Secrets of the M&A Masters

Revealing the paths to a successful deal.
Kate O'SullivanSeptember 7, 2005

The numbers do not inspire confidence.

Over and over, studies of mergers and acquisitions show that deals fail to create shareholder value. One recent survey says that more than 70 percent of acquisitions fail; another, 61 percent.

A third study reports that 89 percent of acquired businesses actually lose market share. True, some observers have suggested that given enough time, the success rate of acquisitions rises.

And some argue that mergers do succeed if measured against the proper yardstick. But while there is debate about the payback, no one would deny that acquisitions are fraught with risk.

Fifty years ago, businesses typically pursued organic growth, and mergers were fairly rare, according to Richard L. Nolan, professor emeritus at Harvard Business School. Today, mergers seem to have eclipsed organic growth as the business expansion vehicle of choice. For a variety of reasons, companies need to buy other companies — to gain market share, to enter new markets, to acquire technologies, to integrate vertically, and so on.

“There are a lot of businesses where growing organically is not enough to meet market expectations,” says David Harding, a partner at consulting firm Bain & Co. and co-author (with Sam Rovit) of Mastering the Merger. Thus, many finance chiefs will find themselves one day confronting the daunting odds of making a successful acquisition.

How can they improve their chances? One way, as evidenced by a number of recent articles and books, is to study and learn from other companies’ merger mistakes — which, unfortunately, are many and varied. Another way, presented here, is to focus on the key habits of frequent, successful acquirers. In the course of studying more than 1,700 companies, Harding and Rovit identified a pattern: companies that do a lot of small deals produce much better results, achieving nearly twice the excess shareholder return of intermittent buyers (calculated by subtracting the company’s cost of equity from total shareholder return). Frequent acquirers learn from each deal; the CFOs at these companies hone their acquisition skills, much like the professional buyers in the private-equity world do.

With a clearly defined acquisition strategy, strictly enforced target-selection criteria, and careful attention to both transaction mechanics and integration planning, these frequent acquirers have been able to generate above-average returns, while at the same time quietly folding dozens of new companies into their businesses. Such small transactions may not grab the headlines of a blockbuster deal like AOL-Time Warner or Hewlett-Packard-Compaq, but few CFOs are looking for such headlines. Instead, learning through experience, they seek to complement their organic growth with well-timed purchases.

From discussions with finance chiefs and business-development heads at six frequent acquirers — Dover, Wells Fargo, Charles River Laboratories, VF, Clear Channel Communications, and CRA International — we distilled the following advice. Their hard-won lessons can cut through the clutter of acquisition statistics and theory and serve as practical deal-making guidelines. Call them the secrets of the M&A masters.

1. Never Stop Shopping

The most critical factor of a successful deal is the most obvious one: finding a good target. “Very simply, you can’t make good stew unless you have good ingredients,” says Bob Tyre, vice president of corporate development at Dover Corp., a diversified manufacturing company with $5.5 billion in 2004 revenues that makes 10 to 20 acquisitions annually.

And as any good cook knows, you have to shop around to find the best ingredients. Companies should be constantly scanning the marketplace for possible acquisition candidates, rather than simply reacting whenever investment bankers bring news of potential targets.

“We’re really always in the market,” says Thomas Ackerman, CFO of Charles River Laboratories Inc., a global provider of research and testing services to the biotechnology and pharmaceutical markets and health-care institutions, with $767 million in revenues. The company has a small-business development team devoted to the task of identifying attractive acquisition opportunities, and business managers throughout the company are encouraged to present acquisition-oriented as well as organic-growth strategies.

VF Corp., a Greensboro, North Carolina–based apparel company that in recent years has bought such well-known brands as Nautica, Reef, and The North Face, has moved toward a similar “always on” approach to acquisitions, says Bob Shearer, CFO of the $6.1 billion company. “In the past, we would evaluate opportunities as they came to us,” he says. “We’ve been much more successful in evaluating our own capabilities and being more proactive rather than reactive. In our more recent acquisitions, we’ve approached companies ourselves.”

