Touching the intangible How to fire up your intangible capital to reap maximum M&A deal value One of the constants amid the on-going economic chaos of the last few years is a continuing interest from business leaders in mergers and acquisitions. Successive falls in global stock markets mean that, for those companies with a strong balance sheet, growth through acquisition is an achievable strategy. >>
Dealmakers who analyze similarities and differences on key intangibles while prospecting for targets or at the due diligence stage will create more shareholder value than those who don t. But how can you assess an asset that has no physical form? We believe that the answer lies in identifying those elements that have the most significant impact on the value of intangible capital. While it is vital to close the gap between the intangible capital of the target and acquirer companies, management needs to devote its attention to the core drivers of intangible capital, rather than to intangible capital itself. Dr. Andreas Raharso Director of Hay Group s Global R&D center for strategy execution
1 Contents Opportunities amid the chaos 2 Grasping the invisible 4 Constant state of flux time, value and volatility 6 Leadership alignment a meeting of minds 8 Cultural alignment agility and risk-taking 10 The broader context the M&A life cycle 12 2011 Hay Group. All rights reserved
2 Touching the intangible: how to fire up your intangible capital to reap maximum value Opportunities amid the chaos One of the constants amid the on-going economic chaos of the last few years is a continuing interest from business leaders in mergers and acquisitions (M&A). Successive falls in global stock markets mean that, for those companies with a strong balance sheet, growth through acquisition is an achievable strategy. The first half of 2011 saw a 22 percent increase1 in global M&A deal values compared with the same period a year earlier and, according to the latest figures, hostile takeovers are particularly prevalent, recently reaching their highest monthly level for almost two years. Source: Dealogic market statistics, June 2011 1
3 Focusing on intangible capital will pay big dividends in the longerterm through increased shareholder value. But buyers should beware. M&A deals are inherently risky and anyone planning a merger or acquisition needs to ensure that their substantial investment pays off. One of the most serious stumbling blocks is that typical methods of deal evaluation (based on GAAP 2 ) are flawed because neither investors nor their advisors evaluate the intrinsic value of intangible capital the non-monetary assets that cannot be seen, touched or physically measured, and so are hard to quantify or value, but which include most of the key drivers of deal profitability. Academic research 3 and Hay Group s work with clients over the past 10 years have repeatedly demonstrated the strong link between the intangible capital of a company and the future business performance of the merged entity. Hay Group s global R&D center for strategy execution completed a global research study in collaboration with Harris Interactive in the first quarter of 2011. Its aim was to identify elements of intangible capital that have the greatest impact on post-merger integration and the ultimate success of M&A transactions. The research found that: Business executives do not spend enough time assessing the value and fit of a target s intangible capital in the early stages of a transaction. Most M&A failures can be attributed to this lack of attention Those who do spend time assessing intangible capital fail to identify the risks attached to it. Consequently, they are unable to mitigate these risks effectively during post-merger integration The value of intangible capital is not fixed but fluctuates throughout the deal process. Those who have not identified the risks or planned to manage them pro-actively often see a corresponding fall in shareholder value Maximizing intangible capital is greatly enhanced by two key drivers that allows for better management of the intangible capital: leadership and cultural alignment Focusing on these two drivers not only improves the transaction success, but also simplifies the process of identifying potential targets and increases the effectiveness of due diligence activities. Focusing on deal-related intangible capital will pay big dividends in the longer-term through increased shareholder value. In order to help executives understand where to place their bets on intangibles and determine where to focus their attention, Hay Group has taken a closer look at which elements have the greatest impact on integration success. 2 Source: GAAP: generally accepted accounting principles; a collection of rules, procedures and conventions that define accepted accounting practices; includes broad guidelines as well as technical procedures 3 Source: Galbreth, 2005, Green & Ryan, 2005 2011 Hay Group. All rights reserved
