By Adriano Allegrini
Mergers and acquisitions are central to most companies’ growth agendas. And while a sub-par acquisition will still deliver growth, it will likely not be profitable growth: more than 50% (Forbes) and up to 90% (HBR) of all mergers and acquisitions fail to perform as planned. This either destroys value or yields less value than originally planned.
All mergers and acquisitions are formally or informally priced based on a set of assumptions: revenue growth, margins, etc., usually codified into a 5-year P&L acquisition model, and measured by either Internal Rate of Return or Net Present Value. When a transaction fails to generate its expected value, it points to the possibility management (and the Board) has made the wrong decision. At some point during the M&A process this project was chosen over other capital allocation options based on the set of assumptions that has just been proven wrong.
The reasons why so many M&A deals fail to achieve their profitable growth potential can be divided in 3 recognizable groups:
1 – Target Specific Reasons: “Now we need to grow into the valuation.”
Either the acquired company failed to grow as planned or did not achieve the expected margins. These can be driven by reasons such as:
- Competitors take advantage of the disruption created by the transaction to capture clients / market share
- Acquiring company ends up generating additional financial burden through “big company programs” that can be onerous to the P&L of the target (sometimes called “reverse synergies”).
- Too little investment in the months leading to the transaction, creating a dry pipeline. This is relatively common and difficult to fully capture in due diligence.
- Talent: either the management team is weak or will not adapt to working under the culture of the acquirer. Not hiring or slow hiring for key positions is also common.
- Management distraction: slow new product / client development, some managers disengage due to “life-changing” bonuses and cultural shock
- Integration leadership often is assigned to the person who leads the deal. While this may make sense in theory as “they know the deal and the players best”, corporate development or the CFO usually lack the operational knowledge to conduct an effective integration without losing track of their core responsibilities. Smart companies create integration teams and dedicate someone with an operations background to lead them.
2 – Segment or Secular Reasons: “We did not see this one coming.”
Sometimes the growth shortfall is driven by external circumstances:
- A major economic event happens: it is rare to see an acquisition model with built-in accommodations for a potential recession. However, recessions happen about once a decade. If the business is cyclical, there is a significant likelihood that a recession will happen during the planning horizon, testing the target’s resiliency. While most advisors would not advocate building a recession into the acquisition model, trying to understand how the target performed during the last recession should be a key part of the diligence effort.
- Some systemic or secular risk comes to play. If one invested in for-profit education or coal mining in 2009-10 it is very likely that the transaction did not perform as planned. This happened regardless of how conservative the acquisition models were, as these sectors underperformed any reasonable projection available at the time.
- The market projection is just too optimistic and the target growth rate starts to decline sooner than predicted, heading to maturity. This is relatively common in high-growth markets, early stage businesses, and developing countries. It is common for these valuations to build in expectations of significant growth for a long period of time. There are plenty of pitch books for $10M operations forecasting to reach $200M in 5-7 years. Some will. Most will not.
3 – Inability to Capture Synergies: “We can’t really cut that, boss.”
Cost synergies are relatively easy to predict, identify and capture at a high level. For these reasons, there are many acquisition models heavily anchored on cost synergies. Unfortunately, achieving goals tracked at a high-level may become much more complicated during the post-merger phase, when new information becomes available and it is necessary to dive into details and implementation plans.
Failure to reach the synergies target tends to happen due to either loss of focus during the integration process or due to shortcomings in the due diligence process: the assumption that the acquirer will be able to eliminate parts of the acquired company structure and execute them centrally at a lower cost may not always be reasonable or feasible.
Also, it is common to see cost synergies captured in the immediate aftermath of the transaction followed by selling or administrative expenses creeping back up in the following years. This highlights the importance of tracking acquisition performance for several years after the acquisition.
On the other hand, revenue synergies are trickier to capture from the very beginning. These are built under assumptions like:
- Accessing the target’s sales channels / customers / resources the acquiring company will be able to sell more of its current portfolio
- Adding the target’s products to the current portfolio will increase its penetration / sales / market share
- Accessing the acquirer’s resources (e.g.: capital, sales force, marketing, R&D) will remove barriers for growth in the acquired organization
- New or unproven products will generate additional revenues
Revenue synergies are usually a contentious area during the negotiation. The acquirer is cautious about its ability to capture them, the target is aggressive in their growth assumptions. On the other hand, revenue synergies are very tempting. The acquirer wants to believe they can be achieved, as they can be source of profitable growth.
