Building the Information Base For Betting on Sound Deals

Good information is increasingly at a premium in the fast-paced m&a world of the 21st Century. Experienced due diligence professionals outline the challenges of supporting acquirers and targets in an age when they must probe a proliferating number of issues in an often-compressed time frame. M&A: There recently have been a lot of contentious disputes involving mergers, acquisitions, and divestitures, including some that have gone to court over allegations of fraud. What is happening here? Does this suggest that the due diligence people are sloppy or that they are missing things that they should be picking up? O’Neill: If the due diligence was sloppy, it likely was not sloppy on the part of the professionals being hired. But there is a need for speed. There are lot of transactions out there and a lot of buyers are after acquisitions, so the need for speed is really the focus today, especially in the public company context. You don’t get access to all of the information that you might otherwise want. To me, the starting point is the data room, and very often in public transactions that is the ending point. If you only look at what is in the data room, you are limiting your due diligence. You don’t get an opportunity to drill down. You trust the public company financial statements and think, how wrong could the earnings be? There are synergies that are coming about here. So you are willing to take a risk. I think it is a lack of drilling down into key areas that is the real issue here. Blitz: In a number of deals that I’ve worked on, there has been a mismatch between the due diligence and the reps and warranties. Often the due diligence is very much focused on the business on an ongoing basis because that is the focus of the business people. The people making the decisions are looking at the synergies going forward and the benefits of doing the deal. The reps and warranties are often the protection for a lot of the problems that are coming up. The problem is that they are negotiated, often as a separate process, apart from the people doing the due diligence. That just doesn’t come together. The information may be there but the deal people who may spot a problem simply are not looking at it. Reszutek: I agree that the number one issue is the deal environment, which creates a lot of downward pressure on the level and scope of due diligence. I also think that one of the other factors in recent years has been the increase in stock market valuations and the pressure on companies to meet analysts’ expectations. There is a lot of pressure on a company to manage earnings. Those are the kinds of problems you would hope that due diligence would uncover, but if there is downward pressure on the level of due diligence, it is less likely that you will uncover them. One of the most important factors in the whole equation is having a buyer client that is willing to make sure that the right things happen and that the right amount of time and attention are spent to get the job done. Musher: I agree with what has been said about the lack of time and the pressures. People often see just the company and the financials and think about what might happen but they don’t always go all the way through to the products and the sales people and the other key factors that make a company work. It is surprising, by contrast, how much time the investors on the Street spend checking out these things. Simonson: I am not sure whether there are greater numbers of problems than there was three or four years ago. I think that the process for doing due diligence and negotiating deals hasn’t changed all that much. While one could argue that it is a little faster now, I am not sure whether that really causes a greater number of problems. You see more litigation now and more acquirers getting into trouble because we are in a down market. In an up market, all things are forgiven. There are very few mistakes you can make when the market is valued on, say, top-line revenue. However, when the market goes down, you get punished – both in terms of your ability to raise capital and on the market price of your stock. I think that we are seeing deal-related litigation because in many recent situations, one party or the other to the deal ended up in financial difficulty, although not wholly as a result of the acquisition. These companies take legal action even though it is embarrassing for them to say that perhaps they bought the wrong thing. They feel compelled to sue because the general market environment is much more difficult. People need to keep in mind that most deals that fail or don’t provide value to an acquirer don’t fail because either the price was too high or there was some hidden bombshell. Those things happen, but they are very rare when you consider the thousands of deals that are done every year. The failures, for the most part, are due to a failure in the postacquisition integration, and one of the things that you can do to make the due diligence process more valuable to clients is to coordinate due diligence with integration efforts. The more you know about the company, its employees, the state of its intellectual property, the state of its contractual relationships, and other factors, the better off you are. Don’t just read the contract to see whether a consent is required. Understand it. Understand the party on the other side and share that information – not only with the deal team, which