S02E13 - Profit - Supply Chains in M&As: the invisible gorilla (original script)
Welcome to The Supply Chain Dialogues, season two, episode 13. I am Daniel Helmig.
The origin of this episode is based on the fact that I fell into a YouTube hole over the holidays. You might know how this feels: you look at a video someone sent you with funny season greetings, and suddenly you end up somewhere asking yourself: how on earth did I end up here, and what happened to the last two hours of my life?
In my case, I re-watched a video of a famous social science experiment conducted two years ago at Harvard University.
Picture this: you, as a participant in the lab experiment, are given the task of watching a short video featuring six individuals passing basketballs around. Three of them wear white shirts, while the others wear black shirts. Your job is to silently count how many times the individuals in white shirts pass the ball. Here's the interesting part: at some point during the video, a person in a gorilla costume casually walks into the middle of all the action. It boldly faces the camera, beats its chest, and then tampers off, spending nine seconds on screen. Can you guess if you would notice the gorilla?
If your intuition tells you the answer is a resounding "yes," then you are certainly not alone. It seems like such an obvious thing to spot, right? However, there's a twist. It turned out that a whopping 50% of participants who watched the video and focused on counting the passes completely missed the gorilla. It was almost as if the gorilla had become invisible to them.
My AI-generated co-host voice for the show, Aimee, will explain the impact of this experiment.
AIMEE:
Sure Daniel. This intriguing bit of research tells us two key things about humans: first, they often overlook a significant amount of what's happening around us, and second, they are often unaware of how much we're missing. Not surprisingly, this experiment has become incredibly renowned in psychology. It's frequently mentioned in introductory textbooks and is featured in numerous science museums. It's been utilized by teachers, corporate trainers, police, and even those involved in counterterrorism efforts. It has also made appearances in popular TV shows like C.S.I. to shed light on the concept of selective attention and what humans perceive or fail to perceive.
DANIEL
Thank you AImee.
While watching the video, my mind connected to my experience with mergers & acquisitions. Like in the gorilla experiment, members of the management board and their M&A team (internal and or external) throw high-speed balls at each other. In the background, the gorilla that appears many times during the project is not seen or heard. Changes in revenue, margin or profit dips or peaks, customer pattern changes, growth or the lack of are often directly related to the, and yes, let's say it, the 600-pound gorilla in the picture that no one actually sees.
It struck me how few companies I dealt with that went through M&As saw the gorilla, which is linked to the 80% of what normally entails a company's value add: its supply chain.
The typical M&A lawyer and financial expert will look at financial statements, obligations, and product pipelines and ensure visits to all the company's major assets. These visits, by the way, are in most cases a joke in themtselves: Busy manufacturing folks are being ask to travel quickly to all sites of the respective target during the due diligence phase. In less than a day, they should know whether any production site is a steal or a handicap. Let’s be real: no one in manufacturing worth their salt, especially the lower down in the ranks, will give a negative report card based on just a few hours of evaluation unless the places are a dump.
Yeah, you look into the regular M&A handbooks, and you see far down in the so-called back end part section (a definition which is a disgrace by itself) something about major contracts, list of top suppliers, maybe even length of lease contracts, but that’s often all that is being asked during the due diligence phase.
And, even if there is more, it is usually provided by an overextended Supply Chain or Procurement head, who is doing this for the first time, or every time in a less than documented way, like: “hey Susan, do we still have the excel from the last acquisition”?
So, let’s assume for a moment that we are part of a company doing well. We have healthy margins, good products, our customers adore us or at least do not run away, and a market-pleasing growth rate.
But that is not enough, is it? Investors and markets always want more, so we look for opportunities to grow inorganically via a merger or acquisitions, or as in our metaphor, corporate marriage, even though it is widely known that Mergers and acquisitions do not always hold what they promise.
AIMEE
According to statistics, the failure rate of mergers and acquisitions is 50% plus according to most top consultancy and academia analyses.
DANIEL
The failure rate is much higher than the number shows since, for the most part, the truthful calculation about how much shareholder value was destroyed is seldom done. As always, the winner tells the story. Often, synergy's objective do not come to fruition, but the CEO and the responsible board members are mostly still in their seats and unwilling to give in to a realistic look...
I have been part of, one way or the other, about 30 plus mergers and acquisitions, and I could observe many more with the suppliers we dealt with. I can confidently say that the shadow rate of M&As that miss their airy objectives defined by the shareholders and supervisory boards is VERY high.
