We published in this space on Tuesday a link to a provocative piecefrom Escape from Averageness poster Fletcher Groves, who riffed on integration and assimilation challenges TRI Pointe Homes may confront as it combines with its much larger $2.7 billion acquiree, the Weyerhaeuser home building operations.
Fletcher focused on a past roll-up of separate home building operations known as The Fortress Group, whose meteoric rise and fallmay serve as a case study in what not to do, or allow to happen.
Fact is, Fletcher only got the ball rolling on a conversation that home building company executives everywhere should be having. What's more, it's our friend Jamie Pirello's contention that Fletcher's observations only got at some of the worthy take-aways from Fortress' fail.
Here, we'll render Pirello's response in full, with two disclaimers for audiences. One, is that we have an ongoing "source" relationship with both Groves and Pirello, which means we regard them both as experts in understanding professional disciplines in home building management, leadership and operations. We don't have financial interests nor stakes in either of their positions.
Two, we feel that the level of discourse here on a topic of critical strategic importance--mergers and acquisition integration during a period of home building industry consolidation--reflects a great deal of progress from practices, ambitions, and instincts of the past. On the surface, it looks like money is the No. 1, 2, and 3 driver of all that's going on in home building right now. Fortunately, and importantly, it goes deeper, as finite resources--people and buildable land--weigh critically into the mix.
Enough of us. Here's Jamie Pirello's response to the Fletcher Groves post, "Tri Pointe: Learning From The Past?"
I read with interest your blog post - Tri Pointe: Learning from the Past? I think I can offer a little insight as I was one of the original founders of the company.
I think I can safely say that the good news for Tri Pointe and other acquirers is that for a variety of reasons they will not be faced with the same unique structural issues that the Fortress Group and other roll-ups of the 1990s encountered.
Your blog references the article by Gerry Donohue. As Gerry pointed out, the success rate of roll-ups in the 1990s was dismal. One needs to understand the fundamental structural issues that led to the dismal success rate of roll-ups. The seeds of this failure are direct result of the unique structure of these transactions. Roll-ups used “pooling of interests” accounting; this accounting treatment is no longer in use. The benefit of pooling of interest accounting was that there was no goodwill to be recognized and placed on the balance sheet as there would be with “purchase” accounting. In order to qualify for pooling of interest accounting under SEC requirements, the owners of the companies being merged could not receive any cash at the time of the merger. These “sellers” could only receive stock in the combined company; stock that was subject to lock-up agreements and dribble out rules. As such, these sellers did not have the benefit of a liquidity event; all of their equity was now tied up in the new company.
Since the sellers received no cash at closing, their total investment was fully at risk. It is this level of risk that led to the underlying reason for the failure of such firms as the Fortress Group – corporate governance. In the case of the Fortress Group, the four selling builders demanded control of the board of directors as they believed this would protect their investment. They were understandably reluctant to contribute all of their hard earned equity without maintaining control. Yet, the lack of a strong corporate function, with the ability to lead the organization and make the tough decisions that needed to be made resulted in a corporate governance that resembled the “Articles of Confederation.” The individual states had strong individual rights and the central function lacked control and was for all intents and purposes, powerless.
Public companies, for all the reasons you alluded to, cannot be managed in such an environment. Each of the founding companies wanted to keep its MIS system; they wanted to manage their business as they always had. Each company wanted to maintain its own organizational culture and they did not support recognizing certain synergies a result of overlapping expenses. For instance, shuttering accounting functions at the local level and moving to a regional or centralized approach would have reduced overhead costs. Other public builder had the ability to effect such a strategy and did so. The corporate management of the Fortress Group understood all of these issues, but lacked the authority to enact them.
While corporate governance would ultimately lead to the demise of many roll-ups, the sale of the Fortress Group’s assets was not a direct result, but rather an indirect result of the corporate governance challenges. The decision to sell the building companies acquired by the Fortress Group can be directly attributed to the Lazard Frères’ investment in and its control over the company.
