The acquisition landscape has changed a great deal in recent times. In the 21st century acquisitions are an acceptable part of strategic planning. In fact, a number of companies owe their entire existence to acquisitions. This is especially true with financial buyers such as holding companies. Unfortunately, the ultimate success of most acquisitions isn't sparkling. With less than 30% of acquisitions resulting in real success it's difficult to understand why there is so much activity in this area.
This article will be the first of three-part series that will attempt to provide the reader with some best practice observations that may be useful in improving the eventual outcome of an acquisition.
Based on the experience that my colleagues and I have had with numerous past acquisitions we feel that there are three distinct parts of the merger and acquisition (M&A) process that deserve significant attention by the buyer. Some of these items listed could involve the seller to the extent that legal and other matters allow.
1) Initial concept and planning. The initial concept and planning stage involves identifying your perceived needs to bring about ultimate success with your strategic direction versus what you have in-house as actual core competencies. This includes the evaluation of options to fill in the gaps; development of criteria to move forward; establishing a short list of potential candidates/solutions; and the establishment and preparation of various internal/external teams through training. Essentially, knowing what you need, possible options to satisfy that need (i.e., acquisition, alliance, license, etc.), understanding what your potential solutions might look like (what you will and will not accept as part of your chosen solution), determining who best fits your requirements and making certain that you have adequate resources that are prepared/trained to carry out your objective.
2) Post letter of intent activities. This stage involves continuing negotiations, commencement of formal Phase I and if needed, Phase II due diligence, integration plan preparation, day one plan preparation, communications plan formation, and purchase agreement formation.
3) Post purchase agreement signing activities. This includes "day one" communications with all stakeholders in an acceptable fashion; establishing integration/transition teams comprised of members from both sides; commencing the finalization of the integration plan; performing audits of the entire process; and facilitating institutional learnings.
A LITTLE HISTORY
As with most subjects, it might prove useful to look at a bit of history involving M&A activities. In other words, how did we get to where we are today?
Acquisitions are not a 21st century happening. In antiquity, when a ruler of a land-we call them CEOs today-felt that they needed to expand their kingdom it usually meant that they would pursue an act of war against one of their neighbors in order to make the needed acquisition. Little or no regard was given to the impact of such an action on the inhabitants who occupied that land or the inhabitants of the attacking ruler's land. Usually there was an act of reprisal by the kingdom being invaded. The attacking ruler would spend countless hours plotting with his military leaders looking at various scenarios of attack (negotiating strategy). The acquisition plan was simple: strike first and strike hard (make a preemptive bid); aggressively pursue a breakdown of the enemy's fortifications (take a firm negotiation stance and wear them down); end the conflict quickly and install an interim ruler (don't worry about due diligence, just complete the deal and replace their management structure with ours).
Integration was even simpler. If anyone complained about the new ruler their complaint was dealt with quickly and severely usually with the complainer losing their head (loss of key people).
Unfortunately, these acts of acquisition usually proved costly to both sides. Assets were lost including buildings, people, livestock, crops and trade while large sums of gold and silver were needed to pay the attacking soldiers as well as the defending soldiers (today we call them investment bankers, lawyers, accountants and consultants). This normally meant that the two rulers had to obtain financial support (debt) from other sources which often meant that valuable items (equity) were put up as collateral (the ruler's wife/husband, daughter/son, other things of value, etc.). Should the war prove not winnable by the invading ruler the collateral was lost and often the kingdom as well since the debt could not be repaid. Hence the expression "to the winner goes the spoils of war."
As mentioned, integration was simple. Inhabitants of the losing side either accepted the new ruler or it was "off to the chopping block" so to speak. Often, there were no clear winners in these acquisition efforts. If one of the rulers were to be declared an actual winner, they usually had accumulated an enormous debt and had precious few resources left with which to pay that debt due to their destruction during the war. In addition, they would then have the burden of rebuilding both kingdoms. Somehow, this scenario sounds all too familiar.