Interestingly, even if most synergy objectives fail, procurement overachieves if the integration is managed correctly: COGS will go down for either the acquired or sometimes as well the buying company, leading to higher margins.
So, in today's episode of the Supply Chain Dialogues, we dive into what companies and M&A advisors can do right to get a happy corporate marriage.
We divide the topic into the three natural subsequent pieces of any M&A:
Preparation
Due Diligence
Integration
Let’s make it real and create a scenario many of us were part of:
There is a reasonable likelihood of an acquisition, and you have signed the NDA to get the ins and outs of the project being discussed in the management board.
Either your internal M&A team alone or with an external advisor have started to prepare the needed material to set up roles & responsibilities, objectives, and action items.
So, the first step for you is to get a separate section in the M&A workbook for third-party supply. Most M&A handbooks and so-called experts combine manufacturing with the supply chain - and call the whole thing the back end. BIG MISTAKE.
It is waving the dog with its tail. In most manufacturing companies, the value added generated in the internal processes is about 10-20%. The rest in today's networked and often overextended value chains come from outside the company.
So, lets start with the preparation phase or pre-diligence:
Preparation Phase (pre-diligence)
Here are three of the ten questions the supply chain expert will look for in the preparation phase, which can be crucial in spotting the gorilla.
At this early stage, the acquisition target, if open to the idea of an M&A, will be asked to provide some rudimentary information to get a first feel of whether or not this should be taken forward. Any of the answers can raise red flags for an M&A activity. My point is that even in this early stage, the gorilla should be made visible with these questions. Three of them will highlight here:
AIMEE
List the top suppliers for product and service categories covering 80% of external spending. It does not matter whether the spend is managed by procurement or not at this stage.
DANIEL
This will provide you with a couple of things: First, does the M&A target company have its numbers under control.?
Several times in my career, the targets had numbers not readily available, and I had to painstakingly put them together in newly created Excel sheets. It is a big red flag if this is reflected in other areas of their lack of professionalism.
It is an opportunity if they have been growing so fast that material cost was not an issue. There are still sharks lurking potentially in the water, but a good procurement team can eliminate them and deliver significant margin improvement via professional practices.
AIMEE
Disclose any pending recalls, claims, and supplier litigation.
DANIEL
What if a supplier contests the IP for one of the best-running products? What if significant recalls or claims are pending due to material quality issues? I know of one company that nearly went bankrupt since they did not do the due diligence about consumer health-impacting ingredients in their newly acquired products. …can you imagine the backlash by shareholders and customers? Nearly all of the management board's leadership team had to go, not seeing the gorilla.
AIMEE
Are there any supplier agreements in direct and indirect procurement and or Real Estate with contractual lengths of over three years?
DANIEL
In the early days of most companies, when there is little differentiation of roles and responsibilities, and checks and balances are available on paper but not necessarily in real life, decisions are taken by enthusiastic local or business leaders that can hurt a company for the next 10-20 years.
I remember very well an acquisition where this question was not asked, and we were suddenly stuck with a manufacturing complex leased for 20 years at exorbitant rates without an exit clause. The respective local president had since retired and had, as it turned out, no real knowledge of how to do good real estate agreements, and neither did his advising legal head. We paid millions to get out of the deal, impacting the synergies of the acquisition.
In another M&A from a supplier of mine, they did not have information about the hazardous materials dumped into the leased brownfield sites of their acquisition target, leading to massive scandals later when a disgruntled employee of the acquired company leaked this fact to the press after the acquisition.
These topics could have been priced into the deal or should have left the acquiring team running to the hills, afraid of the gorilla they’ve seen, instead of wasting shareholders' money in the aftermath.
But, you have to let the procurement folks (assuming they are capable) do their job early on, and then listen closely to what they say, unless management is stuck in their confirmation bias.
AIMEE
Confirmation bias is a cognitive bias where individuals seek, interpret, and remember information that confirms their preexisting beliefs or hypotheses while disregarding or downplaying contradictory evidence. Essentially, people are naturally inclined to favour information that supports their perspectives and avoid information that challenges them, which can lead to skewed perceptions and reinforce existing biases.
DANIEL
Besides the management board and CEO, confirmation bias can often be found in the M&A department and any external consultancy or advising bank.
While it should not be the case, and they should be neutral, in reality, they are clearly interested in seeing this deal go through if they have done their diligence with their instruments and suggested an acquisition based on the availability of their data.
