Issue 3 - November 2010
Making 1 + 1 = 3
Most mergers come up short of their goals. Avoiding these five key pitfalls can help companies realize their full potential.
The primary goal for companies that merge is for the combined enterprise to be stronger on the top line, more efficient and far more profitable than each company had been on its own.
The best private equity firms excel at picking merger targets that will enhance the value of companies in their portfolios. They will look for compelling opportunities to increase market share, extend product lines, expand manufacturing capabilities or push into new geographic regions. Sponsors have carefully modeled the cost savings and related operational synergies. So why do as many as four out of five mergers fail to fully realize their merger objectives?
Consider a merger of two companies with combined revenues of $500 million. A reasonable expectation of annualized savings in this case equates to 8% to 10% of revenue, or approximately $50 million. But often enough, two years after the deal has closed, the new corporation may have realized cost efficiencies of only $10 million — dealing investors $40 million in unachieved savings each year, inhibiting margins and profitability. If the merged companies are in an industry in which the average valuation is seven times EBITDA, the impact of an incomplete integration in this case may decrease the valuation by hundreds of millions of dollars.
All M&A transactions have their own intricacies, and it can be a challenge to consolidate manufacturing facilities, legal and regulatory departments, supplier agreements, customers and sales channels, information technology, supply chains and each of the other functional areas of the business. There are many ways for a flawed integration to erode the anticipated returns on private equity’s invested capital. But as we have seen from our intimate work in many of these transactions, overlooking any of these five common pitfalls guarantees that an investment will not realize the full value envisioned.
Cutting too little too late. Probably the toughest task facing merging companies is deciding how many employees, including senior and middle managers, to eliminate. Many companies wait too long to reduce duplicate head counts, assuming — or hoping — that revenue will expand quickly or that internal politics will cause delays.
Two merging automotive supply companies made this mistake, failing to anticipate an economic downturn that occurred a few months after their deal closed, drastically reducing sales. Despite deep personnel cuts that were then made across the company, it was unable to bring about cost reductions fast enough and ultimately had to file for bankruptcy, wiping out equity. In hindsight, it was clear that if the company had eliminated excess jobs starting the day after the transaction closed, the resulting savings would have provided the company a buffer sufficient to avoid violating key debt covenants despite shrinking revenue.
An alternative approach was taken by two publishing companies that merged. But instead of going only far enough to meet merger model synergy targets, management took a more aggressive approach of planning for additional economies. After 18 months, the combined company had exceeded its cost synergy targets by more than 80%. That overachievement of synergies allowed the company to keep its costs in line with unanticipated revenue losses and to survive in an economic climate that was particularly hard on media companies.
Not understanding true profitability. It might seem obvious, but if a company cannot accurately quantify the cost of producing individual products and supporting customers, it becomes nearly impossible to make informed decisions about how to eliminate duplicate costs, rationalize product or service lines, or understand where investment will generate the highest returns. Inefficient companies tend to analyze profitability in terms of gross margins for each operating unit rather than to look at the profitability more directly by individual product and/or customer, for example. By breaking down profitability by customers, products, service offerings and manufacturing plants before merging, two printing companies learned what was and was not working. They avoided folding unprofitable elements of the businesses into the merged company, instead electing to churn the bottom tier of the combined customer base, collapsing small business units into a more efficient infrastructure, exiting two major customer contracts and shutting down 20% of the manufacturing capacity.
In contrast, operating with inaccurate assumptions about line of business profitability could also stop a merger cold, as it did for a communications company that was embarking on acquiring a large competitor. During due diligence, it became apparent that the acquiring company was not nearly as profitable in key business segments as originally assumed. Without the necessary cash flow and valuation to raise funding for the acquisition — and finding itself out of strategic options in a consolidating industry — the would-be buyer was acquired by another company a few months later. Had the company dug deeper in analyzing its costs before embarking on an acquisition, it would have realized it had to fix its cost structure first and assert more control over its destiny.