- Part 1: Mergers and Acquisitions In The Modern Business Economy
- Part 2: What Is Due Diligence?
- Part 3: The seller’s perspective on due diligence
- Part 4: The role of the Board in due diligence
- Part 5: Success Factors For Due Diligence
This complete guide to due diligence is divided into five parts. Part one provides an introduction to Mergers and Acquisitions (M&A) using case studies that discuss some of the consequences of not performing due diligence thoroughly when buying a company. Part two provides a four stage framework for performing due diligence. The framework includes high level questions needing to be asked during due diligence. Part three considers the seller’s perspective on due diligence and summarises the main activities that a seller should complete in order to minimise disruption and maintain control during the due diligence process. Part four discusses the role of the Board in supporting management during due diligence and lists four aspects of the due diligence process that the Board needs to consider before supporting a decision to purchase a company. Part five presents a summary of success factors for successful due diligence.
Part 1: Mergers and Acquisitions In The Modern Business Economy
During 2015 more than 44,000 Merger and Acquisition (M&A) deals with a total value of US$4.5 Trillion were announced globally. A 2014 Deloitte study of M&A trends found that 31% of responding corporates intended to apply spare cash to mergers and acquisitions, and 31% expected to divest assets. The main objectives for M&A activity and the relative importance of each in the eyes of senior executives are shown in Figure 1.
Sources of value from Mergers and Acquisitions
There are four major sources of value that can be unlocked by acquiring a business:
- Achieve synergy benefits. Synergies come from increased utilisation of resources and often are realised by consolidation of assets or reductions in headcount within the combined entity.
- Achieve revenue growth by introducing new products or services, accessing new markets, entering new geographies or increasing the routes to market for existing products.
- Achieve a strategic advantage that presents new pathways to future growth. This may include industry disruption enabled by acquired technology, extracting value from underutilised assets, or acquiring capabilities that allow level shifts.
- Transform a company’s business model by restructure, financial engineering or changes to management structure.
Value achieved versus value destroyed
Delivering the expected value from an acquisition is difficult. Studies of successes and failures in M&A deals have consistently found that 50 – 70% of acquisitions fail to deliver the expected value..
Case studies of M&A gone wrong
Case study 1: AOL’s acquisition of Time Warner, February 2000[/caption] AOL was the dominant player in US dial-up internet during the dot com bubble of the 1990s. AOL’s share price had inflated massively and AOL’s CEO, Stephen Case, was looking for a deal. Time Warner was a traditional media company with print and cable assets and content. Time Warner had not built a successful digital distribution channel. A merged AOL-Time Warner looked strategically sensible. The consolidated company could be a powerhouse of traditional and electronic media. Today it is recognized that due diligence behind the AOL – Time Warner deal was grossly inadequate. Lawyers and advisers completed ‘due diligence’ in one weekend. Following the due diligence AOL spent $165B on a company with around $1B in annual earnings. The market didn’t initially show concern over the massive overpayment. After the deal the market valued the combined AOL-Time Warner entity at $350B. Due diligence had missed two significant risks.
- Firstly, the dot com fuelled market bubble was eventually going to correct affecting revenue projections and company value;
- Secondly, the value came from synergies that could only be achieved by effective integration of the two businesses into one cohesive company.
What happened when the bubble burst?
A few months after the deal was completed the internet bubble burst and advertising revenue crashed. The short-term impact of this was that in 2002 AOL was forced to write off $99B, the largest loss ever reported by a company. The massive write off was not the only impact though. Managers tried to hide the impact of collapsing advertising revenue by manipulating the company accounts. In 2005 the SEC prosecuted the company for accounting fraud. Time Warner paid a $300M penalty and had to restate its revenues by $500M.
Incompatible cultures reduce synergy benefits
Due diligence had overlooked the incompatibility of the two cultures. Time Warner had a conservative culture. AOL culture was aggressive and arrogant. Toxic relationships in the merged company prevented synergies from being achieved. Eventually the company demerged and in 2015 AOL was worth $4B while time Warner was worth $70B, a mere 20% of the initial combined entity value.
