It is known that 50-70% of acquisitions fail. Many researchers have tried to answer why. Much of the research focuses on post-dealing factors, and “cultural dissonance” emerges as a common theme in failed deals. But acquirers do detailed Due Diligence (DD) before making an investment. Four types of DDs are common: financial, tax, legal and commercial. Acquisitors may also conduct background checks on key leaders of the target company.
DDs are operated 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. In addition, the projects are prestigious and attract their talented 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 selling bankers who are paid a portion of the deal value. Their only incentive is to maximize price. He has no stake in the success of the deal. These bankers design the process to promote unhealthy competition among multiple buyers by limiting DD time frames to just weeks and restricting access to information and seller’s management. Potential acquaintances are forced to make the impression and bid high to win.
The second reason is historical. Most of such DDs are done by private equity (PE) and venture capital (VC) firms. They are investors who do not operate the firms they have acquired. Such firms have small staff and appoint consultants for all their DDs. As a result, the DD processes of accounting, consulting and law firms are tailored to such PE and VC clients and not to strategic investors. They focus disproportionately on the number and mechanism of the deal, not on the human and cultural factors that are important in the post-merger integration (PMI) phase.
The third reason is contradictory. Hard things are easy, and soft things are difficult. It’s easier to analyze numbers, understand revenue and cost trends, and make estimates under a variety of scenarios than it is to develop a deeper understanding of a target’s culture and the motivations of its leaders. Most DD processes focus on the hard stuff, and the soft stuff is ignored (worse, ridiculed). This explains why “cultural dissonance” is a major factor that settles deals.
So how can DD be improved? Our experience points to five ways. The first is obvious, but not always practical: Avoid banker-driven deals, where multiple suitors compete for the same goal under crunchy deadlines. Conduct sector scans to identify targets that are strategically aligned and structure bilateral deals. These deals are done over a reasonable period of time during which the acquirer has exclusivity, and therefore can DD in full. Second, while consultants can lead DD processes, leaders running PMI must be integrated into DD teams. It is not enough to integrate the acquirer’s strategy or members of the M&A teams. The leaders who are responsible should be involved first. Third, maximize FaceTime with the vendor’s management to understand the culture. These sessions can be structured as a ladder interview, a technique based on clinical psychology. It encourages the interviewer to tell their story by circling back to uncover provocative questions, hypotheses, role-playing and contradictions and understand why someone believes something and acts a certain way. Fourth, move beyond top management and engage with operational leadership. The top management benefits the most from sales and therefore may present a rosy picture. True images emerge when the next layer is applied, as they have less gain and pain in the PMI phase.
Finally, make analysis of firm culture and leadership motivation an important part of the DD scope, especially for consultants performing commercial due diligence (CDD). Experienced CDD advisors have ways to delve deeper into the target companies (and their clients) and generate leads. Critical insights around culture, relationships and motivations. Force them to equate the hard soft stuff to the hard stuff.
Better DD, focused equally on financial and cultural aspects, can increase the chances of success of M&A deals.
Abhishek Mukherjee is the co-founder and director of Octus Advisors.