Mergers and acquisitions are fraught with risk. An announcement or even a rumor published in the business media about the potential combination of two companies does not guarantee that the transaction will go through to completion. Additionally, even if the merger does proceed, there are post-merger integration activities that can derail the success of the new, combined entity.
That said, the risks inherent in M&A can be managed, and perhaps even avoided, with proper planning.
Living with Risk in the World of M&A
Risk Management Strategies
Risk management is a strategy to reduce the damages of threatening events that are expected to occur or that are underway. Risk management aims to reduce the financial, legal, or operational consequences of events that an organization is well aware of and that are expected to continue to occur — often the unfortunate cost of doing business.
An adjacent strategy to risk management is risk avoidance — the idea of avoiding threatening events entirely. With risk avoidance, an organization develops strategies, practices, and workflows that seek to eliminate hazardous activities altogether.
While the complete elimination of all risk is rarely possible, a risk avoidance strategy is designed to deflect as many threats as possible in order to avoid the costly and disruptive consequences of a damaging event.
Risk avoidance is not the same as failing to identify or ignoring risk. Quite the opposite: risk avoidance requires in-depth research, planning, and processes in order for the organization to avoid expected negative consequences.
Leaders from several functions across the organization, including finance, accounting, human resources, legal, marketing, and IT, must work together to identify and assess the risks their organization faces and determine how they will eliminate the chances of any of those risks causing disruption to business operations.
There are a number of key risk factors that leaders should address to ensure that an M&A transaction can not only meet its long-term business goals but also serve as M&A risk avoidance strategies. Let’s look at 8 of these.
1. Missing key Talent on the “Dream Team”
While the team of regulars — senior management, bankers, lawyers, and accountants — comprise the obvious choice for evaluating documents during the M&A due diligence process, participants in a transaction should also involve other consultants and professionals who can provide insight into whether the merger makes sense.
This could mean bringing in IT experts, IP and legal specialists, and marketing executives who can provide a more complete picture of what the post-merger company operations will look like. This “secondary” group of professionals can evaluate potential risks and also uncover opportunities.
Nvidia’s $66 billion acquisition of Arm, the British semiconductor manufacturer owned by Japanese investor SoftBank, was called off in February 2022, citing significant challenges from both government agencies and rivals. The deal, first signed in 2020, would have been the largest semiconductor M&A deal in history.
However, while it’s easy to blame government regulators, the companies worked their best to demonstrate what the post-merged companies would look like, including how the merger would result in the hiring of new employees instead of the typical post-merger activity of layoffs. Further, Nvidia demonstrated how its chips would move beyond consumer products and instead toward AI, supercomputing, and robotics (which it still might do, even without owning Arm). Indeed, more than just financial, legal and accounting experts were brought in to evaluate and communicate the value of the deal — even though it was ultimately called off.
2. Ignoring the Regulatory Environment
Corporations involved in M&A need to account for increased regulatory scrutiny, including antitrust laws. Despite synergies related to finance, product management, and sales, the final say in a transaction might come from individuals outside of the companies undergoing a merger. Failure to understand how governments and regulatory agencies will treat the combined entity can be risky. It is possible that the deal will be halted, or if allowed to proceed, concessions will need to be made. Foresight into the regulatory environment is necessary to mitigate or avoid risk.
Back in 2016, pharmaceutical giant Pfizer was to acquire Allergan in a takeover valued at $152 billion. One of the supposed perks was that Pfizer would have had the opportunity to relocate its headquarters overseas, ultimately lowering its tax bill.
However, the Obama administration tweaked the tax rules aimed at preventing such “corporate inversions,” or a strategy for American companies to reduce their tax liabilities by shifting profits abroad. Those changes removed the financial advantages Pfizer hoped to gain from buying Allergan, eventually causing the deal to be abandoned.
3. Not Capitalizing on Technology
Technology facilitates business: it drives innovation, speeds product development, improves collaboration, improves service delivery, increases customer satisfaction, and better manages employees. While businesses can leverage M&A to improve and streamline operations, not capitalizing on the synergies that technology can provide, such as advanced CRM or analytics systems, can bring about risk. A clear understanding of the potential value of technology can improve the bottom line.
However, the opposite can be true: sometimes companies capitalize too much on technology — expecting that technology itself will justify the value of a merger.
Although it took place over 20 years ago, the merger of America Online and Time Warner is a textbook example of a merger that relied too much on technology to sell value. In 2001, America Online acquired Time Warner in a “megamerger” valued at $165 billion — the largest business combination up until that time. Senior management at both companies sought to capitalize on the convergence of traditional mass media with the burgeoning Internet. Shortly after the merger, however, the dot-com bubble burst, causing a significant reduction in the value of the company’s AOL division. Less than one year later, in 2002, AOL Time Warner, as the merged company was called, reported an astonishing loss of $99 billion, the largest annual net loss ever reported.
Further, technologies themselves can bring about risk, especially those related to fraud and security. This is the other context in which to ensure that any newly incorporated technologies, while bringing value to the enterprise, do not also increase the attack surface and serve as an attack vector for fraud or cyber threats.
4. Misunderstanding Post-merger Integration Issues
The success of an M&A deal isn’t guaranteed after the deal is signed and sealed. The integration period is every bit as crucial to ensuring that the acquiring company is able to achieve the goals it intended to with the transaction and that the acquired company’s assets are properly utilized. Unfortunately, most M&A deals destroy value. According to Boston Consulting Group, more than half of M&A transactions fail or underperform.