Case study 2: HIH purchase of FAI insurance
HIH was a compulsive acquirer of insurance companies throughout its history. FAI insurance was a large company with a poor financial history. FAI had recorded losses in four out of the five previous years. Its net tangible asset value had slipped; it was trading at a discount. It is likely that at the time of purchase FAI was insolvent. Despite this poor financial record HIH purchased FAI Insurance in 1999 for $300M. The sale proceeded with no due diligence, a fact that surprised the Royal Commission convened to examine the collapse of HIH resulting from the FAI purchase. “The HIH royal commissioner said a conservative calculation of how much HIH lost by making the poor decision to purchase FAI was $591 million.”
Other examples of value destruction
Figure 3 lists some other industry giants that have undertaken disastrous acquisitions and the losses the deals have produced – usually in a brief period after the deal was completed.
Five lessons we can learn from unsuccessful deals
- External factors can hugely affect markets, and if the risks of a range of probable and possible factors are not considered as scenarios, integration value will be overestimated, and integration complexity will be underestimated.
- Cultures that do not fit together are toxic to creating value. Due diligence teams should determine the target’s culture and understand what drives that culture, then come to a view on whether or not cultural differences will make it possible to achieve synergies, common culture and shared values.
- Synergies are easily overestimated, and dis-synergies are easily underestimated or overlooked.
- Without thorough due diligence acquirers will inevitably overpay, particularly when an auction is involved, or emotional and ego-driven decision making.
- Integration is always difficult. Due diligence teams should be objective in their approach and exercise conservatism to balance the optimistic predispositions of those who finally approve the deal.
In Part 2 of this article we will define the due diligence function and look at a framework that can be applied to any acquisition to answer the two questions:
- Will this deal increase the value of the enterprise?
- Is the acquiring party capable of realizing the value after acquisition?
Part 2: What Is Due Diligence?
Due diligence is a structured process for identifying legal risks and other acquisition and integration risks. The process identifies sources of value, ‘skeletons in the closet’ and the capability of the acquirer to deliver the potential value of a merger or acquisition.
What is the objective of due diligence?
Due diligence is performed with the goal of answering two basic questions:
- Will this deal increase the value of the enterprise?
- Is the acquiring party capable of realizing the expected value after acquisition?
Once these questions are answered the buyer (and the target) can make a call on the most important of decisions “Should we go ahead with this deal?”
10 critical areas explored during due diligence
Ten critical areas form the basis of the due diligence process.
- What value will the deal create for the buyer’s owners?
- How does this company fit into the overall market now and in the future? What strategies does it pursue in the market?
- What is the relative competitive position compared with its competitors in the market?
- How is the company structured?
- What are the values and culture of this company? Are these values evident in day-to-day practice, and are they consistent with the acquirer’s values and culture?
- What are the value streams in this company, how is work arranged and managed in each value stream and in total?
- What is the level of capability of the organization – its functions, and the individuals within the organization?
- Does the target have professional relationships with its regulators, customers, suppliers, financiers, shareholders and other stakeholders?
- Are the future strategies and plans of the business credible?
- Are there legal liability risks within the business?
“…Many executives treat due diligence as an audit to confirm what they think they know, rather than a solution to the problem of “I don’t know what I don’t know” - David Harding & Hugh MacArthur, Bain & Company
A Framework for due diligence
Companies that have a record of success in M&A use a framework for due diligence. The following four stage framework can assist buyers, sellers and consultants increase the effectiveness of due diligence. Figure 4. Four stage framework for due diligence[/caption]
Due diligence begins at the time that the acquirer and the target sign a letter of intent and a confidentiality agreement, and agree on a time period for due diligence to be performed. Planning the approach and process ensures efficient use of resources and ensures a balance between data gathering and data analysis is achieved. Planning activities undertaken during Stage 1 include:
- Determining the range of skills needed in the due diligence team.
- Choosing the team members. Composition of the team will vary from deal to deal depending on the skills needed to test the investment thesis.
