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Conclusions and Implications

THE “WHAT” OF M&A FAILURE: PREVALENCE OF FAILURE AND SUCCESS

Contrary to conventional wisdom M&A is not a loser’s game. A large mass of economic research suggests that investments through acquisition pay about as well as other kinds of corporate investment: On average, they cover the buyer’s cost of capital. This should not be surprising: Competition in markets tends to drive returns toward this cost.

Neither is M&A necessarily a winner’s game. The returns to buyers show a wide dispersion around the average.This dispersion suggests a non-trivial chance that one can lose meaningfully from M&A. But the failure rate in M&A seems no larger than in other business pursuits that are generally applauded, such as new business start-ups, new product introductions, expansions to new markets, and investments in R&D and new technology. I suspect that if the public could see all corporate investing with the kind of clarity with which we evaluate large mergers, we could conclude that M&A tends to be in the range of tolerable risk. Business is risky. One should aim to manage risk better, not eliminate it.

Viewing the dispersion of returns to buyers, my advice to the business practitioner is to be coldly realistic about the benefits of acquisition. Structure your deals very carefully. Particularly avoid overpaying. Have the discipline to walk away from uneconomic deals.Work very hard to achieve the economic gains you hypothesized. Take nothing for granted. M&A is no money machine, and may well not offer the major career-building event you wanted.The only solace is that you could say the same about virtually any other form of corporate investment: On average and over time, your shareholders will tend to earn the cost of capital on M&A activity. Given the uncertainties in M&A as elsewhere, one must remember the ancient advice, caveat emptor (buyer beware).

THE “WHERE” OF M&A FAILURE: NEIGHBORHOODS OF FAILURE AND SUCCESS

A wide dispersion around the average experience for buyers in M&A means that you cannot be terribly confident of hitting the average return simply by acquiring naively. Something must be going on in M&A markets that can help us understand the propensity to gain or lose.

All M&A is local. Research suggests that the market for acquisitions is highly segmented. The large implication is that blanket assertions about M&A profitability are not terribly useful. It is better to have a view of M&A profitability informed by these different segments than to think in average terms.

Chapter 2 summarizes findings along 18 dimensions that explain material differences in returns to buyers. Synthesizing across these areas suggests that buyers are more likely to fail in M&A when:

• The buyer enters a fundamentally unprofitable industry, or refuses to exit from one. All sensible acquiring begins by thinking like an investor. This means making sound industry bets based on expected returns and risks.

• The buyer acquires far away from its core business. “Far away” can be measured in geographical terms: Research suggests that foreign buyers pay a premium for local knowledge. But distance can also be expressed in strategic terms: Acquiring into the same or related industries is associated with higher returns. The discovery and exploitation of merger synergies is more likely when you are dealing with familiar territory. However, a firm’s core competency could be in managing a portfolio of unrelated businesses. Thus, the key strategic driver of profitability has less to do with focus and relatedness and more to do with distance expressed in terms of knowledge, mastery, and competencies. What does your firm know? What is it good at doing?

• The economic benefits of the deal are improbable or not marginal to the deal. The capital market judges merger synergies skeptically. Such skepticism is fueled by long experience with hyped expectations created at deal announcements.Thus, sophisticated investors adopt a “show me” attitude toward synergies. Executives should internalize this skepticism and exercise it in the earliest stages of deal discussions.

• The buyer fails to seek some economic advantage. Bargaining power pays; bargaining weakness is costly. What advantage does your firm have, or can it create, in trying to do a deal with the target? What are the sources of that advantage? Can those sources be duplicated by competitors? The famous “winner’s curse” is associated with auction-type settings. The research suggests that there may be a “winner’s blessing” in negotiated acquisitions for private companies.The point is that you must think carefully about what special resources you have and in which settings those resources can be deployed most profitably.

• The buyer does not adapt the deal design to the situation.Years of capital market research show that tailoring in the design of deals and financial instruments pays. One size does not fit all.You can probably improve the returns from M&A to the buyer through artful deal design.The use of cash, debt financing, tax shields, staged payments, merger-of-equals terms, and earnout incentive structures are all associated with higher buyer returns.

• The buyer has poor systems of governance and incentives. The avoidance of deals from hell begins with effective checks, balances, and incentives among the board of directors and senior managers.

The survey of scientific research tells us that executives have choices in M&A that, when made thoughtfully, can tilt the odds of success in their favor. Though I doubt that success or failure in M&A is predestined, where you choose to do deals (in the sense of the previous elements) has a significant influence on outcomes.

