Six DEADLY M&A Sins
October 14 2009 by Russ Banham
Remember when companies walked the matrimonial aisle without Uncle Sam tying the knot? Lately, corporate mergers and acquisitions seem to be arranged and sealed by the federal government. Private equity deals have fallen by the wayside, and strategic unions are few and far between.
With little to do, the firms that make a living off M&A deals—like law firms, consultancies, venture capitalists and investment bankers—are readying clients for the next matrimonial season. If markets are stable, Goldman Sachs CFO David Viniar was quoted as saying recently, transactions should pick up in the second half of this year. Others are less sanguine and posit 2010 as the turnaround ear. If the slack loosens and past is prologue, it will be a rush down the aisle, virtually guaranteeing messy liaisons and nasty breakups. Companies have been wallflowers itching to make a move, and those with cash hoards are ready to splurge. Once they do, they’re likely to spend unwisely and too much. As David Eslick, CEO and chairman of Marsh & McLennan Agency LLC, puts it, “People get emotional and forget to stick to the plan.”
In his role as CEO of USI Holdings, Eslick presided over hundreds of acquisitions in building the firm into one of the largest mid-sized insurance brokerages in the United States, taking it public in 2002 and then, five years later, selling it to Goldman Sachs. He’s been recruited by giant broker Marsh, which launched Marsh & McLennan Agency in October, to build another USI of sorts, snapping up regional brokerages and smaller insurance agencies. “We have a very good strategy to become a big player in the middle market very quickly,” says Eslick. For now, though, he’s taking his time—sticking to his plan.
Other dealmakers will be less patient. They’d be wise to learn from past mistakes; hence our cautionary tale: the Six Deadly Sins of M&A. It’s a story of companies getting hitched for what seem like smart reasons, except for the fact that they’re not.
No More Confetti
First, let’s take the pulse of M&A. The patient isn’t dead but blood flow is down to a trickle. Total deal volume across the board (3,853 transactions) in first-half 2009 is down 46.8 percent when compared to first-half 2008, a survey by Mergermarket indicates. Deal values ($708.1 billion) are down 43.4 percent.
Of the 59 venture capital-backed deals reported in the first quarter, 46 were in the information technology sector, an industry still consolidating, with the Oracle-Sun Microsystems merger just the latest big to-do. Deal values are clipping along in the sector as if the recession never happened, on par with levels reported in fourth quarter 2007, Thomson Reuters reports.
Small transactions also proliferate to fill out product and service portfolios. Such is the case with TargetSpot, a New York-based Internet radio advertising network that bought Ronning Lipset Radio, a similar firm in the space but one with a better sales team. “We had the technology and they had a great sales approach,” explains TargetSpot CEO Doug Perlson of the complementary match made in 2008. “Our revenue is up 300 percent over last year and is significantly higher than the two companies would have done individually.”
Life sciences/pharma continues to consolidate through M&A transactions, crowned by Pfizer’s $68 billion purchase of Wyatt but also percolating with smaller deals. One can argue that the banking and automotive sectors are making deals, but the primary dealmaker in these cases is Barack Obama. Others, like CEO Roy Salley at Dallas-based Sovereign Bank, are in a “wait and see” mode. “We’re in the middle of raising $150 million to put us in a position to start buying failed banks in
Texas when they come up for sale,” says Salley, who plans to build Sovereign’s assets from $775 million to $2 billion. The bank lists 10 offices throughout the state, at present.
All other sectors are comatose. “When compared to the environment in 2007, when everyone could barely keep up with the number of transactions presenting themselves, it’s quite slow out there,” sums up Len Gray, who leads Mercer’s M&A practice in the Americas.
Can You Spare a Dime?
