Due Diligence Requirements in M&A Deals

Posted on Tuesday, 8 June 2010. Filed under: Business Intelligence, Commentary, Mergers |

In QFinance, a very extensive on-line financial markets resource, I’ve written an article entitled ‘Due Diligence Requirements in Financial Transactions‘.  Due diligence is a critical business intelligence process, and in our book on the use of business intelligence in doing M&A deals better (Intelligent M&A, Navigating the Mergers and Acquisitions Minefield), the chapter on due diligence is the longest.  In it, I make the following arguments:

  • There is an urgency for companies to conduct intensive due diligence in financial deals, both before announcement (when it should be easy to call off the deal) and after.
  • Traditional due diligence merely verifies the history of the target and projects the future based on that history; correctly applied due diligence digs much deeper and provides insight into the future value of the target across a wide variety of factors.
  • Although due diligence does enable prospective acquirers to find potential black holes, the aim of due diligence should be this and more, including looking for opportunities to realize future prospects for the enlarged corporation through leveraging of the acquiring and the acquired firms’ resources and capabilities, identification of synergistic benefits, and postmerger integration planning.
  • Due diligence should start from the inception of a deal.
  • Areas to probe include finance, management, employees, IT, legal, risk management systems, culture, innovation, and even ethics.
  • Critical to the success of the due diligence process is the identification of the necessary information required, where it can best be sourced, and who is best qualified to review and interpret the data.
  • Requesting too much information is just as dangerous as requesting too little. Having the wrong people looking at the data is also hazardous.

The whole due diligence can therefore be summarised with four ‘w’ questions:  What? When and where? Who? 

  • What do you need to review?  Be careful, as note above, of requesting too much as you may then only superfically review even the important things.  Focus on the critical, the potential deal-breakers and the things you need to know to design the best post-merger integration (too often managers seek this information AFTER the deal, but by then it’s too late to design a proper post-deal integration strategy).
  • When do you need the information and where do you find it?  Much due diligence can be done even before a deal is announced … and even before you start discussions with the target.  For example, you often don’t need to ask the target for their sales information:  even if they are privately held and don’t disclose this information, you can get it from industry sources such as publications, government data bases, suppliers and customers.  Management consultants can provide excellent market information.  Thus think about whether you can get information from other sources early, as then you don’t waste time once the deal process has started in earnest (once you’ve contacted the target) on things that you could have found out from other sources.  It also allows you to focus during the intense due diligence process on facts that are only available from the target itself:  such as it’s strategic plans and key contracts (with managers, suppliers, clients, etc).  Also, some information can safely be deferred until after the deal is done.
  • Who reviews the due diligence information?  This critical question is often mishandled because of the (often overemphasised) need for secrecy in the pre-deal announcement period.  At that time in the deal process, the finance departments are often driving the deal on behalf of the CEO and Board.  You then find accountants reviewing human resource due diligence (employment contracts, for example), IT systems and even looking at operational data.  The experts in these area don’t yet know a deal is taking place, but they are best placed to review any due diligence.  This continues after the deal is announced, when you’ll find those same accountants walking a shop floor or factory looking for problems.  But one of your own plant managers is best placed to look at the target’s factory;  your HR team knows best how an employment contract should be written and therefore whether there are problems with the contracts of target company staff.  Expand the due diligence team to allow for this proper review by the proper people!  And do not outsource the review of this critical process, as you will need the findings from the due diligence process for the entire period — often many years — of integration so you will want this information in-house.

Lastly, do not forget that even the target needs to do due diligence on the buyer:  who would want to do a deal only to find out that the bidder could not complete the deal due to circumstances that could have been anticipated.

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Equity Market Reactions to the announcement of an M&A Deal

Posted on Wednesday, 2 June 2010. Filed under: Commentary, Mergers |

Of principal concern to a dealmaker — whether the board of the acquiring company or the CEO recommending the deal — is whether the share price of the company will rise on the announcement of the acquisition of a target company … and by how much.  Of course the target company’s share price will rise;  I’m not talking about them, but rather the bidder’s share price.

