December 2009

THE REACTION OF CORPORATE GROWTH

STRATEGIES TO ENVIRONMENTAL SYSTEMS CHANGE

THE CASE OF THE 2008-09 GLOBAL FINANCIAL CRISIS

David R. Valente

Project coordinated by Prof. Dr. Martin Carree, Head of the Strategy

Department at the Maastricht School of Business and Economics

Presentation developed as an unofficial complement to the formal written document

 Executive Summary

A crisis considered by many as the worst since the Great Depression, and the first at the scale of a globalized world, reached
in 2008 the world financial systems and the global economy. Two key consequences are likely to come out of this crisis: (1)
new regulatory systems; and (2) new stakeholder perceptions on managerial practice. We evaluate in this study the impact
that a business environmental change is likely to have in corporate growth strategies. We find that the debt cost, the firm
stock valuation, the investor ownership structure, the executive remuneration incentives and the shareholder risk aversion
are all factors that significantly impact the preference of firms to choose acquisitive growth. We find also through a survey
of 107 global top executives that the debt cost, the long term executive remuneration schemes and the shareholder risk
aversion are likely to increase in the “new normal” business environment. As a conclusion, we find that the movements in
these three indicators are significant to explain an expected long term increase in the preference for firms to choose high
organic growth strategies in detriment of acquisitions. The conclusions are likely to originate new benchmarks for financial
investors, so that the evaluation on public firms´s performance may be adjusted to a new set of indicators. Finding the
correct firm positioning in the start of a new business environment is key. We hope to provide in this study a fundamental
basis to support new benchmarks and managerial sight over the long term firm competitiveness and performance.

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 Executive Summary

1. We are convinced that the recent wave of acquisitions in the last decade (e.g. mega-deals) is highly
influenced by the systems thinking behaviour that managers tend to adopt when working within the capital
market dynamics. We believe there are non-strategic factors with a strong impact on the willingness for
firms to acquire

2. Vast research finds that in average acquisitions deliver value only in 30 to 50% of the deals (see
Sudarsanam, 2003, ch. 4)

3. We are convinced that the global crisis may bring some structural changes in regulations, stock market
perceptions and others likely to reduce the incentives for managers to focus on quick short term growth

4. Based on the research assumptions, we believe the world post crisis environment will have less incentives
for extreme short term focus and that less but more value creating acquisitions may take place

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 First of all, it is important to understand that corporate growth strategies are a
crucial vector of the firm´s strategic intent…

“Companies that do not deliver in new forms of investments start slowly erasing its value… the value that a company
can create is intrinsically related to its capacity to tackle new projects in order to maintain or increase its revenues
sources, as well as to operate more efficiently (Canals, 2001) Companies that do not deliver in new forms of
investments start slowly erasing its value. Therefore, the value that a company can create is intrinsically related to its
capacity to tackle new projects in order to maintain or increase its revenues sources, as well as to operate more
efficiently (Canals, 2001)”

“Corporate growth is agreed to be the single most important driver of the stock price (Deans & Denneen, 2005; Meer,
2005)”

“Counting from as far as sixty six to seventy five percent of a company’s value (The Boston Consulting Group
research)”

If one wants to study the impact of the Financial Crisis in Corporate Strategic thinking, the
expected influence of it on the preferred firm growth models can be a very relevant proxy!

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 …and that the change in business environments can have an impact on the firm
development of its corporate strategy

“Firms have been continuously focusing on short-term metrics, not taking a deeper approach to value creation. That is in fact
the strongest reason that led to the total collapse of the financial systems in the 2008 global financial crisis. But why do firms
keep forgetting about long-term value creation? We argue that the theory of resource dependence can have a strong explanatory
effect in clarifying how corporate value creation is targeted. Public firms act in different sets of systems, one of which is the
capital market system, making firms to be dependent on the dynamics of the market system for financial resources.”

“As Michael Porter (1992) stresses, the system includes shareholders, lenders, investment managers, corporate directors,
managers, and employees. He adds that all of them make choices in contexts determined by government regulation and
accepted management practices.”

“Public firms, by being dependent on “the system”, are faced with the duty of performing accordingly to their demands.
Different ownership structures, different preferred financing mechanisms, different target growth requests, and many others
can impact the way firms develop their corporate strategies.“

Firms are dependent on business environments for resources and particularly public firms are
dependent on the demands of the capital markets´ system in order to choose their strategies.

