MH Article

Ever Wondered Why So Many M&A Fail To Create Value? Momentum.

Kicking off a deal - and it doesn't have to be an acquisition, it could be a JV or a major investment - usually means someone, somewhere high up the organisation, has got a bee in their bonnet. Once there's sufficient enthusiasm to get a deal going, it's going to take something pretty serious to slow it down.

All too often the people who are enthusiastic about a deal - who've staked their reputation on it - are unlikely to have their ardour dampened by some accountant or lawyer raising questions about numbers in dusty ledgers. Due diligence (DD) often just isn't sexy enough to kill a deal.

The thing is, as FD you're point man on those annoying details. "The first thing to remember about DD is that if it goes wrong, it's the FD who's going to get fired as a result," says Paul Rawlinson, head of transaction Services at PwC. "But a deal often starts when the CEO has been offered something for sale, rather than as part of a well thought-out strategy that everyone everyone's bought into. For example, it's not uncommon for a parent group to decide a subsidiary should make an acquisition and then parachute in a transaction team. They're driven by the deal - the DD is just a rubber stamp." But the local management team has to pick up the pieces. Even in smaller operations, where you might expect the senior management team to share a common sense view of deal-doing, the heat of battle can get the better of an ambitious CEO. And once they've decided the "strategy" is right or they like the guys they're buying the company from, the DD can be blighted with tunnel vision rather than being a thorough examination of facts, values and. potential synergies.

"The DD process often starts with what the acquirers think they know - which might well be incorrect," says Rawlinson. "So the scoping for the DD is wrong. The business you think you're buying is different from the one you're actually bidding for." In other words, if you start off wrong, it's a pointless exercise.

The Environment

Taking a cavalier attitude to DD is a bad idea in the best of times. But with a still-shaky global economic outlook and uncertain corporate profitability, it's business suicide so treat DD with anything other than total thoroughness right now.

"The current climate for deals is probably best described as 'fragile', so people are more cautions," says Duncan Innes, a partner at law firm Marriott Harrison. "Acquirers should be kicking the tyres more carefully when they look at deals. There's two ways to do that. Either you go for a full set of warranties; or more extensive due diligence. Or both, of course"

Based on anecdotal evidence form deals doing FD's we've interviewed over the past couple of years, deal completion times are certainly lengthening. And greater detail in DD is a factor. But it's not just a perceived need to check up on profits that might have been "flattered" due to a sluggish business environment.

"Due diligence has got more complex in recent years," says Innes. "In the late eighties and early nineties there was a rash of environmental legislation and that had a major effect on US purchasers. More recently, we've seen a big change thanks to the new money laundering regulations. DD isn't just a check on the accounts and the management - it goes right through the organisation".

DD certainly uses a more varied palette of colours than it once did. "The many different types of DD all examine different parts of the business," says Mike Fletcher, a director of corporate finance at investment bank Altuim. "Increasingly purchasers are commissioning DD to cover areas such as environmental impact or insurance. They have concerns over the rapidly rising cost of cover in many sectors and the implications of inadequate cover."

"We're also seeing more VC houses do psychometric testing of management in MBO and MBI deals," says Innes. Tim Clarke, FD at private equity group Kleinwort Capital, confirms that this is fairly common. It's not a question of using the results as a hard and fast guide on whether to proceed with the deal, he says. It's more about understanding exactly what you're getting in to.

"A review of the target's IT systems and controls is also very useful," says Rawlinson. "If they're not in good shape, you have to wonder whether you'll be able to rely on the numbers coming out of the business."

But there areas stand out: financials - the basic building blocks of valuation and therefore of DD; HR - because there are few deals where the personnel aren't important and restrictive employment laws (including TUPE) can seriously limit yours options post-deal; and market DD - which will tell you how robust the business is and where you'll find the growth.

Financials are perhaps the best understood of the lot. But don't get complacent. "Watching things like cost allocation," says Rawlinson. "People often don't understand the concept of profitability in their own business. Your DD process may even leave you with a better knowledge of the business than the vendor has."

