M&A strategy

The cascade exists in service of becoming prepared throughout. That begins with developing a proactive M&A strategy—the antithesis of being a reactor who leaps at deals that may appear superficially good without considering others and wastes a lot of time and money on diligence for deals they shouldn’t have considered in the first place. Reactors have few priorities.

Prepared “always on” acquirers play to win instead of only playing not to lose.

They fully use their power of choice to bring strategic integrity to M&A by developing a thoughtful agenda for their capital. And they don’t outsource their strategies to bankers. Prepared acquirers treat capital like it is luxurious—expensive to touch. They have developed a disciplined process allowing them to find good opportunities and avoid predictably poor or inferior ones. Most important, prepared acquirers have established priorities for their M&A program: They know what they want—and why—and how they will create value.

In short, they have determined what role M&A plays in their company’s growth. They have a watch list of companies or divisions that they want to buy, and they know why each target is on the list. They also know what they don’t want to buy and what kind of deals they seek to avoid. They have hypotheses about their competitors’ strategies and, based on that, know what auctions they may need to enter for strategic reasons. Finally, they know the next step in their M&A growth plans, whether or not the current deal closes.

Armed with an identifiable M&A strategy, and a watch list of their most important targets, prepared acquirers enable themselves to accomplish the twin objective of successful corporate development: beating competitors and rewarding investors.

Becoming “always on” is learnable, but you must commit time and resources to the process. That includes performing an assessment of your organic growth versus investor expectations and the M&A activity of your competitors, aligning the top team on the strategic priorities and most important pathways for M&A, developing a master list of targets along priority pathways, and iteratively screening that list based on criteria that allow you to determine a watch list of the most attractive and plausible targets.

By following those steps, if you haven’t done them before, you will have detailed profiles of the most important targets and documented your decisions throughout, especially for those deals that don’t merit your attention. Along the way, you’ll have identified the capability gaps for future growth and decided which pathways (businesses, products or services, end markets, etc.) are the most important for M&A—helping avoid the reality of the “pay me now or pay me later” problem where pathways get mixed up with more fine-grained screening criteria and questions later emerge on what the strategy was in the first place. You’ll know what you want and how you’ll create value and be able revisit and refresh decisions (just like your business strategies). And you’ll be ready for due diligence.

Due diligence

Once you have developed an M&A strategy and are pursuing prioritized targets on your watch list, you must be prepared to test a target’s potential against your investment thesis (the business case). You’ll sometimes be wrong about the attractiveness of a target, and that’s OK. After all, you’re not looking to rush into deals. Each possible deal is an opportunity to learn and sharpen both your thesis and priorities for M&A. Some of our best advice has been to identify problems that led our clients to walk away.

Sellers will present you with pictures of their future revenues and margins—rosy ones, which is why robust diligence is necessary. The future is filled with uncertainty for both the stability of the target’s current business and profitable revenue growth, and the potential of the combined entity. As a consequence, you must do diligence on both the target’s current business and its future growth because you will pay not only for both but also the premium, which is based on a range of potential outcomes.

Additionally, you must earn a cost-of-capital return on all of that luxurious invested capital to satisfy investors. Remember, on Announcement Day investors will almost instinctually multiply the premium by the cost of capital to see if your synergy promises make sense.

As a consequence, take diligence seriously. A strategic due diligence process focuses on understanding a target’s business, confirming how the candidate fits with your strategic objectives, discovering what cost and revenue synergies exist between the two entities and how they can be captured, and setting a purchase price. You are aiming to create a combined entity that better serves customers and produces results that beat the cost of capital on your investment.

In chapter 3, we focused on three kinds of due diligence that are at the core of a strategic process: financial, commercial, and operational. FDD goes beyond the mere baseline audited financials of the target to understand the normalized financial performance of the target’s business—the baseline from which forecasts will be built. Acquirers need to have conviction about the accuracy of historical numbers and understand the business implications of those numbers.

CDD tests the growth thesis of the deal, encompassing the future revenue assumptions for recurring revenues, margins from pricing, stand-alone growth, and the benefits of the combination through a new go-to-market strategy. Primary research is the secret sauce for CDD because, as we say, all of the answers are in the market.