There are plenty of targets for finger pointing, but the chief antagonist is the dearth of debt. Both private equity and strategic buyer deals are dependent upon some leverage for M&A transactions, and financing isn’t available or has onerous rates, terms and conditions. For private equity and leveraged buyouts, the credit fiasco has effectively shut the lid on deals—a far cry from just two years ago when credit was so frothy, firms could make acquisitions at multiples of four to five times EBIDTA (earnings before interest, depreciation, taxes and amortization). “Private equity is dead right now, and I say that noting that we service 370 private equity firms,” says Mark Arian, executive vice president of corporate transactions at Aon Consulting. “They keep talking about [deals] so there’s some light at the end of the tunnel, but the triggers aren’t being pulled. We had a couple deals go through due diligence and at the 11th hour the credit agencies said they’d downgrade the credit and that killed them.”
Adding to the torpor is the virtual impossibility of valuing a target company in the current economy. Questions abound: Will a seller that seems to be worth $50 million today be worth $50 million when the deal closes? Should I sell today when valuations are low or wait until the economy improves? Should I use stock as the currency to acquire a company when the stock is at depressed levels? Rich Scudellari, who has negotiated more than 150 M&A financing deals as chair of Reed Smith’s emerging growth/venture capital team, explains, “There is a lot of uncertainty and doubt about valuations, which throws cold water on possible transactions.”
Not that there aren’t strategic opportunities to be had. “The issue is who will blink first,” says Greg Peterson, a partner in the transaction services group at PricewaterhouseCoopers. “The sellers don’t want to be the first guys out selling at the lower valuations, and the buyers wanting to use their stock as the currency are wary because it isn’t as valuable as it was pre-downturn.”
The vague valuations and tight credit are conspiring to boggle dealmakers, causing inertia. “I don’t think any of us know where this is going,” concedes Joe Johnson, a partner at Goodwin Procter and chair of the law firm’s M&A practice. “We’re all waiting for the ‘come-to-Jesus’ moment.”
The Sin Files
While waiting, idled dealmakers might want to take a page from the M&A bible. Like marriages between humans, mergers between companies fail as often as they succeed. To better the odds, read and heed the following Six Deadly Sins.
Sin Number One: Doing the Wrong Deal
Once a company has set its sights on buying another, there is a tendency to lose perspective. Quaker Oats’ $1.7 billion acquisition of Snapple in 1994 is a case in point. Snapple was a wonder drink and Quaker Oats had made a bundle on another boffo beverage, Gatorade. Wall Street didn’t snap its fingers, however, believing the $1 billion- plus price too much. Three years later, Quaker Oats sold Snapple for a paltry $300 million. “CEOs get carried away with exuberance and then overpay,” says Scudellari. “You can’t fall in love with a company. You need to set a price and stick to it.”
Setting a price requires a clear sense of post-merger financial benefits. “It’s critical to know exactly how you’re going make money—what will drive value after the close,” says David Carney, a principal at Deloitte Consulting. “If you don’t have a clear answer to that you may be buying the wrong thing.”
Mercer’s Gray has a similar perspective. “Acquirers often fail to have a well-defined and articulated business strategy that includes a strong rationale for the deal,” he says. “Back in the 1980s the big thing was the financial services supermarket, where you could go to one company and do your banking, buy insurance, work with a realtor and even handle your travel needs. The problem was maximizing the value of these entities as they were brought together. There were overblown assumptions made about cross-selling and sharing customers, but the incentive structures weren’t changed to accommodate this.” The supermarket fragmented back to the former model.
More modern examples of strategic failure are AOL Time Warner and Citibank-Travelers. “The CEOs fell in love with the idea of transactions that frankly did not stand the due diligence test,” Gray explains.
“Don’t do deals just to do deals,” says Eslick. “Logically and emotionally establish the strategy and then stick to it.”
