An M&A oversight framework for boards
August 2017 | PROFESSIONAL INSIGHT | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
August 2017 Issue
Global mergers & acquisitions (M&A) reached an all-time high in 2015, surpassing the previous record set in 2007. The $4.28 trillion worth of deals exceeded those of 2014 by more than $1 trillion according to Mergermarket’s ‘Global and Regional M&A: 2016’. Today, companies are looking beyond industry boundaries and country borders for external growth opportunities. M&A decisions are among the most important that a board has to make and for many board members the M&A process is one of the most challenging, frustrating and dangerous.
While M&A activity is cyclical, deals themselves have become increasingly complex and sophisticated. In a fast-moving situation, directors are supposed to make all the most important decisions in a very short period of time. The complexity and urgency pose directors a significant challenge in terms of abilities and dedication of time and effort. Personal interests are also at stake, with directors from both the acquiring and the target companies at risk of losing their seats on the board. The M&A process is a stress test for boards ‒ if anything goes wrong, damages can be claimed against the directors for breaches of duty or other alleged transgressions relating to the deals. Even if legal liability is not such an issue, reputational stakes are high. Directors are particularly vulnerable when overseeing M&A deals.
Given the high-stake role that directors play, M&A deals have to be well conceived, planned, structured and implemented. Failure to exercise appropriate oversight and succumbing to deal mania will only make the process stressful.
Creating a dealmaking mindset
M&A deals often start with a phone call. Shell’s chief executive Ben Van Beurden explained how the deal with BG Group arose in April 2015: “I called Andrew (Gould) up and we had a very good and constructive discussion about the idea and it very quickly seemed to make sense to both of us”. In under a month, the two companies had put together a $50bn oil megamerger.
The phone call may appear to be a sudden event with too much information and urgency. However, experienced directors probably would not see it like that – they conceive deals all the time, and are even prepared to sell the business the next day if the price is right. A board with a dealmaking mindset has no problem showing how the deal will fit in with the company’s strategy.
A passive or reactionary approach to M&A is not the right solution for an active board. Boards with a strong M&A DNA have institutionalised M&A processes, possibly through an M&A committee. The task of the committee is to supervise the company’s M&A strategy, challenge the thinking of executives on potential transactions, and analyse potential mergers, acquisitions, investments or the disposition of any business. The board is constantly prepared for transactions and always has current knowledge on how to create value with specific deals.
Stakeholders, including shareholders, are motivated – anybody can propose a deal that might be beneficial. A dry run is typically organised (where investment bankers present a proposal), the deal flow is structured and analysed (looking at the type of acquisition or the type of buyer that the organisation can target, possibly mapping them into a matrix), and simulated discussions are encouraged.
The less informed consensus among the board’s directors on deals usually reveals a lack of preparation. Acquisitions are complex and should be challenged by specialist board members. Typically, contrary opinions can help a board to make a better deal. This requires the appropriate means and structures to collect adequate information. The board needs to ensure that the work is structured, and that there is a good deal of information and specialisation, as well as constructive dissent.
Seeing the bigger picture
Executives and deal advisers are often so focused on the deal itself that they become obsessed with it and lose sight of the big picture. An active board should be willing to prompt a deeper investigation of the assumptions to reassess all the challenges, risks and opportunities. From a board perspective, the full M&A process should include: strategy fit review, risk analysis, due diligence, deal structuring and pricing, integration and post-integration analysis. The board should ensure that the full process is overseen in an objective way.
The big picture could be a corporate strategic shift, conducting a stream of similar transactions to support one strategy. Deals driven by a bigger strategy often succeed. The big picture could also relate to the geographic, macroeconomic, governance, technological, regulatory or societal environment. For example, what are the major differences in M&A practices from one country to another? Why are M&As at a record level? Is M&A activity related to interest rates? Why are investors becoming actively involved in pushing companies to sell businesses? Why is it good for a company to be owned by somebody else? In spite of the complexity of integration, why is it faster and more economical to acquire a company than to achieve internal growth? What are the regulatory barriers to deals? What are the tax implications of a potential deal?
Staging deals with maximum precision
In every stage of the transaction, the board’s comprehensive oversight can help management to follow a disciplined process. In this section, we discuss the board’s oversight role during the full M&A process.
Strategy fit review. The board needs to understand clearly why the deal is being made and should ask questions such as: How was the deal sourced? What are the potential and unique benefits? Is it intended to strengthen the core business, to acquire a technology, to establish market presence or to gain market share from the competition? What are the basic assumptions driving the deal? Are the assumptions about synergies realistic? Synergies are typically highly overvalued by executives and advisers alike. What is the plan to achieve synergies? Who would be negatively impacted in the process of materialising synergies? What other benefits are expected? Does the culture of the target align with that of the acquirer? How does this deal advance the company’s long-term strategy? With a large percentage of M&A deals destroying value, how will this particular deal be different?