Although a bit crude, this concept and process proved effective for many centuries. Unfortunately, if this strategy worked for you, it would also work for another ruler who may be thinking that they needed to expand by acquiring your kingdom. The good news is that we do things a lot different today compared to the example just described-or do we?
Although acquisitions are not new to modern society they only became a viable, sizeable part of most companies strategic planning process in the last half of the 20th century (see Figure 1).
In other words, "What influences the number of M&A deals at any given point in time?"
Regarding the drop off in deals post 1970, if you recall, on October 5, 1973 the Yom Kippur War began following an attack by Syria and Egypt on Israel. When Western countries like the U.S. showed support for Israel, Arab oil exporting nations placed embargos on these nations. The Arab nations cut production by five million barrels a day and despite other nations increasing their production, a net loss of four million barrels a day occurred throughout March of 1974. This action ignited a rapid rise in the cost of energy for several years, which in fact is ongoing to the present day (see Figure 2).
Three years later, the rate of inflation had slowed considerably, with the Consumer Price Index for Urban Consumers (CPI-U) advancing only 3.8% during the year. The success in reducing inflation was largely attributable to monetary policy resulting from actions of the Federal Reserve Board. In October 1979, the Federal Reserve modified its monetary policy by giving greater emphasis to holding the growth of monetary stock within target ranges and allowing interest rates to vary widely. In essence, the Federal Reserve began to target the quantity of money rather than its price. With the supply of money curtailed, interest rates rose sharply. Mortgage rates during this time period were in the mid-teens and the cost of capital for businesses rose beyond the ability of most companies to be able to afford the pursuit of M&A activities.
The reduction in the rate of inflation from 1979 through 1983 was not costless. Two recessions-January 1980 to July 1980 and July 1981 to November 1982-the second a particularly severe one, resulted in double-digit unemployment rates, reduced incomes and a decline in output. The loss of revenue resulted in a sharp increase in the Federal deficit before economic recovery began at the end of 1982.
This had a negative impact on American businesses, especially those businesses pursuing acquisitions. Most companies simply abandoned further acquisition activities. Hence, as shown in Figure 1, the dramatic drop in the number of acquisitions in the 80s versus the early 70s. Even though there were a reasonable number of acquisitions in the 70s, 80s and early 90s for the most part, they were small, "add on" or "Bolt On" types (i.e., simple, low value additions to an existing structure with limited duplication of functions).
This is illustrated more clearly in Figure 3 in terms of the value of the acquisitions during that time period. From the 1960s through the early part of the 1990s most companies shied away from making huge acquisitions. That situation changed in 1996.
Going into 2000 the U.S. government pumped up the money supply in preparation for a Y2K event that never happened. Combined with low-priced labor from China, this increased capital had nowhere to go except the stock market, so rather than seeing price inflation we had "stock inflation." When the market crashed it effectively eliminated massive chunks of excess capital. So we entered the new millennium with much lower levels of inflation than in the 70s and more overseas competition resulting in greater supply. The market crash ushered in a very shallow recession as the government continued to stimulate the economy through lower interest rates. Massive refinancing of high interest home loans for lower interest ones allowed consumers to survive, keep their homes and continue to spend. This is a very different scenario than is present in today's economy.
Just as the 70s began with under-priced oil, an unusual set of circumstances resulted in under-priced oil again in 2000. Supply had steadily increased through the late 90s due to OPEC quota increases and increased production from Russia. By 2001 increased supply met decreased demand for oil because of the Asian recession.
In normal circumstances OPEC would have curtailed supply to keep the price firm. However, it was politically impossible for them to do so because of the events of 9/11, so prices fell drastically and sheltering the U.S. from some of the effects of the stock market crash. In 2002 a strike by Venezuelan oil workers eliminated the excess supply and solved OPEC's problem. This was followed by the war in Iraq, which further reduced supply. Now as the economies of Asia heat up again the demand for oil has increased but supply has not been able to keep up.
In 2002 worldwide excess oil capacity stood at more than six million barrels per day but by 2005 excess capacity had fallen to under one million barrels per day. Combined with the short supply and the increased demand for oil from Asia, especially China, we also have the U.S. government spending unprecedented billions of dollars on hurricane repairs and a war in Iraq. These are all inflationary factors.