Again, we have a bias here, this one is called: availability bias.
AIMEE
Availability bias is a cognitive bias where people rely on readily available information or easily recalls from memory when making judgments or decisions. It often results in individuals overestimating the likelihood of events or risks that come to mind more quickly, leading to potential errors in decision-making by neglecting less vivid but equally relevant information.
DANIEL
…like what the supply chain folks have to say…
Ok, let’s assume we have done the preparation phase, and the information we got to this point is good enough to set up a data room and collect all the data needed to assess and eventually prepare the acquisition. When I talk about acquisition, the same holds for most parts of a merger.
Let’s move on to the due diligence phase:
Due Diligence
Now, at this stage, the gloves are off, and balls are thrown back and forth at hyper speed. We now want detailed information and usually arrange meetings between the two parties on the functional level. This is stuff that the M&A experts know generally well to do.
However, in most M&A handbooks, finance, sales, and manufacturing are the parties that meet in secret hotel rooms, no room for the gorilla. So, let’s make sure that the supply chain folks also have their own rooms to start grooming the ape.
Too often, alignments that could happen in a day take weeks when the supply chains are left to their own devices in the data rooms. What a waste of time and resources.
Now, here we have a lot of topics to cover concerning supply chains. The main areas are:
People and organisational set-up
Strategy
Systems and processes
Reporting
Supply Base
Transportation, warehousing & logistics
Financial processes like payment terms and hedging
Third-party material and service quality
Legal
Sustainability
About one hundred topics are vital in these ten categories, just on the supply chain or procurement side.
Let us pick, again, just three and explain them a bit:
In the category “People and Organisational set-up”, AIMEE has picked one:
AIMEE
Provide Procurement's organisational structure, including a complete headcount of Strategic Buyers, Operational Buyers, Managers, and others.
DANIEL
This has several implications. The simplest is that the M&A team might wrongly assume a high level of productivity if the headcount in the supply chain organisation is low. Depending on the organisational structure, headcount and cost are not attributed to the functional organisation but the respective business set-up - so the costs are not easily found.
More importantly, the organisational structure impacts the effort to integrate the organisation. Procurement or supply chain organisations do not, by default, follow a company's overall set-up. A firm can be organised by region or business and still have a central procurement team or a hybrid organisation.
You do not want to have a situation where, after the acquisition, one part of a regional procurement buys chemicals centrally, while the other part will buy from the same source locally, missing economies of scale and scope. It is also a control issue risk since the local or central side might need adequate knowledge to assess suppliers and products bought in. Lastly, a discrepancy in organisational structure can also be seen as a de-motivational factor for the acquired leadership if they suddenly can no longer decide on third-party deals. While it usually makes sense overall to provide one structure (some call it my way or the highway) early in the process, the transition still needs to be managed. Too often, I have seen this needing to be addressed in M&A deals, leading to significant rows in the leadership team and lost opportunities for better margins.
Next, we head over to the supply base:
AIMEE
Please list all single-sourced suppliers with a spending volume of one million dollars and more.
DANIEL
Now, you think this is a staple in any M&A project. And yes, most M&A experts will have heard that single-sourcing is terrible. But is it, though? And what is the right monetary threshold? And what if the list of single source suppliers is very small when provided in the data room? Is it correct that the procurement organisation of the target company does not even know? The latter is the most probable in many situations. Now, is this a problem? It can be if the single-source supplier has a contract based on a handshake (do you find this funny? Well, in several acquisitions I was involved in during my career, the acquired company did not believe in supply contracts but in good relationships with suppliers, calling them partners. When we then introduced professional procurement practices, including good quality control and contracts, single-source suppliers left us right, left and centre since they were getting excellent profits from their former buyers, and now had to face the reality of a normal competitive set-up, leaving us little room to manoeuvre, since they could stop delivering from one day to the next ilo good contracts.
In another case, the single source agreement was with an external manufacturing service provider, who could not work with the acquiring company based on other customer agreements due to exclusivity clauses.
This supplier was manufacturing three of the ten most profitable products of the acquired company. Finding a new supplier and getting the process and quality know-how to the level of the long-term prior supplier took three years. Years in which product quality deteriorated, customers voted with their feet, and the synergy effects assumed from the deal evaporated into thin air.
Last, but not least, here is another good one to have in your back pocket:
AIMEE
Do you have a hedging policy? What portion of the volume on key raw materials is being hedged, and over what time horizon?
