Performing Cultural Due Diligence to Better Understand the Target Company

Most of the biggest M&A failures of all time are caused by culture clashes. Both companies cannot simply co-exist with each other, and instead of creating more value, they destroyed both of their businesses. This is why cultural due diligence is crucial in M&A. In this episode of the M&A Science Podcast, Ken Bond, Head of Corporate Development at Cetera Financial Group, shares his expertise on how to perform cultural due diligence to better understand the target company.

Performing Cultural Due Diligence to Better Understand the Target Company

13 Mar
Ken Bond
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Performing Cultural Due Diligence to Better Understand the Target Company

Performing Cultural Due Diligence to Better Understand the Target Company

“I wouldn't necessarily walk away from every deal that's got a bad cultural fit, but the integration plan has to adapt and accommodate the findings of the cultural diligence.” - Ken Bond

Most of the biggest M&A failures of all time are caused by culture clashes. Both companies cannot simply co-exist with each other, and instead of creating more value, they destroyed both of their businesses. This is why cultural due diligence is crucial in M&A. In this episode of the M&A Science Podcast, Ken Bond, Head of Corporate Development at Cetera Financial Group, shares his expertise on how to perform cultural due diligence to better understand the target company.

special guests

Ken Bond
Head of Corporate Development at Cetera Financial Group

Hosted by

Kison Patel

Episode Transcript

Person responsible for cultural due diligence

Just like everybody else, the Corp dev team is responsible for executing diligence or ensuring that diligence is done on the target company. Individual functional owners or leaders of those diligence efforts are responsible for their unique areas. 

I would argue that HR is a big portion of evaluating culture and should own an understanding of what the cultural diligence yields. I would put this responsibility on the HR professional, but they need support. 

Let's talk about why this is important first, and then we can discuss how we assess it, and how we mitigate the findings from our assessment. 

Importance of cultural due diligence

Well, one of the presidents I used to work for, probably one of the most influential leaders I've ever worked for, especially when it came to M&A, held the position and said on stage, "Culture eats strategy for breakfast," meaning if you've got a bad cultural fit, it's not going to overcome a good strategy

I would modify that slightly to say that culture is an important consideration that has to drive the integration plan. I wouldn't necessarily walk away from every deal that's got a bad cultural fit, but the integration plan has to adapt and accommodate the findings of the cultural diligence. So that's why you want to do it. 

During diligence, there is already a great deal of cultural diligence. Problem arises when folks don’t aggregate the diligence findings from a cultural perspective.

Let me give you some examples. We review the employee handbook, employee policies and procedures. You're doing a number of one-on-one interviews with functional leaders, maybe it's IT, HR, finance. 

Each of these leaders is probably getting interviewed during your diligence effort to understand aspects of their systems, policies, or procedures. But you're certainly going to have one-on-one interviews with them. 

In that process, you will be able to assess how they make decisions, how they delegate, how they engage with other functional leaders, and how they view their collective team, and whether that's a healthy team or not. 

The employee handbook is also going to give you some good insights there, as well as policies and procedures for everything from time off to diversity and inclusion, all the different policies and procedures they engage with.

They roll into the firm, which you will certainly evaluate. What's missing is bringing together all those findings from a lens of culture. So just ask the question, what insight have we gained from the diligence we've done about the culture of the prospective firm?

Executing cultural due diligence 

Well, I would say it actually starts with making sure that your diligence plan ensures that the data or the findings that come out of your diligence effort are evaluated from a cultural perspective. You probably already have, if you look at your diligence plans, many discussions about how to conduct diligence at a functional level.

If cultural diligence is done right, there is no need to modify the diligence plans dramatically. It’s about pulling together the findings that come out of those functional diligence efforts and evaluate them from the perspective of what insight into culture they provide.

You can then form a view around the key attributes of culture, such as decision-making and community. Another important component of cultural diligence is that the acquiring entity also needs a similar level of evaluation. 

