04_Managing Risks in Mergers and Acquisitions

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Chapter IV

Managing Risks in Mergers, Acquisitions

and Strategic Alliances

There is a serious problem facing senior executives who choose acquisitions as acorporate growth strategy. My study reveals that fully 65 per cent of major strategicacquisitions have been failures. And some have been truly major failures resulting indramatic losses of value for the shareholders of the acquiring company. With marketvalues and acquisition premiums at record highs, it is time to articulate demandingstandards for what constitutes informed or prudent decision-making. The risks are toogreat otherwise.

- Mark L Sirower1.

Understanding the risks in mergers and acquisitions

A combination of factors - increased global competition, regulatory changes, fastchanging technology, need for faster growth and industry excess capacity - has fuelledmergers and acquisitions (M&A) in recent times. The M&A phenomenon has beennoticeable not only in developed markets like the US, Europe and Japan but also inemerging markets like India. In 1998, worldwide mergers and acquisitions were valued2

at $2.4 trillion. In 1999, this figure increased3 to $3.4 trillion. In 2000, the pace seemed toslow down, with only the Glaxo Wellcome SmithKline Beecham merger valued at over$50 billion. However, the total value of the deals worldwide crossed $3.5 trillion. Muchof this activity took place in the first half of 2000. The recent merger proposal by HP andCompaq is a clear indication that merger mania is well and truly alive.

Like capacity expansion, vertical integration and diversification, a large merger or

an acquisition is a strategic move since it can make or break a company. However,mergers and acquisitions involve unique challenges such as the valuation of the companybeing acquired and integration of the pre merger entities. Valuation is a subjective matter,involving several assumptions. Integration of the pre-merger entities is a demanding taskand has to be managed skillfully. So, it makes sense to devote a separate chapter to coverthe risks associated with acquisitions4 and how to manage them.

Mark Sirower, an internationally acclaimed expert in the field of mergers andacquisitions found that two thirds of the 168 deals he analysed between 1979 and 1990,destroyed value for shareholders. When he looked at the shares of 100 large companiesthat made major acquisitions between 1994 and 1997, Sirower found that the acquirersstock, on an average trailed the S&P 500 by 8.6%, one year after the deal was announced.60 of these stocks under-performed in relation to the market, while 32 posted negativereturns. Many of the companies acquired were often sold off later, sometimes at a loss.

1 The Synergy Trap.2 According to Security Data Co.3 The Economist, July 20, 2000.4 In this chapter, we use the terms, mergers and acquisitions interchangeably though there are some

important differences. (See glossary).


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Consider Kimberly Clarks acquisition of Scott Paper in 1995. This acquisitionmade Kimberly-Clark the worlds largest tissue maker. One year later however, saleswere down and profits and operating income had shrunk. By 1999, the merged entity wastrailing the S&P 500 Stock Index. AT&T gave several seemingly valid reasons for itsacquisition of NCR. But after five years of incurring losses, amounting to more than $2

billion, AT&T accepted that the acquisition would not work. In 1995, it decided to spinthe company off.Quite clearly, mergers and acquisitions involve heavy risks. In their excitement

and enthusiasm to close the deal fast, managers throw caution to the winds. Later, there isa gap between expectations and actual performance and shareholders wealth is eroded.This chapter covers some of the important risks in M&As and provides a framework fordealing with them.

Why mergers are riskyMajor acquisitions have to be handled carefully because they leave little scope for trialand error and are difficult to reverse. The risks involved are not merely financial ones. Afailed merger can disrupt work processes, diminish customer confidence, damage thecompanys reputation, cause employees to leave and result in poor employee motivationlevels. So the old saying, discretion is the better part of valour, is well and trulyapplicable here. A comprehensive assessment of the various risks involved is a mustbefore striking an M&A deal. Circumstances under which the acquisition may fail,including the worst case scenarios, should be carefully considered. Even if the probabilityof a failure is very low, but the consequences of the failure are significant, one shouldthink carefully before hastening to complete the deal. According to Eccles, Lanes and

Wilson

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, most companies fail to undertake a thorough risk analysis before making anacquisition. Which is why they end up burning their fingers.The strategic implications of a merger should be understood carefully. Otherwise,

the shareholders wealth will be eroded. As Mark Sirower6 puts it neatly, When youmake a bid for the equity of another company, you are issuing cash or claims to theshareholders of that company. If you issue claims or cash in an amount greater than the

5 Harvard Business Review, July August 1999.6 The Synergy Trap.

2

IdentifyingSynergies

Valuation

Integration

Strategic Issues in Mergers & Acquisitions


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economic value of the assets you purchase, you have merely transferred value from theshareholders of your firm to the shareholders of the target right from the beginning. Inan acquisition, the acquirer pays up front for the right to control the assets of the targetfirm, with the hope of generating a future stream of cash flows. If demanding standardsare not set to facilitate informed and prudent decision-making, the investment made will

not yield commensurate returns. Table ISome top M&A deals in 2001

Target Acquirer Value of deal ($ million)

AT&T Broadband & Internet (US) Comcast (US) 57,547

Hughes Electronics (US) Echostar Communications (US) 31,739

Compaq Computer (US) Hewlett Packard (US) 25,263

American General (US) American International Group (US) 23,398

Dresdner Bank (Germany) Allianz (Germany) 19,656

Bank of Scotland (UK) Halifax Group (UK) 14,904

Wachovia (US) First Union (US) 13,132

Benacci (Mexico) Citigroup (US) 12,821Telecom Italia (Italy) Olivetti (Italy) 11,973

Billiton (UK) BHP (Australia) 11,511

Compiled from various sources

There are two main reasons for the failure of an acquisition. One is the tendencyto lay too much stress on the strategic, unquantifiable benefits of the deal. This results inover-valuation of the acquired company. The second reason is the use of wrongintegration strategies. As a result, actually realised synergies turn out to be well short ofthe projected ones.

Many companies are confident about generating cost savings before the merger.But they are unaware of the practical difficulties involved in realising them. For example,

a job may be eliminated, but the person currently on that job may simply be shifted toanother department. As a result, the head count remains intact and there is no costreduction.

Many firms enter a merger hoping that efficiency can be improved by combiningthe best practices and core competencies of the acquiring and acquired companies.Cultural factors may however, prevent such knowledge sharing. The 1998 merger ofDaimler Benz and Chrysler is a good example. Also, it may take much longer to generatecost savings than anticipated. The longer it takes to cut costs, the lesser the value of thesynergies generated.

Revenue growth, the reason given to justify many mergers, is in general moredifficult to achieve than cost cutting. In fact, growth may be adversely affected after a

merger if customer or competitor reactions are hostile. When Lockheed Martin acquiredLoral, it lost business from important customers such as McDonnell Douglas, who wereLockheeds competitors. So, companies must also look at the acquisition in terms of theimpact it makes on competitors. The acquisition should minimise the possibility ofretaliation by competitors. Some M&A experts look at revenue enhancement as a softsynergy and discount it heavily while calculating synergy value.

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Tata Tea: Tetley acquisition runs into problems

In mid 2000, Indias largest tea company, Tata Tea announced it was buying the UK-based Tetley for 271million in a leveraged buyout. Tetley, which earned a net profit of 35 million in 1998 on sales of 280

million was the third largest brand in the global $600 million packaged tea market - behind UnileversBrook Bond and Lipton. Tata Tea viewed the acquisition as a quick way to gain access to markets in theUS, Canada, Europe and Australia. It also looked at the opportunities created by Tetleys estimated weeklypurchase of three million kg of tea from 10,000 estates in 35 different countries. Besides, Tata Tea hoped togain packaging expertise from Tetley.

Tata Tea did not pay cash upfront. Instead, it pumped 70 million of equity into a special purposevehicle. Then it leveraged the equity to borrow 235 million from the market. Tata Tea hoped that cashflows from Tetley would be adequate to pay off the debt. At the time of finalising the deal, there were pressreports that Tata Tea was probably overpaying7 - it had offered 100 million more than the second highestbidder.

To service the debt, Tetley needed to generate cash flows of at least 48 million per year, whereasit generated only 29 million in 1999. Tata Tea had hoped for a quantum jump in cash flows after theacquisition. But unfortunately for Tata Tea, retail tea prices in the UK market fell. Moreover, the popularity

of tea continued to decline in the UK while the market share for natural juices and coffee went up.By September 2001, the deal was running into short-term financial problems. The Tatas

announced they would bring in an additional 60 million as equity. This would facilitate retirement ofexpensive debt and reduce interest charges by about 8 million per year. If cash flows touch 40 million,the risk of not being able to service the debt will be eliminated. This will however not be an easy task. TataTea Managing Director, R K Krishna Kumar recently admitted 8that additional investments will be neededto revive demand.

