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Myopic Merger Mania

Men in suits get so excited about large mergers. The bigger the better. I think it must have something to do with unlimited testosterone. Personally I have never quite understood what all the excitement is about. But then I’ve never fully comprehended what is so enticing about bags of money as an end in itself. It has little appeal for me. Perhaps such disinterest has been good for my reputation. It means I’ve been able to remain objective when clients have sought my advice on large deals.

Today the business of companies acquiring other companies is big business. But whoever said ‘may you live in exciting times’ didn't necessarily mean that to be a prediction of good things ahead. On the contrary, if you're like most investors, executives or employees it's more of a nuisance. You see, in the corporate world, exciting usually means risky. And there's probably nothing riskier or more prone to failure than merging with another company.

There are basically two kinds of mergers. Those that fail immediately and those that will fail within a five year window. Only 25 per cent of mergers actually work in the long term.

The reasons stare us in the face if we’re prepared to see them. For one thing, to state the obvious, all the excitement is generated around the numbers, large numbers – especially stuff like shareholder value and return on investment. Other significant factors are often ignored – ranging from longer term strategic fit and the harmonization of discrete cultures, through acquisitive management competencies, to customer profitability. 

How am I defining failure? First it is where the original intentions (and promise) fail to materialize. In other words whatever the companies had in mind that motivated them to merge in the first place doesn't work out that way in the end. Secondly it is where shareholders suffer because operating results deteriorate rather than improve. Thirdly it is where one or both of these factors causes the companies to decouple – the most ignominious admission of failure.

If we just take the US market as an example we have seen literally scores of recent botched ventures. There was AOL and Time Warner. HP and Compaq.Alcatel and Lucent. Daimler Benz and Chrysler… need I go on? During the 1995-2000 M&A surge in the US volumes totaled more than $12 trillion. However within this same period, some $1 trillion in shareholder wealth evaporated. Stupid takeovers did more damage to investors than did all the dot-comes combined. What is even more remarkable is that these failed mergers were the work of the world’s most successful corporations advised by highly educated Wall Street investment bankers.

The failure of mergers and the subsequent demise of companies have many unintended consequences. Some acquisitions are just plain daft; ideas that were doomed from the very start. Sometimes the merged entity goes bankrupt, so spectacular is the collapse. At other times the failure results in the downfall of those that masterminded them. Sometimes companies are forced into reversing the process, at great expense, because of poor judgment, lack of foresight, financial miscalculations or cultural incompatibilities. Every so often a disaster is averted and companies pull the plug on the deal at the eleventh hour.

One has to ask why? If most mergers fail then why merge to begin with? If the risks are so high, why take the chance? Generally speaking companies merge for one of two reasons:

First of all it must make sense strategically. In other words, the aspirations of one or both companies can be achieved faster or more easily through the acquisition of the other’s strategic assets. But that, frankly, is rare. Often such synergies are contrived or manufactured by those who have instigated the deal. More commonly, as a result, mergers are undertaken because of greed and the illusion that bigger is better.

Secondly the perceived operating synergies and resulting efficiencies make the merger a seductive proposition. If that is the case we should, at some point after integration, see redundant functions eliminated and shareholder value increasing.

My company is frequently sought by Boards burdened by the ever present prospect of M&A failure to undertake what we have come to refer to as whole-of-system due diligence. This includes analyzing everything from strategic alignment, management capability and organizational design, right through to culture and integration strategy - factors most often ignored, or thought less important, by the teams of accountants who typically drive key decisions.

It's important to appreciate that the standard three-month due diligence process rarely uncovers any of the potential flaws in a merger. That's because M&A due diligence processes typically have a single overriding goal which is to shield executives and directors from possible shareholder litigation.

Because of our work in this field we find ourselves in the privileged position of examining at first hand the holes that can derail a merger – gaping chasms that are sometimes so big you could drive a truckload of MBAs through them. This is especially the case with multinational joint ventures where cultural compatibility is a critical factor.

From our elevated position the reasons for failure become crystal clear. Yet these issues, often overlooked by the number crunchers, can be so easily avoided.

