Therapy for “deal fever” is an objective, disciplined due diligence process for companies and board contemplating an M&A transaction
In this post-financial crisis environment, the mergers & acquisitions market is extremely competitive as both corporate and private equity investors have capital to invest but fewer quality deals in the marketplace to invest in. A competitive deal environment drives up bids and puts pressure on transaction timelines, increasing the potential for deal bias and conflicting interests.
These risks can be exacerbated when public companies are involved. Buyers may pay significant control premiums over the trading price of the stock but may have limited access to the information necessary to assess the deal strategy, risks, and value. The limitations imposed on receiving non-public information can arise from a variety of factors, including the dynamics of the sale process, regulatory considerations, and commercial sensitivity. Since there are virtually no contractual protections if something goes wrong in public deals, buyers are essentially taking the business “as is.”
While audited financial statements are an important data point, their purpose is not to reveal revenue and earnings sustainability, or growth drivers, nor to forecast attainability, all of which are critical to assessing the baseline value of a business being acquired. Areas impacting risk and value, such as key customer or product revenue and margin trends, key performance indicators, manufacturing cost structure, systems, contract terms, and sales pipeline/backlog, may not be obvious or reportable under disclosure rules.
Investors looking to acquire control also need insight into forecasts that extend beyond public disclosures, and must assess synergies, management quality, and other areas of the business plan.
In light of all of these factors, boards should take care in evaluating the due diligence findings and whether an objective, disciplined process was used. As part of their oversight, boards need to see that management can bridge the gap between the bid value and intrinsic value prior to announcing a deal. This entails an assessment of the business drivers for the transaction, underlying earnings and risks of the base business, synergies with the target company, and the current market economics. Ultimately, the diligence findings should be incorporated into the deal model and significant information limitations or sensitivities should be highlighted in the decision process.
“Uncertainty is a certainty in any deal, but risk associated with the unknown has been amplified in the current economic environment,” said Aaron Gilcreast, a principal in PwC’s Deals practice. “As the economy recovers and companies chart a smart course for growth, deal makers will be well served by investing time and effort in valuation on the front end of transactions to avoid surprises on the back end.”
Valuation is just one part, albeit a very important one, of the acquisition process. Objective due diligence informs the valuation, where transparency as to what is known and what is not known is critical.
“Often one of the most revealing pieces of information is the one you wanted but did not get,” said Martyn Curragh, US Deals leader at PwC. The question is how has that been factored into management’s approach and assumptions, and is greater information needed to proceed.
“As a board, when you think about due diligence, you are asking, ‘What are the key strategic objectives of the transaction? What are the key assumptions driving our valuation model? How robust and expansive was our scope around these assumptions? What was it we set out to do that we didn’t do in diligence? Is there a 100-day plan?’” Curragh told directors attending a recent PwC 2012 Year-end considerations for audit committees seminar.
One director who has been involved in several M&A transactions said he remembers his boards taking a substantial amount of time considering the due diligence reports from management and advisors.
“It’s very significant,” said James Brady, who sits on the boards of McCormick & Co. and T. Rowe Price Group. “We’ve had audit firms and legal firms involved in the due diligence work. You have to do everything you can to see that there aren’t going to be any great surprises.”
As for the overall risks involving a deal, Brady looks at three areas: strategic rationale and return on investment, the due diligence process, and the integration plan. “We ask the CEO to tell us how the assumptions for this deal compare to assumptions in past deals,” he said.
Meanwhile, Brady and other directors like him are also cognizant of the possibility of deal bias, or “deal fever,” where the individuals most closely involved become enamored with the deal. If not checked, deal bias can drive up the price and affect management’s perception. This is a matter of human psychology, and it is always present; navigating this is key.
Curragh has seen this happen occasionally. "Sometimes valuations can get stretched when there's strong competition for an asset and the banker says ‘the deal is yours if you can move your bid up to X,’" he said.
In the end, after due diligence is completed the board needs to become comfortable with management’s recommendation to do the transaction or walk away.
Here are some questions boards may want to ask when considering an M&A transaction.
For more insight from PwC’s Deals practice on how to successfully navigate M&A, visit the Deals practice web page. Additionally, here are some PwC publications on M&A deals and valuation: