The M&A Buck Stops at the Board: Directors are learning fast how to screen out no-win deals

A major merger or acquisition can be a company-defining moment. The right business combination at the right price, with good execution, can reposition the company, accelerate profitable growth and shareholder return, and even change the game for an industry as a whole. But a bad deal – whether the failure is rooted in the concept, the price, or the execution – is probably the fastest legal means of destroying shareholder value. After the recent series of high-profile corporate failures, higher expectations have been placed on boards of directors to exercise their duty of care on behalf of shareholders in all matters of corporate governance. In particular, given the stakes and the risks in M&A decisions, the board’s approach to assessing major acquisitions may need to be re-examined. Some board members are ill equipped to properly assess major M&A decisions, and many boards are insufficiently engaged to provide meaningful input or pass reasonable judgment on the merits and shareholder risks associated with large transactions. This article highlights the issues relating to the board’s role in M&A and outlines how directors can be better prepared and engaged in major deal decisions. Governance Issues of the Deal As technology, deregulation, and globalization drive restructuring in almost every sector, most companies are considering mergers or acquisitions to remain competitive and spark growth. Yet the execution of “the big deal” can make or break a company. While many acquisitions have created substantial value and led to significant repositioning, an equal number have destroyed shareholder value. Directors should note that the failures are not limited to the recent rolls of companies damaged by greed, fraudulent acts, or governance disasters. In fact, most value-destroying acquisitions were executed by otherwise well-run companies. The transactions were well intended and not entirely dissimilar to numerous successful deals in the same industries. A reasonable director might agree with the logic of the deal, warn of the execution risks, and approve the transaction. In fact, reasonable directors did exactly that in most cases where the deals failed. Where did these boards go wrong? Directors, just like the CEOs and operating managers, generally are doing their best to serve the interests of the company, at times under difficult circumstances. However, large deals present extraordinary decision challenges, and usually sound judgments can be impaired in several ways. Loss of objectivity The board’s primary source of information, i.e., management, may not be objective. Senior managers, including the CEO, can lose some objectivity as they progress through various stages of the deal. While they may be objective initially, it’s natural, as a deal moves closer to being a real possibility, to get excited – about running a much larger business, about the admiration of their peers, about their legacy, and about increased compensation. When management “falls in love” with a deal, they may see only its beauty and none of its weaknesses. Even when they do not, it’s difficult to contemplate the loss of face and the effort that will have been wasted if the decision is ultimately “no go.” To make matters worse, outside advisers have their own motivations, which may come into play to varying degrees. Investment bankers may have invested heavily in the creation of the opportunity, the valuation, the structure of the deal and/or the negotiation, and may be driven to close the deal in order to recover fees for all the work they’ve done. Accountants and lawyers stand to gain substantial work for their firms if the deal proceeds, or they may simply wish to please their client and defer the business decisions to management. Insufficient knowledge Most boards have wide representation of valuable skills and backgrounds. However, there are generally only a few directors who deeply understand the industry in which the company operates, leaving most directors dependent on management for a meaningful interpretation of the business environment. By the time the board is faced with making a decision on a possible acquisition, management has rallied behind the CEO in recommending that deal. Board members usually do not get the benefit of listening to dissenting views, and unless they request an independent study – which is rare – they are dependent on management’s analysis of the opportunity. Management, with the best of intentions, may have an incorrect view of the situation or may have lost perspective along the way. Lack of time Unless the company is in crisis, most boards meet at predetermined dates chosen in advance to ensure maximum board participation by busy people. Adding special board meetings at the last minute is difficult at best given the directors’ busy schedules. For issues that arise between meetings, boards more often than not resort to conference calls, usually in the evenings. Clearly, this is not the best venue for an important decision, but on occasion an opportunity arises that requires a decision between meetings. Even when acquisitions are discussed face-to-face at a regular board meeting, time and process are often lacking. The agenda of a normal board meeting has a number of predetermined items to cover, such as reviews of the financials and the operations, reports of the various committees of the board, and unavoidable consent agenda items, all of which reduce the time available for critical items. If the chair has committed to end on time or if there are flights to catch, discussion of the pros and cons will be rushed and a decision may be made under time pressure. Group dynamics If there isn’t enough time for reflection or if the decision process is not sufficiently engaging, group dynamics can play a large but dubious role. Assume that management has done its job properly and alerted the board to the possibility of a major acquisition earlier in the year. Directors have been sent advanced reading material outlining why the acquisition makes sense, presenting some of the risks, commenting on the alternatives, quantifying the impact on earnings per share, and citing other relevant factors. When the meeting is convened, the CEO again will articulate why he or she believes that the deal is right for the company, senior managers will present their supporting views, and outside advisers will voice their support. In most cases, the process puts directors in a reactive, questioning frame of mind. It’s not easy to object in these circumstances. As questions are answered and concerns are dealt with, some respected directors may start to voice increasing comfort with the proposal. At that point, discussion will subtly shift from the “if” to the “when” and the “how.” As an implicit consensus is reached, a director may believe it’s inappropriate to raise direct objections. The remaining concerns are often expressed in the form of consenting cautions, such as, “If you proceed with this, you had better make sure that…” Surprises All of these deliberative imperfections are exacerbated if the deal opportunity is a surprise. Usually, management has alerted the board to possible acquisitions if the executives have done the right strategic planning. However, executives constantly are fielding unanticipated opportunities, such as deals that come over the transom, unexpected invitations from bankers to bid on companies up for sale, or targets that look for buyers to deflect hostile offers