ODD tests the opportunity to capture cost synergies—and if they really are possible. That means assessing the current efficiency of a target’s cost structure and its ongoing cost reduction initiatives, and building a bottom-up synergy model including one-time costs, timing of synergies, and interdependencies with the acquirer’s operations that will either challenge or support the “magic 10 percent” offered by the target’s bankers.

Diligence isn’t intended to make you “comfortable”—the results will drive the inputs to your valuation and initial integration planning. At its heart, diligence is intended to reveal if this deal is the right deal. Diligence will allow you to get under the hood and identify market- and customer-related issues, as well as critical operational problems and opportunities. It is also—practically—intended to improve the sensibility of the offer price, identify operating model and integration priorities, increase confidence in your maximum bid, and minimize downside risk. If it makes you comfortable along the way, that’s great.

How much do you need? No, really

Discounted cash flow (DCF) analysis is important, but it is extremely sensitive to the assumptions built into the analysis. As a consequence, it can lead to both inflated pricing of the target and the conclusion that the DCF analysis supports what you have to pay to do the deal rather than the maximum you should pay.

Evidence from our study suggests that the persistent negative group in our sample pays a higher premium than those with persistent positive results. The average premium paid by the persistent negative performers was 33.8 percent whereas the persistent positive performers paid an average premium of only 26.6 percent. And the difference is even more pronounced in all-cash and all-stock deals. Proper valuation is essential because your model assumptions become your promises.

Instead of relying solely on DCF analysis, we introduced the well-accepted concept of economic value added (EVA) as a kind of sanity check of the DCF. The EVA approach will enable you to examine both the acquirer and target as stand-alone companies—their current operations value (COV) and future growth value (FGV)—to understand the performance trajectory already expected by investors.

The EVA approach will also allow you to understand what it means to pay the full market value of the target’s shares plus an acquisition premium—a direct addition to FGV. The analysis also makes clear how the annual improvements you are promising (the synergies) translate into net operating profit after tax (NOPAT). All told, the results must show that you are properly using your capital—meaning that the promised synergies are sufficient to at least meet the cost-of-capital return on the premium. Understanding exactly what you’re promising financially in the mechanics of the deal is an absolute must since your investors can, and will, do these calculations themselves—in seconds. This analysis will also feed the story you tell both the board when you seek its approval and the market on Announcement Day.

Dealing with the board

We put the board chapter at the end of the book, partly as an easy-to-find set of “tools for boards” but also as a summary of the kind of information you’ll need to compile, analyze, and present during the process—information that is built into the M&A cascade. But of course, the board will need to approve the deal before you finalize and announce it. Both board approval and Announcement Day—and the materials that you prepare for them—are outcomes of the steps that came before: M&A strategy formulation, landscape evaluation, target identification, and due diligence including synergies, valuation, and preliminary PMI plans.

The board should already be “read in” to your M&A strategy, so they should not be taken by surprise by the deals you bring before them. On this particular deal, they’re going to want to know the answers to questions we laid out in chapter 9, questions the CEO and senior team must be prepared to answer. If you cannot answer those questions well before the board meeting, you shouldn’t be presenting the deal to the board—or to investors.

The board should also use the tools in chapter 9 to dig into the deal—not so much its bottom-up details but whether the deal makes strategic and financial sense, and whether you have a sensible plan. Is this how the board thinks you should be spending your capital relative to other possibilities?

Fundamentally, the board must know how much shareholder value the deal will put at risk. They should be reassured about the scope and feasibility of the plans for PMI. And the board should also provide another sanity check on the deal as a whole, using the Meet the Premium (MTP) Line and Plausibility Box, reviewing whether the Synergy Mix of cost reductions and revenue increases that you are proposing is sensible given the assets coming together, and assessing how investors will synthesize the information they’re presented.

Announcing the deal

The valuation process that was the detailed subject of chapter 4, which also contributes to the board presentation, feeds right into Announcement Day. That business plan is a story that you now get to tell investors. Be ready.