We have to remember that inflation is primarily a monetary phenomenon. Increased money supply results in increased inflation. Up until recently the government has been able to export our inflation by selling bonds to foreign governments. Recently the combined increase in inflation, the falling dollar and falling interest rates has made those sales less advantageous to foreigners. Fewer bond sales to foreigners results in even more inflation. Given our current level of debt and the falling value of the US dollar there is little doubt that the U.S. will experience high levels of inflation in the coming years.
Inflation in the 70s was much more volatile than in the new millennium but if we look at the trend line of the two eras they appear to coincide fairly well. So even though we have not seen the volatility of the 70s, so far anyway, we are certainly traveling in the same direction. If this trend continues we could see double-digit inflation five years from now and with a little volatility thrown in we could see it much sooner. A lot depends on Washington reigning in their unprecedented spending.
What history tells us is that companies are more or less inclined to pursue an M&A strategy depending on the state of the economy, energy supply, monetary supply, inflation, interest rates, and government actions/inactions. All of these issues have a direct impact on the acquisition market and the eventual success of any acquisition that is made. Considering this jungle of unsavory happenings that companies have to contend with, why do businesses pursue an M&A strategy?
The answer to this question is quite simple. Most businesses believe that acquisitions offer them a better chance for real growth than continuing to try to do that organically by investing in classical in-house R&D activities. Based on a number of independent investigations into this matter the bottom line appears to indicate that the level of success/failure for either internal R&D or external acquisitions is about the same. The primary difference appears to be that in an R&D approach, if you fail you have only expense receipts to show for the effort while in the acquisition case you would at least end up with assets of some questionable value. The problem with comparing these two options is that it's truly "apples and oranges." What it takes to be successful in your R&D programs differs greatly from what it takes to make an acquisition successful.
Although there is some disagreement between experts, somewhere between two-thirds and three-fourths of most acquisitions tend to destroy intrinsic value within the first year (see Figure 4).
Although a lot of external issues do impinge on the number of acquisitions that may be taking place at any given time most acquisitions that fail do so more as a result of internal problems. So, why do acquisitions fail to meet expectations?
Somewhat similar to other questions of this nature, there is no single reason for failure or success. In fact, when it comes to acquisition failures there seems to be an endless list of possible causes. In order to reduce this huge list somewhat we have prepared a listing (see Table 1) that provides ranking, based on my colleagues and my experience, of the ten most common reasons acquisitions fail to meet expectations. The listing is not to be considered an exhaustive inventory of failure causes but rather the more common yet avoidable negative outcomes.
Table 1: Causes of acquisition failure
1. Buyer paid too much for the acquisition.
2. Acquisition is not compatible with the buyer's core business.
3. Lack of an integration plan.
4. Integrated too quickly.
5. Integrated too slowly.
6. Kept separate too long.
7. Loss of key core competencies with departing employees.
8. Loss of key customers.
9. Loss of key alliance partners.
10. Too many "negative surprises."
While the first item in the list flows from unsound assumptions in financial analyses, the rest are often attributable to faulty processes, have significant organizational aspects and/or reflect vulnerabilities related to key stakeholders and are largely avoidable through better upfront planning. The good news here is that with proper discipline, focus and attention to details, many of these problems and areas of vulnerability can be addressed, minimized or avoided altogether.
In shepherding both buyers and sellers through the acquisition process, my colleagues and I have witnessed the same issues-many of them people related-time and again. In alerting the reader to these issues, and sharing approaches we have found effective for averting these problems before they begin to derail performance, I hope it may be possible for the reader-whatever side of the deal he or she may be on-to enhance the likelihood of success for a future acquisition or to better diagnose why an existing acquisition/integration may be ailing.
