Post-merger adaptation of TMT in
cross-border M&A’s
Name: Jeroen van Pagee Course: Master Thesis Student no: 10265740 Supervisor: Johan Lindeque Date: 30 August 2016 Second reader: Ilir Haxhi
ABSTRACT
Research has shown that 65-85 percent of all mergers and acquisitions (M&A) fail. And yet 80% of all FDI still consists of M&As. A managerial view is adopted, through agency and stewardship theory lenses, to study the role of acquired companies’ managers in the due diligence process of cross-border M&A’s and their changing roles in the post merger adaption phase. I argue that managers are either compliant (stewardship) or opportunistic (agency) in the financial, human and legal stage of the due diligence process, and therefore have no problem adapting (stewardship) or problems adapting (agency) and the newly merged company. Nine in-depth interviews are conducted, with top managers of 4 target firms in cross-border M&A’s, showing a clear attitude difference, between agency- and stewardship perspective managers, but not fully supporting the working propositions on the agency theory managers. The stewardship theory managers were compliant in all cases, as expected, thus supporting the working propositions, but there was no clear sign of opportunism in the agency perspective managers actions, which resulted in no support for the working propositions.
Table of contents
Front page
1
Abstract
2
Table of contents
3
1. Introduction
5
2. Conceptual background
2.1 Introduction
7
2.2 Agency and Stewardship Theory
8
2.3 Agency and Stewardship perspective of TMT
9
2.4 TMT roles in M&A
12
2.5 Due diligence process in M&A
13
2.6 TMT role and value creation in M&A Due diligence
21
2.6.1 TMT Post merger adaptation from an agency perspective 23
2.6.2 TMT Post merger adaptation from an stewardship persp 24
2.6.3 Principal Agenct and Stewardship models in comparison 25
3. Method
3.1 Introduction
28
3.2 Research design
28
3.3 Qualitative case study
28
3.4 Selection of cases
29
3.5 Data gathering and analysis
29
3.6 Interviews
30
3.7 Interview analysis
31
3.8 Conclusion
31
4.1 Introduction
32
4.2 Agency-Stewardship Profiles of the respondents
33
4.3 Agency perspective
33
4.3.1 Financial due diligence from an agency perspective
35
4.3.2 Human due diligence from an agency perspective
37
4.3.3 Legal due diligence from an agency perspective
38
4.4 Stewardship perspective
39
4.4.1 Financial due diligence from a stewardship perspective
39
4.4.2 Human due diligence from a stewardship perspective
41
4.4.3 Legal due diligence from a stewardship perspective
43
4.5 Comparison between agency and stewardship theory
43
4.6 Additional findings
45
5. Conclusion and Discussion
5.1 summary of key findings
48
5.2 Practical Relevance
48
5.3 Theoretical Relevance
49
5.4 Future research
49
5.5 Limitations
49
6. References
50
7. Tables and figures
Appendix A
57
Appendix B
58
1. Introduction
M&A’s are perhaps the most important phenomenon of Western style capitalizations (Schenk, 2007). Still 70% of M&A’s fail (Palmer, 2005), and it has been a hot topic for researchers to find what exactly determines the success of a merger (Selden & Coldin, 2003). Explanations such as overvaluing the target company (Jensen, 2004), cultural differences (Hofstede, 1980) and managerial hubris (Hayward & Hambrick, 1997) are thoroughly researched, and more and more there is a focus on a thorough due diligence process to prevent any surprises post merger (Perry & Herd, 2004).
This thesis argues that the role of target firm managers during the merger and acquisition (M&A) process, specifically during the due diligence phase, and the changed role in the integration phase, will make the post merger adaptation of the manager harder for agency perspective managers, than for stewardship perspective managers.
Research question
Schenk (2008) states that most research done in the field of mergers and acquisitions has focused on prescriptive issues, rather than on explanatory ones. The goals of this research is to broaden the research field of mergers and acquisitions by describing the pre-acquisition stage, and in particular the role that the due diligence process plays in this stage. The research question of this thesis will be:
How does the managers perspective (agency vs stewardship theory) effect the post-merger role change of the managers in the Top Management Team, considering different areas of due diligence?
The thesis begins with an introduction to the context of the research and then provides a review of the literature on mergers and acquisitions, with a focus on the pre-acquisition stage, to develop a set of working propositions and a conceptual model of the role of managers in the due diligence process. After explaining the methodological choices made for this qualitative multiple-case study using in-depth semi-structured interviews, the results of the fieldwork are presented and the role of managers in a due diligence process is analyzed through the lens of the agency theory
and the stewardship theory. The thesis concludes by with a discussion of the findings and suggestions for future research.
2. Conceptual Background
2.1 Introduction
To give an answer to the research question, a conceptual background is needed to use as a framework during the research. The conceptual background chapter defines the core concepts for the study and reviews the research that has been conducted in this research-area.
First the distinction is made between agency- and stewardship theory, and how these theories apply on Top management teams of the target company in a merger. Then a general review is given on TMT roles in M&A, followed by a thorough review of M&A’s in general, the due diligence process and the different types of due diligence. This is followed by building a theoretical model, which involves 7 working propositions, linking the role of TMT’s value creation in M&A Due diligence to the agency and stewardship theory.
In this research the concepts of mergers, as well as acquisitions are often used. Although the concepts of mergers and acquisitions are not entirely the same, they often used interchangeably. The definition of a merger, given by Gugler et al (2002, p.10) is “a transaction where more than 50% of the equity of a target firm is acquired”. By this definition every merger is a (partial) acquisition, but not every acquisition is a merger. In this research this definition of mergers will be used as a definition for both concepts and the terms mergers and acquisitions are used interchangeably.
2.2 Agency and Stewardship Theory
The first important part of literature to elaborate on is the view of the manager takes two prominent different views; the agency theory and the stewardship theory.
The agency theory argues that there is a tension between interests of the principal (the shareholders) and the agent (the manager) because the manager has a personal interest apart from creating value for his shareholders (Donaldson & Davis, 2001; Davis et al 1997) ‘shirking and indulging in excessive perquisites at the expense of shareholder interests’ (Donaldson and Davis, 2001). Stewardship theory is a reaction on the agency theory. Where, following agency theory, managers have an individual interest, with stewardship theory the interests of the manager are intrinsically aligned with that of the principals. Managers are good stewards that commit to organizational decisions, and not, as the agency theory argues, opportunistic agents (Donaldson, 1990; Davis et al, 1997).
