By William S. Andronico

By Andrew Crain and Rod Robertson

The knockdown wave that paralyzed merger & acquisition activity in the lower- and middle-market since September 2008 has rapidly receded, promising a rising tide of dealmaking in 2011.  All the components for an active M&A market are in place:  pent-up deal supply, as frustrated sellers adjust valuation expectations and private equity funds seek to realize long-held portfolio investments; pent-up buyer demand, as corporations replace their recent fixation on cost cutting and liquidity preservation with an increased focus on top-line revenue growth and as private equity groups put uninvested funds to work; and increased capital availability, as credit is once again available at favorable rates and companies once again have healthy balance sheets and cash to invest.

M & A TRENDS AT 2010 YEAR-END

Dealmaking began to rebound in the second half of 2010.  Thomson Reuters reports that “as of December 14, dealmakers have announced 7,258 U.S. transactions worth $773.5 billion this year though some may not be completed.  Last year, 6,503 deals worth $731.5 billion were completed.”   PriceWaterhouse Coopers found a similar trend in the middle market, “logging 724 deals worth a combined $240 billion in disclosed value, up 54% over 2009.  Average deal size also grew, elevating to $247 million, compared to $219 million last year, a trend PwC attributes to the availability of debt, strategic buyer optimism and the substantial private equity overhang,” as reported in Mergers Unleashed on December 10.

Our conversations with buyers and sellers indicate that many more deals were pushing to close by 2010 yearend, but sellers motivated to close for tax reasons paused for breath once the Bush tax cuts were extended and those deals will now kick off a strong 2011 instead.

SELLERS RELUCTANTLY RETURN

The decade-long run up to the recession, with both earnings and valuations (as multiples of earnings) growing year after year, set sellers’ expectations at levels reminiscent of the internet bubble.  The downturn paralyzed most M&A activity as the new playing field was met with dismay by owners of small- and medium-sized businesses.  Depressed valuations, the return of in-depth due diligence, and the disappearance of covenant-lite purchase & sale agreements all combined to drive patient sellers to the sidelines.  Those left to sell in 2009 and early 2010 were, typically, distressed companies selling at distressed prices in bankruptcy or liquidations.

As the economy steadied and credit loosened in mid-2010, valuations began their return to pre-recession levels.  According to GF Data Resources, which tracks private equity deals ranging in value from $10 – $250 million, enterprise valuations across that size range averaged 6.0X in the third quarter of 2010, and even the smallest size subset ($10 – $25 million) reached an average of 5.8X EBITDA.

Sellers today have reconciled to the fact that valuations have rebounded to sustainably sensible levels, and they are no longer sitting on the sidelines in hope of higher returns.  Many owners who plowed ahead funding losses, counting on an economic rebound for rescue, now see economic forecasts for slow growth at best.  Aging owners who postponed retirement are now ready to sell.  Private equity owners who held portfolio companies beyond planned time horizons are now rushing to realize their investments, especially those who will be fundraising in 2011 and 2012. Thus we foresee a steady flow of sellers coming into the M&A market this year.

A FIELD DAY FOR BUYERS

Well-capitalized strategic buyers remained active acquiring distressed competitors throughout the recession and, armed with inexpensive credit and abundant cash, continue to be opportunistic.  Other companies are entering the fray as confidence returns and leaders shift their focus from preservation to acquisition.  Others, faced with a sluggish recovery and prospects for slow growth, seek acquisitions to drive growth externally.  The combined impact of these motivations will be substantial, as a recent mergermarket.com survey showed that 82% of US business executives expect increased M&A activity over the next 6 to 12 months.

Private equity buyers are equally motivated to do deals.  With the “overhang” of uninvested PE funds reaching a reported $500 Billion, there is urgency to put those funds to work.  PE managers are also cognizant that acquisitions done during and after economic downturns historically yield higher returns than those completed during boom years.  As a result, according to GF Data Resources, “private equity groups are becoming less discriminating in their choice of targets given the pressure on them to invest funds.  There are more B and B+ properties on the market now and sponsors are willing to pay a little more for them.”

