1. Opinion
Investing in R&D and M&A Is Not an
Either/Or Proposition
May 16, 2016 in Agenda – A Financial Times Service
Roy Dunbar
Roy Dunbar is a director at Humana and Lexmark and has served on the boards of EDS and iGate.
Deciding between investing in research and development (R&D) or mergers and acquisitions (M&A) is
not a matter of choosing one over another, but rather how much is allocated to each.
The critical first step that boards should adopt annually to determine how to allocate resources is to
develop a new or refreshed comprehensive strategic plan that has at least a three-to-five-year view.
This plan should include a scenario framework, which is designed to examine alternative world
views. Shell pioneered this approach in examining long-term oil and gas prices while critically looking
well beyond just the enterprise and the industry to incorporate global macroeconomic outlooks. The
plan should also require critical examination of the assumptions behind the most probable outcome
and those for the best and worst case scenarios. The board should then enter into critical dialogue with
management and any external advisors to understand risks inherent in the strategy and the financial
plan.
During the dialogue, board members need to be mindful of inadvertent incentives that can create
management bias. For example, management may be incentivized toward acquisitions, revenue
growth, etc., as a feature of their compensation.
Boards also require timely knowledge from advisors, but they too may have inadvertent incentives,
such as making more money when there is a deal to be done. Even when their advice is unbiased and
excellent, the issue of success of R&D or M&A investments is always looming. Boards must be sure
there are adequate metrics and fast feedback indicating executional and operational success or not.
The board should also consider macroeconomic risks, including monetary policies of major central
banks in making global decisions.
The outcome of this dialogue and the most probable financial plan will then inform the decision on
deployment of free cash flow — the amount allocated to R&D, M&A, joint ventures (JV), investments in
new segments, and distributions to the shareholders in the form of dividends and share buy-backs.
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Still, these investments carry risks. For example, the coal industry acquisition
of MacArthur by Peabody Energy in 2011 was made when the outlook for coal appeared good, yet
Peabody filed for Chapter 11 bankruptcy on April 13th, 2016, amid reports of “unprecedented
challenges.” Board members do not have crystal balls nor is second-guessing the intent here, but it’s
important to think about the strategic process leading to these decisions on R&D and M&A.
Peabody is not alone in experiencing “unprecedented challenges.” Many U.S. companies have
struggled with shifts in the global environment such as economic slowdowns in Europe and China.
Having the foresight of these macroeconomic factors may have led to more R&D investments in the
U.S. or in other major economies — which may not have been greatly harmed, and possibly could
have benefited from that environment. However, it is important to remember that R&D may be slower
to produce a return than an M&A investment. When analyzing M&A, boards should also note that
investing in adjacencies and in new segments is typically a much greater risk than investing in M&A
within the company’s core business.
In adjacencies, even in the same business, great care must be taken. For example, the Affordable
Care Act has seen many insurance companies enter the health exchanges with offers to the formerly
uninsured. A lack of understanding of how these new members would consume health care services
has seen some of the companies that entered this segment suffer big losses and exit as quickly as
possible.

2. Joint ventures, which typically have poor outcomes due to a tendency for the strategic objectives of the
participants to diverge over time, when formed around R&D and with a potential future acquisition of
the partner in mind, can work very well and effectively provide both companies important options.
No matter which route they choose, boards need to be sure they have a good strategic planning
process along with a summary risk matrix which includes both R&D and M&A risk and return, as well
as looking at other alternatives for investment. They also need to understand that risks are typically
lower in investments in core businesses where cost synergies should drive value, and that adjacencies
can be surprisingly perilous.