The difference between agency- and stewardship theory lies primarily in the assumptions about human nature (Davis et al, 1997). This determines the way in which managers value their own interests and those of the company. Where agents pursue their own interests before those of their shareholder, the steward will put the interests of the shareholder first. Being in a principal-agent relationship depends on two aspects:
“Managers choose to behave as stewards or agents. Their choice is contingent on their psychological motivations and their perceptions of the situation. Principals also choose to create an agency or stewardship relationship” (Davis et al, 1997:43).
Davis et al (1997) conducted a scale to measure a relationship, being stewardship- or agency-based. This research will use this scale to divide the respondents between agents and stewards.
Agency theory Stewardship theory
Model of man Economic man Self actualizing man
Psychological mechanisms
Lower order/economic needs (psychological, security, economic
Higher order needs (growth, achievement, self-actualization)
Motivation
Extrinsic Intrinsic
Social
comparison Other managers Principal
Identification Low Value commitment High value commitment
Power Institutional (legitimate,
coercive, reward)
Personal
(expert/referent)
Situational Mechanisms Management
philosophy Control oriented Involvement oriented Risk orientation Control mechanisms Trust
Time frame Short term Long term
Objective Cost control Performance Enhancement
Cultural
differences Individualism Collectivism
Power distance High power distance Low power distance
Adapted from Davis et al (1997)
2.3 Agency and Stewardship Perspective of TMT
With the separation of ownership control, the tension between agent and principal has led to a lot of research concerning agency theory (Muth and Donaldson, 1998). The aim of the shareholders is to maximize the value of the company, while managers can have different goals, such as maximizing their own value (Donaldson and David, 2001). The underlying ‘model of man’ is that of a self-interested actor rationally maximizing his/her personal gain (Donaldson and Davis, 2001). The loss of value that results from this discrepancy is labeled as ‘agency costs’ (Muth and Donaldson, 1998). The field of organizational economics is concerned with the agency theory and the way to prevent managers from ‘opportunistic behavior’ (Donaldson and Davis, 2001).
Donaldson and Davis argue that there are alternatives to the ‘model of man’. They describe this the following way:
“Here organizational role-holders are conceived as being motivated by a need to achieve, to gain intrinsic satisfaction through successfully performing inherently challenging work, to exercise responsibility and authority, and thereby to gain recognition from peers and bosses” (Donaldson and Davis, 2001:51).
This is the model of man seen from a stewardship perspective. There are no agency costs involved because the manager’s objective is to maximize value for his shareholders, instead of making himself the first priority.
In the agency theory, the principal can limit divergence from his/her interests by establishing appropriate incentives for the agent, and by incurring monitoring costs designed to control opportunistic action by the agent (Hill and Jones, 1992). These incentives are often in the shape of company shares to align the financial goals of the agent and the principles such as (cheap) shares in the company (Donaldson & Davis, 2001).
In an M&A context, the objective of a company is to maximize wealth through the merge of the 2 companies. The acquiring company tries to maximize wealth by buying the target company for the least amount of cost and maximizing synergy between the merging companies. Looking at the role of the Top management team of the acquiring company, Danbolt (2004) argues that ‘cross-border acquisitions may not only be driven by shareholder wealth maximization objectives, but may also be a result of agency conflict, with bidding company management aiming to maximize their own utility, to increase their power, status, and salary’.
The same thing holds for the managers of the target company, maximizing the values of their own shares by maximizing the selling price of the company. For the shareholder of the target company, the ‘maximizing wealth’ objective is simply selling the company for the largest value possible, in other words they want the highest possible price for their shares. The research on this topic suggests that shareholders benefit significant from these mergers; the literature on domestic mergers and acquisitions in the UK as well as in other markets invariably indicate that
large abnormal returns accrue to target company shareholders’ (Danbolt, 2004). Danbolt (2004) found that during the time around the announcement of the bid, target companies in the UK increased significantly, in terms of returns, in both domestic (18,76%) and cross border (19,60%) acquisitions. These results were also found in the US (Danbolt, 2004). But the difference for shareholders is even greater; the return that the shareholders gain in cross-border acquisitions is 30,71%, against 20,64% in domestic acquisitions (Danbolt, 2004).
The agency theory is also applicable to relationship of management and shareholders in the target company, although I propose a slightly different view. As in the acquiring company the manager’s first interest is to maximize his or her own value. He can do this by selling at the highest price as possible. This objective is in alignment with that of its shareholders. The real agency problem though, lies in the friction between the new and the old function of the manager in the target company, and afterwards in the merged company. By selling the company at a high price, the manager maximizes his own wealth, but when holding a position in the new merged company, a role change takes place, whereby the objectives of his ‘new’ shareholders is to maximize their wealth, while the manager just destroyed as much wealth as he possibly could. The real agency problem is, in this case the relationship between agent (old) and principal (new).
Through a stewardship lens, as mentioned, the manager puts the companies’ interests before his own by nature, so there are no agency costs. Better said the ego of the manager and the company are merged (Donaldson and Davis, 1992). In a merger this leads the following situation; the objective of the target companies’ shareholders is to create value. This is done by getting the largest price premium possible; up to this point, the situation is in line with the agency theory. Because the managers’ objective is aligned with that of the target company, he tries to maximize the price premium, without maximizing his own value.
In an international context, the agency problem is thought to be an even larger problem, because of the larger geographical and cultural distance. Danbolt (1995) finds overseas bidding companies to suffer negative abnormal returns, indicating that overseas bidders pay too high a price for their UK targets. Antoniou et al (2008) also found that on average acquiring companies pay 68% premium. One of the
determinants of this premium is geographical (and cultural) distance. In the banking sector Shawky et al (1996) found that in the US, when the merging companies where from different states, the premium would be higher. Moeller & Schlingemann (2005) found a similar result in an international context. Cross-border M&A’s had a much lower return for shareholders than domestic M&A’s, which they link to the higher paid premium. Anoniou et al (2008) has argued that the higher the premium paid, the greater the probability of a value-destroying M&A deal. In summary, the larger the geographical and cultural distance, the higher probability of failure.