- Developing hypotheses based on the investment thesis. These hypotheses will be tested against the data collected and expert knowledge;
- Preparing checklists for each functional area;
- Preparing a data requirements list for the target;
- Identifying supplementary data required from third party sources. This may include strategy papers, previous expert reviews, broader market studies and economic data;
- Preparing the interview schedule for managers, staff, customers, advisors and experts;
- Determining how web-based surveys will be used, prepare survey questions and identify the survey participants;
- Designating the administration and governance processes, team member responsibilities and milestone dates.
The due diligence team The team leader will usually be the integration manager or business manager once the acquisition is completed. It is the team leader’s responsibility to set team values, make sure that each member of the team has a clear understanding of the investment thesis, the process and methodology, and their individual accountabilities during the due diligence process. The due diligence team will usually consist of a mix of internal managers and subject matter experts, supplemented by experienced external advisors with law, business, finance, consulting and M&A skills.
Markets and growth analysis
Investment theses make assumptions about markets. These assumptions must be tested during due diligence.
From this analysis the team will form a view about past and present markets as well as gaining an understanding of the market risks that any merged entity will face. All numerical data supplied by the target should be viewed as incorrect until it is confirmed by two independent data sources. The same applies for the assumptions underlying the target’s plans and market projections.
Strategy and business plan
By looking at the target’s business positioning and future plans the due diligence team will determining what future value the target has identified. This will give insight into the strategic value proposition for the deal. The three activities in Stage 2 should yield enough information to answer the question “Will this deal increase value?” The due diligence team should now prepare its estimate of the forward value of the target, any synergies that have been identified, any dis-synergy items and estimated integration costs. The assumptions that underlie this estimate should be documented.
Stage 3 addresses the question “Does the acquirer have sufficient capability to deliver the value implicit in the deal?”. To make this judgment the due diligence team needs to take the perspective of the new consolidated entity.
Stress test scenarios
Scenarios should be used to stress test the investment value. Four scenarios are recommended:
Scenario 1 – ‘Disaster’. This scenario will consider one or more events that greatly impact on the consolidated company. History shows that the ‘disaster’ scenario is by no means unrealistic.
Scenario 2 - Mild under perform in one or more factors that impact on the consolidated company
Scenario 3 - Mild over perform in one or more factors that impact on the consolidated company
Scenario 4 - Stellar over perform in one or more factors that impact on the consolidated company. The due diligence team should explore the impact of each scenario on costs, sales, margin, market and strategy to test the viability of the new consolidated company. The team should then decide whether there would be sufficient capability and resources to deliver value under each scenario.
Acquirer’s ability to deliver value
The due diligence team should reach a position on the following:
- If the acquisition proceeds, is there sufficient capability among the combined resource pool to deliver all elements of the investment thesis, (particularly if the worst case scenario comes to pass)?
- Will the consolidated company be so complex that current management is not capable of managing the business?
- Is the capacity of the consolidated assets sufficient to meet market volumes at required cost and quality?
- Will the difficulty of uniting the cultures make it unlikely that synergies will be achieved?
- If key personnel are lost and cannot be replaced, will the expected value from intellectual property be achieved?
- Will competitors act in a way that destroys the expected value in the deal?
- What level of funding is needed for the combined operations?
- What is a reasonable first estimate of the price range for the purchase?
The due diligence team should objectively consider these factors, and the ways in which the acquirer could mitigate the risks.
The recommendation report
The due diligence recommendation report will present the opinion of the team as to whether there is value in the acquisition, and whether the consolidated company has the required capability to deliver this value to the owners.
Section 1 of the report presents the strategic perspective of the deal:
- An overview of the market
- The competitive environment and the target’s relative position
- The strategic advantages of the acquisition
Section 2 of the report presents the cost benefit analysis:
- Revenue impact
- Cost impact
- Investment required to complete integration and realise benefits
- The possible risks that may impede the benefits or affect the business
- Mitigations of risk
- Integration program
- Estimate of purchase price range
- Analysis of the impact of not proceeding with the acquisition
Section 3 of the report will have one of three conclusions:
- The investment thesis has been confirmed, no significant issues have been found, recommend that acquisition proceed
- Material issues have been found that impact on the investment hypothesis. These issues may be overcome by a series of actions. The combined company will be capable of taking the required actions. Adjustments to the terms of agreement are required, and the integration program must address the noted issues. Providing these items are addressed it is recommended that the deal proceed.
