Wednesday, November 29, 2006

Due Diligence - Buyers

Questions percolate in about the diligence process, so I thought I'd post some thoughts on various aspects of the process from the differing perspective of buyers and sellers. Today, the buyers:

As a buyer, your primary goal in diligence is simple:

Verify that the asset you are buying is essentially what you think it is.

However, buyers often run their diligence in ways that, at best, cost them money and time, and at worst ruin their deals. The two primary mistakes are using a cookie- cutter approach to diligence and over-reliance on outside help.

If an acquiror applies a standard diligence approach to all deals, it will inevitably be overdoing its diligence on many deals. A screaming deal - either due to price or strategic need - demands a very different level of diligence than a deal that is in the margins financially and for which there are strategic alternatives.

In the latter case, you'll want to go through everything at some level of detail, because even small hiccups could push your marginal deal into the red. In the former case, you should just be doing what I like to call "nuclear" due diligence - take a high level pass and make sure there is no radioactive waste: Subsidiary asbestos mining companies, crooked accounting - you get the idea. Subjecting such a deal to a rigorous diligence process is simply a waste of time and resources. Worse, since it is such a great deal, the delay inherent in doing such detailed work - and the annoyance it causes your target - may open a window for an interloping buyer to push you out of the way. If you went shopping for a new TV or computer last Friday, you would have seen this principle at work at Best Buy and Circuit City stores across the land: Not a lot of consultive selling; just a mad scramble to get the limited-quantity deals.

Relying over-much on outside accountants, consultants and lawyers complicates problem number 1. Diligence is in many ways an ass-covering exercise for those involved. In the absence of very clear guidance, even internal people will overdo diligence out of concern for missing something. External professionals will be even worse. Their incentives - financially, professionally and with respect to potential liability - are all aligned on the side of doing exhaustive diligence. As a buyer, you need to make sure they understand very clearly what your goals are for diligence in each case. Are you looking only for unexploded bombs, or for any accumulation of small liabilities? As is the case in many strategic deals, time to deal execution is often far more important than doing a complete diligence work-up.

As a buyer, it is important that you have a senior person running the diligence process so that the personalities can be controlled and the process tailored to the needs of the specific deal.

One final thought for buyers is the difference between valuation and integration diligence. In strategic deals involving significant integration issues, you need to do some high-level diligence on the integration process: Verify software platform versions, people issues, etc. However, the specifics of the integration process are unlikely to matter in verifying value or deciding whether the deal is go/no go. The tricky part is that your operating people will want to get into the specifics right away, because they are responsible for delivering the post-merger results. And of course, it's critical that integration happen quickly and smoothly so deal synergies can be fully realized. One approach that often works - particularly if you've been reasonable with valuation diligence up front - is to negotiate in the definitive docs a process for integration-related diligence between signing and closing. Such diligence won't be a closing condition, and it will be limited to integration-related information, but it can meet your need for speed in the stage up to signing while still getting the detail your ops folks need to start integration as quickly as possible.

1 comment:

Garnet Heraman said...

Josh,

I’m a partner at a newly launched specialty finance vehicle, Aegis Investment Partners, which is focused on applying mezzanine debt instruments to transaction structures used for corporate acquisitions. www.aegisinvestments.com

I offer some random thoughts on your very solid overview based on my own experience. First, I agree that the cookie cutter approach tends to misallocate scarce corporate resources (time, manpower, etc) on marginal deals. That said, I think general guidelines, such as those below used by a Fortune 50 conglomerate (plastics, coatings, adhesives and technology), can be very useful in practice:

1. Whats real?
What do they have that is tangible, proveable and most importantly leverageable in support of new product offerings….ie, hard IP assets like patents, copyrights, trademarks etc. In some cases, material assets like plant& equipment, esp. if there’s something strategic about them (capacity, location, etc), may be responsive to this high-level filter. The filter itself is applicable across all industries as corporations increasingly pursue strategic product & market development goals via focused M+A activities. But it is even more pronounced in certain industries like biomedical devices, esp. in segments like diabetes management.

2. Whats it really worth?
What is the baseline for the target’s historical financial performance over the past 3 - 5 years. Easy enough, right? Not always in practice though. Most middle market companies will have stumbled performance-wise at some point or another during their recent operating history, and so the art becomes separating non-recurring from recurring events, or worse yet, from systemic or organizational disfunctions.

3. What do they/we really want to do with it?
This filter obviously cuts to the fit between product and market goals of the potential acquirer and the target. But interestingly enough, in my experience it also speaks indirectly to management alignment between the two entities, and also to related issues like which employees are retained and which not, and the implied costs/benefits associated with both groups.

Second, I both agree and disagree with you on the overuse of outside consultants [I’ll skip the cheap headshrinking jokes here :)]
Agreed...that accountants, deal-finders and the like will tend to "run the clock" for financial and CYA reasons. But I think thats because their incentive is tied to the closing of the transaction, not the downstream financial consequences of the acquisition/integration. In short, they have no skin in the game, beyond the close of the transaction, except being used for the DD on the next transaction. In fact, from an incentive standpoint, theres a real potential for accountants in particular to have a bias toward closing, as they can end up doing the audited financials of newly acquired companies. More on this some other time (esp. on the value-add of consultants pre vs. post transaction)....but right now Im feeling like this is getting a bit long-winded.

Thanks very much for your insights into corporate deal-making. With best regards,

Garnet

Mr. Garnet S. Heraman
Chief Development Officer &
Senior Managing Director
Aegis Investment Partners
4600 S Syracuse, Ste 1080
Denver, Colorado 80237
Office Direct 303-531-7011
E: gsh@aegisinvestments