Entrepreneurial buyers, driven to the sidelines in the boom years by larger and better-financed financial and strategic buyers paying high valuations, are now re-entering the game.  The recession flushed many senior- and middle-management executives into the job market through downsizing and corporate closures.  Many of these talented executives are taking matters into their own hands, using their strategic skills to identify and acquire companies with favorable investment characteristics.  However, many entrepreneurs find that they must rely on seller financing or private equity backing in order to credibly pursue and close acquisitions of even modest size.

THE TIPPING POINT

We believe that this confluence of events will lead to a resurgence of M&A activity in 2011.  Orphaned companies and firms mortally stricken during the recession have been purchased, cannibalized or are seeking a buyer as we write.  Sellers realize that if they want to exit, now is the time as the economy rebounds and as favorable tax rates have been extended for another two-year window.  Strategic, private equity and entrepreneurial buyers have returned to the market and enterprise valuations have rebounded to pre-recession levels.  Commercial banks and mezzanine lenders are permitting buyers to place more debt on pragmatic deals.  In sum, sellers, buyers and lenders have all returned to the M&A market and are converging on common ground where excesses have been curbed and sensibility should reign once again, permitting dealflow to flourish in 2011.

By Joseph J. Rahal

Introduction

Many of today’s world conflicts emanate from a clash of cultures. The same can be said of conflicts that occurred during the mergers of the Mercedes and Chrysler, Coke and Snapple and many other similar transactions.

Are these cultural issues any different when merging two established and successful smaller or mid-sized companies?

Are the challenges and obstacles the same?

How much of the success of any of these examples is based solely on the formal review, analysis and integration of financial and legal matters?

What must be done to insure a successful blending of companies? Large and Small.

Consider the following ……

• 60% – 70% of all mergers fail because of a lack of cultural integration
• Culture is ranked higher than salary as a criterion in job selection, satisfaction and employee retention
• Customer service is a direct reflection of a company’s culture – how it treats its employees and the expectations it has on how clients should be treated

This document will provide:

• Further rationale and value to conducting a cultural due diligence as a necessary complement to the standard financial and legal due diligence  
• Components of cultural due diligence
• A practical outline for conducting cultural due diligence
• Role of Rahal Consulting in conducting, and implementing strategies resulting from cultural due diligence

This document also presents Rahal Consulting’s philosophy and approach toward defining Cultural Due Diligence and heightening its awareness and relevance in today’s business world. Additionally, Rahal Consulting seeks to challenge conventional thinking, educate business leaders, and to re-affirm the critical value of conducting Cultural Due Diligence along with tradition financial and legal due diligence.

Description

In describing cultural due diligence, there are many positive examples in business, and they stand out among the many negative situations. The over-riding theme in evaluating true corporate culture is “walking the talk”. Here are two specific comparative examples whereby the company may espouse a cultural value but either “walks the talk” or is inconsistent in what is actually done:

If so much that has been written and discussed specific to culture and its importance, why then is culture so often overlooked when two companies merge, especially during the due diligence process?

There are two primary reasons:

1. It’s all about the numbers and value to the shareholders, public or private
2. The perception of cultural due diligence is that of “soft stuff” with limited impact on shareholder value

Clearly, research in all forms, has proven the critical value of human capital to the success of businesses.

Outcomes of Cultural Due Diligence

Conducting cultural due diligence, along with the legal and financial components of traditional due diligence, will:

• Provide better understanding of who you are
• Streamline the integration
• Expedite operational success
• Improve marketplace acceptance
• Retain key employees, clients and revenue

To make the merger successful, there are three distinct steps to cultural due diligence:

1. Conducting an objective, formal and thorough analysis, evaluation and comparison of the two companies
2. Accepting the findings as a pathway to a smoother transition
3. Creating and executing the right strategies for a speedy and successful merger and integration

Important Merger / Acquisition Considerations

Within these steps are critical questions pertaining to successfully merging cultures that must be asked.

What assets are you buying when you join two companies, regardless of size or industry?

• How do you establish and value these assets?
• How will you measure the success of the merger and integration?
• When will you measure the success of the integrated companies?
• What are the contributing factors to the success or failure of the merger?
• What are the inhibiting factors to the success or failure of the merger?
• What role does human capital play in the merger and subsequent success or failure of the merger?
• What are the consequences of incompatibility?

