More clarity, less bias - better mergers

An objectives hierarchy (see figure) is an excellent tool for displaying the primary, fundamental, and means objectives associated with an activity, and how those objectives relate to one another.

It is also critical to recognize when the information you gather during due diligence is indicating that the merger is unlikely to accomplish your objectives. Mergers (and indeed, most major strategic initiatives) gain a powerful momentum in a short period of time. Maintaining objectivity as data pours in and analyses are conducted requires more discipline than many companies can muster. There are several bias traps to avoid:

• People - all people - preferentially seek out and believe information that tells them what they want to believe. In M&A activity, this leads to over-emphasis on data that supports the merger, and discounting, discrediting, rationalizing, and sometimes even failing to discern information that calls the transaction into question.
• M&A teams often fall into Groupthink. This occurs when it becomes socially difficult or impossible for team members to openly question the team's direction or strategy. Those who do are labeled "non-team players" and are often ostracized.
• Motivational biases can creep in. If senior executives are compensated in part on the basis of revenues or profits, larger revenues and profits will result in higher executive compensation, regardless of whether those larger revenues are the result of improved business practices or simply the merging of two companies into one.
• Sunk costs cloud people's judgment. These costs may be primarily in the form of manpower - the months of time that a team of high-powered company employees have spent dedicated to investigating and progressing the merger. It becomes ever more difficult to pull the plug on such an activity. It's important to remember that all decisions (including decisions to continue) should be made from a point-forward perspective with no consideration of what has happened up to that time. It is also worth remembering that until you actually sign on the dotted line, you can always stop. "There's no turning back now" is a phrase that should be banished from M&A teams.

Having someone play the role of facilitator, whose responsibility is to ensure that a good decision process is followed, can help the team to avoid these pitfalls. However, if this person is a full member of the team, he or she must be careful not to fall prey to the same biases as the other technical personnel.

Decision quality also suffers because of another characteristic of mergers and acquisitions: they usually become "go/no go" decisions. One of the most important features of a good decision-making process is that a variety of strategic alternatives is considered. This may or may not be the case early in the merger process - it will depend on the number of viable acquisition candidates. But once a candidate is selected for detailed investigation, the decision usually is reduced to a yes/no basis. This is a problem because while the team will give extraordinary amounts of thought to what the company and the world will look like post-merger, they usually give very little thought to what the company and the world could look like if they decide to walk away. If they do think about it, it's probably a simple variation on the status quo, plus an air of failure due to their inability to make the merger happen.

It is important not to fall into this trap. Senior management and the team should constantly challenge themselves with the question, "If we decide not to pursue this merger, what would we do? Make a major investment in our own operations? Expand into a new region? Increase the dividend?" In order to spur creative thought in this arena, it is often helpful to ask, "Imagine that, for some reason, we are forbidden from pursuing this merger; it is completely off the table. What would we do?"

Finally, enormous uncertainty pervades any proposed merger. No one knows how well the two cultures will mix, how much redundancy will actually be weeded out of the combined system, whether the market for the combined company's products will expand or contract, etc. In order to make an informed decision, senior management must have a good understanding of the range of possible outcomes associated with the merger (and the range associated with a decision to call the merger off).

The key uncertainties inherent in the business, the companies, the market, etc. must be characterized and modeled appropriately. This usually means taking ranged estimates for key input parameters, and using them to generate ranges for key outputs of interest (including pro forma cash flows). This will provide a much richer understanding of what is invariably an extremely complex situation.

This approach - usually called Decision Analysis (DA), although its principles cover far more than just analysis - is spreading across industries, but it is particularly effective in industries in which large capital investments must be made in the face of broad uncertainty. This is why the oil and gas industry was one of the early adopters of DA.

The basic principles of Decision Analysis are simple:

• Have a clear understanding of your objectives and the tradeoffs between them.
• Consider a wide variety of strategic alternatives.
• Evaluate those alternatives against how likely they are to help you to achieve your objectives (and include appropriate characterization of uncertainty in the analyses).
• Use the insights gained through these analyses to develop a better strategy than any of the ones initially considered.

The steps may be simple to describe, but good implementation takes practice. Done well, DA gives the decision maker as clear a picture as possible of both quantifiable-but-uncertain financial forecasts and the more qualitative issues of corporate objectives and human biases. This has enormous value, especially when considering a move as momentous as a merger or acquisition.

Senior decision makers deserve nothing less.

ABOUT THE AUTHOR

Patrick Leach has more than 30 years' experience in industry and consulting, ranging from New Orleans to Indonesia, Scotland, and now Houston. He joined Decision Strategies Inc. in 2004 as a senior consultant, and became CEO of the company in August of 2011. He is the author of Why Can't You Just Give Me the Number? - An executive's guide to using probabilistic thinking to manage risk and to make better decisions. Leach has a BS degree from the University of Rochester and an MBA from the University of Houston. He is a Charter Fellow in the Society of Decision Professionals and holds memberships in the American Association of Petroleum Geologists, Society of Petroleum Engineers, the Decision Analysis Affinity Group, and the Institute for Operations Research and Management Science.