DD Guarantee: Due Diligence Is a Key Stage of Mergers and Acquisitions, and It's Especially Crucial to Get This Process Right When Economic Conditions Are Uncertain. Stewart Meek Explains How a Thorough Review, Incorporating a Well-Trained 'Virtual' Team Drawn from within the Purchasing Organisation, Can Be a Genuinely Value-Adding Activity. (Business Acquisitions)
Meek, Stewart, Financial Management (UK)
There is a school of thought that suggests the acquisition excesses of the internet boom years resulted from poor due diligence practice. But the reality is that the due diligence process starts only after the intention to purchase has been expressed--often with unbridled enthusiasm during the dotcom gold rush. If blame is to be attributed, it's possible that the findings of due diligence reviews were ignored and unwise deals were concluded regardless.
According to Denzil Rankine in Commercial Due Diligence (Pearson, 1999), the process simply "helps acquirers and investors to decide whether or not to commit their resources to a transaction". It has traditionally focused on financial and legal issues, but other important areas have emerged. The inclusion of commercial, HR and operations risks (and others, such as health and safety) means that fully comprehensive reviews are being conducted more often.
The acquirer wants to get into the detail as quickly as possible, while the vendor would rather wait until it receives an acceptable initial offer before letting anyone see its most confidential information. If there are several suitors, the vendor may prepare the due diligence material or commission a report to be used by all bidders, giving only those it has shortlisted unrestricted access. As a rule of thumb, broad screening should be conducted early on in the acquisition process and a more detailed analysis should occur during negotiations and the on-site review. Going into detail after the deal is completed is too late.
Figure 1, below, illustrates the four main stages of acquiring a private company, where normal principles of English law apply (rather than the purchase of a plc, which is subject to more complex rules). Stage 1 ensures that acquisition activity is in line with the strategic objectives of the organisation, and that it is a structured selection. The identification and selection of internal and external experts with well-defined roles "will greatly improve the chances of success and reduce the time and costs involved", according to the Company Acquisition Handbook (Tolley Publishing Company, 1996).
An initial offer may be unsolicited or a response to an invitation or auction. But, once the acquirer is in the game, stage 2 involves detailed work towards making a definitive offer. When the initial offer is deemed acceptable, the due diligence team springs into action and meets the vendor's management team. It's generally recognised that due diligence takes much longer in today's market conditions and the findings are purportedly used as bargaining chips in price negotiations.
Assuming that a negotiated settlement is reached, stage 3 focuses on deal structuring and the completion of documents. Planning for stage 4, integration, should then begin. The success of the transaction will depend on the ability of the acquirer to absorb the new business and deliver the benefits found in the planning and research phases. HR issues will be much to the fore, hence the heavy emphasis on communication at this stage.
Due diligence is an expensive activity, but the benefits can far outweigh the costs. Conducted properly, the picture of the target organisation, its business sector and its industry should become well understood by all of the key people in the acquiring company.
Scope is important: financial and legal due diligence are seen as the minimum reviews that should be completed, but three other key areas are commercial, management and operations. These are illustrated in figure 2, right, with the results from each fieldwork area feeding through to the review stage.
[FIGURE 2 OMITTED]
The review seeks to corroborate the initial offer, which is likely to have been derived from internal desk research or documents supplied by the vendor, such as an information memorandum. Due diligence will try to identify deviations from the initial valuation, resolve risks identified by the research and uncover any new risks. As the valuation is reforecast, additional or final approvals may be required from appropriate people within the organisation before a definitive offer is submitted.
The legal aspects of acquisitions are wide-ranging and internal legal advisers will invariably need external assistance--particularly for cross-border transactions. According to Tolley's Company Acquisition Handbook, the lawyers' principal aims are:
* to ensure that the purchaser receives shares and assets free from encumbrances;
* to protect the purchaser from any unforeseen-liabilities;
* to ensure that the purchaser has adequate information on fairness of price and for past-transaction operations.
The acquiring organisation will generally engage an accountancy firm to prepare a financial report (including taxation) on the vendor as part of the due diligence process. Here it is important to avoid an overlap with the commercial and legal reviews. The scope of the accountancy firm's activities should be agreed in writing between the parties, noting the litigation fears of the accountants.
The success of the new venture will of course depend on its commercial viability, so understanding the customer and market issues before the acquisition is paramount. In building an initial offer, many assumptions will be made, but the key questions to consider when conducting desk research are:
* Are we looking at the product, the market, the customers or all three?
* How will the intrusion between the vendor and its customers be handled?
* How will commercial research integrate with other due diligence work?
Understanding the capabilities of the vendor's management team is key to the short-term future of the acquired business. If the skills and knowledge of its members are irreplaceable, then care must be exercised in structuring a deal that ensures they can be retained. This may be a problem if they are held by the selling owner, but due diligence can help to structure an earn-out package as part of the transaction. On a wider basis, the early involvement of HR expertise can prevent many problems from arising at a later stage. In European transactions, the legislation on the transfer of undertakings has many national interpretations, so local advisers will have a vital role.
The operations review focuses on the ability of the target company to conduct its business and the practices that make it an attractive prospect. This will involve an early Swot analysis of identifiable factors such as facilities, logistics, operating measurements etc. Subsets will include health and safety, environmental factors and other tangible risk areas.
Senior management's commitment to the acquisition is critical, so a steering group with appropriate authority should oversee the whole process. An acquisition project manager should lead the activity and co-ordinate the stages of the due diligence review. A full due diligence team will comprise internal functional specialists and external advisers.
