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Volume 29 Number 3 2008

ISSN 0275-6668

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Merger deal breakers: when operationaldue diligence exposes risk

Nan J. Morrison, Guy Kinley and Kristin L. Ficery

Chrysler’s new owner, private-equity firm Cerberus Capital Management, LP, probably

knew exactly what it was buying before it bought the struggling automaker, judging

by the job cuts announced in late 2007. Cerberus is moving decisively and quickly

to trim costs as step one toward realizing a profit on its investment.

That was not the case the last time Chrysler was on the block. Daimler-Benz, which bought

the Detroit icon in 1998, has publicly conceded that it did not properly scrutinize Chrysler’s

operations before finalizing its bid. In particular, the German industrial giant glossed over

such crucial factors as excessive inventories, car-buying incentives that kept increasing and

the waning appeal of the Chrysler brand during the 1990s (Automotive News Europe, 2001).

To practiced acquirers, the DaimlerChrysler saga became a warning of how not to conduct

due diligence. But the experience did not reverberate very far (Cerberus’ move excepted).

Judging by the number of mergers that still go sour, there is plenty of room to intensify the

kind of operational due diligence that can uncover deal-breaking factors before they destroy

shareholder value. Two-thirds of respondents to a survey at the Third Annual Due Diligence

Symposium said weak due diligence was the main reason that many mergers collapsed

within a few years (The Risk Management Association, 2007).

Few observers of M&A activity believe there are lingering problems with the main elements of

due diligence: verifying the accuracy of financial statements, sales forecasts and valuation,

for instance. However, those aspects of due diligence are no longer sufficient by themselves

– as evidenced by the problems that occur when dealmakers discount (and sometimes even

ignore) crucial operational issues.

Supply chain and IT are two operations areas that deserve special attention because they

still get short shrift. In a recent Accenture study, nearly half (45 percent) of supply chain

managers said that during merger integration efforts, their companies focused only on

generating cost savings at the expense of other metrics, such as quality, inventory turns,

supply disruption and order fill rates (Accenture, 2006). Respondents said a company’s

supply chain is often the biggest source of cost synergies, accounting for 30 to 50 percent of

the savings achieved. Rationalization of assets such as warehouses or truck fleets, for

example, is often a prerequisite to merger success.

Non-supply chain managers said the main reason that such issues were not being

addressed early on is that executives driving the mergers believed the issues could be

handled later in the merger process. That might once have been so, but it no longer holds

true. Today’s IT organizations, for example, are so complex that any changes require a very

long lead-time. Yet non-completion of IT integration efforts can prevent merger synergies

from being realized quickly or at all.

DOI 10.1108/02756660810873182 VOL. 29 NO. 3 2008, pp. 23-28, Q Emerald Group Publishing Limited, ISSN 0275-6668 j JOURNAL OF BUSINESS STRATEGY j PAGE 23

Nan J. Morrison is a Partner

in Accenture’s SITE/

Accenture Technology

Consulting Practice based

in New York, USA.

Guy Kinley is a Partner in

Accenture’s Corporate

Strategy Practice based in

Florham Park, New Jersey,

USA. Kristin L. Ficery is an

Accenture Partner based in

Atlanta, USA. Accenture is

a global management

consulting, technology

services and outsourcing

company.

Increasing operational complexity – such as the need for integrated supply chain

management systems, logistics processes that often must work in real time and across

international borders, the extensive use of offshore subcontracting and manufacturing, IT

shared services models and outsourcing agreements – means that assessing a target

company’s operational elements is more important than ever.

Traditional due diligence falls short since it focuses largely on pinpointing the biggest visible

risks and clarifying what is being bought. But best-in-class acquirers – serial dealmakers

such as Cisco Systems and Bank of America – are masters of a deeper level of due

diligence that greatly expands their understanding of their targets’ operational elements (US

News & World Report, 2006). These companies stick to several core principles with every

acquisition:

B They have dedicated merger teams composed of a range of operations experts. For

instance, their ITexperts become familiar with the vulnerabilities and plus-points of target

companies’ IT systems and IT operating models, and their supply chain specialists study

the minutiae of inventories and dependencies throughout their targets’ supply chain

pipelines. (See section ‘‘Profile of an operational due diligence team’’).

B They have replicable due diligence processes that are known, documented and can be

executed – and that are in sync with the company’s overall operating model. Cisco notes

that such standard processes mean a shorter time to gain the value expected from each

deal and the ability to pursue more acquisitions, more quickly and at lower risk (Cisco,

n.d.).