In many ways, Announcement Day creates the atmosphere of the deal: It’s when you go public and address shareholders’ questions, both the ones they ask and the ones they’re only thinking about. Their questions are related to the ones the board asks, but investors are most especially interested in the deal logic and synergy targets, the plan to achieve them, and the premium paid. Employees and customers will have questions too. If you don’t, or can’t, address those fundamentals, you’re in trouble. And the trouble will only compound.

Three questions take paramount importance when you’re explaining a deal to investors and other stakeholders:

1. Is there a credible case with defendable and trackable synergy targets that can be accomplished by the acquirer, and monitored over time by investors?
2. Does the story help reduce uncertainty and give direction to the organization so employees can effectively deliver?
3. Does the presentation convincingly link PMI plans to the economics of the transaction?

Remember, if you don’t answer them, investors will assume you can’t answer them and that you don’t have a plan—and they’ll penalize you for it. At their heart, the three questions address one paramount issue that senior management and the board must be able to address: How will this deal affect our stock price and why?

Announcement Day is your first and best chance to get everyone on board—to explain the logic of the deal and how it benefits all parties—and signal you have a plan. Investor relations in M&A must contend with and help solve a classic asymmetric information problem: Management knows more about the transaction than investors, so investors can only go by what management tells them. Put another way, you know the deal thesis, you have evaluated the landscape, you have been through the logic of this deal repeatedly, you have written a board presentation, had seemingly endless discussions, done the math, prepared the premium—but no one on the receiving end of the investor presentation has.

All that means significant tactical preparation, including documenting the deal thesis and defining stakeholders to selecting communications channels and establishing the timing and presence of your leaders. Get started early and anticipate the critics.

All stakeholders will be paying attention—this is the zenith of attention the deal will get. Don’t waste this pivotal moment. Use the attention carefully.

Pre-close planning

Announcement Day is not the finish line. It’s the starting blocks. If you do garner an initial positive reaction—congratulations! Now the intense work begins: Pre-close planning and post-close execution are how you achieve and sustain value creation over the longer term.

Pre-close planning is rooted in the same story that started with the deal thesis and that flows into the board presentation and into Announcement Day. The topics involved in pre-close planning are themselves necessary to consider before going public with the deal. Knowing where synergies will come from and how, practically, they can be achieved should be central to the approval process for the deal, as is the new operating model—how the combined organization will run its businesses differently, and how it will generate value differently than either organization did before the merger. But the planning goes a huge step further toward the practical realization of all the things that will be necessary to integrate the workings of both companies to create the new organization—taking it from the theoretical to the practical.

That we spent two chapters on pre-close planning should tell you something about both the volume of work to do and its importance.

Because by its nature an acquisition is creating something new, few of the pre-close planning decisions are routine. From unveiling the details of a new operating model to determining how the go-forward leadership structure and roles should be created to meet deal objectives to planning for Day 1, acquirers will confront a range of issues from the large and operational, like implementing new enterprise management systems, to seemingly minor ones, like what happens to summer Friday schedules and the quality of the coffee.

Many of those non-routine decisions won’t break the deal, but they all add up. Along with the big decisions, they’ll need to be managed and tracked: Enter the Integration Management Office (IMO). The IMO requires influential leaders who understand the businesses. It drives the planning for the future-state operating model, prioritizes decisions, minimizes disruptions, and preserves momentum. It sets the meeting cadence for the entire process. The IMO follows up on the plans made before the deal was announced (that were developed during and after due diligence), and produces a finer-grained roadmap for success across the new organization for Day 1 and the end-state vision. It oversees the workstreams—where the real work gets done—and establishes the synergy targets for each, identifies critical interdependencies, and interfaces with the executive SteerCo on larger, more consequential decisions and approvals.

Under the IMO structure will be individual workstreams such as finance, IT, real estate, and marketing, each of which have their own leadership and charters of what they must accomplish as they build blueprints for their new functional organizations, or businesses, and how they will deliver or exceed their assigned synergy targets.