Sin Number Two: Bargain Basement Buying
Face it—when the economy revives, all those distressed companies just waiting to be bought will have the word “Discount” hanging in the window. Like a pair of Varvatos boots or Louboutin pumps at “70 percent off!” the price is too good not to buy it. “The pitfall is to assume since you’re getting such a great deal the acquisition can’t be bad,” says DeAnn Brunts, central region manager partner at Tatum LLC, an executive search firm that staffs companies in turnaround situations with C-level executives. “Sure, there will be some fantastic deals once the economy settles, but don’t get lulled into a sense of security that the target is a great fit just because it’s cheap.”
Cash-rich Google’s acquisition of YouTube comes to mind. When you’re a modern-day Croesus swimming in greenbacks, tossing a mere $1.65 billion the way of a company without a definable revenue-generating model won’t break the bank. Nevertheless, monetizing the business down the line will absorb effort and resources that could be allocated elsewhere to better financial effect.
The corollary to buying cheap is mistakenly thinking you’re buying cheap. “Don’t do a deal at the bottom of the market unless you’re sure it’s the bottom of the market,” warns Brian Hoffmann, co-head of the M&A practice for the Americas at global law firm Clifford Chance. “A great example in the private equity space is Cerberus Capital Management’s acquisition of Chrysler a deal that went sour fast.”
Cerberus bought an 80 percent stake in Chrysler from Daimler Benz for $7.4 billion in 2007. The stake was eliminated earlier this year following the government’s bailout deal with the embattled automaker. In June, Chrysler was purchased by Fiat. Daimler looks prescient in hindsight, although its $36 billion takeover of Chrysler similarly failed to live up to expectations. At the time of the 1998 deal, the partners branded it a “merger of equals.” The term rankles PwC’s Peterson. “There is no such thing,” he asserts. “There will always be one business side that will dominate, for better or worse. And the larger the companies making that kind of announcement, the bigger the disaster.”
The counterpoint to bargain basement buying is waiting too long to buy. “If you wait for the recovery you may wait too long and then be outbid,” cautions John Melthaus, partner and co-head of the M&A practice at Choate Hall & Stewart, a law firm serving the international business community. “You’re competing in a global M&A market. There are no hidden gems out there.”
Sin Number Three: Less-Than- Diligent Due Diligence
One sin often begets another, and sin number three is the prodigal son of sin number one—CEOs and boards so besotted with a target acquisition that their due diligence is cursory. “Ego and simply wanting to get the deal done often become a proxy for executive management and the board to validate themselves,” charges David Grinberg, a partner and chair of the M&A practice at national law firm Manatt, Phelps & Phillips. “They’re so wrapped up in transaction fever that when red flags pop up during the due diligence they ignore them.”
Red flags lead to red ink, as HFS and CUC (Comp-U-Card) International learned from their $14 billion deal in 1997 to create Cendant. Accounting irregularities discovered the following year knocked down Cendant’s share price by almost half, costing shareholders about $14 billion. The due diligence, in short, was wanting.
Effective due diligence should uncover any and all post-merger liabilities, from intellectual property disputes to anticipated litigation. Peter Blume, partner and chair of law firm Thorp Reed & Armstrong’s business practice group, cites potential regulatory obstacles as another red flag. “When Bain Capital Partners terminated its proposed $2.2 billion acquisition of networking equipment maker 3Com last year, it noted that the Committee on Foreign Investment in the U.S. Had indicated it was going to oppose the deal for national security reasons,” Blume says. The deal would have given a 16 percent stake to Huawei Technologies, China’s largest networking equipment maker. “By failing to vet this issue more fully with regulators before committing so much management time and money in pursuit of the deal, 3Com’s stock price was crushed the deal finally cratered,” he adds.
Mitch Schmidt, senior vice president at ACE Casualty Risk, a Philadelphia-based insurer that absorbs post-merger legacy liabilities, says acquirers “need to tear the target apart.” To do that he advocates unleashing a “multidisciplinary team of accountants, lawyers, risk managers and others in the organization to dig up everything they can. We see venture capital firms and large organizations pursue this approach but not many middle market companies. You don’t want to be acquiring a company with the next asbestos product exposure.”