For global organizations, each of the countries almost always has its own microcosm of culture. It's common across the global organization or even individual sites. Your California office may look very different from your Kansas City office or your Florida office.

So if the Kansas City office is doing the acquisition, make sure you understand the culture that they're walking into. When both the target and acquirer get evaluated, it’s easier to understand where the friction might be during integration.

In rare instances, you may blow up the deal and just say, listen, this is a bridge too far. They're just not compatible; it's going to be like oil and water. It simply won't work, and we'll either lose the people or the clients, or both. Ultimately, this is likely to be a disaster. Although this rarely happens, in a couple of instances it has occurred.

Killing the deal due to cultural conflict

In my personal experience, I've seen smaller transactions with an owner-operator where the owner is going to become a W2 employee of the acquiring entity and is critical to maintaining client relationships post-close, or consumer relationships post-close. 

Many times, these individuals are larger-than-life figures, very proud of the businesses they've built and may not play well in the sandbox with others, so to speak. It might rise to such a level that you simply don't think they're going to be manageable or that they can be trusted to look after the best interests of the combined entity. 

Fundamentally, if you don't trust them, as you continue to do cultural diligence, and you find out that they are untrustworthy, that's a good reason to back out of the deal.

More likely than not, though, the issue is that they're very centralized and don't push decision-making down like we do. 

As we integrate their functional teams into our teams, they are not going to have as strong direction for how their work should be done that they're used to having, and they'll be asked to operate on a significantly more autonomous basis, and that's simply not going to work well for them. 

So we need to be thoughtful about how we bring the two teams together to overcome that.

Sales teams may go about prosecuting opportunities in a very different way. I'm not talking just about business processes, but how their culture of collaboration or how they engage the rest of the organization in a constructive way. 

If it's very antagonistic between functional areas, then that alone will tell you you've got a bit of work to do. You might want to spend a little more time getting to know them before you bring them in. Not necessarily walking away from them, but the findings around cultural diligence should influence the speed and depth at which you choose to integrate the businesses.

What you do find is that whether you choose to integrate within one month, three months, six months, the reductions that inevitably come with those integrations, those one-time costs don't sink a transaction. 

If they could sink a transaction, you need to rethink your pricing. The deal might be a little too rich. One-time costs like that generally shouldn't be the issue. It's the run rate synergies that you really need to achieve to make a transaction work. 

If you're leveraging, then lenders are going to give you 12, 18, 24 months, depending on the market conditions when you get the lending, to achieve those synergies.

So you've got time. It's better to be thoughtful about the timing of when those savings are realized and to give yourself the greatest chance of success. The more data you have, with culture being a key component, to fold into the architecture of your integration plan, the better chance you have of a successful outcome.

Using playbooks

Absolutely, each organization builds their own playbooks based on past precedent and how they're organized, and how they best ingest organizations that they acquire. 

But playbooks should never be rigid and should always adapt to the circumstances of each transaction. They're really more like guidelines or starting spots, and then it has to adapt to the peculiarities of a transaction. 

And one of the peculiarities of the transaction is the culture of the business, which is how they make decisions, how they manage their people, how they push risk, their willingness to take risks, and how they reward or punish mistakes.

All of these have to influence the integration plan, whether you allow them to continue to operate autonomously and side by side like their own little cell within a functional area. 

So you want to keep the core team together, but it'll now be managed by the acquiring company's department head, or do you intermix the teams such that they're indistinguishable post-close from who was acquired and who was the acquirer. 

There are different ways that could play out and there's no reason not to be thoughtful so that you can get the best possible outcome.

Every company's culture is unique, but you can profile them when going through this exercise. You lay those out upfront in your diligence kickoff. This is one of the work streams that you're going to highlight just like everybody else.

The person in charge of HR generally also says, 'Listen, we're also going to be evaluating culture.' So, just to be clear, I'm looking for the following items. I'm going to come back to each of you after your one-on-one interviews. I'm going to spend 10-15 minutes with you in an interview to debrief on what you found when you were engaging with the sell side.

