Value in Due Diligence

Contemporary Strategies for Merger and Acquisition Success

Ronald Gleich, Ronald Gleich, Gordana Kierans

• Publisher: Routledge
• Year: 2017
• Print ISBN: 9781138358577
• eBook ISBN: 9781351143424
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The recent financial crisis has thrown many of the mergers and acquisitions of recent years into sharp focus. Too many have failed to generate real value for shareholders and many others have only proved lukewarm successes. Although it is impossible to assess accurately the extent to which these failures may be the result of poor planning and execution, they have raised considerable questions about the process, breadth and effectiveness of traditional due diligence activities. Value in Due Diligence explores new applications for due diligence including areas such as corporate culture, social responsibility, and innovation. It also examines the due diligence process itself to draw out those elements that provide effective risk and opportunity management as opposed to simple compliance.

Part I
Strategy Development and Target Identification

Chapter 1
Due Diligence on Strategic Fit and Integration Issues: A Focal Point of M&A Success

MICHAEL N. A. COBBLAH

Ecobank Development Corporation, Accra, Ghana

DR MICHAEL A. GRAHAM

School of Economics, Finance, RMIT University, Melbourne,Australia

DR ALFRED YAWSON

Business School, The University of Adelaide, Adelaide, Australia

Introduction

Mergers and acquisitions (M&A) are a major part of the corporate restructuring process and one of the fastest strategic management tools to grow a business. Many M&A deals run into hundreds of millions, or even billions, of dollars. It is no wonder then that they arouse strong feelings and grab the headlines when deals are announced. According to the SDC Platinum database, M&A transactions involving acquirers in G7 countries in the 2007–2008 period alone totalled 29,131 with a transaction value of USD 3,128,954 million as presented in Table 1.1.¹ Out of the total number of transactions, 79 per cent and 21 per cent were domestic and cross-border deals, respectively. The transaction value of the domestic deals was USD 2,253,472 million.

Synergy is proposed as the main motivation behind these M&A activities. However, the literature suggests that most M&As have a less than stellar record in meeting the financial and synergistic expectations of stakeholders (for example, Rau and Vermaelen (1998); Moeller, Schlingemann and Stultz (2005); Fuller, Netter and Stegemoller (2002)). Both the academic and industry literature suggest that over 50 per cent of all acquisitions have failed (for example, Pautler (2003); Homburg and Bucerius (2006); Chatterjee (2009)). Given the data presented in Table 1.1, this implicitly translates into a loss of USD 1,564,477 million to shareholders in the G7 countries during this 2007–08 period. The many recorded abysmal performances, and indeed outright failures, in M&As are worrying and demand thorough investigation into the factors underlying this phenomenon.

Table 1.1 Acquisitions by Firms in G7 Countries during 2007-08²

In the finance literature, the inability of M&A activities to engender good returns is often explained by the simple fact that the acquirer overpaid for the target. This literature has mainly examined M&As from the perspective of returns accruing to bidding and target firms’ shareholders, with a focus on the relationship between the market for corporate control (for example, mode of payment, type of transaction, and number of bidders) and shareholder gains (Jensen and Ruback (1983); Loughran and Vijh (1997)). The contribution of this body of research has, undoubtedly, been momentous. However, these studies only provide a partial insight into the factors that influence M&A outcomes, as many documented failures are left unexplained. Nonetheless, both industry participants and the strategic management literature (see for example, Shelton (1988); Seth (1990); Birkenshaw, Bresman and Hakanson (2000); Waldman and Javidan (2009)) have regularly cited ‘people’ problems and cultural issues as the top factors in failed mergers.

Typically, the M&A process starts with the identification of an opportunity to create value. Once a decision has been made to progress the acquisition, advisors are appointed to lead the effort in structuring the transaction. These advisors undertake preliminary background work to assist in determining an optimal bidding price subject to due diligence and other regulatory approvals. The due diligence process mainly involves financial, technical, and legal issues which collectively, lead to a business valuation of the target. The valuation takes into account all transactions impacting issues that may directly or indirectly affect the initial bid. Once this process has been successfully completed, negotiations begin. What most due diligence processes fail to unearth is what we consider to be the ‘soft’ issues within the organization. These include people issues and operational due diligence which are intangibles and, hence, difficult to quantify and adjust within the context of the actual valuation of the target.

The objective of this chapter is to highlight the importance of strategic fit, organizational and cultural issues at this early stage of the merger process. Balmer and Dinnie (1999) note firms pay significant attention to the legal and financial considerations when conducting due diligence but neglect the implications for corporate identity. Knowing how to manage the strategic and people challenges that are bound to arise can enhance the chances of a successful merger. As such, in this chapter, we also draw upon both the academic literature and industry commentary to make a case for paying attention to intangible factors that are predictors of merger success at the due diligence stage. Isolating deal making from integration challenges creates problems for the merger. The imbalance between closing the deal and post-acquisition integration results in the loss of an important source of leverage to produce a value-added asset combination. As such, we propose that due diligence should begin in the acquiring firm before a decision to approach a potential target is finalized. Subsequently, the due diligence process must go beyond legal and financial matters to include organizational and human consequences. Further, the advisors involved in the transaction should approach strategic, organizational and cultural due diligence with a dynamic attitude since the business environment is also dynamic. The rest of the chapter is structured as follows. In Section 2, we discuss the content of strategic fit. Section 3 focuses on organizational and cultural fit issues. Following that, we relate strategic fit and integration issues to due diligence in Section 4. Section 5 concludes.

