Kendall Consulting Group - Organizational Due Diligence (M&A) Innovation Article

Organizational Due Diligence:
The Key to Profitable Mergers and Acquisitions

More companies than ever before are turning to mergers and acquisitions as a way to fuel growth for the future. The volume of mergers and acquisitions completed worldwide in 1996 topped the $1 trillion mark. In the U.S. alone last year, 10,000 mergers and acquisitions totaled $650 billion-nearly twice the dollar volume and the number of deals of the peak deal-making years of the 1980s. 1996 also set a record for the number of transactions worth $1 billion or more at more than 100.

The pace of mergers and acquisitions is not expected to abate any time soon. So far in 1997, 26 billion-dollar mergers have been announced, including at least a few "mega-mergers" such as Morgan Stanley/Dean Witter and Banc One/First USA.

Mergers and acquisitions as a competitive necessity

Why the frenetic pace of merger and acquisition activity? For many companies, mergers and acquisitions represent, quite simply, the fastest possible route to explosive growth. Banc One, by purchasing First USA and its nationwide portfolio of 16 million card holders, immediately gains a national platform in the lucrative credit-lending business.

Some acquiring companies seek to grow quickly by flowing more of the same products through a new sales channel, as Gillette has done by purchasing Duracell International. For other companies, formally aligning oneself with another company makes it possible to enter lucrative new markets unavailable before, such as many U.S.- and European-based automobile manufacturers have done in China and other Asian countries heretofore closed to foreign car makers. For some other companies, such as healthcare providers and utilities, mergers represent an opportunity to achieve economies of scale and pare operating costs.

Other companies, such as IBM, have suffered through painful restructuring and cost-cutting and look to mergers and acquisitions to increase their capabilities and jump-start growth. Alliances can make it relatively easy to acquire new technologies or systems that are critical for competitive advantage. Many of the high-flying technology leaders routinely snap up smaller companies that haven't earned a penny of income solely for the promise a new invention may have for the future. The critical nature of time-to-market makes the purchase of companies whose technology is coveted more attractive than actually developing the technology in-house

An increasing number of companies are seeing mergers and acquisitions as an absolute prerequisite to remain viable amidst a globalizing economy, where only the largest players will survive. Raytheon, in successfully competing against Northrup Grumman for the acquisition of Hughes Electronics, has positioned itself as a dominant force going up against other recently-linked aerospace giants such as Lockheed Martin/Loral.

Beyond mergers and acquisitions

While the staggering number of high-profile mergers and acquisitions makes the most prominent headlines, other types of business alliances are also being struck in far greater numbers. For example, partnerships and joint ventures have become more commonplace. Virtual corporations are springing up in increasing numbers to exploit specific time-sensitive opportunities, such as IBM, Motorola, AT&T and Loral collaborating on a new PC chip with X-ray technology. Establishing value-oriented alliances, such as the one Proctor and Gamble formed with WalMart which revolutionized the retailing industry, has become the standard operating procedure for many market leaders.

Wide-scale outsourcing of entire areas of a company's operations-including the design and maintenance of IT systems, manufacturing, marketing, human resources, training and sales-is making more economic sense for companies that want to focus on their "core competencies." Outsourcing of such selected operations, particularly those once considered to be the company's "crown jewels," requires the same careful evaluation and planning as mergers and acquisitions.

And they all looked so good on paper...

Despite the best-laid plans of company leaders who cut the deals, the majority of large-scale mergers and acquisitions fell well short of financial projections. According to one study, of 150 recent deals valued at $500 million or more, about half actually destroyed shareholder wealth, and another third contributed only marginally to it. A recently-completed 10-year study of 340 major acquisitions found that total shareholder returns for 57% of the merged concerns fell behind industry averages for three years after the merger.

