Smart Due Diligence: Beating the Odds in Mergers & Acquisitions*
By Marc Knez who can be contacted at Sibson Consulting at www.imakenews.com/sibson/index000037264.cfm
There is widespread belief that the acquisition craze of the late '90s represents corporate strategies run amok. The "when in doubt, buy" mentality, couched under the guise of a grand vision of multi-business synergies (e.g. AOL-Time Warner), will face significant scrutiny by the markets. While such scrutiny may be an overreaction to some high-profile acquisition failures, study after study continues to find that acquisitions are as likely to fail as they are to succeed in terms of shareholder value.
The bottom line is that acquisitions are extremely risky. In most circumstances, the entire purchase price is paid up front, exposing existing shareholders to considerable downside risk if management is not able to generate the value required to support the purchase price. This reality shouts out for a comprehensive risk analysis prior to making the acquisition decision. Such analysis ranges from culture audits aimed at determining whether there is sufficient fit between the organizational cultures of the two companies, to more rigorous financial analyses aimed at quantifying the potential synergies underlying the acquisition. Unfortunately, the acquisition process does not always lend itself to these types of analyses. Between the confidential nature of the interactions and scarcity of time, the acquirer's attention is confined to financial due-diligence and some high-level strategy considerations. It doesn't help that the primary advisors in this context - the investment bankers, have little incentive to slow the process down by advising that their clients conduct a more comprehensive risk analysis. Given the limited information that is gathered and analyzed, it's not surprising that so many acquisitions turn out to be disappointments.
Of course, stockholders who are about to take on a significant amount of risk would prefer that management finds a way to do this analysis before committing to the deal. Here lies the fundamental issue: Given the information and knowledge possessed relatively early in the deal process, the acquirer needs to determine whether a more intensive due diligence process is warranted. Put differently, an intensive due diligence process is a risky investment, slowing down the deal and thus putting it in jeopardy. The potential return is insuring that the deal is worth doing. The acquirer must decide if this risky investment is warranted.
2. Smarter due diligence
One of the most common mistakes that decision-makers make is not leveraging the information and knowledge they have at the time they make a decision, resulting in the lament "We should have known this might happen." And while hindsight is 20-20, foresight makes all the difference. To improve their foresight, acquirers need to ask themselves the following question relatively early in the deal process:
Given the prevailing logic of the acquisition under consideration, and the information and knowledge that exists (or can be quickly obtained) early in the process, what are the significant risks to the success of the acquisition?
A due diligence process that answers this question is smart in that decision-makers are leveraging the information and knowledge to which they have access. Moreover, by answering this question the acquirer can determine whether a more comprehensive due diligence is warranted.
The remainder of this article introduces a framework that helps acquirers engage in smart due diligence. The framework is designed to force the acquirer to answer a series of questions that reveal critical information relevant to evaluating acquisition risk. Perhaps most notable is identifying human capital risk. In most circumstances, except for the most senior leadership of the target company, acquisition risks related to people are lumped into the broader culture category and left to the post-merger integration experts. This common practice represents a false belief that such risks can be easily mitigated once the deal is done and "these people" join "our" organization. The reality is that except for external market conditions, the most difficult risk to mitigate is the potential loss of critical talent on both sides of the prospective acquisition.
3. Smart Due Diligence—Four Steps
A. Clarify the Acquisition logic
The acquisition logic provides the answer to the following question: How will combining these two organizations create a level of economic value that is significantly greater than their combined stand-alone values? At the most basic level, the acquisition logic will be either scale-based or scope-based. Scale-based acquisitions seek to leverage economies through increases in the scale of a common line of business - doing more of the same activity. Acquisitions within consolidating industries are the traditional example of scale-based acquisition logic.
Scope-based acquisitions are aimed at leveraging economies through the spread of common resources across related but distinct activities. For example, consider Lehman Brothers' recent acquisition of Neuberger Berman, an asset management company catering to affluent and institutional investors. Lehman is hoping to gain access to Neuberger's network of wealthy clients, while Neuberger benefits from having access to Lehman's vast international client base. Hence, a critical scope economy is the complementary customer bases of the two firms. In most large M&A transactions, both scale-based and scope-based economies are at play.
B. Identify high-impact operating activities
Once the acquisition logic is clarified, the acquirer should be able to identify the high-impact activities within the prospective operating model of the merger entity. Broadly defined, a company's operating model is a combination of how it organizes its core business processes and manages the resources required to support those processes. Figure 1 describes the impact of alternative acquisition logics on the prospective operating model of the merged entity.
