Making Acquisitions Work: Human Capital Aspects of Due Diligence and Integration

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By Haig R. Nalbantian, Richard A. Guzzo, Dave Kieffer, and Jay Doherty

Strategic acquisitions are driven by many legitimate business purposes: to achieve profit growth, gain advantages of scope or scale, acquire complementary skills or resources, or capture an important technology, distribution arrangement, or competency. Yet these combinations often fail to deliver the promised gains. Depending on the research cited, 50 to 80 percent of acquisitions never produce the anticipated benefits.

Is faulty pre-deal due diligence responsible for these disappointing results? Due diligence concentrates mostly on measurable 'things' — for example, the valuation of inventory and contracts, financing options, balance sheet impacts, existing labor agreements, supplier contracts, and product and distribution issues. Such analyses often fail to account for the acquired entity's human capital — i.e., the company's stock of knowledge, technical skills, creativity, and experience.

Human capital is seldom evaluated or addressed until after the deal is closed, when integration problems first appear. By integration we mean the harmonization of structures and processes and the alignment of two organizations with common goals. Integration failure is the most frequently cited reason for unsuccessful acquisitions.

Getting the people issues right is an important step toward a successful deal. Acquirers should pay serious attention to the human capital of target companies, their value, and their potential for integration. That attention should be given before a deal is made and again as soon as the deal closes and integration looms.

To Integrate or Not to Integrate

Integration, which is almost always a matter of degree, can be complete, partial, or minimal. Complete integration occurs when the acquired entity takes on fully the properties of the acquiring firm, including styles of operating, infrastructure, identity, and brands. Functions and lines of business are melded into one.

Partial integration occurs when some but not all of the acquired firm's systems, practices, and policies are merged with those of the acquiring firm. The acquirer may handle, for example, all accounting and financial functions, leaving the acquired company substantial independence in product development and marketing.

Minimal integration refers to an acquired organization that operates as a stand-alone 'portfolio' company. There are few examples of 'pure' portfolio companies. Acquirers usually exert some influence on an acquired firm's practices.

Full integration is not always appropriate. In some cases the acquired company's business and human capital base are so different that it should be left to its own devices as a portfolio company. Some operational redundancies usually can be combined, lowering costs, but full integration might create a huge mess and sap the unique qualities of the acquired firm. We believe that a substantial number of acquisitions fail to return value because integration is pursued that never should have been attempted.

How does one know which level of integration is optimal for success? Should integration proceed rapidly or be done in a piecemeal fashion? These are important questions. To help executives answer them, we have developed a practical framework (see Figure 1) that can help decision-makers do three things: know themselves, their target, and the difference between them; estimate the potential scope of integration; and recognize the pace at which integration should proceed.

The horizontal axis in Figure 1 refers to 'forces for integration,' the factors that push the acquirer and the target toward each other. Those forces may be strategic intent, human capital requirements, core business process requirements, or any combination of the three. The stronger those factors, the stronger the need for integration. Since our principal interest is the people side of acquisitions, we will focus on human capital requirements.

In terms of human capital, the forces for integration are low when an acquisition:

• meets a need for a product, patent, location, and so on, but not the employees; and
• brings with it employees who are easily substituted for by new hires — i.e., employees with low firm-specific skills.

Conversely, the forces for integration are high — from a human capital perspective — when the acquisition:

• creates opportunities to leverage or join various people-driven capabilities, such as sales and research and development;
• requires collaboration on projects or contracts; and
• presents significant new opportunities to attract, retain, and develop talent through integration.

These are precisely the factors that are often overshadowed by traditional concerns about the price of the deal and the identification of physical assets to keep and to sell.

As is indicated on the vertical axis of the decision framework matrix in Figure 1, barriers to integration can be high or low. Human capital barriers to integration occur in varying degrees with every deal. Some barriers arise because of differences between workforces; others because of differences in the way workforces are managed. In terms of human capital, workforce barriers to integration are high when the acquired company:

• has a very different demographic profile (age, gender, ethnicity);
• differs culturally or linguistically; and
• has a different skill base. Barriers in the form of differences in workforce management practices exist when, for example, the acquired company:
• defines jobs with a different degree of breadth;
• differs in terms of the access to autonomy and information given to employees;
• uses different methods of selection, training, and development;
• locates authority for decisions at different levels (degree of decentralization); and
• differs in pay practices — e.g., pay relative to market, the mix of fixed and variable pay, the use of stock options.

This is a long list of integration hurdles, but each is important and should be examined as part of pre-deal due diligence. The same list should be revisited when a deal has been consummated and people are ready to move forward with integration.

The framework shown in Figure 1 is a guide for structuring thinking about the integration of acquired firms and business units. It identifies a wide range of human capital issues to consider and raises issues that should be addressed as part of the due diligence work. Typically during this period the acquiring firm does not have access to all the data about the target company that it needs to resolve uncertainties about what barriers to integration exist and how strong they are. However, the issues should be considered as explicitly as possible to prevent wishful thinking. The framework is especially applicable as soon as the deal is completed. That is when the integration team — perhaps consisting of representatives from both companies — can truly go after the facts needed to make informed decisions about the extent and speed of integration.

Applying the Integration Framework

'Company A,' a large and well-known public corporation, acquired another large institution, 'Company B,' which had operations in several of the markets Company A served. Over the years, Company A had made several acquisitions and developed an approach to integration that was based on speed and adapting the acquired company's systems, practices, and procedures to its own. Our involvement in this situation came about at the request of Company A, which was eager to understand similarities and differences in the human capital systems of the two organizations before making any drastic changes.