Last year, 2009, reflected a down year for acquisitions, mostly brought on by the numerous external, economic related issues described earlier. Recent surveys have shown that in the middle of 2009 less than 16% of participants felt confident about the U.S. economy with 35% of the opinion that things would improve in 2010. Participants in the survey were essentially split on the issue of how the Federal Government's actions within the past 12-months have impacted the U.S. M&A market. Twenty-seven percent think the Federal Government has made a positive impact, or increased activity, while 22% think it has made a negative impact, or decreased activity. The greater percentage of respondents think that government's actions have made little to no difference in the overall level of M&A activity. Most of the deals that did not close last year were due either to financing issues or a material change in the business conditions of one of the parties.
Although 2010 is not expected to be a particularly strong year for M&A activities, it should show some small increase over 2009.
There is an old saying that states, "Everything has a price and everything is for sale at the right price." While the validity of this statement may be in question the simple truth is that, in general, it's much easier to acquire a business than it is to make that acquisition work as the buyer expects. Companies tend to spend enormous amounts of time and money on the front end of the M&A process (i.e., negotiation, due diligence, etc.) and precious little if any time in developing an integration plan for both sides to follow. Often the personnel involved in the purchase part (negotiation, due diligence) are not involved in the integration and worse, those individuals involved in the integration are often precluded from being a part of the pre-close portion. This action alone makes for a very messy if not awkward hand off between the two parts of the M&A process which in turn interjects a potential for misst EPS and miscommunication between parties. Research has shown that most of the root causes for acquisitions failing to meet expectations owe their origin to issues that existed in the pre-close portion of the process. Unfortunately, since many buyers do not involve their integration people and/or don't have an integration plan it becomes somewhat difficult to look for these potential caused of failure.
INITIAL CONCEPT AND PLANNING
There isn't a "magic bullet" that will ensure ultimate success for any given acquisition. However, there are a few things that the buyer and seller can do to help improve the odds.
With every acquisition, the problems encountered in the integration process are more likely to be associated with people than with things per se. People, unlike equipment, buildings or other hard assets are unpredictable in terms of their response to a change brought on by an acquisition. Most acquisitions are made to acquire skills, competencies and experiences that the buyer does not possess. If in the process of making an acquisition the buyer loses a good portion of the knowledge that resides inside people who are being let go, chose to leave on their own or are considered to be redundant, then the value of the acquisition is diminished and the potential for failure will increase.
Experience has shown that employees on both sides of an acquisition have three important questions that they want answered. In fact, until these questions are answered to their satisfaction, chaos, uncertainty and loss of productivity will likely occur. These questions are:
- What is happening to me?
- What is expected of me?
- What is in it for me?
It is strongly suggested that the buyer develop suitable answers for these questions well in advance of closing. On day one post closing, a lot of people will want to hear the answers to these questions. I'll talk more about this in future editions of this subject matter.
In my experience I have found that most upper level managers feel that their people can do almost anything. Although on the surface this sounds like a good thing it can set the stage for false expectation. The buyer would be well advised to remember that the employees that are chosen to participate in the acquisition effort most likely have a full time job. Although everyone can work 110% for short durations, they cannot keep that level of intensity up for long periods or else productivity starts to decline. Before embarking on an acquisition the buyer should conduct a skills inventory to ensure that there are sufficient resources available to support the acquisition effort including the integration phase as well as keeping the current business intact. In some acquisitions whereby resources of the buyer or seller are stretched a bit thin, competitors can often take advantage of that situation and chip away at major pieces of business without fear of reprisal. It's the old "bird in the hand versus two in the bush" scenario. Buyers cannot afford to give up what they have today in the hopes of gaining much more in the future via an acquisition. For most companies, having an adequate resource allocation plan is vital to the success of existing strategies and to any future acquisition endeavors. If the buyer discovers that there are missing skills or that there are significant gaps in the total resource plan there exists the option of bringing in outside personnel to act as a temporary bridge, and thereby ensuring that momentum on all fronts is properly maintained.
The buyer should ensure that there is universal agreement within the ranks of the company's management team regarding:
- Why they are pursuing an acquisition;
- What is the ultimate objective/goal;
- Why an acquisition will provide a better pathway than other options to achieving that goal;
- What are the expectations (timing, resource allocation/burn rate, financials, internal/external support, etc);
- What criteria will be used to select possible candidates; and
- What are the options that can be considered (alliance, joint venture, license, etc.).
