A decade or so ago, it wasn't uncommon for acquirers to do
"handshake deals without a lot of due diligence," says veteran adviser
Alan Alpert, senior partner in M&A Transaction Services at Deloitte
Tax LLP. "Today," he says a bit wryly, "I don't think you see a lot of
those."
What you see instead are a lot of deals in which due diligence is
conducted with a thoroughness and a sophistication about what makes
deals work that would have been hard to muster back then. These days,
according to Alpert and other longtime deal pros, kicking the target's
tires and looking under its hood are mere preliminary rounds in the
pre-deal investigation that leads to closing. No savvy buyer --
strategic or private equity -- signs off today before executing a full
diagnostic workup that includes myriad strategic and operational
aspects of the target while continuing to probe traditional concerns
like the health of the balance sheet and the P&L statement.
Often, before reaching the negotiating table, the value-conscious
buyer is armed with vital information on the target's position in its
industry as well as the prospects for the broader industry. A careful
acquirer can then go on to seek a firm handle on everything from a
target's pricing power to its ability to fight competitors, the
viability and quality of its products, its customer concentration and
the strength of its intellectual property, as well as information about
its financial and other systems. It can also use a cache of data --
much easier to come by these days than it was even a decade ago -- to
test the target's revenue and cash projections with finely honed
precision.
If there's more information available, there are also more and
better ways to manage and make sense of it. Most notably, buyers now
often review the information that sellers provide through online
virtual data rooms. Yet if the tactics and tools have expanded, the
basic objective of digging out the information needed to strike the
right business deal hasn't changed.
Tom Flaherty III, senior vice president in the energy and utilities
practice at Booz Allen Hamilton Inc., describes a movement from a
compliance orientation to a more investigative approach. "There is much
more of a strategic approach in due diligence, with the primary
difference being the manner in which information is utilized in pricing
and in valuation of an asset," he says. "In the former days, it was
focused more on whether the numbers were realistic. Today, it addresses
if the business can be run effectively, is it positioned well and does
it really provide a good business fit considering the mix of business
position and operations."
Similarly, Jeff Gell, who heads M&A in the Americas at Boston
Consulting Group, says, "You want to make sure that the economics of
what you are acquiring are right, that it makes strategic sense and
that there are no massive surprises that are going to bite you after
the fact."
"The short answer is how does the company make money and what is the
plan going forward for that cash flow stream or the new product
development," adds Daniel D. Tiemann of KPMG LLP's audit and advisory
practice. "It's more than just quality of earnings. Now, that's just
the bare-bones minimum."
Although the goals haven't changed, the stakes in unearthing the
right information have surged. Buyers, sellers and their consultants
have been forced to refocus their investigatory approaches as a
response to a welter of pressures.
Deals are getting bigger, and more cross-border transactions are
getting done. That combination forces the buyer to take on more risk at
the very time the Sarbanes-Oxley law, enacted in 2002, is holding
corporate boards and executives accountable if they don't exercise
adequate care when they pursue strategic initiatives. Boards are
demanding more rigor in deal analysis, and investors, already skeptical
of M&A because of a long history of value-crunching transactions,
are ratcheting up pressures for strong performance.
Inevitably, the new investigative discipline has killed deals that
might have gone forward, presumably to a buyer's regret, in another
era. Whether it also stymies some deals that deserve to get done is a
matter of debate. What's certain is that the current climate also
creates a need for sellers to pony up the right information, even
pre-emptively if necessary (see sidebar).
Booz Allen's Flaherty points to a utility that walked away from a
deal after intensive inquiry revealed a series of pitfalls. The outcome
was striking because the traditional attitude in the merger-prone
utility industry was that new ownership could fix the problems.
"The buyer walked away because of an inability to get comfortable
with the seller's regulatory position, its ability to improve that
position and the impact of the adverse policies on future revenue
streams," he says. "The business would have required much more
significant investments to bring it to appropriate standards, and that
would have negated some of the deal value. In the old days, the
acquirer of a utility would largely say it could fix a regulatory
problem simply because it was somebody else."
Flaherty also cites the case of a target in the retail energy field
that lost a deal because the bidder "determined it could not meet its
forecasts." The determination was made by drilling into the various
segments of the revenues, checking out the "differentiated margins" and
looking into the "nature of the marketing practice by segments." "It
was clear that margin enhancement was not going to be possible because
of the nature of existing contracts and the nature of the brand of the
seller," he says. "Formerly, due diligence probably would not have
gotten down to that level. Forecasts would have gotten scrutiny but not
at the level they receive today."
On the success side, Alan Scharfstein of M&A advisory firm DAK
Group says he was able to complete the sale of an electronics
components producer in a deal that underscored buyer concern over
customer concentration. The client seller sold more than 40% of its
output to one customer, and the buyer was nervous. The tactic was to
let the bidder's people check out the prospects by having them talk
directly to the customer.
"The issue that clearly existed for our client was whether
the buyer could feel comfortable that the customer was going to be
there," Scharfstein says. "The only way we could get the buyer over
that concern was to allow them to spend some time with the customer."
On the front lines of these changes, of course, are the corporate
dealmakers themselves. Robert E. Puissant of frequent acquirer School
Specialty Inc. says he believes due diligence has become much more
formalized, with more bases to touch. A result is that strategic
acquirers more frequently tap outside consultants for expert help, even
while building their own in-house teams.
