The Other Side of the Table

Diligence goes both ways — lessons from Knoxville

Diligence goes both ways...lessons from Knoxville

We had been inside the building maybe five minutes when someone offered us coffee, and my client asked whether they had oat milk. Or almond, he said. Either was fine.

I had done my job that morning, and I want that on the record. It was eighty-five degrees outside Knoxville, Tennessee, before ten o’clock, and my client had wanted to wear the suit he’d flown down in. I talked him out of it in the rental car. Chinos, I said. The polo. You do not walk onto a warehouse floor in East Tennessee dressed like the man who has come to fire everyone. He grumbled and changed, and he looked, I thought, like a normal person by the time we came through the door. I had handled the suit. It never crossed my mind to handle the coffee.

The managing director ran the place, and he did not have oat milk. He did not have almond. What he had was a tub of powdered creamer, the kind that comes in a plastic cylinder and outlives the people who buy it, because that is what sits in the coffee room of a working warehouse. He offered it without a trace of apology. Then he said the thing I have not been able to forget. The floor and the office drink the same coffee, he told us, on purpose. He was not going to have the people upstairs sipping something nicer than the people loading the trucks.

My client took the creamer. He had already told the managing director something about himself, without noticing. And the managing director had just told him something back, which my client also missed, because he was busy building a number.

This is the part of an acquisition nobody puts in the model.

Here is what is supposed to happen when a private equity firm buys a company. The buyer arrives with a thesis and a checklist. The checklist is long and it runs one direction. The buyer scores the target. He scores the revenue and the margins and the customer concentration and the lease. He scores the management team, their track record, their bench, whether they can scale. There are whole software platforms built to do nothing but help the buyer keep score. The industry has a phrase for it, due diligence, and they make it sound like a law of physics. The work flows one way, from the people with the money toward the people with the company, and the people with the company stand still and get measured.

That is the theory. My client believed the theory. He had a spreadsheet open on his phone and he filled it in as we walked the racking aisles. He asked about throughput. He asked about the lease renewal. He asked about margins on the lines that mattered. Good questions, fast and clean. He was very good at his job, which was building a number.

The managing director answered every one of them without a flicker. Throughput, lease, margins. He had it cold. Then my client, almost as an afterthought, asked why the night shift had turned over twice in a single year.

The managing director paused.

He looked at us. At the two of us, standing in his warehouse in our sensible chinos, holding our cups of crappy coffee. He was deciding something. It took me an embarrassingly long time in this business to understand what that pause was. The managing director had not come to be valued that morning. He had come to do some valuing of his own. And on the question that mattered to him, he was already much further along than we were.

There is a small mountain of research on this, and almost none of it gets read by the people doing the buying.

For decades, the academics who study mergers have known something the deal industry treats as a footnote. Whether an acquisition works does not depend only on whether the buyer priced the target correctly. It depends, more than buyers like to think, on whether the target’s people decide to trust the buyer. And the people inside form that judgment early, often before the deal even closes, reading signals the buyer does not know he is sending.

Two business-school professors, Günter Stahl at the Vienna University of Economics and Business and Sim Sitkin at Duke, built a model of how that trust gets made. Their paper has an unlovely title: “Trust Dynamics in Acquisitions: The Role of Relationship History, Interfirm Distance, and Acquirer’s Integration Approach.” The punchline is a surprise. The intuitive story, that trust grows out of a long shared history, is mostly wrong. What predicts whether the acquired people trust the new owner is how the new owner behaves: the quality of his communication, the way he handles the integration, whether he shows up as something other than a conqueror. The history barely matters. The conduct is most of it.

Then there is the finding that should stop a buyer cold. In a companion study, Stahl teamed with Amy Pablo, a management professor at the University of Calgary, and a few colleagues to run a decision-making simulation. The paper is called “Antecedents of Target Firm Members’ Trust in the Acquiring Firm’s Management.” They lined up five things that drive a target’s trust in a new owner and measured which one mattered most. It was not his competence, or his vision, or the price he paid. The strongest predictor by a wide margin was the attractiveness of the acquirer’s HR policies, meaning how he treats the people already inside the building. The managing director, the one who refused to let the office drink better coffee than the floor, was not testing whether we understood his warehouse. He was testing whether we could be trusted with his people. He had known the throughput number for years. The thing he was studying was us. The audit had started with the oat milk.

This would be a charming bit of academic color if it were not for what it does to the money.

The team you are buying can leave. A study in the Journal of Strategy and Management looked at 113 acquisitions. Its title is “Retaining Acquired Executives Through Action.” The senior people at the target were more likely to walk in the bigger, more disruptive deals. What kept them, when anything did, was whether the buyer behaved fairly. He explained his decisions. He shared real information. He treated the process as something done with them rather than to them. For a private equity thesis, this is not a soft consideration. It is the whole consideration. You did not buy a warehouse outside Knoxville. You bought the managing director and the people who know why the night shift turns over, and every one of them is, right now, grading you on a test you do not know you are sitting.

