Acquisitions — Myths and Reality

THE RISKINESS OF acquisitions as a vehicle for corporate renewal is reflected in both empirical studies of acquisition results and managers’ comments about their experiences. Although many factors contribute to acquisition performance, a variety of recurring patterns in the acquisition process offers clues to the disappointing results. By considering how this process affects the results, we believe managers may gain insight into ways to control negative outcomes. In addition, we hope to expand the debate about acquisitions to the domain of corporate strategy, lb achieve this end, managers must first be willing to adopt a “new” perspective—one that counters the prevailing truths to which many of them subscribe. This perspective hinges on six observations.

• Acquisitions don’t succeed… acquisitive strategies do.
• Shareholders are the least important constituency.
• Managers try to capture rather than create value.
• Strategic analysis plays only a small role in successful acquisition strategies.
• Nothing can be said or learned about acquisitions in general.
• Companies do not learn all they could from their mistakes.

Acquisitions Don’t Succeed . . . Acquisitive Strategies Do

Unfortunately many executives see acquisitions as ends in themselves, not as means to an end. We, however, view acquisitions as an alternative to other equally viable forms of corporate renewal such as internal development, joint ventures, and license agreements. All are means for the firm to secure a capability or a position important to its development and renewal strategy.

Most managers long ago abandoned the practice of judging capital investments solely on a project-by-project basis. Typically, each project is viewed in the context of its contribution to the firm’s overall strategy. Acquisitions, however, are still often considered in isolation from that strategy, even though their monetary value and strategic importance are usually much greater to the firm than most capital investment projects.1

This isolation stems from an inevitable element of opportunism in the acquisition process mat tends to shift the focus of evaluation immediately to the acquisition prospect and its price, thereby neglecting consideration of the acquisition in its strategic context.

Adequate acquisition analysis goes beyond a study of the candidate firm itself and includes an examination of a potential acquisition’s contribution to the firm’s corporate development strategy as well as to the quality of that strategy.2 In other words, we believe that what determines the success of an acquisition is not the acquisition itself, but the acquisitive development strategy that underlies it.

Shareholders Are the Least Important Constituency

Most management literature, statements by executives, and the prevailing theory of the firm imply that shareholders are the most important constituency in an acquisition—with the key objective being the maximization of shareholder wealth. Yet, the preponderance of empirical evidence from financial economists indicates that acquisitions create value only for the shareholders of the acquired firm, not for those of the acquiring firm.3

Compared with managers, employees, investment bankers, commercial bankers, and lawyers, we contend that, in practice, shareholders are often given the least consideration because they are the farthest from the acquisition and therefore have the least influence. To paraphrase Churchill, “Shareholders are the most important constituency in an acquisition, except [for] all the others.”

If influence is the most critical element in the acquisition process, then the senior executives of both firms and key outside advisors (e.g., investment bankers and consultants) end up being the most important constituency. Alternatively, if the criterion is the extent to which one is affected by the transaction, then the managers and employees of both firms (especially the target firm) are surely the most important. In addition, there are indirect constituents—suppliers, communities, and outside advisors (e.g., investment banks and consultants). All of these groups have a stake in the outcome of an aquisition. The irony here is that the party least able to make its wishes known is the farthest from the action — the shareholders.

We do not mean to imply that those parties who are more directly involved in acquisition decisions (i.e., managers and outside advisors) malevolently neglect the interests of the shareholders; rather we suggest that their personal interests are foremost in their minds and that these interests are not always congruent with those of the shareholders. This problem is exacerbated by our next point.

Managers Try to Capture Rather Than Create Value

The ostensible purpose of an acquisition is to create economic value for the acquiring firm’s shareholders through a superior combination of the skills, resources, and capabilities of the two firms. Because this intention has proven difficult to achieve in practice, quite often managers try to capture value at the time of the transaction rather than create value after the acquisition.

We see capturing economic value as a one-time event that is due to the transaction. Examples of this are asset stripping and the tax benefits associated with a particular acquisition. In contrast we view economic value creation as a long-term phenomenon that directly results from managerial actions.4

The preference for value capture rather than value creation stems from the difference in predictability and timing of the benefits. Capturing value via tax benefits or selling off parts of acquired firms offers quick, predictable returns; whereas creating value is a difficult and uncertain process.