Know your HR position

"The financials are the financials," says Stuart Bridges, FD at insurer Hiscox. He's done around 30 acquisitions over the past ten years. "but HR due diligence presents some particular challenges. Simply getting all the information together is the first one. It can be found, but it takes time to put it all into sensible formats. And while getting your head around the salaries is pretty straight forward, the contracts can be a lot harder."

It's not just a question of post-deal integration. HR issues can have a major bearing on price. Hiscox recently bought a Belgian business where many of the senior staff were on three-year notice periods. That's a big stick to wield round the negotiating table.

"Then you have to get a feel for how good the people really are and how they'll fit into your future plans," says Bridges. "In smaller deals, you can interview everyone at the target company. Your own HR people can do a lot of the leg-work. With a lager company, it's a question of picking on the key people. Either way, you have to remember that DD is a two-way process. You have to sell yourself to the team."

You'll need to check any works council issues. And you must check all the contracts, benefits and pensions. Pension commitments could be high value, and it's a really emotive subject for the workforce you're inheriting. So you need to tie down the responsibilities with the vendor. Will they retain any of the fund liabilities?

Bridges stresses that although his own HR people are often better equipped to make the right calls on HR DD than external advisers, he likes to get the lawyers in on TUPE issues. He's wary of spending too much expensive adviser time on looking over the information gathered in a DD process. "I see them as ideal for gathering information, but our in-house people are probably better qualified to asses it in the context of our business and our industry."

Know The Market

That's not to say getting external advice on markets is a bad idea, particularly if you're using a deal to expand into new areas. "We certainly thought we knew what questions to ask and what the answers would need to be," says Mark Sater, an accountant who became chairman of Hunter Boots after doing a buy-in deal. He and other members of the buy-in team had extensive experience of running branded goods companies. But their VC backer was looking for additional reassurance.

"We didn't want to get caught up in a very expensive process, so we asked a firm to test our assumptions about the business," he says. "They interviewed customers and found out what the treats and opportunities actually were. And, in fact, some of our assumptions were shown to be wrong."

Sater used Brand Finance, the boutique run by former WCRS FD David Haigh. "Brand DD is just a name for a process," says Haigh. "You could equally well call it 'demand DD' - it's really a market audit. You're looking to answer the question, is this a strong brand, and why?' Business-to-business companies are often resistant to the idea of brand DD - they think in terms of consumer brands. But we can still assess the market, their share and, importantly, project both into the future. This s about measuring the drivers of the business that come from marketing."

Look out fo0r brand support costs. Again, it goes back to whether you'll end up buying what you think you're buying. The vendor CEO or chairman might have an emotional attachment to certain brands. That could mean they're absorbing far too much support and are not as profitable as you - or they - think.

"Are the intellectual properties owned and secure? How much money does the business make from its own exploitation of it brands and how much from licensing them? How does the p&l stack up in its own operations? We'll do a sensitivity report on the valuation, and we'll also look at the capital employed in maintaining the brands," says Haigh. "We go into detail on the historical profitability by brand and by segment. All that stuff forms the background for our projections going forward."

As an acquirer, you should be looking to verify some of the key assumptions you've made for the size of the market and the brand's strength within it. Where's the growth? What share will the brands have in the key segments? What's the margin going to be like? Basically, is the revenue line credible? So you need to look at market research, at the consumers and the trends. Only ten can you make a judgement.

"We used the brand DD in other ways," says Sater. "First, we got the incumbent management to read through the report and tell us whether it changed their view of their own business. Second, it was some comfort for the bankers and private investors backing the deal. The big benefit is the ability to test the way the market see you in a way that accountants and lawyers can't."

Bottom line? If the deal doesn't fit for any reason - if the assumptions, values, people or synergies aren't there - DD should expose the problem. "I'm happy to walk away from deals based on meeting people at the target companies," says Bridges. "If you don't get the detail of the DD sorted out, the best you can hope is that you're delaying serious problems for a couple of years." And the best you can hope for then is that you're not around to carry the can. As Rawlinson says, "sometimes often the most value we add to a deal is to kill it."