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 In this project we argue that the very quick growth in the level of acquisitions on
the last decade was unsustainable and is likely to slow down in the long term

“Vast research finds that in average acquisitions deliver value only in 30 to 50% of the deals (see Sudarsanam, 2003, ch. 4).
At the same time, firms used in the last 10-15 years acquisitions as never before, many times with all but no clear
synergistic thinking.”

“Deans & Denneen (2005) argue that from a sample of value growers, 87% of their growth comes from internal activities.”

“The recent environmental storm [financial crisis] has proven the un-sustainability of the “system”, as well as of the players
that followed its incentives. Most of the survivors took a different path; they recognized the need to manage risk
management and to manage for the long term”

If acquisitions still destroy value in

30 to 50% of the deals, why is it that
such quick and big peaks of
acquisitions occurred in the last 2
decades?

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 First of all, we would expect the below exposed non-strategic variables to be
explanatory in the appetence for firms to prefer different growth strategies

We believe the described variables can (in)directly affect preference for different growth strategies

Independent Resource
Dependent variable
variable Dependence

Cost of Debt
Cost of
Financial Crisis
capital Acquisitive
growth
Stock market valuation

Investor ownership structure

Long/ Short term System pressures on
Corporate
pressures executive decision-
making Growth Strategies
Executive compensation

Investor
Organic
risk awareness
Growth

Capital system Corporate Strategy

As public firms are dependent on investors´resources, they have to adjust their strategies to
the adjusted set of factors that follows the 2008-09 financial crisis

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 Secondly, we would expect the financial crisis of 2008-09 to bring changes in the
long term course route of the hypothesized variables…
The hypothesis were set in the belief that the “new normal” post crisis may bring permanent
changes into the following factors…
Hypothesis

Debt Cost likely to increase

FINANCING COSTS
Equity overvaluation periods
likely to decrease
09
8-

Long term investor ownership

0
20

structure likely to increase

SIS

INTERNAL AND
RI
LC

EXTERNAL
CIA

MARKET PRESSURES
AN

Long term executive incentives

FIN

likely to increase

SHAREHOLDER
RISK Shareholder risk aversion likely to
PREFERENCES increase

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 …leading to the hypothesis setting that firms will feel the need and pressure to
increase their organic growth focus in the long term
H1
Cost of capital H2

Long/ short term H3

09
L C R IS IS 2008- managerial H4
FINANC IA
pressures
Shareholder risk H5
preferences

 H1: The debt cost is likely to increase…

 H2: Periods of stock overvaluation are likely to decrease…

…which may lead to an increase in the focus

 H3: The share of short term investors is likely to decrease…
of firms in organic growth strategies to the
detriment of highly acquisitive strategies
 H4: The long term executive incentives are likely to
increase…

 H5: The shareholder risk aversion is likely to increase…

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 We started the research by empirically evaluating whether the independent variables
had been somehow historically related to the intensity of acquisitive growth
Variable/ Interest PER Investor Compensation Investor
Year Rates structure structure Confidence Notes:
1981 13,9 8,07 0,90
1982 13 10,17 0,89  The Cost of Debt is analyzed through the government bond
1983 11,1 12,41 0,87 yields on the secondary markets with maturities of close to 10
1984 12,5 9,93 0,87
years (Source: UNECE Statistical Division Database - compiled
1985 10,6 13,48 0,86

1986 7,7 16,78 0,82 from EUROSTAT, IMF, OECD official sources.
1987 8,4 15,41 0,81
1988 8,9 12,20 0,81  The PER is the indicator of overvaluation of the S&P 500 index
1989 8,5 14,71 0,80 64,00
(Source: Bloomberg data services, 1980-2000).
1990 8,6 15,20 0,81 51,71
1991 7,9 21,83 0,81 78,44  The Investor Structure is calculated as the ratio of the
1992 7,0 24,04 0,78 63,7 72,65
private pension funds, the government pension funds and the
1993 5,9 23,53 0,74 108,5 57,30
1994 7,1 16,98 0,71 96,7 66,11 insurance firms to the total value of mutual funds´ holdings in
1995 6,6 17,42 0,69 94,1 70,10 the US equity market (Source: The Flow of Funds Accounts of
1996 6,4 20,70 0,64 145,2 67,58
the United States, 1980-2008)
1997 6,4 24,51 0,61 143,2 67,25
1998 5,3 32,15 0,60 26,0 69,82
 The Executive Compensation Structure is the ratio of the
1999 5,6 32,57 0,56 38,7 59,54
2000 6,0 25,38 0,56 85,0 65,45
restricted stock options and long term incentives to the value of
2001 5,0 25,97 0,58 30,8 78,24 stock options, salary and bonus in the US (Source: Compustat
2002 4,6 19,12 0,61 28,2 81,53
database of the Wharton Research Data Services, 1992-2008)
2003 4,0 20,53 0,59 32,6 87,79

