Operational Due Diligence: Antidote for the Silent Deal Killer
By Michael Sarlitto and Dan Roman
Operational Due Diligence: Antidote for the Silent Deal Killer
Organisations such as AT. Kearney, McKinsey, Business Week and Pricewaterhouse Coopers have produced conclusive research- there is a startling high failure rate for newly-acquired or merged businesses.
Within 18 months of closing, 80 percent of large cap, 50 percent of small cap and 80 percent of micro cap transactions fail to meet stakeholder objectives.
Separately, Mergerstat.com spent two years tracking results of the 8,224 domestic transactions conducted in 2001. The study estimates that within two years, a staggering $560bn of business value was destroyed due to M&A failure. What was their conclusion? "Companies continually embark upon the merger and acquisition trail without fully understanding the risks ahead."
Many reasons are cited for M&A failure (Exhibit 1), including culture clashes. integration challenges and changing market conditions. But, are these reasons merely a collection of industry accepted excuses masking the true root cause of failure?
Exhibit 1: Top 10 Excuses for M&A Failure
How can an industry that prides itself on conducting meticulous due diligence activity and unparalleled detail-driven analysis produce such horrific results? Answering the question of why so many M&A transactions fail to meet stakeholder objectives requires turning a self-critical eye into the merger and acquisition market itself.
Having conducted detailed root cause analysis on more than 200 cases of failed merger and acquisition transactions, we found that the majority of merger and acquisition failures are, in fact, preventable.
By identifying a number of frequently recurring characteristics that are found both with failed transactions and are also conspicuously absent in successful transactions, the process of predicting and ultimately preventing unfavorable outcomes becomes less an exercise in working harder and clearly a case for working smarter.
Based on this root cause analysis performed on a wide variety of M&A transaction failures occurring across a wide spectrum of industries, one fact is clear: very few M&A failures occur because of weak financial valuations, flawed legal opinions or poor auditing skills. Rather, poor outcomes most often result from a failure to discover and address operational risks inherent in business and work processes during the due diligence phase of the deal.
Savvy investors are quickly recognizing that the days of double-digit returns fueled primarily through financial engineering of newly merged or acquired businesses are numbered. Sophisticated investors, business owners and stakeholders of all varieties are beginning to recognize the value of incorporating operations due diligence - which we call "operations assessments" into traditional financial and legal due diligence activities.
The examination of certain operational factors that have demonstrated an impact on the likelihood of long-term M&A success will have a positive influence in ensuring that investors conclude the "right" deal with the "right" structure.
What is an Operations Assessment?
An operations assessment is the methodical process of investigating and evaluating the operational details related to a potential investment or business initiative. Its purpose is to:
The value derived from the identification and mitigation of operational risks is not just limited to mergers and acquisitions, but has also been shown to dramatically improve success in debt or equity placements, joint ventures, institutional lending and performance improvement initiatives. There are two important aspects to conducting operations assessments as part of due diligence activity.
First, it is important to understand that "operations" in this context must include all business and work processes throughout very functional area of the organisation. Limiting the assessment to only those few "overhead" functions of a company that visibly support its main activity may omit important factors that could impact the deal's future success.
Typically, merger partners are driven by a "follow-the-cash" mentality which tends to unjustifiably focus a majority of both resources and attention to higher profile "shared services" in hopes of creating "synergies" necessary to justify consummating the deal in the first place.
Without including all business and work processes in a comprehensive operations analysis, less insightful decisions are made with respect to future resource allocation and prioritizing integration activities causing a predictable and avoidable failure scenario to play out.
Based on root cause analysis of over 200 causes of failed mergers we found that a majority of failures can be directly linked to a failure discover, assess and account for operational risks in inherent in business and work processes. Second, a properly conducted operations analysis will recognize and account for the cause-and-effect or dynamic nature inherent in business and work processes.
For example, as is typical with most mergers, assumptions are made during the due diligence phase of a merger regarding proposed staff reductions premised on the opportunity to eliminate duplicate functions.
In one such recent case, a combined engineering workforce used to support outage related activities for a fleet operating units was to be reduced by over 25 percent. Implementation of the reduction was to include "converting" a large percentage of engineering personnel to operating as a "mobile workforce" servicing multiple plants in staggered planned maintenance outages.
Synergies of the engineering workforce reduction were to include institutionalizing best-in-class outage procedures for fleet plant improvements and commercializing their in-house expertise in the "off-season" to service other similar but non-competitive plant environments. Based on assumptions regarding value creation in this aspect of the merger, the engineering workforce synergy was quickly elevated to "deal maker" status due to the salary premium paid to this portion of the workforce and the intellectual capital assumed to be resident and retain-able in analysis of the deal. As it turns out, this logical and key synergistic benefit from the merger ultimately proved to be a "silent deal killer".