In QFinance, a very extensive on-line financial markets resource, I’ve written an article entitled ‘Coping with Equity Market Reactions to M&A Transactions‘.  In it, I make the following arguments:

  • Overall, stock returns to acquirers tend to be negative or insignificant—in contrast to target companies, where stockholders can benefit greatly.
  • Companies that believe they may be targets can influence the value of an ultimate acquisition through the design of defensive techniques and by how they react to bids when they occur. Similarly, acquirers can influence the target share prices through their actions prior to the bid.
  • Most acquirers are overconfident in their ability to conduct acquisitions successfully.
  • Careful planning, including a robust internal and external communications plan, is required to mitigate the impact on equity markets of acquirers.
  • Many factors influence equity market reactions to an M&A bid, including how friendly or hostile the bid is, the financing structure of the bid, the relative size of the two companies, and whether the transaction is a merger or an acquisition.
  • Deals conducted in the most recent merger wave appear to have taken some of these issues into account and show better relative performance (relative to the market) than deals conducted in the 1980s and 1990s.

Read in light of the downturn in activity that has taken place since that article was written, this is another reason for caution in executing deals at this particular time.  Where there are markets with great uncertainty, as we certainly have now here in Europe if not globally, boards are cautious anyway about announcing large M&A transactions.  When the share price is volatile, further negative pressure is the last thing that shareholders need.

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Article on CEOs and M&A deals

Posted on Sunday, 23 May 2010. Filed under: Commentary, Mergers |

Thanks to Stefan Stern, the ‘On Management’ columnist in the Financial Times for his article on 18 May on our recent report on what happens when a new CEO takes over: ‘Here’s the deal:  move fast as a new CEO’.  That is, they do M&A deals.  See my blog entry ‘What comes next? Change your CEO and (bang!) you’re acquiring another company‘.  The report was written by Cass Business School and the M&A Research Centre (MARC) (which I head).

In an excerpt from Stefan’s article:

Scott Moeller, director of Marc, says we should not be surprised to see new CEOs deciding pretty fast that a big deal is just what the company needs…

Whatever they choose to do, most new CEOs know that they may not have a lot of time in which to act. The median tenure period for CEOs in the Marc survey, not including those who stayed for less than 12 months, was 4.4 years. “I suppose there may be some CEOs who are confident that they will beat the odds and even go on for ever,” says Prof Moeller, “but they will be the exception.”

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What comes next? Change your CEO and (bang!) you’re acquiring another company

Posted on Tuesday, 18 May 2010. Filed under: Commentary, Mergers |

Many things happen when a company gets a new CEO.  Cass Business School and the M&A Research Centre (MARC) (which I head) have just released a study showing that CEO’s embark on M&A deals very quickly after being appointed.

In the study which looked at 276 CEO changes from 1997 to 2009 in the UK, France, Germany and Spain, we found that CEOs were more likely to invest than divest assets in their first year in office, although it is important to note that most did neither.  This shows that most CEOs look to kick off their new strategy rather than first unwind the strategy of their predecessor.

We looked at a subsample of the CEOs who were hired with a mandate for change (when the previous CEO had been forced out of office or the new CEO recruited externally).  For these CEOs, they were more likely to perform a major deal, again evidence of needed to change the strategic direction of the company.

Most notably, those CEOs who did perform a major deal in their first year in office outperformed their peers in the long run in terms of shareholder performance.  Success does go to the bold.

However, it doesn’t pay off to be too bold, as those new CEOs who performed more than one major deal in their first year in office showed lower returns.  Anecdotally, it appears that they had not yet fully integrated the first acquisition before embarking on the second.

And lastly, we looked further at the divestiture vs acquisition decision.  It turns out that those who do a divestiture in their first year will outperform (albeit only for two years) those who do an acquisition in the first year.  It appears that the cash infusion and refocus of the organisation from the divestiture do help the company, but only for a time.

You can request a copy of the full study here.

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Why is European M&A so slow right now?

Posted on Monday, 10 May 2010. Filed under: Commentary, Mergers |

In the past two weeks, I’ve received numerous calls asking to explain why the M&A market in Europe was so slow in April.  Some of my comments have appeared in the Wall Street Journal and Financial News in articles entitled ‘Europe M&A Lags Behind World‘ and ‘European M&A set for worst month in a decade‘ respectively.  I’ve had inquiries from other reporters both in the US and here in Europe.

The questions arise because, in April, Europe represented only 15% of the global market activity, which is the lowest monthly proportion of global M&A since August 1998, when Europe made up 11%.  But it isn’t only on a relative basis, and this can’t be explained solely on the growth of M&A in other regions.  As Liam Vaughan wrote in one of those above articles, ‘April has also been dire for European M&A in terms of both the total value and number of deals. Not since August 2001 has the total value of deals been less and not since August 2004 have there been fewer deals.’