DANIEL
One would think that every company with a sizeable commodity spend would do hedging. Right?!
Well, you might be (Or not) astonished to learn this is not the case. Now, why is that? I wrecked my brain about this for many years, and the simplest explanation I could come up with was:
The treasurer should have thought about it and focused on more than what treasurers usually do: keep the company liquid, maintain contact with the banks, and hedge currency exposure.
Getting involved in the hedging of commodities requires reaching out across the organisation to operations or supply chain with less detailed information than you used to in the finance world - in other words - it is inconvenient and potentially error-prone.
And this is correct: I remember a mighty Procurement Finance Head of a major hardware manufacturing company who hedged metals wrongly in a year when it mattered. Two months later, he was gone.
When you plan to acquire a company with an immature hedging process for commodities, assessing the exposure and the opportunity can be huge for your margins and profitability in the upcoming months to two years. Exposure due to potentially missing hedging paragraphs in the contracts with the suppliers (which then show up in highly volatile cost and savings reporting of procurement) and the chance to get raw materials exposure managed better and risk-free by a professional treasury department. You do not make money off commodity hedging; you take the risk of volatile margins out of your equation.
Nothing is rocket science, but it is astonishing how little of this is done in many companies. Why this happens is different from company to company.
In the Supply Chain Dialogues podcast Season 1, Ep. 11 and 12, we highlight a few hacks to integrate acquisitions appropriately. Check them out if this is of interest to you.
These were three due diligence aspects, about one hundred, ninety-eight to be precise, of actions and questions you ask when assessing the viability of an acquisition from a supply chain perspective - again, the area where 50-80% of the value add of manufacturing products reside.
Integration
The third area is, to no surprise, the integration of an acquired company. Here is where the real magic happens, and all gorillas and other animals should be part of the show. Here you can find out whether all the fantastic synergy ideas you assessed (and sometimes dreamed up) come to fruition.
AIMEE picked three from different dimensions out of the ninety-plus actions we have in the supply chain portfolio.
Let’s start with the most important one: People
AIMEE
On the day of the official acquisition or merger announcement, the Head of Procurement of the Acquiring Company plus local/divisional Procurement heads meet the CPO of the acquired company either at the NEWCO site or the Acquiring Company headquarters. If no physical presence is possible, at least a longer Video Conference is in order. Here, you welcome the new leadership colleague to the acquiring company team. You walk them through the subsequent integration steps and ask for advice on how to handle communication in their organisation. Now, it is crucial to build up a personal rapport.
Daniel
I remember a story from one of the companies I had the privilege to lead the supply chain integration. Over dinner, they told me of a failed transaction with another multi-national conglomerate some years ago:
On the day of the transaction, the new leadership team swooped in (no contact before).
They rented a large hall where they herded all employees together. When the lights dimmed and the new leadership team entered the stage, the speakers blasted the incredibly insensitive Scorpion's song “Wind of Change”.
Later, during the presentation, they showed the reach of their organisation. They used the map they usually used, which did not even include the country where the acquired company was located. Clearly, all people in the audience felt very special…
It is so awkward that you feel this is the script of a cheesy movie about corporate hybris - but this happened.
Guess how much support the conglomerate achieved in the integration phase. It got so bad that they pulled the plug, and lost a pretty penny in fines established in the contract.
The story's moral is that one acquires the excellence of those working in the acquired company. This is the most critical asset, the so-called salt of the earth. Keep them happy, engaged, and motivated; listen to them, and you will have a winner.
It sounds simple, but finding the balance between ensuring a good integration, keeping the new staff engaged, and aligning all processes and systems with the new mother company requires diligence and sensitivity - without being shy about establishing who is in charge.
You would need more of a social psychologist than an M&A finance expert to get this done, but a bit of common sense about human beings and humility can go a long way.
Let’s take the next bite:
AIMEE
Next, we look into the aspect of risk:
With the help of legal, finance, risk and sustainability departments, conduct a risk review of NEWCO's general terms and conditions vs. the standards of the Acquiring Company.
DANIEL
This is the finalization of a desktop exercise by your procurement process and excellence team (if existing), that has started in the due diligence phase.
Now, you take both teams and the experts from other departments, sit them down and address any outliers between the acquiring company processes and that of the NEWCO.