No significant effort should take place until this is done as conflicting opinions, positions and understandings will impede the overall effort. The resulting acquisition strategy should be seen as "the management team's strategy" and not "the CEO's strategy." This becomes especially critical when different parts of the buyer's organization starts interfacing with the seller's personnel. What you want to see happen is that each person conveys exactly the same understanding of why the acquisition is being made and how it fits into the buyer's strategy. We will discuss this in more detail in the next edition of this subject under "Post LOI Activities."
ACQUISITION TEAM PREPARATION
Selecting proper personnel with the best fit of background, experiences and skills to become participants in the acquisition effort (negotiation, due diligence, etc.) is another essential success enhancer. An added feature would be to conduct appropriate training of the various teams to ensure that everyone is on the same page with the same understanding. This will be discussed in more detail in the next edition of this subject matter.
SETTING THE TONE WALKING THE WALK
An extremely important role for management to play in an acquisition is to provide commitment, support and oversight to the various acquisition teams. By their very nature, acquisitions can become a serious diversion of attention for management and their employees. History has shown that when an acquisition is announced one of the first outside entities that get involved are "head hunters." If employees inside the buyer or seller are concerned about the acquisition and feel that they are not getting the information they need, the good ones will take action, which sometimes means that they will look for employment in a more stable environment.
One of the very first items that management needs to take ownership of involves communications. Acquisitions bring about uncertainty and interject a level of confusion and chaos into the orderly world of most professionals. Management's role has to include addressing that issue and calming the waters wherever possible. Due to the very nature of most acquisitions a lot of information, especially early on, can't be shared with all employees. However, there are things that can be shared and management should work closely with their legal advisors in crafting appropriate communications. Above all, management should not forget to address the question, "What's happening to me?" To do so risks losing valuable employees and critical knowledge.
The bottom line here is that before any company chooses to embark on an acquisition, they should conduct an appropriate audit and investigation to determine if they are structured and poised to undertake such an objective. History has shown that acquisitions will highlight every single weak point in your organization. Acquisitions should not be taken lightly. The reader is advised to not assume that the pursuit of a "small" acquisition will result in less resource requirement. Although smaller acquisitions may be the right thing to do for your strategy, the amount of resources required is not linear or directly proportional to the size of the acquisition. Acquisitions often become a huge consumer of resources on both sides. Reality has shown that most acquisitions take longer than expected, require more resources than projected, yield returns a lot lower than forecasted and often result in the loss of approximately five percent of value.
In the next article in this series, "Post Letter of Intent Activities," we will discuss more specific things that can be done in the negotiation, due diligence, integration planning, day one preparation and purchase agreement formation. I will share with the reader some of the tools and processes that my colleagues and I have found to be useful in improving the ultimate success of the acquisition.
**NOTE: The data represented in Figure 1 and Figure 3 are not 100% accurate due to the fact that it is based on information that is required to be made public (Hart-Scott-Rodino Act).The Hart-Scott-Rodino Act is an antitrust law that requires companies to file with and get the approval of the Federal Trade Commission (FTC) before they merge. Information about the Pre-Merger Notification process is posted on the Hart-Scott-Rodino section of the FTC web site. The European Union laws equivalent to Hart-Scott-Rodino are posted on Europa. The Official Journal on Merger Control, cases and other materials are available through Europa's Competition page under the heading "Mergers."The filing rules are somewhat complicated. The general rule was a filing was required if three tests are met; (1) the transaction affects commerce; (2) either (a) one of the parties has sales each year or assets of U.S.$100 million or more [as of 2010, raised to $126.9 million] and the other party has sales or assets of $10 million or more [2010:$12. million]; or (b) the amount of stock the acquirer has is valued at $200 million or more [2010:$253.7 million] at any time; and (3) the value of the transaction is $50 million or more [2010:$63.4 million]. Obviously, there are many "small deals" whose value falls below the public reporting threshold requirement.