2004 4,3 17,92 0,57 23,9 78,43  The Investor Confidence (as to “risk aversion”) is studied
2005 4,3 18,28 0,56 19,8 77,52
2006 4,8 16,18 0,55 30,5 82,56
using the investor confidence index published (Source: State
2007 4,6 17,79 0,54 24,5 77,73 Street Investor confidence index, 1992-2008)
2008 3,7 13,81 0,54 10,1 80,60

* This is a study at a macro economic level. The lack of micro level data did not allow a firm level study
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 In fact, we confirmed that all variables were significantly related to the acquisitive
activity, even when controlled by the S&P 500 growth and GDP growth variables

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 As summary, the first half of the research finds evidence on the positive relation the
hypothesized factors have in explaining the acquisitive activity

The strength of the research conclusions has some limitations:

 The data availability allowed only for a macro level analysis – a micro level analysis should be in the future researched if one wants to
evaluate more in depth the relations found
 The data available allowed only for a 28 year sample period. Due to the small sample of data ( N=28), there were issues with
multicollinearity

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 The second part of the research involved a survey of 107 top global executives that
estimated the impact that the Crisis could have in their firms' growth strategies
Geography

TARGETED SAMPLE

 Large corporations (>1000 employees)

 Key executives: CEO, Vice-President, Executive

Position in the company
Director, Senior Director, Head of M&A

 Key functions targeted: Exec. Board level,

Business Development, Strategic management

13% response rate – 107 respondents

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 In the first survey question, we asked which were the “non strategic” factors most
likely to impact the preference of firms toward different growth strategies

The importance of the hypothesized “non-strategic” factors in the planning of growth

strategies (organic vs. acquisitive growth strategies) :

The pressures that firms face from external environments (e.g. capital markets) can be
confirmed as highly important in the definition of corporate growth strategies

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 The second step was to understand how could the Crisis impact each of the
variables studied

The expected long term impact of the Crisis on the following variables:

There seems to be little doubt that the executive long term incentives, the shareholders
risk aversion and the cost of debt financing are likely to increase in the future

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 However, the hypotheses of lower future periods of stock overvaluation and of lower
short term minded investor structures were rejected by the surveyed executives

The expected long term impact of the crisis in the following variables:

Not clear whether the periods of stock overvaluation and the short term minded investor
structure are likely to decrease. Against what was expected, executives believe capital
market market short term pressures may increase in the future.

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 After this, building upon the importance and the expected changes of each
variable, we asked how the compound effect was likely to be…

The impact of the crisis in the preference toward M&A growth (per factor):

The cost of debt, the shareholder´s risk aversion and the executive long term incentives illustrate
the lower expected preference of executives toward M&A growth in a long term post crisis period

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 …and we observed that the preference toward long term acquisitive growth
strategies seems to be lower than it was before the crisis*

The impact of the crisis in the preference toward M&A growth, per factor:

Confirmation that the cost of debt and the executive long term incentives seem to be responsible
to impact the decrease in preference towards acquisitive corporate growth strategies**

•Indexed to 50% (the level of acquisitive growth before the financial crisis)
14-01-10 ** The conclusions are proved in the writen document David R. Valente 18
 In overall terms, executives expect an increase of 10% in the number of firms
highly focusing in organic growth strategies…

The long term impact of the crisis in the preference toward growth strategies:

We can see already an increase in the number of firms that are likely to increase their focus in
organic growth strategies.

