Merger and acquisition activities have risen to unforeseen levels. At the same time, dwindling selection of quality targets has driven absolute values and relative prices to historic heights. What if the required return on investment can only be achieved with a post-acquisition growth strategy? Will the existing management be able to adapt to the different set of expectations? How do we know if a marriage is made in heaven or hell? 

Much like the morning after a romantic fling, the morning after an acquisition can be equally unnerving. What looks great the night before may lose its glow in the day-to-day world of running a business. Today’s competitive world of institutional investments does not allow for much time to make the right investment decision. Even an extensive courtship – or due diligence involving financial, legal and market analyses – may fail to find all the trouble spots. 

Potential Trouble Spots
The eroding competitive strength of the acquisition candidate can be easily missed, even when current numbers look strong. It takes a thorough assessment and understanding of the market players and forces to determine whether the company will be able to maintain and improve its competitive positioning. Solid numbers can also hide problems due to aging products or technology.  Strong net income and cash flow might mask deferred investments in research and development and tangible assets. Yet, constant innovation and new product development are essential to superior margins.           

Overall profitability can conceal under-performing product lines. Unprofitable segments may be presented as great opportunities, when, in reality, they can be a significant drain on precious resources. Fragile customer or supplier loyalties can be difficult to uncover; the company being acquired may object to attempts at verifying those loyalties.

Such reluctance may stem from a fear of upsetting customers or suppliers rather than a desire to conceal information. In any case, a company with strained customer or supplier relations often is the last to learn about them. Liabilities and operational risks within the supply chain can remain hidden until a costly letter arrives from government authorities. This is especially true in unfamiliar countries where complicated local tax laws make non-compliance difficult to uncover and quantify. Operational risks associated with facilities around the globe require a knowledgeable eye and are frequently overlooked as a risk to the potential acquisition.

Smooth Integration
Addressing strategic management and other significant issues before closing the deal is essential to a smooth integration of portfolio companies. In the heat and excitement of getting the deal done, many investors fail to develop an advance plan and provide the hands-on resources for resolving merger-related issues, causing morning-after frustration and unmet expectations on both sides of the transaction. 

Failure to consider the compatibility of corporate cultures and value systems can make for severe morning-after headaches. A family business’ view of priorities and financial performance indicators can differ greatly from those of a private equity group charged with delivering superior returns to its investors. A culture clash can kill assimilation, resulting in the inability to achieve synergies that originally made the merger look attractive. 

A capable management team is the cornerstone of a good company. Yet, acquirers will bring to the deal not only a new ownership structure, but also a different mindset combined with new expectations. Former masters become servants. Investors must quickly and accurately assess the real talent of the existing management team as it relates to the new environment and tasks ahead.

KPX Medical
In a fictional account based on an actual merger and acquisition transaction, two middle-market healthcare manufacturers competed in adjacent segments. Each dominated its respective market. Believing that these companies could create a stronger competitive advantage together rather than alone, the CEOs agreed to merge, forming KPX Medical. 

On the surface, the two U.S. companies did not appear to be a cultural fit. But, at the same time, the CEOs made a perfect match. To one CEO, the merger represented a vehicle for value realization and growth. To the other, it provided an exit strategy and succession plan. Additionally, the CEOs recognized compatible value systems in both organizations. 

The due diligence process involved a financial player with strong operating experience and close contact between senior management. Before the deal was done, KPX anointed the smaller company’s CEO as its future leader, and senior management jointly tackled strategic issues. 

In addition, transition teams with representation from both companies’ technical, sales and accounting functions addressed tactical issues. Upon completing the acquisition, managers attended a retreat where they formally agreed on a mission for the newly formed company. As the two CEOs had envisioned, the new KPX solidified an enviable position in its industry. 

KPX Medical exemplifies the ideal corporate union, in which companies with complementary cultures and a shared sense of direction join together to create a more powerful organization. In today’s world, however, such easy combinations are the exception rather than the rule.

More often than not, platform acquisitions or roll-ups experience morning-after problems. With valuations at historic heights, achieving the same returns in the future as in the past will require more than financial engineering on the part of acquirers. Institutional investors may have to consider adding expertise to critical areas such as technical innovation, supply chain, marketing and change management.

The key is to recognize problems early, find their root causes and take decisive action. Outside assistance may be necessary in order to gain a clear, objective understanding of the situation. Experience shows that even marriages with rocky beginnings can succeed in the end due to a common vision, effective planning and a willingness to make it work. 

Ron Norelli is founder and chairman of The Norelli Group LLC, which has  offices in Charlotte, N.C., and Beijing. For more, visit www.norelligroup.com.