2.4 TMT Roles in M&A’s
The top management team (TMT) plays an important role in the acquiring as well as the selling process. The top management teams are responsible for the pre-acquisition process, the integration phase and the post-acquisition performance. The top management team of the target company can also be a very important motivation for the acquiring company to make the acquisition. Indeed the top management team of the target company can possess valuable tacit, physical or/and intangible knowledge of the market process and relationships inside the firm (Athanassoui and Nigh, 1999), and on the outside with key stakeholders (Davis and Nail, 2003). For this reason the top management team can be the key attraction of the merger (Walsh, 1988; Mukherjee et al, 2003).
But the full acquisition process is also very determinative for the success and failure of the merger. Research has shown that managers are often frustrated about being part of a larger and unknown organization (Hayes, 1979). The context of the negotiations can affect the willingness and ability to work together in the merged company for the top management teams (Walsh, 1998). Hayes (1979) argues that these negotiations, when done in a professional way, should be associated with multiple stages. But further research shows that this statement is a) not true, or b) that the negotiations are done the wrong way, and not ‘professional’ in the way Hayes describes it. Walsh (1988) found evidence that the turnover is significantly higher than in a normal situation: in the 5 years after a merger nearly 59 percent of each company’s top management team departs. Davis and Nail (2003) add to these results that the target companies’ top management team members are often early casualties in the post-acquisition reorganization process.
2.5 Due diligence process in M&A’s
There are several types of M&A’s. Kitching (1967) distinguishes horizontal, vertical integration, concentric marketing, concentric technology and conglomerate acquisitions. Nowadays these merger types are seen as old-fashioned, and the common categorization of mergers is; horizontal, vertical and conglomerate mergers. Horizontal mergers are within the same branch, distributing the same products or services. Vertical mergers are between companies within different value chain stages, but within the same branch. Conglomerate mergers are between companies, who are not each other’s competitors (Elgers & Clark, 1980). Feringa et al (1991) add the diversified merger to the previous 3 types. This is comparable with the conglomerate type; it’s between companies who are not competitors, but whose activities are still related. The geographic and demographic clustering of mergers is also being used (Delong, 2001).
With larger merger waves and increased globalization, the amount of international, cross-border, M&A’s also increases. A cross-border M&A typically involves two companies from different countries. Budzinski (2003) however argues that large mergers, for example between Exxon and Mobile, are, despite their American roots, also international since the are effecting not only there market at home, but all over the world. Shimizu et al (2004) argue that headquarters of both companies should be in different countries. In this research the distinction made by Shimizu et al will be applied. International mergers and acquisitions are a type of foreign direct investment (FDI). The motives of international mergers and acquisitions are aligned with this. The most important motives to engage in FDI are market seeking, resource seeking, efficiency seeking and strategic asset seeking (Dunning & Lundan, 2008).
In 1967, Kitching (1967), one of the pioneers in M&A research already predicted that it was inevitably that larger acquisitions would get socially and economically accepted. If we look at acquisitions over time here is a clear pattern in the development of M&A’s; they arise in waves, here simply called merger waves (Schenk, 2008). In the past century there have been 6 waves in the western world: in
the 1920s, 1960s, 1980s, 1990s, around 2000, and in 2004 (Gugler et al, 2002, Schenk, 2007). As predicted by Kitching (1967) every wave was characterized by larger and more complicated mergers. The recent merger wave of 2000 (fifth wave) was already characterized by international and trans-continental character of the mergers, due to globalization (Budzinski, 2003). In the sixth merger wave the expenditures on mergers and acquisition were as large as 7 times the Gross Domestic Product of Britain (Schenk, 2007).
The focus of this study is the due diligence process, which from a managerial
perspective can be argued to adopt the position that “ideally, it would be desirable to know everything there is to know about the target firm prior to the closing” (Schweiger et al, 1993:54). This is, unfortunately, almost impossible, because the due
diligence process is done by humans, facing time and money and cognitive constraints (Harvey and Lusch, 1995). But striving towards ‘knowing everything’ should be there to rule out as much as possible that could go wrong. In this section, the concept of due diligence is further explained, assessing different types of due diligence, together with the stages of the process.
Due diligence originally consisted of documenting the financial background of a potential target company. This included legal information such as incorporation documentation, stockholders and potential lawsuits (Harvey & Lusch, 1998). In the 1980s this view changed and it was argued that the costs of a merger or acquisition were not only what you paid to acquire, but also what you paid after the acquisition to solve the problems in the acquired company (Harvey & Lusch, 1995). In other words, the old aspects of due diligence were not sufficient anymore (Morrison, Kinley and Ficery, 2008). Epstein (2005) elaborates on that by addressing the non-financial elements of due diligence:
“The due diligence process focuses on formal financial review of assets, liabilities, revenues, and expenses and substantiation of the financial records. It also includes numerous nonfinancial elements, including the investigation and evaluation of organizational fit, ability to merge cultures, and the technological and human resources
Over time research has suggested that due diligence covers a larger area of information, which should be approached with a large set of sophisticated tools. Applying due diligence as a purely financial documentation can lead to failure. There are even cases where the due diligence led to a judicial claim, like in the case of Halliburton and Dresser in 1997 (Epstein, 2005); The failed merger cost Halliburton half a billion dollar, because as they claim, of due diligence. A possible reason is the friendship between the two company leaders, which led to a lack of precision and vigilance (Epstein, 2005). After disasters like the Halliburton and Dresser case the importance of a thorough due diligence process is underlined. Perry and Herd (2004) analyze that it is not that companies fail to do due diligence but they don’t do it the right way. Salama et al (2003) found similar results in their case study; mergers failed because they focused merely on financial information in the due diligence process.
Therefore, it is necessary to elaborate on the larger area of due diligence, and the other aspects that exist, except for the financial dimension. The due diligence process is a very sophisticated process because on the one hand there has to be dealt with a specific case, but on the other hand there should be a standardized methodology and templates (Bhatia, 2007).