Our argument about value capture may seem to contradict the fact that most acquisitions are justified on the basis of a list of predicted synergies found in acquisition dossiers. Quite often, though, these expected synergies serve foremost to gain support from various groups: they rarely represent a realistic appraisal of what the two firms can create together because operating managers play a limited role in the pre-acquisition analysis.5 Furthermore, although value creation opportunities are emphasized at this stage, the actual deal structuring is geared to capturing rather than creating value because the benefits are more clearly definable.

We do not suggest that managers not try to capture the transaction-related benefits from an acquisition, because these can indeed be important. Instead we encourage them to shift their focus to a longer-term development strategy that has at its core creating economic value through acquisition.

Strategic Analysis Plays Only a Small Role in Successful Acquisition Strategies

The process of making the aquisition—what you do before the agreement—and integrating it—what you do afterward—determines the success of an acquisition as much as the original purpose, the good intentions of the managers involved, and the quality of the analysis. Despite the prevalence of logical advice on what to look for in acquisitions, many firms have experienced disappointing results with their aquisition programs. This suggests that something more than inadequate analysis or lack of good intentions may be at work. In fact, recent research indicates that the aquisition process is an important but neglected part of the activity.6 Thus three points merit further examination: (1) the process itself contains impediments to ultimate acquisition success; (2) value creation takes place only after the agreement; and (3) the acquisition process often destroys more value than it creates.

Seeds of acquisition failure are sown in the process.

The acquisition process makes it difficult for an acquisition to achieve its intended purpose because of the diversity of people involved, time pressures, and ambiguity of purpose.

The number and variety of specialists working in isolation leads to divergent, unintegrated perspectives. To make matters worse these experts usually harbor personal agendas and goals, few of which relate to how the acquisition should be managed after the agreement is signed. Severe time and secrecy pressures also come into play in such a way that the acquisition process gathers momentum and assumes a life of its own. These pressures allow the technical, legal, and financial perspectives to dominate negotiations, thereby driving out strategic analysis, as well as considerations of how to integrate the firm afterward.

In addition the process creates a situation where ambiguity during negotiations is endorsed by both parties. In other words, because of dissimilar interests and pressure to reach an agreement, the parties agree to disagree on major points. Thus, key issues that can fundamentally affect the outcome of an acquisition are left unresolved. The situation is likely to worsen after the agreement is signed: neither party is inclined to alter his or her position and attempt to resolve these ambiguous issues. The problem is compounded by a buildup of mistrust. Suddenly, constructive conflict resolution is replaced by the parent firm imposing its will on the subsidiary.

Value creation begins when the agreement is signed.

Although the transaction may enable managers to capture economic value, such value is created only after an agreement is signed and indeed depends entirely upon the two firms’ working together over time. Yet often, after the initial flurry of activity, effort, analysis, and communication subsides, senior management tends to move on to other activities, thereby delegating the integration task to line managers who often were not involved in developing the acquisition’s rationale.

Regardless of its presumed merits on paper, the success of an acquisition is fully dependent on the quality of integration and post-acquisition management. The integration phase involves combining the skills, capabilities, and destinies of the two organizations and may take several years: even then the outcome is difficult to predict. Thus, before integration begins, managers should consider: What should be integrated? Who should be involved? When should integration take place? Even beyond this phase, problems may arise if the acquirer’s top management cannot effectively operate a business that has a strategic logic different from the firm’s core businesses. The truth about general management is that it is not always that general.

The acquisition process often destroys more value than it creates.

It is important to recognize the distinction between economic and noneconomic value, both of which are present in an acquisition. Economic value can be thought of as benefits that ultimately accrue to shareholders via the stock price. Noneconomic value represents nonmonetary benefits that accrue to other constituencies in the acquisition (e.g., managers, employees, and communities). Such benefits include job security, opportunities for career advancement, or the status of being affiliated with a particular organization.

