Kellogg World Alumni Magazine, Spring 2003Kellogg School of Management
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  Profs. Lys and Gulati
  Profs. Zajac and Dranove
Merging their insights: Kellogg Professors Thomas Lys and Ranjay Gulati (top, left to right) and Ed Zajac and David Dranove (bottom) help students and executives understand the dynamicsof mergers and alliances.
© Nathan Mandell
Why bigger is not always better where corporate mergers are concerned

By Matt Golosinski

Would you invest your money in a project that offers an expected return of minus 3 percent and has odds of losing capital 55 percent of the time?

Kellogg School Professor Thomas Lys believes the question is one business leaders should contemplate before getting involved with corporate mergers, especially since research indicates that more than 60 percent of the record 302 major mergers transacted between July 1995 and September 2001 actually lost money for shareholders.

“History is full of these kinds of examples,” says Lys, the Gary A. Rosenberg Distinguished Professor of Real Estate, and one of the Kellogg mergers and acquisitions experts who teaches a course on M&A financial planning. “One of the biggest deals in the 1980s was the AT&T and NCR acquisition, which totaled about $10 billion. AT&T lost $6 billion on this.”

Other blockbusters, such as America Online’s $166 billion stock bid for Time Warner that resulted in their January 2000 merger, promised to launch juggernauts facilitating investor windfalls and enhanced customer services. The reality has proven more problematic, with a raft of problems dogging the firm. Today, the company is listing, having shaken up senior leadership after losing more than 75 percent of its post-merger value. Some observers believe that marketplace shifts, particularly the development of broadband in the three years that AOL Time Warner tried to find its new legs, have left the media firm’s plans DOA.

Kellogg School scholars note that the difficulty in making mergers work can manifest itself in any number of ways, but the challenges come down to these fundamentals: business strategy and implementation.

Supersize me!
If most firms can’t pull off a merger that creates valuable synergies, why did five times more merger activity occur in six of the last eight years than in the entire history of M&A? According to a BusinessWeek study, deals totaling about $4 trillion took place between 1998 and 2000 alone.

Part of the reason has to do with those odds. Forty percent of the time, mergers do make a positive financial impact for the firm, and excessive confidence may drive CEOs to believe they can create one of the winners.

“A lot of ego goes into merger attempts,” says Walter Scott, professor of management and strategy and a merger expert who has himself been on the front lines of M&A as former president and CEO of Minneapolis-based IDS Financial Services (now American Express Financial Advisors). “You get seduced by your own press clippings so you think you won’t make the same mistakes others have.”

Other factors contributing to merger mania included inflated stock value during the Internet boom that resulted in dot-com executives looking to unload the paper without alarming shareholders. One way to achieve this goal, while keeping Wall Street happy, was orchestrating spectacular deals using new economy stocks to trade for real, old economy assets. In these cases, due diligence was sometimes sacrificed for perceived immediate benefits.

Some Kellogg School faculty, including Management and Strategy Professor David Dranove, believe this is what CEOs such as AOL’s Steve Case was doing when he teamed up with Time Warner’s Gerald Levin. Neither man hurt his reputation or company, in the short term, when they announced the merger and appeared on the cover of The Wall Street Journal, arms trium- phantly raised.

“It was as if they’d just won the Super Bowl,” says Dranove, the Walter J. McNerney Distinguished Professor of Health Industry Management. “But to win the Super Bowl you actually have to accomplish something. You can’t just sign a free agent at the beginning of the year and declare victory.”

One of the abiding faiths of commercial culture is that “bigger is better.” Today, beverages and burgers are “supersized,” but that’s merely the fast-food example of a model that appears everywhere, including the automotive industry. During the 1990s, many CEOs also discovered an appetite for big deals.

Too often, though, their decisions demonstrated leadership big on vision, but small on strategy.

“Big is not necessarily better. You tend to give up speed, flexibility, entrepreneurial character when you get bigger,” says Scott.

Scott adds that firms usually suffer when poor logic underpins their merger attempts. He recalls his tenure as executive vice president at Pillsbury Co., coming on board after the company had “listened to the siren song” that recommended becoming a “concept stock” — a boutique stock that typically sells at a higher price. In Pillsbury’s case, the concept translated into “finer living.”

As a result, Pillsbury became involved with businesses it had little expertise in, including fresh flowers and wine. There was no logic in this strategy, says Scott, who contends that the company was charmed by prevailing Wall Street wisdom.

Similarly, he notes that “nearly every food company entered the restaurant business” in the 1980s, based on the flawed logic that because it involved food, managing it would entail the same skills. Not so, says Scott, pointing to the industries’ different dynamics.

His rules of thumb? Never get involved with a company that you don’t have at least a basic understanding about and be clear on your motivations for merging.

“I want to know why I’m doing the deal; what the inherent business logic is that will make the combined enterprise better than it was before the merger,” Scott explains.