The perspective of financial due diligence dominated the merger- and acquisition process for a long time. Over time this view was replaced by a broader perspective arguing that there are 3 main types of due diligence: financial, legal and commercial (Rankine et al, 2003). Financial due diligence was in this perspective still covering the financial side of due diligence; Identifying future costs, savings, capital expenditures and major operating risks (Bhatia, 2007). Legal due diligence is the structure of the due diligence process; uncovering potential liabilities, finding legal or contractual obstacles are the most important activities in the due diligence process and shape the basis of the final agreement (Howson, 2003). Commercial due diligence is information gathered from outside the target company, assessing the market size and –growth and the future determinants of that market for the target company (Rankine et al, 2003). Commercial and Financial Due diligence can be seen as complementary, because they both assess the size, growth and future determinants, but on a different level (company-level vs market-level).
began the rising of importance of human/cultural due diligence. Carleton (1996) speaks about cultural due diligence and its possible outcomes. When two cultures don’t match, there is a ‘culture clash’; they have different beliefs about how decisions should be made. Harding and Rouse (2007) also argue that the human due diligence is also a very important part of the process. There is a great lack of understanding the cultural aspects of the organizations and their people. A great deal of time and money is spend on aligning the physical assets of the two companies, but to little attention is given to the cultural alignment (Carleton, 1996).
After that, the due diligence processed was broadened even more by the exploration of other types of due diligence. McKiernan & Merali (1985) added the technical due diligence; the specifications of both technical backgrounds and the alignment between them. Morrison et al (2008) also recognize the technical side of due diligence and argue that in the due diligence process, special attention should be given to the supply chain and the IT, because they get short thrift. But there are also other aspects that should be assessed, such as the companies’ assets; “Rationalization of assets such as warehouses or truck fleets, for example, is often a prerequisite to merger success.” (Morrison, et al 2008). Van Wijngaarden and Doornbosch (1996) also describe fiscal and juridical due diligence. They describe the first as assessing all tax-related activities and the latter as drawing the lines for an acquisition contract, assessing the legal position of employees and other legal issues regarding competition or merger specific laws.
There are a lot of other types of due diligence that can be discovered. Howson (2003) made a summary of all these types by giving their focus of enquiry and the results sought through the type of Due diligence. Table 1 provides this summary
Due diligence Focus of enquiries Result sought Financial Validation of historical
information, review of management and systems
Confirm underlying profit. Provide basis for valuation Legal Contractual agreements,
problem spotting Warranties and indemnities, validation of all existing contracts, sale and purchase agreement
Commercial Market dynamics, target’s competitive position, target’s commercial prospects
Sustainability of future profits, formulation of strategy for the combined business, input to valuation
Fi
na
nc
ia
l
Human/cultural Make-up the workforce, terms and conditions of employment, level of commitment and motivation, organizational culture Uncovering any employment liabilities, assessing the potential Human Resource costs and risks of doing the deal, prioritizing the HR issues that need to be dealt with during integration
Management Management quality, organizational structure
Identification of key integration issues, outline of new structure for the combined businesses
Pension Various pension plans and
plan evaluations Minimize the risks of underfunding
Tax Existing tax levels,
liabilities and arrangements
Avoid any unforeseen tax liabilities, opportunities to optimize position of combined businesses
Environmental Liabilities arising from sites and processes, compliance with regulations
Potential liabilities, nature and cost of actions to limit them
IT Performance, ownership
and adequacy of current system
Feasibility of integrating systems; associated costs. IT plans for operational efficiency and competitive advantage
Hum
an
Technical Performance, ownership and adequacy of technology
Value and sustainability of product technology
Operational Production techniques, validity of current technology
Technical threats; sustainability of current methods; opportunities for improvement; investment requirements
Intellectual
property rights Validity, protection of patents and duration and other IPRs
Expiration; impact and cost
Le
gal
Property Deeds, land registry records and lease agreements
Conformation of title.
Valuation and
costs/potential of property assets
Antitrust The various national filing requirements (some of which can be expensive if not complied with)
Merger control filings and clearance; an assessment of any antitrust risks posed by the target’s activities; an assessment of the enforceability of the target’s contracts
Str
ate
gic
Insurance/Risk Present, future and, most importantly, past exposures of the business. The structure and cost of the existing programme
The costs and benefits of retaining risk versus transferring it.
Table 1: Consistency of the due diligence process Source: Adapted from Howson (2003)
Table 1 consists of large and small types of due diligence; not every type can be given the same weight of importance. To theorize the due diligence process in this research, clusters of due diligence will be conducted to get 4 major ‘blocks’ of Due Diligence that are the core of the process.
The 3 kinds of Due Diligence that Rankine et al (2003) describe; Financial, Legal and Commercial (here called strategic) are broadened, but will, in this theoretical framework, still be the core foundation of the due diligence process. These 3 are extended with Human Due diligence.
Financial due diligence keeps the basis of the traditional financial due diligence process, extended with tax, property, IT, technical and operational due diligence, because these both deal with value within the target company. Human due diligence consists of human/cultural due diligence, extended with Management and Pension due diligence, because they all deal within the human research area. Legal
due diligence consists of the basis of due diligence, as Howson (2003) formulates, extended with other juridical assessments, such as intellectual property rights, antitrust and insurance/risk due diligence. Environmental due diligence also partly contributes to legal due diligence by assessing the legal environment of the market (Rankine et al, 2003; Howson, 2003). Strategic due diligence consists of the large area of commercial due diligence; information from outside the firm, extended by a part of environmental due diligence dealing with the companies environment looking from an outside perspective.
Identifying financial, human, legal and strategic due diligence, the question is how this different kinds of due diligence can be measured. Generally there are 4 steps in the due diligence process which can be detected; the preliminaries, the programme, the verification and the report (Howson, 2003).
Financial due diligence is perhaps the most easy type of due diligence to be
measured, because of the quantitative approach. But financial due diligence is not the same as the yearly audit; it also gives an interpretation to the numbers (Howson, 2003). It is measured by internal information from the target companies, such as annual- and financial reports and the use of specific checklists and systematic research methods.
Harding and Rouse (2007) argue that a good human due diligence starts with two questions: What structure will be implemented and whose culture will be adapted? Answering these questions, the human due diligence process can be done with the help of 2 methods and tools. The first method is to analyze the companies’ strengths and weaknesses regarding their human capabilities, the second is a qualitative approach using interviews to assess executives’ issues and capabilities (Harding and Rouse, 2007).