is reviewing and negotiating the reps and warranties, but also with the rest of your client’s integration team so that when the deal closes they can hit the ground running. If it takes three or four or five months after closing for the integration team to get a sense of what they bought and what they have to do, the market opportunity that the deal represented can be completely wasted. Calabrese: There hasn’t really been a slippage in the due diligence process. Most mergers that don’t succeed fail because of the integration. I think it is fundamental to the due diligence process to marry the integration with the core analysis. Buyers should have the patience to look at it and be disciplined against a deal environment in which everyone is trying to do deals quickly and to gain synergies that just weren’t there. Ross: We need another arrow in our quiver. Legal and financial due diligence alone is not providing the assurances that investors are expecting. When I ran a law firm I found that there was a gap between the expectations of the investors and the responsibilities of the law firm and the auditing team. As lawyers, we were charged with the responsibility of determining whether there was any legal impediment to the transfer of assets. We were not charged with investigating any of the underlying facts unless we saw a red flag. The auditors had similar limitations on their responsibilities. To put it bluntly, the lawyers and the auditors were not responsible for looking where they walked. But if they stepped in it, they had to clean it up. Neither the law firms nor the auditing firms are properly staffed to investigate statements of fact. About 10 years ago I looked at this due diligence gap and saw that the solution would be to use research analysts and licensed investigators trained in the methodologies of developing facts. This kind of due diligence is neither legal nor financial. At Ross Financial Services, we refer to this investigation as either “investigative due diligence” or “acquisition intelligence.” M&A: What is all of this telling you about the areas where due diligence investigators should be looking harder? Are there any significant new methodologies that are refining the state of the art? O’Neill: We talked about speed and why some of these bad due diligence things happen. But every single industry has its own risks. We need people that are skilled in doing due diligence, not skilled in doing auditing, and they need to understand the industry in which they are working. At Arthur Andersen we have industry specialists and we have templates that we work with that point out the risk issues we are likely to see in a due diligence. We have to drill down from there. So if we are working on a pharmaceuticals deal, for example, we need to understand what the new products are, how long it will be before they will be ready to go to market, and what the cost of getting them to market is. If it’s a technology deal, we are looking at the advancements in existing products and what the customer acceptance of these products is. Cash flow may be king, but don’t loose sight of the balance sheet. Are there inventories on that balance sheet that are higher than what you might expect to see given the level of sales? What about reserves on the balance sheet? The whole area of revenue recognition plus capitalization should be probed. The accounting rules are certainly not the be-all and end-all in doing the due diligence, but they provide a sort of fence around what you are looking at. Again, we need to drill down. You can’t be stuck talking just to the senior-level people at the target company. You have to speak to the audit firm on the other side. They have a different focus in auditing than we do in due diligence, but you need to understand what they have done, what adjustments they have passed, and why they passed them. You need to talk to the people in the trenches. What are they doing? What direction have they gotten from top management? All of these things are important to understanding the business and to understanding the cash flow aspects. Ross: I would like to give you an illustration that demonstrates the difference between legal and financial and investigative due diligence. We had a situation in which a software company was distributing its products through distributors to retailers. The contracts required the distributors to pay when the software was shipped. The software company’s law firm looked at the contract and said it was valid and that sales are really occurring when the software is shipped. The accounting firm went along and, applying the “all events” test, permitted the company to accrue income when the software was shipped. We took a look at what was actually happening and we found that the distributor had so much power it could do anything it wanted. It was not actually paying when the software was shipped; it didn’t feel it had any responsibility for that software, and if the product didn’t sell at the retail level, it was sent back. I have asked people at the SEC and I have asked accountants whether it is proper to accrue sales according to contract terms that both parties are ignoring. Everybody gave me a “well, it depends” or an “I don’t know” answer. But the truth is that it was very important to our client, the buyer, because the accounts receivable of the seller were growing at a very rapid rate when compared with sales. O’Neill: I had a similar situation in which the words on