Even seemingly innocuous liabilities can doom a near-done deal. Fabian Pal, a member of the M&A team at Fowler White Burnett, says the law firm recently represented a buyer that learned the target owed outstanding bonuses for the last three years to the directors on its board. “One of our attorneys with an accounting background looked through the board’s employment agreement and incentive stock plan and his eyes popped open,” Pal says. “The company was owned by two organizations, a hedge fund and a private equity fund, and one of them was selling its share. Unfortunately, they couldn’t agree on who [was paying] or how the bonuses would be paid, and the deal died on the vine.”
Due diligence should be proactive and predictive. Mattel’s $3.6 billion acquisition of Learning Company in 2000 exemplifies a disregard for technological trends. The toymaker bought Learning Company, an educational software firm, to leverage its CDROM gaming platform, just as the Internet was making CD-ROM yesterday’s technology. Mattel sold the company for pennies on what it had paid, and showed its CEO, Jill Barad, the door.
Once such harbingers are identified they don’t necessarily kill the deal. “Precise due diligence will ascertain the real value drivers and the risks; if the latter are known and manageable that’s fine,” says Johnson. “If it’s an IP risk and you understand it, O.K. If it’s litigation and you have people there who can define it from a cost perspective, that’s O.K., too. You need to know the realistic pros and cons. Do your homework.”
Sellers also must do their homework, getting their houses in order before buyers come knocking. Titan Corp. didn’t clean up its mess and that forced Lockheed Martin to scrap its plans to buy it for $1.66 billion. “During Lockheed’s due diligence review of Titan’s overseas business, it was discovered that bribery payments had been made by Titan employees in violation of the Foreign Corrupt Practices Act [FCPA],” says Blume. “After Lockheed made resolving the violations a condition to its obligation to close, Titan reported the violations to the Justice Department in hopes of reaching a settlement or having any charges dismissed.”
Instead, the Justice Department and the SEC launched lengthy investigations into Titan’s foreign business practices, and Lockheed cancelled the deal rather than risk any successor liability. Titan ended up pleading guilty to the FCPA violations. Had it resolved the federal investigation before things went awry, Blume says the merger would have closed.
Sin Number Four: Post-Merger (Dis) Integration
Integrating two companies following a merger often is more wishful thinking than realized dream. “Major integrations are massive change programs that can last one, two or even more than five years,” Carney says. “Leadership teams can burn out on the volume of change, [making] it tempting to stop. Moreover, individual leaders or power bases might resist the integration or try to stop it in certain business units, functions or regions.” The result? “Partial integration, which breeds inflexibility,” he says.
Integrating two companies essentially requires creating a new third company, yet few mergers forge one. Dissimilar management styles, cultures, strategies or technologies kill the alchemy. “Look at the disastrous Sprint-Nextel merger,” says Blume. “These two networks operated on different wireless technologies that made it nearly impossible to merge operations and failed to produce any real synergies. Each company also had different marketing targets, with Nextel focused on gaining more business customers while Sprint went after individual consumers.” The consequence was “brand confusion,” he says.
A similar case in point is the old DaimlerChrysler. “You had two companies— one with a premier brand in Mercedes and the other represented by cars that were perceived as utilitarian,” says Rob Weible, a partner at national law firm Baker Hostetler and chairman of its securities and corporate governance practice. “The integration was a total disaster.”
Bob Farrell, CEO of Metastorm, a maker and distributor of business process management software, concedes he has mounted some good acquisitions and some bad ones over the years. He attributes the good ones to “understanding the integration issues from day one,” he says. “You have to think about how the companies will come together in a new organization from a product and services perspective, more so than from a revenue perspective. Bankers are always telling me the deal is the first step, but the deal doesn’t matter if you can’t figure out the integration.”
