The buzz is back around mergers and acquisitions (M&As) as businesses explore consolidation within their industry ranks as a way to survive or thrive in challenging times marked by high interest rates and fears of a recession. For instance, the recent standoff in Hollywood between writers and producers sparked talk of a rash of M&As. More broadly, a familiar theme returns: Why do many M&As fail and how can they pay off?

M&A deal flow in the first half of this year has been the lowest since the corresponding period in 2020. According to Wharton management professor Emilie Feldman, financing M&A deals is tough in the prevailing environment, with high interest rates, sluggish stock prices, and companies being much less cash-rich than they were at the end of the pandemic. She shared her insights on why M&As fail in a recent episode of the Wharton Business Daily radio show that airs on SiriusXM. (Listen to the podcast.)

Below are edited excerpts from Feldman’s comments.

Why Mergers and Acquisitions Struggle To Achieve Revenue Synergies

It’s important to distinguish between two phases of the M&A process. The first is target selection and decision-making. The second is implementation and execution.

The high failure rate that accompanies mergers and acquisitions can be linked to both of these phases. On the target selection side, a lot of times companies make poor decisions in terms of which targets are the right fit. [M&As also fail because of] poor execution of due diligence processes, overestimation of synergies, and overpayment, especially when synergies are overestimated. To compound those problems, we have post-merger integration where you see challenges of culture clash, bringing together the two organizations, making them work together, talent retention, [combining] leadership teams and how they might meld, and so on.

It’s important to break the M&A deal process down into its component pieces because each of these phases contributes in a unique way to the lack of success that sometimes accompanies mergers and acquisitions.

“A lot of times when companies under perform in their business operations, they will often turn to M&A as a desperation move under the argument that if we buy this, it will fix our problems, miracles will happen, and everyone will be happy.”— Emilie Feldman

I’ll distinguish between cost synergies and revenue synergies. When we think about cost synergies, we’re talking about efficiencies that you can gain from consolidation, eliminating redundancies, and perhaps layoffs. There are also revenue synergies, which [may come from] entering new markets, gaining new customers, and building new service lines together with the target company. [These are] gains that relate to increasing the top line as opposed to reducing costs.

On expectations, the problem lies with revenue synergies much more so than cost synergies. One study concluded that on average, the realization rate of cost synergies was somewhere between 60% and 90%. But the realization rate for revenue synergies was between 15% and 30%. It’s more straightforward to realize cost synergies — to gain efficiencies, to consolidate. So, companies tend to be much more successful when they try to pursue cost synergies in their mergers and acquisitions.

But revenue synergies are a whole different ball of wax in the sense that you have to get people to work together, you have to learn about geographies or markets or sets of customers that you might not have had exposure to. And so, the workload and the challenges associated with realizing revenue synergies tend to be much more significant.

There’s an interesting link between the phases of the M&A deal process and how that relates to performance of the acquiring company in both the short term and the longer term. On average, we tend to see a small negative impact on the acquiring company’s stock price, at least in the short term, following the announcement of an M&A deal. I would argue that that reflects the target selection part of the story. If we look at longer-term performance, the deals where acquirers continue to under perform are those where some of the execution challenges start to become more apparent.

Avoid Distorting Due Diligence Process

In M&A deals, two aspects of due diligence are challenging for companies. One problem is that a lot of times companies have in mind the answer that they want to receive — that it’s a good target, and that it fits well with their organization. They make the due diligence process lead to the answer that they seek. It is almost like a backward-looking process.

The other challenge is companies oftentimes don’t use due diligence to plan ahead for post-merger integration. Yes, they kick the tires [and check if] what the target company says about its financials and its operations are true. But they don’t stop to think about: How will we integrate their target company? Is it a good fit from a cultural perspective? Will its leadership team work [smoothly] with our leadership team? Could we retain the talent in this organization, and if so, how? So, when it comes time to execute that deal, they encounter many problems that they didn’t even think about in the first place.

Dig Deeper To Understand Cultural Fit

There is a huge misconception that I’d like to just debunk right off the bat. Very often when you say the word “culture” or the words “culture clash” in the context of mergers and acquisitions, companies or people will say, “We both wear jeans to work and have beer at the end of the day on Friday,” and then they say, “Our cultures are the same, therefore things will be fine when we do mergers and acquisitions.” That’s a completely misplaced view of culture.

I would point much more to the notion of “how we do things.” What are our processes for getting things done within our organization, and are those compatible with what the target has in place in terms of its own processes, its own ways of doing things? Think about a company that has a vertical hierarchy in terms of the reporting structure: You have a boss, and they have a boss and the boss’s boss has a boss, and so on. You can’t get anything done within that structure unless you follow the way that reporting has to work.

Contrast that to a very flat organization where there’s not much hierarchy, if any, and decisions are made in a faster way, and there’s more collaboration. Both of those companies might drink beer after work on Friday and wear jeans. But in terms of how stuff gets done, in terms of how decisions are made, you might imagine having a ton of clashes because one company is just used to working in a very different fashion than the other.

There are tons of other ways this can manifest itself. Think about compensation, or think about capital allocation processes. So, it can be deceptive when companies say they have similar attitudes or something like that. It’s much deeper than that, and has more to do with the operating processes, and how companies work day-to-day.

Plan Ahead To Retain the Talent You Want

Talent retention is a huge concern in M&A deals. Think about [a situation] where you’re trying to accomplish revenue synergies by entering a new product market or a new geography that the target previously had access to and you as the acquirer didn’t. You really need the talent from the target company in order to be able to execute on that strategy effectively. This is where companies often find themselves in a good deal of trouble after they do mergers and acquisitions. If you need the talent to attain synergies, but you don’t put plans in place to retain the talent, or if everyone just walks out the door because they can’t function in a different organizational environment that the acquirer has, you’re going to be in a lot of trouble when it comes to talent retention. It’s actually an area where companies tend to do very poorly when they complete mergers and acquisitions.

“[Talent retention is] an area where companies tend to do very poorly when they complete mergers and acquisitions.”— Emilie Feldman

Watchwords in Regulatory Compliance

We’re in a much more rigorous antitrust environment now; it’s a big consideration for companies to be mindful of. Let’s run through a few of them: Will the deal get blocked by regulators in the first place? If they do allow the deal to go through, will there be conditions associated with it? Are we going to have to divest or get rid of certain businesses [for regulators] to permit the merger to go through? That implies a whole other set of transactions that might need to accompany the M&A deal that you might not have even thought about in the first place. So, antitrust regulation is a key consideration that impacts M&A deal-making. 

Getting Mergers and Acquisitions Right in Today’s Environment

The current financial environment is completely different than it was two years ago. Interest rates are obviously much higher. That makes financing much more expensive. Stock prices are more muted than they had been. That makes equity less attractive as a vehicle for funding stock-based M&A deals. To top it all off, companies have a lot less cash on their books now on average than they did on the tail end of the pandemic; companies had built up huge cash balances because they weren’t really doing all that much during the pandemic. So, all three avenues of financing are much tighter right now, which is putting a damper on M&A activity. We’ve certainly seen that in the numbers this year so far.

The thing I worry about a bit is that a lot of times when companies under perform in their business operations, they will often turn to M&A as a desperation move under the argument that if we buy this, it will fix our problems, miracles will happen, and everyone will be happy. But that expectation can often be misplaced and lead to pretty significant challenges for companies.