(This article originally appeared in the Spring 2009 edition of Philanthropy magazine, pp. 14-17)

M&A is typically associated with strategic reorganization in the for-profit sector. New research from Bridgespan suggests that — under the right circumstances — it can also be beneficial in the nonprofit sector. Here’s what donors need to know.

A troubled economy has many funders taking a long, hard look at their budgets, seeking better ways to allocate diminished funds. At the same time, many direct service organizations are struggling to survive, even as they are being asked to serve increased social needs. The scramble is on to do more with less. As a result, nonprofit mergers and acquisitions have become an increasingly frequent topic of everyday conversation.

Many funders view mergers as a tool to save endangered grantees. Some believe that mergers could create valuable cost efficiencies in a moment of need. Others (perhaps only privately) hope that consolidation will allow them to make fewer grants without having to cut off funding to any of their traditional grantees. And certainly all of these benefits do exist.

But it is also possible to see M&A in an altogether different light. When used with strong rather than weak organizations, when used in a moment of calm rather than in a moment of desperation, when used where it has the greatest strategic potential rather than where the pain is sharpest, M&A has the ability to create important structural changes that will contribute to a stronger and healthier nonprofit sector.

Strategic M&A: Potential and Challenge

Current tough times will only increase the number of grantees facing these challenges. In a poll of 117 nonprofits in late 2008, the Bridgespan Group found that 20 percent already were considering M&A as a response to the economic downturn. These findings dovetail with a more extensive Bridge- span study which found that the majority of mergers and acquisitions were born out of challenges to sustainability—as a way to shore up finances or address a succession vacuum.

The time is also ripe, however, for healthy organizations to consider M&A proactively, as a way to strengthen effectiveness, spread best practices, and expand reach. All of this can be done more cost-effectively by making best use of scarce resources. There is far more potential for M&A to create value in the nonprofit sector than most people realize.

When used strategically, M&A can help nonprofits:

• Improve the quality of existing services (e.g., enhance programs, training, and supervision);
• Improve the efficiency in existing services (e.g., use assets more effectively, reduce overhead);
• Increase funding (e.g., gain access to better fundraising capabilities or build effective new relationships);
• Develop new skills (e.g., acquire new program expertise, leadership capacities);
• Enter new geographies (e.g., overcome barriers to entry, build community relationships).

Despite its potential, M&A is not, by and large, being used strategically by the nonprofit sector. In interviews with people involved with 29 M&A deals in child and family services (CFS)—a nonprofit sector that has seen high levels of M&A activity—the Bridgespan longitudinal study found most deals were inspired by financial pressure or a leadership vacuum, not by strategic rationale.

Patrick Lawler, CEO of Youth Villages and one of those interviewed, helps explain why. Youth Villages, the largest provider of services to emotionally troubled children in Tennessee, has undertaken a number of mergers and acquisitions. But Lawler explains that there are few supports to help nonprofit leaders identify valuable opportunities. For example, in the for-profit world, investment bankers pitch merger ideas to company leaders. The closest nonprofit equivalent, he says, is when an executive search firm contacts one nonprofit executive because another CEO is retiring.

Nonprofit M&A faces other barriers as well. There are no financial incentives driving deals, as there are in the for-profit arena—a situation that is unlikely to change. And—apart from a handful of experts, like LaPiana Associates and the Lodestar Foundation—there is scarce guidance on how to evaluate potential deals and structure them effectively.

Therein lies the opportunity for funders. As nonprofits seek out the deals that will enable them to survive, funders have to help identify and implement those opportunities that provide the most benefit. More importantly, in the nonprofit fields where M&A offers the greatest potential, funders can play a pivotal role in helping the strongest, most effective organizations create greater impact.

This is not a blanket call for mergers in the sector. The right mergers are hard to find and difficult to implement. Many (perhaps most) do not create value. That is why it is essential for funders and nonprofits to consider mergers in the most deliberate and strategic way possible.

The Best Candidates for M&A

As funders weigh M&A as a possible option, it is worth noting that M&A does not present the same level of opportunity throughout the nonprofit sector. Certain fields are characterized by factors that make them especially suited to M&A activity.

As mentioned above, CFS is particularly fertile ground for strategic M&A. Encompassing a diverse array of services, including foster care and mental health, CFS has annual expenditures of approximately $70 billion nationwide. While the 11-year overall cumulative M&A rate for nonprofits is 1.5 percent, the comparable rate for CFS (based on Massachusetts data) is 7.1 percent.

What characteristics make CFS so well-suited for M&A?

Market fragmentation. Like many nonprofit fields, CFS contains many organizations that are fragmented by geography and service-type. Most of the approximately 40,000 CFS nonprofits operate on less than $100,000 per year.

Real competitive pressure. In the CFS arena, metrics allow for easy comparisons among nonprofits. Moreover, approximately 85 percent of all funds come from impersonal government sources, which are increasingly looking for one-stop contracting—pressuring organizations to grow and making smaller organizations less viable.

Barriers to organic growth. Consider that CFS is:

• A relatively saturated market, with most children already covered by some type of service;
• Asset-intensive, requiring long stretches of time to grow provider networks and substantial resources to build the facilities through which many services are delivered;
• Delivered locally to children and families who want well-known, well-regarded entities with a strong local brand. Referring organizations, as well as state and local agencies, which provide most of the contract funding for CFS, have similar priorities; and
• Highly regulated, since the government dictates how services are provided; how staff members need to be educated, trained, and certified; what reimbursement rates apply; and how facilities need to be licensed. Licensing and accreditation vary based on services and geography. All of this training and compliance can be time-consuming and expensive.