Sin Number Five: Culture Clash
Just because two companies play in the same industry doesn’t mean they will mesh culturally, especially if the merger is cross-border. Daimler- Chrysler again comes to mind, as does Universal’s merger with Vivendi in 2000, another union that fissured. The ongoing culture clash between merger partners Lucent and Alcatel is a more recent example. Last year, the two executives who forged the deal to make the transatlantic telecommunications equipment maker called it quits, following pressure from shareholders miffed at billions of dollars in losses. “Meshing the cultures of a French company and American company is quite difficult and in the case of Lucent and Alcatel has yet to be solved,” says Ana Dutra, CEO of KornFerry’s leader leadership and talent consulting group.
Aon’s Arian concurs: “You may be able to change organizational cultures but you can’t change international cultures. That’s the lesson of Alcatel-Lucent.”
Culture clashes aren’t confined to international transactions. Blume cites the AOL Time Warner merger.
“[AOL’s then-CEO] Steve Case learned too late that Time Warner’s infamous culture of semi-autonomous fiefdoms run by more conservative managers could not accept the idea of submitting to their new open-collared AOL business,” he says. In May, Time Warner announced it would split off AOL by the end of the year.
Culture is a broad term describing disparate ways of managing an organization, from how executives are compensated to the collaborative framework for making decisions. Mercer’s Gray contrasts a company with a culture of collaborative consensus building with another that has a “command and control” culture accustomed to fast decisions and decisive moves. “Merging two companies with such contrary cultures almost guarantees clashing,” Gray comments. “Behaviors within an organization are critical to its success, yet people tend to think of ‘culture’ as something soft. The solution is to determine an ideal future culture based on strategic imperatives.”
Dutra has a similar view: “Step back and define what the desired culture will be given the combined company’s value proposition.”
Eslick assesses culture in terms of human behavior. “You cannot forget you’re going into business with people,” he says. “If you find a company that fits your goals strategically, you need to ask is this is someone you’d go into business with as a partner? Does this company have the same values, ethical approach to business, treat people the way you treat them and is someone you can trust? All business is a human capital business.” Arian flips the statement to make the point: “Human capital is the tripwire in M&A.”
Sin Number Six: No-Talent Talent Management
Eslick and Arian are right about the human equation in deals. Cavalier treatment will flip the spigot on a talent drain. “In most merger scenarios, the employees of the acquired company are given little information about the transaction’s impact on them until well after the deal has closed,” says Blume. “Employees are left on their own to sort through rumors and can quickly become bitter and worried about their jobs and co-workers, becoming less productive and more disruptive as a result.”
Such problems trickle up as well. “A major acquisition can disrupt the well-oiled team you’ve so carefully built,” says Carney. “You will see new group dynamics emerge and individual performances swing up and down.” He advises CEOs to view the prospective merger as “an opportunity to reset expectations as a leader and to rebuild your team.” If an acquirer doesn’t address executive anxieties, “Don’t think your stars will stick around post-merger,” Gray warns. “You are essentially building a new talent management strategy from scratch.”
To do that, Arian says to spend time with staff discussing their careers post-merger. “Tell them the acquisition is a make-or-break career opportunity, and then introduce what you have in mind for them,” he says. “That makes them feel immediately like they are part of this new exciting thing about to happen.”
Not everyone should be kept postmerger, of course. “Just because a company is a great acquisition opportunity doesn’t mean the people on the executive team are the ones you want to keep,” Arian says. “Many companies retain the senior guys in the business and not necessarily the guys driving the business, only to suffer the consequences.”
Google and Cisco are examples of companies that seem to do right by their talent, retaining the key people in the acquired organization to run it post-transaction. “You look through Cisco’s senior ranks today and you see many of the people they picked up through their acquisitions,” says Rand.
There you have it, for better or worse. Failure to recognize the Six Deadly Sins of M&A means a corporate marriage that is made in hell. “Buying is easy,” says Peterson, “owning is hard.”
Russ Banham is a veteran journalist and author. His new book is The Fight for Fairfax, published by George Mason University Press.