On one extreme the acquired company remains a stand-alone and relatively autonomous business unit; on the other, the acquired company is completely absorbed in the acquiring company's existing organizational structure. Under highly scale-based acquisitions, a high degree of absorption is typically required. Alternatively, if the acquisition is more scope-based, only partial integration will be required and the operating structure of the acquired company will be left partially or almost completely intact. Given the long list of ingredients to an operating model, it's unrealistic for the acquirer to fully define it before the deal is closed. In fact, much of the post-merger integration process is about designing and implementing a new operating model.
From a smart due diligence perspective, only the high-impact operating activities within the prospective operating model need to be identified. These are the activities that require the greatest coordination and integration to generate the sought-after scale and scope economies of the acquisition. In the case of Lehman's acquisition of Neuberger, the formal coordination of the respective sales activities of the two companies is one of the high-impact operating activities underlying the success of the acquisition.
C. Identify Integration Risk Factors
Given a basic understanding of the post-acquisition organizational form and the high-impact operating activities, the acquirer can identify the factors that will impede performance. These risk factors are all created by the need for change. Changes tend to come in two forms - required changes in the underlying business processes and changes in the way decision rights of employees participating in these processes are allocated. Characterizing all of these changes requires identifying the details of the prospective operating model to a degree that is not consistent with smart due diligence.
Instead, the acquirer should draw upon its basic understanding of prospective changes in the operating model to identify two basic types of integration risk factors. First, there are factors that represent employee behaviors that impede successful integration. Second, there are factors that may lead to the turnover of critical talent. To be sure, there are other important risk factors that are less employee-driven, such as the difficulties in integrating distinct IT platforms. However, while these operational risks may require more attention, employee-driven risks are much more difficult to control and mitigate.
# Behavioral risk factors
Behavioral risks reside at two levels: Senior management responsible for each of the organizational activities, and more generally, critical talent within both organizations who have the greatest affect on high-impact activities. There are four fundamental behaviors that create the greatest risk within a partially integrated operating model:
>> Unwillingness to share tangible resources
>> Unwillingness to share information and knowledge
>> Unwillingness to adjust organizational processes
>> Unwillingness to allocate time and energy to critical integration activities
All four of these behaviors represent a general resistance to changes required under the prospective operating model. The acquisition logic will determine the degree to which a particular type of resistance generates significant performance risk.
The merging of sales activities is one of the most common and visible areas where resistance should be anticipated. This typically arises in the context of introducing a team-based sales model, where sales people from the merged companies are expected to coordinate their sales and account management to sell a broader portfolio of products. Standard industry examples include consumer goods, pharmaceutical and financial services.
For instance, consider an acquisition in any professional or financial services context that is predicated upon the cross selling of products and services across the two organizations' distinct clientele. Most successful cross selling in financial services requires formal mechanisms along the following lines. Relationship managers in each of the merged companies are expected to identify high-potential customers for cross selling and engage in fact-finding with these customers to assess sales potential. Customers judged as high potential are referred to a sales rep of the "sister" division. If actual sales follow, the original relationship manager receives some form of financial reward.
Unfortunately, the financial reward is typically not sufficient to overcome the perceived costs of engaging in the cross selling. Not only is the relationship manager expected to re-allocate a significant amount of her time away from the primary selling activity, she is expected to relinquish control over her most critical resource -client relationships. A successful relationship manager often views this type of cross-selling as very risky. Client relationships represent long-term investments that she needs to exercise some degree of control over to generate a sufficient return. The appearance of attempting to sell alternative products and services potentially tarnishes her existing "advisory relationship" with the client. Moreover, if clients do not receive high quality service from the sister division, the relationship manager's long-standing relationships could be at risk. Hence, despite the strategic rationale of sharing client relationships, relationship managers on both sides of the acquisition often will have a significant incentive to resist cross-selling.
Note that the question is not whether some level of employee resistance will takes place, but how severe will the resistance be? As in the cross-selling example, the acquirer should anticipate significant resistance when employees are expected to change the way they perform their jobs and/or are expected to relinquish control over resources they believe to be critical to their individual performance. In the extreme, this resistance leads to turnover, which is the second category of risk factors.