Of course, not every field that is suited to strategic M&A activity will have the same mix of defining characteristics as CFS. But our research suggests that some subset of these characteristics will likely be necessary for M&A to be a strategically viable tool. As such, they are key characteristics funders should look for as they review their grant portfolios for potential M&A opportunities.

Case Study: Arizona’s Children Association

Fifteen years ago, the Arizona’s Children Association (AzCA) was a $4.5 million organization, focused primarily on offering residential services in Tucson. As they looked to the future, AzCA’s leaders knew they needed to modify their mission to have the kind of impact they wanted. "We were primarily a residential treatment organization, and we didn’t have any services in primary prevention and early childhood work," says AzCA president and CEO Fred Chaffee. "With our mission of protecting kids and preserving families, we had to serve kids earlier to give families the tools and reach kids needed before they arrived at residential services."

But AzCA didn’t have the staff expertise, donor relationships, or brand name to serve families. So, 10 years ago, AzCA acquired an organization that did—marking the beginning of a rapid, strategic expansion through M&A. Six acquisitions later, AzCA has grown into a $40 million statewide nonprofit offering a broad continuum of care for children and their families. This growth did not just come from the "purchase" of other organizations. Each acquisition allowed AzCA to add new services and skills and to spread them across the organization. Then, once the expanded organization had solidified its reputation and built community and brand awareness, AzCA engaged in competitive bidding to further organic growth.

AzCA thus gained footholds in new services and with new beneficiary populations. "We might have been able to enter new service areas by ourselves, but I think it would have been a much slower process," reflects Chaffee. "The idea was to buy an existing entity—one with good brand awareness, good funding sources, and good people in place—at a level that was relatively small but upon which we could build. By acquiring these providers and keeping their names, we immediately had credibility in those services and in the communities in which they operate."

AzCA’s approach proved prescient, as the trend in recent years has been to move more children from residential to out-patient or in-home care. As a result, AzCA’s diversification has positioned the organization to weather the corresponding changes in funding priorities.

As AzCA has gained experience with M&A, it has developed practices and resources for managing past acquisitions and looking for future M&A opportunities. These include:

• A regular meeting cycle—five or six times a year—for leaders to discuss when and where the organization should grow, and to evaluate possible M&A candidates;
• Robust internal capability for vetting and integrating acquisitions, as well as solid benchmarks on the costs and benefits of merging, which AzCA can use to raise funding for merger-related expenses; and
• An experienced post-merger integration team that focuses on joining the two cultures.

AzCA’s leaders see the organization’s strength as an M&A partner as essential to its ongoing M&A efforts. Chaffee says, "The biggest fears as a CEO or board member when you get acquired are, ‘I’m going to lose my sense of identity, and I’m going to lose my mission.’ We have people on the AzCA board who represent every acquisition, and we have two of the five former CEOs still on staff. When we go in to have an initial discussion, we say: ‘Here are the names of former CEOs who either worked for us or in the community of agencies we acquired.’ They don’t sugarcoat it, but they give positive feedback and help to allay those fears."

Excluding its two most recent mergers, both less than a year old, AzCA has been able to expand the reach of each of its acquisitions. What these numbers do not capture is the increase in quality that has come from sharing experience and expertise. "We now train adolescent therapists in lessons from our early-childhood acquisition, and all of a sudden, they can see where a teenager got stuck because of a trauma at age two and are better able to figure out what to do about it," says Chaffee.

While cost-savings were not the strategic goal of AzCA’s M&A efforts, its growth in scale and successful integration of each new organization have allowed it to reduce cost per beneficiary between 11 and 40 percent.

A Call to Action for Funders

M&A is by no means a panacea for the many and varied challenges facing nonprofits. Nevertheless, it can and should be seen as a forward-thinking strategic tool, particularly as nonprofits feel increasing pressure on funding and performance.

How can funders encourage nonprofit leaders to pursue M&A activity strategically?

• Provide funding to support due diligence and post-merger integration, enabling organizations like AzCA to make upfront investments with long-term paybacks in efficiency and effectiveness. Some foundations such as Lodestar in Arizona are already doing so—and seeing the rewards. "We have found that the leveraged economic savings can easily be 10 or 20 times the amount of the merger grant," says Lodestar chairman Jerry Hirsch, "and that doesn’t include other potentially huge benefits." Such benefits include increasing the quality and impact of the service provided while strengthening the organization. Hirsch believes that even unconsummated mergers can reveal underlying issues that in turn lead to the creation of a more viable organization. The good news is that, unlike for-profit mergers, no payments are needed for an ownership stake. The costs are related to undertaking due diligence, executing the transaction, and integrating the organizations.
  
  "Because funding M&A is such a powerful opportunity for funders," concludes Hirsch, "and because funders often lack the expertise and confidence to fund in this area, we are exploring starting a national funder’s collaborative solely for the purpose of funding M&A and other types of nonprofit collaboration."
• Invest in intermediaries that can create a more efficient "organizational marketplace" through which nonprofits can identify potential merger options safely. Such matchmakers can help provide guidance as to which organizations might explore M&A, under what conditions they could carry out a merger, and how they should conduct post-merger integration.
  
  Funders may also find themselves in a unique position to play a matchmaker role. Those working in nonprofit fields that are well-suited for M&A might want to assess their portfolios to see if their grantees could benefit from mergers—particularly the stronger organizations.
• Take steps to educate the sector by developing a broader knowledge base about when to think about M&A, how to explore it, and—if pursued—how M&A can succeed in creating its intended value. As Chaffee says, "Based on what I know now, I would have loved 10 years ago to have some guidance on merging operations."