An M&A Process That Creates Value: What Every CEO Should Know (Part 3 of 3 – Due Diligence on the Target)5 minute read
Part 1 of this series focused on the most important aspects of planning and strategy in a mergers and acquisitions (M&A) process. Part 2 detailed the necessary components of due diligence on a target company. Part 3 will describe how to manage present and emerging risks that can crop up in any M&A transaction.
The CEO and their internal and external legal team should confer about the best acquisition structure to manage risk, while still accomplishing the business goals for the transaction. The purchase of assets and the assumption of identified liabilities (versus the purchase of the target’s stock) will typically produce a more controlled risk profile. However, the acquisition of assets is not always possible due to tax concerns as well as the inability to convey key contract rights, licenses, or permits.
Risks can further be managed through the use of representations, warranties and indemnification, and either purchase price holdbacks or escrow funds. In certain transactions, such as the acquisition of a public company, traditional indemnification arrangements are unavailable and indemnity insurance may provide at least some coverage for post-closing claims. In the absence of such arrangements, where the buyer essentially is proceeding on an “as is and where is” basis, the importance of a thorough due diligence investigation is heightened. Many experienced acquirers work hard to at least maintain their ability to sue a seller for misrepresentation or fraud, even where broader contractual indemnification rights are not obtained.
Involve The Tax Team Early
One of the common mistakes in the acquisition process is to conduct extensive discussions relating to the transaction structure without first seeking the input of tax advisors. If tax consultants are brought into the process late in the day, they may identify significant tax issues or opportunities, but the ability to negotiate measures to deal with them advantageously can be hamstrung if the parties are already locked in on a promised transaction structure. It is a good practice for the CEO to insist that the company’s tax advisors be involved as early as the Letter of Intent stage when the rough shape of the transaction is beginning to take place.
Test The Financial Return Economics
It is common for acquirers to evaluate the economics of a transaction solely by reference to projected increases in revenues and earnings and by “synergies” in the form of cost reductions. While all of these are important metrics, it is also important to examine the transaction within the framework of return on invested capital. Acquiring a business at a price that is not likely to provide a return on investment capital commensurate with the acquirer’s stand-alone performance may be dilutive to the acquirer’s equity holders.
Establishing appropriate return on invested capital targets is particularly important for serial acquirers that otherwise might find themselves on a treadmill of making acquisitions that build the size of the company, without building value for shareholders.
Cross-Border Deals Are Different
Entering a new market through acquisition can jump-start the financial growth of a company. On the other hand, acquiring a business in one or more countries where the acquirer has never previously operated is replete with challenges, particularly where the acquirer’s organization has no experience with foreign operations. Augmenting internal resources with country-specific experts can mitigate the risks associated with the acquisition, but caution is still the watchword.
Understanding how business is done in the target’s sphere of operations is crucial. Local practices with respect to contracts versus purchase orders, scope of warranties, intellectual property provisions and the like can vary widely from the acquirer’s practices. Harmonizing those business practices, while presumably desirable, may simply not be possible if the target is to sustain its customer base and revenues.
Assessing the labor and employment practices in the new country will be important, as will be analyzing the litigation profiles of the countries in which the target operates. While it was once safe to assume that the U.S. was the most litigious of all potential locations in which to do business, other countries (such as those in Latin America) are sadly catching up.
Finally, the intricacies of local taxation and currency regulations can dramatically impact the attractiveness of the transaction from a financial point of view. It does no good to make money abroad if you cannot repatriate the funds.
Use The Due Diligence Process As The Foundation For Integration
Planning for effective integration begins long before the closing. The negotiation and pre-purchase investigation will identify areas that must be addressed immediately, as well as others that can be tackled over time. Where competitive and antitrust concerns are not operative, the two management teams can begin having joint discussions about how they intend to function following the closing. In other cases, where one competitor is acquiring another or antitrust or other regulatory concerns prevent such sessions, limited planning can still occur, although the acquirer should not begin to integrate the operations of the target before the closing in order to avoid potential legal and regulatory exposure.
Effective leadership and coordination of team activity is important to virtually all large-scale business activity, and certainly no less important in managing an M&A transaction. Designing the process with the sole goal of “getting to the right answer” is within the unique province of the CEO.