B They have firm guiding principles for how the company manages key functions such as IT

or supply chain operations. Then, as targets are acquired, they are quickly moved onto

the same operating platforms that the acquirer uses, unless there is are sound business

reasons not to do so. This approach makes cost estimating much more accurate.

B They are crystal-clear about the criteria they are looking for in their acquisitions and the

metrics that the deals will be judged by. They can then balance the cost of integrating

operations and making any necessary known investments against the benefits expected

to flow from the ongoing ‘‘to be’’ operating model.

In short, best-in-class acquirers gain insights that give them a leg up in merger integration

planning. They get early warnings of potential deal breakers – the investments required, the

true ongoing operating costs of the ‘‘to be‘‘ operating model, service agreements and

licenses, and thus the likelihood of achieving the projected post-merger cash flows – along

with any planned synergies or opportunities to create value.

When seasoned operations experts are involved in due diligence and pre-merger planning,

the major risks and potential deal breakers are exposed quickly, before deal momentum

pushes things to the point where participants are reluctant to walk away. Also, deal makers

can accurately assess the true investments needed as well as the ‘‘to be’’ operating costs of

the joined companies. Those numbers can be used to adjust post-merger cash flow

projections, which are often extrapolated based on percentage estimates and projected

top-down rather than bottom-up based on major projects underway or on operating model

complexity. And the operations experts allow potential new sources of value to be identified

and considered as part of the valuation of the target company. The purchase price may then

be adjusted up or down.

Three examples illustrate the benefits of utilizing operational expertise:

1. Exposing major risks early. A big computer reseller paid close attention to the logistics

infrastructure and systems of its target, an online PC store selling in small quantities to

multiple customers. The asking price was predicated on the online company’s intended

significant growth. But the acquirer’s operations due diligence team discovered that the

target would not be able to support such growth. A few months prior to the transaction,

the online PC store had outsourced maintenance and development of its IT system. The

deal was called off because it carried unacceptable risks for the buyer.

PAGE 24 j JOURNAL OF BUSINESS STRATEGYj VOL. 29 NO. 3 2008

The issue in this case was not that the target was outsourcing key aspects of its IT

operations. but that when the reseller analyzed the target’s contract with the outsource

firm it found risks in how the contract was structured.

In another situation, a company was evaluating a venture capital-backed startup whose

semiconductor technology promised to greatly expand the capacity of the products then

on the market. However, a step-by-step due diligence analysis of the startup’s

manufacturing process concluded that the technology could not be manufactured at the

scale required to move the product out of the lab and into the market. Later, another

company acquired the startup but was then stymied by the roadblock to scale.

2. Understanding future investments and ‘‘to be’’ operating costs. Accenture recently

assisted a major private equity firm by conducting operational due diligence in the

potential acquisition of a company in the music industry. The effort unearthed a runaway

project in IT operations. Maintaining the project would have had a major impact on

operating cash flows and on the exit multiple because it would have increased specific

portions of operating expenses by 70 percent in perpetuity. Without direct participation in

the operational due diligence phase, the buyer would not have discovered this

investment requirement (the target lacked the capabilities to really fathom the problem as

well as the incentives to make the problem clear) and the growth of the business would

have been impaired. Also, the project would have required significant management

attention and might even have prevented the company from being able to support the

upcoming industry transition to digital content.

Part of the key to understanding to-be operating costs is to estimate well. For instance, a

target may have a naturally higher cost base. Certain technologies or processes may

require particular skills that are expensive and that may even need to be expanded. If the

target is being separated from its parent, it may lose the benefits of shared services or

contracts. Or the new combined entity may require new technology investments to

support its business strategy if it needs to enter new markets, for example.

3. Identifying new sources of value. Recently, Accenture was asked to help a major Eastern

European mobile operator in a bid for the majority share of a state-owned telecom

company. The original rationale for the acquisition was defensive: the mobile operator

was eager to protect its existing market position and its managers were not anticipating

any significant synergies. However, a value-seeking due diligence process uncovered

$1.5 billion (in net present value) of synergies beyond what was originally estimated in

product expansion, product bundling (ADSL/mobile), and cost savings. These estimates

helped refine the acquirer’s final bid.