Why is this happening?  And why now?

As I have noted on several occasions on this website (see ‘Mergers & Acquisitions and Behavioural Finance‘) and elsewhere (as in the Financial Times in a special section ‘Deals and Dealmakers’ in March that had an article that I authored entitled:  ‘A tough challenge for M&A markets’), M&A markets depend on CEO and board-level confidence to be high.  In Europe, a ‘perfect storm’ of uncertainty has arisen over the past several months, including most notably the Greek debt crisis with fears of contagion to other European states and the uncertainty over the British elections.  From the vantage point of today, both were certainly valid concerns:  the Greek crisis continues unabated and here in the UK we have had an inconclusive election leading to the first hung parliament since 1974.

Another factor is the rise in cross-border M&A activity.  CEOs need even greater confidence to do a deal outside their own country.  In Europe, as Cass Business School reported together with Towers Watson in the recent Towers Watson Quarterly Deal Performance Monitor, cross border deals are only 27% of the North American M&A market, but represent 60% of European activity in the first quarter 2010.  With the uncertainly in foreign exchange levels due to the euro turmoil surrounding Greece, it is no surprise that companies are avoiding taking a stance on Europe at this moment.  Also, it is generally accepted that cross-border deals are more difficult to conduct, and thus if they represent more of the European M&A market, again this contributes to the slowdown in activity in a time of uncertainty.

Will there be a change soon?  I think not.  Again, as I have noted here in March (‘Another view on the M&A Market in 2010 and 2011‘) and before that terrible month of April, there will be stickiness at these lower levels of activity for a while.

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Why you should do an M&A deal now

Posted on Monday, 3 May 2010. Filed under: Commentary, Mergers |

Several months ago, Legg Mason strategist Michael Mauboussin published a report entitled ‘Surge in the Urge to Merge‘.  Based on some academic research reported in 2008 in the Academy of Management Journal, companies that invested in deals early in a merger cycle are more likely to be successful with their takeovers than those who invest at the peak or later.  From his own and that research, Mauboussin concludes:

  • An M&A wave may be on the way. If history is any guide, M&A activity tends to follow the stock market with a modest lag. The market’s bounce off of the March 2009 lows, when combined with more amenable credit market conditions, have set the tone for a resumption of active deal activity.
  • The early bird gets the worm. Academic research strongly suggests that companies doing deals early in the M&A cycle provide better returns for their shareholders than the companies that participate later. The reason is straightforward: early in the cycle there are more companies to choose from and the targets are cheap. As the cycle matures, options dissolve and valuations rise.

I agree with both of these conclusions.  As I have noted elsewhere (‘“Upside Risk” in M&A‘ and ‘M&A Forecast for 2010 — Update’), I believe we have bottomed out of the M&A cycle, which does mean that I agree that we are soon to be on the upswing … although I don’t think this will really happen until 2011 for behavioural reasons discussed several weeks ago in an article I wrote for the Financial Times entitled  ‘A tough challenge for M&A markets‘.  However, some industries will lead the market:  pharmaceuticals and media are two that I hear discussed more often recently, so they may already be at the start of their upturn.

I also concur and have done additional research that doing deals early in the M&A cycle will reward those who are brave enough.  In research that Cass Business School conducted for Towers Watson back in January 2010 (‘Corporate Deal Makers Have Reason for Optimism‘), we found that companies that completed a deal in 2009 outperformed their peers that were too timid to acquire — and by a not insignificant 3.2 percentage points.  Notably, those who did deals in the fourth quarter of 2009 outperformed their peers by 4 percentage points.

If more executives were bold enough and willing to use this information, they could convince their boards that they should not be shy but should seize the opportunities to expand through acquisition now.

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M&A Forecast for 2010 — update

Posted on Monday, 19 April 2010. Filed under: Commentary, Mergers |

Well, we’ve got more than one quarter of the year gone.  Is it really possible to see more clearly how 2010 will develop for the M&A markets?  I think so, and one reason is the behavioural aspects of the market that cause it to be ‘sticky’, as discussed several weeks ago in an article I wrote for the Financial Times entitled  ‘A tough challenge for M&A markets‘.  There is a slowly growing confidence in business, bouyed by the rising equity markets, but for M&A deals to be announced, an even greater level of confidence is required.  This will take time.