THE “WHO” OF M&A FAILURE: PROFILES OF FAILURE AND SUCCESS

The best and worst transactions are significantly different from each other and from the middle of the distribution. Chapter 3 gives some new findings about the profile of buyers in the most and least successful deals.These findings are consistent with the broader mass of research in Chapter 2, especially the virtues of staying close to what you know and of tailoring the deal terms. The profiles of the standout successes and failures added two more conditions that the buyer is likely to fail where:

1. The buyer acquires out of weakness. How the buyer and target complement each other has a big effect on outcomes. Successful buyers bring to the acquisition capabilities that can help the target prosper. Unsuccessful buyers tend to bring weaknesses to the acquisition that they hope the target will fix. Failure may be more likely because of flaws of the buyer, rather than flaws of the target.

2. The buyer goes “hot.” Deals done in “cool” markets and industries tend to be more successful than deals done in “hot” markets and industries. Under hot market conditions, prices are high and buyers are numerous. It is easy to get caught up in deal frenzy and overoptimism, and to overpay. In cool markets, one can be more judicious and disciplined as a buyer.

One can always find exceptions to generalizations such as these, but such exceptions merely prove the larger rule that all M&A is local. The wise M&A practitioner thinks in terms of the different neighborhoods rather than the entire metropolis.

THE “HOW” OF M&A FAILURE: THE “PARABLE”

Chapters 2 through 4 offer a glimpse into the kinds of drivers associated with financial and real disaster. From that research, I distilled six dimensions of failure: complexity, tight coupling, adverse management choices, business not as usual, execution failures associated with the malfunctioning of a team, and cognitive biases. Viewed through the lens of these dimensions, the 10 case studies of M&A failure display many points in common. Appendix 15.1 offers a summary comparison of the failure cases.The similarities are striking and might be summed as the following parable of merger failure:

One day, a buyer decided to acquire a target. Because of size, technology, and/or breadth of products or markets, each firm was complex. This made it hard for the operating managers and senior executives to know what was really going on or to take quick and decisive action in response to problems. In addition, units within each firm were interlinked so that changes in one part would be felt in the others. Thus, each firm was a “system.”The proposed acquisition would increase the complexity. In addition, the nature of the companies and of the deal terms themselves offered little tolerance for error. However, the environment for the deal was uncertain; external forces made it a turbulent world. In this context, management of the buyer made some choices that seemed reasonable and perhaps innocuous but that actually amplified the stress and exposure to risk. Perhaps sounder judgment would have counseled slowing down, changing, or canceling the acquisition, but management and the organization had a different mind-set, a focus on sunk costs, overoptimism, arrogance, or a sense of momentum and deal frenzy. The team of employees who were chartered to manage the integration of the target into the buyer failed to function effectively: Inattention, miscommunication, bickering, and poor planning diverted them from resolving problems that mattered.

So . . . the acquisition occurred. Business did not go as usual, which produced errors from plan. Because of complexity and tight coupling, the errors radiated through the company and out into the marketplace. Customers complained and departed; so did key employees. The integration team reacted poorly to these errors: They disbelieved the significance of the errors, took their time, and over- or under-corrected. Thus, the errors festered and compounded. Eventually deterioration became obvious to all: Business meltdown was in progress. Under great stress, the team broke down. A new team came in, but by then the wreckage was so complete that their mission became disgorging the target with the least remaining damage to the buyer.

In addition to points of similarity among the cases, one also sees rich variation. These variations lend texture to our understanding of what can go wrong. Consider the variations we see among the deals:

• Business complexity makes it difficult for managers to understand what is going on in the merger or to take action. Given that these are large firms and transactions, complexity is a fact of life in the deals from hell and the comparison deals. By itself, complexity is not a predictor of failure though it is probably a necessary precondition. The preeminent example of the confounding role of complexity is the Pennsylvania/New York Central merger. Other cases displayed high complexity based on large size and conglomerate organization (Tyco), logistics (Revco), project diversity (Sony), organization (Renault /Volvo), and technology (AT&T).

• Limited or no flexibility.With tight coupling, the absence of “buffers” or flexibility to absorb shocks, the crisis radiates through the firm, leading to a compounding of problems. Trouble can travel. Overpayment or aggressive financing of the deal eliminate degrees of freedom for managers to respond to problems. Though leveraging the firm, for instance, can create incentives for management to run a tight ship, it can also asphyxiate the firm: The case of Revco Drug Stores is the classic example here.