We began, as always, by gathering the facts from the two entities. What are the rates of movement of employees into, out of, and upward in the two organizations? How are rewards structured: by years of service, performance, movement from job to job? To answer such questions, we conducted Internal Labor Market (ILM) analyses, which provide fact-based answers to questions about who joins, who stays, who advances, how rewards are distributed, and how talent is developed. The analyses are based on data routinely maintained in employers' databases and provide unparalleled insights into management practices and workforces. The ILM maps for Company A and B appear in Figure 2.

The ILM map of company A reveals an organization with a steep hierarchy with many employees in the lower levels and dramatically fewer people at higher levels. Company B, in contrast, is relatively less hierarchical. Its map indicates a more equal distribution of employees through the various job levels and much less thinning out toward the top.

Investigation revealed that the two firms had very different reward systems attached to their respective job levels. At Company A, moving up through levels produced sizable financial rewards that rose at ever increasing rates — what we call a 'tournament' reward structure. That practice encouraged a career orientation among Company A's employees, who apparently understood that simply doing satisfactory work and sticking with the company would not be rewarded anywhere near as much as moving ahead in their careers and advancing up the career ladder. Although Company A employees in most lower- and middle-level jobs were paid somewhat less than their counterparts at Company B, their upward 'pay trajectories' were more dramatic, encouraging retention and a willingness to develop careers with the company. Company B's employees actually could advance more rapidly, as the high numbers of individuals above the mid-mark of job levels testified, but advancing up the ladder produced less dramatic pay increases. Company B's employees could be consoled by the fact that they were nevertheless paid at or above market rates. Above-market pay encouraged retention.

The bottom line was that Company A had a career culture while Company B had a pay culture. Which was better? That did not matter as long as the companies were independent and the workplace culture served the respective company's strategic goals. Integration changed this. Management had to determine which culture would best serve the strategy of the combined entities. That determination was made more interesting by the fact that some key executives from Company B were retained in high-level positions in the combined entity. Being accustomed to an environment with fewer job levels and a more market-focused, pay-oriented culture, they urged Company A to move in that direction. Those features, they believed, were easier to manage and produced good results. Company A's management, however, understood the singular importance of their career culture for retaining top-flight employees. They also recognized that such a culture could better serve the strategic goal of strengthening and growing relationships with customers because it fosters longer-term commitment to the organization among employees. Not surprisingly, the new combined organization maintained a strong career orientation.

Staying on Track

A large technology company offers another example of how measuring internal labor market dynamics can help executives facing post-deal integration. In this case, the executives of a major technology company had to evaluate the effectiveness of post-deal integration to see whether they were on track toward achieving their integration objectives.

This company was a major acquirer of smaller companies and their human assets. The patents conveyed by those acquisitions were critical, but so was the human capital that generated them. It was hoped that the expertise of the acquired employees would complement the expertise of the acquiring company, potentially accelerating the pace of new product development. Thus, the strategy called for integration of the technical personnel of the acquired companies.

An analysis of the acquiring company's internal labor market dynamics over time revealed the extent to which integration was being achieved in terms of human capital. The results were disappointing. Incumbent employees (those already employed in the acquiring firm) fared differently than acquired employees in several important ways, with one being turnover. Acquired employees were leaving the company at higher rates than incumbents were, particularly in some units. This signaled integration difficulties.

Employee turnover is one of the more commonly tracked indicators of integration difficulties. ILM analyses involve many additional indicators. In this case, for example, the facts showed that the rate of pay growth of acquired employees was equivalent to that of incumbents, suggesting that integration was on track. However, the two groups differed significantly in several other ways, including promotions. Incumbents were 1.5 times more likely to be promoted than were acquired employees after accounting for differences in performance ratings, job, level in the organization, and other relevant factors.

Internal mobility also set the two groups apart. In general, the parent organization had relatively high rates of movement between jobs, mostly within functional areas but sometimes between them. That rate of mobility was well suited to the project nature of much of the work and to the development of skills and expertise in related technical areas. However, it was the incumbents who were doing most of the moving; acquired employees rarely changed jobs. When they did move, they tended to remain in the same functional area. In fact, there was little evidence of integrating talent into the broader workforce.

The story told by this ILM analysis is one of opportunities lost and a need to get back on track. Acquired employees lost the opportunity for upward or lateral mobility in the parent organization. The acquiring organization lost the opportunity to benefit from collaborative product development efforts. The ILM analysis did, however, identify where in the organization integration was going well. Where it was not, the analysis helped prioritize the actions needed to get integration back on track. Further, it provided a dashboard of metrics that executives could use in monitoring the success and shortfalls of their integration efforts.

Lessons on Acquisitions

The two cases presented above underscore the point that rational decisions are made only when executives observe the three principles of human capital strategy:

Systems thinking. The acquiring company must be very clear about the purpose of the acquisition and the strategy to be pursued. The human resources of the acquirer and the acquired are parts of a larger system whose purpose is to execute the chosen strategy. Whether the acquirer accepts the human capital practices of the acquired company or bends them to its own way of doing things, they will have an impact on the system.

Base integration decisions on relevant facts. Many integration decisions are based on hunches or a superficial understanding of the facts. These often lead to disappointing results. A company can avoid disappointments by taking the time to dig out the facts about the workforces that will be integrated. ILM analysis can be used to get the facts.

Select the course of action that will create the greatest value. A company should not get hung up on the issue of cost; instead, it should focus on value.

This article has been adapted from a chapter in Play to Your Strengths: Managing Your Internal Labor Markets for Lasting Competitive Advantage (McGraw-Hill, 2003) by Haig R. Nalbantian, Richard A. Guzzo, Dave Kieffer, and Jay Doherty of Mercer Human Resource Consulting. For more information about the book as well as ideas and material related to the measurement and management of human capital, visit www.lastingadvantage.com.