Companies making an acquisition not only have to meet the performance targetsthe market already expects, but also the higher targets implied by the acquisitionpremium. When they pay the acquisition premium, managers are essentially committingthemselves to delivering more than what the market expects on the basis of current

projections. This is a point which is often forgotten.Even when the numbers do not justify an acquisition, executives may insist on

going ahead for strategic benefits that cannot be quantified. In the heat of finalising thedeal, what is conveniently overlooked is that most strategic benefits ultimately should bereflected in some form of cost reduction or revenue growth. Similarly, rushing ahead tofinalise a deal before a competitor does so, is not always a wise move. In many cases, itmakes sense to allow the competitor to pay a higher price and weaken its competitiveposition rather than rush into the deal.

Acquisitions involve changes and often have a destabilising effect. During theintegration of the pre-merger entities, stress, tension, uncertainty and an exodus ofemployees are likely. To avoid this, building a climate of trust among the employees of

the merging entities is extremely important. Most companies underestimate thedifficulties involved in integrating the pre-merger entities. A recent example is the ICICI ICICI bank merger.

7 Business World, September 10, 2001.8 Business World, September 10, 2001.

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International Paper: Aggressive acquisitions strategy creates problems

The paper industry has been known to go through boom and bust cycles. Size and market share are criticalin the paper industry, whose products look more like commodities than brands. John Dillon, the CEO ofInternational Paper (IP) the worlds largest paper company looks at acquisitions as a way to control prices.

After paying $7.1 billion to acquire office paper company Union Camp in early 1999, IP purchased itsrival, Champion Paper Corp for $9.6 billion in June 2000. These expensive acquisitions left IP with a debtof $15.5 billion, (50% of capital and four times cash flows) towards the end of 2000. Dillon has beendivesting non-core businesses such as petroleum and minerals to pay for the acquisitions. The marketshowever, remain cynical about IPs moves.

IP is yet to prove it can integrate its acquisitions and realise the synergies it has projected beforeits acquisitions. It has been slow to close down factories, an important step in reducing industry capacityand consequently improving prices. In October 2000, Dillon announced that he would be shutting 1.2million tonnes of capacity or 5% of total production.

Much more however needs to be done. Reaction to the Champion deal has been lukewarm. Thecompanys stock price has fallen during the period 1995-2000. IPs growth-by-acquisitions strategy maywell turn out to be risky, especially at a time when the US economy has gone into a recession.

A disciplined approach to acquisitions is necessary to weed out unviable deals. AsEccles, Lanes and Wilson put it9, Over half the deals being done today will destroyvalue for the acquiring companys shareholders. Whats the reason for the disparitybetween these simple lessons and these poor results? We believe that far too manycompanies neglect the organizational discipline needed to ensure that analytical rigourtriumphs over emotion and ego.

Porter10 argues that acquisitions make sense only when three conditions holdgood:

The acquired companys management is more keen on withdrawing, than

continuing to run the operations. So, the minimum price, it expects, is quite low. The market for companies is imperfect and does not eliminate above-average returns through the bidding process.

The buyer has unique abilities and competencies which it can use tomanage the acquired companys business far more efficiently and effectively.

The collapse of Indiainfo.com

The experience of Indiainfo.com highlights the risks involved in the kind of reckless acquisitions andalliances made by dotcom businesses in India. During the period December 1999 February 2000,Indiainfo kicked off its launch in the Indian market with an ad blitzthat cost Rs. 11-15 crore and announcedthat it would catch up with leader Rediff.com. When founder Raj Koneru brought some seniorprofessionals into the management team, venture capitalists expressed their happiness. Impressed by thecompanys vision and aggressive plans, Morgan Stanley decided to pay $11.5 million to acquire a 7%stake. But, managing the rapid growth proved difficult. A cultural clash between the erstwhileentrepreneurs whose websites had been taken over by Koneru and the new breed of professional managersmade matters worse. While these entrepreneurs were known to live frugally, the professionals led a fancylifestyle. Meanwhile, Koneru plunged headlong into acquisitions without detailed consultations with his

9 Harvard Business Review, July-August 1999.10 Competitive Strategy.

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senior team. In many cases, payments were made in cash. One deal involved a payment of Rs 200 crore($45 million) to VSNL, Indias leading Internet Service Provider, so that every time a VSNL user wouldlog on, he would land on the Indiainfo home page. Senior executives first came to know about the deal at apress conference! Koneru apparently estimated that the increase in traffic would take the companysvaluation to about $1 billion. Koneru also made a big mistake in deciding to postpone his IPO. The reasonfor the delay was probably preoccupation with integrating the acquisitions which had been made at a

furious pace, one after the other. The huge expenditures on advertising, salaries and acquisitions added upto Rs. 30 crores by September 2000. Many senior executives began to desert the sinking ship.

Identifying the synergiesThe aim of an acquisition is to make the merged entity more valuable than the sum of thevalues of the pre-merger entities. As mentioned earlier, synergies can add value only ifthe merged entity registers a performance that is better than what is already reflected inthe market prices of the pre-merger entities.

In almost two out of three acquisitions, the acquirers stock price falls after thedeal is announced. This is a clear indication that the markets tend to be cynical about therealisation of the synergies projected. One reason could be that the markets have already

discounted the expectation of an improvement in the operating performance of theacquired company. In extreme cases, the markets may even feel that by divertingresources from stronger divisions, for the purpose of realising synergies, value may besubtracted, rather than added. At a more strategic level, acquisitions, by engaging the topmanagement in the integration process may allow competitors to leap ahead. Boeingfaced a major crisis in its production line in the late 1990s, when its attention was entirelyfocussed on its integration with McDonnel Douglas. (See Box item on pg. 9)

Much of the risk in an M&A deal arises from the acquiring companys inability toidentify and quantify synergies accurately. Often, the synergies which are highlighted, donot materialise, while those which may have been completely overlooked become veryimportant. Usually, it is years after the acquisition that it becomes clear whether the price

paid for the acquisition was the right one or not. Alex Mandi, who negotiated theacquisition of Mc Caw Cellular on behalf of AT&T recalled,11 Everybody said wedpaid too much. But with hindsight, its clear that cellular telephony was a critical asset forthe telecommunications business and it would have been a tough proposition to build thatbusiness from scratch. Buying Mc Caw was very much the right thing to do.

As mentioned earlier, it is easier to achieve cost reduction than to boost sales.According to Dennis Kozlowski, CEO of Tyco International12: You can nearly alwaysachieve them because you can see up front where they are But theres much more riskwith revenue enhancements; they are much more difficult to implement. Kozlowski addsthat people are often too optimistic about revenues. When Citibank merged withTravelers, the merged entity quickly reaped profits from cost cutting, but its expectations

on cross selling different financial services to customers did not quite materialise.However, achieving revenue enhancement through an acquisition, though difficult, is notimpossible. When the specialty chemical company, Rohm and Haas acquired Morton, itaggressively used the acquired companys expertise in polyurethane adhesives and powder coatings and its access to new markets, to generate more sales. The TimeWarner-Turner Broadcasting System merger was also quite successful in this regard. The

11 Harvard Business Review, May-June 2000.12 Harvard Business Review, May-June 2000.

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AOL-time Warner merger has also shown a lot of promise for cross selling, though it istoo early to pass a final judgment.

Arriving at the premiumOne of the most thoughtful analyses of the premium involved in acquisitions is provided

by Porter13

. Porter points out that an efficient market precludes the possibility of the newcompany generating more returns than what the pre-merger entities generated before themerger. If the management of the acquired company is sound and the company itself hasa bright future, its market price would already have been bid up. On the other hand, if itsfuture is bleak or the management is weak, the stock price could be low, but the infusionof capital and effort required to turn it around could also be massive. As Porter puts it:To the extent that the market for companies is working efficiently, then, the price of anacquisition will eliminate most of the returns for the buyer The market for companiesand the sellers alternative of continuing to operate the business, work against reapingabove-average profits from acquisitions. Perhaps, this is why acquisitions so often seemnot to meet managers expectations.