• Business not as usual, trouble in one or more parts of the firm. Complexity and tight coupling mean that little errors can become big problems. Turbulence in the business environment produces errors. Every one of the 10 deals from hell featured major turbulence, including from technology (AT&T/NCR), capital markets (AOL/Time Warner, Dynegy/Enron, Revco), industry overcapacity (Renault/Volvo), rising costs (Sony/Columbia), competitor entry (Quaker/Snapple), or government action (Tyco, Penn Central).

• Cognitive biases cause management and employees to ignore or deny risks and the crisis. Deals from hell are typically launched with confident assertions of benefits and a happy future. Appendix 15.2 summarizes choice statements by CEOs in the 10 cases presented here. To be fair, CEOs face the task of rallying the employees and other stakeholders to meet a major challenge and will say things like these to win support. But the evidence from archives and interviews tends to suggest that the CEOs believed sentiments like these. Overoptimism (also called “hubris”) is pervasive at the start of most of these failed deals. Quaker Oats suffered from recency bias:William Smithburg had succeeded with Gatorade, so doing it again with Snapple seemed like a cinch. AT&T suffered from escalation of commitments and sunk cost mentality. Having declared in 1984 that they would carve a new identity at the convergence of telecommunications and computing, Robert Allen insisted on doubling the bet in acquiring NCR. Jill Barad (Mattel) and Dennis Kozlowski (Tyco) adopted policies consistent with momentum thinking. In contrast, the evidence from case studies of successful corporate change suggests that effective leaders have a sober assessment of the situation, are candid with employees about the opportunities and the potential threats, are disciplined emotionally and intellectually in their evaluation of the change, and lead as servants of the enterprise and its stakeholders.

• Adverse management choices increase the risk of the deal or the firm. Each of these deals from hell entailed senior management choices that bore unintended consequences.The existence of unintended consequences is nothing new; most decisions have them. But in the case of the deals from hell, these decisions seem especially ill-considered. Penn Central’s decision to accelerate the pace of integration triggered higher capital spending and operational chaos. Revco’s decision to change merchandising strategy sacrificed profitability at a time when the firm depended on stable cash flow. Sony decided to bet the ranch on a couple of relatively inexperienced Hollywood producers. Rather than enhancing the likelihood of success, these decisions worsened it.

• Flaws in the operational team hamper response to the crisis. A common theme in the deals from hell is cultural difference between the buyer and target organization. Such difference can stem from nationality (Sony/Columbia, Renault/Volvo), operating rivalry (Penn Central), or different industries (AOL/Time Warner, AT&T/NCR). Lack of candor, political infighting, aberrant leadership, and failure to exploit a response window also reflect flaws in the operating team.

THE “WHY” OF M&A FAILURE: THE PERFECT STORM

Mergers and acquisitions fail because of a convergence of forces, a “perfect storm” of poor choices, poor execution, cognitive biases, and bad external conditions. It may not be necessary for all of these forces to be present or to be individually powerful to trigger a failure. A deal between two very weak firms (such as the Pennsylvania and New York Central railroads) may be more susceptible to disaster than a deal between two robustly healthy firms.This is a fertile subject for future research; with more experience and analysis it may be possible to illuminate the “locality” or contingencies of M&A success and failure. But the perfect storm analogy can help executives understand the storm warnings of where failure is more likely. And it lends a number of important insights.

First, the foundation for failure-avoidance is systems thinking, seeing the complexity of the drivers of failure with sufficient clarity to anticipate failure. There is no single fatal flaw that explains merger failure. Avoid the tyranny of sound-bite explanations. All of the research, both the case studies and the large-sample work, suggest strongly the jointness of causes. As Victor Hugo said, “Great blunders are made like large ropes of a multiple of fibers.”

Second, many of the drivers of M&A failures are not merely common; they are prevalent in business. For instance, business is almost never “as usual.” Most companies and mergers immerse the decision-makers in complexity. Behavioral economists tell us that cognitive bias is the rule, not the exception.Thus, how can it be that failure is the exception rather than the norm? The answer lies in the jointness of the perfect storm. The likelihood of a whopping failure depends on the joint probability of each of these forces occurring at the same time. Just for the sake of illustration, suppose that there is a 75 percent chance that the buyer and target will be complex firms, 75 percent chance of tight coupling, 75 percent chance of business not as usual, and so on. Then the joint probability will be (0.75)⁶ or 18 percent. One could argue that life is more complicated than this little illustration, but even with refinements, the general idea would hold: The various seeds of failure might be prevalent in the business environment, but it is when the slot machine shows all six together that you are really at risk.