The legal due diligence process is almost synonym to the word ‘lawyers’ (Howson, 2003). Preliminary a questionnaire should be conducted with detailed questions for the target company (Rankine et al, 2003). Next lawyers of the acquiring company should, from their expertise, assess legal obstacles by inspecting documents, checking certificates of share- and stakeholders and checking licenses (Howson, 2003).
As mentioned before, strategic due diligence differs from financial due diligence by extracting information from external sources. This type of due diligence does not consists of a range of checklists and standard questions, but should be a tailor-made process, depending size, the perceived level of risk and other factors concerning the deal (Howson, 2003). But it usually starts with desk research, followed by gaining knowledge from primary sources involved in the market, such as costumers, distributors, specifiers, regulators, suppliers, competitors, new entrants and former employees (Rankine, 2003).
To get a complete overview of the different types of due diligence, table 2 provides a systematic overview of the different stages. This model will be used as a guide in this research.
Financial Due Diligence Human Due Diligence Legal Due Diligence Strategic Due Diligence
Pre-liminaries Internal analysis:
Determine strategic objectives Target analysis: Collecting annual- accounting- and management reports(1) Determining the structure of the organization (4) Getting a lawyer,
visit the target
company (3)
Mapping external
sources (3)
The programme Assessment of financial aspects : strengths and weaknesses, financial risks, financial position (1)
Assessment of
organization charts,
compensation and
promotion processes, job descriptons and responsibilities, employee turnover rates and employee loyalty (4) Questionnaires, data rooms, research certicificates (3) uncover potential liabilities (2) Assesment of cusJordaners, distributors, specifiers, regulators, suppliers, competitors, new
entrants and former employees (3)
Verification Assessing the validity, and consistency of the information (1)
Interviews with
key-executives, role plays (4) Draft of disclosure letter (3) Alignment with financial due diligence (3)
The report Financial report
consisting the objectives, the programme, sources of information, financial findings, prognoses (1) Report on how to conduct the board, retain key talent and mix the cultures (4)
A long, incoherent,
rambling affair,
stuffed full of every detail (2)
Strategic report with
the market and
company forecasts (3)
Tabel 2: Stages in different due diligence components
Sources: Adapted from (1): van Wijngaarden & Doornbosch, 1996. (2) Howson, 2003. (3) Rankine et al, 2003. (4) Harding and Rouse (2007)
As already mentioned, the due diligence process, done poorly or rather well, can determine the success or failure of an M&A. But exactly what does it determine? Morrison et al. (2008) argue that the due diligence process can help companies; exposing risks early, understanding future investments and to be operating costs and identifying new sources of value. Analyzing these aspects the company can decide whether to embrace or kill a merger, and determine the price they will pay for the target company. Harding and Rouse (2007) argue that in mergers and acquisitions where human due diligence is done thoroughly, the success ratio is higher than in those who lack the human aspect.
On the other hand when due diligence is done poorly, this can result in a potential failure of the merger (Epstein, 2005). Also a poor human due diligence results in a direct loss of talent, and on the long term, a great loss of executives and a decline in productivity (Harding and Rouse, 2007). Another downside of the due diligence process is that it can offend the target company, which can lead to an “analysis paralysis”, due to a flood of information (Bhatia, 2007).
Literature suggests that international M&A’s are often more risky, one of the reasons for this are the complications in due diligence. The due diligence process is in mergers within borders expected to be neutral and objective, but across borders this is not necessarily the case. Due to differences in national culture the possibility of variations in expectations of merger partners and the role of due diligence may arise (Angwin, 2001). Acquiring across national borders requires the buying firm to understand differences in political, economic, legal and cultural issues (Schweiger et al, 1993).
But the literature also notes that a perfect due diligence is very hard to conduct. Harvey and Lusch (1995) found 3 issues that directly impact the level of due diligence. First time restrictions influences the extensiveness of the research towards due diligence, second, cost constraints make it ineffective to do extensive research when the target company is relatively small. Last, situational factors such as hostile takeovers and foreign acquisitions shortcut the due diligence process. Reverting to the quote, with which this section about due diligence began; It would be ideal to know everything about the target company there possibly is to know is almost impossible, but trying to do conduct the process as perfect as possible, eg with the right types
within the right stages, can protect the merger from failure, and can even create success.
2.6 TMT Role and Value Creation in M&A Due Diligence
The ubiquity of M&A activity does not necessarily mean that all M&A’s are successful; research has shown that approximately 65-85% of all M&A’s fail (Schuler and Jackson, 2001; Pautler, 2003). Still M&A’s account for almost 80% of all FDI-decisions. This ambiguity is most commonly known as the merger paradox (Schenk, 2006). Managers are thought of as rational an to have the ability to learn, so why do they make this mistake over again (Schenk, 2008).
Cartwright (2006) provides three possible explanations for the ‘merger paradox’. The first is that managers are undertaking acquisitions driven by non-value maximizing motives, second, that the theoretical literature has not reached the practitioner community; third, the research is incomplete in some way. Schenk (2006) adds to possible reasons by posing the following propositions. Either corporate executives are not sufficiently equipped to run the firms they are heading or they do not care as much about the economic results of their actions as economic theory predicts they should.
Given this level of activity, there has unsurprisingly been a lot of research on how to manage an M&A successfully (Epstein, 2005). Epstein (2004) found 7 determinants of merger’s success: strategic vision, strategic fit, deal structure, due diligence, pre-merger planning, post-merger integration and external environment. Though there is a lot of prescriptive research about how to manage a successful merger or acquisition, explanatory research, about why they fail or succeed is not so extensive (Schenk, 2008).
Perry and Heard (2004) state that cross-border M&A’s are intrinsically more risky. Olie (1994) elaborates on that arguing international mergers are more difficult because they bring together people with different values and beliefs about the workplace. Kissin and Herrera (2007) come to a similar conclusion; primary deal-breakers of M&A’s are often not economic issues, but personal and cultural conflicts during the negotiations. This is due to the use of standardized scripts for effective deal making, which will not work, because it won’t fit the context (Schenk, 1998).
