Why Mergers Fail: Beyond Culture Clashes

When companies merge, they often highlight the potential "synergies" to be gained from the merger. Recent research provides a framework for understanding when a merger is likely to be profitable.

In the recent study “Organizing for Synergies: Allocating Control to Manage the Coordination-Incentives Tradeoff,” University of Chicago Graduate School of Business professors Wouter Dessein, Luis Garicano, and Robert H. Gertner examine the “organizational cost” of achieving synergies in corporate mergers. The term synergy refers to the higher potential profit companies can realize from a merger.

Merging companies may attempt to realize synergies by sharing resources in areas such as research and development, manufacturing, or sales. If it were possible to keep all operations the same except for the area where there is overlap, such mergers would always be profitable. Organizational costs, however, limit the ability of two units or firms to capture synergies through the coordination of several previously independent units. To put it in the perspective of an analyst evaluating a merger, there exists an “organizational discount factor” that must be applied when estimating the efficiency gains of a merger. For example, say the potential profit from a merger is $10 billion. If the organizational cost of the synergy is low, the merged company may realize the full $10 billion. If the organizational cost is high, the company may only earn half that amount. This organizational discount factor can be studied systematically. Dessein, Garicano, and Gertner developed a theory that predicts conditions under which the synergies that two merging firms hope to realize likely will be difficult to capture.

High synergies are valuable in two ways. “The higher the synergy, the more valuable the merger,” says Garicano. “Also, the higher the synergies, the lower the ‘organizational discount’ that must be applied to the merger—all else constant—because as synergies get sufficiently high, contingent decision making and balanced incentives become less important.”

Determining Optimal Organizational Structure

Dessein, Garicano, and Gertner developed a theory of organizational structure where decision-making authority is allocated to either functional or product managers. Giving control to functional managers (generalists) indicates that the company has chosen to centralize to achieve synergies. Giving authority to product managers (specialists) suggests a decentralized structure.

What is the best organizational structure after a merger? The authors found that this depends on the value of synergies, the importance of incentives, and information about, and the value of “local adaptation”—catering to the existing clients/audiences.

Functional managers (generalists) are better informed about the value of synergies, the value of sharing resources across business units, and standardizing operations. In contrast, product managers (specialists) know more about the value of adapting the product to the circumstances of the local market and doing things in “their own way.” Determining whether or not synergies between business units should be implemented requires honest and open communication between managers.

The authors argue that decision-making rights must be allocated in a way that encourages communication and efficient synergy-implementation decisions. Moreover, managers must be motivated to work hard, and this requires that compensation be linked to performance. However, when the incentives of managers are too strong, the interests of the functional manager and product managers are directly in conflict, and no credible communication takes place. “A local manager whose pay is tightly linked to his performance will always argue that his needs are special, and will refuse to agree to standardize his product for the entire company’s sake,” notes Dessein. “This creates a fundamental tradeoff between coordination and incentives.” The authors refer to the general cost of putting two units together as the “incentive cost of synergy.” In order to ensure efficient coordination and communication between business units, the organization must mute incentives of managers.

Dessein, Garicano and Gertner analyze two possible structures for mergers:

1. Functional authority (centralization): The functional manager has control rights over implementation decisions.
2. Product authority (decentralization): Product managers retain control over their local units.

The tradeoff between incentives and coordination takes two forms. As incentives become stronger, implementation by whichever manager has authority becomes more biased. Product managers tend to block all synergies, whereas functional managers are too eager to implement synergies. Thus, stronger individual incentives lead to managers working harder but also lead to inefficient synergy implementation decisions. In addition, as incentives become stronger, credible communication between managers becomes more difficult. The organization must deal with these tradeoffs, using the tools of allocating authority and incentive pay.

With functional (centralized) authority, attaining synergies involves organizational costs in the form of lost local adaptation and weaker incentives. Centralized authority may be preferred when synergies are high and when performance incentives are less important. Product authority (decentralization) is not as effective when it comes to achieving coordination, but it allows local managers to have stronger incentives.