Sometimes a new source of value actually reduces the total acquisition cost. Accenture

recently helped a company develop its ‘‘to be’’ manufacturing and network plan as part of

the company’s assessment of a target in the electronics industry. The operations due

diligence pointed to overcapacity in Asia, opening up the possibility for rationalizing the

target company’s facilities. The sale of some of this capacity was negotiated concurrently

with the deal, allowing for a large reduction in cost and debt.

Walking the due diligence walk

Given these three benefit areas, how do private equity and corporate buyers start practicing

enhanced due diligence?

1. First, they get seasoned functional experts involved. The new due diligence team might

include manufacturing quality control managers (to compare underlying philosophies of

quality assurance, for instance), logistics experts, environmental experts, IT experts or

customer service professionals. Data rooms and management presentations are of

limited help because they are designed to present information in the most positive light.

But experts can spot disconnects that may affect the cash flow of the standalone

valuations and the sustainability of cash flow and they can usually do so with limited

access to the target company. The exact composition of the expert team will depend on

VOL. 29 NO. 3 2008 jJOURNAL OF BUSINESS STRATEGYj PAGE 25

the nature of the deal, of course, but the starting assumption should be that deep, specific

expertise is better.

2. Second, acquirers need to bring their operations experts aboard early in the due

diligence process. This is especially true for supply chain and IT personnel, who are often

tasked with ‘‘getting things to work’’ after the deal is done.

Logistics, business processes and supply chain issues can be difficult to identify in due

diligence checklists, so the earlier they can be explored the sooner good data can

emerge. It is much the same story with IT: bringing ITsystems together requires long lead

times and significant investment, factors that need to be accounted for pre-deal from a

risk and financial perspective. After the deal, investment in IT precedes savings. It takes

time to properly understand viable applications and technology alternatives for the to-be

state, to renegotiate contracts and procure equipment, and to move data, build

interfaces, and retrain IT staff and business users on the new systems.

Just one example: It may sound simple to consolidate warehouses and move all

customers and vendors to a single set of systems. But that’s far from true. There are plenty

of operational challenges in managing and moving inventory and in managing personnel

transitions. From an IT perspective, there are item master issues (such as product

numbering) and customer master issues that need to be resolved from both a business

perspective and a technology perspective. The idea is to make sure that all transitional

items are identified and planned for and that customers are tended to and inventory is not

lost – none of which happens overnight.

Managers also have to anticipate disruption to even the most carefully planned

processes. For instance, when one company was consolidating its distribution facilities

and processes following a merger, its largest customer demanded a critical change in

labels that required significant effort from ITand the distribution teams. In order to keep to

the timeline and satisfy the customer, the implementation team had to minimize any

nonessential changes during the transition.

Transitions can also mean additional investments in capacity. For example, if the

consolidation of data centers into one facility at a lower-cost location is expected to have a

big impact on the success of the merger, it will almost certainly take time and money to

find a new location or increase capacity at the old premises.

3. Third, the experts should help to build truly realistic versions of the future-state operating

models and future cash flows. Their calculations will incorporate major operating risks

such as bringing capacity on line to support growth over the required timeframes. They

need to identify investments required to complete migrations from IT-shared services

model to a new sourcing models, for example.

The science of M&A has come a long way in the last 20 years. Dealmakers have greatly

improved their understanding of many elements of mergers and acquisitions, especially

valuation and merger integration. Yet in example after example, due diligence processes

have proven to be an Achilles heel.

Dealmakers today must use every tool at their disposal to improve their odds of a successful

deal while at the same time avoiding bad acquisitions. That means placing the same

importance on operational due diligence as on valuation, traditional due diligence and

merger integration. It also calls for using operational due diligence to pinpoint initiatives that

protect and create value after an acquisition.

The shift to this next level of due diligence requires enhancing rather than replacing

traditional due diligence activities. The due diligence lists will be longer but they will be

forward-looking, gauging current observations against future operating needs.

Cisco’s rules for due diligence

Cisco Systems knows where merger integration can go wrong and how effective due

diligence can help acquirers avoid most integration glitches. Cisco’s IT teams are

PAGE 26 j JOURNAL OF BUSINESS STRATEGYj VOL. 29 NO. 3 2008

particularly alert to the challenges of integrating networks and other IT elements, which is

why the company has developed a standard set of principles and processes to help

accomplish these integrations rapidly, consistently, and with minor disruption.

