acquisition is international, the complexity of these processes isoften compounded by the difference in national cultures.

If planning is done early enough, companies can pinpoint gaps and potential problems.Then they can make informed decisions regarding how to fill holes and avoid friction.Knowing upfront who will stay and who will go, what IT systems will be utilized, etc. canprevent fallout later. More specifically, issues involving the consolidation of administrativeand back office functions need to be addressed to best leverage performance. Also,geographic questions – will everything stay where it is or be moved to a centralheadquarters? Integration of the target’s owners and key executives is challenging – theirroles need to be determined quickly and communicated immediately. Naturally the HRteam will need to be involved from the beginning. The target’s capital assets, people andbusiness process should be sorted before the merger as well.

Key elements of an integration strategy are establishing clear communication amonginternal teams, and having skilled leadership. The following are a few of the key items tobe discussed at this stage to help ensure a successful deal completion andimplementation:

1. Clear communication2. Leadership and/or create a focused team3. Setting priorities4. Integration support5. Training and development opportunities6. Key metric and MOP identification7. Plan execution and strategy

15

Frost & Sullivan

Conclusion

Long-term success of a merger or acquisition is the goal, and identifying the right targetis a crucial first step in getting it right. When that is done correctly upfront, it facilitatesthe flow of analysis, due diligence and strategy. Integration planning is also a key part ofthe process and will ensure a smoother post-deal transition for people and systems.Utilizing best practices can help make a complex and delicate process a bit easier tonavigate.

16

Frost & Sullivan

06. FOR ADDITIONAL INFORMATION

Business & Financial Services Contacts

Ken HerbertVice President/Partner650.475.4547kenneth.herbert@frost.com

Jennifer O'GradyResearch Director210.348.1019jogrady@frost.com

Clare WalkerResearch Analyst212.967.2517clare.walker@frost.com

Corporate Communications Contact

Mireya CastillaNorth America Team Leader 210.247.3830mireya.castilla@frost.com

17

Frost & Sullivan

References:

“10th Global CEO Survey.” PriceWaterhouseCoopers. 2007.

“After Years of Trial and Error, Companies Take a More Focused Approach to M&AIntegration.” <http://www.prnewswire.com>

Gitelson, Gene; Bing, John W., Laroche, Lionel. “The Impact of Culture on Mergers &Acquisitions.” <http://www.itapintl.com/mergersandacquisitions.htm>

Economist Staff, “The Business of Making Money.” The Economist 6 July 6 2007.

“Evalueserve-Greenfield Business Sentiments Survey on Indian M&A Trends.”<http://www.evalueserve.com>

“M&A marketplace difficulties.” <http://www.wikipedia.com>

Palter, Robert N. and Dev Srinivasan, “Habits of the Busiest Acquirers.” McKinsey &Company Perspectives on Corporate Finance and Strategy, Number 10, Summer 2006.

Platt, Gordon, “Cross-Border Mergers Show Rising Trend As Global Economy Expands.”December 2004. <http://findarticles.com/p/articles/mi_qa3715/is_200412/ai_n9466795>

Warsh, Kevin, “Corporate Cash Balances and Economic Activity.” Speech. 18 July 2006.

18

Frost & Sullivan

877.GoFrost

myfrost@frost.com

http://www.frost.com

Silicon Valley2400 Geng Road, Suite 201

Palo Alto, CA 94303

Tel 650.475.4500

Fax 650.475.1570

San Antonio7550 West Interstate 10, Suite 400,

San Antonio, Texas 78229-5616

Tel 210.348.1000

Fax 210.348.1003

London4, Grosvenor Gardens,

London SWIW ODH,UK

Tel 44(0)20 7730 3438

Fax 44(0)20 7730 3343

CONTACT US

Palo Alto

New York

San Antonio

Toronto

Buenos Aires

Sao Paulo

London

Oxford

Frankfurt

Paris

Israel

Beijing

Chennai

Kuala Lumpur

Mumbai

Shanghai

Singapore

Sydney

Tokyo

ABOUT FROST & SULLIVAN

Frost & Sullivan, a global growth consulting company, has been partnering with clients tosupport the development of innovative strategies for more than 40 years. The company'sindustry expertise integrates growth consulting, growth partnership services and corporatemanagement training to identify and develop opportunities. Frost & Sullivan serves an extensiveclientele that includes Global 1000 companies, emerging companies, and the investmentcommunity, by providing comprehensive industry coverage that reflects a unique globalperspective and combines ongoing analysis of markets, technologies, econometrics, anddemographics. For more information, visit http://www.frost.com.