When is it optimal to organize for synergies? The authors find that strong incentives hinder the ability of an organization to implement tradeoffs between synergies and adaptation. Ensuring communication requires dulling incentives to make sure managers are sufficiently aligned, and this imposes costs. Organizations thus can choose between strong incentives with little information flow between units or weak incentives with better communication. The analysis suggests that if providing incentives is important, firms may therefore prefer to forego synergies and forego the merger gains, even in the presence of potential synergies.

Real World Examples

The problem of organizing to achieve synergies is not unique to mergers. All companies with related lines of business must decide which activities to centralize, how to allocate control rights over complementary decisions, share relevant information, and create incentives for effective coordination and efficient operations.

The authors focus on two notable examples that illustrate tradeoffs between incentives, coordination, and implementation of synergies, and the role that organizational structure and the allocation of control may play in dealing with these tradeoffs: 1) the attempts to reorganize the FBI after the first World Trade Center bombing in 1993 and 2) the reorganization of Suchard, the Swiss chocolate company, after the push toward a single European market in 1992. The FBI faced a set of organizational issues in the period between the first World Trade Center attack on February 26, 1993, and the second attack on September 11, 2001, as highlighted in the 9/11 Commission Report.

Traditionally, the FBI operates as a decentralized organization based around field offices that set their own priorities. After the first World Trade Center attack, the FBI determined that this decentralized structure was not well-suited to the counterterrorism task, which requires gathering a wide array of information from human intelligence, satellite intelligence, and communication intercepts.

To deal with these problems, the FBI created the Counterterrorism and Counterintelligence Divisions. However, the FBI did not change the career incentives or authority of local offices. The new head of the division was left to try to impose new strategies on powerful local offices. Thus, the same organizational features that made the FBI a powerful and effective machine for securing prosecutions and fighting crime made it weak as a counterterrorism agency. Consistent with the authors’ theory, placing a functional manager on top of a decentralized organization without altering the incentives of field office managers is unlikely to allow for synergies. Field managers have little incentive to provide the right information or implement the directives of the functional manager. The authors conclude that improving the FBI’s effectiveness at counterterrorism may imply weakening its effectiveness at fighting crime, since it may result in weaker incentives (in order to encourage sharing knowledge and information), more diffuse career paths, and more centralization of decisions to be able to capture the intelligence synergies.

In the late 1980s, Jacobs Suchard, a Swiss coffee and confectionary company, had a leading EEC market share in confectionary products. Suchard had a decentralized organizational structure with general managers for large independent business units organized around products and countries. Each business unit had its own sales, marketing, and manufacturing divisions. The autonomy and incentives of the general managers created an entrepreneurial environment that was able to attract and retain talented executives as general managers. Tarriff reductions, open borders, and the standardization of regulation in advance of the 1992 European integration created an opportunity for Suchard to achieve cost savings by combining manufacturing plants across companies and developing common marketing strategies. The company planned to shift from nineteen plants to six primary plants that would serve all of Europe. Under the new organizational structure, country managers retained control of sales and marketing, but not manufacturing decisions. The company appointed “global brand sponsors” for each of its five major confectionary brands. These general managers were given the responsibility to promote their brands globally, develop new products, and standardize brands and packaging across the world.

Suchard’s disappointing experience with its new organizational structure demonstrates the tradeoffs that arise in attempts to reorganize to realize synergies. The outcome was reduced coordination within business units and increased time and effort to communicate, defend, and debate strategic choices. This in turn diminished the firm’s entrepreneurial culture, blunting incentives for general managers. The costs faced by Suchard took the form identified by the theory—poor coordination and incentives within business units, increased conflict, and communication and influence costs.

Beyond Culture Clashes

One practical implication of the study is that it discusses the relations between potential synergies and those that actually can be achieved. The authors argue that one should not rely on the headline value of the potential synergies, but must first consider the costs from reduced local adaptation and the costs from reduced incentives.

“ People take too many shortcuts when discussing the culture conflicts that can happen in mergers. Culture is often a black box where every possible difference between existing companies is thrown in. Some of the conflicts result from the incentives provided to managers and the allocation of authority after the merger, and these conflicts can be understood and managed,” says Garicano. “Organizational culture is interesting and has to be understood, but there are many ‘noncultural’ organizational costs to be analyzed that can provide us with insights into the organizational costs of synergies.”