Risk analysis. No matter how diligently the board works, there are always information gaps between what it needs to make the best decisions and what it can obtain. There is no doubt that acquisitions can offer growth opportunities, but they are by nature complex and risky. When considering an M&A strategy, opportunity is often accompanied by risk and uncertainty. Typical risks include human dynamics. Typically, in the leadership team, ego and office politics obstruct objective debate. Advisers make deals for a fee and are not accountable for the results or leadership differences which exist between the acquirer and the target. Human dynamics can lead to other risks, such as a flawed strategic rationale, pricing discrepancies, financing flaws and post-acquisition execution.
Due diligence. Boards should engage in oversight of the entire due diligence process. Due diligence should focus not only on financial risk but also on non-financial matters – the technological, operational and reputational dimensions of the deal. In terms of tangibles, boards need to devote sufficient time to issues related to intellectual property and technology before these issues begin to cause problems. In terms of intangibles – non-financial due diligence – boards need to consider cultural compatibility, stakeholder reactions and employee morale. What if the specialised employees and talents do not believe in the deal? How can all the intangibles be managed? The board must undertake a thorough, well-documented investigation before acting.
Deal structure and pricing. Boards should be especially vigilant when it comes to evaluating the financial aspects of a deal. Is it worthwhile? Are we paying the right price? Who is pricing the deal – the bankers or an internal team? Is the financing reasonable? What is the impact of potential holdbacks and escrows? How is a cash plus share offer different from an all-cash deal? Why is an acquisition better than the alternatives (joint venture, organic growth, alliance or partnership)? Companies must have strong in-house valuation skills; if they put themselves in the hands of others, they will probably run the risk of overpaying. Vodafone’s $183bn takeover of Mannesmann in 2000 marked the biggest cross-border bid in history. In total, Vodafone paid 56 times earnings, a 72 percent premium to Mannesmann’s closing share price. Five years later, Vodafone announced it would take a goodwill charge of $40bn. The company admitted that, embarrassingly, the record post-acquisition write-downs were due to overpayment.
Integration. Before the deal is approved, directors need to carefully review the integration plan. What is the timeline? How fast can the company be integrated? What are the expected problems? Who will lead the integration? Will the same team be involved throughout the pre-deal, deal, and post-deal process? What are the major milestones? What technical problems, IT and others, can be expected? How can the two company cultures be aligned? Who are the key people from the acquired company to retain? How long should an acquirer retain the management of the target company? What are the key metrics for measuring integration success? The board should get regular updates on the progress of the integration.
Post-integration analysis. Finally, the board should review the integration process after the acquisition and ask: How successful was it? Have we achieved the strategic goals? Have we focused on the right issues? What have we learned in the process to help make the next deal more successful? Have we established a process for evaluating the success of deals? Ideally, such a step should be planned at an early stage of the deal negotiation.
Confronting litigation involving M&A
In the M&A process, boards should recognise that directors are vulnerable to litigation in many legal environments and not only in the US. Failure to do the necessary homework, as well as to obtain adequate insurance coverage, could result in significant damage to the deal and the company. In this section, we discuss how litigation typically arises when boards fail to handle deals properly.
Conflicts of interest continue to dominate the discussions in M&A litigation. Typical conflicts of interest include large shareholder involvement in the deal, management negotiating employment and compensation packages during the deal, and advisers dealing on all sides. Boards that fail in their oversight could be sued for breaching their duty of care.
Class action lawsuits are often filed alleging that boards have failed in disclosure. This could cause a dilemma for the boards of target companies – premature disclosure can be damaging to shareholders; if the disclosure is too late, shareholders could allege that they were injured since they sold their shares just before the large price increase following the merger announcement. A lawsuit can also be brought against the acquiring company because the M&A negotiations or the future prospects and effect on the acquiring company have not been fully disclosed by the board in a timely manner.
The directors of a target company who resist a hostile takeover could be sued. Shareholders could allege that the directors are breaching their fiduciary duty and denying the shareholders the opportunity to profit from the high offer price. Likewise, the directors of a target company who approve a friendly takeover could also be sued. Disgruntled shareholders could allege that the company is being sold for too little and the directors have failed to make a good decision.
After a company has been acquired, the previous directors and executives of the target company could be sued by the new company. They could claim that the directors of the acquired company mismanaged the company prior to the acquisition, which could be problematic for the former directors since they no longer control the company and may have no insurance coverage. The board and directors of the acquiring company could be sued after the acquisition if, for example, the new management team has little experience in the industry or markets of the target company.
How can the board and directors add value to the M&A process and reduce the risk? This article aims to help boards and directors to rethink their M&A oversight framework and identify questions or issues when overseeing potential deals. The main principles are creating a deal-making mindset, seeing the bigger picture, staging deals with maximum precision and confronting litigation involving M&A. Boards and directors are crucial in helping their companies to capture value during the M&A process and reduce the risk of failure. We encourage every board and director to consider these principles and prepare for the M&A challenges.
Didier Cossin is professor of finance and governance and Abraham Hongze Lu is a research fellow at IMD. Mr Cossin can be contacted on +41 (21) 618 0208 or by email: firstname.lastname@example.org. Mr Lu can be contacted on +41 (21) 618 0505 or by email: email@example.com.
© Financier Worldwide
Didier Cossin and Abraham Hongze Lu