You don’t have to go far to read something about a failed M&A transaction. One that comes to mind is the Sears-Kmart transaction which is cratering as we speak. It’s been called “the greatest destruction of retail value in history.” Remember the mega-merger between Kraft and Heinz? The New York Times recently called it a mega-mess. Oh, and that includes its accounting – I will talk more about that below.
But it goes without saying that this area is full of failures. If you are in FP&A and the Big Kahuna tells you to do an analysis on a possible transaction, how do you go about it in a credible manner?
As they say, the definition of insanity is doing the same things again and again and expecting a different result. So, should you use a traditional M&A transaction proforma analysis that usually fails?
I guess the M&A area badly needs a new approach, maybe a revolutionary one given how ineffective the current ones are. What could that be? I’m sure you’re going to think I’m going to suggest behavioral finance, and you would be right. It’s clear that the one variable we never look at in M&A transactions in a formal way is the behaviors of the leaders, managers and employees on the two sides of a transaction.
That’s kind of weird right? After all, the financials rarely work out as planned and the only big variable you have any sort of control over is behaviors of managers and leaders. So clearly, we need to account for that.
Let’s take an example. Remember when AT&T acquired NCR in 1991? That acquisition was a total flop and the deal was vacated in 1996. But how come everyone got it so wrong when on the surface it all looked hunky-dory?
Here’s an angle. NCR was an innovative tech company and all the leaders had been hired for their comfort with innovation and disruption. AT&T of course was the opposite; that’s why it wanted NCR. So, the status quo bias in one was low and the other high. Actually, you don’t really need to know much more. There was a dramatic difference between the two in a critical cognitive bias of the two sets of leaders and employees.
Cherchez la femme (kind of)
So duh, shouldn’t transaction architects, leaders and analysts be checking off the key cognitive biases in the two sides of a transaction to see the level of alignment? And since, as I have shown in previous articles in FP&A Trends, you can use these biases to predict the actual financial impact on a company, this means you can actually model an M&A transaction outcome. We call this a behavioral proforma.
But you’ve never heard of that right? That’s because the state of the art is still behind the state of knowledge. The academics have gotten us the knowledge, but they haven’t gotten us to the behavioral proforma because they don’t do the transactions. And the investment banks and financial analysts have either never heard about behavioral finance or they haven’t worked out how to use it as the basis of real-world models.
Now I’m not suggesting you suddenly drop traditional M&A proformas. I’m just suggesting that analysts construct a behavioral proforma and then use it as another set of data points on the future of the transaction. Actually, it’s not so difficult. We have done it ourselves. You just have to be a little bit low yourself on the status quo bias, so you feel comfortable working with a new approach.
Behavioral M&A for dummies
I guess most readers of this article are financial analysts themselves so they will know about traditional proformas. But if you want to really use the full potential of behavioral finance for M&A transactions you need to go much further than that. At a minimum you need to apply the behavioral approach to the following phases of the transaction lifecycle:
- Development of our acquisition strategy — what behaviors (i.e. cognitive biases) do we lack? What behaviors do we need so that the analysis won’t fail due to a lack of behavioral diversity or lack of cognitive biases that are aligned with the place where both sides want to go?
- The target screening process — what are our behavioral criteria for the right target? What are the mandatory behavioral, not just financial, product and market criteria we need for transaction success?
- Predicting future valuation outcome — how do we develop a behavioral proforma? How do we improve and optimize the financial outcome using behavioral modification, behavioral engineering and organization change?
- Designing the acquisition team and putting it together — how do we designing the acquisition team composition to match target financial styles – so that we don’t miss the wood for the trees?
- Post-acquisition and absorption strategy — what actions do we take considering the actual behaviors that have been acquired, and how best to align both sides to get the best financial result?
Where’s the beef?
No doubt most analysts have been taught to look at actual and predicted revenues and costs when analyzing a transaction. Their goal is to figure out profit (or loss) and EBITDA. But is this the appropriate approach?
Surely analysts should also be looking at the behavioral sources of economic and financial value and then also adding that into the analysis? That’s what seems to be missing from the current approach. Some might say that’s being done. But it isn’t, not formally. That’s the problem.
That means you have to look at key people and key parts of the organization to see what levels of cognitive bias there are especially in the status quo and the illusion of control bias. The first gives you a leading indicator of gross margin and the second a leading indicator of expenses.
Often that is going to tell you a completely different story from revenue and cost forecasts. You really, really need to get a handle on those issues if you want to get a real-world perspective on how the transaction is going to fare in the future.
You might tell me that you are a financial person, not a psychoanalyst. But you don’t need to be one; that’s the wrong thing anyway.
Financials are a symptom not a cause. They are a lagging, not a leading indicator. You are always looking in the rear-vision mirror. Is that what you want to be doing in analyzing an M&A deal? Looking at the past and not the future?
Behaviors cause things to happen and that results in actions which are measured using financial metrics. So, shouldn’t you need to know the behaviors to figure out what’s going to happen, at least in part?
Otherwise you are only seeing a small part of the picture and, as we know, that can be very misleading if not financially fatal, as many organizations have found, to their cost. Not to mention that of their shareholders and investors.