# Turnover risk factors
In Lehman Brothers $2.63 billion acquisition of Neuberger Berman, $120 million was set aside as a retention pool for key Neuberger employees. This huge sum reflects the significant turnover risk that exists in acquisitions, especially in human capital-intensive industries such as financial services. Viewing the employment relationship with this critical talent as a long-term exchange relationship between a buyer (employer) and seller (employee) is an effective way to assess the degree of this turnover risk. In the pre-acquisition environment, the existing benefits of the exchange are sufficiently high to prevent either party in the relationship from exercising their alternative options-that is, the employee will not seek employment elsewhere and the employer will not fire the employee. From the employee's perspective, the exchange relationship includes benefits outside of pure monetary exchange, such as affiliation to the organization and the quality of the work environment. These non-monetary factors are often associated with a long-term employment relationship and in many cases are as important, or more important than the monetary rewards. This more complete set of benefits has become known as the employee value proposition (EVP).
If the success of the acquisition requires a significant change in important features of the EVP, then the employee has an incentive to reconsider his or her employment options. Most notable here are the non-monetary factors that are greatly diminished in the context of an acquisition. In the extreme, from the perspective of the critical talent of the acquired firm, the acquiring firm is on a level playing field with all potential alternative employers. The "clock" on the employment relationship has been reset to zero. Note that this reality does not go unnoticed by the competition. Consider the recent acquisition of Insignia Financial Group by CB Richard Ellis, creating the largest commercial real-estate brokerage company. Richard White, president of CB Richard Ellis stated "Our competitors have created a 2003 business plan for this year, which was 'Go steal CB Richard Ellis employees,' and they failed, and it's not for want of trying."1
The acquirer needs to assess the degree to which the prospective EVP will be sufficiently attractive to the critical talent to prevent significant turnover. Note that beyond the senior leadership of the target company, the focus is not on incremental turnover, which is inevitable. The focus is on the potential for a "turnover tipping point," where dissatisfaction with the new EVP accompanied by the departures of the senior leadership, leads to the turnover of a large group of critical talent. For example, in G.E.'s prospective acquisition of Vivendi Universal SA's entertainment assets, receiving buy-in from Universal Pictures chairman, Stacey Snider, is critical. However, the greatest risk is losing the entire executive team (and their direct reports), whose recent success has been attributed in part to their resistance to traditional, autocratic approaches to management.
4.Perform Integration Risk Assessment
The final step in the risk analysis is to assess the degree to which the identified risk factors are sufficiently severe to warrant a more comprehensive due-diligence exercise. This is determined by answering the following question:
With respect to the critical operating activities and the performance objectives associated with those activities, what is the potential magnitude and likelihood of bad outcomes created by the identified risk factors?
The answer to this question is more of a conceptual judgment than an analytical calculation. One way to be more rigorous in this judgment process is to use the risk factors to construct a reasonably plausible low-performance scenario, and then judge the likelihood of this scenario occurring. Note that while the low-performance scenario may appear to be a worse case scenario, it is not unlikely. Not only do cross-selling initiatives often end up as considerable disappointments, they can be the direct cause of considerable employee turnover.
Translating the risk factors into actual low-performance scenarios can be a powerful way of raising the importance of integration risks within the high-level strategic and financial discussions that tend to dominate the pre-deal process. First, it forces the acquirer to articulate how value will be created, or not created, by the acquisition. Second, traditional sensitivity analysis conducted on the valuation of the target tends to be a mechanical exercise in which various value drivers (e.g. sales) are adjusted up or down by some small percentage. Generating an explicit low-performance scenario that has clearly stated and plausible performance outcomes will provide a much more robust sensitivity analysis. Finally, it allows the senior leadership to answer the following question: "Why might this acquisition fail and how are you going to prevent that from happening?"
This acquisition risk analysis framework is designed to enable the leaders of the acquiring firm to assess the major integration risk they face prior to making the decision to invest in a comprehensive due diligence process. First, it requires understanding the prospective operating model and the critical operating activities that will be the primary source of the value creation. The next step is to identify the primary organizational and human capital risk factors that will impede the performance of these critical operating activities. Perhaps the most distinctive element of the smart due diligence framework is the emphasis on human capital risk. In most deal situations, only the risks surrounding the most senior leadership are considered. As many acquirers have found, this can be a profound mistake. A basic understanding of the prospective operating model should allow the acquirer to recognize significant human capital risks, and hence, avoid making this mistake.
* Reprinted by permission of Sibson Consulting