Managing transactional risk
February 2012 | TALKINGPOINT | MERGERS & ACQUISITIONS
FW moderates a discussion looking at transactional risk between Matthew Altham at AMR International, Stephen M. Joiner at Deloitte and Neo Combarro at Lockton Companies LLP.
FW: In your experience, do acquirers pay enough attention to identifying and assessing risks during the deal process? What are the benefits of allocating more time and resources to this process?
Altham: Of course there are many examples of companies paying insufficient attention to risks in acquisitions – one only needs to think about RBS and ABN Amro, where minimal due diligence was carried out. In general, however, our clients are hyper-sensitive about understanding risks in the deal process. Unfortunately, sellers and their advisers can sometimes try to squeeze the time available for due diligence programmes. The discovery process in due diligence is non-linear, and often the juiciest insights are revealed only after several weeks of research and analysis. Of course, this is precisely why advisers want to run tight deadlines.
Combarro: In the current economic environment, due diligence process is very thorough. That is not to say that it wasn’t before, however, there has been a fundamental change in the risk appetite of buyers. This has shifted significantly to a far greater reduction in the risk factors that acquirers are willing to assume. Consequently, they are looking to clearly identify all risk factors and illuminate and minimise those risk factors as much as possible.
Joiner: Mergers and acquisitions can create significant risks but through proper planning, execution, and valuation these risks are generally manageable. That’s why it is important to identify and assess risks throughout the deal process. We do see acquirers with varying risks appetites and strategies that approach the identification and assessment of risks in different manners and with varying degrees of diligence. We see some companies that choose an integrated approach that executes a transaction with a diverse and broad team spanning from corporate management to the business unit and functional leaders. This broad team is involved to identify the full spectrum of risks which includes financial, operational, strategic and regulatory. Ultimately this team must not only identify these risks which will be assumed but also determine if such risks can be eliminated or reduced to an acceptable level commensurate with the transaction’s expected returns. Other companies seem to limit the responsibility for assessing risks to a specialised deal group that owns and drives the process. These acquirers may ultimately accept more deal risks and seek to reduce transaction risks in the integration process or through legal protections.
FW: On the buy-side, could you outline the key areas that every buyer should at least consider factoring into the scope of their due diligence?
Combarro: As an insurance broker we often see the insurance elements not being adequately addressed within the due diligence process and used to mitigate balance sheet risk. This can range from the adequacy of the programme to ring-fence those risks. The use of insurance can provide critical protection that would otherwise be assumed by the balance sheet. This can translate into added liabilities which created added burdens which could otherwise be removed.
Joiner: Every transaction is different and due diligence should be tailored to each situation with a focus on matters that impact the deal value drivers. Financial, legal/regulatory, operational, and tax due diligence are generally the core essentials to identify risks and exposures, as well as to support these value drivers or quantify the impact on acquisition price of a deviation from the value driver. In addition, in certain industries and in certain geographies there are other critical key areas that should be addressed. For instance, environmental diligence could be critical in a manufacturing environment and US buyers may want to consider target compliance with the Foreign Corrupt Practices Act (“FCPA”) in certain developing countries.
Altham: The classic commercial due diligence scope looks at the market and the competitive situation, using detailed research, analysis, and customer referencing, and puts this all together to come up with a view of the achievability of the forecasts. Good due diligence will also look at post-acquisition planning and integration. This model is well established and still holds true today, however it can lend itself to a somewhat formulaic approach. It is important to identify the two or three key issues which will impact performance, and then drill down from there. So rather than merely ask the question “what is the size of the market and how fast is it growing?”, buyers should ask more strategic questions, such as “at what rate is usage shifting from print to online and what will the impact be on advertising budget allocation?” and then break that question down. Good due diligence also needs to provide clear answers to the questions “what do I do with the business after I own it?”, “what kind of an owner should I be?”, and “how do I add value?”.
FW: Given the heightened sensitivity to risk in today’s market, how important is it for buyers to ensure that the target company is meeting its regulatory compliance obligations – including in areas that may not be immediately obvious?
Joiner: It is extremely important for buyers to evaluate the target company’s compliance with various regulatory compliance obligations. Non-compliance can result in financial costs – one-time and ongoing – that impact the target company’s operating results and in some instances harm the buyer’s reputation in the market. For instance, non-compliance with the FCPA may have significant implications from a reputational standpoint and can result in significant costs post closing. Also, many developing countries have complex and burdensome regulations regarding both income taxes and indirect taxes which sometimes promote intentional and unintentional non-compliance. This non-compliance can result in significant penalties and interests by developing countries for a buyer post deal. Buyers should seek the advice of seasoned M&A professionals that know the industry and the market to ensure that these risks are addressed in the M&A diligence process.