The classic view of acquisitions focuses on creating economic value for the shareholders. Ironically, acquisitions often destroy noneconomic value for those who are asked to create economic value after the transaction is made. Creating economic value requires the cooperation and commitment of operating-level managers of both firms in order to combine the skills, resources, or knowledge of the two firms. Yet it is precisely this group and their subordinates for whom the acquisition destroys noneconomic value through the loss of job security, status, or career opportunities. The human cost of acquisitions tends to be very high.7 We contend that it is unrealistic to expect this group to neglect their own interests in favor of anonymous shareholders.

Nothing Can Be Learned or Said about Acquisitions in General

Although much of the academic research on acquisitions has used large samples to draw general conclusions about their success and failure, practicing managers have a right to be skeptical because the issues, reasons, and chances for success vary with (1) the type of acquisition, (2) the type of synergy, and (3) the degree of interdependence.

• Type of Acquisition. Acquisition managers should consider four questions to help them understand the benefits, risks, and decision-making processes involved in an acquisition.8
• Why are we acquiring? Are our motives defensive, or do we want to capitalize—in an offensive way—on underutilized competencies or resources?
• Who is acquiring? Does the initiative for the acquisition and the responsibility for subsequent management lie with corporate or divisional management?
• What do we know about the business? Is this an entry into a completely new field? Is it a step out from our existing business? Or is it merely a horizontal acquisition of a competitor?
• What are we acquiring? How significant a part of our development strategy does the acquisition represent’ Are we acquiring just a competence needed for that development strategy; a platform that provides initial entry into a desired business, but which will need major follow-up investment to be viable; or an existing viable business position?
• Type of Synergy. It is important to note that nothing much can be said about synergies in general. Different synergies correspond to different types of benefits as well as to different sources of problems. Rather than drawing the traditional distinction between related and unrelated acquisitions, we suggest a more subtle view of related-ness that distinguishes among four sources of benefits: resource sharing, functional skill transfer, financial transfer, or strategic logic.9 Managers can address this issue by asking these questions.
• Is the relatedness between both firms such that resource sharing is possible? Keep in mind that tangible resources (e.g., distribution systems) as well as intangible ones (e.g., brand names) can be shared.
• Are the functional competencies in the acquired firm really similar enough to allow for value creation through functional skill transfer? The marketing, manufacturing, or R&D skills possessed by companies are not that general. In fact, competitive advantage is based on a set of much more specific functional capabilities. Successful skill transfer in acquisitions requires an awareness of what these are.
• Are the financial requirements of both firms complementary enough to create economic value through, financial transfers in order to allow one of the firms to grow at a rate faster than that possible using only its own cash generation potential?
• Is the strategic logic of both businesses similar enough so that top management can ensure adequate strategic control and improve the general management of the acquired company?
• Degree of Interdependence. Examining the nature of relatedness is only the first step in value creation. The realization of benefits depends solely on the extent to which, and the ways in which, the interdependence of the two firms is actually managed. This decision involves a tradeoff between the benefits of integration and the benefits of autonomy. In turn, that tradeoff depends not only on the relatedness and nature of the businesses but also on the acquiring firm’s management approach and its ability to integrate the two firms. In our experience, most firms tend to overestimate the latter.

A common assumption is that the more closely related two companies are, the greater the economic benefits. The evidence, however, is inconclusive.10 The main reason seems to be that the benefits offering the greatest potential in theory are also more difficult to implement in practice. Resource sharing, for example, implies rationalizing and disposing of assets. This, in turn, implies the destruction of noneconomic value. Indeed, the power, status, and prestige that an employee has built up over a career may be dashed to the rocks by the “economic” rationalization of the work force. Skill transfer assumes the mobility of people and cooperation among organizational units. But this too may destroy noneconomic value by asking employees to move to a new location. In contrast, the limited benefits of financial transfer require less interaction among parts of the firms and may be more easily realized.

A major reason for the difficulty in gaining the hoped-for benefits from a related acquisition is that acquisition analysts rarely consider implementation issues before the acquisition. Instead, they tend to justify acquisitions by adding up benefits they can easily observe.11 However easy it is to see multiple benefits in theory, successful implementation depends on creating proper organizational conditions and prioritizing objectives. When faced with managing diversity, all firms can structure themselves to achieve one benefit. Some can even handle two dimensions of diversity rather well. But, simultaneously pursuing different types of interdependence across different functions is an illusion. In practice value creation stems from focused and managed interdependence.12 Thus, the integration phase in an acquisition is the key to value creation because sustainable economic value is created after the transaction.