One approach to building an internal support unit is to create a virtual due diligence team. Members are drawn from across the business, based on their functional specialisms. After initial training on the acquisition process and the importance of due diligence they are kept informed of potential acquisition targets. When interest in a target increases, the team is activated and its members can start desk research on their specialist subjects. This can be particularly important in the case of a cross-border transaction where logistical, cultural and language issues may arise.
The approach helps to control costs, because the virtual team will conduct many of the early-stage reviews. As the team members gain experience, their ability to engage and direct external consultants will also improve. Instead of issuing general terms of reference, they can seek specific solutions.
Virtual teams require significant trust and support from the senior management. Team leaders must carefully manage the workload of the members while they are on the assignment, because their day jobs will obviously still demand much of their time. The external advisers will be guided by the nature of the acquisition on the style of reporting that will be appropriate. For an unlisted company, a report will be offered either as a short document or a PowerPoint-style presentation, as agreed in the terms &reference.
Legal reports lean towards a documentary format and may require internal interpretation. The HR and contractual issues will tend to be in a similar style, whether completed by the same law firm or not. The functional leader on the virtual team plays a key role in interpreting and summarising these. Synopses of the main problems should be reported to the steering team regularly, together with recommendations or actions for their mitigation.
The benefit of having a team briefed and ready to conduct research and prepare its own groundwork is that it enables the acquiring business to move quickly and steal a march on the competition. Although due diligence will not set the price of a transaction, it can unearth risks and ensure that you don't pay too much for what you're getting.
1 THE FOUR STAGES OF AN ACQUISITION PROJECT 1 Initial offer * Strategic planning * Acquisition objectives * Acquisition tactics * Identify team * Target identification * Initial approach * Initial offer 2 Definitive offer * Initiate team * Due diligence * Revalue target * Obtain final internal approval * Negotiate price * Definitive offer 3 Completion * Share or asset purchase * Purchase consideration structure * Document preparation * Negotiation * Document execution * Integration planning * Completion 4 Integration * Implement the integration strategy * Initiate steering team * Deliver synergies * Communicate, communicate, communicate
CASE STUDY IGNORE THE HR ISSUES AT YOUR PERIL
When a well-known OK multinational bought out a US-based multinational in 2002, the seller warranted that all of its employee benefits had been properly accounted, for under US Gaap, writes Graham Pearce, European partner at Mercer Human Resource Consulting. This claim was verified by a vendor's due diligence report that was signed off by one of the Big Four. The buyer's actuaries also confirmed that the actuarial method and assumptions used in the due diligence report were reasonable.
Luckily, further along the due diligence process, the buyer discovered more than $250 million of hidden liabilities before it was too late.
How could this be? First, the seller's stock plans did not provide for vesting in the event of a company sale. This meant that employee stock options, which would lead to a profit of over $100 million, would be lost if exercised at that time. This could create significant industrial relations problems if the buyer were not to compensate employees accordingly. The outcome of the negotiations was that the seller would continue to vest the stock options in accordance with its previous vesting schedule for the transferring employees.
Second, there were "change of control" clauses in the pension plan documentation and in some of the senior managers' contracts. The outcome here was not so satisfactory. While the seller agreed to reduce the purchase price, allowing for $40 million of the expected extra payments and benefit improvements, the likely retention rate of key senior managers was going to be extremely poor. Some had enjoyed windfall payments that were so large that they would never have to work again.
Third, the accounts were prepared using US Gaap, which, like international accounting standards, allows actuarial gains and losses up to 10 per cent from retirement plans to be carried forward without being expensed through to the balance sheet. This so-called 10 per cent corridor is to per cent of the higher of the total assets and liabilities. So, if global pension plan assets total $800 million, investment losses can run to $80 million before any losses need to be taken account of in the profit and loss account or balance sheet.
Furthermore, once the 10 per cent corridor has been exceeded, the balance of any gains and losses can generally be spread over the remaining working lifetime of the active population (15 years is often used). So a company's balance sheet is often based on a totally outdated value of the pension plan assets. This is a real problem, given the steep market falls of recent years. This timebomb hits buyers of companies very hard, because any unrecognised losses must be booked immediately on acquisition. In this case, the unrecognised losses attributable to the target business totalled $90 million.
Unfortunately, the purchaser still found further hidden costs after the sale went through. The restructuring plan had relied on closing down half the German production facility and moving the production to lower-cost sites in the Czech Republic and Poland. While the restructuring budget had taken account of employees' notice periods and contractual severance pay, the lengthy procedure of consultation with the target company's works councils and trade unions meant that the severance terms went considerably over budget. In the event, the whole process overran badly, delaying the time at which the savings began to flow.
Unexpected problems also arose when the acquiring company thought it would have much more control over which employees would lose their jobs. In the end, Germany's strict labour laws saw to it that the "wrong" people were made redundant, resulting in a loss of efficiency after the restructuring.
The acquirer also underestimated the time it would take to recruit and train the new workers in eastern Europe, so the new production facilities were late in reaching their target output.
Stewart Meek (firstname.lastname@example.org)is managing director of Cibek, a consultancy and training company…
Questia, a part of Gale, Cengage Learning. www.questia.com
Publication information: Article title: DD Guarantee: Due Diligence Is a Key Stage of Mergers and Acquisitions, and It's Especially Crucial to Get This Process Right When Economic Conditions Are Uncertain. Stewart Meek Explains How a Thorough Review, Incorporating a Well-Trained 'Virtual' Team Drawn from within the Purchasing Organisation, Can Be a Genuinely Value-Adding Activity. (Business Acquisitions). Contributors: Meek, Stewart - Author. Magazine title: Financial Management (UK). Publication date: May 2003. Page number: 28+. © 2009 Chartered Institute of Management Accountants (CIMA). COPYRIGHT 2003 Gale Group.
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