Effective and appropriate use of the acquisition strategies can facilitate firms’ efforts to earn above-average returns. However, even when pursued value-creating reasons, acquisition strategies are not problem-free. Firms using acquisition strategies should be aware of problems that tend to affect acquisition success.
Problem 1: Integration Difficulties
The importance of a successful integration should not be underestimated.
Indeed, the integration process may be the strongest determinant of whether either a merger or an acquisition will be successful. Post-acquisition integration is often a complex set of organizational processes that is difficult and challenging. The processes tend to generate uncertainty and often resistance because of cultural clashes and organizational politics.
How people are treated during the integration process relative to perceptions of fairness is an important issue to consider when trying to integrate the acquiring and acquired firms.
Among the challenges associated with integration, processes are the need to: (1) meld two or more unique corporate cultures, (2) link different financial and control systems, (3) build effective working relationships, and (4) determine the leadership structure and those who will fill it for the integrated firm.
Problem 2: Inadequate Evaluation of Target
Due diligence is a process through which a potential acquirer evaluates a target firm for acquisition.
In an effective due-diligence process, hundreds of items are examined in areas as diverse as the financing for the intended transaction, differences in cultures between the acquiring and target firm, tax consequences of the transaction, and actions that would be necessary to successfully meld the two workforces.
Due diligence is commonly performed by investment bankers, as well as accountants, lawyers, and management consultants specializing in that activity, although firms actively pursuing acquisitions may form their own internal due diligence team. Even in instances when a company does its own due diligence, companies almost always work with intermediaries such as large investment banks to facilitate their due diligence efforts.
Using investment banks as part of the due-diligence process a firm completes to examine a proposed merger or acquisition is a complex matter requiring careful managerial attention.
Although due diligence often focuses on evaluating the accuracy of the financial position and accounting standards used (a financial audit), due diligence also needs to examine the quality of the strategic fit and the ability of the acquiring firm to effectively integrate the target to realize the potential gains from the deal.
Commonly, firms are willing to pay a premium to acquire a company they believe will increase their ability to earn above-average returns.
Determining the precise premium that is appropriate to pay is challenging. While the acquirer can estimate the value of anticipated synergies, it is just an estimate. Only after working to integrate the firms and then engaging in competitive actions in the marketplace will the absolute value of synergies be known.
When firms overestimate the value of synergies or the value of future growth potential associated with an acquisition, the premium they pay may prove to be too large. Excessive premiums can have dilutive effects on the newly formed firm’s short- and long-term earning potential. The managerial challenge is to effectively examine each acquisition target for the purpose of determining the amount of premium that is appropriate for the acquiring firm to pay.
Paying excessive premiums to acquire firms can negatively influence the results a firm achieves through an acquisition strategy. Determining the worth of a target firm is difficult. This difficulty increases the likelihood a firm will pay a premium to acquire a target. Premiums are paid when those leading an acquiring firm conclude that the target firm would be worth more under its ownership than it would be as part of any other ownership arrangement or if it were to remain as an independent company. Overall though, paying a premium that exceeds the value of a target once integrated with the acquiring firm can result in negative outcomes.
Problem 3: Large or Extraordinary Debt
To finance a number of acquisitions, some companies significantly increased their debt levels.
Although firms today are more prudent about the amount of debt they’ll accept to complete an acquisition, those evaluating the possibility of acquisition for their company need to be aware of the problem that taking on too much debt can create. Executives need to be aware of these possibilities and challenge themselves to engage in rational decision-making only when dealing with an acquisition strategy.
In this sense, firms using an acquisition strategy want to verify that their purchases do not create a debt load that overpowers their ability to remain solvent and vibrant as a competitor.
A financial innovation called junk bonds supported firms’ earlier efforts to take on large amounts of debt when completing acquisitions.
Junk bonds, which are used less frequently today and are now more commonly called high-yield bonds, are a financing option through which risky acquisitions are financed with money (debt) that provides a large potential return to lenders (bondholders).
Additionally, interest rates for these types of bonds tend to be quite volatile, a condition that potentially exposes companies to greater financial risk.
