Looking under the hood: Key M&A advice
The economic rebound is making access to capital funds easier. With more than $7 billion potentially available for investment, partners, investors and corporations are stepping up to complete more mergers and acquisitions. Activity was 44 percent higher for the 12 months ended March 2011 as compared to the same period in 2010, according to Wilcox | Swartzwelder & Co.
Despite this upswing, mid-size corporate buyers and private equity investors are still licking their wounds from the last few years. They are proceeding with even more caution, requiring higher rates of return and exhibiting less tolerance for failed acquisitions. This sensitivity puts even greater pressure on buyers to target the right companies, make smart investments and generate quick returns.
Buyers Missing Critical Components During Due Diligence
To achieve these objectives, buyers must gain a clear understanding of the risks of a proposed transaction and how synergies will be achieved. Typically, organizations deploy a team to conduct the requisite accounting, legal and valuation due diligence prior to completing a transaction. However, research published in the Harvard Business Review indicates that 70 percent of mergers still fail to create meaningful shareholder value. Something must be missing.
Based on our firm’s experience leading more than 100 transactions, we believe both strategic and financial buyers pay insufficient attention to a target company’s operational and technical capabilities, including sales, production, distribution and service delivery. Assessing these capabilities takes additional effort, structure and expertise. However, this extra level of evaluation yields a much more comprehensive understanding of the true risk and value potential of a targeted company.
This deeper level of analysis should include these components:
Assess operational, technical capabilities to gauge true deal costs. To reach expected operational synergies, buyers expect some level of investment above and beyond the purchase price. The magnitude of the investment is critical to the overall value equation and, ultimately, the purchase price. But how much will be required? Making assumptions about how quickly aspects of operations or technology can be folded into the acquiring company will not work. Instead, buyers must conduct operational due diligence to understand the true costs involved—and factor this knowledge into the overall deal cost. This effort includes meeting with key operational personnel, as well as evaluating processes, scheduling walk-throughs to review throughput, validating metrics or analyzing documentation. Similarly, it is critical for buyers to understand the condition of the targeted company’s technical infrastructure. Underestimating the costs involved in integrating networks, migrating platforms, upgrading applications or replacing devices can cut deeply into the return on investment. In working with clients on post-close integration, our firm has uncovered significant, unplanned operational investment requirements, as well as operational opportunities to improve the combined business. These investment items may have been noted in diligence at a cursory level, but not accounted for in the purchase price or deal financing.
Validate, do not assume, cost savings opportunities. Reductions in sales, general and administrative costs are often viewed as low-hanging fruit and are built into the synergy plan. Unless these expected savings are based on a full understanding of the details of the operation, however, they may not be achievable, at least in the short term. After close, buyers may discover that specific functions, such as finance or purchasing, should be kept separate because combining them is them is too costly or risky. To find the true savings potential in a targeted company, buyers must conduct operational and technical due diligence to confirm the back-office savings they will, or will not, be able to realize through consolidation. This level of scrutiny will also help them identify more important operational and technical gross margin efficiencies that could be gained in areas ranging from supply chain and manufacturing to IT and customer service. Lastly, the operational review can provide a clear roadmap for driving revenue through product rationalization and sales channel consolidation.
Protect the source of intellectual and technical capital. One operational issue that often gets overlooked during due diligence is talent retention and management. Buyers often target companies for their groundbreaking business ideas or technology breakthroughs. Although this is a valid motive, buyers also need to recognize that merger and acquisition transactions are traumatic for employees—the people responsible for the ideas. Intellectual capital is a fragile asset, especially in the middle market. Key leaders are often retained with employment contracts, but the agreements are frequently misdirected. Talented employees are at risk due to the uncertainty of the transaction, or due to attractive equity/stock options that trigger after the business changes control. Prior to an offer, buyers must identify and quantify the source of the knowledge capital. They must pinpoint the people to be retained and design incentives to encourage them to stay.
The Bottom Line
Failing to conduct detailed operational and technical due diligence before a merger or acquisition is like foregoing a mechanical inspection before a used car purchase. In today’s environment, buyers must take the time to thoroughly examine a potential acquisition, and ask the deeper, more revealing questions. In doing so, buyers gain the knowledge needed to avoid a catastrophe or proceed with a set of known risks that can be mitigated. The buyer’s advantage comes from understanding and articulating the economic value of these risks during negotiations and integration planning to achieve the desired return on investment.