The Deal
"Merger pressure." The phrase seemed ubiquitous this summer in the wake of the back-to-back announcements of the marriage of telecom equipment suppliers Alcatel SA and Lucent Technologies Inc., followed by the union of Nokia Oyj's and Siemens AG's phone equipment businesses. But while technology convergence issues may no doubt force competitors like Nortel Networks Corp. and Motorola Inc. into similar moves, telcos aren't the only companies facing intense pressures to combine. The urgent need to cut costs, build scale and add capabilities to combat new global competitors is hitting nearly every sector. And that lies behind today's frenzied M&A activity, which tops $1.6 trillion so far this year, or 41% ahead of last year's pace, according to deal tracker Thomson Financial.
In the face of what's been dubbed 2006's "perfect M&A storm," senior executives need a better method for making the right calls about acquisition targets. This ultimate art of the deal, called due diligence, has a slim success rate, however. Data show that fully half of all "strategic" deals end up destroying value. And when Bain & Co. recently surveyed 250 senior managers with M&A responsibilities, half said their due diligence process had overlooked major problems, and half also found that targets had been dressed up to look better for deals. Two-thirds said their approach routinely overestimated the synergies available from acquisitions. Overall, only 30% of executives were satisfied with their due diligence processes. One-third acknowledged they hadn't walked away from deals despite nagging doubts.
What can companies do to address these common shortcomings? For starters, they can rid themselves of their assumptions. Private equity firms tell us their acquirers' advantage lies in being industry outsiders: They force themselves to ask basic questions about how an acquisition truly will make money for investors—and they expect answers. As a managing director at one leading PE firm put it: "We walk away when management is uncooperative. For us, that's a deal breaker."
Top corporate buyers take a similarly rigorous approach: "When I see an expensive deal, and they say it was a 'strategic' deal," says Craig Tall, vice chair of corporate development at the diversified financial services firm Washington Mutual Inc.," 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 standalone 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.
Successful acquirers create a detailed picture of their target's customers. They begin by drawing a map of the target's market—its size, its growth rate and how it breaks down by geography, product and customer segment.
European private equity firm Bridgepoint Capital Ltd. is particularly adept at this kind of strategic due diligence. In 2000, Bridgepoint was considering buying a fruit-processing business that we'll call FruitCo. As the leading producer of the fruit mixtures in yogurt, it seemed a likely bet. Western consumers had been spending between 5% and 10% more each year on yogurt, and the market was growing faster still in the developing world, particularly in Latin America and Asia. FruitCo looked like a winner to Bridgepoint managing director Benoît Bassi. Yet just four weeks later, Bassi killed the deal.
During those four weeks, the due diligence team dispatched to interview customers, suppliers, competitors and lenders had discovered many worms in the FruitCo transaction. For instance, when the team tested FruitCo's price and revenue forecasts, they found that although the market for fruit yogurt was indeed growing, profitability in many markets—particularly in Latin America—was falling rapidly toward commodity levels. Further, consumers told Bridgepoint's researchers that they would be unlikely to tolerate increased prices.
Next, the team examined the capabilities of competitors. They found that while the company boasted considerable global scale, regional scale turned out to be the more relevant driver of costs. That was because the economics of transportation and purchasing made the global sourcing of fruit—a major cost component—unfeasible. At the same time, advanced processing technologies enabled FruitCo's competitors to achieve competitive economics at the country level.
By performing painstaking due diligence, Bassi says he came to recognize that "what we thought we knew turned out to be wrong."
What Bassi and other successful acquirers realize is that the ultimate goal of due diligence is to determine a walkaway price. And for this price to have any meaning, it can't be academic. Successful dealmakers are willing to walk away and often do.
In the end, effective due diligence is about balancing opportunity with informed skepticism. 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.
Hugh MacArthur, a Boston-based partner with Bain & Co., directs the firm's Global Private Equity Practice. Dan Haas, also a partner in Boston, directs Bain's North American Private Equity Practice.