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— Industry Insight —
Yet the adage couldn't be a more apt description for today's M&A players. Last year was taxing, to say the least -- the kind of slowdown that goes beyond the cyclical slumps from which the ever-resilient M&A market always recovers. But it was a year of very important learning. The events of the past few months will transform the takeover market, and dealmakers would do well to take note. We're at the end of an era on Wall Street. It took only seven months for investment banking as we know it to change forever. The equity markets buckled after the bankruptcy of Lehman Brothers Holdings Inc., and 1,194 announced deals failed. Fourth-quarter deal volume dropped more than 50% from a year earlier, to $115 billion in the U.S., the worst quarter in six years. Worldwide M&A decreased in 2008 by about 30% from 2007 totals. Companies and some CEOs behaved much like the U.S. consumer -- as the economy went in the dumps, they hunkered down and put their cash under the mattress. Much of the M&A activity that did happen occurred at the urging or with the assistance of the federal government.
Yet for those who would despair, I would suggest history offers cause for optimism. Yes, the market is depressed, but M&A is not like some transitory financial product. It's a permanent part of the corporate landscape because it is almost always cheaper to buy than build. Companies need growth to maintain price-earnings multiples, and private equity will remain an established investment class. The drying up of leveraged finance, the lifeblood of leveraged buyouts, may have humbled the once feverish market for elephantine take-privates, but headline LBOs are not the future of M&A activity, anyway. Ironically, as long as credit remains frozen, it will likely produce more, not less, M&A as businesses are forced into shotgun weddings because they can't find the means to refinance. A recent Ernst & Young LLP survey found 50% of companies reported themselves either stressed or distressed from a balance sheet perspective. Capital restructuring, cost reduction and liquidity management are crucial for many of them just to stay afloat, yet many lack access to needed cash. As a result, we'll see a rise in mergers by necessity. Many deals will be done through prepackaged Chapter 11 processes. High debt, increased competition and the credit crisis will press many companies into Chapter 11 filings, with acquirers providing debtor-in-possession financing and getting attractive operations at good prices to boot. Distress investing is already the new focal point of the 2009 deal markets. We'll see more so-called stalking-horse buyouts of companies going into Chapter 11 that have good underlying businesses-brands but are beaten down by unsustainable debt or depressed industry conditions. One point of contention that will work its way out of the markets, though painfully, is the issue of deal valuations in a distressed environment. M&A pricing, like the S&P 500, has come down about a third between fourth-quarter 2008 and fourth-quarter 2007 (8.5 times Ebitda compared with 12.4 in fourth-quarter 2007). This makes companies much more affordable and suggests that, like every other post-crash period (the 1980-'82 recession, 1987 market crash, Gulf War recession and 9-11/dot-com bust), M&A should pick up dramatically sometime this year. The credit crisis will prompt a further string of shotgun weddings in the vein of the recent bank mergers. Companies with cash will scoop up valuable strategic assets; the strong will get stronger as the weak get bought. Big-balance-sheet corporates will enter center stage by taking advantage of lower pricing and the lack of credit. For private equity, dramatically lower transfer prices will lower the need for leverage. They can expect to be strongest in unleveraged infrastructure deals, including as state governments sell turnpikes and bridges (Pennsylvania), airports (Wisconsin) and even parking meters (city of Chicago) to plug budget deficits. So as we peer into a new world in 2009, we should really look forward, instead of looking back and pining for the good old days, as though their return is right around the corner. Those days are gone and should be essentially forgotten. But those that look forward will truly be stronger. Robert A. Profusek is global head of M&A at Jones Day in New York. Comments |
When Friedrich Nietzsche claimed, "That which does not kill us makes us stronger," he probably wasn't thinking about corporate dealmakers. 
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360-degree approach to due diligence process
The frenzy in M&A activity of past few years has been fuelled not only by cheap debt and the rise of private equity, but also by companies' strategic focus on consolidation. However, studies reveal that approximately 40% to 80% of mergers and acquisitions prove to be disappointing. An analysis of more than 200 major European mergers and acquisitions (M&As) during the period 2004-2007 by consultancy Hay Group has found that senior business leaders believe just 9 per cent were "completely successful" in achieving their stated objectives.
All of those M&A deals had gone through hundreds of pages of a due diligence process prior to being approved by respective shareholders and sometime regulators. What went wrong? With such a high rate of failure we believe it is fully legitimate to challenge the scope of current due diligence process and its questionnaires.
Fundamentally due diligence means assessing price and identifying financial risks. Traditional questions to be addressed include:
• What value e.g. specific competitive advantage or market share the acquirer expects to gain from the deal?
• What are tangible and non-tangible assets being acquired (on- and off-balance-sheet)?
• What are the liabilities and costs being acquired?
• What are the off-balance-sheet liabilities?
• What is cash flow performance/requirements of the target?
• What value can be drawn for potential synergies?
• What are the risks that need to be managed?
After the process, we normally learn about our target’s assets and liabilities and past profitability in depth. However, apart from the balance sheet which has to be paid for, we don’t want to pay for past profitability, rather we commit our funds to organisational capability to generate future profits and cash flows – yes, we want to buy future performance!
In their Balanced Scorecard Model, Norton and Kaplan (1996) look at the organisation’s performance from four different angles: financial, customers, internal processes, and learning and growth. They find a financial angle to provide only for yesterday’s perspective. In order to have perspective on current business capability, one should look at the portfolio of business customers and internal processes and, finally, tomorrow’s potential of a business can be best identified if we understand its organisational human capability for learning and growth.
My proposal is to adopt Norton and Kaplan’s model for our restructured due diligence process and place equal weight on assessing four different perspectives: (1) financial, (2) process and culture, (3) customers and (4) capability for learning, innovation and growth. We will need to answer (1) about the needs of current business customers and their satisfaction with the company’s products and services (our M&A target) as well as to position the target among its competitors which is the key factor for forecasting future revenue, (2) what is the company’s capability i.e. processes and decision making structure to respond to customer needs in an efficient and profitable way, and (3) which capabilities the company has to innovate its products and services and to expand its current market(s).
If we have a proposed merger on a table, then we should address both companies and check if their business models and customer propositions are compatible and can lead to a positive synergy even if both companies deliver positive results and their processes and cultures appear ‘smooth’ when observed separately.
This prompt us to conclude that due diligence process preceding the M&A needs to be restructured in a manner to include and place equal weight on other perspectives such as the culture. The acquirers must learn what they are buying and why, along with strategies to maximize synergies using this expanded due diligence.
In order to best mitigate M&A risk of failure we adopted a holistic approach when performing a due diligence and specifically look for incompatibilities of cultures and processes between the target and the acquirer.
While developing a set of analytical tools for non-financial part of due diligence we had the following questions in mind:
1. Are these two teams, their business processes and customer value propositions compatible for integration within reasonable time and resources?
2. What effort and how long will it take until merged operations achieve desired efficiencies?
3. How much the integration (time, resources and temporary dip in performance) is going to cost the acquirer i.e. by how much will it increase the purchase price?
Under-performing non-financial part of due diligence can cost you much more on a long-term than under-performing the ‘financial perspective’.