2. Know What You Want

A clearly articulated vision of what makes a target attractive also helps frequent acquirers stay on track. Grasping for a company simply because it’s on the market, or because a competitor wants to buy it, can lead to overpayment or a misguided purchase.

Charles River Labs has a careful definition of what it seeks to gain from its next acquisition. “We focus on areas close to our core, within the same customer base and with the same area of focus: assisting pharmaceutical and biotech companies from drug discovery through market approval,” says Ackerman. Currently, Charles River’s business-development team is looking for a U.S. company that runs phase-one clinical trials. The company is also aiming for smaller targets at this point, after digesting the $1.5 billion October 2004 acquisition of Inveresk Research Group, an operator of preclinical and clinical trials that added nearly 50 percent in revenues to Charles River’s size. “We wouldn’t want to rush into another big deal,” says Ackerman.

The closer an acquisition’s business is to the buyer’s, both in strategy and geography, the greater the chances for success, according to Robert F. Bruner, Dean of the Darden Graduate School of Business Administration at the University of Virginia. “One of the better-documented findings in M&A research is that buying into related businesses and industries appears to be correlated with higher returns,” says Bruner, whose most recent book is called Deals from Hell: M&A Lessons that Rise above the Ashes. “It appears that unrelated deals account for much of the loss in M&A.”

Properly assessing a target company also involves self-evaluation, says Howard Atkins, senior executive vice president and CFO of Wells Fargo & Co., a San Francisco–based financial-services firm with $435 billion in assets. “We spend a lot of time thinking through what we bring to the table in addition to what the target company may bring,” he says. In the course of its history, Wells Fargo has purchased many small banks throughout the West and Midwest to gain access to their local customer bases, says Atkins. But the banking behemoth has reaped additional benefits by bringing its broad product line to that ever-expanding customer base, creating a cross-selling ratio of five products per customer, up from just one or two for the target banks prior to the deal.

3. Set Limits

If the CFO doesn’t set and enforce limits on acquisitions, no one will. In particular, setting specific hurdle rates is a key tool for preventing deal failure. At Wells Fargo, for instance, any potential transaction must have at least a 15 percent internal rate of return, and it must be accretive to earnings per share within three years.

“Some acquirers rationalize deals by saying they are strategic — ‘Don’t worry, it’s all going to work out in the end no matter what price we pay’ — but you really have to stick to your financial discipline,” says Atkins. Having hard numbers to rely on enables CFOs and boards to resist persuasion from business-unit heads, salespeople, even the CEO. “It helps us say no and keeps us from wasting time,” says VF’s Shearer, whose company insists on a target’s ability to meet its revenue, operating margin, and return-on-capital goals of 8 to 10 percent, 14 percent, and 17 percent, respectively, within three to five years of a transaction’s completion.

At the same time, maintaining reasonable expectations is critical, says Randall Mays, CFO of media giant Clear Channel Communications Inc., which has acquired hundreds of radio stations in the course of its growth to $9.4 billion in 2004 revenues. “Make sure when you’re doing a transaction in an industry or market that may be new to you that you have a realistic view of cash-flow projections,” says Mays. “Don’t overestimate what you’re going to be able to do. As we go into new business lines or new geographic areas, we always run into issues that we don’t expect. That may be one of the most significant things we have learned over the course of the last decade.”

VF learned a similar lesson. “We had always had great strengths in the supply-chain and operational side of the business, and in some of our earlier acquisitions, we were looking at companies that we felt we could help from an operational standpoint,” says Shearer. “That can be an important element, but you’ve got to be able to grow the top line. From a Wall Street perspective, once you take the costs out, it’s ‘What have you done for me lately?’” Today, VF looks for healthy brands with strong growth potential, rather than fixer-uppers.