the contract indicated very specific terms as to delivery, payment, and the like. When you looked at the accounts receivable, the customer didn’t pay. Clearly, something was not making sense. There was a binding obligation to make a payment, so why wasn’t the payment made? When I asked about it, I was told, “We have a side deal, and that side deal is just as much a legal binding contract as the written contract.” If you don’t dig down and ask those questions you are not going to discover things like that. If you knew all of the facts, you wouldn’t have booked the sale to begin with. These are tough issues, but you just have to keep your eyes open. Reszutek: To tie that together at the end of the day, it is absolutely critical to have the right combination of deal experience and industry expertise. That doesn’t always reside in the same person. Regardless of the time frame, we need to be more thorough. The time frame in a typical transaction is not going to expand greatly. These things run in cycles, and perhaps the pendulum is swinging back toward being more cautious and taking more time. But you are never going to have enough time to get two and three bites of the apple. So it is absolutely critical to have people involved in the process who will ask the right questions and do that drilling down at the first opportunity. M&A: How has technological advancement affected the investigative process? Are there technologies that have helped you in conducting investigations and, by contrast, are there technologies that have made the job harder because they allow important information to be hidden or disguised? Blitz: Technology has provided much greater access to information. It is much easier to transfer information from a seller to a buyer without going to a document room. The sellers tend to have more documents and information in a form that can be easily transferred without someone standing endlessly at a copier. Documents also can be posted to a Web site. The technology is wonderful. The downside is that there is more information to cut through. Having more and more information provided sometimes makes the job that much tougher because important data does get lost in the piles of information. Ross: One of the great disappointments I experienced when I left the tax profession is that I was not able to get off the treadmill of constantly updating my expertise. When I got into investigations, I thought that I would be dealing with a fixed body of knowledge, but there are tremendous hays-tacks of information available, and very few of them contain needles. Our job is to go through all of those haystacks cost-effectively and pull out the needles that are needed by our client. It takes a lot more time than I expected to just stay up on the latest Web sites, what the proprietary databases offer, the nuances of search commands, etc. The technology now available is wonderful for gathering information, but I have to stay on top of investigative techniques with the same determination I had to employ to keep up with the tax code. Musher: We are getting tremendous leverage with the technology that is being used for finding out early what is going on with the customer base and what customers are buying and selling. We can use simple survey software or sensitivity software and use the right tools to train our folks to feel comfortable with it. We found that we can handle projects where we have to talk to a couple of hundred customers and competitors over five days and turn the aggregate data into real-time analysis quickly. Part of the process is to make sure that your team is built to circle back to a management team. If they find a problem a day or two into the analysis, it can get floated up to management so they can address it. Those are pretty useful things to keep in mind to be in sync with the technologies. O’Neill: At my firm, technology has helped us in a couple of ways. We have a huge database of best practices and benchmarks and they are broken down by industry. It is not a substitute for thinking but it has been very helpful to our people. In addition, we have data analysis specialists. You give them information electronically and they can slice it and dice it in any way. You can find out if there is concentration in customers or suppliers or you can get information on product line profitability that the target company may not have. For example, you may find out that a particular supplier is pretty critical. When you dig deeper into that supplier, you may find out whether that supplier has the financial wherewithal to continue delivering the raw material or whatever it is that makes this particular target go. The ability to get at all kinds of information that the target doesn’t readily give to you is essential. M&A: Is there anything new coming along in the area of regulation, particularly as it deals with risk management, such as pensions, the environment, and things in that sphere? Simonson: Looking at your question strictly from the m&a lawyer’s point of view, I would like to think that we are going to get a little bit more strict construction of the new class action securities laws that were meant to cut out some of the silliness that often goes on in securities litigation, particularly cases related to m&a deals. In addition, we have a new administration that at least looked in the campaign like it was going to do something about tort reform. One of the frustrating things that I find in my practice is to have