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Four Tests for Successful Acquisitions

By Peter S. Cohan

A lot of academic research shows that the odds of making an acquisition work are not high. Should companies just forget about M&A, and focus exclusively on innovation and organic growth?

Maybe not, at least in some cases.

Careful thinking about what it means for an acquisition to succeed, coupled with an analysis of why deals fail, can lead to some practical advice for managers, thus helping them to develop a more refined view. More specifically, in order for acquisitions to pay off, they ought to pass four tests. I describe the tests below, showing how each offers a way to head off common sources of merger malfunction.

The Industry Attractiveness Test

If the industry in which the acquired company participates has the potential to remain profitable, then the target passes the industry attractiveness test. One reason that mergers fail is that the inherent profit potential of the target company’s industry is low. That is, the average player in the industry does not earn very high returns and the factors that drive those investment returns are likely to keep them low in the future. Such was certainly the case, for example, with JDS Uniphase, which paid way too much for SDL because a huge drop in demand in the wake of the dot-com crash, was turning its optical components industry into a huge money loser.

The “Better Off” Test

If the acquirer and the target boost their market share and growth potential in the industry as a result of their combined capabilities, then the deal passes the better off test. A second reason for merger failures is that when the acquirer and the target combine, they end up being weaker as a combined company than they would have been separately. As a result, the combined companies end up as hobbled competitors in that new market. Consider here a merger between two tech firms in Silicon Valley, both of whom had IBM as a leading customer. When the merger was announced, they both lost IBM’s business. “IBM wanted to know why they were not told of the change.”1

The Net Present Value (NPV) > 0 test2

If the future cash flows from the deal discounted to the present significantly exceed the price paid, then it passes the NPV > 0 test. One of the most common reasons mergers fail is that the acquirers overpay. The high tech mergers I cited above all failed this test miserably. In retrospect, that failure was obvious. And although many people at the time complained about the frothy market valuations of high technology companies, many of the acquirers did not take those warnings seriously because their own stock prices were similarly inflated and they convinced themselves that they were too smart to be trapped by the problem.

The Integration Test

Finally, if the acquirer and target companies can agree on who will run the combined company and put in place the systems, processes, and culture needed for it to appear seamless to customers on the day the deal closes, then the deal passes the integration test. Most companies that do mergers go into the closing with a conqueror’s mentality. This means the acquirer’s management team will replace that of the target. Often this leads to the loss of much of the talent that made the target worth acquiring in the first place.

At the core of these people problems is a gap between the cultures of the acquirer and the target.Then, there are other big integration problems—such as taking too long to get the processes and systems of both companies linked together so the deal will appear seamless to customers. One example that comes to mind is the merger between Sweden’s Electrolux and Italian appliance manufacturer, Zanussi. This deal in 1984 took years to integrate, and shareholders, customers, and employees suffered as a result.3

Most acquisitions fail. But they can help companies grow profitably if done well. The four tests of a successful acquisition can help managers seize the opportunities and avoid the many pitfalls. With today’s market values remaining below their peak levels, the profitable growth potential of carefully analyzed acquisitions is worth capturing.

  1. Knowledge@Wharton, Ibid.
  2. The Net Present Value calculation estimates the future cash flows from an investment and discounts them to the present at a discount rate which reflects the risk of the investment and the time value of money. Note: Harvard Business School Professor Michael E. Porter refers to this test as the Price test—the idea that the price of the transaction should not capitalize all its future gains.
  3. Dag Andersson et. al., “Electrolux: The Acquisition and Integration of Zanussi,” INSEAD-CEDEP, 1989. Electrolux tried to bend over backward to avoid the perception—developed before the merger closed—that Zanussi employees perceived Electrolux as “Viking invaders.” To change that perception, Electrolux took a very long time to work with key Zanussi stakeholders to be very sensitive about issues such as cost cutting.
  4. Details about how to conduct such an analysis are available from Porter’s Competitive Strategy (Free Press, 1980)
  5. To develop such forecasts, it is crucial, but often difficult, to analyze the NPV objectively. This can be difficult because if the CEO is determined to close the deal, he or she will expect the deal team to come up with numbers needed for the deal to pass this test. One way to fight this confirmation bias effect is to deputize a separate team, led by an outside consultant, that is charged with analyzing the deal from the most conservative and/or pessimistic perspective.
 

 Five-step process for applying the four tests:

 

Step 1. Form a team
The first step is for the acquirer’s CEO to form a team to evaluate the merger candidate. The team members should consist of the CFO, the general manager of the division in which the target will fit after the merger, key functional managers, and outside advisers.

To apply the four tests, the team will need to apply concepts, gather data, conduct analysis, and draw conclusions about whether the proposed deal passes each of the four tests in turn.

Step 2. Analyze the target company’s industry profit potential
The second step requires the team to assess the average profitability of the industry in which the target company competes. And it must provide insight into the factors that are driving that level of profitability in the future. Doing this depends on conducting a “five forces analysis.”4

Step 3. Assess whether the combined companies will be better off.
If the target company competes in an attractive industry, the team must next consider whether the combined companies will be better off. The key to this analysis is knowing which activities are most critical to succeeding in the industry in which the target company competes.

Step 4. Analyze whether the cash that will flow from the acquired company exceeds the purchase price.
If the target company passes the attractiveness and better off tests, then the team must analyze whether its NPV is positive. To accomplish this, the team ought to forecast the future cash flows from the acquired company—taking into account potential cost savings as well as new revenue that might flow from the strengths of the combined companies.5

The team should, of course, take into account the purchase price for the company and discount all the cash flows back to the present. If the NPV exceeds zero and the assumptions used to generate the cash flow forecasts are robust, then the deal passes the NPV > 0 test, and the team should proceed to the final step.

Step 5. Evaluate whether the acquirer can integrate the target company effectively and efficiently
Finally, the team must assess whether the target will fit well with the acquirer. To assess that, the team must decide whether it will be able to put the best people from either company in the key jobs and will succeed at integrating the two company’s systems and processes so that by the time the deal closes, the acquisition will appear seamless to customers. If a deal passes the integration test, the odds are far better that it will make both the acquirer and the target companies better off.