Forcing a deal team to place specific numbers on expected cost savings or synergies is another prudent practice. “The major mistake we’ve made in some of our add-on acquisitions was not requiring the deal teams to be more explicit about what was going to be different when they bought the company,” says Dover’s Tyre. “In some cases, they didn’t make the changes and didn’t get the synergy they expected.” He now requests much more detail on synergy estimates, including anticipated timing for the realization of savings and information about how the company will measure synergy after the acquisition closes.

4. Do the Diligence

While some corporate acquirers may judge a deal by relying on numbers provided by the seller, or on their own gut feel for the market, the best buyers look for a level of detail similar to that required by the private-equity investors who do deals for a living. They commission outside help when necessary and look well beyond the financial statements of each potential target.

At CRA International, a Boston-based consulting firm that has made 10 acquisitions in the past seven years, vice chairman and former CFO Phil Cooper spends much of his time determining whether there is a cultural fit between his firm and the target company. The fastest deal CRA has ever done took a year. “We can produce a term sheet in a week to three weeks, but that’s not what we’re trying to do,” says Cooper.

While this approach may not be surprising in consulting, where human capital is the main asset of the business, other frequent acquirers also stress the importance of finding and retaining strong management teams. “We look for transactions where we can actually keep management of the target company in place,” says Wells Fargo’s Atkins. “That goes against the grain of many acquisitions that you hear about, where the deal is all about cutting expenses and getting rid of the people. If you’re losing the people who are actually running the company, how does that work?”

Clear Channel’s Mays agrees. “We have found that it has generally not been necessary to change out management,” he says. “If you provide a good idea of what you want to accomplish, the existing management team generally has the skill set to provide a good return. They just need a clear vision.”

Active buyers often supplement qualitative research on the management team with quantitative research on market trends. Independent market surveys, including interviews with customers and distributors, can provide a very different picture from what company insiders expect. “There was one fairly large opportunity that we recently passed on because of the research,” says Shearer. “The operating folks, including me, thought it was the right opportunity, but the consumer research said no.”

In its recent acquisition of Inveresk, Charles River Labs hired an outside firm to look into the clinical-services market, since it didn’t have any experience in the area. “We wanted to make sure we had the appropriate knowledge and comfort level in that industry,” says Ackerman.

5. Keep a Foot on the Brake

If the due-diligence process does unearth problems, companies need mechanisms in place that allow them to walk away. “There are people absolutely down in the weeds looking at the transaction, and at that level there is a tremendous amount of deal momentum. It can be difficult to extricate yourself from that,” says Mays. “Make sure that you can have people at varying altitudes looking at the deal.” The CFO says either he or his brother, chief executive Mark Mays, typically provides the higher-level perspective that quashes enthusiasm for an acquisition that isn’t going to work.

Sometimes, walking away from a transaction can pay off in the form of a better deal down the line, as CRA learned in its recent purchase of InteCap, an intellectual-property consulting specialist. The two companies first began talking about a merger in the fall of 2001 and came to agreement on a term sheet, but in the course of examining the company, CRA identified too many problems for its liking, including two underperforming offices. In April 2002, it backed away. InteCap then hired someone to help improve their accounting processes and closed the lagging offices. The deal was revived and closed in the spring of 2004.

Of course, it’s easier to turn down a deal when you’re acquiring from a position of strength. “When you have a strong business model where you’re not dependent on doing acquisitions, they become a complement to the business strategy, and you’re able to be selective as an acquirer,” says Atkins. He notes that Wells Fargo has not been buying banks of late, because he believes that valuations are too high. Nonetheless, the bank has continued to grow at a double-digit rate.

