South China Morning Post

When to walk away from a deal

Making the right calls about acquisitions, for buyers and sellers, is a challenge that more and more executives face, and it's getting harder.

By Oliver Stratton and Michael Thorneman

Published on July 13, 2006
min read


It is supposed to be a lucky year for marriage in the Chinese calendar. But PCCW has stonewalled two foreign suitors - Macquarie Bank of Australia and private equity firm TPG-Newbridge - while agreeing this week to sell a 23 per cent stake in its business to Hong Kong investor Francis Leung Pak-to. And China Mobile Communications got left at the altar last week by its takeover target, Millicom International Cellular. Indeed, the question of the hour may not be: "How to close the deal?" but, "When to walk away?" Making the right calls about acquisitions, for buyers and sellers, is a challenge that more and more executives face, and it's getting harder. When Bain & Company recently surveyed 250 senior managers responsible for mergers and acquisitions, half said their due-diligence process—background checks and research—had overlooked major problems; half found that targets had been dressed up to look better for deals. Two-thirds said their approach routinely overestimated the synergies available from acquisitions. Only 30 per cent were satisfied with their due-diligence processes. What can companies do to address these common shortcomings? For starters, they can rid themselves of their "going-in" assumptions. Private-equity firms like Newbridge tell us their advantage as acquirers lies in being industry outsiders: they force themselves to ask basic questions about how an acquisition will make money for investors. Such coldly realistic calculations lie beneath a rising tide of private-equity-backed mergers and acquisitions across Asia. Last year, private-equity investors accounted for about 11 per cent of all merger and acquisition activity in the region. Top corporate buyers take a similarly rigorous approach. Craig Tall, vice-chairman of corporate development at US mortgage firm Washington Mutual, said: "When I see an expensive deal and they say it was a 'strategic' deal, it's a code for me that somebody paid too much." Due diligence starts with verifying the cost economics of the proposed deal. Buyers must ask such questions as: Do the target's competitors have cost advantages? Why is the target performing above or below expectations? To arrive at a business' true stand-alone value, all accounting idiosyncrasies must be stripped away. Often, the only way to do that is to look beyond the reported numbers, by sending a due-diligence team into the field. But it's important to focus these efforts. By some accounts, China Mobile's exhaustive approach to due diligence fostered concerns at Millicom which—along with pricing issues—helped scupper the deal. Successful acquirers focus on creating a detailed picture of their target's customers. They begin by drawing a map of the target's market—its size, growth rate and how it breaks down by geography, product and customer segment. It's just as important to examine the capabilities of competitors. For example, in the bid of one global food company to buy an overseas maker of fruit flavorings—which we'll call FruitCo—the acquirer found that while FruitCo boasted considerable global scale, the key competitors were national: local factors, it turned out, were the more relevant driver of costs. The global sourcing of fruit was not feasible after all. In the end, effective due diligence is about balancing opportunity with informed scepticism. It's about testing every assumption and questioning every belief. It's about not falling into the trap of thinking you'll be able to fix problems after the fact. By then, it's usually too late. Oliver Stratton is a partner with Bain & Company in Hong Kong. Michael Thorneman is a Bain partner in Shanghai.

It is supposed to be a lucky year for marriage in the Chinese calendar. But PCCW has stonewalled two foreign suitors - Macquarie Bank of Australia and private equity firm TPG-Newbridge - while agreeing this week to sell a 23 per cent stake in its business to Hong Kong investor Francis Leung Pak-to. And China Mobile Communications got left at the altar last week by its takeover target, Millicom International Cellular.

Indeed, the question of the hour may not be: "How to close the deal?" but, "When to walk away?"

Making the right calls about acquisitions, for buyers and sellers, is a challenge that more and more executives face, and it's getting harder. When Bain & Company recently surveyed 250 senior managers responsible for mergers and acquisitions, half said their due-diligence process—background checks and research—had overlooked major problems; half found that targets had been dressed up to look better for deals. Two-thirds said their approach routinely overestimated the synergies available from acquisitions. Only 30 per cent were satisfied with their due-diligence processes.

What can companies do to address these common shortcomings? For starters, they can rid themselves of their "going-in" assumptions. Private-equity firms like Newbridge tell us their advantage as acquirers lies in being industry outsiders: they force themselves to ask basic questions about how an acquisition will make money for investors. Such coldly realistic calculations lie beneath a rising tide of private-equity-backed mergers and acquisitions across Asia. Last year, private-equity investors accounted for about 11 per cent of all merger and acquisition activity in the region.

Top corporate buyers take a similarly rigorous approach. Craig Tall, vice-chairman of corporate development at US mortgage firm Washington Mutual, said: "When I see an expensive deal and they say it was a 'strategic' deal, it's a code for me that somebody paid too much."

Due diligence starts with verifying the cost economics of the proposed deal. Buyers must ask such questions as: Do the target's competitors have cost advantages? Why is the target performing above or below expectations? To arrive at a business' true stand-alone value, all accounting idiosyncrasies must be stripped away. Often, the only way to do that is to look beyond the reported numbers, by sending a due-diligence team into the field.

But it's important to focus these efforts. By some accounts, China Mobile's exhaustive approach to due diligence fostered concerns at Millicom which—along with pricing issues—helped scupper the deal. Successful acquirers focus on creating a detailed picture of their target's customers. They begin by drawing a map of the target's market—its size, growth rate and how it breaks down by geography, product and customer segment.

It's just as important to examine the capabilities of competitors. For example, in the bid of one global food company to buy an overseas maker of fruit flavorings—which we'll call FruitCo—the acquirer found that while FruitCo boasted considerable global scale, the key competitors were national: local factors, it turned out, were the more relevant driver of costs. The global sourcing of fruit was not feasible after all.

In the end, effective due diligence is about balancing opportunity with informed scepticism. It's about testing every assumption and questioning every belief.

It's about not falling into the trap of thinking you'll be able to fix problems after the fact. By then, it's usually too late.

Oliver Stratton is a partner with Bain & Company in Hong Kong. Michael Thorneman is a Bain partner in Shanghai.