From that, I will then aggregate findings across all the different interviews and our own diligence materials, such as policies, procedures, handbooks, etc. I'll form a view around what they look like and I will share that at the final due diligence readout. This is so that people, especially the leaders, are aware of what they're walking into. The leader of the integration, that business executive, will certainly care a great deal about whether there's likely to be friction or not.

Cultural due diligence during early conversations

You're always getting it whether you realize it or not. It's playing a role in your bid strategy, your engagement strategy, and how you are positioning the combination of the firms. If they care a great deal about autonomy, you're going to try to feed that. 

You're trying to find a solution that allows them to get what they need out of the transaction. But at the same time, you're starting to evaluate whether it's a healthy organization or not. It is a process, though. 

Here's the point that's probably most relevant: in a process where your engagement with the management team is very limited and controlled, like a bank-controlled process, you only get a four-hour management meeting, some very scripted meetings that are supervised by either parent co or the banker.

You might have a couple of hours, 30-minute meetings with functional leaders. So, add that up, you probably get another four or five hours max with the Sell Side management team. You don't have a lot of time there to come to an understanding of what their culture actually is. 

It could be all theater, and you're very likely getting the best of who they are. We've all seen that, where once you get into diligence, inevitably, you're two weeks away from signing the transaction and you realize that, oh, the CEO actually hates the head of HR and the IT guy can't be in the same room as the CEO. 

That's not helpful and it impacts your retention plan as well. There are personalities there that you need to make sure you understand. Your ability to evaluate culture is more constrained in that environment.

However, if you are doing a bilateral where you either have prior history or you've got an elongated engagement with the seller, then it's a lot easier to form a real view around the culture of the business. 

That's another reason why bilaterals are so much better than auction processes and generally yield significantly better outcomes because you get a better feel for who the actual people are and a more true assessment of their culture.

Understanding how the target company makes decisions

You're going to find that out either at the management presentation, when you start talking through different functions. There's a need to understand what you call service and ops and what we call service and ops, and who does call center work. 

Everyone has different lingo, and you need to go through the process of lining all of that up. If for nothing else, you need that to ensure you're making apples to apples comparisons either on gearing ratios or work structures when looking at merging things together. 

In that process, you're also going to talk about control and how particular decisions get made. You could discuss large capital expenditures, large IT programs, or how individual hire-fire decisions are made, and what a budget means. 

There are lots of different nuggets that will come out of a free-flowing conversation during that four-hour management meeting that need to be captured from that perspective.

Alternatively, you're also going to be having conversations with the CIO so that you can better understand the architecture of the business. In some instances, a discovery session where you've got a broad range of stuff you want to get a feel for, a free-flowing discovery session is the most efficient way to muddle your way through the discovery or the diligence process. 

You will almost always be asking some specific questions like, who makes that decision? How do you manage? How many people do you manage? What are their roles and responsibilities? How engaged are you in this architecture decision, or in these particular programs, or are they delegated to X, Y, or Z?

You'll get a feel for that during those engagements. You can’t just send a checklist.

Everyone is super busy with due diligence efforts. The last thing you want to do is add a new work stream for somebody to go do. It's much better if you can leverage the existing materials that are going to come out that you require anyway, and just analyze the data from a different perspective.

So, I'd argue cultural diligence is a bit like that. You're already gathering that information, we're just simply applying a different use to that data and that information for a different purpose.

Things to look for during due diligence

Nothing specific jumps to mind other than analyzing whether they have certain policies and procedures. We've seen them, of course. There are many things you're looking for, like compliance with local labor laws, which is somewhat critical. 

Understanding how centralized control is and the levels of gifts they're allowed to receive from vendors, what they can do for office entertainment, or even office parties and celebrations. There are many different tidbits that you can pull out there to say, 'This is an attribute of their culture that's very different than ours and just be aware.'