6. Tailor the Terms

Not surprisingly, CFOs who make frequent acquisitions spend a great deal of time structuring the terms of a deal. “Tailoring pays,” comments Darden’s Bruner. “Adapting the terms of the deal in subtle ways has a huge influence on outcomes.” Such features as earnouts, in which a portion of the purchase price is not paid until the acquired company reaches a certain level of sales or achieves some other performance goal, can help companies reach a deal’s full potential by providing an incentive for the target company’s management and employees. “Using earnouts limits the downside, yet provides upside for the target company,” says Bruner. Such deals can be difficult to structure, however, and are most practical when acquiring a private company with a relatively small group of owners.

To retain all-important consulting talent at the companies it acquires, CRA has devised strong noncompete agreements and often uses earnouts, says Cooper. “We’ve seen at least one of our peer companies lose an entire group of employees the day after the noncompete expired,” he says. “Ours extend for a minimum of one year after termination.” All of the key business leaders from companies CRA has purchased are still with the firm, according to Cooper.

Bruner, meanwhile, also suggests using termination fees to lock in a deal, thus forestalling auction situations and keeping prices down.

7. Make It Work

Integration, the final phase of an acquisition, is nearly as important as the target-selection phase, say experienced buyers (see “It’s Not You, It’s Your Technology”). A good deal on paper can easily fall apart during the postdeal marriage of the two companies.

Timing is everything in the integration process, says Charles River’s Ackerman. “The longer you stretch it out, the harder it becomes to change certain practices,” he warns. To lay the groundwork for a speedy integration, CRA establishes a full integration team before a transaction closes. Cooper emphasizes the importance of facilitating interaction between employees at the two companies as quickly as possible. And in an E-mail culture, he adds, it’s important to make the time for face-to-face meetings. “I know how quickly people can get ticked off, and how quickly [situations] can become emotional,” when plans are misinterpreted or misunderstood, says Cooper.

Wells Fargo gives itself enough time to do integration properly, by stating in every transaction announcement that the deal will be accretive to earnings within three years instead of the typical one year. “Rather than assigning an arbitrary time frame of one year and running the risk of cutting expenses arbitrarily to rationalize the purchase price, we want to take the time to do it right,” says Atkins. The company’s acquisitions typically become accretive well before the promised three years, he adds.

To ensure the smoothest possible integration, CFOs can take another lesson from the private-equity sector. Private-equity investors typically develop 120-day plans, says Jeffery M. Bistrong, a managing director at boutique investment bank Harris Williams & Co. in Boston, who suggests such a tool for CFOs. “These are very detailed plans that explain how management teams are going to be integrated, what the operating metrics are going to be, how management will be measured, and what changes need to be made,” says Bistrong. After combining with Inveresk, Charles River employed a similar strategy, working with an outside firm to manage the integration process for the first 100 days, says Ackerman.

All this, of course, is not to say that experienced acquirers don’t stumble from time to time. Despite careful selection and planning, an acquisition may ultimately fail to deliver value. “You have to be both lucky and good,” says Cooper. “If you do it right, it almost looks easy.”


Kate O’Sullivan is staff writer at CFO.

Practice Makes Profits

Bain & Co.’s research on why deals fail shows that frequent acquirers have a better chance of creating value from acquisitions. Below are the most active buyers from the period studied, 1986-2001. Aside from Wells Fargo at #6, three other companies features in this story — Clear Channel Communications (#31 with 41 acquisitions and a 36 percent average annual total shareholder return for the period), Dover (#35 with 38 deals and 15 percent TSR), and VF (#208 with 14 deals and 10 percent TSR) — also make the list. — K.O’S.

Rank Company No. of Deals (1986–2001) Average Annual Total Shareholder Return (% Rounded)
1 General Electric 161 20
2 Airgas 132 20
3 Interpublic Group 127 19
4 Omnicom Group 125 23
5 Thermo Electron 92 12
6 Wells Fargo 91 23
7 Ikon Office Solutions 81 8
8 AON 69 14
9 Cisco Systems 68 NA*
10 Arthur J. Gallagher 67 14
*Cisco did not go public until 1990.
Source: Bain & Co.; Thomson Financial