In this paper, we offer a new hypothesis as to the real reason so many alliances have fallen so short of their promise and expectations. Most mergers and acquisitions fail not because the pro forma projections were faulty, or that the terms and conditions weren't well thought out, or that the premise for the alliance was fatally flawed. The majority of such alliances fail because the up-front rigorous analysis that was applied to the financial and legal aspects of the union was not applied to the organizational aspects of the union. An "organizational due diligence" is a key requirement for the success of any new alliance.

The focus for this paper is mergers and acquisitions; however, many of our observations and recommendations may be applied to other alliances. We explore some of the root causes of failures, and provide a powerful new framework by which companies that are considering a merger or acquisition -or undergoing one- can build a foundation for success.

We also provide some practical recommendations and next steps based on our own experience working with several of our clients who have undergone dramatic change as a result of mergers and acquisitions over the last decade.

Learning from Failures

Given that so many of today's mergers and acquisitions are regarded to be crucial for the long-term success of both companies, why do so many falter? When so much time and money is invested prior to the signing of the contract, why do so many unravel after the ink is dry?

When the whole is less than the sum of the parts - In many cases, the synergies that sounded good in theory did not represent true synergy at all. The high-technology industry provides some illustrative examples. When Borland International Inc., a maker of languages, paid $440M for Ashton-Tate in 1991, the then-dominant supplier of PC database software, the deal seemed to represent a sure win for both companies. Both companies could manufacture, market, sell and distribute their popular PC applications together, saving considerable time and money. What Borland didn't know at the time was that it was inheriting an extremely weak balance sheet from Ashton-Tate, along with a set of products that by then had already become industry laggards.

Novell, a leading supplier of networking software, snapped up several software companies in the early 90's, culminating with its most costly and ill-fated purchase of all in 1994: the $855M acquisition of WordPerfect Corp., the developer of a word processing program which by then was trailing Microsoft's industry-leading Word. Novell had envisioned that with WordPerfect's word processing software, Novell could offer a powerful alternative to Microsoft's integrated Office suite. Due to a combination of marketing miscalculations and clashing corporate cultures, the acquisition never brought a penny of profit to Novell. Today, Microsoft enjoys more than 95% of the market for PC software "suites," while Novell's share has plummeted to well below five percent.

Even deals that may represent true synergy in some areas sometimes fall apart when synergy is lacking in other areas. When German auto maker BMW bought Rover, Britain's last major independent auto producer for close to $900M in early 1994, BMW beat rival Mercedes-Benz in the race to create a new sports utility vehicle with the four-wheel-drive Range Rover. BMW was able to quickly broaden its product range and beat the competition in a key area. However, BMW had to invest far more heavily in R&D than it had envisioned, given that Rover had depended on former partner Nissan for engineering and design. The result: BMW's net profits were cut by at least half after the acquisition.

"Unless you understand the long-run strategic value of intent (of mergers and acquisitions), you will grow frustrated when it proves-as it must-not to be a cheap and easy way of responding to the uncertainties of globalization." ---- Kenichi Ohmae, "The Global Logic of Strategic Alliances," Harvard Business Review, March/April 1989.

Focusing on financials to the exclusion of all else - Few companies would consider entering into any size merger or acquisition without rigorous due diligence performed by a cadre of attorneys, bankers and media relations firms-all of whom stand to reap significant financial gain if and when the deal goes through. Most of these professionals are compensated, and many quite lavishly, when the deal is consummated. However, nowhere on the team is there an organizational specialist whose job is to perform a due diligence on the fit of the two organizations, their business processes, and their cultures.

Repeatedly, companies learn that despite the best-developed financial plans, it is the people who make the alliance succeed or fail. Take the case of the Homedco Group and Abbey Healthcare, two leading home healthcare companies, which merged to become Apria Healthcare Group in the summer of 1995. Many hailed the merger as a true union of equals. The new structure clearly favored the Homedco side for key management positions, though this bias was not necessarily in the best interests of the company, its customers, or shareholders. At first, the selection process for top posts seemed fair, but then an imbalance soon became glaringly apparent. Said one retired Abbey executive: "They said the best person would prevail, but then they hired the people they knew. That's the way it always is." A wrenching dismissal process prompted many Abbey employees to seek other career opportunities. Many of the people who left went to the competition, and are working together against Apria today. The company's stock value hovers at about half of what it was when the merger first occurred.