It gives you the groundwork for when you do have those in-person conversations of what areas to look into. For example, if they have free snacks and coffee in their offices and we don't, be aware. That's an attribute they find valuable, and it's been that way for a while. When you bring the two teams together, that's going to come up.

I haven't got any great horror stories other than the transactions we walked from because the cultural fit was just too bad. Or probably should have walked from. We certainly highlighted a couple of deals where the cultural fit was obviously so bad that we didn't recommend proceeding forward. 

And that ultimately led to a lot of bad behavior, a lot of self-serving behavior, and ultimately firing and lawsuits against the seller. At that point, it's very late, and it looks bad for everybody. There are no winners when that happens."

You find some instances where people like to come together for group celebrations, and they've got a number of those that happen throughout the year, including holiday parties. Then there are others who, when they've had bad behavior at an event or something happened at one of those events, have locked those down and no longer engage in that type of activity. 

So when you bring those teams together, it's about how they celebrate success, how they form friendships and camaraderie between individuals, especially if they're not in the same office location, if you're not coming together.

They have to figure out how to solve the fundamental problem without saying, 'I'm right, you're wrong.' But really, there's a reason they're doing what they're doing, and you need to figure out how to solve that problem without mandating a solution that's going to be unacceptable to one or the other side.

Using questionnaires for cultural due diligence

Many times people use questionnaires today to evaluate culture, which is fabulous but not really practical in the context of a confidential M&A transaction where there are generally only a few people in the loop, and most are completely unaware of the transaction. 

However, I was at a conference talking to another CorpDev professional in the IT sector. They already had questionnaires and had engaged a third party to conduct cultural surveys of the target firm, whatever the target might be.

They had a pretty slick engagement methodology that obfuscated why they were doing the survey. They would come in as part of diligence and survey the employees to get a better understanding of what they were walking into. 

They had it couched under some innocuous reason, but it was done as part of the transaction for the entire organization. Those findings then informed both whether they wanted to proceed with the transaction and how they built the integration.

But it's not a super common thing for all deals to conduct that kind of cultural survey. It's expensive, and in my industry, it would be exceptionally difficult to pull off. Sellers in general would not permit that type of engagement, even if you were willing to foot the bill. It's just too expensive and too intrusive.

Bilateral deal vs. Auction process

It impacts more probably because you've got more data from the other side. In a bilateral, your engagements are more frequent, and you're gathering more data, making it easier for the acquiring firm to build that information into their integration plan. 

But in auction processes, you're still going to have to form a view one way or the other, and you're going to have to take some bets. You're just taking less risk because you probably have a better feel for exactly what the firm is if it were one-on-one.

When it comes to outcomes, the probability of a bad outcome increases in an auction process compared to a bilateral. To the extent you can, being more thoughtful and better understanding the acquiring firm allows you to build a better integration plan

This is fabulous because you'll have a better potential for retaining people, retaining clients, continuing to grow the business, and losing less critical talent. It's all the same metrics that outline what a successful transaction looks like.

Everybody would prefer to do a bilateral than run through an auction process. You can also end up paying more during auction processes.  So you're paying more and taking more risk when you go through an auction. 

However, participating in an auction is a good learning experience. The larger the deal, the more likely the owners have a fiduciary duty to some shareholder or whoever's running the process or managing the business. They have a fiduciary duty to their shareholders to maximize value, so they're obligated to run a process.

For sure. I know buyers, especially 10 years ago, especially on smaller deals, weren't willing to engage with bankers or run through processes. They'd only do bilateral transactions. They were generally doing small roll-ups, and that was how they set up their processes. 

Hardest part of cultural due diligence

The most challenging part is for people to actually take it seriously and to get the conclusions acted upon. So, pulling together the findings and then ensuring that they are acted upon in the integration plan is another aspect. You're probably juggling 16-17 balls at the same time trying to get a transaction over the line.