But it is useful as well to look at the activity for the first quarter.  I believe that it demonstrates that we have bottomed out.  The annualised volume for the first quarter globally for announced deals is still at around $2.2 trillion, which is the level of 2009.  First quarters, as we have shown before, tend to be the strongest quarter (see our posting on 8 February 2010) and in fact represent up to 50% of the mega-deal (but not total) volume.  We’ve not seen too many of these mega-deal announcements, which just confirms my belief that the confidence needs to return first, especially for those huge headline deals.

Nevertheless, the people I talk with are talking up the backlog of deals.  So there’s a lot of planning for the right moment.  One of my favourite reports on trends in the market is Intralinks‘ quartely Deal Flow Indicator.  They note that March 2010 deal flow was up 25% over February which itself was up 5% over January.  The trend is thus right.  Except for Europe, all regions saw an increase.  Notably, the deal flow level in Q1 2010 was at the same level as their benchmark Q1 in 2008.

Another indicator of growing confidence in doing deals is the increased percentage of cross-border deals. In a study (‘Deal Makers Continue to Outperform the Market’) conducted by Cass Business School for Towers Watson, it was reported that cross-border deal activity rose to 36% of all completed deals in the first quarter, which is up from 24% a year ago.  These deals are more complex and typically more difficult to get approval, and thus an increase in this activity does indicate confidence.  Another positive trend is the re-emergence of private equity buyers, albeit still no where near the level of activity seen several years ago.

Net-net?  I see the markets staying at around this level through 2010.  That in and of itself is an accomplishment as many were looking for a double dip in 2010.

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Politics and M&A

Posted on Friday, 16 April 2010. Filed under: Commentary, Mergers |

There’s a proposal in the UK to revise the rules governing public takeovers.  This has been prompted by the takeover of Cadbury by Kraft, but has been bubbling under the surface for years and gains attention each time there’s a large, contested offer.  The forthcoming election has given the proposals new life as well.

There are certainly arguments to be made to make some tweeks to the takeover code, but the overhall suggested by some of the white paper ideas seems to many to be the proverbial ‘meat cleaver’ approach where a paring knife would suffice.

What’s been suggested?  According to Financial News and discussed in an article entitled ‘M&A industry gears up for changes to the Takeover Code’, the full list is the following:

  • Raising the threshold for acquirers to secure ownership of a target from 50% to 66.7%
  • Forcing companies involved in a transaction to disclose the fees they pay their advisers
  • Reducing and formalising the time frame between a bidder announcing its interest in a company and the publication of a ‘put up or shut up’ deadline
  • Halving the disclosure requirement for investors in a takeover target from 1% to 0.5%
  • Restricting voting rights on a takeover to investors who held their position in the target before the announcement of an intention to make an offer
  • Forcing bidders to disclose greater detail how they intend to finance bids and their future plans for the acquired business
  • Forcing institutional investors to make public when they have accepted an offer
  • Forcing target boards to explain in greater detail the reasons behind accepting an offer
  • Making company boards accountable to employees and other stakeholders as well as shareholders.

The reaction in the City has generally been negative.  Although there are always problems arising from some parties in every contested M&A deal, the general feeling is that the current system works, it is well known and investors are certainly familiar with how the takeover code operates.

It is unlikely anything will change soon in any case.  First, the aforementioned election makes any change impossible until resolved.  Second, unless there’s another very large contested deal in the UK where the target is perceived by many to be a ‘national asset’ such as some considered Cadbury to be, it is likely that this attention by the politicians on takeovers will have been fleeting as they move on — and properly so — to other issues in the economy that demand immediate attention, which this issue does not.

Where will it end up?  I believe that there will be some tweaking at the edges.  And by-the-way, this happens all the time.  Each year, the Takeover Panel issues consultation papers, and since 2000, this been as high as five (and each individual paper may have multiple suggestions).  Most are not as radical as the above changes such as increasing the ownership change threshold to 66.7% or prohibiting certain shareholders from voting on the change of control, but it is unlikely those big changes would be approved anyway.

Note that some of these suggestions (such as the final one) would move the UK more in the direction of Continental European companies in terms of their accountability, and another suggestion — greater disclosure of fees, for example — are clearly populist suggestions of a political nature.