What we have here is a failure to integrate - Experience has shown that the real deal-killer is the failure to effectively integrate the two merging organizations. Good integration rarely makes a truly bad deal work, but failure to integrate well almost always ruins the chances of even the most financially promising union. Most often, the responsibility for implementation is virtually "thrown over the fence" for the two companies to sort out. Sometimes a transition leader or team is appointed, however, most times the leader and team members are inexperienced or unschooled in many of the skills so critical for an effective and efficient integration.

Let's look at some of the areas where organizational integration is most critical, yet often overlooked.

When a clear, compelling case for action is not communicated

When two companies are considering a merger, rumors run rampant and fears abound. Which managers will dominate? What will the new priorities be? Which products lines will be kept and which will be cut? Will anyone be laid off? Who will be promoted and who will be demoted? Will any plants or offices be closed? Will my skills be valued by the new organization? Will I still have a job?

By failing to establish and communicate a business case for the union, rumors and fears will soon depress the best business opportunities. In lieu of a credible, clear and mutually-beneficial case for action, employees-and frequently, customers-assume the worst. And their assumptions are often well-founded.

Few companies take the time to share with their employees why the union will make good business sense, and how each organization is expected to contribute to the other's success. Roles and responsibilities are left vague. The extent to which each company is risking and being rewarded is unknown. Resentment and fear prevail over trust and optimism. Top employees, who represent the true strength of the organization, decide that their best interests would be served by leaving the company.

When Electronic Data Systems (EDS), a fast-growing giant in the IT consulting and outsourcing business, merged in 1995 with A.T. Kearney, a successful management consulting firm, many in both companies had difficulty understanding how a merger would work, and why it was needed. The hierarchical, technology-driven approach of EDS was at odds with the entrepreneurial style of Kearney. "But what really could hurt [the merger]," according to the Wall Street Journal, "is the arrogance and hubris that exists in every management consulting firm." Kearney consultants didn't find the prospect of selling IT consulting services to be promising; nor did many EDS salespeople relish the idea of suddenly having to promote the benefits of management consulting services. EDS and A.T. Kearney management did not make a compelling enough business case for the merger, and as a result, many successful consultants from both companies left before, during and after the merger.

When the blueprint for change has major holes

Imagine an architect focusing entirely on the cafeteria and customer conference room of a new office building, and paying virtually no attention to the integrity of the design of the building itself. Even if the cafeteria and conference room set new standards for comfort, class and professionalism, the office building taken as a whole will ultimately be unsuccessful.

Many companies likewise focus only on some of the most obvious, or easiest, aspects of integrating the two organizations, and avert their attention from equally important aspects. For some, integrating the product lines, sales or service organizations takes top priority. For others, it's merging plants, offices and geographic locations to achieve increased market coverage or economies of scale. Rarely is the entire business system of the two combined organizations considered in total and planned for.

Clashes of culture can unravel the whole

Cultural clashes are frequently at the root of many misguided mergers and acquisitions. While the business case for the merger of discount warehouse leaders Price Club and Costco seemed strong in the Fall of 1993, the cultural differences undermined the merger. Observed analyst Michael J. Shea of Carter Investment Group: "The Price guys had... a real estate strip-mall mentality. The Costco guys were the type who started bagging groceries...and worked their way up the ladder." The two companies maintained separate headquarters and sharply different management styles, and broke up in less than 12 months. Said one analyst: "The best thing to happen to that marriage was the divorce."

Differences between corporate cultures are difficult enough to overcome, but when differences between national cultures also come into play, the challenges increase exponentially. That said, companies are attempting cross-border mergers and acquisitions in record numbers. In 1996, the number of cross-border mergers and acquisitions jumped to 6,377 from 6,113 in 1995, with the combined value rising to $296 billion, from $226 billion in 1995.