Some viewed debt as a means to discipline managers, causing the managers to act in the shareholders’ best interests. Managers adopting this perspective are less concerned about the amount of debt their firm assumes when acquiring other companies. However, the perspective that debt disciplines managers are not as widely supported today as was the case in the past.
Bidding wars, through which an acquiring firm overcommits to the decision to acquire a target, can result in large or extraordinary debt.
While managers will make rational decisions when seeking to complete an acquisition, rationality may not always drive the acquisition decision.
Hubris, escalation of commitment to complete a particular transaction, and self-interest sometimes influence executives to pay a large premium which, in turn, may result in taking on too much debt to acquire a target.
Problem 4: Inability to Achieve Synergy
Synergy exists when the value created by units working together exceeds the value that those units could create working independently. That is, synergy exists when assets are worth more when used in conjunction with each other than when they are used separately.
For shareholders, synergy generates gains in their wealth that they could not duplicate or exceed through their own portfolio diversification decisions.
Synergy is created by the efficiencies derived from economies of scale and economies of scope and by sharing resources (e.g., human capital and knowledge) across the businesses in the newly created firm’s portfolio.
A firm develops a competitive advantage through an acquisition strategy only when a transaction generates private synergy.
Private synergy is created when combining and integrating the acquiring and acquired firms’ assets yield capabilities and core competencies that could not be developed by combining and integrating either firm’s assets with another company.
Private synergy is possible when firms’ assets are complementary in unique ways. That is, the unique type of asset complementarity is not always possible simply by combining two companies’ sets of assets with each other.
Although difficult to create, the attractiveness of private synergy is that because of its uniqueness, it is difficult for competitors to understand and imitate, meaning that a competitive advantage results for the firms able to create it.
A firm’s ability to account for costs that are necessary to create anticipated revenue and cost-based synergies affects its efforts to create private synergy.
Firms experience several expenses when seeking to create private synergy through acquisitions. Called transaction costs, these expenses are incurred when firms use acquisition strategies to create synergy. Transaction costs may be direct or indirect.
Direct costs include legal fees and charges from investment bankers who complete due diligence for the acquiring firm. Indirect costs include managerial time to evaluate target firms and then to complete negotiations, as well as the loss of key managers and employees following an acquisition.
Firms tend to underestimate the sum of indirect costs when specifying the value of the synergy that may be created by integrating the acquired firm’s assets with the acquiring firm’s assets.
Problem 5: Too Much Diversification
Diversification strategies, when used effectively, can help a firm earn above-average returns. In general, firms using related diversification strategies outperform those employing unrelated diversification strategies. However, conglomerates formed by using an unrelated diversification strategy also can be successful.
At some point, firms can become over-diversified. The level at which this happens varies across companies because each firm has different capabilities to manage diversification.
Related diversification requires more information processing than does unrelated diversification. Because of this need to process additional amounts of information, related diversified firms become over-diversified with a smaller number of business units than do firms using an unrelated diversification strategy.
Regardless of the type of diversification strategy implemented, however, the firm that becomes over-diversified will experience a decline in its performance and likely a decision to divest some of its units. Commonly, such divestments, which tend to reshape a firm’s competitive scope, are part of a firm’s restructuring strategy.
Even when a firm is not over-diversified, a high level of diversification can have a negative effect on its long-term performance. For example, the scope created by additional amounts of diversification often causes managers to rely on financial rather than strategic controls to evaluate business units’ performance.
Top-level executives often rely on financial controls to assess the performance of business units when they do not have a rich understanding of business units’ objectives and strategies.
Using financial controls, such as return on investment (ROI), causes individual business unit managers to focus on short-term outcomes at the expense of long-term investments. Reducing long-term investments to generate short-term profits can negatively affect a firm’s overall performance ability.
Another problem resulting from over-diversification is the tendency for acquisitions to become substitutes for innovation.
Typically, managers have no interest in acquisitions substituting for internal R&D efforts. However, a reinforcing cycle evolves. Costs associated with acquisitions may result in fewer allocations to activities, such as R&D, that is linked to innovation. Without adequate support, a firm’s innovation skills begin to atrophy. Without internal innovation skills, a key option available to a firm to gain access to innovation is to complete additional acquisitions.
