Who do so many M&A fail?
In an earlier post we discussed what are the reasons that a firm, at least theoretically, decides to merge with or acquire another firm. These basically fell into two categories, horizontal integration and vertical integration. And yet, we know that a huge number, 70% to 80% or more, depending on who you ask, fail, most miserably. A question that recurs regularly is why these events fail, and, by extension, what can be done to reduce the failure?
In the closing of the previous post, we looked at the very basic mathematics. For an M&A transaction to not be considered a failure - which is distinct from achieving the publicly stated goals, something that is much more difficult - the total return from the transaction, the value of the combined entities, must be at least 1 penny (or pence, or ruble, or yen, etc.) more than the amount paid plus transaction costs. Of course, almost every acquisition involves payment of more than the value of the firm on its current trajectory, so there is the added burden. Thus, the total amount gained must be at least one penny more than:
- The current value of the firm, which is normally the market capitalization for a publicly held company, or some discounted cash flow (DCF) or similar valuation for a privately held firm. For example, as of close of trading on Friday, September 12, Merrill Lynch was valued at $17.05 per share with 1.53BN shares outstanding gives a value of $26.1BN; plus
- The premium paid for the firm, i.e. the amount that was paid above and beyond the current value. Bank of America agreed to buy Merrill Lynch this past Sunday, Sept 14, 2008, for $44BN, a premium of about $18BN; plus
- The costs of the transaction. These fall into several categories, and include investment bankers fees, often around 7% of the value of the deal, lawyers fees, and other related fees; plus
- The costs of integration. These are the costs of actually putting the two businesses together. These involve everything from managing people and conducting hiring or layoffs, through systems integration and books merging, to joining sales forces and merging headquarters.
Offsetting all of these, of course, is the value gained. This value is really composed of two very simple components:
- The current value of the firm, which should be fairly identical to #1 above; plus
- The integration value, i.e. the horizontal and/or vertical value added discussed in the previous article.
Looking at the above, the basic reasons why so many M&A fail to achieve real value and usually lead to a loss is as follows. The first three costs and the first value are fairly fixed and straightforward, known right from the beginning of the transaction. The real killers in the deal are always the costs of integration and the integration value. Inevitably, in every failed transaction, either the integration costs are much higher than expected or the value of integration is much lower than expected, or both.
Costs of Integration
Why do the costs of integration end up being so much higher? To be fair, I cannot think of a single transaction I have seen, read about or been involved with that the costs of integration estimated upfront are even close to the final costs of integration. Most firms that have some form of integration have some element of integration that is literally left hanging for many years thereafter. There are a lot of reasons for this cost underestimate:
- Humanity: People are human and make mistakes. They make the same mistakes again and again. What holds true for renovating a kitchen or building a house - the final cost is always much higher - holds true for merging firms.
- Secrecy: Very often, these transactions are discussed in secret, due to fears of market manipulation, pressure to complete or undo the deal, or regulatory requirements. This secrecy causes many employees - those who daily deal in facilities, sales, technology or other areas that would need to be integrated - to be unaware of the deal and unable to give their input. The same management that seeks this input as critical before engaging on expansion into a new line of business avoids it before engaging in a merger of acquisition.
- Consultants: Coming from a consultant, this may sound self-defeating, but consultants are often a source of the problem. Many of the large consulting firms bill out untold millions in consulting hours to plan and assist in the integration. First, in order to get the business, they will often underbid, expecting to make up in "additional hours" or "change requests" to the contract. These additional hours come through as additional transaction costs. Second, if they feel the need to stick to the bid, they will do less work than management expected, leaving the clean-up to the in-house staff, creating additional hidden costs. Third, the large consulting firms have an unenviable track record of putting large numbers of young, just-out-of-college-or-business-school associates on the job in order to bill lots of hours at a higher profit margin. These associates, quite frankly, do not know how to manage the integration, let alone the people involved. Fourth, to be brutally honest, many of the partners at these firms do not have a clue how to piece together the elements and costs of integration. Many have climbed the consulting ladder by billing our more hours, but have never had to actually live through and manage an integration from the corporate side, i.e. pay the price for failure and receive the rewards for success. I have seen consultants from PriceWaterhouseCoopers, Ernst & Young, Accenture and all of the other firms destroy the goodwill within a firm for the transaction by their heavy-handed behaviour and absolute ineptness. Even the high end firms such as Boston Consulting and McKinsey have shown similar lack of true understanding of the real world.
