Using Kaizen to reduce the risk of failure in mergers and acquisitions

The number of Mergers and Acquisitions (M&A) that end in failure is a matter of conjecture, but it is commonly estimated that more than 50% of all M&A deals fail. If true, that represents a staggering loss of investment dollars, as well as the loss of time, energy, reputation, and everything else that goes into closing an M&A deal. Therefore, reducing the failure rate by even a small amount has the potential to save billions in lost dollars. While specific reasons for individual failures are usually cited, it is difficult to generalize about a root cause of failures that would allow investors to avoid or at least mitigate their investment risk. To find a global means of reducing the risk of M&A failure, we must look for the systemic causes of the problem.

By M&A failure I mean failures that occur after an M&A deal has been closed, not a failure to close the deal (an issue in itself). Specific reasons cited for M&A failure generally include objective business issues, such as failure to deliver anticipated or promised performance, culture clash, loss of key employees and management team, changes in the market…and so on. But again, while these may be the cause of a specific failure, citing the cause of an individual failure does not help us identify the systemic causes. So for our purposes, we will need to use a more generic definition of an M&A failure. To achieve this, we can simply define an M&A failure as a merger or acquisition that, after 2 or 3 years, the investor would not do again given the chance. I limited it to 2 or 3 years because after that there is a good chance the business will fail for other reasons.

To find a systemic cause of failure, we need to focus on the M&A process itself. Dr. WE Deming was a mid-20th century scientist who did much of the original research on quality control techniques. In his work he showed that product failures were the result of the manufacturing processes used to produce the product and that by improving the process it is possible to reduce the resulting failures. More recently, we have seen this principle demonstrated by Toyota when they adopted the “Kaizen” method. “Kaizen” is the Japanese word for a good or positive process change. To improve the quality of its cars, Toyota uses “Kaizen” to eliminate systemic manufacturing defects. “Kaizen” is now being applied in many other industries. While the M&A process is not a manufacturing process, it is a repeatable process and by analyzing that process, it is possible to identify the systemic root cause of some M&A failures. So we can use a “kaizen” approach to modify the process to reduce the failure rate of mergers and acquisitions.

In general, the mergers and acquisitions process is a methodical and legalistic process integrated with activities related to letters of intent, the definition of terms and conditions, the creation of an acquisition agreement and other documents necessary to transfer the ownership of the target business of diligent manner. Activities such as negotiating the terms of the agreement or preparing the transfer of documents can be tedious but they have demanding results and are not generally the cause of M&A failures.

Due diligence, by contrast, is the most subjective step in the M&A process. Many investors do not fully understand the role of due diligence and begin with only a theoretical understanding of what they hope to achieve. This gives us the first clue as to the cause of many M&A failures.

To understand the issue, let’s take a closer look at the M&A due diligence process. To be effective, due diligence must assess three distinct facets of the business; legal, financial and operational, and these must be carried out with equal efficiency. Most investors do a good job of legal and financial due diligence, but fail to conduct effective operational due diligence. This is due to the fact that legal and financial due diligence relies on the frameworks of law and accounting as guiding principles and, assuming the investor has a competent attorney and accountant, there is little reason not to perform these evaluations of effective way. Operations due diligence is a different story. There is often confusion about exactly what to assess during an operations due diligence or how to measure and report the results. To understand the nature of this issue, this would be a good time for the reader to take a moment to write down what you think constitutes effective operations due diligence. Later we will see if its definition has changed.

While not entirely accurate, it is fair to say that financial due diligence primarily looks at the past performance of the business, while legal due diligence looks at the current state of the business (at the time of closing). Operations due diligence, on the other hand, is trying to uncover potential issues that could affect future operations and business sustainability. If an operations assessment determines the likelihood of a negative future event occurring, then, by definition, operations due diligence is a risk assessment. Specific failures such as cultural mismatch, loss of market, and loss of key customers are examples of events that have the potential to negatively affect future business operations. If the definition you wrote down did not have the word risk, then you have not fully understood the role of due diligence in operations.

What about events that have a positive impact on the business? Is there, for example, an opportunity for the company to improve its sales after the merger? Risk and opportunity are often described as “two sides of the same coin.” An operations due diligence should also be an opportunity assessment. Opportunity is the probability of an event that will have a positive impact on future business operations. If an operations evaluation finds that the company has a great product but sales are weak because the sales force is immature and the acquiring company already has a strong sales organization, an opportunity to improve sales has been discovered. Not capturing potential opportunities is also a cause of M&A failure because the business will not achieve its full potential.

Operations due diligence should be a company-wide assessment. When asked, most people name only one or two key functions to assess and do not provide a holistic, company-wide answer. “Operations” is a very broad term and potentially covers a wide range of operational functions. Without an established framework similar to that of law or accounting, the business framework tends to be an ad hoc list of functions. Therefore, standardizing a framework that defines the company is crucial to reduce failures. Processes that do not produce repeatable results are prone to errors. Without a consistent and clearly defined framework, results are not repeatable and mergers and acquisitions are more likely to fail.

Investors trust their CPA and lawyer to set the legal and financial framework, but who do they trust to do a deal review? A CPA can tell you the financial maturity of the company, but how do you determine the maturity of a company’s operations infrastructure? The tendency of most investors is to “go it alone” by focusing on just one or two areas. “It was a software company, so we had an engineer review the code.” The lack of a consistent operations framework, or established practice that defines one, reinforces the potential that operations due diligence is the weak link in the M&A process due to the potential for bypassing critical functions. commercials during the evaluation.

Operations due diligence should be conducted as an enterprise-wide assessment that encompasses the entire operations infrastructure of the business. There may be a greater understanding of operational needs during a strategic acquisition over a purely financial investment, but my experience is that a “go it alone” approach during a strategic investment tends to miss key operational areas. Without a guiding framework, it is difficult to determine what constitutes “complete” and without a framework that can be used as a guide, the potential to miss an operations function is great, and therefore so is the risk that it will miss the potential cause of a merger and acquisition. failure. An operations review should cast a wide net to prevent potential risks from slipping in and reduce the risk of failure of an M&A. Treating operations due diligence as an enterprise-wide risk/opportunity assessment based on the development of a holistic framework and ongoing M&A process improvement program is a clear way to reduce the failure rate of M&A operations. fusions and acquisitions.

Improving the way due diligence is performed in operations demonstrates how “Kaizen” can be applied to the M&A process. “Kaizen” requires a continuous process improvement program that continues to eliminate defects over time. The examples given here are only a first step. Applying a “Kaizen” approach would mean continually reviewing the operations framework to better identify latent risks and opportunities in operations. To achieve this, we would need to analyze the specific causes of failure of mergers and acquisitions and constantly ask ourselves if this problem had been discovered during our evaluation of operations. If the answer is no, then the operations framework needs to be further improved. Continuous process improvement requires resources. Investors who are continually involved in the M&A process will benefit the most from this type of program. The benefits that this type of process improvement program provides by reducing investment risk should justify the commitment of those resources.