The top management team of the target company can also be a general explanation for failures of mergers and acquisitions are: poor synergy, bad timing, incompatible cultures, off-strategy decision-making, hubris and greed (Perry and Herd, 2004). Rossi and Volpin (2004) argue that ‘frictions, such as transaction costs, information asymmetries and agency conflicts can prevent efficient transfers of control. Olie (1994) argues that companies usually give disproportional attention to strategic fit, such as financial and strategic data, without looking at ‘soft’ integration issues. From another point of view, Epstein (2005) argues that M&A’s often fail because there is a lack of a careful evaluation of financial, personnel and organizational issues, which are very important in reaching organizational success.
This research focuses on the role that the Top Management Team plays during the acquisition and in specific during the different parts of the due diligence process
2.6.1 TMT Post Merger Adaptation from an Agency Perspective
In this research I propose that this agency problem is related to the earlier mentioned high turnover in the post-acquisition stage of international mergers. The role change that the manager makes will influence the adaption process in the integrations stage, because the manager has just helped his old shareholders, while dissatisfying his new shareholders. This results in an agency conflict, bringing influence costs such as managerial entrenchment, the misallocation of funds and rent seeking (Fulghieri & Hodrick, 2006).The interest of the manager differs between the multiple types of due diligence, because of its different objectives. Here I propose that 3 types of due diligence influence the adaption process; financial, human and legal. Strategic is excluded, because the information gathered is coming from outside the company, and can hardly be influenced by the TMT of the target company.
The financial status of the target company will determine the price of the target company largely. Therefore the interests of the agent will be large, because he wants to maximize his economic gains (Walkling & Long, 1984), even when it the merger suffers or fails because of it (Cooper & Finkelstein, 2007). Because the interest is larger, the role change after the merger will be larger, which makes it much
harder to adept for the manager. This will lead to opportunism (Anderson et al, 2003). and leads to the following proposition:
Working proposition 1: From an agency perspective the role that the TMT plays in the financial due diligence process will result in a difficult adaption in the merged company, due to the large role change post-merger
The human due diligence process is very important for the actual merger in the integration phase. Applying the agency theory, the agent will try to maximize his own interest before the interests of his shareholders and other employees. Therefore the manager will secure his own position in the merged company (Fulghieri & Hodrick, 2006) , neglecting the interest of the companies’ employees. The agent will overvalue the human resources of the target company, bringing problems to the employees of the target companies in the merged company (Cording et al, 2002) and losing trust from the TMT of the acquiring company. This leads to the following proposition:
Working proposition 2: From an agency perspective the role that the TMT plays in the human due diligence process will result in a difficult adaption in the merged company, due to the role change post-merger
The agent is expected to fully corporate in the legal due diligence, because it is in his own interest that the legal part of the deal is well arranged. Carleton (1996:4) proposes that there is little room for opportunism, because “In legal due diligence no such ‘Act of faith’ is acceptable”This leads to the following proposition:
Working proposition 3: From an agency perspective the role that the TMT plays in the legal due diligence process will result in a smooth adaption in the merged company, due to the limited role change post-merger
2.6.2 TMT Post Merger Adaptation from a Stewardship Perspective
The financial due diligence is important for the steward, because this largely determines the price premium, which the steward strives to make as high as possible to follow the objectives of his shareholders (Walkling & Long, 1984); maximizing value. In the new merged company, the steward will make a role change, so that his ‘stewardship’ is suddenly devoted to the new shareholders instead of the old shareholders. His new objective is to maximize value for the new shareholders, wherehe just destroyed value. This will lead to a difficult adaption. The steward will have opportunistic behavior (Anderson et al 2003), but not for the same reason, self gain (Walkling & Long, 1984) , but to maximize value for his shareholders. This leads to the following proposition:
Working proposition 4: From a stewardship theory perspective the role that the TMT plays in the financial due diligence process will result in a difficult adaption in the merged company, due to the significant role change post-merger.
The human due diligence is important to a steward, because one of the (secundary) goals of each company is to take care of their employees (Chuang & Liao, 2010) The manager will keep this in mind by representing his team fairly in the due diligence stage and the following negotiations. Because he has no self-interest (Walking & Long, 1984), he will keep this secundary goal in mind, and not overvalue the human resources. This leads to the following proposition:
Working proposition 5: From a stewardship theory perspective the role that the TMT plays in the human due diligence process will result in a smooth adaption in the merged company, due to the limited role change post-merger.
The steward is expected to fully corporate in the legal due diligence, because it is in the interest of his shareholders (Waling & Long, 1984) that the legal part of the deal is well arranged. This leads to the following proposition:
Working proposition 6: From a stewardship theory perspective the role that the TMT plays in the legal due diligence process will result in a smooth adaption in the merged company, due to the limited role change post-merger.
2.6.3 Principal-Agent and Stewardship Models in Comparison
On first sight the objectives of the steward and the agent look the same; they both try to maximize value by getting the largest price premium possible (Walking & Long, 1984). Their reasons, however, are different. Where the agent is maximizing his own value (and thereby maximizing that of the shareholders), the steward is maximizing the value of his shareholders directly (Donaldson & Davis, 1991). The result is still the same; the shareholder’s value is maximized, by giving favorable information during the different types of due diligence. The difference is the maximization of theagents’ own interests (Davis et al, 1997) and the possible opportunism because of it (Anderson et al, 2003). After the pre-acquisition stage, the time has come to really merge into the new company. In this ‘integration phase’ the organizations are reorganized and the TMT of the target company will be fitted into this new organizations. Both the agents’ and the stewards’ objectives will change, and so we can speak of a role change. The agents’ own interests will conflict with the objectives of the merged company, being creating value for its shareholders (Davis, 1991), whereas the agent has just destroyed value for the merged company by maximizing the price premium. The steward has no personal conflicting interests with the merged company, but has also destroyed value, where his new objective is to maximize value for his new shareholders. Both agents, and stewards make a role change, but the difference is the part of the conflicting personal interests, which the agents have with the shareholders of the merged company. This leads to the following proposition:
Working proposition 7: The adaption to the new merged organization structure is more difficult for those taking an agency perspective, than those with a stewardship perspective, because of the role change between the role in the due diligence process and the role in the new merged company.