Transactions can certainly proceed, but the reason why these transactions fail to unlock their full potential is due to the complexity of the post-merger integration — ignoring the unique processes, structure, culture and management of two distinct companies. There is much risk inherent in the post-merger integration, and understanding these issues before the deal is signed can serve as a form of risk avoidance. Once a company decides that a bid will go ahead, due diligence should include scenario analysis to test the operational and strategic alignment of the businesses.
“It sounds obvious, but if you can’t explain what the combined business looks like, the exact sources of synergy and their expected value before the deal, you will not be able to explain them post-execution either. Moreover, you’ve missed the opportunity of doing proper due diligence for your deal,” notes Maya Gudka, Director of the Leadership and Strategy Program at London Business School.
5. Avoiding Liabilities and Write-downs
Oftentimes, senior management and shareholders are so focused on a future roadmap of combined product and sales leadership that they fail to account for hidden liabilities and potential write-downs. These would of course be uncovered during the due diligence process, which serves as a risk avoidance measure. Due diligence should identify liabilities that the buyer is expected to assume and quantify those liabilities for ultimate loss costs and should identify collateral requirements tied to those liabilities, and assess opportunities for reduction or even removal. Indemnification clauses should also be included in any M&A deal contract in order to further protect both parties from liabilities that were both uncovered during the due diligence process, and those that may be revealed after the integration of the two companies has begun.
An example of liabilities that were missed during due diligence occurred after the August 2005 announcement of Sprint’s intention to acquire a majority stake in Nextel Communications in a $37.8 billion stock purchase. At first, the merger made sense: each company catered to different markets: Sprint with consumers, Nextel for business, transportation, and logistics. Unfortunately, there were too many integration issues soon after. Aside from cultural differences and incompatibility, there were unforeseen liabilities related to capital expenditure requirements, and by 2008, Sprint found itself needing to write off a whopping $30 billion in one-time charges due to impairment to goodwill.
6. Ignoring Fraud, Corruption and Compliance issues
According to a poll of 1,300 professionals across industries ranging from financial services to technology and manufacturing conducted by research aggregator LexisNexis, nearly 90% fail to conduct due diligence for compliance risks such as corruption, money laundering and fraud. LexisNexis found that only 10.4% express confidence in their management of M&A risks.
Scenario planning, especially as it relates to compliance, can expose the true value of a deal in a way that balance sheets and assets alone often cannot. The current companies might be fighting fraud and corruption in their own way, but as a merged company, the compliance posture may shift significantly. Understanding these issues is a key part of a risk avoidance measure.
7. Devaluing Human Capital
A successful M&A risk avoidance strategy should also take into account human capital management. The merger might suddenly make the workplace unattractive, leading to attrition. This could prove to be a huge misstep, especially because the value of many companies is tied more closely to their human capital than the actual product or service they provide. Conversely, the merger might also produce the opposite effect, with senior management of the new company needing to take measures to reduce headcount in order to realize post-merger efficiencies.
While organizations cannot predict human behavior, they need to develop various human capital scenarios, including the risks inherent in each, so that post-merger operations are not disrupted. This is a key M&A risk avoidance strategy.
8. Lack of Awareness of the Costs of Doing the Deal
Even if two companies agree to a friendly merger, and their internal senior management teams are already working on integration strategies, M&A transactions themselves carry significant costs in the form of a potentially lowered value in the assets used for the acquisition or in new professional fees that each company must pay. For example, during the due diligence process, the acquiring company’s stock price declines. Or, companies hire new, costly external auditors and valuation experts to perform a fairness opinion to determine whether the value of the transaction is justified.
The acquiring company might be using stock, debt or another asset class to finance the deal. The company might find itself using current assets or hiring one or more investment banks to issue new securities to raise capital from investors in order to have the funds to acquire the target company. Oftentimes the deal is predicated on the value of these securities, and if the value drops significantly from the time a merger is announced, the deal can fall apart.
This is what occurred in September 2021 when video conferencing provider Zoom and call center software provider Five9 scrapped their $14.7 billion merger agreement after Zoom’s shares suffered a steep decline. The decline in Zoom’s stock price — from $361.97 per share in July 2021 to $261.50 in September 2021 — slashed the deal’s value by almost a third, leading Five9 shareholders to ultimately reject the offer.
While deals principally seek to create shareholder value, successful mergers can also uncover and avoid unforeseen risks. According to corporate services company CSC, M&A deals can extend corporate power, increase market share, aid in diversification, and enhance a company’s likelihood of obtaining future financing.
A world-class virtual data room is a crucial component in successfully executing any risk-avoidance strategy for M&A. A VDR needs to be more than simply a version of cloud document management and security for those involved in corporate and financial transactions. Organizations should consider an enterprise document security solution like Caplinked that has years of experience providing data rooms for sensitive and complex M&A transactions and their integrations afterward.
Jake Wengroff writes about technology and financial services. A former technology reporter for CBS Radio, Jake covers such topics as security, mobility, e-commerce, and IoT.
The One Brief – Planning for M&A: How to Avoid Hidden Risks
SearchCompliance/TechTarget – Risk Avoidance
Boston Consulting Group – Post-Merger Integration
Investopedia – 4 Biggest Merger and Acquisition Disasters
Digital Trends – Nvidia’s $66 billion ARM deal has fallen through. What now?