to explain to a party in a takeover – particularly in a public company context – that there is a high likelihood that no matter how careful it is, no matter how smart it is, and no matter what kind of record it has, there is going to be some sort of litigation. There is a large number of what I think are strike suits. It is an organized shakedown racket, very often done by very powerful and very politically connected firms, including firms that were very politically connected to the past administration. Aside from the federal securities litigation reforms, I don’t think that in the previous administration there was any real credible effort to try to curb litigation abuse. Whether we get something beneficial out of this administration is an open question. I think it could only be a good thing. I am not sure whether all my colleagues necessarily agree with me, but as someone who does transactional work and has seen the nature of many of these lawsuits, it is extraordinary to me that people can file lawsuits based on interpretations of words in plain-English documents that are so twisted and strained in order to suggest that there was a misstatement. Some day we may see a change of the tide on that. I haven’t seen it yet. I can only hope for it. Ross: Not that many years ago, Rule 11 of the Federal Rules of Civil Procedure was rendered toothless by an amendment. It seems to me that, as a disincentive, what we need is some kind of a federal statute, and maybe state statutes, that put the burden on parties that bring strike suits. M&A: The SEC recently changed the rules on revenue recognition and pooling-of-interest accounting is headed out. Do these issues have any effect on your investigations? Reszutek: Revenue recognition probably is the single most frequent issue that has come up on transactions. It is present in virtually every transaction as an issue that requires further investigation. It is mind-boggling to many who aren’t involved because it seems like the simplest thing in the world is to recognize revenue at the proper time. If you just ask the question, “What is your revenue recognition policy?” you are going to get an answer that sounds like the policy is in accordance with the rules. It’s almost guaranteed that you will get that answer. It is the next step you take and the following steps that make all the difference. Another development at the SEC is that we are going to have a new chairman. Some people think that maybe there will be a more business-friendly or registrant-friendly environment at the SEC, but people overlook that as a sort of byproduct of the slowdown in the IPO market; the SEC staff suddenly has a lot more time on its hands to look at recurrent filings. I think that the ratio of regular annual filings that will be looked at in detail is going to change from one out of 15 to one out of five – without any change in staff levels. Despite the change in administration, which most people assume will be more business-friendly or more relaxed, I think you might actually get the opposite trend. O’Neill: That accounting pronouncement is not really anything new. It codifies a bunch of rules that were in different places and puts them in one place. But it also provides very specific implementation guidance. Internet companies didn’t think that it applies to them, but it is clear that it does apply. There is now a set of rules that have to be applied by everybody. This specific guidance is very helpful. They are not new rules but they have created a consistency in the marketplace as to how to apply the rules. M&A: Are there any new developments in buyer protection features in the deal structure, such as escrows or baskets, or any innovations in this part of a deal? O’Neill: In buying service businesses, there are going to be earn-outs all the time. You don’t know what you are buying so you want to have a situation in which you tell the seller that if it earns the revenue, you’ll pay it the money when it earns it. I see earn-outs all the time in the service business. I am seeing fewer escrows. That goes back to the need for speed in due diligence. You don’t get to drill down. The buyer shouldn’t be quick in that situation, but that is what is happening in an auction process. As a result, I am actually seeing less escrow. M&A: Is that typically a part of an auction – that the buyer will waive some of these surety features? Blitz: It depends on negotiating power. If you have a seller with a company that buyers want and more than one buyer wants it, the seller can dictate all sorts of things. Simonson: It also depends on both the company you are buying and its stockholders. If the company is owned by one or two people, an escrow can be helpful. But if you know where they are, you get your money back. It sometimes adds unnecessary complexity to a deal and you have to pay escrow agents. It can be a big pain in the neck, in my opinion. However, even a private company could have 100 to 200 shareholders – particularly in the technology area, where employees and ex-employees could be stockholders. There is no way to enforce an indemnity obligation unless you get everybody to sign the merger agreement – something that is never going to happen with 100 shareholders. In those situations I still see a lot of escrowing – involving 10% or 15% of the aggregate consideration. It creates deal complexity and other issues for negotiators, such as how you value the shares coming out of escrow compared with the