Problem 6: Managers Overly Focused on Acquisitions
Typically, a considerable amount of managerial time and energy is required for acquisition strategies to be used successfully.
Activities with which managers become involved include (1) searching for viable acquisition candidates, (2)completing effective due-diligence processes, (3) preparing for negotiations, and (4) managing the integration process after completing the acquisition.
Top-level managers do not personally gather all of the information and data required to make acquisitions. However, these executives do make critical decisions regarding the firms to be targeted, the nature of the negotiations, and so forth.
Participating in and overseeing the activities required for making acquisitions can divert managerial attention from other matters that are necessary for long-term competitive success, such as identifying and taking advantage of other opportunities and interacting with important external stakeholders.
Managers can become overly involved in the process of making acquisitions. The over-involvement can be surmounted by learning from mistakes and by not having too much agreement in the boardroom.
Dissent is helpful to make sure that all sides of a question are considered. For example, there may be group bias in the decision-making of boards of directors regarding acquisitions. Possible group polarization leads to either higher premiums paid or lower premiums paid after group discussions about potential premiums for target firms. When a failure does occur, leaders may be tempted to blame the failure on others and on unforeseen circumstances rather than on their excessive involvement in the acquisition process.
Finding the appropriate degree of involvement with the firm’s acquisition strategy is a challenging, yet important, the task for top-level managers.
Problem 7: Too Large
Most acquisitions result in a larger firm, which should create or enhance economies of scale. In turn, scale economies can lead to more efficient operations.
For example, two sales organizations can be integrated using fewer sales representatives because the combined sales force can sell the products of both firms.
However, size can also increase the complexity of the managerial challenge and create diseconomies of scope. That is, not enough economic benefit to outweigh the costs of managing the more complex organization created through acquisitions.
Thus, while many firms seek increases in size because of the potential economies of scale and enhanced market power size creates, at some level, the additional costs required to manage the larger firm will exceed the benefits of the economies of scale and additional market power.
The complexities generated by the larger size often lead managers to implement more bureaucratic controls to manage the combined firm’s operations. Bureaucratic controls are formalized supervisory and behavioral rules and policies designed to ensure the consistency of decisions and actions across a firm’s units.
However, across time, formalized controls often lead to relatively rigid and standardized managerial behavior.
Certainly, in the long run, the diminished flexibility that accompanies rigid and standardized managerial behavior may produce less innovation. Because of innovation’s importance to competitive success, the bureaucratic controls resulting from a large organization that might be built at least in part by using an acquisition strategy can negatively affect a firm’s performance.
Thus, managers may decide their firm should complete acquisitions in the pursuit of increased size as a path to profitable growth. At the same time, managers should avoid allowing their firm to get to a point where acquisitions are creating a degree of the size that increases its inefficiency and ineffectiveness.
Resources
Further Reading
- Biggest Challenges During M&A & How to Overcome Them (dealroom.com)
- Biggest Challenges in Mergerse and Acquisitions and Key Areas (predictiveanalyticstoday.com)
- What Are The Biggest Problems Companies Face During A Merger Or Acquisition? (forbes.com)
- Three key challenges of a merger or acquisition (icas.com)
- 5 M&A Obstacles And How To Prevent Them (vikingmergers.com)
- The four main challenges of a merger or acquisition (sia-partners.com)
- Big Issues and Small Challenges with Mergers and Acquisitions (workforce.com)
- Biggest Merger and Acquisition Disasters (investopedia.com)
- Opportunities and challenges you may face in an M&A and how to tackle them (bdcnetwork.com)
Related Concepts
References
- Hitt, M. A., Ireland, D. R., & Hoskisson, R. E. (2019). Strategic Management: Concepts and Cases: Competitiveness and Globalization (MindTap Course List) (13th ed.). Cengage Learning.
- Hill, C. W. L., & Jones, G. R. (2011). Essentials of Strategic Management (Available Titles CourseMate) (3rd ed.). Cengage Learning.
- Mastering Strategic Management. (2016, January 18). Open Textbooks for Hong Kong.
- Wheelen, T. L. (2021). Strategic Management and Business Policy: Toward Global Sustainability 13th (thirteenth) edition Text Only. Prentice Hall.