or shareholder pressures. Most experienced acquirers profess to have a system that allows them to respond quickly to a surprise opportunity. But the problem is that the response timetable often doesn’t leave much a window for directors to examine the proposal in the detail that it requires. Haste, although necessary to be in the race, may lead to a problem-riddled deal. The Well-Prepared Board So how does a board meet its duty of care on M&A? The board will be most effective in its role in major deals if it’s prepared for the deals that may be presented and educated on industry restructuring issues and opportunities. No surprises In a well-governed public company, an acquisition usually should not come as a surprise to the board, although some fast footwork on suddenly developing opportunities is inevitable. The board should be aware of the company’s overall growth strategy, which would move forward only after its endorsement. But the directors should be specially prepped if the company is operating in a restructuring industry and it should be fully cognizant of the potential for mergers, acquisitions, divestitures – or even an outright sale – of the company because of the competitive dynamics. More important, the board should be better prepared to recognize the right deal when it’s presented. Directors must ask: * Why is the industry changing? * What is the vision for the industry and the company’s intended role in the field? * How will value be created as the industry restructures? * What are the criteria for the right deal? * What are the alternatives to a sale or acquisition? In rapidly evolving industries, it may be too much to expect that all directors have sufficient time and industry understanding to stay abreast of all developments. As a result, some boards have established a strategy committee to zero in on industry dynamics and competitive positioning on an ongoing basis. Knowing the risks and imperatives For many directors, the lessons of earlier acquisition booms – e.g., the conglomerations of the 1980s and the consolidations of the 1990s – have been hammered home through personal experiences. They instinctively will look for “hard” synergies, such as cost-cutting opportunities and increased revenues, and pose excellent questions about the financials and the management team of the target. However, the basis for value creation in 21st Century restructuring often goes beyond these experiences and their universal lessons. In a restructuring industry, a greater understanding of the company, the industry, the competitors, and the target may be required to properly assess the logic of the deal, the value, and the risks, including the risks of not acquiring. If there is a strategy committee in place, it can be a useful resource to educate other directors at the time of a major deal. Decision Process The board’s consideration of a major deal should be put on virtually the same footing as if it were dealing with a major crisis, because an acquisition that changes the company’s size, strength, or configuration is a similarly company-defining moment. Throughout the process, the board must remain in its governance role and avoid re-crafting the strategy, the deal, or the implementation plan. However, given the potential consequences, a thorough review of management’s proposal for an important deal is entirely appropriate. The process for deciding on the proposed deal should ensure that directors have sufficient depth of understanding, adequate time for reflection, and the opportunity for input to fulfill their responsibilities to shareholders. An in-depth review should follow a strict procedural menu. Setting the table Assuming that the board is already aware that a large deal may be part of the company’s strategy, the proposal should be brought forward on a preliminary basis early, to “set the table” and agree on how it will move toward review and approval. The CEO should arrange for a briefing to cover the basics of the transaction, highlighting the deal logic, the financial and competitive stakes, and the risks. Limited discussion should take place at this session, but a final decision should be set for later. Rules of engagement Terms of reference for the review of the deal should be determined at the initial meeting or communicated to the directors shortly thereafter. They should highlight the specific aspects of the deal that warrant attention by the board. Deal committee While it would be preferable to have the full board review a major deal in detail, that might not be practical. In fact, having too many people do too much could create inappropriate constraints on the review process. More desirable is the formation of an ad hoc deal review committee, including an independent chair. If needed, an independent consultant should be hired to help facilitate the review. The committee should be an extension of the strategy committee, if one exists, and at minimum add representatives of the audit committee and the human resources committee, because most acquisitions involve issues in these areas that could make or break the deal. The board or the deal review committee should examine the critical aspects of the deal identified in the terms of reference. For a large, complex transaction, the board or committee may have to meet several times to review: * Logic of the deal versus company strategy; * Key sources of value-creation potential; * Architecture of the combined organization and key executive assignments; and * The integration plan as well as its metrics The board or deal review committee should have access to supporting studies and the experts the company employed to analyze specific issues to ensure a careful and unfiltered interpretation of the facts and analyses. The final step involves a full board review of all deal details, consideration of alternative scenarios that will “stress test” the deal and implementation plan, and input based on the M&A experiences of all directors to assess the risks of the transaction from a shareholders perspective. This would ideally take place in a workshop setting. The deal should be the only item on the agenda, and the pre-meeting material and the process should be designed to ensure thorough scrutiny of the key issues and give-and-take questions and discussions among all board members. To reiterate, a large acquisition is truly a company-defining moment. Given the substantial shareholder value at risk, it also can be a defining moment for the board. In the worst case, often because of a seemingly convincing presentation by management with only a short time allowed for independent consideration, a board decision is reached too quickly, with insufficient reflection, challenge, and advice. Statistics suggest that in these circumstances the board may just as well flip a coin as to whether shareholder value will be created or destroyed, with 50-50 odds on either outcome. In the best case, the board is well prepared and at least some of the outside directors have developed a deep understanding of the industry’s evolving structure. The entire board is engaged in a decision process commensurate with the stakes. Directors talk to management, independent advisers, and each other, asking the right questions, providing considered and independent perspectives, and ultimately making a decision that they are confident is in the best interests of shareholders. Ken Smith is Managing Partner of SECOR Consulting, a Toronto-based consultancy focused on corporate development. (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com