Third, the drivers of failure may be mutually-reinforcing. For instance, cognitive biases such as overoptimism or momentum thinking may promote bad managerial choices or hamper the responsiveness of the operational team. Crisis conditions outside the firm (business not as usual) may distract senior executives and operating managers from the task of merger management. Complexity may promote a false sense of security that sustains cognitive biases and bad managerial choices. And so on. Where there is some correlation among the major drivers of failure, then the probability of failure outlined in the preceding paragraph will rise.

The important implication of these insights is that you can enhance the success of an acquisition by attacking the system of failure, the mutually reinforcing nature of the six drivers, and the likelihood that they will converge at a point in time. As the example of the probability calculation suggests, one can attack the individual probabilities of the six forces and the correlations among the forces. This is the approach of the “high reliability organization” (HRO) such as a hospital emergency room, an intensive care unit, and an aircraft carrier flight deck. Chapter 4 outlines some of the attributes of the HRO:

• A preoccupation with failure. HROs are obsessive about the potential for things to go wrong.

• A reluctance to simplify.This attribute fights “mindlessness,” a reliance on rote application of decision rules, checklists, and past experience.

• A continuous sensitivity to operations, vigilance to changes from plan or from a benchmark.

• A commitment to resilience. HROs assume that surprise is around the corner and prepare for it.

• A deference to expertise. HROs presume that the best decisions will be made by those who are best-informed, usually people at the front lines. Thus, decision-making is decentralized.

Though I know of no organization that explicitly has adapted to M&A the terms and concepts of the HRO, my field interviews with successful serial acquirers have revealed the HRO’s spirit and concepts at work.

FURTHERMORE: A FAILURE-FREE WORLD OF M&A?

Every CEO should want his or her firm to avoid the deal from hell. But do we really want a world completely devoid of M&A failure? Such a world is unimaginably costly to construct and police. All insurance is costly.You would need to insure against a range of factors within and beyond managers’ control. And the policing function inside corporations (“no mistakes, never, ever”) would probably suppress success as well. Economics teaches that where there is no risk, the best you can expect is, well, the risk-free rate of return. The human spirit seeks to exercise ingenuity and risk-taking in the pursuit of a better life. Is the risk-free rate all that we will settle for?

Get a grip.The huge advances in civilization came from people who, at some considerable commitment of personal wealth and comfort, took a risk. We want the business economy to take risks—new drugs, environmentally-efficient housing and transportation, comfortable clothing, better connectivity with others, and food that is more nutritious and better-tasting—all these are the dividends of entrepreneurial risk-taking. But to get this, we need to put up with a certain amount of trial-and-error. Failure is the price we pay for the experimentation that brings breakthroughs.

How much failure must we tolerate? As Chapter 2 outlines, material and significant economic failure in M&A is relatively rare. Some neighborhoods of the M&A field are more profitable than others. But on average, M&A does pay.

The kinds of corporate boners sketched in this book test our tolerance for corporate risk-taking. As consumers, investors, and taxpayers, we suffer when M&A fails on this scale. But rather than banning large mergers, we should mitigate the risk of failure through better systems of management. Everything begins with setting the highest expectations of corporations. These expectations should be focused on processes rather than on outcomes in the belief that how you do business has a big influence on the results. For instance, we should expect:

• Ethical behavior of corporations and their advisors. Where there is no trust, corporations forfeit their support from the public.

• Systems of governance that are loyal to the interests of stakeholders and careful in the sense of keen attention to the details of M&A proposals.

• Deal design with enough slack in their transactions to allow for adequate variance from business as usual.

• Systems of merger integration that employ best practices in planning, information, and implementation.

• Teams of executives to work together in ways that permit dissent and foster high reliability.

• Suspension of hubris and other cognitive biases at the door of each M&A transaction.

These six process-oriented expectations will not forestall all failures. But the research offered in this book suggests that adoption of practices such as these will lower the odds of failure. Managing the odds, rather than eliminating them, is what we should aim to do.

In short, the attitudes that we bring to our corporations really matter. Let us focus our intolerance for failure on promoting good processes rather than on suppressing risk-taking and the benefits that come with it.

APPENDIX 15.1 A COMPARISON ACROSS THE CASES OF MERGER FAILURE