Combarro: Purchasing and assuming the liabilities of a company that has not met its regulatory compliance obligations would be a clear breach of the obligations of the acquiring directors to their shareholders. Therefore, the brief given to those conducting due diligence work is extremely important.
FW: For cross-border transactions, what additional areas of investigation should potential buyers undertake?
Altham: From a commercial perspective, the key areas to consider in particular detail for cross-border transactions are probably post-acquisition planning and integration. Cross-border transactions are otherwise generally no different in terms of the key market and competitive issues to consider, but there are clearly increased risks in integration as the acquirer tries to manage and integrate a business with a different culture or language. I have come across numerous examples of overseas subsidiaries which were badly integrated or not integrated at all. For example, I once met the managing director of the US subsidiary of a UK media organisation and asked him what interaction he had with head office since they were acquired. His reply was: “They come and see me once a year and tell me to put the prices up.” Successful acquirers need to be clear what kind of a corporate parent they are going to be.
Combarro: Insurance programmes must comply with local regulatory requirements. This is very often overlooked. The result is that an insurance programme is unable to respond to certain liabilities in a particular territory. The consequences of this can be catastrophic. It is, therefore, critical that this is addressed.
Joiner: Cross-border transactions can be complex and typically require buyers and their advisers to know the industry, business culture, and legal/regulatory environment in the countries where the target operates. Transaction structure, including financing, should be considered early in the process to address possible government restrictions on foreign investors – some countries restrict foreign ownership in certain industries or types of business activities – or foreign currency risks such as volatility, limitations in repatriating dividends, and so on. In addition, as mentioned, US buyers should consider performing FCPA diligence to identify compliance issues that may significantly damage the buyer’s reputation.
FW: Broadly speaking, what options are available to acquirers to help them mitigate any transactional risks they do identify?
Combarro: The ability of insurers to tackle many of the risks that emerge as a result of the due diligence process is very broad. The key is to establish those that are ‘insurable risks’. ‘Financial guarantee’ is uninsurable; however, the line between the two can sometimes be unclear. It is, therefore, important to clarify this to ensure that you are achieving the broadest insurance coverage available. Once there is a clear understanding, the opportunities to ring-fence risks with insurance can be of significant value to the transaction.
Joiner: Acquirers can choose to either absorb a certain amount of risk or factor this into their valuation model of the target company. In addition, the acquirer can sometimes obtain protection mechanisms from sellers in the purchase agreement. Depending on the identified risk, uncertainty in exposures from risks can impact the deal dynamics. For example, uncertainties in growth projections for the target company can be addressed in the pricing model. We continue to see earn-out agreements where the acquirer pays additional consideration if and when certain defined growth projections are met, thus reducing the overall transaction risk if the projections are not met. With regard to protection mechanisms, the acquirer may obtain indemnification provisions from the sellers for other uncertain or undisclosed matters that arise post-transaction. In these cases, acquirers should evaluate the financial wherewithal of the seller to support any indemnifications or protection mechanisms and assess whether there is a need to set aside a portion of the purchase price in escrow. In certain instances we have seen acquirers choose to use insurance products to mitigate transaction risks.
Altham: Some transactional risks that come up in due diligence are genuine deal breakers, and we have frequently told clients to walk away from bad deals, whether because of market disruption, competitive positioning or management weakness. One of the advantages of commercial due diligence, however, is that risks which are identified can be used by the buyer to negotiate a better price. They can also be used to structure the deal in a way which takes into account those risks. An obvious and widely used example is earn-outs, but commercial risks can also be used to develop more realistic financing structures for the acquisition.
FW: Could you explain how acquirers can feed the results of their due diligence into the merger integration process to reduce risk early in the post-deal phase?
Joiner: Closing a transaction can be hard, but successful integration can be even harder. As a result, merger integration planning should commence prior to the transaction closing. The deal team and the merger integration team should communicate throughout the diligence process to identify and address promptly any issues that may have a significant impact on the integration, and potentially on deal value. This aids the integration team in assessing and buying into the integration plan and ultimately the transaction synergy estimates.