Take the recent merger between Upjohn Co. of Kalamazoo, Michigan, and Pharmacia AB of Sweden. Both were second-tier players fighting for survival amid a world of global drug giants, with complementary strengths and markets. The expected result: A global drug company whose whole was far greater than the sum of the parts. Few predicted the obstacles cultural differences would pose.

The cultural differences appeared in many areas. The Swedes chafed at the idea of having to write frequent detailed reports, which was the American norm; Americans resisted when the Europeans opposed Upjohn's policy of drug and alcohol testing of employees. Americans frequently scheduled meetings that bumped up against the Europeans' extended summer vacation schedules. In Pharmacia's Italian business center, wine was poured freely in the company dining room, while in the boardrooms, humidors were stuffed generously with fine cigars. At Upjohn, alcohol and smoking were strictly banned at all facilities, though eventually that prohibition was relaxed in Europe.

Management styles presented the greatest differences. The Swedes were used to an open system, where small teams work autonomously and make decisions. The Americans followed a command-and-control management style. Though it's too soon to tell how successful the merger may eventually be, CEO John Zabriskie departed abruptly in early 1997; many believe the Europeans simply could not accept his "hard-charging American management style."

When the leaders are not prepared to lead

Most executives have little experience melding together two entirely different organizations. And experience, it seems, does contribute to success. Close to three-quarters of companies that have completed six or more deals of at least $5 million have yielded returns above the industry average, compared to just 55% of companies that closed fewer than five such transactions.

Percy Barnevik, who heads Asea Brown Boveri (ABB), a Swedish-Swiss engineering giant, applies a "30%" rule to the business he acquires. He allocates 30% of central staff to independent profit centers, 30% to operating companies, and gets rid of 30% entirely; only 10% are left in head office. Like many leaders experienced with mergers and acquisitions, Barnevik makes concessions to win over the employees of the newly acquired companies. For example, when he first merged Asea, his Swedish engineering group, with Brown Boveri, a Swiss company in the same business, he established his headquarters in Zurich rather than Stockholm to make the operation look less like a takeover.

Often the leaders of the merger have vastly different management styles and objectives. These differences can thwart even the most promising deals. Many observers are watching the Morgan Stanley/Dean Witter deal to see if the CEO and president can work together. Dean Witter's Philip Purcell, named as the new firm's CEO, is known for his slow, steady approach, while Morgan Stanley president John Mack-now holding the number two post-is known for his sense of urgency and impatience. Observed one journalist: "Mr. Purcell faces difficult decisions. The direction in which he takes the company will be influenced by his own need for control and his qualities of innovative leadership. Above all, he must not be ambiguous."

A foundation for a successful integration

If so many of the biggest and-allegedly-brightest of mergers and acquisitions have failed to live up to their promises of profitable growth, what can companies do differently than the ones that came before to ensure success?

To ensure a successful acquisition or merger, companies should do these four things well:

Due diligence analysis of the organizations

When an acquisition is first considered and a candidate company has been selected, acquiring companies normally do a due diligence assessment of the candidate company's markets, products and financial condition. It is at this time we recommend an assessment also be done of the candidate company's business system - it's processes, organizational structure and capabilities, its information and management systems, and its cultural norms. The condition of the candidate company's business system and its fit with the business system of the acquiring company should be a major consideration in the deal.

Two companies considering a merger should also perform a due diligence assessment of their business systems. Are they compatible? Do they compliment each other? Will the whole be greater than the sum of the two systems? Will the combined business system meet the objectives of the merger?

A structured process should be used to make the data gathering and analysis fast and efficient. An experienced, two-to-three person team should visit the candidate company and gather data first-hand on its business system. This data should then be analyzed, and a recommendation made to the business team responsible for the merger or acquisition. Particular attention should be paid to the objectives of the merger or acquisition. Experience shows that the candidate company must have compatible cultural norms and sufficient strengths in its business system to compliment the business system of the merging or acquiring company.

