Using Kaizen to Reduce the Risk of M&A Failure

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 do not achieve their intended objectives. 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 a M&A deal. Reducing the failure rate even by a small amount has the potential to save billions in lost dollars. While specific reasons are generally cited for individual failures, it is difficult to generalize about the 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 failures I mean failures that occur after an M&A deal has been closed, not failure to close the deal (an issue in itself). Specific reasons cited for M&A failure typically include target business issues such as lack of anticipated or promised performance, culture shock, loss of management team and key employees, market changes … 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 systemic causes. So for our purpose 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 2-3 years, the investor would not do again if given the opportunity. I limited it to 2-3 years because after that there is a good chance that the business will fail for other reasons.

To find a systemic cause of failure, we must focus our attention on the M&A process itself. Dr. WE Deming was a mid-20th century scientist who did much of the original research on quality assurance techniques. In his work he demonstrated that product failures were the result of the manufacturing processes that were used to produce the product and that by improving the process, resulting failures can be reduced. More recently, we have seen this principle demonstrated by Toyota when they adopted the “Kaizen” method. “Kaizen” is the Japanese word for 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. Then we can use a “kaizen” approach to modify the process and reduce the rate of M&A failures.

In general, the M&A 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 ownership of the target business of diligent manner. Activities such as negotiating the terms of the agreement or preparing to transfer the document can be tedious, but they have demanding results and are generally not the cause of M&A failures.

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

To understand the problem, let’s take a closer look at the M&A due diligence process. To be effective, due diligence must evaluate three different facets of the business; legal, financial and operational, and these must be carried out with equal efficiency. Most investors do a good job of financial and legal due diligence, but they don’t do effective trading due diligence. This is due to the fact that legal and financial due diligence relies on legal and accounting frameworks as guiding principles and, assuming the investor has a competent attorney and accountant, there is little reason not to perform these assessments effectively. Operations due diligence is a different story. There is often confusion as to what exactly should be assessed during the due diligence of a transaction 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 they think constitutes effective operational due diligence. Later we will see if your definition has changed.

While not entirely accurate, it is fair to say that financial due diligence primarily focuses on 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, market loss, and loss of key customers, are examples of events that have the potential to negatively impact the future operations of the company. 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 that an event will occur that will have a positive impact on the future operations of the company. If an operations evaluation finds that the company has a great product but sales are weak because the sales group is immature and the acquiring company already has a strong sales organization, then an opportunity to improve sales has been discovered. Not taking advantage of potential opportunities is also a cause of M&A failure because the company will not be able to reach its full potential.

Due diligence of operations should be an assessment of the entire company. When asked, most people mention only one or two key functions that need to be evaluated and do not provide a comprehensive answer for the entire company. “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 business is crucial to reducing failures. Processes that do not produce repeatable results are prone to errors. Without a coherent and clearly defined framework, results are not repeatable and increase the possibility of M&A failure.

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

Operations due diligence should be performed as an enterprise-wide assessment that encompasses the entire operations infrastructure of the enterprise. There may be more understanding of operational needs during a strategic acquisition than there is of a purely financial investment, but my experience is that a “go it alone” approach during a strategic investment tends to overlook key areas of operations. Without a guiding framework, it is difficult to determine what constitutes “complete” and without a framework to use as a guide, the possibility of losing an operations function is great, and so is the risk that you will miss the cause. potential of an M&A. failure. An operations assessment should cast a broad net to prevent potential risks from escaping and reduce the risk of a merger and acquisition failure. Treating operations due diligence as a company-wide risk / opportunity assessment based on the development of a holistic framework and an ongoing M&A process improvement program is a clear way to reduce the rate of merger failures and acquisitions.

Improving the way you conduct business due diligence demonstrates how “Kaizen” could 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 just a first step. Applying a “Kaizen” approach would mean continually reviewing the trading framework to better identify latent trading opportunities and risks. To achieve this, we would have to look at the specific causes of M&A failures and constantly ask ourselves whether this problem would have been discovered during our evaluation of operations. If the answer is no, then the framework of operations needs to be further improved. Continuous process improvement requires resources. Investors who are continuously 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.