While acquiring a company, firms must be careful about irrational bidders withnon-profit motives or those who are pursuing the deal purely because of theidiosyncrasies of the top management. In the race to the finishing line, companies mayend up paying too high a price because of the influence of such bidders. The board shouldexercise some control in such situations.

According to Sirower, the acquiring company must consider the following whileworking out the premium:

Market expectations about the acquired company, when considered alone.

Impact on competitors and their possible responses

Tangible performance gains from the merger and the management talentnecessary to achieve the gains

Milestones in the implementation plan Additional investments which will be necessary

Comparison of the acquisition with alternative investments.

The Time Warner Turner Broadcasting System Merger

The Time Warner (TW) Turner Broadcasting System (TBS) merger of 1995 has been one of the moresuccessful mergers of our times. The two CEOs, Gerald Levin of TW and Ted Turner of TBS becameunlikely partners in a merger deal that few expected to click. At the time of the merger, TBS was in seriousfinancial difficulty. After buying MGM in 1986 for its content, TBS had accumulated a lot of debt. TBSwas also dependent for distribution on two cable systems companies, Tele-communications In (TCI) andTW, which had been investing heavily in cable infrastructure. Meanwhile, TWs competitive position wasthreatened by the merger of Walt Disney and Capital Cities / ABC.

When the merger was announced, analysts were cynical and few thought that Levin and Turnerwould be able to work together. The two companies had significant differences in management style. TBSmanagers went by instinct, while TW was more methodical. TBS managers initially felt uncomfortablewhen their decisions were subjected to a rigorous analysis.

But gradually, the two parties realised the benefits that could be reaped from the merger. Cablenetworks could buy material from the movie business and leverage the publishing assets like Time andSports Illustrated. A brand like Batman could be exploited by the movie studio, publishing and cabletelevision. Many brands not only gained more visibility but also generated more revenues.

13 Competitive Strategy.

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With a presence in both content and distribution, the merged entity could change the relationshipbetween the two to its advantage. In the past, movies, reached the cable stations very late, typically six toeight years after they were released. In other words, cable was regarded as the end of the line. With itsclout in distribution, TW could now bring movies to the cable network much faster. This increasedsubscription and cable advertising revenues.

Investors perception of the merger improved rapidly. TW developed the image of a formidable

media company with a presence in publishing, movie and television production, music, cable systems,cable networks and a small television broadcast network. The strategy of using different media platforms todistribute the same piece of content seems to have worked. Now, TW has entered a new phase after themerger with America Online. (See Box Item on pg. 8).

Behavioral issues also affect the way in which the premium is arrived at. A studyby Wharton professor, Julie Wulf14 has revealed that CEOs often strike deals that benefitthem personally, but are not in the interests of the shareholders. CEOs of poorlyperforming companies and of companies in industries which are rapidly consolidating,are more concerned about retaining their position on the board rather than negotiating thebest deal for their shareholders. The board has to ensure that senior managements personal interests do not supersede the interests of shareholders, while fixing the

premium.

Stock Vs Cash dealsThe way the deal is financed determines how risk is shared between the buyer and theseller. In general, there are two types of financial risk faced during an acquisition thefall in the share price of the acquiring company from the time of announcement of thedeal to its closing, and the possibility of synergies not being realised after the deal isclosed. In a cash deal, the acquiring company assumes both the risks completely. In astock swap, where a fixed value of the acquiring companys shares is offered to theacquired company, the first risk remains with the acquiring company, but the second riskis shared by the two companies. In a stock swap where a fixed number of shares isoffered to the acquired company, both the risks are shared between the two companies.

The method of financing the deal is influenced by several factors. If the acquirerfeels its shares are undervalued, it prefers a cash deal as any fresh issue of shares wouldfurther erode the wealth of existing shareholders. If the acquirer is very confident aboutactually realising the projected synergies, a cash deal makes sense. Where suchconfidence is lacking, a stock deal allows the risk to be at least partially hedged. Ingeneral, a fixed value offer is an indication of greater confidence on the part of theacquirer than a fixed number of shares and tends to be better received by the market. Afixed share offer, ironically enough, by minimising the pre-closing market risk for theacquirer, acts as a kind of self fulfilling prophecy and drives the share price downwards.

IntegrationMany mergers fail at the integration stage. So, it is important to understand the risksinvolved in integration and the ways to manage these risks. All acquisitions must beginwith a strategic vision, which should serve as a guide for the integration process. Thereshould also be an operating strategy which addresses the issue of how the value chainperformance can be improved, whether competitors will react aggressively, and if they

14 knowledge.wharton.upenn.edu. January 4, 2000.

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do, how they can be dealt with. Vision and operating strategy must be backed by propersystems and processes to align the behavior of managers with corporate objectives. Someoperations should be tightly integrated while others should be left alone. What tointegrate and what to leave alone is a matter of judgement but there are some guidelines,that could prove useful. We will cover this point later in the chapter.

The AOL Time Warner Merger

On January 10, 2000, America Online (AOL) and Time Warner (TW) announced that they were merging.For all practical purposes, the deal was a reverse takeover by AOL. While the icon of the internet world hadjust 20% of TWs revenues and 15% of its workforce, its large market cap made it the senior partner. AOLshareholders received one share in the merged entity while TW shareholders got 1.5 shares for each of theirexisting shares. AOL shareholders owned 55% and TW shareholders 45% of the new company.Effectively, AOL paid a premium of 71% over the market value of TW. The combined entity was valued at$350 billion.

Though the two companies were confident of boosting revenues, many analysts expressedconcerns that the merger would slow down AOL and rob it of its entrepreneurial drive. AOL however,remained confident that TWs cable network and content would generate new growth opportunities.

Before the announcement of the deal, TW shares traded at a multiple of 14 times EBITDA(Earnings Before Interest Tax depreciation and Amortisation ) while AOL shares traded at a multiple of 55.The immediate reaction to the deal was negative. By January 12, the combined market capitalisation wasactually lower at $260 billion, compared to $270 billion before the announcement. The market value ofAOL shares fell by 19% while that of TW shares went up by $22 billion.

AOL which had a strong brand and enjoyed a large customer base was clearly one of the pioneersin the new economy. However, anticipating the rapid commoditisation of the Internet access business, AOLrealised it needed the pipes of cable television to carry Internet content. Moreover, AOL did not reallyhave much content of its own. It decided to move fast and make full use of its high market capitalisation. InOctober 1999, Steve Case, CEO of AOL called TW CEO, Gerald Levin to discuss the merger, Levinsensed an opportunity as his companys stock was not doing particularly well in the market. In December1998, TW had been worth more than AOL. But by December 1999, AOLs worth was 2.5 times that ofTW. Quite clearly, TW was on the decline. Case also sweetened the deal for TW by inviting Levin to be themerged entitys CEO.

After the merger was announced, the Federal Trade Commission (FTC) began to interrogate thesenior executives of the two companies to determine whether the merger would come under the purview ofanti trust legislation. Case and Levin refused to accept a demand by FTC to regulate the placement ofAOL-TW content. However, they agreed to report any complaints from competitors if they were deniedAOL-TW content.

Low hanging fruit synergies were quickly identified. CNN.com programs could be featured onAOL, while AOL discs would be bundled with TW product shipments. Warner movies could be promotedon AOL-owned Moviefone. The merged entity could offer books, movies, magazines and music tocustomers on TV, paper, PC, cell phone or any of the other wireless devices.

Even as the FTC was in the process of approving the merger, integration efforts began. Inter-divisional committees were set up to facilitate the integration. Efforts to generate cross selling opportunitiesin the areas of subscriptions, advertising and promotions began. An attempt to sell TIMEs magazinesthrough AOL was very successful.

A year later, the merger was showing signs of trouble. The projected revenue growth of 12-15%and $1 billion in cost savings looked way off target. According to Merrill Lynch estimates, growth wouldonly be 11%, while losses would cross $5 billion due to merger write-offs. A slowing US economy and asharp cutback on ad spending by companies was hitting growth. By early 2001, AOLs stock had droppedby 48% to $37.50. (See graph showing the stock price movement).

One positive feature of the merger is that the transition at the highest level of management has been smooth. Levin has been clearly in charge of both day-to-day operations and key strategic andpersonnel moves. Case has disengaged from day-to-day operations to concentrate on macro level issues. In

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an email toFortune15, Case said that the management set-up kept him informed about what was happeningand allowed him to provide his perspective where required, without in any way meddling with the day-to-day operations.