Companies Do Not Learn All They Could from Their Mistakes

Our final observation is that the experience factor cannot be underemphasized: companies can learn general lessons from acquisition activities, especially along the points we discussed earlier. They can also learn which company-specific factors impede success. Based on their experiences, managers can and should make some conclusions that may influence future acquisition activities.

However, even in firms where acquisitions are no longer unfamiliar events, senior managers do not draw on their valuable and often expensive experiences with acquisitions. In fact, since many operating executives who will manage post-merger integration are not included in the analytical process, firms forgo the best way to provide continuity in a given acquisition. Consequently, implementation issues are not considered early in the process. In the firm’s next acquisition, for instance, few managers with previous hands-on experience are likely to be on the team. Thus, it is not surprising that the same mistakes are made repeatedly.

Although many firms have put together in-house acquisition teams, these teams serve more to provide technical, legal, financial, and negotiating support than to accumulate broad-based acquisition experience. Few companies, even those that have acquisition teams, have conducted extensive postmortems to probe into “what happened” and “why it happened.” Instead, each divisional manager is left to reinvent the wheel at his or her own risk.

The Debate Continues

The current debate on acquisitions is encumbered by a number of myths, several of which have been discussed here. Out of these myths, two extreme views seem to be emerging. One suggests that acquisitions are a ready-made solution to managers’ problems. The other suggests that shareholders of acquiring firms never benefit from acquisitions. Neither view is true, and together they have the potential to impede management’s attempts to provide realistic corporate renewal opportunities for its firm.

The first misguided view is that an acquisition by itself can offer immediate and sweeping solutions to a firm’s problems of strategic redirection and renewal. The argument goes something like this: “Why should we spend time on internal development activities when both profits and growth can be more easily and speedily bought outside?” In contrast to this philosophy, we presented a series of observations that focus on the efforts needed to make an acquisition achieve its strategic purpose, and on the difficulties managers often encounter when doing so. These difficulties, which are deeply embedded in the process of analyzing, negotiating, and integrating the acquisition, can be overcome if the acquisition process takes into consideration the specific circumstances of both the parent and target firms.

To address these problems, each firm must first consider a series of delicate tradeoffs. Commitment and detachment must be balanced before the agreement is reached. In the same vein, the tradeoff between involvement and autonomy after the acquisition must also be considered. Finally, throughout the process, managers should guard against tendencies toward excessive opportunism and determinism in the final purpose.

The other viewpoint—that acquisitions are essentially driven by managerial motives and never benefit the acquiring firm’s shareholders—has been fueled by the spectacle of major hostile takeovers. It also appears to have been reinforced by the studies of financial economists, who in observing the immediate impact of an acquisition event on a firm’s stock’s price, conclude that there is little or no positive impact on the acquiring firm’s shareholders.

We should keep in mind that the methodology in these studies relies on large samples, and arguments are made about averages that cover a wide range of outcomes rather than any particular firm’s acquisition strategy. More important, these outcomes represent the security market’s a priori expectations within a narrow time span around the time the acquisition is announced. As such, they focus on whether the perceived value captured exceeds the price premium paid. We argued that the real payoff comes from the value creation process that often takes several years to unfold.

Acquisitions often present unique corporate development opportunities, of which the scope or time frame can neither be entirely predicted beforehand nor replicated through internal development alone. This means that for a company to get the most out of an acquisition, managers need to adopt a process view for acquisition decisions and a development view for acquisition integration.

Our observations should not be used as arguments to abandon acquisition opportunities. Acquisitions will continue to be an important form of corporate development and strategic renewal. The pressures and opportunities presented by industry restructuring and environmental change argue for a continued ability to combine firms. Rather, in light of the perils and costs associated with acquisitions, we urge executives to examine their own corporate myths about acquisitions and to give more thought to how they manage the acquisition process itself.