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Merger Due Diligence The Devil in the Details

October 1, 1999
Related Topics: Mergers and Acquisitions, Featured Article
If there's one thing that Daniel Jones has learned from more than two decades of working in human resources, it's that mergers and acquisitions are a fact of life. At some point, probably sooner rather than later, a company will find itself eyeing another enterprise-desperately trying to make sense of physical assets, intellectual property, legalities, pay, benefits and culture. "In today's business environment, mergers and acquisitions are essential. The difficult part is ensuring that you know what you're getting into upfront," he states.

Jones, the director of human resources for Steelcase Inc., a Grand Rapids, Michigan, manufacturer of office furniture, speaks from experience. Over the last three years, the company has acquired eight other firms. Some have added manufacturing capability, others have pumped up the Steelcase product line. All have added to the bottom line. Today, Steelcase tallies fiscal 1999 net sales of over $3 billion. It operates 50 manufacturing plants, with over 20,000 employees in 15 countries.

In every instance, human resources was heavily involved in the upfront due diligence. While financial analysts, attorneys and MBAs were scrutinizing details and poring over spreadsheets, Jones and other key individuals in HR were taking a close look at myriad other factors that could make or break the deal. Armed with a checklist, they studied benefits, compensation, pay, OSHA and ERISA records, employee handbooks, HR technology and a whole lot more. "The more you know, the better you can structure the deal," says Jones.

Unfortunately, Steelcase is an exception rather than the rule. Although most companies that engage in a merger or acquisition take due diligence seriously, human resources is often left out of the loop. Or it's asked to jump into the fray only after senior management has made an announcement-at which point it's often too late to provide strategic consulting. "HR has a critical role in due diligence-both from the benefits and compensation side and the cultural side," explains Deborah Rochelle, a senior merger and acquisition consultant for Watson Wyatt Worldwide. "Successful companies examine leadership models, recruiting, and what makes the organizations different or similar-as well as specific benefits and legal issues."

Planning makes all the difference.
It's no simple task. Due diligence can involve long checklists, and combine hard logic with intuition. As Jones puts it: "It's an ongoing learning process. It's necessary to constantly tweak and adjust thinking to reflect changing business conditions and greater knowledge about how to conduct due diligence." Adds Mark N. Clemente, president of Glen Rock, New Jersey-based M&A consulting firm Clemente, Greenspan & Company, and author of the self-published book, Empowering Human Resources in the Merger and Acquisition Process (1999): "Ultimately, many mergers fail because of human resources-related issues, such as culture clash. A company that embarks on a merger or acquisition without early and direct input from HR is living extremely dangerously."

In fact, the numbers speak volumes. According to Thompson Financial Securities Data, based in Boston, worldwide M&A activity through August 1999 hit nearly $1.6 trillion, a 12.7 percent increase over the same period a year earlier. Meanwhile, various studies have found that a staggering 50 to 75 percent of all merging companies fail to retain their book value two years after stepping to the altar, and many others are torpedoed by ongoing culture clash and an erosion of top talent. "Many CEOs gloss over softer HR issues, including potential cultural problems, only to realize later that they've made a huge mistake," says Mitchell Lee Marks, a San Francisco-based management consultant who has worked on more than 60 mergers over the last 15 years.

Marks, co-author of Joining Forces: Making One Plus One Equal Three in Mergers, Acquisitions and Alliances (Jossey-Bass, 1998), believes that the biggest problem is getting top human resources professionals to plan ahead and provide strategic input. "The most successful companies have HR on the due diligence team, and the most successful HR departments prepare ahead of time by creating checklists, contingency plans and knowing who will handle specific tasks as soon as an announcement is made."

That's certainly the situation at Steelcase. Over the years, Jones has created an entire plan of action. When senior management contacts him about a potential acquisition, he has a 30-plus page checklist ready and a team of human resources experts prepared to examine specific factors or data. When he doesn't have the expertise in-house, he uses outside consultants. Moreover, Jones works closely with the company's CEO to identify potential takeover targets, and analyze the cultural fit upfront. And when discussions begin, he's ready to step in and begin interviewing key managers at the other company.