Culture clash
Even if companies clear the strategic hurdle by initiating a merger that promises real synergies, they still must manage the integration challenges and inevitable culture clashes, says Ed Zajac, the James F. Beré Distinguished Professor of Management and Organizations.

Zajac, along with Professor Tony Paoni, traveled to Washington, D.C., earlier this year to assist with the implementation of a merger at top levels of U.S. government; namely, the newly formed Department of Homeland Security.

“There can be enormous cultural impediments when creating mergers, and with government agencies there are special challenges,” says Zajac, who shows students in both the full-time MBA program and Executive Education Program how to extract real value from mergers and alliances as in such courses Creating and Managing Strategic Alliances. For example, the course provides an analytical framework that identifies the environmental, strategic, structural, and behavioral factors predicting the relative desirability of mergers versus alliances versus outsourcing options.

In the case of merging government entities, Zajac notes that internal cultural issues idiosyncratic to government organizations, such as politically motivated hiring and promotional systems, create additional complexities.

“Even details as seemingly trivial as uniform insignias can present challenges. Whose badge will survive the merger? These things matter to the people wearing the uniforms,” Zajac says.

Lys agrees, citing other cultural considerations such as whose accounting system survives and what managerial protocols the post-merger company will follow. Personnel issues can be another significant challenge.

“Mergers are frequently an adverse selection for excellence,” Lys states. “You can end up with an exodus of the most brilliant people, which leads to keeping — out of necessity — the people you should get rid of.”

For Ranjay Gulati, the Michael Ludwig Nemmers Distinguished Professor of Strategy and Organizations, a key to successful merger strategy is formulating a strong integration plan.

Gulati says that executives often make the critical error of underestimating the costs and challenges of integration, while overestimating the value they perceive in merging. Gulati is currently teaching a course called Strategy of Implementation that addresses ways to leverage good ideas in real-world contexts.

“Post-merger integration is a nightmare,” he says. “If you’re not adept at it, you are in a total mess.”

The synergy myth
Zajac says that among the misconceptions held about mergers is their justification. “Many corporate leaders couch the merger in terms of efficiency gains, because that is the socially acceptable answer. We hope that it’s also true,” he says.

Gulati contends that merger architects often believe they are creating these efficiencies via synergies. In his research and teaching, he refers to “the synergy myth” and uses the equation 1+1=3 to demonstrate the flawed logic behind this belief.

While he says that mergers can create value through economies of scale (such as eliminating operational redundancies to reduce costs in common activities), or through economies of scope (in operational, financial and anticompetitive domains), Gulati notes that synergies are more difficult to create than is commonly believed.

His research cites the “failed synergies” of companies such as Vivendi Universal, The Walt Disney Co. and Bertelsmann Media Worldwide, each of which gambled poorly on Internet communications to increase sales and productivity. Each company’s stocks suffered big losses in the aftermath of their miscues.

Scott is equally dubious about using merger buzzwords, and says that very few guaranteed synergies exist. One true synergy results from deals that increase availability of additional capital to support expansion and improve operations.

In his research and consulting, Dranove has found that when some hospitals tried to create synergies either by merging, or else through strategies such as buying up physician practices or selling insurance, the results were usually a prescription for disaster.

“The deals that hospitals struck with insurance companies were amazing,” says Dranove. The hospitals agreed to take on all the risk themselves so long as the insurance companies did the marketing. Hardly a plan that encouraged due diligence on the latter’s part, since their financial incentive came from signing up more patients, regardless of existing health problems.

The theory, says Dranove, was the same as for any for any merger. The organizations would lower costs and reap the profits by creating new methods of delivering care that would produce higher quality at a lower cost. In the end, these organizations spent time and money on mergers that failed to create any new product, and certainly didn’t discover more efficient ways of delivering existing products and services.

“We learned that two fundamental rules of business always apply: Don’t do things you don’t know how to do; and merger does not equal synergy,” says Dranove.

Kellogg School faculty indicate that, for a decade now, the school’s core strategy course has advised managers to adopt extreme caution when growing their firms through acquisition. They always counsel executives to ask themselves why they could not achieve their goals as an independent firm, rather than taking on merger or alliance risks.

“The key is figuring out what you must own versus what you can farm out,” says Lys. “Generally there are two types of assets you must own — anything that determines the barrier to entry, and whatever defines the product. Typically managers assume too broadly what they must own.”

But sometimes, admits Dranove, economists such as himself put the brakes on deals that really are worth the gamble. He says academics have to do a better job of identifying the really excellent mergers so that when they do preach caution others will listen.

“Economists spend a lot of time saying, ‘I don’t think that will work,’ Dranove says. “We’d be terrible CEOs because when the time comes to make a killing in the market, we would still be skeptical.”

©2002 Kellogg School of Management, Northwestern University