Getting a Head Start On The Deal’s People Issues

No firm enters into deal discussions believing anything other than its deal will be a huge success. However, numerous studies over the last five years have come to essentially the same conclusions: Acquisitions encounter enormous difficulties, and people problems rank high in the list of difficulties that ultimately derail the financial success of the transactions. So, why is it that a few companies such as Cisco Systems Inc., General Electric Co., and Microsoft Corp. are acknowledged as “best in class” acquirers while the majority of firms struggle with what they’ve bought? The main difference is in the approach. These firms evaluate the people and numbers issues concurrently. They have a “begin with the end in mind” mentality in which the end is the successful transfer of the target’s operations into its own. In contrast, too many other acquirers with less stellar records separate the two key issues, and often consider the “end” to simply be the closing date of the deal. The purpose of this article is to focus on the major human resources (HR) issues that have the most significant impact on successful acquisitions and to underscore how they must not only be addressed early but in concert with other key matters in m&a analysis. Unfortunately, the HR professional often is missing from the m&a table or relegated to a minor role. Yet, if used the right way, the HR professional has multiple contributions to make as a strategic adviser and business partner to the: * Senior leaders responsible for the success of the acquisition as a whole, specifically as a counselor on significant people and organizational problems; * Transaction team on the financially significant people issues relating to the deal price; and * Integration team on the key people issues impacting achievement of integration and synergy goals. Achieving this strategic partnership status is not easy and we will review how HR people must make more effective use of the due diligence phase in dealmaking to reach a more important advisory level. We also will counter two key criticisms of HR in the deal process – the widely held beliefs that HR professionals can’t add strategic input early enough in the process to make a difference, and that they don’t understand the deal flow and business issues well enough to help management solve the big issues when they arise. Most deals can be broken down into three components: Targeting – Planning for the acquisition and preliminary talks with the target. Transaction – The actual mechanics of putting the deal together and obtaining all necessary approvals. Integration – Absorbing the target into the acquirer’s organization. The transaction phase focuses on completing the written agreement, which results in a change of ownership of the target. It starts with the letter of intent, a non-binding agreement to conduct more detailed investigations, and culminates with the sale and purchase agreement. Actual completion requires approval by regulatory authorities, the boards of both buyer and seller, and, in some cases, their shareholders. Integration formally starts when all approvals have been granted and the target business becomes the property of the acquirer. Successful acquisitions require that both stages be superbly executed. One without the other is insufficient. Flawless execution cannot make up for a badly priced deal, and a great deal price can lead to erosion of value by poor integration. However, the majority of unsuccessful deals can be traced to the poor execution of one or both of these stages, and the lack of a clear linkage between them. There are four common reasons why the transaction and integration phases are so loosely linked. Divided focus In the transaction phase the acquirer concentrates on the major issues involved in getting the deal done, e.g., confirming the strategic rationale and operational fit, negotiating the deal price, financing the deal, and finalizing the legal aspects of the purchase contract. It is only after the deal is signed that the focus shifts to integration, where the people issues and the achievement of the integration and synergy goals predominate. Disconnect between the teams Given the split focus, the teams see their roles as being parts of distinct phases, with goals that may or may not overlap. They usually involve different people, different timelines, and different dynamics. This can be seen most visibly by the resources allocated to each phase. The transaction has a “cast of thousands,” including a host of outside advisers such as investment bankers and lawyers, which enjoy a generous allocation of up-front resources. It also has the prestige attached to the victory of owning a rival. On the other hand, integration involves backend resources, often drawn totally from existing internal staff, and carries little of the prestige associated with the deal closing. As a result, integration often carries a second-class stigma, reflected in the lesser resources allocated to it and the lower skill level of the people assigned to staff it. Tight screening A lot of deals die on the vine. Frequent acquirers evaluate many more targets than they actually buy. As a result, the people aspect often drops off their radar screens. After several failed or aborted bids the transaction team’s enthusiasm for considering the people factor wanes. The “ego and adrenaline” rush syndrome In reality, individuals drive the buying. Just like gamblers in Vegas, these senior individuals can get caught up in the rush to beat out a likely competitor or in the frequent bidding wars that come with the territory. Consequently, bids proferred in the heat of battle or under pressure may be made before the target is thoroughly evaluated by the transaction team, and before any integration team has been assembled. These weak linkages mean that risks and liabilities are not accurately assessed and that the integration team is way behind in collecting the information it needs to plan for the combining of the two operations. The results are that the acquirer may pay more than it needs to, and further value can be eroded if the integration falls apart. This is illustrated in the next section. The total value that is eroded in poorly constructed acquisitions is illustrated in Figure 1. This erosion reflects the difference between the results achieved from the deal and the deal price. This can be further subdivided into the two main components, with the HR factors contributing to each part. Transaction gap – The difference between the price paid and the real value (i.e., the price that should have been paid), reflecting the overpayment in price at the deal closing. Integration gap – The difference between the real value and the achieved results, reflecting the value eroded after the deal has closed. So, how can HR people help eliminate these gaps and truly