The first two integration process steps concern discovery and due diligence. They are

completed before the pending merger or acquisition deal is publicly announced. A Cisco

integration team begins to gather essential information, prioritize tasks, and plan

communications and schedules. A scope definition process uses checklists and

questionnaires to identify:

B the integration goals and business drivers;

B the new company’s sites and special facility needs; business applications and systems;

and security requirements;

B customer commitments, regulatory issues, and legal considerations;

B contracts for original equipment manufacturer (OEM) products, services, and outsourced

functions;

B the new company’s IT team expectations, employee assignments, governance practices,

relationships, and policies;

B determination of whether a ‘‘shadow’’ IT presence or separate ITcontrol will be necessary

on a temporary or permanent basis;

B evaluation of short-term procurement decisions and interim processes; and

B key stakeholder interviews – often held at the new company’s site – also identify

integration concerns and company cultural issues.

The due diligence processes lead naturally into the planning of actual integration activity.

This planning starts just before the deal is announced and continues until the day when the

deal closes (Cisco, n.d.).

Profile of an operational due diligence team

The best operational due diligence teams are typically top-heavy, with a high concentration

of seasoned expertise. These ‘‘been there, done that’’ individuals bring the experience and

judgment to make good assumptions and to quickly develop hypotheses that help them

gauge the size of projected investments, the potential savings, the likely future operating

model, and the risks. A typical team might consist of:

1. Team lead. Often a generalist, but seasoned enough to have good judgment. Key

responsibilities include identifying critical points of expertise; working with area experts to

develop hypotheses around key risks, about areas for potential investment, baseline

spend, etc.; overseeing financial models of potential required investments, the to-be

operating state and all relevant scenarios; and making assumptions explicit and clearly

documenting the case for the overall merger team.

2. Area experts. Experienced individual who can quickly develop the necessary questions

as well as the hypotheses around the answers. Specifically, they will be well-qualified to

identify the likely risks and the areas for potential investment. A strong due diligence team

typically includes these IT experts:

B IT enterprise architect. Team member who can quickly assess the technical and

functional adequacy of the target’s systems to see if they can support existing

operations and projected growth, and who can authoritatively say whether immediate

IT investments need to be made.

B IT applications specialist(s). Experts in application analysis who help identify

application stability, currency and relevance to the future operation of the business.

These individuals review continuing application efforts to determine investment

profiles and status v. plan. They work closely with database administrators and IT

VOL. 29 NO. 3 2008 jJOURNAL OF BUSINESS STRATEGYj PAGE 27

enterprise architects to analyze the overall application portfolio, and recommend

investment or rationalization options.

B IT infrastructure/network architects. Similar to application architects, these experts

review the overall network and technical infrastructure environment to identify areas of

risk and the relevance of those risks to the business’s future operating model. They

also evaluate ongoing technology programs for compliance against plan. Their scope

includes but is not limited to data centers, local and wide area networks, telecom and

IT security.

B IT database architects. At times, it makes sense to involve experts in the database

technology being deployed. Their role is to provide perspective on the quality and

structure of the data being used to manage the target’s business – and to advise on

the effort required to combine the data with that of the acquirer.

Keywords:

Acquisitions and mergers,

Due diligence

References

Accenture (2006), Supply Chain Post-merger Study, Accenture.

Automotive News Europe (2001), ‘‘Daimler could have examined Chrysler’’, Automotive News Europe,

21 May.

Cisco (n.d.), ‘‘How Cisco IT standardizes the acquisition integration process’’, Cisco IT Case Study, IT

Acquisition Integration, available at: www.cisco.com/web/about/ciscoitatwork/downloads/ciscoitatwork/

pdf/Cisco_IT_Case_Study_IT_Acquisition_Integration.pdf

The Risk Management Association (2007), ‘‘Middle market executives deem M&A due diligence

inadequate’’, RiskCenter, The Risk Management Association, May 9.

US News & World Report (2006), ‘‘Cisco’s connections’’, US News & World Report, June 18, available at:

www.usnews.com/usnews/biztech/articles/060626/26best.htm

About the authors

Nan J. Morrison is a Partner in Accenture’s SITE/Accenture Technology Consulting Practicebased in New York.

Guy Kinley is a Partner in Accenture’s Corporate Strategy Practice based in Florham Park,

New Jersey.

Kristin L. Ficery is an Accenture Partner based in Atlanta who focuses on corporate strategy

and mergers and acquisitions. Kristin L. Ficery is the corresponding author and can be

contacted at: ficery@accenture.com

PAGE 28 j JOURNAL OF BUSINESS STRATEGYj VOL. 29 NO. 3 2008

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