Strategic Fit

The concept of strategic fit has its theoretical underpinning in contingency perspectives found in both the strategy and organization theory literature (Ginsberg and Venkatraman (1985)). In business studies, the general notion of fit is rooted in the concept of ‘matching’ or ‘aligning’ organizational resources with environmental opportunities and threats (Andrews (1971); Chandler (1962)). According to Miles and Snow (1994), the process of achieving fit begins by aligning the company to its marketplace and this practice defines the company’s strategy. Zajac, Kraatz and Bresser (2000), in a model of dynamic strategic fit, identify environmental and organizational contingencies that influence changes in the firm’s strategy. Generally, strategic fit is viewed as having desirable corporate performance implications. These implications include cost reduction due to economies of scale and the transfer of knowledge and skills. Strategic fit is, thus, an important factor to consider when firms make investment decisions that result in the combination of assets as with M&As.

Strategic Fit in Mergers and Acquisitions

The merger contingency framework espoused by Lubatkin (1983) posits that the benefits accruing to a merged firm are contingent upon the degree to which the two firms achieve a strategic fit. This, in turn, can contribute to the competitive advantage of the merged firm. Different types of firm combinations are capable of achieving different degrees of strategic fit. Generally the stronger the fit, the greater the performance gain to the merged firm. Accordingly, related mergers should provide superior value creation compared with unrelated mergers (Salter and Weinhold (1979); Lubatkin (1983)). Such synergistic benefits arise out of economies of scale and scope. Furthermore, there is the possibility of transferring core skills, across the firms involved, in such amalgamations. Selecting a related merger partner would imply the bidding firm is striving to achieve a strategic fit between the merged entities. Surprisingly, Seth (1990) finds no significant difference in the overall value creation (combined for the bidding and target firms) between related and unrelated acquisitions. However, Lubatkin (1987), Singh and Montgomery (1988) and Shelton (1988) provide some empirical support for the relatedness hypothesis. Broadly, these studies conclude that mergers with more similar characteristics are more likely to create value for shareholders.

Additionally, common business sense suggests that, finding a better-fitting partner will lead to less complicated mergers. The business consulting and academic literature are in agreement that anticipated synergy gains from M&A may not be realized if firms donot choose their partners well.

Measuring Strategic Fit

The consensus viewpoint in the literature is that there must be good strategic fit between the acquiring firm and the target to achieve success in M&A. Therefore, an explicit measurement of strategic fit is required to make decisions about whether or not there is in fact a fit. Socorro (2004) proposes the cost of technological transfer, which affects the diffusion of technology across firms, as a measure of strategic fit. He argues that if manufacturing firms merge and they decide to operate the production lines of bothfirms, the most efficient firm transfers its technology to the less efficient one. Given that there are considerable costs involved in transferring technological knowledge, the amount of resources deployed to accomplish a successful transfer can be used as a measure of the transfer cost. The transfer cost could be high when the technology is complex and the recipient firm does not have the capacity to absorb it, indicating difficulties in achieving strategic fit (Teece 1977).

Shelton (1988) presents an alternative model for measuring strategic fit by focusing on how well the assets of the merging firms can be combined to facilitate production. The model depicts how assets combinations change the product market opportunities of the bidding firm. The model further shows that whilst a merger, as a whole, can create value, certain combinations of assets may destroy value. As a result, a system of classifying M&As that measures the various types of strategic fit between target and bidder assets will provide an indication of the amount of value mergers can create. This will provide the bidder with a much clearer idea of which types of asset combinations they should be aiming for.

The system of classifying acquisitions by Shelton (1988) is based on the related-complementary and related-supplementary concepts developed by Salter and Weinhold (1979). A related-complementary fit, and a related-supplementary fit, are denoted by vertical and horizontal integration, respectively. In a related-complementary fit, the target assets provide the acquiring firm with new products and skills for product markets currently served by the bidding firm. This strategy provides the merged firm with the opportunity to strengthen its market position by serving current customers with new products and improved technology. A related-supplementary target asset, on the other hand, provides the acquirer with access to new customers and markets with the same product.

Even though related-supplementary and related-complementary fits both provide opportunities for reducing marketing and production costs, the former provides greater opportunities to harness excess capacity in managerial talents. Related-supplementary fit involves expansion into new markets with new customers. This is achieved by utilizing managerial creativity in order to use combined assets effectively in exploiting the new markets made available by acquiring the target. According to Shelton (1988), strategic business fits can be ranked in descending order of synergy creation potential as follows:

1. Identical: where the merger results in similar products being offered to similar customers.
2. Related-supplementary: where similar products are offered to new customers.
3. Related-complementary: where new products are offered to similar customers.
4. Unrelated: where new products are offered to new customers.

Different categories of fits create different values for the merged firm. There is evidence that unrelated fits provide the least amount of value creation in mergers (for example, Lubatkin (1983); Shelton (1988)).

Linking Strategic Fit to Organizational and Cul...

Table of contents

• Cover
• Half Title
• Title
• Copyright
• Contents
• List of Figures
• List of Tables
• Acknowledgments
• Preface
• About the Editors
• List of Contributors
• PART I STRATEGY DEVELOPMENT AND TARGET IDENTIFICATION
• PART II DUE DILIGENCE AND RESULTS EVALUATION
• PART III DEAL NEGOTIATION AND POST-MERGER INTEGRATION
• Index