It is now clear that the fortunes of AOL-TW are closely tied to the erstwhile AOL group. Many ofthe top executive positions have gone to AOL. Most of its senior executives are still around, 18 monthsafter the merger was announced. While AOLs performance in the first quarter of 2001 was good, TW has

continued to struggle due to falling advertising revenues. Moreover, making Hollywood movies remains anunpredictable, low margin business.The markets perceive the integration to be still incomplete. In response to the 2001 second quarter

results, the share price declined by 9% even though EDITDA jumped by 20% over the previous year.Cultural differences continue to be a formidable barrier to the integration process. As the Economist16

recently reported: There is a wide cultural gap between the restless 20 somethings from AOL and NewYork institutions such as the 78 year old Time Inc There is much grumbling among journalists (at TimeWarner) about a new tightness with money and the fears, this has prompted for editorial quality.

AOL feels things are moving in the right direction. As an example of the synergies beinggenerated, it cites a recent Madonna world tour arranged by Warner Brother Records, in which AOLsubscribers can buy advance tickets and see unreleased photos and videos. AOL remains confident that itscommunity can be persuaded to buy a range of entertainment products.

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The 1986 merger of Borroughs and Sperry illustrates some of the difficultiesinvolved in the integration of pre-merger entities. The two computer makers who came

together to form Unisys, felt that the merger would generate economies of scale, improveefficiencies and boost price competitiveness. The integration of the distribution systemswas however a disaster. The companies had different order-entry and billing procedures.After the attempted integration, equipment orders were executed late and customers werefrequently frustrated by delayed delivery. By November 1990, the stock price of Unisyswas only $3 per share. About 90% of shareholder value had been destroyed.

15 July 23, 2001.16 July 21, 2001.

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The 1986 acquisition of Republic Airlines by Northwest Airlines also ran intointegration problems. The two computer systems could not be synchronised. Integrationof crew and gate scheduling and human resources functions also ran into serious problems. Republics employees, on an average, drew lower salaries than those ofNorthwest. Low morale led to a deterioration in customer service. In August 1987, a

Northwest plane crashed after taking off from Detroit. Matters continued to worsen till1989, when Northwest was bought out by a group of private investors.Personal chemistry, especially at the top, matters a lot during the integration of

the pre-merger entities. In general, it is advisable not to have two bosses. Decisiveleadership is best provided by a single individual, not by a two-man team or a committee.Indeed, if two co-CEOs are named after the merger, there will ensue a period ofuncertainty during which people wait to see who finally gains the upper hand. In theCiticorp-Travellers Group merger, Sandy Weill of Travellers has taken control, oustingCiticorps John Reed and in the Daimler Chrysler merger, Jurgen Schrempp has gainedascendancy over Chryslers Bob Eaton. In both cases, until a clear leader emerged, thingswere in a state of flux and employees remained confused.

Tatenbaum

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has argued that, a top Human Resources (HR) executive must beinvolved in the negotiations before a merger deal is finalised. HR managers usually entermuch later, to deal with issues like compensation. Instead, if they join the discussions atan early stage and conduct a cultural audit, potential trouble spots can be identified, veryearly on. Tatenbaum provides seven guidelines for managing the integration process.

The integration team should build organisational capability by retaining talentedmanpower. Tatenbaums research reveals that 47% of the senior managers in anacquired firm leave within the first year of the acquisition and 72% within the firstthree years.

Downsizing activities must be managed smoothly and sensitively. Otherwise, theymay fuel a large scale exodus of people. A related issue is finding the right roles for

the people. Cisco for example tells employees clearly what their new jobs will beafter the merger and to whom they will report.

Systems and procedures that are implemented must be in line with the strategic intentof the acquisition. For example, bureaucratic procedures can be highlycounterproductive if the acquired company is known to have a flexible,entrepreneurial culture.

The integration team must identify the cultural traits that are consistent with thebusiness goals of the merged entity and take steps to spread them across the twoentities. The team must manage cultural differences by collaborating with managersthroughout the organisation. Superordinate goals can be set to motivate the twoentities to work together.

Post merger drift tendencies should be minimised by managing the transition quickly.If decisions and changes are not implemented fast, the acquirer may become focussedon internal issues and lose sight of customers and competitors. Decisions about lay-offs, restructuring, reporting relationships, etc must be made within days of the dealbeing signed and communicated quickly to the employees. However, care must betaken to ensure that people are treated with respect and sensitivity.

17 Organizational Dynamics, Autumn 1999.

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Hearing of employees tends be selective during the early days of a merger, whenanxiety levels are high. So, some messages may have to be repeated. Besides internalcommunication with employees, management must also keep external stakeholderssuch as customers, vendors and the community informed.

When a company has decided to pursue a strategy of growth by acquisitions, clearly

defined integration plans can be helpful. The company should identify the team whichwill conduct the due diligence and the team which will plan and implement themerger. Checklists must be prepared to indicate the tasks and suggested deadlines.Cisco, which makes acquisitions at regular intervals, uses a standard business processfor managing acquisitions.

The Boeing Mc Donnell Douglas Merger

In 1993, the US government announced that its military procurement budget was being cut by 50% andinformed defence contractors that they must consolidate. One company which looked at the turn of eventswith concern was Mc Donnell Douglas (MD), a leading manufacturer of military aircraft. Meanwhile, themuch stronger Boeing realised that its excessive dependence on the cyclical market for civil aircraft wasrisky. To address this concern, it acquired a major stake in Rockwell International, a defence supplier.

When MD realised its competitive position was deteriorating rapidly, it even considered acquiringthe defence businesses of Hughes Electronics and Texas Instruments. At this point, Boeing CEO, PhilCondit and MD CEO, Hary Storecipher felt that the time had come to revive merger talks which had failedin 1995. Boeing knew that if MD went ahead with other acquisitions, it would be priced beyond its ownreach. So, it rushed to close the deal. The merger was announced in December 1996 and received approvalsfrom competition authorities in the US and Europe by August, 1997.

After the merger, Boeing ran into problems on account of a factor it had totally failed to anticipate.In the wake of competition from Airbus, it had aggressively booked orders by slashing prices. Whendemand rose sharply, Boeings production system was thrown out of gear. Due to a parts shortage, muchwork had to be done outside the normal production system. By September 1998, Boeing was in big trouble.It had to take a charge of $4 billion. Quite clearly, the task of implementing the merger had distracted theattention of the top management from operational issues.

In February 1999, Boeings share price reached a low. Condit warned his top management that the

company was a potential takeover target. These were rumours that GE had its eyes on Boeing, but GEdenied them. Boeing made some changes in senior management and put in place a new organisationstructure with different businesses focussed on different customer needs. It decided to tap new businessessuch as broad-band communications, satellite navigation for air traffic controllers and services such asrunning airforce bases. Boeing also realised the importance of sharing knowledge and leveraging itsresearch capabilities across the organisation. Phantom Works, the R&D centre of MD became the focalpoint for new initiatives to improve manufacturing processes across the group. The idea was to integrate theexpertise of Boeing, MD and Rockwell, through both short-run and long-run programs.

Looking back, it is quite evident that the Boeing-MD merger was not really well planned. Theintegration process was faulty and consumed a lot of precious management time. Core functional areas didnot receive the attention they needed. Most of the synergies realised came by sheer chance than by anygreat planning. An important lesson from the Boeing MD merger seems to be that synergies often comein areas where they are least expected.

Source: This box item draws heavily from the article, Building a new Boeing, The Economist,

August 10, 2000.

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Understanding the role of communicationCommunication plays an important role during the integration of the pre-merger entities.Genuine communication increases the perceived benevolence of the management andconsequently promotes trust. It minimises the negative reactions of employees in theacquired company. As a popular saying goes, the certainty of misery is better than themisery of uncertainty. Lack of communication increases uncertainty and weakens the

confidence of employees in the management. A good communication strategy isnecessary to ensure that rumours are not allowed to fill the information gap. Employeesmust be informed about the acquiring company, the proposed changes and the impact ofthese changes on the employees. All efforts should be made to reassure the employees ofthe acquired firm and make them understand the intentions and philosophy of theacquiring company. In the case of cross-border acquisitions, the role of communication iseven more critical.