Traditional Due Diligence

Due Diligence has been defined as ‘the independent investigation of a company, its management team and its prospects for success by an investor before funding is provided’. A more terse but no less accurate definition describes it as ‘a well-established mating ritual … which allows [the parties] to explore the benefits of the marriage’. (a)

Conducted primarily by lawyers and accountants, it focuses on:

• Financial structure and performance
• Product portfolio
• Customer base
• Marketing, sales and distribution structure
• Research and development
• Management and personnel
• Legal matters

Traditional Due Diligence occurs between the signing of letters of intent and the closure of the deal, covering typically a ninety-day period during which the parties are still negotiating even as the lawyers and auditors are gathering their information. It can be a draining process. As Charles Crosthwaite, Partner at Bird & Bird, observes, “Due Diligence reports are usually compiled and delivered to extremely tight deadlines. Lawyers cannot, however, guarantee that their reports will be read or acted upon. Professionals should strive to collaborate with clients to create a more effective intelligence gathering and assessment process.”

Many of the components of Due Diligence – the warranties and disclosures which have to be supplied by the legal entity being acquired – are statutory and formula driven. Focus throughout is on evaluating the evidence which will allow the transaction to be concluded. The link between orchestrating the deal and realizing the potential of the new organization is not the responsibility of lawyers and accountants, who may well have no further role to play after the agreement has been signed.

A New Component

Despite the assumption that there is only one component to the due diligence process, there are actually two primary components of Due Diligence –

1. The more recognized and traditional “Confirmatory” process outlined above
2. The less considered “Operational or Business” due diligence process to understand the practical issues that are the day-to-day  heart beat – strategies, structure, practices, people, i.e. the Cultural Due Diligence

Defining Cultural Due Diligence

Cultural Due Diligence, with its focus on the future life of the company, integration of the entities and practical operations of the new organization, has much to offer. As Richard Lee, Partner at Clarks Solicitors, observes, ‘Many companies are extremely unsophisticated in their approach to the cultural aspects of their Due Diligence. Family businesses, in particular, can be hard to integrate”.

Cultural Due Diligence differs from standard Due Diligence procedures in that:

• It is not mandatory in law
• It may be variously conceived and implemented
• It may be conducted by a range of parties

 A Cultural Comparison

A parallel can be drawn between the merger of cultures between nations and the merger of cultures between corporations and businesses of all sizes. Elements in this comparison are numerous but often not considered in the business world. Examples of these elements are:

As analogous as this comparison is, the culture of a business is more difficult to distinctly express, yet everyone knows the importance of culture in the success of a business For example, the culture of a large, for-profit corporation is quite different than that of a hospital that is quite different than that of a university or a strong entrepreneurial business.

You can often identify the culture of an organization by looking at the arrangement of furniture, what the employees and management brag about, what people wear, etc. — similar to what you can use to determine an individual’s personality.

The concept of culture is particularly important when attempting to manage organizational change. Practitioners are coming to realize that, despite the best-laid plans, organizational change must include not only changing structures and processes, but also changing the corporate culture as well.

It is essential to consider that when creating change, the critical components are not setting forth what the goals are but rather the “HOW’ to achieve the desired outcome. The “HOW” is all about implementation and execution. It requires understanding obstacles, outcomes, ramifications, planning and the impact of change on the people who must execute the strategies and tactics.

(a) – Source: Written by Carter McNamara, MBA, PhD, Authenticity Consulting, LLC. Copyright 1997-2007.Adapted from the Field Guide to o Leadership and Supervision.

Done simultaneously with traditional confirmatory due diligence, Cultural Due Diligence is a practical, step-by-step approach for making rapid, cost-effective cultural assessments of both the acquirer and the target. It can make the difference between deal success and disappointment.

Culture and Change

Because cultural change involves hard and soft issues, it requires both qualitative and quantitative analysis of a corporate culture, including visible manifestations such as:

• Dialogue between levels
• Decision making process
• Accessibility to decision makers and leaders
• Sales process and positioning
• Channel management, and “go-to-market” strategies and tactics
• Market positioning
• Client interaction
• Dress codes
• Office layout
• Annual reports
• Recruitment brochures and employee interaction
• Less tangible corporate values and assumptions about how a company does business

Traditional Mergers and Acquisition (M&A) due diligence has consisted mostly of crunching numbers, securing intellectual property, examining executive compensation plans, reviewing legal document, etc. There are several reasons for this:

• Tradition has established a mystic around the “confidentiality” surrounding the legal and financial undertakings
• It is a more specific and easier route to gather and analyze numbers
• Acquisition teams are comprised mostly of financial analysts and attorneys
• Top managers are generally more comfortable with “hard,” easily quantifiable issues than softer ones like culture
• The due diligence team is rewarded and recognized for the accomplishment of the process and seldom, if at all, involved with or tied to the successful integration and future outcome of their assessment
• Less emphasis has been placed on the actual integration and implementation of the merger
• These same managers may have believed they already understand the cultural differences between their companies and prospective partners, particularly if they operated in the same industry and feel that a formal analysis is superfluous
• Managers may have undertaken a kind of implicit or intuitive cultural assessment that lacked documentation and objectivity and therefore defied replication
• Many simply choose to ignore potential conflicts even a rudimentary cultural assessment may reveal.

Cultural Due Diligence: The Process

Cultural Due Diligence can be explicit and measurable. It provides a discipline that compels senior managers to understand it own culture and to subject their gut perceptions and conclusions to tough scrutiny as well as to recognize culture as a critical ingredient in deal success.

Indeed, it takes a fair amount of courage for leadership to submit their preconceived notions of their own corporate cultures, or that of their prospective partners, to such a test. Moreover, if conducting a rigorous cultural assessment up front might be regarded as courageous, failing to do so could conceivably be considered a breach of fiduciary duty, particularly if a deal turns sour.

Source: Accenture / Mergers & Acquisitions: Irreconcilable Differences)

The procedures of Cultural Due Diligence cannot be “owned” in the way that accountants and lawyers own the statutory preserve of Financial and Legal Due Diligence. There is, however, a strong case for external specialists to conduct this work in close liaison with internal teams, as is the case with conventional due diligence. This ensures rigor of methodology, impartiality, and also adherence to agreed objectives and deadlines. Often, this team, or portions of the team, can transition to the integration process to insure continuity and accountability.

• Obtaining an impartial view of the organizations being merged in order to maximize the business benefits deriving from the deal
• Developing an integration plan that insures a rapid and successful merger

It is the task of Cultural Due Diligence, core areas include an objective view of:

• Profiles of senior management and their actual philosophies and styles
• The management and employees of an organization
• Talent
• Organizational structure
• Historical and projected headcount
• Personnel turnover patterns
• Operational patterns
• Compensation arrangements
• Organizational culture
• Industry culture
• National/regional culture
• Leadership style
• Corporate values
• Interaction among departments and divisions
• Brand values
• Knowledge behavior
• Market position
• Position of the client
• Training
• Sales process
• Territory and account management
• Customer relations
• Sales performance against market indicators
• Assessment of product compatibilities.

The following lists a sampling of the most crucial cultural due diligence questions:

Acquisition

• Why do you want to buy the company? What is the objective?
• What do you expect to gain?
• What makes the target company attractive – product, management, operations, financial, sales, subject matter expertise, people, products, strategic value, etc?
• How did they get where they are?

Values

• How are values defined and lived in practical terms?
• What are the official values of the organization to be acquired?
• What are its unofficial values?

Perceptions

• How do employees perceive their own company?
• How do they perceive the other company?

Procedures

• On what basis are decisions made (top-down, consensus-based, rapid, slow)?
• Is the organization relationship-focused or deal-focused?

Motivators

• How are managers motivated and rewarded?
• How are employees motivated and rewarded?

Uncomfortable questions

• What is regarded as absolutely unacceptable behavior?
• What subjects are regarded as taboo?
• Who is likely to embrace change, and who to obstruct it?

Sales

• What are the market and industry variables and trends?
• How are products and services presented to the marketplace: as commodities or value-added?
• What are the customer service dynamics?

Cultural differences can manifest themselves in the way people dress, communicate, use e-mail, and make decisions and more. The irony in all this is that such diversity can benefit the new organization, but only if it is fully harnessed. The most successful companies make concessions and combine the strengths of both companies to develop a new organization. And that must begin in the Cultural Due Diligence process.

Cultural Due Diligence was created to meet the growing need for a comprehensive “user friendly” process for assessing and analyzing organizational culture and also for integrating and transforming cultures successfully.

Summary