You might ask why this is such a big deal: Let’s assume that you acquire a smaller company that has not particularly weighted supplier compliance right so far. Every department could select suppliers and send them via procurement with an order (or, worse, just an e-mail). If your company has standards on child labour, slave trade, and dangerous chemicals - just to name a few, suddenly, you are in the driver's seat. So quickly, the new colleagues must learn that integrity and compliance mean different things now than before.
You might think:
Come on, Daniel, these are just horror stories - today, this is no longer an issue in established companies.
Without going into too many details here in the podcast, let me be clear: Child labour, forced labour, mishandling of dangerous materials and much more happen all the time if the focus is not laser-like in the supply chain.
Hence, there is nothing easier for a disgruntled employee to call you out - and you have a major scandal.
Ok, what else did you pick, Aimee?
AIMEE
Next we go to synergies: Short after the official date of the acquisition, face-to-face Synergy workshops of all major categories are to be held. Present in this workshop are the Procurement integration leaders from both companies and their category team leaders.
Setting the stage is done by the leadership team of the NEWCO.
Both Procurement leadership teams should be reviewing results and, if possible, be engaged in the workshop by walking the floor.
DANIEL:
Nothing is more exhilarating for motivated buyers than comparing notes, prices, and contracts with other experts. Usually, due to confidentiality reasons, this is not possible. So, these synergy workshops are a gift sent from heaven for most buyers.
When leadership sets the stage, it is crucial to point out that every gap, wherever we find it, is brilliant and will be celebrated. The success of a new benchmark level in categories will be shared between both teams, NEWCO and the acquiring company.
Here is one of the situation, where my old motto applies: Gaps are good. Closing them is great.
The probability that prices and specification are different is near 100%, so the teams need to get aligned to look at the best solution neutrally.
There will be many proposals that are not procurement or contract related, but have to involve R&D or sales. These should be bundled and then discussed with the top layer of the other departments, which were also part of the due diligence leadership team.
What most acquiring companies, often larger will find out, is that the better processes and prices are only sometimes on their side.
When a large company acquired a smaller player in the automotive industry in the 90s of the last century, it became quickly clear to the involved team that many categories were priced lower at the smaller company. This was partially based on an excellent procurement team there, plus the fact that many suppliers wanted to have a foothold in that country, which offered a few interesting challenges they felt they needed to understand. That meant that in their mixed price calculations, they valued the small company as a customer higher, and were willing to sell smaller volumes at lower prices - sometimes even at cost.
While the large company did not get the same deals after the integration, it opened so many opportunities for re-negotiations that the material costs of both sides decreased to unheard levels, increasing product margins significantly.
…as you can see, doing an M&A without a professional supply chain assessment is acting with gross negligence.
Therefore, it is astonishing that shareholders and institutional investors do not call the bluff much more in this kind of transaction.
I am convinced that the success rate of M&As is seriously improved if the supply chain due diligence is considered a major part of any M&A project. In other words: See the gorilla, and make the gorilla your friend…
We cover a few unsung heroes when we do an episode without an interview partner. People that helped me in my career. Each stands for many people who do similar things for all of us on our way through the game we call work.
Today, I like to give a shout-out to Pia de Angelis, who I was lucky to work with for many years. Pia was the assistant assigned to the position I held, and as I moved through my different jobs, she kindly stayed with me.
Pia was what you wished for when you were an executive. She is kind, professional, efficient and effective (something Germans are said to like particularly - although I learned this to be true for all nationalities), and an excellent photographer in her private life.
Pia and I worked as a highly interdependent team - I could fully rely on her, and I hope she felt as well to fully rely on me. Without her, I would not have been able to concentrate on my many tasks and objectives as I did. If she called, wherever I was, she was the first person I called back - knowing it was important.
Over my years, I was blessed to have a number of excellent executive assistants who allowed me to operate at maximum speed. My thanks to all of them, and if you have a colleague who supports you in being your better self, I recommend finding the time to thank her or him from time to time for the work they are doing. Like icebergs, 80% of their support happens below the surface that you even see. Thank you, Pia, for being a great colleague over the years. You are a clear, un-sung hero.
(MUSIC)
With that, I hope you enjoyed this episode of “The Supply Chain Dialogues”. If you did, please subscribe if not already done before. Share it with a colleague, friend, or any decision-makers you know in your company.
With that,
Stay safe, be bold and see you two weeks - and watch out for gorillas - they are everywhere if we keep our minds open.
These are “The Supply Chain Dialogues”, produced and copyrighted by helmig advisory AG in 2024.