Immediately after the acquisition, employees need to know what will happen totheir job, their colleagues and their company. It is only through honest communicationthat their anxieties can be set at rest. Here, the quality of communication is the over-riding factor. Later, when employees have to adjust to the changes, frequency of

communication becomes important. Frequent communication however does not meanthat all details must be communicated, especially when the management itself is not clearabout what will happen. A high level of transparency will send the right signals to theemployees even if all the information cannot be shared with them.

Acquirers also need to demonstrate to the employees of the acquired companythat there will be consistency and openness in the new environment. When Intel acquiredChips & Technologies in 1997, it decided to integrate it with one of its divisions, thoughit had at first announced that it would keep it as a separate unit. Many key people left and

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the benefits of the acquisition were sharply undermined. Similarly, when IBM acquiredtelecommunication equipment maker Rolm in 1984, it made the mistake of dictatingterms to the acquired companys employees. Some key technical employees left. Thetakeover was not effective and IBM sold Rolm to Siemens.

France Telecom: Growth by acquisitions leads to huge debt burden

With its traditional telecom business shrinking due to deregulation and intensifying competition, FranceTelecom (FT), has been strengthening its presence in faster growing segments such as mobile phones andinternet services. Under CEO Michel Bon, FT has purchased Orange, the mobile phone services providerfor $40 billion, Free Serve, Britains biggest internet service provider, for $2.5 billion and Equant, the dataservices provider, for $4 billion. The government controlled FT is now Europes second largest cell phonecompany after Vodafone. It has joined T Online and Telefonica as one of the leading ISPs in Europe. FTgenerates (early 2001 figures) almost 20% of its revenues outside France, compared to only 2% five yearsback. Acquisitions have bolstered FTs market share, but resulted in a debt burden of some $53 billion. Thecompany faces a cash crunch at a time when it has to invest heavily in next generation wireless networks,which have long gestation periods. Investors are worried about FTs financial health and have driven downthe share price by almost 60% during the period early 2000 to early 2001. Bon himself has admitted, Itsfrightening. Only time will tell whether FT will be able to manage the risks arising out of its aggressiveacquisition strategy.

Source: Carol Matlack and Stanley Reid, France Telecoms $53 billion burden, Business Week,

January 8, 2001, pp. 22-23.

France Telecom

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The Bayerische Vereinsbank Hypobank Merger

In July 1997, the two Bavarian banks, Bayerische Vereinsbank and Hypobank merged to formHypo Vereinsbank (HVB). The move seemed to make sense in the context of Germanys inefficient andfragmented banking market. The two banks were long time rivals, located close to each other. With asimilar branch network and a similar mix of businesses, they identified several opportunities to cut costs.

HVB also hoped the merger would enable it to become a major player in the German mortgage bankingmarket.However, the merger was more a reaction to the prevailing circumstances than a proactive, well-

thought-out strategy. Vereinsbank was on the verge of a hostile takeover by Deutsche Bank. It hadapproached Commerzbank for support in warding off this takeover attempt but later resigned itself to a dealwith Hypobank. On its part, Hypobank even though it was making decent profits was worried about beingtaken over by Dresdner Bank. Bavarian politicians actively supported the merger as they wanted to create anational champion. This was a part of their grandiose plan to convert Munich into a financial centre thatcould rival Frankfurt. The government offered a one-off tax waiver on the exchange of shares involved inthe transaction. Without this concession, the merger might not have gone ahead.

It was quite clear that several issues had been left unresolved at the time of the merger. Moreover,there was tension in the air due to rumours that Vereinsbanks ultimate goal was a takeover of Hypobank.Albrecht Schmidt, the head of Vereinsbank, took charge of the merged entity. Vereinsbank took nine of the14 seats on the Board of Management and also gained control over many key departments. EbenhardMartini, the Chief of Hypobank decided to move on to the more ornamental Supervisory Board. (UnderGerman laws, limited companies typically have two boards, a Board of Management, vested with executivepowers and a Supervisory Board which oversees the functioning of the Board of Management).

These moves were however, consistent with Martinis delegating philosophy and Schmidts handson management style. Martinis hands-off-approach could also have been due to Hypobanks nonperforming assets (NPA) in the property business. These assets had resulted from Hypobanks aggressivelending in East Germany during the construction boom following German unification.

Only a year after the merger, did the seriousness of the bad loans problem become evident. InOctober 1998, Schmidt announced that loan provisions of $2.1 billion would have to be made. He alsohinted that these losses had been covered up by Hypobank. This led to a serious clash with Martini. Themerged entitys reputation was damaged. People felt that a backroom struggle was going on between thechief executives of the pre-merger entities.

Only in October 1999, after an auditor submitted his report, was Schmidts assessment vindicated.

Martini and the four remaining members on the Board of Management, from Hypobank resigned. Later,Schmidt signalled peace by putting ex-Hypobankers in charge of the property division and giving themmany of the top jobs in accounting and controlling.

Meanwhile, the integration proceeded smoothly. 500 overlapping branches were closed. Much ofthe systems integration was also completed in less than three years, well ahead of schedule. In May 2000,encouraged by the performance of HVB, Schmidt announced he was acquiring Bank Austria, the biggestbank in Austria.

Source: This box item is drawn heavily from the article, A Bavarian botch-up, The Economist,

August 5, 2000, pp. 68-69.

Understanding the importance of cultural differencesMore often than not, significant cultural differences exist between the pre-merger entities.

Managing these cultural differences is the strategic challenge during integration.Consider the following examples.

The merger of UK-based Beecham and the US based SmithKline involved not onlytwo national cultures but also two business cultures - one very scientific andacademic and the other more commercially oriented.

The American pharmaceutical company, Upjohns centralised and aggressive cultureclashed with Swedish major Pharmacias decentralised laid back management style.

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After the merger between Daimler Benz and Chrysler, the Germans and Americanshave struggled to understand each other and their ways of working. Daimlersbureaucratic engineering culture in which different departments work separately hasclashed with Chryslers free-wheeling, cross-functional product developmentapproach. (See case at the end of the chapter).

Cultural clashes can be significant in industries such as the media, where egos tend tobe big. This was so in the case of the 1989 merger between Time and Warner.

Cultural differences became an important issue when Aetna, a tradition-bound, stodgyand slow-moving organization merged with US Healthcare, generally considered tobe a brash, aggressive and entrepreneurial Health Maintenance Organisation (HMO).

Citicorps staid buttoned-down world of traditional commercial banking has had totake on Traveller groups free wheeling, deal making, investment banking culture.One pressing issue in this merger has been the overbearing attitude of investment bankers who are typically paid much higher salaries than their counterparts incommercial banking. (See case at the end of the chapter).

The Exxon-Mobil merger has also seen the coming together of two contrasting

cultures. Exxon is generally considered to be independent and not particularly good atmanaging the media. Mobil on the other hand, is more accessible, accepts new ideasand is good at public relations. Exxons slow decision-making processes focus oncutting costs, while Mobil has been known to take big risks. It moved into centralAsia in the aftermath of the break-up of the Soviet Union, ahead of many other oilcompanies.

Cultural problems have been an important issue in the AOL-Time Warner (See Boxitem the end of the chapter) and Norwest/Wells Fargo deals as well.

Cisco: Growth through Acquisitions

In technology-driven businesses, mergers and acquisitions (M&A) give quick access to new skills,competencies and people. Since September 1993, Cisco has acquired 73 companies. In spite of the recentslowdown of the US economy, the company has not given up acquisitions. . In 2001, (till October), Ciscocompleted four acquisitions. In October 2001, John Chambers, Ciscos CEO announced that the companywould buy eight to 12 small companies in the near future, primarily in the fibre optics business.

Before making a new acquisition, Cisco assesses the merits and downsides. It examines the targetcompanys vision, its success with customers, its long-term strategy, its compatibility with its own cultureand its geographic proximity to Cisco. A team headed by Mike Volpi (Volpi), senior vice president,(Business Development and Alliances), examines the depth of talent of the target company, the quality ofthe management and venture funding. The engineering team examines the technology, while the financeexecutives scrutinize the companys books.

Volpis team consults Ciscos business units and customers to know more about their

technological needs. Sometimes, customers influence Ciscos acquisition strategy. For example, in March1998, at the instance of US West, an important customer, Cisco acquired Netspeed, which made high-speedInternet access products for home users.

Cisco has a separate integration team, which tailors the integration process to suit the specificneeds of each new acquisition. The team assembles a customized packet of information that includes adescription of Ciscos organizational structure and employee benefits and the strategic importance of thenewly acquired company. Immediately after an acquisition is announced, Ciscos human resource andbusiness development teams travel to the acquired companys headquarters and meet people in smallgroups to set expectations and clarify doubts.