This is normally a difficult (or impossible) gap to bridge, making revenue synergies one of the leading reasons why transactions are structured with earn-outs or performance clauses. A performance clause can be described as acquirer and target “agreeing to disagree.”
How can the risk in executing an M&A program be mitigated?
Don’t be daunted! Even with all these risks, M&A tends to be a very important tool in a CEO’s toolkit to deliver on growth expectations, rapidly acquire new capabilities, or penetrate new markets. An approach for mitigating the risks in M&A is to ask yourself questions around three areas: Corporate Strategy, the M&A Process itself, and the Tools and Structure needed to source, negotiate, and integrate an acquisition. These questions will help you diagnose where your organization is regarding M&A readiness and take the corrective actions before a major transaction fails on your watch.
1 – Is the Corporate Strategy well defined and understood?
Corporate strategy must be well understood in multiple fronts:
- Capital: What are the capital allocation priorities? What is the desired capital structure? How much capital is available to invest in M&A (vs. organic growth or direct return to shareholders)?
- Risk Profile: making an honest assessment of the organization’s appetite for risk will help define how far out of the comfort zone you can venture, balance the appetite for small vs. large acquisitions, and if a transformational merger / acquisition should be considered or not.
- Role of M&A: What role M&A plays in your organization? Typical roles include: Life cycle management (need to replace declining products); geographic expansion (need access to new geographies); or diversification (need to diversify into adjacencies due to identified weakness in the core business).
- Talent: Is there an M&A team in place? Are there relationships with external advisors (consultants and bankers)? Do you have the team in place to prospect potential deals and build relationships with owners? Is your team ready to project-manage an acquisition process? Can they handle multiple processes concurrently? Is the investment committee in place and with a clearly-defined charter? Is the team ready to perform a successful integration?
- Culture: Is there a clear understanding of the corporate culture and a good assessment of how the target culture will fit?
2 – Is there a well-defined M&A process?
A well-defined M&A process should include:
- A clearly defined “deal flowchart”: a process with clear “go / no-go” gates where the decisions are incremental and aim to minimize “bad” M&A spend. It is all about aborting processes early, before too much time and too many resources have been invested.
- A clear process to charter, select and deploy diligence teams. These are usually exciting activities but are also added workload, high pressure and tight timelines. Ideally, people selected need to be able to dedicate a good part of their time for the diligence program.
- A process to communicate with multiple workstreams during diligence and integration. The M&A team usually plays a project management role here.
- The knowledge to execute or the resources to outsource initial market scans and target selection
- A process and systems to manage, fill, and refill the deal pipeline
3 – Are there good tools and structure in place?
They simplify decision-making and ensure that the focus on the strategic objectives is never lost
- The initial diligence leads to the initial acquisition model. Usually built with imperfect information, it will lead to the first key gate of the acquisition process, a “go / on-go” decision on pursuing the target: “should we invest the capital and bandwidth to pursue this target further?” Investing the right amount of time, talent, and capital in this phase of the process is critical: too little and you will either pass on good opportunities or worse, spend a lot of time and capital pursuing an acquisition you will give up later in the process.
- A well-established and chartered investment committee is the forum for all key decisions during the M&A process. It needs to meet regularly to discuss ongoing transactions, enabling the team on the front line to move forward in the diligence / negotiation.
- If M&A is an integral part of your corporate strategy, a strong target scoring tool can help focus the discussions in the investment committee. A scoring tool helps steer the investment committee into the data on the target and prevents the conversation from becoming unfocused or emotional.
Just because most mergers and acquisitions don’t deliver on their potential, doesn’t mean that yours shouldn’t. By understanding the three core reasons transactions fail and ensuring that corporate strategy is well-understood, tools and structures are in place and key processes are well-defined, you’ll be well on the road to success.