It's not something that's going to hold up a transaction document. It's not a burning platform that needs to be solved immediately or a risk that requires buying insurance to push onto a third party. It's an attribute that has to be accommodated. It's important but not urgent to get the transaction signed.

It gets mentioned in the business case. In our diligence findings, especially in the HR section, we absolutely talk about culture. The findings are pulled together there.

If you've built the integration plan and have a track record of executing integration plans appropriately, the board's not going to scrutinize exactly how you're executing or demand to see the plan in detail. 

If you've built a level of trust and demonstrated capabilities, they're going to let you run with that. The assumption is that you're executing the same playbooks that have yielded positive outcomes in the past, so they're not going to care. 

If it's your first transaction, they might dig into different aspects, especially around how you're going to integrate the management teams together.

The bigger stakeholders are going to be the integration leads and the steering committee overseeing the process. If it's a material acquisition, then you're going to have the integration steering committee made up of key executives and ultimately the business unit owner, whose responsibility it would be if it goes sideways. 

They're the ultimate accountable party, so they're going to care a great deal about making sure that the cultural aspects of the two different firms are respected when we bring them together. 

Successful partnership between corporate development and integration

Those that performed the due diligence should build the integration plans. Everyone should be one virtual team, even if they sit within different functional areas.

I've always had integration leads either reporting to me on a solid or a dotted line. The people responsible for integration should be the program managers managing the due diligence activities as well. They should be the exact same individuals so that they deeply understand the diligence findings and the plan to mitigate them.

The integration plan needs to account for cultural differences. So, if your integration plan is for an adjacency, where we're going to buy this firm that doesn't look like anything we have today, provides new capability or functionality to our business, and we're going to operate it on a standalone basis off to the side. 

It's going to hang underneath one of the operating companies and keep doing what it's doing. It will continue to maintain its old culture effectively. You need to make sure that there's not going to be something catastrophic that happens, but for the most part, it's going to keep operating the way it is and maintain its cultural identity, as opposed to something that will be deep integration.

So, if you're doing an asset deal where you're lifting out a big chunk of the seller and you're going to integrate it into an existing entity where people are going to be working side by side, shoulder to shoulder with new colleagues, that's a whole different challenge, and a much bigger challenge on the integration than just buying something that's going to continue to operate as pre-close.

Geographic proximity is always a problem as well, which is ultimately you're going to be buying firms and there needs to be a way to inject the DNA of the acquirer into the acquired. So, if you're picking up a new office in Seattle where you don't have an existing presence, how do you bring them into the fold?

How do you take the culture of your firm to the new Seattle office that you just picked up? There has to be a plan to do that, and it has to be thoughtful. It has to be a prong of your integration plan. In other words, it can't be accidental. You need to be intentional.

Subculture due diligence

There are always nuances from the core ethos of the organization, and there will be variations of that as you go into either different offices or different countries. But the core should still be the same, and that's what needs to be respected. Ultimately, that's what you're bringing to the new entity that's being acquired.

They're going to impact you as well, and the bigger they are, the more they impact you. You're not unchanged after you do a transaction. People bring with them aspects and elements of their former company.

Everybody experiences it. That is exactly why you need a strong integration, model governance model for transactions. So those issues can be surfaced quickly. We can identify what's going sideways and what we need to do to counteract that.

What you don't want is the integration lead solving it all by themselves. You want them bringing it to the steering committee so that they can understand what the issue is and create a response that can be replicated across multiple areas. It's not a point solution, so that's an argument for a broader governance model across bigger integration activities.

Advice for practitioners

There's no silver bullet. What people should take away is that it's simply trying to understand the data that you're going to gather in a standard diligence effort anyway, but with a different objective.

This objective isn't about understanding if there are any undisclosed liabilities on the balance sheet that haven't been accounted for either from past operating practice or otherwise. 

In this instance, you're looking at it from the perspective of what insight you can glean from this information about their culture, how they make decisions, and how they act as a community. You're going to use those findings to then influence how you might want to bring those two organizations together.

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