The number of Mergers and Acquisitions (M&A) that end in failure is a matter of conjecture but it’s commonly estimated that over 50% of all M&A deals fail to achieve their intended goals. If true, that represents an astounding loss of investment dollars as well as the lost time, energy, reputations and everything else that goes along with closing an M&A deal. Lowering the failure rate by even a small amount has the potential therefore to save billions in lost dollars. While specific reasons are usually cited for individual failures, it’s difficult to generalize about a root cause of the failures that would allow investors to avoid or at least mitigate their investment risk. To find a global means of lowering the risk of an M&A failure we need to look for systemic causes of the problem.
By M&A failure I am referring to failures that occur after an M&A deal has been closed, not a failure to close the deal (a subject all to itself). The specific reasons cited for M&A failure usually include target business issues such as the lack of anticipated or promised performance, culture clash, management team and key employee loss, changes in the market… and on and on. But again, while these may be the cause of a specific failure, citing the cause of an individual failure doesn’t help us identify the systemic causes. For our purpose then, we will need to use a more generic definition of an M&A failure. To accomplish this, we can simply define an M&A failure as a merger or acquisition which, after 2-3 years, the investor wouldn’t do over if given the chance. I limited it to 2-3 years because after that there is a good chance the business failed for other reasons.
To find a systemic cause of failure, we must turn our focus to the M&A process itself. Dr. W. E. Deming was a mid Twentieth Century scientist who did much of the original research on quality assurance techniques. In his work he demonstrated that product failures resulted from the manufacturing processes that were used to produce the product and that, by improving the process, it is possible to reduce the resulting failures. More recently, we have seen this principal demonstrated by Toyota when they adopted the “Kaizen” method. “Kaizen” is the Japanese word for good or positive process change. To improve the quality of their cars, Toyota uses “Kaizen” to remove systemic manufacturing defects. “Kaizen” is now being applied in many other industries. While the M&A process is not a manufacturing process it is a repeatable process and by analyzing that process, it is possible to identify the systemic root cause of some M&A failures. We can then use a “kaizen” approach to modify the process to lower the M&A failure rate.
Overall, the M&A process is a methodical, legalistic process embedded with activities tied to letters of intent, the definition of terms and conditions, the creation of an acquisition agreement and other documents needed to transfer ownership of the target business in a diligent manner. Activities like negotiating the terms of the agreement or preparing the transfer of document can be tedious but they have exacting results and are generally not the cause M&A failures.
Due diligence by contrast is the most subjective step in the M&A process. Many investors don’t fully understand the role of due diligence and begin with only a notional understanding of what they hope to accomplish. This gives us the first clue to the cause of many M&A failures.
To understand the problem, lets break the M&A due diligence process down a little further. To be effective, due diligence should assess three distinct facets of the business; legal, financial, and operations, and these should be performed with equal effectiveness. Most investors do a good job at legal and financial due diligence but fail to perform an effective operations due diligence. This is due to the fact that legal and financial due diligence rely on the frameworks of law and accounting as their guiding principles and, assuming that the investor has a competent attorney and accountant, there is little reason not to perform these assessments effectively. Operations due diligence is a different story. There is often confusion regarding exactly what needs to be assessed during an operations due diligence or how to measure and report on the results. To understand the nature of this problem, this would be a good time for the reader to take a moment to write down what you think constitutes an effective operations due diligence. Later we will see if your definition has changed.
While not totally accurate, it is fair to say that financial due diligence is primarily looking at the past performance of the business while legal due diligence looks at the current state of the business (at the time of closing). Operations due diligence on the other hand is trying to discover potential problems that could impact the future operations and sustainability of the business. If an operations assessment determines the likelihood of a negative future event occurring than, by definition, operations due diligence is a risk assessment. Specific failures, such as cultural mismatch, missing the market, and the loss of key clients are examples of events that have the potential to negatively impact the future operations of the business. If the definition you wrote down didn’t have the word risk in it than you have not fully understood the role of operations due diligence.
What about events that have a positive impact on the business? Is there, for instance, an opportunity for the business to improve its sales after the merger? Risk and opportunity are often described as “two sides of the same coin”. An operations due diligence should also be an opportunity assessment. Opportunity is the likelihood of an event that will positively impact the future operations of the business. If an operations assessment discovers that the business has a great product but sales are weak because the sales group is immature and the acquiring company already has a strong sales organization than an opportunity to improve sales has been discovered. Not capturing potential opportunities is also a cause of M&A failure because the business will fail to achieve its full potential.
Operations due diligence needs to be an enterprise wide assessment. When asked, most people name only one or two key functions to be assessed and fail to provide a holistic, enterprise wide answer. “Operations” is a very broad term and potentially covers a wide range of operating functions. Without an established framework similar to that of law or accounting, the enterprise framework tends to be an ad hoc list of functions. Standardizing a framework that defines the enterprise therefore is crucial for reducing failures. Processes that do not produce repeatable results are prone to error. Without a clearly defined, consistent framework the results are not repeatable and increases the chance of an M&A failure.
Investors rely on their CPA and attorney to establish the financial and legal framework but who do they rely on to perform an operations assessment? A CPA can tell you the financial maturity of the business but how do you determine the maturity of the operations infrastructure of a business? The tendency for most investors is to “go it alone” by focusing on only one or two areas. “It was a software company so we had an engineer look at the code”. The lack of a consistent operations framework, or established practice that defines one, re-enforces the potential that operations due diligence is the weak link in the M&A process due to the potential to overlook business functions during the assessment.
Operations due diligence needs to be performed as an enterprise wide assessment that spans the entire operations infrastructure of the business. There may be more understanding of the operational needs during a strategic acquisition over a purely financial investment but my experience is that a “go it alone” approach during a strategic investment tends to overlook key operations areas. Without a guiding framework, it is difficult to determine what constitutes “complete” and without a framework to use as a guide, the potential to miss an operations function is great and therefore so is the risk that you will overlook the potential cause of an M&A failure. An operations assessment must cast a wide net in order to keep potential risks from slipping through and the lower the risk of an M&A failure. Treating operations due diligence as an enterprise wide risk/opportunity assessment based on the development of a holistic framework and a constant M&A process improvement program is a clear way to lower the M&A failure rate.
Improving the way operations due diligence is performed demonstrates how “Kaizen” could be applied to the M&A process. “Kaizen” requires a continuous process improvement program that continues to remove defects over time. The examples given here are just a first step. Applying a “Kaizen” approach would mean continuously revisiting the operations framework to better identify latent operations risks and opportunities. To accomplish this, we would need to look at the specific causes of M&A failure and constantly ask, would this problem have been discovered during our operations assessment. If the answer is no, then the operations framework needs to be further improved. Continuous process improvement requires resources. Investors that are continuously involved in the M&A process will gain the most from this type of program. The benefits that this type of process improvement program provides by lowering investment risk should justify the commitment of those resources.