At Cooper Industries, a Houston-based manufacturer of electrical products, tools and hardware with 28,100 employees and $3.6 billion in 1998 sales, M&A activity is a regular part of the picture. The company typically pulls the trigger on 10 to 15 deals a year, acquiring both public and private companies. George Moriarty, assistant director of pension design, typically spends several days poring over records, with the assistance of a detailed checklist. Among other things, he examines day-to-day business costs and looks for potential liability, especially related to retiree medical benefits, severance pay obligations and employment contracts for executives. When the deal involves an overseas acquisition, he often spends hours interviewing senior executives of the targeted firm.

Many failed mergers aren't a result of inept management or inadequate due diligence. More often, chronic problems occur because the two organizations haven't determined whether they have compatible cultures.

The entire due diligence process usually takes a week to 10 days, though complex deals can require three or four weeks of analysis. Cooper Industries uses anywhere from 7 to 20 people, depending on the complexity of the due diligence. Moriarty is one of three or four HR professionals who focus on different aspects of the deal. He says, "The idea is to understand exactly what you are buying. It's rare to spot something that kills the deal, but it isn't uncommon to uncover some information that leads to a re-valuing of the deal." Moreover, the due diligence can identify personnel who are crucial to the transaction. That allows Cooper Industries to enter long-term contracts with key executives and others, or lower the value of the deal based on the possibility that these individuals might leave for another company.

According to Watson Wyatt's Rochelle, HR due diligence must encompass people, programs, plans, policies and processes. The financial and legal side of the equation must focus on pay, defined benefits such as 401(k) plans, health insurance, vacation policies, immigration standards and more. These factors usually aren't enough to derail a deal, but they can affect the pricing and subsequent human resources strategy. "Often, hidden pitfalls and liabilities exist. If a company conducts the proper due diligence, it's possible to address the issues effectively and avoid many serious problems," she argues.

In one case, a company found itself saddled with a $1-million expense after the deal closed, simply because it hadn't bothered to adequately check the other's firm's 401(k) plan for government compliance, notes Rochelle. Other companies have discovered, only after the ink is dry on a deal, that the acquired company hasn't fully complied with EEOC requirements or immigration law. The latter can be extremely serious, resulting in fines and the loss of workers. That makes an I-9 audit essential, according to Katie Shan, an analyst in the Chicago office of labor law firm Baker & McKenzie.

Information uncovered during due diligence can also help an organization devise a highly focused compensation and communications strategy. A 1999 survey conducted by Watson Wyatt found that retention of key talent is a critical concern for 76 percent of companies involved in a merger. Yet because productivity, performance and morale almost always take a nosedive during a merger, the threat of losing the organization's superstars is very real. Then, instead of realizing the anticipated synergy of uniting two organizations, management finds itself desperately trying to avoid entropy.

To be sure, the business world is littered with the debris of failed human resources strategies during mergers. When one Northern California bank acquired another several years ago, senior management was pleased with the acquisition and thought it had everything on track, says Rochelle. However, eight weeks after the merger took place, the company had lost 75 percent of its key managers. The culprit? "They did not pay attention to how to hold onto the managers. They never considered retention bonuses or other processes that would help ensure positive results," she states.

Remember the importance of culture.
Financial and legal considerations, however crucial, are only part of the process. Many organizations have discovered-sometimes only after it is too late-that cultural issues can determine whether a deal sizzles or fizzles. According to Marks, many failed mergers aren't a result of inept management or inadequate due diligence. More often, chronic problems occur because the two organizations haven't determined whether they have compatible cultures, or how to work out differences if the cultures don't align. What's more, senior executives often do not regard cultural differences as important.