earn their place at the deal table? The answer lies in the effective use of the due diligence phase, which affords the opportunity to assess the target in depth and on multiple levels. The key is to use this stage to assess the key people and organizational issues at the target, quantify the hard HR numbers to negotiate a lower deal price, and provide a preliminary plan for integration from this information. All of this can be done by understanding the total opportunities afforded by the due diligence phase, and how a seasoned HR professional can pull these opportunities together. However, for HR to play this role it must be recognized that HR holds a credible position within the acquiring company and that this role goes well beyond the relatively ministerial functions of routine reviews of administrative processes, compensation structures, and analysis of benefit plan costs. Due Diligence: Linking Transaction And Integration In-depth due diligence begins in earnest once the letter of intent is signed. Typical activities at this stage include: * Senior management meetings at the acquirer and target to review the target’s historical financial statements, current budgets, projections, and the target management’s views of the company and its industry. * Direct visits to selected facilities and sites by executives to assess firsthand what they have been hearing at the meetings. * Review of key contracts and agreements between the target and its employees, customers, suppliers, and other persons deemed important. * Specific due diligence of legal, accounting, insurance, HR, and environmental issues. * Review of any major areas of current or potential concern. However, while the ability to conduct this comprehensive due diligence may be restricted by the bidding process, the savvy acquirer makes the most of what is available as soon as possible to evaluate the target in more depth. The prerequisite to making the most of these activities is to fully understand all of the important business issues and the effect of these issues on the deal as a whole. Most people involved in deals get an understanding of only some of the issues. Few people understand them all. Major Business Issues: The Prerequisite To Strategic Advice Business reasons for the deal The business rationale will drive the key HR issues that must be addressed. For example, if the target is a high-tech firm whose value resides in the “brains” of its people, identifying and retaining all of the key players becomes the number one priority. If the acquisition is the result of industry consolidation in which the firms have overlapping skills and customers, broad personnel retention will be of lesser importance. While many other reasons exist for doing a deal, the important point is that the business rationale must be clearly articulated by senior management and used to drive HR activities and priorities. Type of deal Deal type may affect the employment terms and conditions to be offered to the acquired company. For example, acquisition of the target’s stock generally requires transfer of its employees and their labor contracts virtually intact while acquisitions of assets may allow the buyer to terminate and rehire the workforce under different terms. The compensation issues can pose an extremely sensitive problem, especially if the target’s total compensation package is far more generous that the acquirer’s. It is important to identify the extent of the disparity in the total compensation packages early on and determine how the acquirer intends to resolve this disparity. Global extent of the deal The basic problem to resolve is whether the acquirer has the talent and experience to manage cross-border deals. These deals can involve many countries and languages, as well as multiple organizational and national cultures. Synergy estimates for employee reductions This affects the savings estimates produced by the valuation model. Many estimates are revised downward or deferred for years beyond the expected achievement date when legal and works council barriers, particularly in Europe, get factored into the equation. While this is largely due to the transaction team’s basing its estimates on U.S. models, e.g., U.S. severance assumptions and “at will” employment assumptions, it is essential to gather HR input to produce the appropriate assumptions. Bidding process Important matters include the ability to gather reliable data for the deal bid and assess the key talent and retention issues likely to be encountered at integration. The four primary approaches to acquiring a target are an open auction, taking the position of preferred bidder, serving as the sole bidder in an agreed sale, and launching a hostile bid. The preferred and sole bidder methods will result in having the most precise information made available in the following areas: Financial materiality The team must focus on the key HR financial issues as they relate to the deal price. Normally, materiality limits will be identified by the deal team and will be expressed as a percentage of the deal price or a percentage of income, and issues below these limits can be left for later investigation. Level of integration versus deal size These factors dictate the extent of integration planning that is required and the amount and experience level of resources needed for the integration. Many efforts have been wasted by acquirers because of a lack of clear definition about what integration actually means and what is to be integrated. Basic questions to consider include: How will the operations be run? Have decisions been made about operating the target on a stand-alone basis versus full absorption into the acquirer or only partial integration? Addressing these issues and their consequences enables HR people to provide high- level strategic input early enough in the deal for senior management to reconsider or refine their approach. With this understanding, we will review how HR can maximize the results of due diligence investigations. These major findings relate to the numbers part of the deal, which are fed through the valuation model and into the negotiations over the purchase price, terms, and conditions. Financial: Issues Directly Reflected In the Purchase Agreement The major HR “big-ticket” items usually are: Executive employment costs These are the costs from all sources associated with terminating and retaining executives or change-of-ownership payments as a result of the acquisition. These liabilities can be large and complex to dissect, and range from three to 25 times each executive’s salary. They can be only partially recognized on the target’s books, and may call for an explicit payment of cash on deal closing. Executive costs are generally largest in the U.S. Pension liabilities These liabilities are sometimes greater than the deal price itself, particularly where major defined benefit pension