Far too many mergers and major acquisitions have underperformed in building shareholder value, despite the lofty goals with which executives always justify their deals. This observation is as true for the oil and gas industry as for American industry as a whole. Yet M&A activity continues at a brisk pace in every cycle and, despite soft product prices during this summer, deal-making activity was expected to continue strong through 2001 and 2002. There are several reasons for this expectation. First, the high product prices enjoyed through most of 2000 and 2001 have strengthened balance sheets. Second, as the megamergers rationalize their portfolios, and pooling restrictions wind down, divestiture of noncore properties will provide opportunities for the independents to add to their asset base. Third, the continuing pressure for efficiency improvement will drive companies to concentrate areas of focus. But new mergers may have a difficult time ultimately being deemed successful. In fact, in an environment of lower product prices, a merger or acquisition may be at greater risk unless all of the synergies that justified the combination are actually achieved. Why do so many mergers and acquisitions fail on this score-and how can management assure that the necessary synergies come to pass? Failures are due to inadequate attention to the people aspects: corporate culture, adequate internal communication, change management and a clear direction from management. When these issues are addressed, the chance of succeeding increases significantly. Deal calculus Mergers and acquisitions are a risky way to grow a business profitably. Upon examination of the economic calculus of a representative deal, the risks involved are more easily seen. (See Exhibit 1.) A public company's stock price reflects investor expectations for future performance and management's ability to deliver value from the asset base (reserves) and growth plans (prospects). But an M&A transaction fundamentally changes the calculus. To be successful, the newly formed company must actually beat the preannouncement market expectations for the acquired company by a significant margin. That's because, to satisfy shareholders and the board of directors, the buyer pays a premium over the target's current stock price, betting that the intangible assets and future growth prospects of the newly formed company will be worth more than the current value of the target. These premiums can be substantial, with some well over 50% of the premerger price. For example, Barrett Resources' stock price jumped 33% on the day Shell announced its intention to acquire the company. By the time The Williams Cos. actually made the deal, Barrett's stock price had risen even more substantially. This was a pay-day for the Barrett shareholders, but it should be noted that Williams' stock lost value. When transaction costs are added to the premium-time spent, legal and investment banking fees, the cost to divest portions of the asset portfolio, employee severance payments and so forth-the financial burden on the newly formed company can become almost overwhelming. Immediately, the pressure is on to create efficiencies through synergies. If the buyer is unable to do this in a timely manner-if it cannot realistically recover the acquisition premium and transaction costs-its stock price will likely drop below where it was trading before the acquisition, and possibly below the industry average. Unfortunately, in the heat of a deal, companies can significantly overstate the perceived synergies of the deal, thereby increasing their chances for failure. It is interesting to note the importance that cost synergies played in the recent megamergers. Exxon Mobil and BP have been extremely communicative to shareholders by announcing the synergies being achieved, in comparison with the synergies promised at the time of the merger. Security analysts are following this closely and are watching for reserve and production growth in excess of the growth prospects of the companies prior to the combination. Exxon Mobil, BP and acquirer Devon Energy Corp. each went after cost-cutting right away. They have reported to analysts that the savings achieved arrived faster, or were greater, than they first promised. Some observers thought Kerr-McGee Corp. may have paid too much for Oryx a few years ago, yet the deal worked because the buyer needed the can-do culture of Oryx and its international growth prospects and Gulf of Mexico deepwater assets. Successes since then tend to validate the deal. Acquiring-company executives must meet the challenge of creating new value by drawing on the strengths inherent in the company, namely: Its human capital, meaning the tacit know-how, relationships, and skills of its employees; Its intellectual property, which is primarily reflected in its prospects and the exploration skills that developed those prospects; Its structural capital, meaning the ways in which its management, engineering, production and exploration processes are organized and how its corporate culture influences its success; and Its customer equity, encompassing brand perceptions and the strength and value of customer relationships. In other words, a successful merger or acquisition depends on excellent integration. It means harnessing the skills of employees, the intellectual value of the combined organization and the ways in which the business operates to create a venture that can negotiate the obstacles and make the most of the cost-saving and growth synergies. After the deal, two things must happen: the overhead and duplication must be taken out of the equation, and the way the business is run day-to-day must change to reflect the strengths and assets of the new combination. For example, it is likely better to own 10 core properties in two states than to own or operate two core areas in each of 10 states. The best people, practices and prospects of each company must be cherry-picked so that capital and time can be deployed effectively. The soft stuff Too often, dealmakers dismiss people factors as the "soft stuff" and assume that it will take care of itself. Instead, it is precisely this soft stuff-people, organizational and cultural issues-that makes or breaks a deal. In 2000, Towers Perrin and the