We spent an entire chapter on the major cross-functional workstreams that will involve regular coordination across the individual workstreams. Organization design works with the new enterprise operating model, the new L1 leadership, synergy targets, and the functional and business operating model choices as they design the structure and roles. Organization design will choose between two process options: 1) design roles and pick the people layer by layer; or 2) design the organization structure and roles all the way down to the ground and then pick the people.

Synergy planning—the heart of the economics of the deal logic—begins with the handoff from the deal team that did the commercial and operational due diligence and built the valuation model. Those projected synergies will be converted into actual bottom-up workplans for each workstream that has synergy targets. The synergy team works with FP&A from both companies to develop a combined functional or business baseline budget; the synergy plan is built on top of that baseline. Synergy plans evolve from initial ideas into prioritized initiatives and detailed project plans aiming to confront the dreaded leakage that can derail synergy programs.

Communication and employee experience works under the presumption that you have borrowed trust you haven’t yet earned. The communications team will develop plans for all relevant stakeholders—employees, customers, vendors, unions, retirees and, of course, investors. Employee experience planning recognizes that you are not onboarding employees; they are not new recruits. The team aims to build employee confidence, establish early trust in leadership, reduce anxiety through targeted communications, and allow a mechanism for feedback so employees feel heard throughout their journey and ready for the forthcoming changes.

All of this leads to Day 1 readiness. Day 1 may seem like a daunting milestone and a never-ending list of decisions and activities. And while it is, it should be, operationally speaking, a quiet one. It is a laser-focused exercise separating absolute must-haves from nice-to-haves. Day 1 is a prioritization exercise and should be flawless because any major hiccups can spell serious consequences for morale and in kicking off the work of post-close execution.

Post-close execution

All of that pre-close planning pays off. It forms the foundation for a series of post-close transitions, when plans are put into effect.

Post-close, the IMO structure shrinks over time as workstreams graduate and the combined organization transitions to business as usual. Graduation signifies that workstreams no longer require active coordination by the IMO—and workstream leads don’t have to go to any more IMO meetings. Workstreams must complete all their integration objectives and achieve their synergy targets, and interdependencies with others should be concluded such that nothing else relies on them.

The organization design team, which has been considering and planning how to combine the two workforces, moves to the talent selection and workforce transition phase. Once L2 or L3 leadership has been announced, talent selection will be based on applying agreed criteria for the new roles consistent with the chosen design option and not at odds with legal guidelines. The process must avoid “death by a thousand cuts.” The team also develops leadership and employee transition plans that facilitate the knowledge transfer that must happen for the smooth operation of businesses as employees move into their new roles.

Synergy planning moves to synergy tracking and reporting. Synergy plans and results that are not managed and tracked aggressively will likely go off plan. The synergy team installs three major mechanisms: financial reporting that tracks benefits realized and their associated costs, milestone tracking for each initiative, and leading indicators that serve as a forward-looking health check that major initiatives are on track. The IMO and synergy team push an aggressive cadence for reporting results, and significant financial bonuses for achieving synergies can be a very valuable incentive.

The growth team(s) will focus on growth opportunities and designing the customer experience—achieving results that neither company could have achieved on its own. Revenue synergies present a special case of go-to-market strategy challenges and M&A can offer myriad opportunities for approaching customers and realizing new growth from cross-selling existing products, new valuable bundled offers, and new innovative products that will delight customers.

Finally, the employee experience team moves on to managing change and creating a new culture to guide all other activities. Executive teams are expected to quickly create inspiring points of view about the possibilities for the future that investors and customers find believable and demonstrate progress. They must simultaneously calm the workforce’s anxieties and inspire employees as they move up their hierarchy of needs and see themselves and their futures with the new organization. These two goals require two carefully crafted—but different—messages. We said that “culture begins at announcement.” Acquirers have to be careful because they, whether they realize it or not, send signals about the new culture—how work gets done around here—with their actions.

Post-close execution moves from the theoretical to empirical, from planning to doing. The merger is all about managing myriad decisions guided by all of the work that came before to fulfill the promise of the deal.