Cultural differences can manifest themselves in the way people dress, communicate, use e-mail, make decisions and more. Too often, says Marks, the two companies butt heads and condemn the other's way of doing business. They might view the other organization as too bureaucratic or simply incompetent. Eventually, one side wins. "Their way is adopted in the combined organization, leaving the other side feeling like losers," he explains. The irony in all this is that such diversity can benefit the new organization, but only if it is fully harnessed. And that must begin in the due-diligence process.

Although many companies claim that a deal is a "merger of equals," Rochelle believes the term is a misnomer. "There is no such thing," she states. "In any acquisition or merger, there always is a dominant company and a subordinate company. One of the organizations will emerge as the one that runs the show, and imposes its culture on the other. However, the most successful companies make concessions and combine the strengths of both companies to develop a new organization."

Developing a cultural audit tool and detailed checklist can guide organizations through the due diligence process. These allow the organization to evaluate the things that are most important, including what senior management's vision is for the combined organization, how the leadership styles differ, how executives interpret terms such as "customer satisfaction" and "competitive performance," and the types of general policies each company has in place. For example, an Internet start-up might allow employees to bring their dogs to work and decorate cubicles, while a more button-down culture might forbid all personal items in a workspace. One organization might discuss matters politely at meetings and online, while another relies on a more combative approach.

Clemente believes that success usually results when HR uses "discreet, measurable and quantifiable analysis that can be combined with the proverbial 'gut' feel." Interviews with senior managers-and a representative sampling of the rank and file-can also help an acquiring company understand the mindset of the other organization. If the takeover is hostile, then third-party interviews and public information, including SEC filings, can prove useful. The end result, he says, should be a "portrait" of the other company and its culture. "Once you have something to benchmark against and take action from, it's possible to adjust compensation, benefits, communications and other methods to address the specific needs of the deal."

Take a look at the big picture.
In a worse-case scenario, culture clash can unglue a deal before it's finalized. However, a more common approach to dealing with cultural incompatibilities is to develop strategies, and ultimately programs, to address cultural integration. That might include signing a long-term employment contract with key executives before the merger is complete or establishing a task force to combine the best practices of both companies.

That's exactly the tack taken by Abitibi-Price, a Toronto-based paper manufacturer, when it announced a merger with Stone Consolidated of Montreal in early 1997. At the time, CEO Ron Oberlander of Abitibi recognized that industry consolidation was inevitable, and that his firm could benefit by a merger. However, with dozens of potential partners, he felt that he had to ensure a solid culture fit before moving ahead with the deal. For companies that passed his firm's strategic and financial requirements, cultural fit would be used as the criteria to decide the deal.

Oberlander brought the firm's senior vice president of HR, Jean Claude Casavant into the process as an internal consultant. After creating an evaluation system dubbed Merging Cultures Evaluation Index (MCEI), they sent a questionnaire to potential suitors, tabulated the results and generated rankings for various firms. That served as the basis for the merger with Stone Consolidated. Despite their presence in cities that speak different languages (English and French), it became clear that the combined organization would produce financial gains and that the cultures could be melded together effectively. Today, the combined entity, Abitibi Consolidated has become the world's largest newsprint producer, generating over $2.15 billion in sales during 1998.

Like most successful merging companies, Abitibi developed a contingency plan early on. The fact that HR was part of the strategy meant it could examine the deal in total rather than the sum of the parts, says Marks, who coached the CEOs and served as a consultant. "There's a hard side and soft side to mergers," he says. "HR has to understand both parts of the equation. It must be proactive and not reactive for [all parties] to succeed."

A wake-up call? Perhaps. Especially if you consider many companies still don't use HR effectively during the due-diligence process. Concludes Rochelle: "The merger and acquisition frenzy isn't likely to abate anytime soon. Regardless of the industry or circumstances, human resources must be prepared to provide the level of due diligence necessary to ensure that a deal can work, and that it is valued fairly. The HR department that is prepared to act can become a strategic participant in the process rather than a spectator."

Workforce, October 1999, Vol. 78, No. 10, pp. 68-74.

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