Using Kaizen to reduce the risk of failure in mergers and acquisitions
The number of Mergers and Acquisitions (M&As) that end in failure is a matter of conjecture, but it is commonly estimated that more than 50% of all M&A deals fail to achieve their intended objectives. If true, that represents a staggering loss of investment dollars, as well as the loss of time, energy, reputation, and everything else that goes along with closing an M&A deal. Therefore, reducing the failure rate by even a small amount has the potential to save billions in lost dollars. While specific reasons for individual failures are usually cited, it is difficult to generalize about a root cause of failures that would allow investors to avoid or at least mitigate their investment risk. To find a comprehensive means of reducing the risk of M&A failure, we must look for the systemic causes of the problem.
By M&A failure I mean failures that occur after an M&A deal has been closed, not a failure to close the deal (an issue in itself). Specific reasons cited for M&A failure typically include objective business issues, such as a lack of anticipated or promised performance, culture shock, management team and loss of key employees, market changes… and so on. But again, while these may be the cause of a specific failure, citing the cause of an individual failure does not help us identify systemic causes. So, for our purposes, we will need to use a more generic definition of an M&A failure. To achieve this, we can simply define an M&A failure as a merger or acquisition that, after 2-3 years, the investor would not do again if given the chance. I limited it to 2-3 years because after that there is a good chance the business will fail for other reasons.
To find a systemic cause of failure, we must focus on the M&A process itself. Dr. WE Deming was a mid-20th century scientist who did much of the original research on quality control techniques. In his work, he demonstrated that product failures were the result of the manufacturing processes 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 principle demonstrated by Toyota when they adopted the “Kaizen” method. “Kaizen” is the Japanese word for a good or positive process change. To improve the quality of its cars, Toyota uses “Kaizen” to eliminate 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. Then we can use a “kaizen” approach to modify the process to reduce the M&A failure rate.
In general, the M&A process is a methodical and legalistic process integrated with activities related to letters of intent, the definition of terms and conditions, the creation of an acquisition agreement and other documents necessary to transfer ownership of the target business from diligent manner. Activities like negotiating deal terms or preparing to transfer documents can be tedious but have demanding results and are generally not the cause of M&A failures.
Due diligence, by contrast, is the most subjective step in the M&A process. Many investors do not fully understand the role of due diligence and start with only a theoretical understanding of what they hope to achieve. This gives us the first clue to the cause of many M&A failures.
To understand the problem, let’s take a closer look at the M&A due diligence process. To be effective, due diligence must assess three different facets of the business; legal, financial and operational, and these must be carried out with equal effectiveness. Most investors do a good job of legal and financial due diligence, but fail to perform effective operational due diligence. This is due to the fact that legal and financial due diligence is based on the frameworks of law and accounting as guiding principles and, assuming the investor has a competent lawyer and accountant, there is little reason not to perform these assessments. effective way. Operations due diligence is a different story. There is often confusion regarding what exactly should be assessed during an operations due diligence or how to measure and report on the results. To understand the nature of this issue, this would be a good time for the reader to take a moment to write down what you think constitutes effective operations due diligence. Later we will see if its definition has changed.
While not entirely accurate, it’s fair to say that financial due diligence primarily looks at the company’s past performance, while legal due diligence looks at the current state of the company (at the time of closing). Operations due diligence, on the other hand, is trying to uncover potential issues that could affect future operations and the sustainability of the business. If an operations assessment determines the probability of a negative future event occurring, then, by definition, operations due diligence is a risk assessment. Specific failures, such as culture mismatch, loss of market, and loss of key customers are examples of events that have the potential to adversely affect future business operations. If the definition you noted did not have the word risk, then you have not fully understood the role of due diligence in operations.
What about events that have a positive impact on the business? Is there, for example, an opportunity for the company 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 evaluation of opportunities. Opportunity is the probability of an event that will have a positive impact on future business operations. If an operations assessment finds that the company has a great product but sales are weak because the sales group is immature and the acquiring company already has a strong sales organization, an opportunity to improve sales has been discovered. Failing to capture potential opportunities is also a cause of M&A failure because the business will fail to reach its full potential.
Operations due diligence should be an assessment of the entire company. When asked, most people name just one or two key functions to assess and don’t provide a holistic, company-wide answer. “Operations” is a very broad term and potentially covers a wide range of operational functions. Without an established framework similar to that of law or accounting, the business framework tends to be an ad hoc list of functions. Therefore, standardizing on an enterprise-defining framework is crucial to reducing failures. Processes that do not produce repeatable results are prone to errors. Without a coherent and clearly defined framework, results are not repeatable and the potential for mergers and acquisitions to fail increases.
Investors trust their CPA and attorney to set up the legal and financial framework, but who do they trust to conduct trade evaluation? A CPA can tell you the financial maturity of the company, but how do you determine the maturity of a company’s operations infrastructure? The tendency of most investors is to “go it alone” by focusing on just one or two areas. “It was a software company, so we had an engineer review the code.” The lack of a consistent operations framework, or established practice defining it, reinforces the potential that operations due diligence is the weak link in the M&A process due to the potential for overlooked functions. business during the evaluation.
Operations due diligence should be conducted as an enterprise-wide assessment encompassing the entire operations infrastructure of the enterprise. There may be a greater understanding of 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 operational areas. Without a guiding framework, it is difficult to determine what constitutes “complete” and without a framework that can be used as a guide, the potential for missing an operations function is great, and therefore also the risk of it being missed. the potential cause of a merger and acquisition. failure. An operations assessment should cast a wide net to prevent potential risks from slipping away and reduce the risk of an M&A failing. Treating operations due diligence as a company-wide risk/opportunity assessment based on the development of a holistic framework and an ongoing M&A process improvement program is a clear way to reduce the failure rate of operations. fusions and acquisitions.
Improving the way due diligence is performed on operations demonstrates how “Kaizen” can be applied to the M&A process. “Kaizen” requires a continuous process improvement program that continues to eliminate defects over time. The examples given here are just a first step. Applying a “Kaizen” approach would mean continually reviewing the trading framework to better identify latent trading risks and opportunities. To accomplish this, we would need to look at the specific causes of M&A failure and constantly ask ourselves whether this issue was discovered during our operations evaluation. If the answer is no, then the trading framework needs to be further improved. Continuous process improvement requires resources. Investors who are continually involved in the M&A process will benefit the most from this type of program. The benefits that this type of process improvement program provides in reducing investment risk should justify the commitment of those resources.