The numbers are worse than the story. After an acquisition, the target’s top managers leave at roughly twice the rate they otherwise would. James Walsh, a management professor at the University of Michigan, documented that in the late 1980s. Jeffrey Krug, a strategic-management professor at Virginia Commonwealth University, tracked more than twelve thousand executives over fifteen years and found the bleeding does not stop at the first bad year. Within five years of a deal, close to seventy percent of the target’s senior team is gone, and the instability can run for a decade. Estimates of how much of the acquired top team eventually gets replaced run as high as sixty percent.

None of that would trouble the model if the people were interchangeable. They are not. In a study of ninety-six acquisitions, two scholars of corporate leadership, Albert Cannella of Texas A&M and Donald Hambrick of Penn State, found that when executives left an acquired firm, performance suffered. It suffered most when the highest-ranking people, the chief executives and presidents, were the ones who walked. The reverse held too. Deals where target executives were given real standing in the combined company did better. The managing director with his tub of powdered creamer was not a line item to be optimized away. He was, in the flat language of the research, part of the resource base you were paying for.

The scoreboard is unkind to buyers who forget this. In its study of corporate dealmaking, PwC found that fifty-three percent of acquirers underperformed their own industry peers over the two years after a deal closed, measured by total shareholder return. The acquirers who treated value creation as the priority from day one beat their peers by as much as fourteen percent. A good part of the distance between those two numbers comes down to how the buyer behaved once the people inside started watching. Which they do, from the parking lot on.

The strange thing is that the sellers already understand this perfectly. Walk over to the other side of the table and you will find a whole little genre of advice telling founders how to size up a private equity suitor before they sign. Do not just meet the deal lead, it says. Call the firm’s old portfolio CEOs. Watch how they behave away from the boardroom, when the charm is off. Learn who they are when things go wrong, not only when things go right. The sellers have been told, in plain language, that the courtship runs both ways.

It is only the buyers who arrive thinking they are the only ones holding a clipboard.

So if you are the one with the money, the cheapest edge available to you is also the most embarrassing, because it costs nothing and you already know how to do it. Treat the site visit as the two-way exam it has always been. Send people who behave well when they think no one is watching, because someone always is. Answer the uncomfortable question straight, the way you would want it answered if the wire were going the other direction. And before you walk into anyone’s warehouse, do to yourself what every good founder is already doing to you. Call the people you have owned before, and ask them who you really are.

We left the Knoxville site a little after eleven. My client was happy. The numbers were good, and the managing director had walked us out himself, gracious right up to the door, where he shook our hands and watched us drive off.

In the car my client said the visit had gone well. And it had. He had assessed the business, and the business was sound.

He just never noticed that the business had spent the whole morning assessing him. It had started somewhere around the oat milk, before the coffee was even poured. And of the two verdicts reached in that warehouse, his was not the one that would decide whether the deal made any money.

Sources. Günter K. Stahl and Sim B. Sitkin, “Trust Dynamics in Acquisitions: The Role of Relationship History, Interfirm Distance, and Acquirer’s Integration Approach,” Advances in Mergers and Acquisitions 9 (2010): 51–82. An empirical case-survey version followed in Human Resource Management (2011), with Larsson and Kremershof. Günter K. Stahl, Amy L. Pablo, and colleagues, “Antecedents of Target Firm Members’ Trust in the Acquiring Firm’s Management: A Decision-Making Simulation,” Advances in Mergers and Acquisitions, the source of the finding that the attractiveness of the acquirer’s HR policies is the strongest of five trust antecedents. “Retaining Acquired Executives Through Action,” Journal of Strategy and Management 18, no. 2, a regression analysis of 113 domestic acquisitions (2008–2014) on relative size, target-executive turnover, and the mitigating roles of procedural justice, informational justice, and corporate commitment. On the scale of departures: James P. Walsh, “Top Management Turnover Following Mergers and Acquisitions,” Strategic Management Journal 9 (1988); Jeffrey A. Krug, “Executive Turnover in Acquired Firms,” Journal of Management and Governance 7 (2003), and Krug and Aguilera (2005). On the performance cost: Albert A. Cannella and Donald C. Hambrick, “Effects of Executive Departures on the Performance of Acquired Firms,” Strategic Management Journal 14 (1993): 137–152. On the scoreboard: PwC, “Creating Value Beyond the Deal” (2019), reporting that 53 percent of acquirers underperformed industry peers on total shareholder return over the 24 months after a deal. One honest caveat.

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