liability. It raises a lot of issues. In the public company context none of those things work or are accepted. You occasionally see a device called the contingent value right, or CVR, which is sort of like an earn-out for a public company, but it is very, very rare. In the past few years I suggested it to clients on the buy side two different times and in both cases the seller shot it down. It raises problems that are more unmanageable in a public company context than in a private company context. After the deal closes, there is a new owner and the issue is how to ensure that it is going to operate the business to maximize the value of the CVR as opposed to some other corporate strategy. Indemnities and escrows and all that stuff really sound great and give some protection, but if you are buying a closely held company, you are really buying the employees. That is a major key to value, particularly in the tech area, where you don’t really buy anything else. If these people are going to be your managers and are going to be the people who will create the wealth to justify the acquisition, the idea of saying to them that they will be sued for indemnity is unthinkable. It is not a way to motivate your employees. There is limited utility for these kinds of devices. Obviously, indemnities and escrows are helpful if there is a real meltdown. But a 10% holdback on a real meltdown doesn’t make you whole either. Reszutek: We are also more frequently seeing additional due diligence or more detailed investigation into issues between signing and closing as a way for buyers to achieve a greater level of comfort but still reach terms quickly. That always used to be a sort of perfunctory exercise in the past. But I think now, given the pressure on identifying the winner of the auction or coming to terms in a short time frame, more of this work gets done after the fact. At the end of the day there are lots of clever ways to protect a buyer – whether by earn-outs, holdbacks, or various escrow or contingency mechanisms – but if you don’t get it right at closing, you are almost surely going to lose no matter what your protections are in the agreement. M&A: What types of protective products are being offered by the insurance industry? Calabrese: There are three categories to talk about. One is the reps and warranties product, which is utilized by both buyers and sellers to help facilitate a transaction. Another is environmental liability insurance. It has been around a long time but in the last three years there has been a growth in the category because of more competitive pricing. More carriers are willing to offer that coverage, and they show flexibility in structuring. You can get up to 10 years of coverage on certain environmental liability policies. Another kind of insurance is the loss-due-to-litigation policy. If the seller faces existing litigation or an existing claim, the acquirer can buy additional coverage to protect itself from coming into a securities class-action suit, for example. Blitz: These insurance products are true innovations in how deals are structured. They are allowing for an increase in the liquidity of the seller. They are permitting a buyer to ask the seller to put less on the table, whether it is as an escrow or an indemnity or how long the seller will be kept on the hook to make up for a breach to a rep or warranty or a tax problem. We have seen all sorts of interesting structures that have incorporated the insurance in the divestiture and the auction contexts. Another type of coverage is tax insurance, which allows deal parties to transfer the risk of a tax exposure. There is a similar application in the regulatory area where the insurers have been willing to pick up, for example, antitrust risk or FDA risk. These are custom-molded products. When they fit, they can change the whole dynamic of a transaction. M&A: Beyond the basic financial and operations issues, some unusual problems are surfacing in connection with acquisitions, such as predatory lending in financial services, irregularities in health care, and even questions about whether foreign buyers did business with the Nazis. Are these coming on to your radarscope now and, if so, how do you get at them? O’Neill: Generally, the quality of due diligence is directly related to the access to information that you get. It is in the buyer’s best interest for you to get as much access as you can possibly get. So the net should be spread as wide as possible, relative to the cross-benefit. We can help the buyer determine whether access is good enough. The seller should not object to this, as long as we are not getting in the way of how the seller operates its business. I would say to spread that net wide and far and focus on the key areas that you find as you drill down. Blitz: In some of these cases, it is not so much a case of not finding the information or not knowing of the problem. It is a matter of stepping back and effectively using your due diligence to size up what a company is going to look like after an acquisition and how some of those problems might be viewed in the context of a bigger, more high-profile organization. Ross: We have developed a methodology that sidesteps the tremendous pressure on due diligence from the letter of intent to the closing. We try to get our clients to start with acquisition intelligence before they fall in love with the deal, and we have divided acquisition intelligence into three steps. The first step relies