Companies that thoroughly evaluate the cultural incompatibilities of their respective organizations ahead of time are rewarded for their foresight. For example, Southwest Airlines spent two months exploring its cultural compatibility with Morris Air before buying the smaller rival in 1993. This enabled the two companies to comfortably shave two years off of the planned integration process. Computer Associates, which has bought more than 50 businesses over the last two decades, invests considerable time understanding the cultural differences prior to making a purchase decision, and takes steps to ensure that any such differences are resolvable.

Creating a common vision and shared blueprint

For a merger to succeed, both companies should have a common vision of the organization that will result from the merger. They must see the new enterprise as a way to create new value and open doors for expanded opportunities in the future. Both should be clear on the intended benefits and have realistic expectations of the timeframe. Most mergers and acquisitions take far longer to yield hoped-for benefits than anyone had predicted at the outset. When there are unrealistic expectations, frustration and disappointment can easily derail integration efforts.

The newly-formed Lockheed Martin, widely predicted to be a success by all measures, is dedicated to one overriding mission: Winning and executing a targeted piece of the business by combining capabilities from various parts of the company. The goal is to develop a seamless organization in which formerly different businesses act as one entity. Effectively, Lockheed Martin will redesign itself for every major program the company targets. This will be a strong competitive advantage.

All the attention to detail in the world, pre- or post-merger, will not produce a successful union if the strategic vision behind it is flawed, or if the vision one company holds is dramatically different from the other.

The vision of the merging companies should also include a holistic and well-balanced business system (sometimes called the Business Diamond - see Figure 1 below). An organization's business system consists of its:

• Business processes

• Structure, jobs and skills

• Information systems

• Culture, norms and beliefs

• Systems for managing the performance of employees

Figure 1 - Business System or Business "Diamond"

Companies that successfully merge their business systems have a blueprint to guide them. The blueprint addresses and resolves the following questions:

Developing a shared plan of action

Once a vision and a blueprint for the union has been established, which takes into consideration important organizational differences and strategic objectives, the process for integration must be clearly defined and communicated, early and often.

Here are some important steps companies must take to ensure a successful integration. While it is tempting to forego some of these steps in favor of "quick results," there are no short-cuts. Circumventing any of these steps is likely to put the success of the merger or acquisition at risk.

Learning from each experience

The company that learns with each integration, whether as a result of a merger or acquisition, a joint venture, or a major outsourcing deal, will be far better positioned to take advantage of the next opportunity that comes along. How can learning be encouraged and shared throughout the organization?

Summary

Mergers and acquisitions can fail for any number of reasons. Sometimes the economic reasons are unsound; other times the hoped-for synergies fail to materialize. An important determinant for a successful union lies in the ability and discipline to perform a "due diligence assessment" of the two organizations and to conceptualize a balanced and winning business system that can be created out of the union. Studying and planning only one or two important aspects, such as the company culture or the distribution system, presents only a piece of what must be managed. It is the total picture that must be envisioned and developed as part of the integration effort.

There is no silver bullet or magical formula. It takes discipline, openness, trust, respect for each other's strengths, and experienced, capable leadership. It also takes time. But imagine the time and money wasted, and the windows of opportunity lost, in the many mergers and acquisitions that have failed because this kind of organizational due diligence was not done.

Kendall Consulting Group helps its clients to navigate their way through successful mergers and acquisitions, partnerships, joint ventures and other alliances. Kendall Consulting Group's clients are in a range of industries and include Fortune 500 multinationals, and a number of small- to medium-sized companies. For more information, please call 978-474-9109 or 941-366-1774 or email info@kendall-consulting.com.

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Most executives have little experience melding together two entirely different organizations

While it is tempting to forego some of these steps in favor of "quick results," there are no short-cuts

To ensure a successful acquisition or merger, companies should do these four things well ...

Clashes of culture can unravel the whole

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