Lazard Frères investment was a PIPE (private investment in a public entity). The letter of intent with Lazard Frères for their investment contemplated a specific structure. This structure was in compliance with the then current accounting requirements regarding the issuance of contingent shares. The transaction was being structured such that the investment would not negatively impact Fortress’ earning per share and therefore it share price. Prior to closing, the company’s auditors, made the company aware of a recent Statement of Position (SOP) that would require a change in the calculation of earnings per share when contingent shares were to be issued. This new requirement would negatively impact the Fortress Group’s earnings per share and share price. Lazard’s investment was convertible into Fortress common shares, the lower the market price of Fortress shares, the greater the number of contingent shares that would have to be issued to Lazard. The SOP now would require these contingent shares to be included in the earnings per share calculation. More shares, with the same earnings, results in lower earing per share. Lower earnings per share would negatively impact the share price. The lower share price then required more contingent stock to be issued to Lazard, once again lowering the earnings per share and the share price. The structure would create a downward death spiral for the price of Fortress’ stock. Management was opposed to Lazard’s investment and recommended against it.
As part of their investment, Lazard Frères had agreed to purchase for cash some of the existing builders’ stock giving the builders their first liquidity event. Given their control of the board and their understandable desire to finally achieve some level of liquidity, in a split vote, the board voted in favor of the transaction. As Donohue wrote, the company’s stock price fell “to about $4 at the end of 1997.” This was direct result of the significant dilution attributable to the PIPE transaction. Given that the number of shares Lazard was entitled to was a function of the share price, the death spiral could not be stopped.
The Lazard investment also changed control of the Board of Directors. Lazard required a super majority of the voting rights. Lazard, with its voting control, was in a position to execute the sale of the company’s assets in order monetize its investment. While the Fortress public debt did create challenges, Fortress did not sell any of its assets to repay its public bonds as the bonds were non-callable.
Fletcher, learning is a result of reflecting on one’s experiences. Individuals learn from their success, and often more so from their mistakes. I spent the last twenty years with the goal of ensuring I learned from this experience. I went back to school to earn MBAs from two of the top business schools in the world, Columbia University and the University of California, Berkeley. While these are great schools with great programs, it didn’t answer the underlying question. According to a KPMG study, 83% of mergers and acquisitions fail to increase shareholder value – why is this? I decided to undertake a doctoral program at the George Washington University in Executive Leadership; my doctoral research focuses on improving the success of merger and acquisition transactions through effective integration.
The research is robust. The reason so many of these transaction fail, as you correctly pointed out, is a result of “the lack of management integration, and corporate culture.” My research indicates that success depends upon a number of key components: first is a thorough understanding of the unique characteristics of the acquiring organization and that of the acquired organization; secondly a strong central management function that empowers its people in order to avoid the pitfalls of ambivalence and resistance that so often dooms successful integration. The integration of an acquisition is a significant organizational change event.
What we know, as a result of complexity theory and chaos theory from the mathematical realm, is that the majority of change is emergent. It is a result of self-organization around common individual schemata and it is non-proportional where the relationship between cause and effect is non-linear. Leadership teams today, need to understand the roots of organizational change in order to successfully implement the synergies that are the key to ensuring the success of merger and acquisition transactions.
Finally, true competitive advantage is a result of innovation, and innovation is fostered by individual and organizational learning. In today’s highly competitive global environment, M&A transactions that strengthen innovation will create organizations with true competitive advantage leading to industry leading shareholder returns.
Tri Pointe and other acquirers will be successful if they take this reality to heart; the issues of corporate governance that impacted the Fortress Group, will thankfully not be their concern.
Wow! All you got to do is spend $2.7 billion, or about $100,000 per lot, for five companies in five regions of the nation and, suddenly, we're talking about complexity and chaos theory. Deals don't appear to be what they used to. However, when Jamie refers, as a success indicator, to "a thorough understanding of the unique characteristics of the acquiring organization and that of the acquired organization," we think we get that.
A senior-level official for a financial services organization was asked to comment after a home building executive pitched her on a nine-figure investment opportunity at the ground floor.
Without a pause, she said, "Who are you, really? What do you do that's different, that you do the best?" It's a good starting point for any conversation that leads toward integration following an M&A deal.
There's obviously more to say on the topic, but we'd love to know your answer to the question, "have lessons been learned?"
Pirello's contact information, by the way, is
Jamie M. Pirrello
Learn more about markets featured in this article: Washington, DC.