By-Lined Article
Due Diligence
By Duane Morris Private Equity Connections
Summer 2012
Duane Morris Private Equity Connections
Both strategic and financial buyers devote a significant amount of time to diligence activities before signing a purchase agreement. While the mechanics of the diligence process are largely the same, the two sides can take fundamentally different approaches to the numbers.
Every acquisition involves a high degree of scrutiny, irrespective of the nature of the buyer. Once a letter of intent has been signed, accountants, lawyers, market consultants and sometimes even private investigators are brought in to perform an exhaustive analysis. Foremost in this probe is the quality of earnings, says Wade Kruse, partner in charge of transaction advisory services for the Southeast region at Grant Thornton. All buyers want to see an objective assessment of the business' earnings and what it can realistically be expected to earn in the future. For buyers, the quality-of-earnings report or "Q of E" is frequently the most fundamental and controversial element within the due diligence process because the valuation spelled out in the letter of intent is often based on a normalized and adjusted EBITDA.
Buyers will also look at the quality of working capital, both in terms of what is needed to run the business and to clarify exactly what a buyer can expect to see on the books when the keys are handed over. "We end up spending a disproportionate amount of time talking about working capital," says Voorhees of RockTenn. Not only is it something that can be measured, as opposed to the more intangible aspects of a business, but buyers also need to know that a business can support itself going forward.
Buyers need to know that a business can support itself going forward. "We end up spending a disproportionate amount of time talking about working capital." Steve Voorhees, RockTenn
Next, there are what Kruse of Grant Thornton calls the deal drivers—"anything pertinent to the deal, such as the quality of the customer base, the workforce or technology." These aspects of a business are more subjective and may be particular to the industry or to the buyer. Depending on the deal, buyers may bring in outside experts specializing in human resources or technology to assess potential issues in these areas. "The purpose, however, is the same as any other diligence exercise," says Kruse. "We are looking for risks."
Then there are the details. Tax structuring is an issue that Grant Thornton likes to plan up-front, even though it is part of the back end of the deal. For companies operating abroad, a law firm or other qualified evaluator will be called in to assess compliance with the Foreign Corrupt Practices Act. Third-party firms are sometimes hired to evaluate environmental compliance, investigate insurance issues or conduct background checks on senior management. "Another two or three people digging for a few days can turn up some things," say Kruse. "The numbers may be correct, but when you add some color to the picture, perceptions can change."
"Five years ago, many more deals blew up over something uncovered in diligence. [Now, sponsors] are doing more of their own diligence before they start incurring deal costs." Wade Kruse, Grant Thornton
Conducting basic diligence can be particular challenging when dealing with the smaller, family-owned companies that inhabit the middle market. "Everything that is communicated verbally has to be backed up in files for the diligence exercise," says Chang. UPS can spend as much as $1 million on diligence before closing a deal. "There's nothing more disappointing than finding out that all the information we're looking for is not substantiated." He is often surprised when a prospective seller cannot answer questions as basic as "Do you own the trademarks and other intellectual property used by your company?"
Diligence occasionally turns up something that sends buyers and sellers back to the negotiating table, such as a difference of opinion between the seller and the auditor over the quality of earnings. Private equity buyers base valuation on normalized EBITDA. If an auditor determines that EBITDA is less than the seller represented, financing arrangements and valuation assumptions have to be revisited. This is an outcome that everyone tries to avoid because it can scupper a deal after all parties have invested considerable time and money. "Recutting" or "retrading" a deal is not much better; the seller ends up with less and the buyer risks gaining a reputation as an unreliable partner.
"Five years ago, many more deals blew up over something uncovered in diligence," says Kruse. "While unusual, accountants sometimes visited target companies before their private equity clients in 2006 and 2007. Strategic buyers have always been more cautious, but financial sponsors are also much more careful now. They are doing more of their own diligence before they start incurring deal costs." In the current market, Kruse says many deals still do not make it past the diligence phase. However, it is not always a financial issue; sometimes, it is a question of deal drivers and the color behind the numbers.
Informed Seller Strategies, Backed by Transactional Support Players, Help Smooth the Process
"[W]hat bankers also do is they get to a real price, a market price." Joseph Ibrahim, The Riverside Company
Bryant of Roark Capital has experienced the dilemma of sellers with unclear objectives. "It's amazing how many processes in which we participate where the initial objectives tend to morph over time," he says. Then there is the special conundrum when ownership is shared among partners who have different views of their ongoing involvement and what they believe their business is worth.
No wonder most buyers—both strategic and financial—would like bankers, accountants and lawyers to be involved from the beginning, preferably before a company puts itself up for sale. "We are doing more sell-side diligence, especially for companies that are selling a carve-out business, do not have an audit, or have messy accounting," says Kruse. "Most bankers would love to have sellers undergo a readiness assessment before approaching buyers," he adds. Grant Thornton will sit down with management for a couple of days and help them determine if they really are ready to sell. Sometimes, it results in a full quality-of-earnings report before the company is even on the block.
"It's money well spent," says Riverside's Ibrahim. "When someone asks, ‘Do you like having an investment banker in the process?' what they really mean is it drives the price up. But what bankers also do is they get to a real price, a market price," he says. Bankers collect all the information in advance, "so we see it the way we expect to see it."Naturally, SunTrust's Bomar agrees with that assessment and recommends "you pre-wire everything to the extent you can." Investment banks are more familiar with the different stages of diligence that buyers need to conduct. "If we're going to set up a process that's going to include both strategics and sponsors, then we're going to ensure the time line enables both to reach where they need to be in order to keep that competitive tension between the two," he says.
Real-World Diligence: Human Capital Valuation
"[I]n a bigger organization with a lot of resources, some people are not going to be in the positions that they’re in." Ronald Chang, UPS
"We have to be a better business after the acquisition than we were before it." Steve Voorhees, RockTenn
Beyond the tangibles, one of the thornier aspects of diligence is assessing the management team that comes with an acquisition, especially for a company where value lies in the personnel and the intellectual know-how—particularly in the service and technology sectors. One red flag for Chang: a situation where only one person has the business knowledge and controls the key relationships that made the company a success, and the rest of the management team is there as support. "This is usually the founder of the company or a key principal," he says. Chang steers clear of these acquisitions.
A parallel situation occurs where there is one outstanding salesperson and everyone else needs a little help. This sort of dynamic would pose particular problems for a strategic investor because chances are high that only the sales star would make the grade after the acquisition. "When you're taking a look at integration, you know how the company's going to look and it's going to be uncomfortable," Chang cautions. "I find it best to be honest and straightforward and tell them that in the world in which they operate, that may suffice. . . . However, in a more competitive environment, in a bigger organization with a lot of resources, some people are not going to be in the positions that they're in."
Once the lawyers and accountants have done their work, there is one question that overrides all others, says Voorhees of RockTenn. "We have to be a better business after the acquisition than we were before it," he says. "Price is an important element of making the acquisition work. We're very aware that we cannot overpay for any acquisition that we make."
The Duane Morris View
Darrick Mix: - The prepared seller has likely faced squarely the questions outlined here: What are my post-transaction expectations? Is the thinking aligned among my partners and/or family? Am I realistic on my company’s potential valuation? Have I engaged the transactional professionals early enough to conduct a smooth process with no surprises, and to achieve the optimum deal for my company, my employees and myself?
