As a follow-up to the previous discussions, we will analyse a particular merger that was looked at before it occurred – a rare event – and understand how we knew well in advance it was doomed to failure.
A number of years ago, I was asked to analyze two firms contemplating a merger. Because of confidentiality considerations, I cannot give the locations, names or industries of the firms. The details I can provide are as follows. Firm A was a US-based, technology service firm providing management and support services for legacy technologies, mostly to large customers. These legacy technologies provide critical customer management services for these firms, but is largely viewed as back-office costs. Firm B was overseas, with an Anglo culture and language, providing related software. This software was the next generation of the back-office technology services that firm A managed. Firm B’s software is viewed as providing greater flexibility and the ability to provide new, more closely integrated services for customers. In other terms, the new software becomes more closely related to the front office and even a possible revenue driver, if used correctly.
The management teams of both firms were looking for ways to jump-start growth, and, upon discovering each other, decided to explore a merger. For many reasons it seemed to make a lot of sense, with each firm providing benefits to the other firm that its partner would have great difficulty in achieving on its own.
- Firm A: Firm A had excellent contacts and a trusted relationship with many Fortune 500 customers. It was already on approved vendor lists, regularly received payments from these firms, knew the systems managers and their needs intimately, had direct access to people with budgets to spend. All of these were critical assets that Firm B, with its new technology and overseas base, were struggling greatly to achieve.
- Firm B: Firm B had new technology with a much longer lifespan than the current technology, proprietary software with intellectual property protections, much higher operating margins and, like most software firms, very high gross margins due to lower variable costs. Firm A, recognizing that the next generation of technology would eventually replace that which Firm A managed for its customers, was hungry to extend its viability and increase its profitability.
To the management of both firms, the merger seemed a slam-dunk. Firm A would gain higher margins, intellectual property, and a renewed lease on life, while Firm B would gain access not only to the large US market, but direct entree to senior executives at its preferred clients. This is a classic horizontal merger with cross-selling advantages in mind.
Neither of the two firms had a significant size or cash advantage over the other, leading it to be a true merger of equals rather than an acquisition of one party by the other. In order to maintain expertise advantage where it was best suited, and to avoid a sense of “defeat” and “takeover” by one firm, the merged firm would be managed by a co-CEO team, with joint headquarters in the US and overseas. The overseas headquarters would focus on new technology development, while the US headquarters would focus on sales and support.
While the potential merger was in advanced planning stages, I was contacted by the investment bank advising Firm A to analyze the merger and give my opinion. Interestingly, it was the investment bank that contacted me, rather than one of the two parties.
At first blush, the strategy made sense: a horizontal merger where each party brings something to the table that makes the whole greater than the sum of the parts. When digging deeper, however, it became clear that this merger was a very bad idea.
- Market Position: One of the key elements that Firm A brought to Firm B is access to the markets. Firm A, the servicer, already had a very positive market reputation… as a servicer. Firm A was known as a stable, reliable, staid provider of back-office services. They understand how to keep the systems running, and stick to service levels (SLAs) when there are issues. They are the utility, the one you call for more power. However, no one ever calls PSE&G or Consolidated Edison to design a new computer system, only to provide the power to it. Firm A simply did not have the market reputation it would need to bring cutting-edge, revenue-driving, high-profit services to customers. It would be as difficult, if not more so, for Firm A to change its reputation – and likely harm its existing “utility” business at the same time – as for Firm B to penetrate the market directly or, preferably, find a better partner.
- Sales: Related to the market position, Firm B expected that Firm A had direct entree to senior executives, decision-makers who could spend money on Firm B’s new software. Indeed, Firm B did have direct access… to the operations managers, plant managers, systems managers, everyone who ran the back office, everyone except the front-office people who were exploring new areas, new revenue opportunities. Depending on the politics of a target customer, the back-office contacts could introduce the new merged Firm to the front-office people, along with their solid, dependable, utility reputation, exactly what front-office is not looking to hear. Once again, Firm B could do better directly accessing the front-office decision-makers, or finding a more suited partner, than with Firm A. Once again, Firm B was likely to harm its back-office relationship and cash cow business by leveraging it into front-office for Firm A.
At core, the assumptions underlying the value of the merger were not only incorrect – they were diametrically opposed to reality and likely to harm both firms, possibly permanently.
Even if the firms nonetheless decided to merge, operational issues with the merger plan itself were serious enough to give pause.
- Geographic Culture: Although both firms spoke English and were from Anglo-oriented countries, there were enough cultural differences to make close cooperation difficult, at the very least. These were overlooked by the management plan with a wishful, “both are Anglo.”
- Professional Culture: Unsurprisingly, and a requirement for any kind of success, each firm had an internal culture that reflected its market brand. Firm A had defined hours, detailed procedures, innovation in a well-defined space, essentially a utility firm: dependable, reliable, always the same result. Firm B, on the other hand, was largely staffed with software developers, each pushing the envelope in his or her own way. The ability of the staff of the firms to merge and leverage the skills of the other was questionable at best. It is doable, but requires a very strong hand on the tiller, rapid success, good cultural leadership, and significant investment in human needs and skills, the “touchy-feely” employee satisfaction needs on which small firms rarely have the cash or time to focus. Exacerbating the issues was…
- Poor Management Structure: Even in a merged firm, the buck has to stop somewhere. In order to make the merger politically palatable to both sets of owners and management, the co-CEO structure was replicated throughout. The planned structure, a company of a few dozen people at most, had an organization chart that would have made the HR staff from my old days at Deutsche Bank blush. The lack of a clear chain of command, and a clear sign that the best interests of the firm’s growth, not political sops, were what mattered, would have drained the merged entity of energy and skilled personnel just as fast as its market failures.
Even a merger with the best strategic alignment, which this one certainly did not have, operational execution is paramount. A merger of acquisition must be planned and executed with an eye towards market and business success, and must trumpet it to competitors, customers and, especially, staff. In this case, not only were the strategic assumptions wrong, but the execution plan was awful.
I presented a report, detailing all of the above, along with an executive summary to my client. Before opening it, the investment banker asked me for the verbal summary. I told him, “the merger sucks; don’t do it.” If I had known how he would react, I would have had paramedics standing by; I am glad he didn’t go into cardiac arrest. I am not sure to this day if it was the tone – as a consultant, I am paid to speak the truth as bluntly as necessary – or the content that did it.
As most people know, investment bankers make their money as a percent of the deal. In this case, not doing the deal would have cost the banker a lot of potential income. Needless to say, he was displeased. He then forbid me from speaking directly to his client, Firm A, and blowing his deal. Of course, in this case, the investment banker was my client, and confidentiality forbid me from even letting Firm A or Firm B know that the banker asked me to analyze the deal, unless either approached me and retained my services for a separate analysis. In my opinion, the banker was ethically and legally bound to inform his client that he had received an expert opinion about the deal that was negative and to recommend to his client not to do the deal, or, at the very least, to share the concerns. I do not know if he did so.
- Always examine your assumptions as deeply as possible
- When done, have an outsider without a stake in them reexamine them
- When you perform any transaction (or any project), structure the results for business success
- Broadcast to everyone – competitors, customers and especially employees – that you are building for success and how
- Politics should serve the business, not the other way around
- Never, ever, ever rely on an investment banker, business broker (or large consulting firm that stands to make money from the integration) or anyone with a vested interest in the deal going through to figure out if a deal is good or bad. Their job is to get you the best deal possible from an immediate financial standpoint. Get someone who will get paid exactly the same amount whether you do a billion-dollar deal or no deal at all to determine if a deal really makes sense. Once you decide it does, then get the banker or broker to do it for you.