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Ciscos integration team collaborates with the acquired companys management in mappingemployees based on their experience. In general, product engineering and marketing groups remain asindependent business units, while sales and manufacturing groups are merged into Ciscos existingdepartments. The integration team puts the employees of the acquired company through a tailor-madeorientation program, that introduces them to Ciscos hiring practices, its products and developmentprojects.

On August 26,1999, Cisco announced that it was paying $6.9 billion (in a stock deal) to acquireCerent, a two year old start-up, with cumulative sales of only $10 million. Cerents technology integratedvoice and data traffic and zipped into optical fibres efficiently. Cisco viewed Cerents technology as criticalfor linking the Internet and telephone systems and for taking on rivals like Nortel Networks. Chambers wonover Cerent CEO Carl Russo by assuring him that all personnel decisions concerning the employees of theacquired company would be made jointly.

Some of Ciscos acquisitions have made a significant contribution to its growth. CrescendoCommunications, acquired for $95 million in 1993, generated revenues of $7 billion in 2000. However, notall the deals have been successful, a good example being Granite Systems, for which Cisco paid $220million in stock. Ciscos investment in Ardent Communications, (whose product range includes integratedvoice, video and data equipment that can connect a companys branches with its headquarters) has also notbeen very successful. Though Cisco obtained two seats on the board and worked closely with Ardentsengineers, Volpi later acknowledged that Cisco had interfered too much in the acquired companysoperations and that results had not been satisfactory.

Another acquisition which has run into trouble is Monterrey (1991). When it was acquired,Monterrey was two years old and a year away from a marketable product. Recently, Cisco dropped theMonterrey wavelength router from its product line. Looking back, analysts feel the company was acquiredtoo early in its life. Cisco has written off $108 million from the $517 million acquisition.

Many of Ciscos acquisitions have been funded with its highly valuable stock. However, it hasalso used cash or a combination of both stock and cash to fund acquisitions. The way in which the purchaseis funded depends on the objectives of Cisco and the target company, the tax implications and finallyliquidity. Ciscos share declined from a peak of $80.06 in March 2000 to $11.48 in early 2001. So, thecompany will presumably use more of its $18.5 billion cash pile, rather than its stock to make acquisitionsin the immediate future.

A recent change in the method of accounting in the US will have a significant impact on Ciscosfuture acquisition plans. All deals have to be classified as purchases. This means goodwill, the differencebetween the purchase price and the value of assets, must be written off, if impaired. Cisco has traditionally

used the pooling method of accounting in which no goodwill is created. In pooling, at least 90% of thepurchase must be conducted in stock.

One of the reasons for the relative success of Cisco in managing acquisitions has been the clearvalue proposition it has brought to the table. The company has targeted small start-ups on the verge oftakeoff. Using its well oiled distribution channels, it has been able to increase sales of the acquiredcompanys products significantly, in most cases. Ciscos broad product line has strengthened itsrelationship with customers who like one company to take care of their networking requirements.According to Howard Charney, CEO of Grand Junction Networks at the time it was acquired by Cisco 18,Even though at moments, it was painful, what saved it was that they wanted us to become bigger by twoorders of magnitude. Our engineers could see we really had the potential to go from 5% market share to25%.

18 Leading the Revolution.

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Kilman19, et al, have vividly described, the culture clashes which often take placeduring integration: Picture two icebergs in the ocean, where the tip of each representsthe top management groups primarily financial people deciding the fate of the twocompanies and how the merger will work. As these top management groups set themerger in process, the two icebergs begin moving towards one another until the tips meetand mesh as one. Such a consolidation, however, can never take place. As the icebergsapproach one another, it is not the tops that meet, rather it is the much larger mass below

the surface of the water, the respective cultures that collide. Instead of synergy, there is aculture clash.

It was mentioned earlier that a decision regarding the degree to which the pre-merger entities should be integrated is a matter of judgement. To a great extent, thedegree of integration depends on cultural factors. Clayton Christensen20 makes aninteresting observation on integration. He points out that an organisation has three broadtypes of capabilities resources, processes and values. Resources can be easilytransferred, while processes and values are deeply entrenched and are difficult to change.If the acquired companys processes and values have been the main reason for itssuccess, the company should be left well and truly alone. The parent company can pumpresources into the acquired company. If a company is being acquired for its resources,

tight integration may make sense. Many of Ciscos acquisitions have been aimed atacquiring resources in the form of products and people. The companys acquisitions aretypically start-ups, which do not have deeply entrenched values. Cisco typically transfersthe acquired companys resources into the parent companys processes and systems. Ingeneral, management of cultural differences is a critical issue while integrating the basic

19 Gaining control of the corporate culture, Jossey-Bass, 1985.20 Read his book, The Innovators Dilemma. We referred to this book in chapter III.

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work processes, and systems. When the cultural differences are too sharp, it may makemore sense to keep the acquiring and acquired entities separate.

Managing high tech acquisitionsAcquisition is an important growth strategy in high tech businesses. It takes quite a bit of

time to develop new technology in-house. Acquisitions not only allow a firm to make useof a new technology faster, but also bring talented manpower into the organisation.

Like in other acquisitions, due diligence is very important when high techcompanies are involved. The acquiring company needs to make sure that the capabilitiesof the firm being acquired are both unique and valuable. AT&T acquired NCR in 1991,hoping that telecommunications and desktop computing technologies would converge.After the acquisition, AT&T discovered that substantial differences existed between itscompetencies in switching and NCRs Personal Computer (PC) technology.Consequently, synergies were very difficult to achieve. NCRs PC capabilities were alsoweaker than what AT&T expected. Advanced Micro Devices (AMD) conducted athorough check on Nex Gen before acquiring it in 1996. Nex Gens unique chip design

capabilities enabled AMD to develop new products and take on the mighty Intel.All acquisitions have to be managed with a high degree of sensitivity to people.

But this is even more so in the case of high tech acquisitions. How the purchasedcompany fits in and the role of the employees of the acquired company need to be clearlycommunicated. Often, it makes sense to keep the new people together in a separatedivision and make the owner of the purchased company a key member of the integrationteam. In particular, companies acquired for their skill in developing breakthroughtechnologies, must generally be allowed to continue as separate entities. Very often, it isa good idea not to disturb the key technical teams of the acquired company. By keeping people with complementary capabilities in one place, their productivity can besignificantly enhanced.

Whenever a high tech acquisition is planned, it is important to examine whetheremployees of the company being acquired have enough incentive to stay. Employeeswhose stock options are already vested, if they sense that their importance will diminishor their creativity will be stifled after the merger, may decide to quit. So, hostiletakeovers are almost always bad in high tech businesses. They create suspicion in theminds of the employees of the acquired company. Once trust is breached, retainingtalented people is virtually impossible.

When Cisco acquired Crescendo, the head of the acquired company, MarioMazzola became a rich man. But he decided to stay on rather than retire or form a newcompany. Cisco gave him plenty of responsibilities and made him the head of thecompanys line of enterprise products.

According to Howard Charney, CEO of Grand Junction Networks, another Ciscoacquisition21, Chambers (Ciscos CEO) treated me like a peer. He asked me what Ithought and never talked down to me. Despite differences in size, Cisco treats everyacquisition like a merger of equals. Cisco delivered on its promise.

21 Leading the Revolution, pp. 236-237.

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Dilemmas/paradoxes in mergers and acquisitions

Slow Vs quick change: Some advocate rapid change within the first 100 days of the merger. Otherssuggest a slower process that carries people along. More than speed however, compassion and goalcongruence are the more important factors .

Information sharing: Though all efforts should be made to share as much information as possible,it must be kept in mind that people caught in the process of integration will still tend to perceive that they

are not being kept fully informed.Managing Vs coping: It is important to have a plan, but also to keep in mind that all factors maynot be fully within the control of managers. Peoples fears and tensions will always disrupt organisationalprocesses to some extent.

Strategic significance: Studies indicate that the more significant, the target is to the acquirer, thegreater the likelihood that the acquiring company will step in and take control of the situation, especiallywhen progress is below expectations. (Daimler Benz certainly seems to be doing that to Chrysler). Thiscreates antagonism among various employee groups and prevents a more iterative, evolutionary processthat seems to characterise many successful mergers.