- There are significant issues and/or risks that make it unlikely that the investment thesis can be met, even at a reduced cost. Recommend that the deal not proceed.
Part 3: The seller’s perspective on due diligence
From a seller’s perspective due diligence is a very disruptive process. It is to the seller’s advantage to minimize the duration and scope of due diligence. The following activities need to be performed by sellers prior to and during due diligence. Appoint experienced advisors Advisors can assist sellers in navigating the due diligence process. Typically sellers will select a group of advisors from investment banks, legal firms, accountants and consultants. Prepare initial documentation The seller will need the following documents:
- M&A plan outlining the activities to be undertaken, the resources to be dedicated to the sale process, and the timeframes during which buyers will have access to information and staff
- Confidentiality agreement and information memoranda
- Letters of intent
- Management and Board must agree the scope of data to be made available. The buyer and seller will each have different expectations about what is a reasonable scope of information disclosure. The seller may decide that some information is too sensitive to reveal, or that some information is to be held back until late in the process.
- Data room/virtual data room. The data room should be populated before due diligence commences. A mechanism to receive requests for data, and protocols for responding to buyer’s requests should be established.
- Prepare presentations.
The market will find out that a due diligence process is in effect. The seller needs to control communication with its customers and other stakeholders throughout the process to ensure that commercial relationships, deals in process and new customer acquisition are not negatively impacted.
Part 4: The role of the Board in due diligence
Management is accountable for M&A strategy and execution. The Board has a vital role to play in sharing M&A experience and in providing effective, independent oversight of the overall process. [caption id="attachment_4484" align="aligncenter" width="770"] Table 7 contrasts the role of Management and the board for each step in the due diligence framework.[/caption] The due diligence recommendation report should allow the CEO/MD of the acquirer to demonstrate to the Board that:
- The scope of due diligence covered everything necessary to determine value and risk for the target and the combined new business
- The due diligence team was appropriately skilled and that external members were independent
- The calculated value of the deal is credible and adequately reflects the risks
- The deal makes strategic sense
Part 5: Success Factors For Due Diligence
How can you minimise risk and capture value when performing due diligence? Here are 11 lessons learnt from successful acquisitions.
- Successful acquisitions fit strategically. Due diligence proves or disproves the strategic fit as described in the investment thesis.
- Use a due diligence framework rigorously
- Appoint an experienced team leader who has ‘skin in the game’
- Appoint a broadly skilled team that is able to test the investment thesis objectively
- Use experienced advisors – they aid objectivity
- Search for hidden value in the deal in addition to identifying risk
- Understand the target’s culture and its possible impact on the integration of the two businesses.
- Never rely on target provided data until it is collaborated
- Expect synergies to be harder to achieve and slower to realize than predicted
- Integration must be performed quickly and assertively
- The effectiveness of integration must be measured. Success measures include retention of key personnel
- M&A trends report, 2014, Deloitte Development LLC
- Kevin Rollins, interview with Andy McCue, ZDNet, Jan 18 2005
- The brave new world of M&A, Kees Cools, Jeff Gell, Jens Kengelbach, Alexander Roos, BCG, July 2007
- Sara B. Moeller, Frederik P. Schlingemann, René M. Stulz, Working Paper 9523, http://www.nber.org/papers/w9523
- Lessons from the AOL-Time Warner Disaster, Katie Benner, Bloomberg View, Jan 14, 2015
- Aswath Damodaran quoted at https://www.businessinsider.com.au/damodaran-the-acquisition-process-destroys-more-value-than-anything-else-corporations-do-2012-6#xT3p9ctOVMFrPk0h.99
- Anne Lampe, Sydney Morning Herald April 30, 2002
- SMH April 16, 2005.
- Quoted by Firmex.com, Business Insider Australia, May 11, 2013
- Some content in the due diligence activity tables has been adapted from Overseeing Mergers and Acquisitions, John E Caldwell and Ken Smith, ISBN 978-1-55385-902-1