Manufacturing Trends: Vertical Integration

Consolidation through Mergers & Acquisitions (M&A) is commonplace in most mature industries and allows companies to increase their market share through acquisitions in the same business segment, whilst benefiting from synergy effects within product development and marketing. Traditionally, established industry players have been the main drivers of market-defining M&A activity. More recently, private equity firms with significant capital reserves have ramped up investment in the manufacturing industry, partnering private capital with proven management teams. Their aim is often to acquire and restructure small to medium-sized companies in turnaround situations and resell them for a profit.

The pandemic and subsequent component shortages as well as rising geopolitical tensions in zones that are critical for global manufacturing supply chains have forced manufacturers to reconsider their sourcing, production, and distribution strategies. One route being increasingly explored by companies is that of vertical integration, which entails taking greater direct ownership of hitherto outsourced upstream or downstream operations, either by creating internal expertise or via acquisitions.

In certain cases, vertical integration implies building in-house capabilities from scratch of products and processes that were previously not considered part of core company competencies. Prime examples include multiple European and American automakers that have started pursuing dedicated EV battery know-how, especially at the cell level, to reduce their dependency on a handful of suppliers concentrated in the Asia-Pacific region.

Another area where vertical integration is gathering momentum is the semiconductor industry. The recently introduced EUR 43 billion European Chips Act and USD 52 billion US CHIPS Act aim to increase domestic semiconductor production in these regions to bolster competitiveness and resilience. After opening their new EUR 1 billion chip plant in 2021, Bosch have pledged a further EUR 3 billion investment in chip production by 2026.

Automotive OEMs General Motors, Tesla and Hyundai have announced plans to develop and produce their own chips, while technology giants Apple and Google are already equipping their devices with self-developed M1 and Tensor chips respectively. However, the high costs associated with erecting modern-day chip factories means that this avenue is accessible only to a select few cash-rich corporations.

Establishing new technological and fabrication capabilities from the ground up poses a multitude of financial, logistical, and talent-centric challenges. Hence, several players within the semiconductor space have instead relied on acquisitions to expand their upstream or downstream portfolio. For instance, Intel completed its takeover of specialty chip foundry Tower Semiconductor for USD 5.4 billion in early 2022. This deal underscores Intel's end-to-end foundry ambitions, which were kickstarted with the founding of Intel Foundry Services in 2021. In an example of cross-industry integration, Qualcomm incorporated Veoneer's Driver Assistance sensor and software assets as part of a USD 4.5 billion acquisition of the Swedish automotive supplier in Q2 2022.

A wave of upstream vertical integration activity has also been observed recently in the steel industry, driven by pandemic induced supply constraints, and diminishing margins. Luxembourg-based steelmaker ArcelorMittal has tried to secure long-term supply by acquiring a metals recycling company in Scotland and numerous scrap yards in Germany in 2022. Cleveland-Cliffs, North America's largest flat‑rolled steel company, following their acquisitions of AK Steel and ArcelorMittal USA, entered the steel scrap segment in 2021 after purchasing a prime ferrous scrap processor for around USD 775 million. The push for decarbonization in steelmaking has increased demand for high-quality, low-residual scrap. As per some estimates, around half of the top 10 largest North American ferrous scrap processors are now controlled by steel mills.

Mergers and acquisitions inherently entail substantial organizational change that can potentially disbalance and disrupt many of the underlying business processes. The transition period carries with it numerous uncertainties and should be comprehensively planned, whilst being kept as short as possible. Complications arising from mismanaged integration efforts can have adverse effects from a liability risk perspective too.

Major differences in the respective corporate cultures of involved companies may cause cultural clashes as well as territorial disputes preventing a smooth transition and negatively impacting worker morale. Insufficient application of necessary health and safety protocols can result in higher accident rates, which in combination with increased visitor frequency during the acquisition phase may lead to a rise in employers' liability and general liability claims.

Moreover, significant systemic and operational discrepancies can complicate the harmonization process, leading to inadequate product and process due diligence as well as efficiency losses. Misaligned and underdeveloped quality control procedures increase the risk of higher product defect rates and subsequent product liability and recall claims.

Risk accumulation resulting from backwards integration impacts the avenue of recourse actions against suppliers in case of product failure. Adding new unknown suppliers and vendors into existing pools poses further challenges, since previous supplier selection and vendor onboarding may not have been performed thoroughly.

This article is an excerpt from the Manufacturing Industry Trends – Casualty Risk Landscape report.