- Hubris: It had to come up eventually. Executives often have inflated views of their own abilities to manage the integration. Further, these numbers often come from the CEO, rather than the COO and line managers who really know what it takes.
- Incentives: CEO pay is often tied not to profit margins or comparable margins, but absolute revenues, profit or comparables. Thus, the CEO of a $1BN revenue $200MM profit company will make a lot more money as the CEO of a $2BN revenue $300MM profit company, even though the margins have now shrunk from 20% to 15%. Many of these contracts are not available to the public - and kudos to John Mack of Morgan Stanley who instituted high transparency and close tie of compensation to company performance, as well as full annual director elections, after his successful coup against Phil Purcell in June 2005.
Value of Integration
From the value of integration side, similar factors come into play. Executives consistently overestimate the value the integration will bring to the merged entity. The reasons are actually quite similar to the reasons costs are underestimated.
- Humanity: People make mistakes, and executives are no different. People overestimate how big a market will be, how much value cross-selling or how much cost-saving will bring. Using the prior analogy, people invariable underestimate the cost of renovating the house, and overestimate the increase in resale value the renovations will bring.
- Secrecy: Once again, because of the secrecy in transactions, the very people who truly know what that value will be - the IT managers who are expected to wring cost savings out of the systems, the sales staff who are expected to bring more profit per sale due to cross-selling, the marketing managers who are expected to drive demand for the better and more complete "whole package" - are left out of the conversation. It is often said that startup CEOs are the best, because they spend real time talking to every single customer, until they can practically step into the customers' shoes. In larger firms, the sales staff and marketing managers are the ones who spend time living and breathing the customer and must be involved.
- Consultants: Once again, consultants, who have a strong incentive to push a transaction that will bring them huge consulting fees, along with too strong a belief in themselves and their firms' abilities, push for a transaction by sugar-coating the results. To their credit, it is highly likely that the consultants themselves do not realize what they are doing. It is unlikely to be malicious or intentionally misleading except in rare circumstances. Nonetheless, the damage is done. One of the top brand of consulting firm in the world once gave a strategic presentation, which I was not privileged to attend but did see the slides, in which they showed a "hockey stick" graph of net present value over time. If the two top country partners of this firm do not understand "net present value" and what it means, they cannot possibly understand the true value of a merger.
- Hubris: Every CEO likes to believe that he or she is the next coming, will make their mark as a really huge CEO. In software, Eric Raymond once said (and I paraphrase, errors are mine) that the software is finished not when there is nothing left to add, but when there is nothing left to remove. A really great CEO is not one who knows how to build his/her empire, but one who knows how to focus a business. Like presidents (and I always avoid politics in these posts), the CEO who focuses on his or her legacy does damage to both their charge and their legacy; one who focuses on just doing the best job, is a benefit to their charge and their legacy.
- Incentives: These incentives are the same. If pay is tied to size, rather than profitability, who can possibly blame the CEO or Board for wanting to jumpstart company grow the company
The only way to get properly estimate these costs and the value gained upfront is to get a fully independent person, working with the board and the line staff (managers on down) to fully figure out the costs, and ensure that the compensation of the CEO is not tied to the overall size of the company, but rather its profitability. Whoever does this analysis - consultant, executive, anyone - must have zero incentive to make it work. They must be paid to figure the value and costs out, and not have millions in bonuses or consulting fees hanging on recommending a transaction. Finally, the staff who live and breathe the day-to-day operations - running the business, marketing its goods and selling to customers - must give input on the true value and costs of the integration.