4 Touching the intangible: how to fire up your intangible capital to reap maximum value Looking at the intangibles today is what will make the deal valuable tomorrow. David Derain Global M&A Director Hay Group About the research Over 220 senior executives were interviewed worldwide, each with experience in the past three years of large M&A transactions (average annual post-merger sales turnover of $1 billion or more). Respondents were drawn from a pool of business leaders including CEOs, CFOs, strategic business development and other M&A decision-makers and experts. The research covered a range of sectors, including: financial services; life sciences; FMCG; oil and gas; manufacturing; technology; media and telecommunications. We used Structural Equation Modelling (SEM) to analyze and test causal relationships and identify the key drivers of post-merger integration success from selected elements of Hay Group s intangible capital model illustrated in figure one. Grasping the invisible During the M&A process most companies and their advisors focus only on assessing the value or fit of tangible assets, such as access to new products or clients. All too often, companies ignore the intrinsic value of the target s intangible capital, which accounts for up to 75 4 percent of the value of any organization. Intangible capital covers three core areas (figure one): Organizational capital, such as management processes and organizational culture Relational capital, such as brand position, customer management, partnerships and networks Human capital, including knowledge, skills, leadership and employee engagement. It is vital to assess these intangible elements in addition to tangible assets as early in the deal lifecycle as possible, as doing so helps to identify and manage post-merger integration risks. According to research carried out by Hay Group 5, two-thirds of executives believe that an increased and earlier focus on intangible capital during the M&A process would have improved the success of their mergers. Furthermore, just over half of executives say that failing to audit non-financial assets such as governance, brand image and client relationships increases the danger of making the wrong acquisition 6. 4 Source: Ocean Tomo Research LLC 5 Source: Hay Group global research, The silver bullet of success, 2010 6 Source: Hay Group European research, Dangerous liaisons, 2007
5 Two-thirds of executives believe that an increased 5 and earlier focus on intangible capital during the M&A process would have improved the success of their mergers Figure one: Hay Group s intangible capital model Organizational capital Culture and market convergence Shared values, attitudes, beliefs and customs Governance Aligned business processes Clear and effective governance Agility Capacity to manage internal business transformation React quickly to new market demands Communication and teaming Willing to share information Simple channels/information flow Energy and clarity Communicated and understood business strategy Clear direction for people to mobilize their energy Organizational structure Effectiveness of the organization to deliver the strategy Tacit know-how and information Willingness to innovate Unpatented intellectual property Relational capital Brand External and internal image and reputation All that touches the customer experience Client intimacy Knowledge of the client Market coverage Client loyalty Client satisfaction Low turnover and high rate of referrals External networks Strong relationships with suppliers, distributors and other partners or centers of influence Internal networks Effective internal communication High impact cross functional teams Enabling relationships across organizational and geographic boundaries Human capital Leadership Clear vision established and communicated Conflicts of interests coordinated and balanced for all stakeholders Team commitment and employee recognition Employees High potentials identified, developed and rewarded Demonstrate strong commitment and loyalty and valued by the organization Development and management New skills, knowledge and leadership styles acquired with training and coaching Engagement Employee empowerment and degree of attachment to the company Productivity Efficient management of costs, resources and time 2011 Hay Group. All rights reserved
6 Touching the intangible: how to fire up your intangible capital to reap maximum value To increase deal value, it is crucial for business leaders to understand and manage the dynamic nature of intangible capital. Dr. Andreas Raharso Director of Hay Group s Global R&D center for strategy execution Constant state of flux Executives often assume that intangible capital is static and retains its value throughout the lifecycle of the deal. In reality, intangible capital fluctuates in reaction to internal and external change. Hay Group s research has found that the value of intangible capital typically decreases during the course of a transaction. As illustrated in figure two, below, its value falls most sharply during post-merger integration. A number of analysts have estimated that between 50 and 90 percent 7 of pre-tax earnings are dependent upon intangible capital. A target firm s intangible capital is usually at its strongest in terms of value and stability at the start of a transaction. However, as the market hears rumors of a potential buy-out, intangible capital such as client loyalty, brand image and employee commitment begins to destabilize, decreasing with each step of the pre-deal process. By the time the deal completes, intangible capital is at its most volatile and the proportion of shareholder value at risk is at its greatest. This is why so much of the ultimate success of any deal hinges on the willingness and ability of managers to look after the intangible capital before, during and after the transaction. But managers, themselves a key element of intangible capital, are not always so willing to play their part. Some 45 percent of the executives we surveyed had opposed the mergers that they experienced, and 30 percent said this was an active opposition 8. Figure two Healthy EBITDA value Intangible capital value The success of M&A largley depends on how buyers manage intangible capital over time Unhealthy Timeline of M&A Strategic planning Target screening Due diligence Pre-closing Post-merger integration Source: Professor Baruch Lev, Stern Business School New York University 7 Source: Saikh 2004 8 Source: Hay Group European research, Dangerous liaisons, 2007
