It is known that 50-70% of acquisitions fail. Many researchers have tried to answer why. Most research focus on post-deal factors, and “cultural incompatibility” emerges as a common theme across failed deals. But acquirers conduct detailed due diligence (DD) before investing. Four types of DDs are common: financial, tax, legal and commercial. Acquirers may also run background checks on key leaders of the target company.
The DDs are conducted by top accounting, law and consulting firms and their fees add up to millions of dollars and often account for 2-3% of the deal value. Most of these firms do tens, if not hundreds, of such DDs every year, and are very experienced. Also, the projects are prestigious and attract their brightest employees. So, why do deals fail despite such DDs? There are three main reasons for this.
The first reason is structural. Many of these deals are run by sell-side bankers who are paid a part of the deal value. Their only incentive is to maximize the price. They have no stake in the success of the deal. These bankers design the process to foster unhealthy competition among multiple buyers, by crunching DD timelines to mere weeks and restricting access to information and the seller’s management. Prospective acquirers are forced to make assumptions and bid high to win.
The second reason is historical. Majority of such DDs are done by private equity (PE) and venture capital (VC) firms. They are investors who do not operate the firms they acquire. Such firms have small staff and hire consultants for all their DDs. Consequently, the DD processes of the accounting, consulting and legal firms are tailored towards such PE and VC clients, not strategic investors. They focus disproportionately on the numbers and mechanics of the deal, not the human and cultural factors that are crucial at the post-merger integration (PMI) stage.
The third reason is paradoxical. The hard stuff is easy, and the soft stuff is difficult. It is easier to analyse numbers, understand revenue and cost trends, and make projections under various scenarios than developing a deep understanding of the target’s culture and the motivations of its leaders. Most DD processes focus on the hard stuff, and the soft stuff are ignored (worse, scoffed at). This explains why “cultural incompatibility” is a key reason why deals unravel.
So how can DDs be done better? Our experience indicates five ways. The first is obvious, but not always practical: Avoid banker-run deals where multiple suitors compete for the same target under crunched timelines. Conduct sector scans to identify targets that are strategically aligned and structure bilateral deals. These deals are done over reasonable durations during which the acquirer has exclusivity, and hence can do thorough DDs. Second, while consultants may lead the DD processes, the leaders who will drive the PMI must be integrated into the DD teams. It is not enough to integrate members of the acquirer’s strategy or M&A teams. The leaders who will be responsible must get involved upfront. Third, maximize facetime with the seller’s management to understand the culture. These sessions can be structured as laddering interviews, a technique based on clinical psychology. It encourages the interviewee to tell her story augmented by provocative questions, hypotheticals, role-playing and circling back to uncover contradictions and understand why someone believes something and acts in a certain way. Fourth, go beyond the top management and engage with the operating leadership. The top management has the most to gain by selling and hence may portray a rosy picture. Truer pictures emerge when the next layer is engaged, as they have less to gain and will suffer the pain at the PMI phase.
Finally, make the analysis of firm culture and leadership motivation a critical part of the DD scope, especially for the consultants doing the commercial due diligence (CDD.) Experienced CDD consultants have methods to go deep into target companies (and their clients) and generate critical insights around culture, relationships and motivations. Force them to treat the difficult soft stuff on a par with the hard stuff.
Better DDs, focused equally on financial and cultural aspects, can increase the chances of success of M&A deals.
