Acquisition strategies remain relevant even in this economic climate: the average large company gets 33% of its revenue growth from merger and acquisitions (M&A). But it's not enough to simply spot a well performing company and snap it up; Sven Smit from McKinsey & Company, co-author of the recent book "The Granularity of Growth" explains how you shouldn't be asking "is M&A good or bad?" but rather "how good am I at M&A?".

Most studies don't really answer the question of whether M&A creates value. Admittedly, it's a difficult question to answer. The studies that stand up to the closest academic scrutiny measure 'announcement effects': statistically significant stock-price moves in a narrow trading window around the time of a deal announcement. The idea is that the deal is probably the most important fact on investors' minds during this period, so that any stock-price fluctuations are likely to be influenced by their reactions to it.

The problem with this approach is that the only information that investors have to go on when a deal is announced is the price and the identity and nature of the participants. Though this is important, it is far from the whole story. The most important factor, the outcome of the transaction, cannot be known in the announcement window; it will depend on the subsequent integration and performance of the businesses involved. While M&A has its failures as well as successes, without reliable data, the costs of M&A are often overestimated, which explains the caution of some executives.

Leaders do more M&A than you realise

The growth decomposition database developed for 'The Granularity of Growth' shows that the average large company gets 33% of its growth – 3.1 percentage points a year – from M&A. For a $35bn company, that's nearly $1bn in acquired revenue each year. It is also important to note that this contribution to growth is net M&A, taking into account divestments done over the time period. Moreover, a review of the growth strategies pursued by large companies suggests that companies that aggressively leverage acquisitions have been at least as successful as those that grow organically.

Simply engaging in M&A is not enough, what is important is using it successfully as part of a growth strategy.

How growth companies use M&A

So how can companies use M&A to grow? One important factor to consider is scale - should companies favour large or small deals? While both have their role, large deals are more often found in industry consolidations and divestitures and smaller deals in platform building and scope expansion. On average in large companies 3% of revenues per annum come through M&A. While 3% every year represents real flow, for a £10bn company it is only £300m per annum – not exactly a megadeal.

For 'The Granularity of Growth', we identified three broad strategies used by successful growers during the 1990s:

The platform-builders were particularly interesting in the way they created an advantage. Over 90% of them used acquisitions in support of their growth strategies, with 75% engaging in more than three acquisitions a year. These companies typically patched together multiple small deals to build their growth platforms, assembling basic capabilities and then going for scale.

The average new platform builder made 65 deals over a ten-year period, 58 of which were small (less than 1% of the acquirer's market cap). Also noteworthy was the role that large acquisitions played. The average size of the largest acquisition made by a platform builder was 17% of their market cap; for the high-growth low-TRS (total return to shareholders) companies, it was much larger, at 40%. But there is one type of company that has turned the making of acquisitions into a fine art: private equity firms.

Lessons from private equity firms

In recent years, private equity has become much more important: almost 30% of buy-outs now go to these companies. Private equity companies have a distinctive approach to M&A, selling almost as quickly as they buy. This gives them a unique set of advantages and there is much that corporations can learn from this approach. We have found that private equity firms are now regularly outpacing corporations in the incentive structures they offer, giving them a clear edge in attracting and motivating talent.

Long-term focus, not incrementalism

Managers often complain about the market's relentless pressure to improve earnings quarter by quarter. They have a point: if you take historical data for margins, revenue cash flows, or any other measure of performance you care to examine, there is hardly any performance pattern that is consistent quarter after quarter. In fact, there is barely any difference between volatile patterns and more stable ones in terms of TRS. One reason why managers are so nervous about quarter-by-quarter performance is that companies that issue quarterly earnings guidance find markets swift to punish them if they miss their pre-announced targets. They issue the guidance despite this risk because they believe that the increased transparency will reduce the volatility of their stock price and/or increase their earnings multiple. However, a recent study which looked at 4,000 publicly traded companies from 1994 to 2004 found no difference in valuation multiples or volatility between companies that issued quarterly guidance and those that did not.

Granular investment insight

The advantages enjoyed by private equity firms start from the way they gather the information they need for M&A. Conventional wisdom has it that markets are perfect and that all available information is traded upon, yet in reality the texture of the market is far more granular than the information available in the wider market. Though the market is quick to act on information released in a company's quarterly and annual updates, these updates can never do justice to the detail and complexity of the company's performance. Moreover, updates never look more than a couple of years ahead, whereas the company will often plan and invest on a much longer time-horizon.

Private equity firms are not restricted to this kind of information. Because they have access to data rooms and management interviews when conducting due diligence they are able to obtain information that is far more granular than that available to public company investors.

Attention to the assets

Because investment insight is so important, the amount of attention you give to an asset matters a lot, particularly when you are trying to understand how it performs at a granular level. Private capital, including family capital, often has an advantage in the time and attention it gives to its assets. A typical private equity partner devotes most of their time to purchased assets and the rest to buying additional ones. Compare this with the practices of a typical board director and it looks like an awful lot of time, especially since the average private equity partner has no more assets to look after than the average director, who may attend only six to ten board meetings a year. In addition, private capital usually draws on extensive analytical and other kinds of support.

Sven Smit is a director in McKinsey & Company's Amsterdam office. He is co-author of 'The Granularity of Growth: Making choices that drive enduring company performance'(with Patrick Viguerie and Mehrdad Baghai) published by Marshall Cavendish and Cyan Books.