Long-term and short-term focus: Sometimes, integration efforts tend to have an overly long-termfocus. However, it is often the handling of short-term people-related issues that tend to have the biggestimpact on the integration process.

It takes time: Mergers and acquisitions result in severe disruptions and impose a tremendous strainon those involved. It may take up to five years for the change process to be fully completed. Expectationson both sides must be adjusted accordingly.

Source: AON Risk Services, Edition 3, 1998.

Anti-trust issuesAn important risk in the case of mergers and acquisitions is anti-trust action. Whenever abig merger deal is announced, competition authorities view it with suspicion. If they feelthat the merger will limit competition, they may impose several restrictions on the newcompany. World Coms planned $115 billion takeover of Sprint in June 2000, and therecently announced deal between GE & Honeywell were blocked by the EuropeanUnions competition authorities. (See Box item on the GE-Honeywell deal in ChapterVII). When a company is big and enjoys an overwhelmingly large market share,competition authorities tend to watch it very closely. Take the case of Microsoft. Theglobal software giant has by and large concentrated on acquiring small companies or hastaken minority stakes in large companies. The image of the company makes a differencehere. A company like Cisco, with a very positive, friendly image will be viewed morepositively by the anti-trust authorities than Microsoft, which is perceived to be a toughno-non-sense competitor. A more detailed discussion on anti-trust issues is included inChapter VII.

Managing risks in strategic alliancesAcquisitions are different from strategic alliances. While an acquisition involves gaining

control of another corporate entity, a strategic alliance is a more flexible and open-endedarrangement, in which the different partners retain their individual identities even if theyexchange equity stakes.

Strategic alliances offer more flexibility than acquisitions. In an acquisition, anunduly high premium may be paid. Another problem with acquisitions is that only a partof the acquired business may be valuable, and along with it may come undesirable parts.Where uncertainties about the market size and technology are large, acquisitions can be

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very risky. Strategic alliances are much more flexible than acquisitions, because theygenerate more options.

Guide to a happy merger

Question the logic: Ask how exactly the combination will generate synergies.Specify roles clearly: Arrive at an agreement over the degree of integration and define clearly the

roles of top leaders.Design the integration process carefully: Combine the pre-merger entities in ways that preserve

the anticipated sources of strategic leverage.Dont escalate commitment carelessly: Avoid making additional acquisitions to justify the deal. If

one deal does not click, cut losses and withdraw, instead of throwing good money after bad.Dont give autonomy without a clear logic: In some cases, the acquired company must be allowed

to operate with a great degree of independence. In other cases, this should not be so. Autonomy should begiven based on the merits of the situation, not just because the acquired company demands it.

Apply what has worked in the past: Core practices that have contributed to past success, must beapplied to the new business.

Dont be carried away by favourable short-term results: In many cases, it makes sense to grant

autonomy to the acquired companys managers only after a period of sustained excellence.Dont give key jobs to top executives who missed out on promotions earlier: Such a move often

creates problems. These executives may be upset at having been overlooked for the top job. As a result,trust may become a problem over time.

Dont compromise on values: No matter how good the numbers look, if the core values of themerging entities clash, the merger is heading for big trouble.

Source: David A Wadler, The New York Times, 1998.

But, strategic alliances are also more difficult to manage. A McKinsey study of 49multinational alliances conducted in the early 1990s revealed that two thirds of these hadrun into serious problems in the first two years. Joel Bleeke and David Ernst 22, McKinseyconsultants, have mentioned that in many alliances, one of the partners opts out. In 1990,

Porter argued that strategic alliances involve significant costs in terms of coordinating,reconciling goals and sharing profits, and could at best be transitional. Thus, one needs tounderstand the pros and cons before going ahead with a strategic alliance.

Much time and effort have to be invested in managing alliances to make themsucceed. According to Gary Hamel, Yves L Doz and CK Prahalad23, an alliance isnothing but competition in a different form. Since the partner might take unfair advantageof the situation, the strategic objectives should be clearly defined and the company mustunderstand how these objectives may be influenced by the hidden agenda of the partners.In the late 1980s, Schwinn, Americas largest bicycle manufacturer tied up with Giant ofTaiwan, since it needed additional capacity to meet the soaring demand. The bicyclesmade by Giant turned out to be cheaper and better than those made in the US. From

thereon, Giant went from strength to strength. By 1992, Schwinn had gone bankrupt,while Giant emerged as one of the leading bicycle manufacturers in the world.

Typically, alliances involve a delicate balancing act between control andautonomy. It is often the attempt made by one partner to dominate the other that leads to

22 Harvard Business Review, January February, 1995.23 Harvard Business Review, January February, 1989.

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the break-up of an alliance. As Kenichi Ohmae24 puts it, You cannot own a successfulpartner any more than you can own a husband or a wife.

Alliances often create new strategic options for the partners, who may startcontrolling the tasks and competencies most critical to the success of the alliance. As aresult, the sharing of benefits may become lopsided. It is precisely because of such

difficulties that strategic alliances have to be conceived and structured carefully.Before going ahead with an alliance, companies should carefully analyse thevalue chain to determine which activities should be retained internally and which can beshared with partners. It is also important to examine carefully whether the scope of thealliance should be limited to start with and expanded over time. A related issue is whetherto choose one partner for many activities or different partners for different activities.

Unintended leakage of knowledge is a big risk in strategic alliances. While friendlyrelations between the partners are desirable, information leakage must be discouraged byputting in place proper controls and firewalls. Indeed, occasional complaints from thepartner that lower level employees are not providing the necessary information should be

viewed as a positive indication. The company which systematically monitors the type ofinformation the partner is requesting and the extent to which these requests are being met,may well turn out to be the ultimate winner.

A systematic and pragmatic approach right from the negotiation stage canminimize risks in strategic alliances. The executives involved in the negotiation should beallowed sufficient time to get to know each other and to develop personal equations. Freeand frank discussions and realistic targets will help the firm avoid futuredisappointments. The partners should painstakingly identify potential problems anddevise ways to solve them. Crisis situations should be anticipated and a code ofbehaviour prescribed for dealing with them. It may also be useful to maintain writtenrecords of informal and oral commitments and agreements. These records can be referredto, as and when disputes arise.

Like in many other business activities, top management commitmentholds the keyto the success or failure of an alliance. When senior executives of the companies involvedare willing to invest time and effort in building strong personal relationships with eachother, the chances of success multiply.

The success of a strategic alliance depends critically on the partners commitmentto learning. When top management sends out clear signals that learning is veryimportant, employees take the message seriously. The top management should alsoproperly brief the lower level employees on what can be learnt from the partner and howthis knowledge will strengthen the companys competitive position. Employees can betrained and encouraged to ask probing questions such as: Why is their design better? Whyare they investing in a technology when we are not doing so? Companies can also learnmore about the competitive behaviour of their partners - how they respond to pricechanges, how they launch a new product, etc.

Management of expectations is a crucial issue in strategic alliances. When twopartners view an alliance differently, they may have different expectations. For example,one may treat it as an acquisition while the other may believe it to be an equalpartnership. One way of bridging this gap is for each partner to put itself in the others

24 The Borderless World, p 119.

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shoes. The partners could also share with each other, the problems they have faced in the past while managing alliances. At the same time the differences between the pastexperiences and the new situation should be appreciated. People who will be activelyinvolved in the negotiation should be carefully selected. Managers who are familiar withthe cultural differences and command respect in their respective organizations will come

off as more credible when they interact with their counterparts in the partner company.Alliances can run into rough weather for various reasons. The size of the marketmay have been overestimated at the time the alliance was formed. If technology ischanging rapidly, the value of the alliance for each partner may change dramatically overtime. The actions of competitors can turn a potentially attractive alliance into a weakarrangement. Regulatory changes, in industries which governments view as strategic,may totally upset the initial calculations of alliance partners. For all these reasons,partners may switch loyalties.

The right approach to deal with these potential problems is to think and actflexibly. According to Hamel and Doz25: Calls for commitment make good rhetoric butare a poor basis for action. Commitment increases only over time and an uncritical belief

in commitment is naive and misleading. People being largely risk averse, will always betempted to hedge commitments and keep their options open in the face of uncertainty.Alliance partners must appreciate that their objectives are bound to change with time andnot cling to the initially set objectives. Indeed, if the partners are alert, unforeseenopportunities for knowledge generation and sharing can be tapped.