plans exist, including the U.S., the U.K., Japan, Germany, The Netherlands, Canada, and countries with substantial termination indemnity programs, such as Argentina, Brazil, Italy, and Mexico. Post retirement medical liabilities These are normally unfunded, and usually a major liability in the U.S. Book accruals These issues can involve liabilities that are 20% to 30% greater than what is reflected on the target’s books. They commonly occur because the liabilities reflect the local tax laws rather than serve as accurate statements of liability. They also can include commitments to future cost increases for pension plans, vacation grants, and sales commissions. These issues arise in many foreign locations, particularly in Germany and Japan. Synergy estimates In this area, the HR synergies factored into the valuation model must be verified, as noted earlier. Other major costs may include transition services from the target when a division or subsidiary using shared or corporate services is purchased. Also included are integration of diverse or incompatible human resources information systems, such as payroll, benefit administration, and employee database systems. For employment costs, pension liabilities, post-retirement medical costs, and book accruals, it is critical to estimate the differences between the reserves or assets backing the liabilities and the true actuarial liabilities, rather than the liabilities recorded. For synergies, the critical point is to ensure that the valuation model reflects realistic and accurate data and appropriately allows for local legal issues that affect the timing and size of these synergistic benefits. With the transition and systems factors, the estimated cost of these services is the vital calculation. Legal Aspects: Using the Information In Deal Negotiations The sale and purchase agreement is the master legal contract, covering all aspects of the transaction, and is finalized after negotiations between the acquirer and target. Once the financial impact of the major HR issues identified above have been quantified, the negotiation options are to: * Adjust the bid price to fully reflect these figures; * Leave the price intact but agree to a framework for set tling any differences after the deal closes by making adjustments to the final working capital, net assets, or goodwill; * Ignore any differential if the HR issue amounts are less than the materiality limits used in formulating the bid; or * Use the differentials as leverage to get concessions and tradeoffs elsewhere in the overall negotiations. As an additional safeguard, HR people can help the legal professionals insert clear warranties and indemnities in the agreement to cover for inadequate or incomplete information in the due diligence investigations and to clarify the legal ramifications of any planned terminations in each country. Otherwise, the acquirer is liable for anything subsequently uncovered. Integration: Managing Existing Businesses And Reaching Synergy Goals “Buying is Fun…Merging is Hell!” goes the quote from an anonymous frequent acquirer. Typically, there is a short time lag, measured in months, before the results of poor integration start to show through in deteriorating financial results, productivity declines, and the loss of key employees. HR findings identified in the due diligence inquiry must be delivered initially to senior management, and thereafter to the integration team created to execute the combination of operations and people. The reason for this is that HR’s strategic advice must cover delicate people issues regarding the capabilities of not just the target’s key employees but also the acquired organization’s skills and talent. Less successful acquirers often sidestep these issues in the due diligence phase, only to see them reappear during integration. While integration strategy is critically dependent on the business issues mentioned earlier, the common “big-ticket” items affecting transition and integration include: Retention of key people The HR people should be called on to help management objectively and consistently identify, rate, and re-recruit the key people at the target. No one should make early assumptions about who will stay and who will go, since the most capable employees will be sought after by competitors and headhunters. Identifying and filling talent gaps HR professionals also should assess the talent within both organizations to both manage the integration and maintain the existing business while integration efforts are going on. If there are gaps, the HR people should help identify where they are and what needs to be done to fill them. Motivation issues Motivation to perform can affect employees at all levels as they become distracted by rumor and uncertainty over their own futures. The more senior the employee the more likely that this will happen. HR pros must help plan a substantial communication campaign to focus on maintaining or increasing the employees’ motivation to keep focused on the immediate business. This involves delivering consistent messages to not only the acquired employees but to customers, suppliers, and the capital markets so that no mixed or contradictory messages are given out. Organizational problems An assessment of the key organizational differences likely to affect integration should be done as early as possible. Common questions to resolve include: Is there likely to be a culture clash? What is its potential impact? What are the recommendations for dealing with conflict? Are there gaps in either or both companies’ will and commitment to making the deal work? Is there agreement on post-closing structure or leadership goals? Are there profound differences in the two companies because of operations, functions, and the countries in which they do business? Transition and integration HR should help identify the best people to lead transition and integration efforts. Once they are identified, the senior management should be advised as to how they can be released from their normal duties so that they can dedicate full time to the combination. If these things are not done, the integration can quickly become a series of uncoordinated efforts delegated to managers not equipped to lead the task. In summary, the senior management in charge of a major acquisition can get the most from their deal by: * Confirming up front that the people and numbers issues will be attacked together; * Demanding more from the due diligence investigations based on that joint review; * Expecting more cooperation and coordination from the transaction and integration teams; and * Appointing a seasoned HR professional to act as their strategic adviser and coordinator for the transaction and integration teams. Jim McKay and Imran Qureshi are Senior Consultants in the Chicago office of Watson Wyatt Worldwide, a human capital consulting firm based in Washington, D.C.