My favorite reports concerning mergers not living up to their initial excitement are things like one entity embellishing the truth while the other buys a persuasive PowerPoint pitch. I’ve actually witnessed that! Or two desperate companies merging on impulse, thus creating one big desperate company…

Seriously though, the most critical factors are as follows. The lessons to be learned from these are salutary:

  • A lack of comprehension concerning globalism (or globaility if you're in the US) – the current business conditions that have arisen through various processes of globalization. This frequently raises fundamental questions such as whether there are real synergies to be found in a potential merger or whether these could be found using alternative means such as harnessing new technologies, collaborative ventures, strategic alliances, etc. Lesson: Frame M&A discussions and make key decisions within the context of global markets and business ecosystems
  • A flawed corporate strategy in one or both entities. So many contemporary corporations fail to use rigorous, real-time strategic intelligence to inform their planning and decision making that assumptions can be way off the mark. This leads to an illusion that they understand a particular market when in fact the opposite is the case. Lesson: Establish mechanisms for continuously channelling real-time strategic intelligence about dynamic conditions and market opportunities to key decision makers
  • A paucity of experience and knowledge of M&A in the acquiring company’s executive team can often lead to the most elementary mistakes. Lesson: Ensure that you have M&A experience and the right skills on your team – if necessary buy it in for this purpose.
  • Acquisitions are really about buying customers. Other assets are immaterial in comparison. But although customer acquisition is mostly taken for granted, customer profitability, which can vary widely, is frequently ignored. Consequently, where a small group of customers might account for a large part of a company’s capitalization, another group of customers might actually reduce the company’s value significantly. Acquisition analysts must appreciate that long-term company value is a function of the aggregated value of their customers. By understanding the economics of customer profitability companies can avoid doing deals that hurt their shareholders, identify surprising deals that create substantial wealth, and even salvage deals that would otherwise be losers. Lesson: Analyze customer segments and associated profitability to determine what to buy
  • Misalignment of any number of emotional and cultural factors ranging from intentions and motivations to expectations. Cultural incompatibilities in particular can lead to an exodus of talent after retention agreements expire. Lesson: Make sure that you fully understand the two cultures and what drives people to work in both businesses. Be prepared to adapt recruitment and development processes to suit the merged entity
  • A sub-optimal or non-existent integration strategy. We often find that the acquiring player expects to impose its corporate culture on the other entity. There is no better way to enflame fears and entrench animosities, thus making the task of integration much harder than it needs to be. Lesson: Take time to plan and co-design all aspects of the integration strategy. Be prepared to shape a desired corporate culture that transcends both current states
  • The lure of profits can seduce executives into ignoring impacts on the balance sheet that might unwittingly destroy shareholder value. CEOs are under increasing pressure to reinvest cash and grow earnings, especially with competition being so volatile. If acquisitions are not undertaken, or so it is argued, competitors may clinch profitable deals instead. The danger is that succumbing to these pressures often has the effect of reducing the return on invested capital to value-destroying levels. Lesson: The balance sheet is just as important as projected profits – perhaps more so in the long term. Examine all options for growing profits and revenue before rushing in to an unwise acquisition
  • Companies often resort to cost-cutting in order to increase return on invested capital. Perhaps duplication is identified in the merged entity. If two banks merge and they both have adjacent branches, for example, one can be closed. Merged companies, however, become myopically optimistic about the effects of cost-cutting. A lack of transparency and flawed assumptions in calculating potential benefits and synergies often lead to errors of judgment. Substantial savings usually don’t materialisebecause acquirers, caught up in the excitement of the deal, tend to overestimate what is possible. Of course yet another reason cost-cutting doesn’t work is that potential savings might have already been bargained away in the negotiation of the selling price. Lesson: Cost-cutting is not a panacea. It is a risky strategy and too often the result of lazy management habits. By all means manage costs sensibly. But resist the urge to cut deeply, or at whim, especially if that means wielding the axe to activities that grow long-term value - such as staff training, management development and customer access, for example
  • If cost-cutting and other supposed efficiencies fail to make the deal sufficiently attractive, increasing revenue is another way executives believe they can make high-priced mergers pay off. The most frequent claim in this regard is that the deal will create enormous opportunities for cross-selling. While cross–selling does happen it is almost never to the extent the acquirer imagines. Lesson: Get real! Much of what you imagine in terms of additional revenue may not eventuate. Develop a worst case scenario and be prepared to live within that reality

Although I grant that some of these are comical, none are intended as jokes. They are real examples from recent, serious, multi million dollar merger proposals. Furthermore they draw attention to concerns that only came to light after standard due diligence processes had been completed and a green light given to the project.

The culprit, pure and simple, is ineffective governance and non-systemic due diligence. Surely it would be wise to insist that the burden of proof for mergers to make sense should be as high as their risk, their failure rate and the pain they inevitably cost all stakeholders. I can see no rational reason why Boards would not insist upon such a rigorous evaluation given today’s complex M&A environment.

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