Corporate acquisitions and mergers have become a key component of modern, global industrial development strategies. However, along with the potential benefits, a merger or acquisition also brings high-level risks that are hard to ignore. Worldwide merger statistics reveal that more than 70% of M&A deals end in failure. That is to say, the buyers fail to achieve the strategic or financial goals they established when they made their deals. Except for strategic errors, however, the failure of an acquisition is almost always rooted in one or more of the following three causes: One – the acquisition price was too high; two – the buyer's interests were not rigorously protected in the acquisition agreement; and three – the acquired company cannot be smoothly integrated.
Whereas it is generally recognized that various sorts of pre-acquisition due diligence can greatly reduce the risk of failure alluded to above, and that "financial due diligence" is especially important, indeed essential, there is much disagreement, however, about which elements of financial due diligence should be receive the most attention. In this author's opinion, there is no one-size-fits-all formula, but at a minimum, it should include operational, financial, accounting and tax aspects. As for the main focus of evaluation, I have drawn together for discussion some of the common concerns of most decision makers on the buyer side, as well as a few of the financial black holes that sellers might conceal.
What Are "Financial Black Holes"?
To put it simply, financial black holes are where the seller is involved in certain operational arrangements or financial operations that give rise to risks or hidden liabilities. Although there are accounting rules about the recognition of liabilities, in an acquisition deal, there are considerations of hidden liabilities beyond what is covered in the usual financial statement audit. As a result, not all hidden liabilities are found in CPA audit-certified financial statements, and a thoroughgoing disclosure is in order.
Hidden liabilities can generally be separated into two types: under-accruals and off-balance sheet liabilities. Under-accruals include underestimated liabilities, such as product warranty obligations and under-funded pension commitments; off-balance sheet liabilities include binding commitments and liabilities such as endorsements and guaranties or funds to accommodate possible losses by third parties, commitments to purchase machinery and equipment, and exposure to lawsuits for environmental damage, legal damages and claims, and taxes owed.
What to Do When Financial Black Holes Are Discovered
In this author's opinion, the aim of uncovering black holes is first, to adjust the price of acquisition; second, to guide the negotiation of related provision in the stock purchase agreement (SPA); and third, to inform the consolidation process following the acquisition. In addition to these three purposes, it is also very important to understand the reasons and motives that led the seller had not disclosed significant hidden liabilities. If there is a question of trust, where the seller is suspected of deliberate concealment, then one must carefully consider whether it is worth proceeding with the acquisition. Additionally, if the discovered liabilities are large enough, or have a high degree of uncertainty, one must consider calling off the deal.
1. Adjusting the Acquisition Price
In general, how the uncovering of hidden liabilities affects the price of acquisition depends on the circumstances in each case, especially where negotiations to work out the logistics of the deal leave the two sides still at odds with each other. For instance, let us say that excluding product warranty obligations from the books makes annual earnings before interest and taxes (EBIT) higher by NT$20 million, then for an acquisition price that is 12 times the most recent EBIT, putting this one excluded commitment on the books would knock NT$240 million dollars off the price – not a trifling sum, to be sure.
In addition, commitments in uncancelable contracts signed by the seller may also impact the purchase price to a considerable degree. For example, suppose the seller has recently signed a technology licensing agreement under which royalties, which had been US$1.8 million a year for the last five years, go up to US$3 million a year for the next five years. Due diligence procedures discover that the accounting entries were still based on the old US$1.8 million rate. If we use a simple discounted cash flow calculation with a discount rate of 12%, putting in the seller's overlooked 5-year commitment to higher royalty payments would take NT$130 million off the purchase price.
2. Negotiating the Stock Purchase Agreement
The biggest challenge facing the buyer carrying out due diligence on the seller is that they have to find a way through mountains of complex data in a short period of time, lock-in acquisition-related risk, and write a set of appropriate provisions into the SPA, so that risks are contained within acceptable levels. For example, suppose the seller has used its name to endorse a guarantee of NT$1 billion on behalf of a company in which the seller's chairman has invested in personally. The buyer may consider adding a precondition to the SPA requiring that the endorsed guarantee be transferred under the chairman's own name, at the same time freeing the seller of its responsibility as guarantor.
3. Considerations for Post-Acquisition Integration
The biggest challenge in an acquisition is undoubtedly figuring out how to concentrate ones efforts and resources on the most important integration issues as quickly as possible (within 180 days at the most). In practical terms, when buyers face integration-related challenges, they must give particular attention to the strategy they adopt to accelerate integration. As a rule of thumb, concentrating on the most important 20% of integration tasks will be rewarded by increased integration effectiveness – as much as is gained from the remaining 80% – and much higher chances for the success of the acquisition.
An example from human resources will illustrate how liabilities concealed by a buyer relate to integration after the acquisition: Suppose a certain seller has a serious unfunded pension liability. When the payout obligation is estimated under the new retirement pension system, the funding shortfall comes to NT$70 million. In addition to considering the effect on the acquisition price, one must also realize that allaying the concerns of the seller's employees, boosting their morale, is key to successful integration following the acquisition. Thus, if negotiations lead to assistance and a requirement that the seller quickly obtain the money needed to adequately fund the pension scheme, employees who are willing to stay on but lack a sense of security may take such action as an indication of one's good faith, and it can make employees willing to invest the hard work that integration will require. Succeeding or failing to integrate an acquisition really depends on details such as these, and buyers would do well to take them to heart.
Conclusion
The execution of financial due diligence is necessarily an occasion for the buyer to take the initiative and demonstrate good corporate governance, and it is the only way to control the risk associated with an acquisition. The above discussion of financial black holes leads to an important conclusion. Namely, that effective financial due diligence, completely focused on an acquisition deal, is relied upon to get three important things right: the valuation of the company, the provisions written into the stock purchase agreement, and post-acquisition integration.
Kenneth Liu is a partner at PricewaterhouseCoopers Taiwan. Please send your comments and questions to: Kenneth.Liu@mail.pwcglobal.com.tw