Society for Human Resource Management (SHRM) Foundation surveyed 447 human-resource executives from large companies on M&A issues. The respondents included oil and gas industry executives as well as officers from across all industries. They were asked which obstacles are the most significant when trying to make a deal work. (See chart at left.) The results show that of the top seven obstacles cited, all relate directly or indirectly to people issues. For example, the inability of the combining companies to sustain financial performance translates into a loss of productivity, which may reflect confusion and uncertainty in the workforce. Employee uncertainty-about the reasons for the merger or acquisition, strategic direction of the new entity, or whether their jobs will be secure and who they will report to-can lead to anxiety, paralysis and ultimately, loss of key talent. When looking at how the respondents coped with these obstacles, the differences between companies that said their mergers or acquisitions were successful and those whose experience was unsuccessful is telling. (See Exhibit 2.) Successful companies were much more adept at leaping these hurdles than were unsuccessful companies. It's interesting to note that for unsuccessful companies, among the largest gaps were dealing with cultural dissonance and managing change during the integration process. Clearly, understanding and addressing these people and cultural issues is of paramount importance in bringing about a successful merger or acquisition. The question then becomes, What is the best way to contend with these problems? If we look at the M&A life cycle as a four-stage process, the first two stages-predeal and due diligence-take place before the deal closes. Integration planning and implementation make up the merger-integration process. However, integration planning should actually begin during the predeal phase, well before the merger is consummated. This gives the acquiring company time to do adequate planning and avoid slipshod and hasty decision-making. (See Exhibit 3.) When considering the breadth of tasks and decisions that must be considered during integration planning, it's clear that the process must begin early and that it cannot be ignored. Just as clear is the role that the human-resources function should be prepared to play during integration planning and subsequent implementation. For virtually all of the integration planning activities HR is likely to be the most qualified function in the organization to understand and be able to execute these activities. Integration activities include Developing an employee communication strategy, Developing programs to retain key talent, Planning and leading integration efforts, Helping employees cope with change, Developing an organization and staffing plan and Developing a strategy for the new entity. Interestingly, successful companies are much more likely to have significant HR involvement in integration activities than are unsuccessful companies. A key question, however, is whether the HR function is prepared to play such a strategic role. But even for those HR functions that have the requisite strategic capabilities, there remains an outstanding issue: are the HR specialists viewed as strategic partners by management? Will they get a seat at the decision-making table? Some HR executives will take a first step by becoming strategic in their nonmerger activities. They will forge a link between the goals of the organization and the rewards of employees, for example. They will focus their efforts on retaining key talent. They will understand and respond to the ways that future demographic trends will affect the organization's business and its staffing. However, wise executives will reach out to HR and seek its help early on-even, for example, when the company is devising its organizational integration philosophy. Let's assume, for example, that an E&P company decides the time is right to acquire and it identifies a target company whose asset base and production capabilities complement its existing exploration strength. But what about the talent needed to turn that potential into reality? How will the acquirer identify those key employees? How will it keep them? What is the plan for replacing those who do leave? Most executives think of due diligence in terms of justifying the purchase price and making sure there are no surprises behind the numbers. But cultural due diligence can turn up surprises too, such as extreme differences in management style (e.g., hierarchical versus entrepreneurial) that, if not understood and resolved, could make achieving synergies difficult if not impossible. From a financial perspective, adequate due diligence on the HR side can uncover problems, such as underfunded pension plans, that can have a material effect on the price of the acquisition. Highly capital-intensive oil and gas industry combinations are among the most challenging around, and no wonder. Think about the possible global nature of the work (far-flung locations, multinational work teams, challenging logistics). Consider the increasing need to be big enough to participate in some of the most exciting opportunities (e.g., the deepwater Gulf of Mexico, offshore Africa and Asia). Finally, recognize the importance of a relatively few talented people to drive both growth and returns on the existing asset base. With the risks of M & A come great opportunities. The right merger or acquisition can provide growth through the reprioritization of the combination's prospect inventory. The combined company's broader capital base gives it access to larger and potentially more attractive projects. But for these factors to work together to increase shareholder value, management must agree on a plan of action and the company must retain its technical talent. In reaching out to HR for help with these issues, management will likely find a willing partner with untapped sources of expertise. M Bill Montgomery is a principal in the Dallas office of Towers Perrin, the global human-resources consulting firm. Jeff Schmidt, a principal in the Chicago office, is managing director for the firm's innovation initiative. Both received MBAs from Harvard Business School.
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