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 …as well as an increase in the strategic acquisitions, which are likely to somehow
replace the financially leveraged acquisitions that were usual before the crisis

“Before, large corporations tend to demonstrate growth through acquisitions, often to 'avoid' the need to re-think organic
growth challenges (sales approach, cost structures...). In the future, if executive incentives become more moderate, the
pressure for dramatic growth may be off, and there should be a renewed focus on the internal challenges and organic
growth (for the better of the corporate mission, I would say). That is also because M&A has too often been focused on
inflating growth - without tackling internal challenges first. I believe that this is due to the fact many top executives are
not "in there" for the long run, and have incentives to show short-medium term results. With more moderate incentives,
there should be more focus on long-term health, as corporate executives may stay on longer.” (Senior Executive, France,
IT)

“Higher financing costs will reduce the incentive to invest in acquisitive growth simply for the sake of achieving higher
top-line numbers. The impact of the economic crises will also increase the incentive to leverage organic growth via
strategic acquisitions.” (US, Head of M&A, Industrial Manufacturing)

“The FGC had made us look at our growth targets with more strategic intent. We have made considerable
changes to our business and revenue model, and we put a greater importance on executive time and the
types of relationships and partnerships they should form. Interesting for our industry (accounting) we are
exploring a new acquisition model to pay a premium over a three year period, by financing the acquisition
through an outsourcing fixed gross margin and debtors collection” (Senior Executive, US, FMCG)

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 We find indeed that the cost of debt, the executive compensation and the
shareholder risk aversion are likely to reduce the preference toward acquisitions*

•Preference for acquisitions in the long term, period of sustainable growth after the economy passes the crisis environment
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and company valuations return to normal levels David R. Valente 21
 In order to take advantage of such expectations, we developed 4 micro level
recommendations to help strategic change to become a reality
Although not new recommendations, we believe they make particular sense in the moment of change we are living in…

1 Give up inflated growth

Martynova & Renneboog (2008) have concluded that firms acquiring at later stages of a takeover wave trigger lower
gains to shareholders than do acquisitions in normal environments. It is also prooven that organic growth takes time
but can be more sustainable. In the trend of change we present, it becomes easier for an individual firm to change.
Now is the time to focus attention on the innovation pipeline. Stakeholders may better reward it in the future.

2 Build a long term minded investor structure

Investors need to give stability to firm decisions. If a firm decides to move into a lower acquisitive growth strategy,
better be that its investors support it. In the other side, shareholders and boards need to be there also to establish
the right incentives for executive members. The described strategic change needs back-up from long term investors

3 Build a long term scheme of executive compensation

A new trend is expected already when it comes to executive compensation. It is easier to increase long term
managerial compensation in such a trend than it was before the crisis. If firms want to commit to long term value
creation, they need to start using intensivelly tools as restricted stock options, mandate bonus, etc.

4 Communicate a vision of change to the market

Aghion (2008) confirms that “firms’ strategies must drive the market’s valuation model, not the other way around”.
It is perfectly rational for investors to pay more attention to a firm’s internal growth numbers if they know
management is devoting most of its effort to it. A firm choosing to give up intense acquisitive activity is in the right
time to do it. Communicating such a vision to investors needs to be a key action to change the old benchmarks.

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 In conclusion, environmental business systems change may create new ways in which
financial analysts evaluate firms, creating new sets of incentives for firms´ behaviour
Two major findings in this project are of critical relevance for the management academy:
1.External and internal environmental systems as the case of capital markets functioning do impact the firms´ decision
between different growth strategies;
2.Business environmental change can bring disruptive incentives and new benchmarks for firms to engage in different
corporate growth strategies philosophies with a controlled hazard* in the relation with financial resource owners requests.

Ben
chm Acquisitive
Cost of debt ar king
indi growth
cato
rs

System
Compensation pressures on Accepted managerial practice Corporate
structure Growth Strategies
executive
decision-making
tors
dica
Investor risk tio n in
a
aversion m valu Organic
Fi r Growth

Firms who understand markets changing dynamics can be expected to move earlier out of the old highly
acquisitive and short term world and get into a new paradigm of managing for the long run…

•Controlled hazard takes into consideration that no strategic change can completely disrupt the capital markets thinking
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due to the theory of financial resource dependence we exposed before for public firms. David R. Valente 23
 Thank you for your interest in this study!

If you are interested in reading the full text version or in any other
information on the project, please contact me at the following address:

davidrvalente@gmail.com

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