"People bring in specialists to drill down in various areas, whether
it's environmental impact or real estate or financial specialists to
help dig into financials," says Puissant, the company's executive vice
president for strategy and business development.
"The specialists know of the rules and regulations that apply, so
we'll bring in environmental specialists, engineering specialists,
insurance specialists. The external teams can get the numbers quickly."
Ultimately, the decision rests with the buyer, and Puissant says
closing the deal can be a tough process in the educational products
industry, which has a lot of mom- and-pop-type targets that may enlist
advisers who are relatively inexperienced in deals. By contrast, he
reports, School Specialty's most recent large deal, the $272 million
acquisition of Delta Education LLC in 2005, went relatively smoothly
because the seller was "very sophisticated about due diligence" and was
"well aware of what was needed and how to provide it."
There's a consensus among dealmakers that virtual data rooms
providing online access to a target's documented information represent
one of the most of important technological advancements in
investigative tools. Most dealmakers like the convenience, especially
in cross-border deals, although there's no unanimity about whether the
technique generates more information or improves the quality.
One of the bigger enthusiasts is Joseph Dunning, vice president for
mergers and acquisitions at J.M. Huber Corp., an active privately owned
buyer dealing in engineered materials and other products. In Dunning's
opinion, virtual data rooms have "virtually revolutionized the due
diligence process," which he described as formerly "byzantine." VDRs
not only reduce travel time and costs but also allow multiple bidders
to look at the information at the same time. Before the rooms came
online, he says, a bidder was allotted a specified time slot in a
physical data facility and sometimes couldn't assemble all experts on
its team at the allotted time.
"It doesn't change the quality of the information," Dunning says,
"but it frees up more time for quality thinking around the data.
There's no question it creates a lot higher quality of analysis,
although it doesn't change the decision on whether you do the deal."
So much for the longer-term trends. What has happened to due
diligence more recently as the credit crunch has brought down the
curtain on the seller's market of the past few years? One result, says
Peter McKelvey of L.E.K. Consulting LLC, is that many buyers are
spending more time in "protecting the downside" and somewhat less in
"support of the upside."
That means, he says, establishing the strength of key fundamentals,
such as customer relationships and length of contracts, while cooling
it on the tenets of ambitious post-acquisition growth plans, such as
entering new markets, doing follow-on acquisitions and expanding market
presence to jump-start the top line. "Both are still relevant," Mc-
Kelvey says. "It's just been a shift in mix."
But veteran deal lawyer Bruce Fenton of Pepper Hamilton LLP in
Philadelphia thinks the reversal of leverage has helped buyers conduct
more due diligence that generates detail on whether they want to
complete a deal at all and what price they will pay. When sellers
ruled, it was not uncommon for them to demand that bidders mark up a
bare-bones purchase agreement and get them to comply.
"Sellers had the bargaining power to make diligence a much later
stage in the process and a truncated part of the process," he says.
"Buyers didn't have as much opportunity to say, 'We discovered this or
that in due diligence and we need to retrade the deal.' "
Deloitte's Alpert believes the rising incidence of deals overseas
has triggered more intense due diligence in areas such as cultural
compatibility. At the same time, local sensibilities are often not
attuned to a lot of aggressive diligence requests early in a process.
Chinese sellers in particular expect a buyer to develop a relationship,
not barge in with a checklist.
Most deal pros believe strategic buyers have improved their
diligence work but still can't beat private equity acquirers for
thoroughness. The most often cited reason is that PE funds are
exclusively in the deals business and can deliver 100% of their focus
to acquisitions.
McKelvey, who works a lot with private equity buyers, also points
out that financial buyers don't have to worry about synergies and
integration and can put "more emphasis on how we can improve cash flow
of this business by cost cutting or efficiencies or increasing the top
line."
Progress is slower in the area of human talent. Joanne Stroud, SVP
for organization consulting at Right Management Consultants Inc., says
that while human resources consultants are brought in earlier, often
before deal closing, it's largely to get a start on integration.
Inclusion in actual diligence to size up the target's talent or
leadership is still spotty. Independent consultant Mitchell L. Marks,
who has logged more than two decades of integration, says only "a
handful of companies" are putting HR people on the up-front diligence
team.
Maybe that's the next frontier in this evolving art.
The view from the sell side
If pressures on buyers to get due diligence right are mounting, the
message to sellers is to get in line. It's preferable, deal pros
advise, for owners of standalone businesses or large companies
divesting divisions and subsidiaries, to take the initiative in
anticipating what a buyer wants to know and serve it up promptly.
Acting pre-emptively can telescope the deal process and generate a
better price.
Audited
financials are only for openers. More important is an understanding of
why the business makes strategic sense for the buyer. Alan Scharfstein
of DAK Group says a large part of his job in representing sellers is to
determine in advance what the buyer wants to know. "We always try to
identify significant transaction issues early on in the process," he
says. "What exactly are the deal killers? We want to know that early."
Dan Tiemann says a KPMG LLP survey has found that 46% of corporate
divestors and 25% of private equity sellers thought they did not
maximize value in selling. Often, that means the seller cashed out too
fast and didn't understand the business as well as the buyer. He
advises sellers to know their businesses and put themselves in the
buyer's shoes. "If you've got inventory issues, people are going to
find it," he says. "If you've got quality-of-earnings issues and the
company really made less, that's going to come up. So let's talk about
how you are going to solve those issues. - Martin Sikora
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