7 Quantifying the intangible Dealmakers who analyze similarities and differences on key intangibles while prospecting for targets or at the due diligence stage will create more shareholder value than those who don t. But how can you assess an asset that has no physical form? We believe that the answer lies in identifying those elements that have the most significant impact on the value of intangible capital. Dr. Andreas Raharso, director of Hay Group s Global R&D center for strategy execution, makes this point: While it is vital to close the gap between the intangible capital of the target and acquirer companies, management needs to devote its attention to the core drivers of intangible capital, rather than to intangible capital itself. Hay Group s extensive research suggests that the value of intangible capital depends heavily on the extent of alignment of the leadership of the two companies involved, and on the alignment of their respective cultures. These two elements can make or break any M&A deal. Figure three: How intangible capital creates value Drivers Leadership Culture 1 Intangible capital Organizational capital Relational capital Human capital 2 Risk and return Shareholder value Value at risk 3 Intangible capital value creation pathway 2011 Hay Group. All rights reserved
8 Touching the intangible: how to fire up your intangible capital to reap maximum value The time to appoint a new leadership team takes an average of 74 days resulting in almost two and half months of leaderless operations; time too valuable to lose. 9 Leadership alignment: a meeting of minds One of the most common M&A deal breakers is the lack of alignment among leaders on both sides of the deal. Common beliefs shared by the leaders of two merging firms will lead to a consensus, which in turn increases the chances of cost and growth synergies. Early in the post-merger integration, executives should take the time needed to align their individual and collective expectations around the answers to key questions, such as: What should the brand position be? Who owns the client relationships and how should client relationships be managed? On what basis should the new company compete for market share? What is the new governance model? Will decisions be made only in the corporate center, or devolved throughout the enterprise? How do we need to change business or operating models to deliver cost synergies? How can innovation and R&D centers be combined to help drive competitive advantage? Equally important is leadership decision-making behavior. Two-thirds of respondents to Hay Group s M&A pulse surveys said that slow decision-making was a key barrier to effective integration. When decision-making roadblocks occur, leaders need to display the ability to overcome these situations and quickly. In order to show colleagues and counterparts how the business will be run, right from the start leaders need to be clear about: Who is responsible for which decisions How decisions will be made when executives cannot agree What approach will be used to analyze decision-making obstacles Finally, post-merger integration creates uncertainty for customers and employees alike. Open and honest communication from leaders can help address this. The research findings reinforce the idea that leaders at every level should relay information accurately and in a timely manner. However, leaders have a natural tendency to protect staff morale, productivity and customer service by delaying communication or glossing over difficult issues, such as staff redundancies. 9 Source: Hay Group European M&A research, Dangerous liaisons, 2007 10 Source: Ibid 11 Source: Ibid
9 Figure four: The impact of a new leadership team Companies take too long to get a new leadership team in place: On average 74 days Perception of value added by leaders 50% 19% For executives that did put in place a new leadership team, 50 percent of respondents agreed that it had unlocked a significant amount of value. 10 Old leadership New leadership Figure five: Productivity and the impact of a new leadership team New leadership team in place in less than 30 days Productivity Delayed leadership team confirmation Executives that prioritized a leadership capability review were four times as successful in achieving their merger objectives. 11 Due diligence Deal announced Post-merger integration Time 2011 Hay Group. All rights reserved