These 7 working propositions are visualized in the conceptual model in figure 1.
3. Method
3.1 Introduction
This chapter will focus on the methodological issues of this research. First the chapter begins with the conducted research design and its applications. Next the concept of a qualitative case study will be exposed and there’ll be elaborated on the selection of cases and the analysis of the collected data. The concept of in-depth interview will be conducted and the analysis of this data will be described. This chapter will end with a conclusion of the methodology.
3.2 Research Design
To get an in-depth understanding of the M&A, and in particular the due diligence process an embedded design of 4 case studies will be conducted. The four cases will be the main units of analysis. As the research is focused from a target company point of view, the 4 case studies will be coupled with at least 2 in-depth interviews with managers of the target company involved in a merger or acquisition in the past 10 years. The managers will be the smaller units of analysus to look for consistens patterns within a case (Yin, 1994). To assess the managerial perspective, a short questionnaire has to be filled in before the interview to determine whether the respondent has a stewardship or agency perspective.
3.3 Qualitative Case Study
The cross-section analysis is the most common method to study pre- and post merger efficiency (Schenk, 2006). Although this method can present a quantitative description of the effects, it is also criticized because it leaves out the firm- and situation specific aspects of a merger. An in-depth case study can solve this problem by giving a comprehensive and precise analysis of the firm-specific situation (Yin, 1994). Four short case studies will be conducted give a broad picture of the case in which the interviewed managers where acting. A replication logic is used to reveal support for theoretical similar results between the 4 case study’s (Yin, 2009).
The data will be gathered at several companies from the Netherlands. These companies should have been the target company in an international merger or acquisition, within the past ten years. There should work, at least, 2 managers from the target company, which will be interviewed. These companies will be approached for the collection of data with their managers who were involved in the pre-acquisition process. This data consists of financial and strategic data, pre- and post-merger to picture the financial and strategic picture of the 2 companies previous to the merger, and of the merged company after the merger.
age time at firm (years) Role
Avalax Jordan 31 5 Technical Mitchell 32 5 Sales Rae 31 5 Sales Betaware Bob 20 2 Technical Alan 21 2 Sales Crosstech Vince 39 4 CEO Peter 42 4 CFO Divercity Eryn 34 7 CEO Caleb 36 7 CFO
Table 3: Descriptive cases and subjects
3.5 Data Collection and Analysis Method
From the data I hope to extract a broad view of the pre- and post-acquisition phase, from the perspective of the target company. This consists of multiple parts from the the selection of a target company, through the actual merger, and up to the post-merger adaption of the TMT.
These descriptive statistics will be collected from the company management, reliable newspapers and other related reliable sources. The statistics will be a framework for the rest of the research.
The selected cases are bound by a confidentiality agreement between the researcher and the interviewee. This agreement was requested by all interviewees because of the sensitivity of the information given by the interviewee about the company, as well as the sensitivity of the views and opinions from the interviewees towards the initial acquiring company, which they now work together with in the merged company. The names of the companies as well as the interviewees are pseudonyms.
The variety of the cases used in this research is limited to start-up companies in the technology industry in the Netherlands. This is not a methodological choice, but mere a consequence of the approachability and participation willingness of the companies that fitted the profile. The fact that all 4 acquiring companies are American-based Tech-companies is a direct consequence of this limitation.
The 9 subjects had an average age of 31, with the youngest being 20 years, and the oldest 42 years old. The gender of all subjects was male. This is partly justified by the numbers of top-managers in the Dutch business environment; in 2014 this was only 10% (Grant Thornton, 2014). This number is one of the lowest in the world. The number is even lower looking at the technology sector in Holland, being only 8% women in top managing teams (Vhto, 2015). The top management team consisted in al cases between 2 and 5 managers, and all subjects were also shareholder in the company.
3.6 Interviews
The in-depth interview is the main instrument to measure the due diligence process in a qualitative manner. The main focus of the interviews is on the behavioral aspects of the managers in the target companies; their role in the different types of due diligence and their role in the new merged company. First the relationship between the shareholders and the manager will be assessed through a questionnaire; using the distinction matrix of Davis et al (1997) the managers will be divided in adopters of the agent- or stewardship theory. To test cultural differences I used the scale of
Hofstede (1980) to be found in appendix A, to measure Risk orientation and management philosophy, I used Bearden et al (2006), to be found in appendix B, and Meertens and Lion (2008) was used to measure time frame and power distance, to be found in Appendix C.
In the second phase I will conduct an interview protocol; this protocol will increase the consistency between the interviews and therefore the reliability of measurement. A raw interview script will be conducted to cover all topics for the interview, but leaving space for interview specific in-depth questions. The answers to the questions will likely be sources of evidence, but not the literal questions asked in the research. The level of the questions will be general, as well as case-specific. There will be no specific interviewees questions (Yin, 2009).
In the third phase the interviews will be held and made into a transcription. The last phase will be the writing of the report and evaluation of the used research method.
3.7 Analysis of Data from Interviews
After the approach of 84 companies that fitted the target company’s description in this research, 4 case studies delivered a total of 9 interviews with the involved managers. The collected data will be analyzed, together with the background information from the case studies and the outcome of the questionnaire, determining whether managers adopt a stewardship or agency perspective. From both the interviews and the questionnaires a descriptive framework will be built, to analyse the 4 cases separately, and to do a cross-comparison between them (Yin 1994). The tool that I will use for thematic decoding is Nvivo. The analysis will be structured following the conceptual model, and therefore take the working proposition as the main structure. These propostions will be used to adapt the technique of pattern matching, to analyze the expected outcomes of the case studies (Yin, 2009). To sketch the situation of the 4 mergers, the analysis begins with a short introduction of each individual case, followed by the analysis of the working proposition, and finishing with a conclusion of these results.
3.8 Conclusion
The collection of the data was the hardest part of the research, because managers either are to busy adapting in the newly merged company, or didn’t want to talk about the merger at all. Finally four companies, and 9 managers were prepared to take an interview.