primarily on public information and occurs before the other party even knows of the existence of the buyer. The second step in the methodology takes place during the negotiation process. You already have the publicly available information gathered in step one, which is used to focus questions that clarify your understanding of the business. By the time you get to that stressful third step, you can rely on the body of knowledge you have gathered. Thus, when the letter of intent is signed, you have a running start. You have a real perspective, developed over a much longer period of time, to use as a tool to analyze the seller’s documents. Not every client is willing to follow this three-step methodology, but those who do save themselves a lot of heartache. Musher: People aren’t really going to acquire companies that are totally new to them. But a good source of additional information involves people like former employees of the target who know what is going on at the company. So we spend time identifying these ex-employees who still worry about the company and give their names to the acquirer’s deal team. We suggest that they be contacted and told that someone will interview them and ask them about all the spiders and snakes in the closet that they know about. We put them on a list, prioritize them, and give the names to the deal team. That goes beyond access to just the top-level people and gets you to the mid-level folks who will be able to tell you what they know. M&A: How do you go about checking out the target’s executives and their reputations when there are suspicions about the way they operate or when they have consistently issued forecasts that don’t pan out? Simonson: If there are executives who have had bad track records of predicting how well the company is going to do, the markets take care of that with brutal efficiency. If you are buying a public company, you are acquiring it in relation to its market price with a premium. The markets are pretty wise and, in fact, they might even overreact to that sort of thing. There is a limit, though, as to how far you can dig. It is particularly difficult in a public company context. We have talked about talking to the lower-level employees, but I advise my sell-side clients to absolutely prohibit that sort of thing. There is a danger of selective disclosure and insider trading, and it can create real liability. It also depends on who people are talking to. There are lots of people in any large organization who think that they know everything and are always really happy to tell everybody about it. They are usually malcontents who are pleased to point out problems and screw things up. You ought not to hide information. That is wrong and it may be fraudulent. But you can’t give an acquirer the right to just walk down the hall and talk to anyone. That person may know less than someone else may. He may have an ax to grind, and he may even have an aunt in Dubuque who has an offshore account in the Bahamas and is making a lot of money from call options. Frankly, I think the answer is not to dig that deeply in a public company context before you sign but to do the best you can and to price the deal so it includes uncertainties. In the tech area, you have no idea what the market is going to be for the particular product you are creating when it finally comes out in two years, so you have to discount that. Will one kind of optical switching component work better than another? Nobody is ever going to know those kinds of answers at the time of the deal. In new and rapidly advancing areas like biotechnology, telecommunications, and software, you can’t market test any of this stuff right now so you need to discount it and come up with an intelligent pricing. I am not sure that there is a better way to deal with it than that. Musher: I wouldn’t go out there and talk to everybody all the time. But if you talk to only the top five or 10 people at the seller and somebody doesn’t give you access to something, you may have to do more. Our job is to go out there and talk to everybody we need to in order to find out what is going on. We make sure to discount the information when it appears that somebody has an ax to grind. Sometimes, however, the extra research shows that there may be some problems that the sellers did not make you aware of. You can bring that back to the buyer client and say that there is a market problem or a sales force problem that needs correcting. They can use it to their advantage when negotiating. Simonson: We also try to get access to the target’s customers and their suppliers. They are going to give you the real story. Everybody thinks that he or she is doing a great job in his or her job. If we all evaluated ourselves we would say that we are brilliant and it always would be somebody else’s fault when something goes wrong. Someone else can have a different view. Talking to customers can be an effective check on whether the target is really servicing the market. It’s sort of soft information but may be more important than the hard information when you value the company. Are these people good to their customers and suppliers or are they not? M&A: When you do hit problems, do you find that they are the more traditional types of balance sheet or P&L problems or are there some new gimmicks that are coming up to challenge you? Ross: More often than not the misrepresentation is not made by someone who is deliberately being dishonest. It is made by an entrepreneu