10 Touching the intangible: how to fire up your intangible capital to reap maximum value Cultural alignment: agility and risk-taking Merging firms that have comparable organizational cultures are more likely to understand and support each others actions and decisions. Leaders who take this one step further during post-merger integration and create a single, unified corporate culture also reap tangible benefits: a more unified culture delivers better company performance in terms 12 of earnings, sales and market share. However, our research suggests that executives targeting companies for merger or acquisition typically focus their due diligence efforts on the wrong issues. When asked if they conduct cultural analysis during the pre-deal phase, only 38 percent of executives surveyed said they did. 13 And while executives are not blind to the value of carrying out a culture due diligence study, nearly 60 percent 14 said they struggled to obtain information about the culture of the target company. Consequently, the majority (54 percent) admitted that failing to audit business culture increased the danger of making the wrong acquisition. Our research looked more deeply into what makes culture such a strong driver of merger performance to identify two key elements: attitudes to risk-taking and organizational agility. M&A is intrinsically a risky business but our research shows that firms with the same relative tolerance to risk-taking are better able to deliver merger objectives. Culturally, it is imperative that both firms display a common positive appetite for risk-taking so that critical actions can be taken. Driving through cost and growth synergies requires bold decisions, and business leaders cannot afford a risk-averse culture. We have also found that an agile culture is more likely to win the M&A game. During a merger, executives tend to consult widely to ensure everyone s interests are considered before decisions are made, in an effort to display cultural sensitivity. But not making any decision is a decision in itself, and one which could jeopardize M&A success. In an agile culture, leaders understand the impact of timeliness and decisions are made as quickly as possible, on the basis of sound information, judgement and experience. 12 Source: Very, P. Lubatkin, M., Calori, R., & Veiga, J. (1997). Strategic Management Journal 13 Source: Hay Group global research, The silver bullet of success, 2010 14 Source: Hay Group global research, The silver bullet of success, 2010 Driving through cost and growth synergies requires bold decisions and business leaders cannot afford a risk-averse culture
11 Example of Fit Survey output illustrating a high-risk deal fit Risk tolerance/ aversion Customer focus 80 70 60 Quality Company A Company B 50 40 Individual autonomy 30 20 10 Operational efficiency 0 Learning and development Innovation Collaboration Long-term horizon Social responsibility Intangible drivers Hay Group s research suggests that the value of intangible capital depends heavily on the extent of alignment of the leadership of the two companies involved, and on the alignment of their respective cultures. Leadership alignment There are three main features to leadership alignment: Forthright speaking the ability of individual executives to demonstrate open, honest and timely communication Decision-making behavior the speed of decision-making and the ability to overcome blocked situations Aligned views the extent to which leaders views on intangible capital (such as governance, operating model and organizational structure, client management and other management processes) differ. Cultural alignment There are two elements that make culture a strong driver of merger performance: Calculated risk-taking if both organizations encourage a culture of risk-taking, important action plans can be fulfilled in times of uncertainty Timeliness of decisions and actions a merger is more likely to succeed if an organization is agile and employees understand the impact of timeliness on their decision-making. 2011 Hay Group. All rights reserved
12 Touching the intangible: how to fire up your intangible capital to reap maximum value The M&A lifecycle A successful M&A strategy depends on application of the right insights: first to identify the best transaction; and second, to create value as quickly as possible. Having a clear understanding of what you are buying and how it fits with your existing company through intangible capital analysis will help you achieve both of these goals. Paying close attention to intangible capital during the three phases of a M&A transaction initial screening, due diligence and post-merger integration brings critical and valuable insight to the deal, maximizing the chances of success at every stage. During the initial screening, executives who invest time and effort in reviewing intangible capital and assessing the degree of risk will make more informed decisions about the best buys available. During the due diligence process, a careful assessment of the elements of intangible capital highlight the potential risks and gains of the deal. And this groundwork lays the foundation for the effective management of intangible capital in the months following the deal. Executives who pay active attention to intangible capital are more likely to create the right conditions for deal success and to deliver significant shareholder value from their acquisitions. This will be particularly valuable to their organization in an unpredictable economic environment where growth is increasingly dependent on effective strategic decision-making.
Leaders to do list priorities for intangible capital management Recognise that intangible capital value fluctuates and actively manage it at every step of the deal Leadership actions including honest and open communication are key activities in ensuring intangible capital is properly managed Get the top team in place quickly and clearly assign roles and decision-making rights. Be really clear about how, when and by whom decisions will be made Prospect for companies that are similar in organization culture and management style Take the time to argue out the key business and operational issues such as brand positioning, governance and the operating model Make sure everyone is committed to creating one single, unified culture
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