4. Findings
4.1 Introduction
In the period from 2007 until 2013, the amount of mergers in the Netherlands grew from approximately 2000 to 5000 per year (CBS, 2013). The trade-sector is with a proportion of 20% the largest sector in the M&A industry. There is however no data available on how many of these mergers are cross-border, the only information is that one of the companies (ie the target or acquiring company) had a Dutch nationality.
The first case is about the company Avalax, founded in 2009 by 4 friends: Bert, Mitchell, Rae and Jordan. Straight from the university they had the idea of developing an analytic tool for the creators of apps, to gain data on their buyers. While developing, they went to a conference in Barcelona where they presented their idea. After the presentation someone from Vodafone came up to them and told them that he was interested in the data of all the apps, and they changed their idea, giving the analytics tool to app-creators for free and selling their data. In 2014 they were looking for their first investment to keep up with their only big competitor HighApp, situated in the US, when they received an offer from HighApp for the sale of Avalax. They had a meeting and finally sold in November 2014 for an amount between 20 and 250 million (amount disclosed) according to Jordan.
The second case, is the case of Crosstech, which was founded in 2005 by Vince and Peter. In the coming of age period of the internet they designed a way to save the backup from your computer on to the ‘cloud’. They developed the software and soon started doing business in over 18 countries all over the world. In 2014 the company was acquired by Growthinc, a US-based tech company for a disclosed amount of money.
The third case is a company called Betaware, which was founded in the University of Amsterdam in 2014 by 5 friends: Bob, Alan, David, Walter en Mike. In 2016, only a year after founding Betaware, they sold there company to the US-based F-tech for a disclosed amount. Because of the any international students on the campus, they developed a tool so that students could borrow other students’ bikes. When they saw that worked perfectly, the enlarged their reach to the whole country of the Netherlands.
The fourth case, which was studied, is the case of the Utrecht based company Divercity. Caleb, Eryn and William founded the company in 2012, creating an online platform for retailers to better measure and control the needs of their costumers. Divercity was acquired in 2015 by the American based ad-company Easytech for a disclosed amount of money
4.2 Agency-Stewardship Profiles of the Respondents
The questionnaire on managerial perspective showed that 5 managers had scores that explicitly pointed to a managerial perspective trough a stewardship lens, whereas 3 managers had scores that showed an agency perspective. One respondent had no clear perspective as he scored high on risk orientation, but low on power distance and long-term orientation, indicating no clear perspective.
Company Agency perspective Stewardship perspective
Mixed
Avalax Rae, Mitchell Jordan
Betaware Bob Alan
Crosstech Vince, Peter
Divercity Eryn Caleb
Tabel 4: Agency-stewardship distribution
4.3 Agency Perspective
From an agency perspective the managers all seem focused on selling the company (ie creating value), although they had their doubts. When you look at the case of Avalax, Rae tells the story of how the idea of merging began:
“While searching for an investor the people from New York asked us if we had ever thought about teaming up with HighApp. The first reaction was: off course not. But that was just because we spent the last 2 years fighting battles over clients with them. Our whole staff was constantly trying to be one step ahead of HighApp, also technically. So when they first suggested it we were not too fond of the idea.”
“Of course you know that M&A’s take place, but in my imagination, it would always be us as the acquiring company, in stead of the target company. But when I looked at the broader picture, we immediately saw that it was the best thing to do, and we went for it”
They both tell in clear language that although their ‘entrepreneurial heart’, as Mitchell (Avalax) calls it, they instinctively disagree with the idea of the merger, but using logic and their entrepreneurial skills, they both think it is the smartest thing to do, because, as Rae unfolds:
“Our sales-machine has always been the least strong component of our product, whereas the technicality of the product was, I dare to say, better than HighApp had. But if you cannot sell quickly enough or you don’t have the right channels, you lose territory from your competitors. And are eventually forced to sell, despite of maybe a better product”
They both do not explicitly say that they put there own interest before the company, as the agency theory suggests, but it is clear that both managers, although attached to their firm, clearly state that this attachment is also a kind of entrepreneurial instinct, and the actual decision is a rational one. This could be argued in line with the agency theory and thus with the outcome of he questionnaire
In the case of Divercity the motives of merging are less clear linked to an agency perspective. Eryn states that the fact that “We built the company from scratch,
made it difficult to sell”, although he understood that this was a unique opportunity,
and that “the offer was more than fair”. This statement does is not entirely in line with the agency theory because the emotional detachment to the company, is harder to rhyme with self-interest.
In the case of the due diligence in general we see the same tendency. Avalax had got a tender offer, and had to start the due diligence process by handing over all the client-data to HighApp, giving them everything the company was based on (aside from the technical part). Rae had a hard time dealing with this decision:
“For me personally this was a tricky part, because you give away you’re whole foundation, and although it felt right, and the intensions of HighApp appeared to be more than sincere, it was hard for me handing over the client-details.
Maybe it is something in my entrepreneurship, which tells my gut not to trust anyone except us 4. But we all agreed it felt good. And don’t misunderstand me, I totally agreed with it, because deep down I knew it was the best thing to do. But I guess it makes you vulnerable, where, in this situation you’d like to be the strong party”
Eryn (Divercity) had less problems handing over data in the due diligence process, but it has to be mentioned that they did not have to hand over their client-data, as Avalax had, but only their financial data (prospects, balances) and technical data.
4.3.1 Financial Due Diligence from an Agency Perspective
Both Avalax and Divercity admitted that the financial aspect of due diligence was the largest of all different types of due diligence, and was the main focus of the process. Avalax, as already mentioned, had to hand over their client-data, as well as revenue numbers and prospects. Divercity had to hand in revenue numbers, annual reports, balances and prospects.
Rae (Avalax) argues that, different from all types of due diligence, such as human and technical due diligence, which take a lot of time to explain to the acquiring party, because of its complicity. Financial due diligence is more straight forward:
“With numbers, that is totally different. Of course there is an interpretation of the numbers, but it still is simpler, and there is no cultural difference in numbers.”
Mitchell (Avalax) described the process and his feelings about the process:
When we decided to submerge in the due diligence process, we were asked to give all our data to HighApp. That year we had hired a financial expert to prepare an audit for Price Waterhouse Coopers, so our administration was up to date and complete. We handed over the data and waited, after that we had a couple of skype-calls to get every detail clear.