Debate should be encouraged at all times.  But ‘if it ain’t broke, don’t fix it’.  At the moment, it is my opinion that the way that mergers and acquisitions proceed in the UK currently works — and works well most of the time both for investors and boards.  When it doesn’t work, there is recourse through the Takeover Panel, the Stock Exchanges and the courts.  (Of course, there’s fall-out for employees (see my other blog on how M&A deals cause redundancies) and other stakeholders, but those groups also have recourse.)  However, unless the new government in May wishes to look at the entire way that companies operate in the UK, focus shouldn’t be only on one aspect of their operations (M&A).  But let’s discuss…

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Joint Ventures: Are they a viable alternative to a full merger or acquisition?

Posted on Wednesday, 24 March 2010. Filed under: Commentary, Mergers |

Much of the research and reporting in M&A get done about the headline-grabbing large acquisitions and mergers.  However, the unsung hero of corporate alliances are joint ventures.  But we expect to see more of these, including some very big JVs.  Note the announcement on 1 February of a $12 billion joint venture between oil companies Shell and Cosan.  The Telegraph, one of London’s leading daily newspapers, noted in their Sunday paper (21 March 2010) the need to consider alliances and joint ventures instead of acquisitions — citing the recent announcement by Prudential to acquire AIG’s Asian business and whether Resolution should do the same when planning for the next year.  You can see this in the three paragraphs at the end of the article here.

Liam Vaughan, of Financial News, in an article on 23 March, also commented on the study and linked it to the above-mentioned Royal Dutch Shell joint venture with Brazilian counterpart Cosan, and then wrote that ‘Shell’s Brazilian JV follows high-profile joint ventures in the telecoms and natural resources sectors, announced in the second half of 2009. In Septembers Deutsche Telekom and France Telecom announced a joint venture between their UK operations T-Mobile and Orange; and in October Rio Tinto and BHP Billiton ditched merger plans in favour of a 50-50 iron ore joint venture.’  His article can be found here (although do note that access to that article is by subscription).

Cass Business School, through its M&A Research Centre (of which I’m the Director) recently completed what we understand to be the largest global study ever of joint ventures and strategic alliances.  Together with the sponsorship and support of the law firm Allen & Overy, investment bank Credit Suisse, accountancy and advisor Deloitte and the Financial Times / Mergermarket, the M&A Research Centre looked at over 122,000 deals over a 24-year period from January 1985 to May 2009.

The full report is entitled ‘Sharing Risk:  A Study of Corporate Alliances’ and can be ordered here.  Some of the key findings include:

  • Historically, joint venture activity is highest in the recovery period following a major economic downturn.  This is very significant, as we have (hopefully!) recently entered such a period and therefore, if history is any indication, should be seeing greater use of JVs over the next several quarters.  This increase is over 20% higher than average levels.
  • Joint venture deals reduce the participating company’s risk.  These firms see their beta decline by 3.9% as a result of the announced deals, and following a major crisis (such as we’ve recently had), the decrease is larger at 6.2%
  • Overall, joint venture deals create value for participants’ shareholders both in the short- and long-term.
  • Some joint ventures are listed companies themselves.  These do demonstrate year-on-year improvement in a number of financial factors, including return on equity over a five year period.
  • However, most JVs don’t last that long.  Contrary to conventional wisdom, the average JV lasts around three years.  Fortunately, when the termination of the venture is announced, the owners are rewarded with an improved stock market reaction.

We also noted some factors of note for companies considering such alliances.  For example, don’t do a JV with too close a competitor, look for a partner who is similar in size and consider a JV if you are entering a new geographic market.  JVs are an excellent precursor to an M&A deal, probably as an example of ‘dating before getting married’.

Details about all the above findings, as well as additional findings, are available in the full report.

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Another view on the M&A Market in 2010 and 2011

Posted on Friday, 19 March 2010. Filed under: Commentary, Mergers |

On Thursday, 18 March, the Financial Times in a special section (‘Deals and Dealmakers’) had an article that I authored entitled:  ‘A tough challenge for M&A markets’.  In it, I argue that that a number of unavoidable behavioural factors are the principal impediments to a rising M&A market:  just as the growth of the market from 2004 to 2007 was driven by some of these factors, there will be a stickiness to the lack of M&A activity over the next year or two.  I’ve touched before on some of these behavioural factors (see ‘Mergers & Acquisitions and Behavioural Finance‘), but have expanded the discussion in the FT article to include additional factors such as optimism, over confidence, belief perseverance, data anchoring, bias towards recent events, and, of course, management hubris. 

I would very much like to see more debate over the role of behavioural finance in the mergers and acquistitions market, and would welcome further comments here.

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