Altham: There are a number of topics that should be in any post-deal integration planning process. A lot of attention is typically paid to legal, finance, and IT issues where it is vital to ensure continuity, and this is as it should be. On the commercial side, an area where there can be surprisingly little attention is the question of customer continuity. It is important to work out a communication plan to tell customers about the transaction. It is often good practice to introduce key customers to the new purchaser in a timely manner after the acquisition and give them reassurances on what the change of ownership means for them. Some target companies I have worked with have even communicated the impending acquisition to certain key customers in advance, to ensure there is minimum scope for unpleasant surprises.
Combarro: The due diligence phase will highlight the risk factors within the business. Once these have been identified, insurance can be used to either eliminate or significantly reduce those risks. Some of the issues that are discovered during the due diligence process could be deal blockers. However, through an insurance solution, this could be rectified, enabling the deal to complete. We have assisted in this way on numerous occasions. Elements such as tax, title, representation and warranties can be ring-fenced by insurance. In some instances there are concerns regarding the ability to claw-back in the event of non-performance of warranties or representations. It could be that there is very limited representation or warranties. Insurance can provide some security in this regard. The possibilities here can be significant; it depends on the issues and the ability of your broker to provide you with solutions.
FW: In the current market, where risk-aversion is paramount, what can sellers do to assist the transaction process and maximise the value of their business?
Altham: My advice to sellers would be to run as open and honest a process as possible. In today’s environment companies are still keen to do deals but are looking for increased comfort, and that means increased transparency. Auctions that are too stage-managed tend to be counter-productive as the buyer will eventually get the information they need one way or another. Increased risk-aversion implies a healthy absence of the deal fever which was a feature of many M&A markets before the recession. Hopefully, the days when buyers were happy to delude themselves about unrealistic growth prospects in order to get the deal done are gone. It is not yet a buyer’s market, but the willing seller in today’s environment should by all means present the business in a favourable light, and they should be sensitive to buyers’ concerns if they want to achieve a successful sale.
Combarro: Warranty and indemnity insurance can be a very useful tool to both the seller and buyer in the sale process. Buyers, regardless of the due diligence work they carry out, will always be concerned that the fortuitous event will emerge at some point after the closing of the deal. Therefore, as a seller, you can introduce this insurance option early in the process as an additional security for the buyer, if it would enhance the deal process. With the knowledge of the existence of such a policy, the buyer will be able to achieve greater security when considering a deal.
Joiner: Sellers should determine they have correctly presented the operations and financial position of the target and have provided to the acquirer an appropriate level of quality information to support the offering memorandum to expedite the diligence process. Sellers should also evaluate areas that may be of concern or that may raise additional scrutiny from acquirers. Taking the time to adequately and systematically support the target’s results and forecasts will greatly enhance the diligence process. Leaving significant deal issues for the buyer to identify and quantify will slow the process and may negatively impact value and negotiations. In today’s uncertain M&A environment, we are definitely seeing sellers invest heavily into its sell-side efforts including establishing more detailed data rooms and even having outside advisers provide seller and vendor due diligence reports to prospective buyers.
Matthew Altham is an associate director in AMR International’s London office. Mr Altham has over 15 years of experience in the strategy consulting, telecommunications, and financial services industries. Whilst at AMR he has managed a wide range of transaction and strategy assignments in media and publishing, travel and leisure, and industrial products, for both corporate and private equity clients. Mr Altham speaks fluent German and Russian. He can be contacted by email at: email@example.com.
Stephen M. Joiner is a partner at Deloitte & Touche LLP. He currently works as the managing partner for the Southeastern United States Merger and Acquisition Services practice. Mr Joiner has 25 years of audit and acquisition due diligence experience in a variety of industries including manufacturing, consumer products and business services. He also has served as lead client service partner for a number of high-growth strategic buyers providing him with deep experience with public offerings of debt and equity securities, transaction structuring options, internal control assessments, and SEC matters. Mr Joiner can be contacted on +1 404 220 1439 or by email: firstname.lastname@example.org.
Neo Combarro is a director at Lockton Companies LLP. He has extensive experience of advising financial and commercial institutions on appropriate risk transfer solutions including transactional and contingency liability matters. His role includes assisting clients to identify coverage needs, advising on placement strategy, and negotiating coverage terms, whilst extending to all aspects of day-to-day management of a client’s insurance programme. Mr Combarro can be contacted on +44 (0)20 7933 2123 or by email: email@example.com.
© Financier Worldwide
Stephen M. Joiner
Lockton Companies LLP