One common reason for conflicts is that one partner may have skills that are noteasily transferable, while the other may have expertise which can be more easily pickedup. The design of a component or a product can normally be learnt through a manual oran engineering drawing. On the other hand, manufacturing skills are more intricate,typically developed over a period of time and combine several competencies. A discrete,stand-alone technology, such as the design of a semi conductor chip, can be more easilytransferred than a process competence. Japanese companies often tend to learn more fromtheir American partners because their manufacturing skills are less transferable than thedesign skills of western companies.

Contrary to popular notions, absence of conflicts may not necessarily imply thatthe alliance is succeeding. It is quite possible that the two partners have given up or onepartner is dominating the other. Occasional conflicts may reflect a more normal situation.The trick obviously lies in managing these conflicts tactfully.

Concluding NotesIn this chapter, we have tried to understand the risks associated with mergers,acquisitions and strategic alliances. In their anxiety to close the deal or in their

enthusiasm to grow, companies often strike deals of questionable merit. A dispassionateanalysis of the potential benefits and pitfalls involved is important before going aheadwith a merger or a strategic alliance. Board members have an important role to play here,especially the external directors. CEOs must be thoroughly grilled and asked to explainthe benefits of the merger. Once the decision to go ahead with the merger is announced,the focus shifts to integration. This is a task which is underestimated by most companies.

25 In their book, Alliance Advantage.

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In the final analysis, it is the efficiency with which the integration process is managedthat decides whether the projected synergies materialise. The difficulties in planning andexecuting acquisitions and alliances make them very risky. Managers should neverunderestimate these risks when they strike such deals.

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Case 4.1 - The Daimler Chrysler Merger

IntroductionOn May 6, 1998, two of the worlds leading car manufacturers, Daimler-Benz and

Chrysler, agreed to combine their businesses to form the third largest automobilecompany in the world in terms of revenues, market capitalization and earnings (fifth interms of the number of units of passenger-cars and commercial vehicles sold). In the newcompany, called DaimlerChrysler (DCX) Juergen E Schrempp and Robert J.Eaton theCEOs of Daimler and Chrysler respectively were named co-CEOs. Both appearedconfident that the merger would generate various synergies and growth opportunities.

Schrempp remarked26, The two companies are a perfect fit of two leaders in theirrespective markets. Both companies have dedicated and skilled workforces andsuccessful products, but in different markets and different parts of the world. Bycombining and utilizing each others strengths, we will have a pre-eminent strategicposition in the global marketplace for the benefit of the customers. We will be able to

exploit new markets, and we will improve return and value for our shareholders. This is ahistoric merger that will change the face of the automotive industry.

According to Eaton, Both companies have product ranges with world classbrands that complement each other perfectly. We will continue to maintain the currentbrands and their distinct identities. What is more important for success is our companiesshare a common culture and mission. both clearly focussed on serving thecustomer.. both have a reputation for innovation and quality.. By realizingsynergies we will be ideally positioned in tomorrows market place.

ChryslerIn 1993, the Chrysler board had appointed Robert Eaton, then a senior General Motors

(GM) executive, as the new chairman and CEO, following the legendary Lee Iaccocasretirement. Eaton divested unrelated businesses to concentrate on car and truck makingactivities. He emphasised quality and efficiency, strengthened the balance sheet byreducing debt and increased Chryslers commitment to new product development. By1995, Chryslers position had significantly improved. Chrysler reported net earnings of$2.4 billion in 1993, $3.7 billion in 1994 and $2 billion in 1995.

In 1997, Forbes which selected Chrysler as the Company of the Year.mentioned27: No company in recent years has faced greater odds than Chrysler. Startingas a weak number three in a murderously competitive business facing competitors withfar greater resources, Chrysler management devised a disciplined strategy out of chaosand rose to the top of the American car industry in profitability. Eaton received praise

from analysts for making Chrysler a customer oriented company and for developing aclose knit team of talented managers driven by a clear vision.

26 Press release, May 7, 1998.27 Fling Jerry, Company of the year Chrysler, Forbes, January 13, 1997, pp. 83-87.

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Daimler Chrysler

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Daimler BenzWhen Juergen Schrempp had taken over as Daimlers CEO in May 1995, the companywas facing a crisis. To some extent, Schrempp himself was responsible for this state ofaffairs. To cite an example, he had supported the acquisition of Fokker, the Dutchairplane manufacturer. However, price wars, unfavorable exchange rates and globalrecession had resulted in massive losses. Fokker slid into bankruptcy less than three yearslater.

Schrempp however, made up for these mistakes through ruthless restructuring. Heannounced that Daimler would return to its roots as a car maker and began divestingunprofitable businesses. These divestitures, helped in reducing headcount and sharpenedthe business focus. The Aerospace division alone lost around 40,000 people through lay-offs, attrition and divestiture. Even the Mercedes division, which had employed 180,000people in 1991, saw its manpower strength fall to 140,000 by 1995.

After restructuring Daimler, Schrempp set about revitalizing the culture andpromoted what he called value driven management. Each of Daimlers 23 businessunits had to earn a return of at least 12% on the capital employed (ROCE). During thefirst half of 1997, Daimler showed a remarkable improvement with ROCE of 9%. In1997, Daimler generated revenues of DM 124 billion and net profits of nearly DM 6

billion.

The mergerIn the early 1990s, Daimler executives noticed that their traditional markets werebecoming saturated and started looking for new growth opportunities. The price of thevaunted Mercedes marque was beyond the reach of most customers in emerging markets.If matters were allowed to drift, Mercedes would remain a niche player and lose itscompetitive strength. So Daimler began to look for a partner to broaden its appeal and

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give it the scale it needed to retain its technological strengths. After considering variouscar manufacturers in the world, Daimler executives decided that Chrysler topped the listbecause its product line and geographical reach were both complementary.

In 1995, Daimler and Chrysler began exploratory talks, and discussed ways ofdealing with their weaknesses in the rapidly growing Asian markets and, to a lesser

extent, South American markets. They proposed to set up a new, jointly owned projectcode-named Q Star that would operate outside the US and Europe to develop vehicles,build factories, and establish dealer networks in new markets. The talks however ran intoa stalemate over issues of responsibility and money -- who would manage which projectsand how the costs would be allocated.

Chrysler, however, realized very soon that it was too thinly staffed to boostoverseas sales by deploying managers around the world. Moreover, due to smallervolumes, its R&D cost per vehicle was higher than that of its formidable rivals, GM andFord. Clearly, Chrysler was too small to take on its bigger rivals. It made sense to have apartner.

Meanwhile, Daimler was having its own problems. After building a plant in

Alabama to assemble the M-class sport-utility vehicle, many defects/problems appearedduring its first year of production, making it the most defect-ridden vehicle in its class.The German manufacturer had to spend about $180 million in 1997 to retrofit aninnovative small car called A-class, because it lost balance when turning around cornersat high speeds. The company formed a partnership agreement in 1997 with Swatch28 todevelop a two-seater, plastic-bodied city car called Smart. But the co-venture dissolved inacrimony. Meanwhile, larger manufacturers like Toyota and Volkswagen, were buildingcompetitively priced premium cars such as Lexus and Audi. On the positive side,Schrempp had restructured Daimlers non-auto businesses, adopted US GAAPaccounting principles and listed Daimler on the New York Stock Exchange. This wouldgreatly facilitate any transatlantic deal.

The ground realities they faced, motivated Daimler and Chrysler to get back to thenegotiating table. In January 1997, Schrempp met Eaton at Chrysler headquarters duringthe Detroit Auto Show. But doubts about the deal again arose when Ford chairman AlexTrotman approached Schrempp in Detroit in January 1998 for a joint venture. Topexecutives from Ford and Daimler held two days of discussions in London in March.Daimler had never viewed Ford as a possible partner since it was big enough to surviveon its own. The London meeting was successful. However, a second meeting, wascancelled at the last minute after Trotman informed Schrempp that the Ford family didnot want to lose management control.

After the talks with Ford broke down, the negotiations between Daimler andChrysler proceeded smoothly. On March 2, 1998, Eaton and Schrempp met in Lausanne,Switzerland, to discuss issues like governance and organization structure for the mergedentity. In April, working teams went into details and reached agreements on big issues(Computer operations would be centralized the Chrysler way, with a Chrysler executivein charge) to small issues (Business cards would be wider and longer, European style).

On May 6, Daimler and Chrysler signed the merger agreement which wasannounced worldwide

04_Managing Risks in Mergers and Acquisitions

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