The art and science of merger execution have made great strides since the late 1990s — a period when stock-market frenzy often led to a rush to judgment, and ultimately to buyer’s remorse. Since then, a more prudent, systematic approach to mergers and acquisitions has emerged, and many companies with an articulated M&A strategy have gone so far as to institutionalize an M&A capability within their walls.
These corporate M&A groups have proven especially good at managing financial and legal due diligence — and at focusing on these critical items early in the integration process. This is all well and good; yet even the best financial and legal due diligence practices do not uncover the whole story for any given prospect, and they certainly do not guarantee success. There is a critical third component to due diligence. We call it “strategic due diligence,” and it is vital to anticipating the problems that can derail a merger. Indeed, strategic due diligence is increasingly being demanded by boards of directors who want to be certain that a merger is the right choice.
What exactly is strategic due diligence? Whereas financial and legal due diligence ascertain the potential value of a deal and concern buying the company “at the right price,” strategic due diligence explores whether that potential — however enticing — is realistic. It tests the strategic rationale behind a proposed transaction with two broad questions. Is the deal commercially attractive? And are we capable of realizing the targeted value? The first question requires external inquiry; the second demands an internal focus. Each question partially informs the other, reinforcing an inquiry that thoroughly plumbs the wisdom of the deal.
Above all, strategic due diligence ensures that no two transactions are treated the same way; each deal has its own value drivers, and thus the composition of each due diligence team must change. Executives should determine which areas of the organization will produce value in the merger, and draw members of the due diligence team from those areas. (See “Building the Diligence Team,” below.) Strategic due diligence counterbalances the danger of institutionalizing and replicating a diligence capability ill-suited for the task at hand. Although some standard due diligence best practices can be adopted wholesale into strategic due diligence (see Exhibit 1), companies must tailor their process to the issues and potential integration challenges of each specific deal.
Strategic due diligence thus adds an important deal-screening filter. After all, executives must be convinced not only that the potential deal value justifies the significant investment being made, but also that the business is truly capable of realizing this value. Indeed, a sober strategic due diligence evaluation should help set the purchase price. The buyer should demand a price that is commensurate with the level of integration risk uncovered and be willing to walk away if that price isn’t met.
Two Big Questions
The first question, testing the commercial attractiveness of a deal, involves validating both the target’s financial projections and any identified synergies using an external lens. Companies can achieve this by assessing overall market attractiveness and the competitive position of the target, and how these might change over time.
Whether the buyer is out-of-market (e.g., a financial buyer) or in-market (e.g., a competitor), this analysis is indispensable. However, for an in-market buyer, the commercial attractiveness issue may be more complex. The due diligence team involved in an in-market deal must gaze into the future and calculate the competitive position of the combined entity, including its impact on customers, competitors, and overall market dynamics. (Will the merger invite new entrants, for instance?) After all, customers and competitors will react to the merger in ways that will benefit them — ways that might threaten the combined businesses’ value-creation assumptions.