PROBING A TARGET IN A TOUGH M&A MARKET

The convergence of a drooping economy, diminishing corporate profits, and a profound sense of uncertainty triggered by the September 11 terrorist attacks has prompted many acquisition-minded companies to postpone or cancel their acquisition ambitions. Merger and acquisition activity, which already had been lagging the previous year’s volume by more than 50%, came to a virtual standstill in the first few weeks following the attacks before resuming a sluggish pace at year end. Dealmakers agree that uncertainty is the bane of m&a. And until the uncertainty subsides, they expect that the deals environment will remain rather listless. For the moment, many CEOs are hunkering down and focusing on their own businesses, rather than scouring the market for possible acquisitions. The economic slowdown – exacerbated by the terrorist attacks – has produced a level of uncertainty about the future for which m&a professionals say they have no real experience in factoring into decisionmaking and deal pricing. Many acquirers are finding that they can’t predict the targets’ earnings streams – which is what many deals are based on – with any reliability, so they are shelving their purchases for now. Yet for all the gloom and doom, buyers that are willing to forge ahead with acquisitions in this unpredictable environment may find this a good time to pick up sound businesses at attractive prices. Acquirers that had avoided doing deals because of high valuations may come off the sidelines and hunt for bargains. But for potential buyers, m&a mavens have a word a caution: The uncertainty arising from the economic slowdown and fear of future acts of terrorism calls for deeper investigation of a target before signing on the dotted line and parting with money. In the current, tough m&a market, the margin for error in deals is decreased, so buyers need to put maximum effort in up-front detective work, dealmakers say. And since there’s a dollar sign on virtually every issue probed during due diligence, buyers should not hesitate to use their due diligence findings to renegotiate purchase prices if they expect hefty post-deal costs in bringing the company up to snuff, they note. This renegotiation could involve a purchase price reduction or other deal provisions that shift risk from the buyer to the seller. Some of the areas that require a closer looking-over in this uncertain, post-September 11 environment are the target’s revenue forecasts, relationships with customers and suppliers, insurance coverage, security systems, and contingency plans. Companies that have been thoroughly investigating targets as a matter of course would have been probing these areas in past transactions, dealmakers say. But buyers that have skimped on due diligence will have to start kicking the tires a little harder. In crafting deals after September 11, Robert Filek, leader of multinational transactions at PricewaterhouseCoopers, says that his clients’ main concern has been how the terrorist attacks and resulting loss of confidence in the health of the economy will impact a target’s revenue streams. Buyers are trying to calculate any risk associated with projected income, and are taking a harder look at a target’s revenue forecasts because they realize that there is a possibility that an event could occur in the future that could negatively impact the company’s earnings, he says. In forecasting revenue, Filek adds, buyers have to decide whether they think the September 11 attacks are a “nonrecurring item” or represent a “fundamental change in terms of increased risk and uncertainty that impacts value” that dealmakers will have to factor into pricing models going forward. “I don’t see companies taking the attitude that this is a nonrecurring item that should be added back to the base earnings. I much more see a focus on getting a handle on the potential impacts going forward, because September 11, by definition, is not a nonrecurring event; we hope it won’t happen again, but there has been a profound change in the world in which we live today,” he says. Sam Rovit, a director and head of Bain & Co.’s merger integration practice group, agrees. He expects that dealmakers will begin factoring a random event into their scenario planning. “People will be more attuned to the fact that a random event of significant magnitude could happen, which would significantly change your business scenarios. You will have had to run the worst-case scenario, and make sure you have a contingency plan in place in case that event occurs,” he notes. In his work with buyers, Lindsey Alley, senior vice president of mergers and acquisitions at Houlihan Lokey Howard & Zukin, says that he is spending most of his time on trying to “box” the impact of the September 11 tragedies on a particular business – that is, to extract from a company’s revenue the losses it incurred from the attacks in order to determine the true value of the company. The biggest challenge he faces is convincing buyers not to pay a lower price for understated cash flows of a target resulting from the terrorist attacks. “We haven’t gotten to the point, though, where we are forecasting revenues using a worst-case, two-week shutdown analysis, trying to figure out what would happen the next year or the following year if that scenario were to occur again. That is something that the banks would more likely do,” he says. For strategic buyers, the long-term prospects of a target are usually so compelling that the past quarter’s revenue is not a big issue for those buyers, says Rovit. Not so for financial buyers. Uncertainty can be a deal killer for them, he says, because much of the valuation in financial deals hinges on the target’s recent earnings and on the revenues it is expected to generate in the first year or two after deal closing. Being able to determine how much of a company’s recent downturn in revenue is due to the September 11 attacks and to forecast how the business will perform over the next couple of years becomes much more important in financial acquisitions, he says. “Historically, we would have looked at revenue forecasts as a matter of course, but they have definitely been ratcheted up in importance now.” Part of the revenue due diligence exercise includes investigation of the target’s customer base and supplier network, says Greg Benning, a managing director and co-head of mergers and acquisitions at Adams, Harkness & Hill. Buyers must check out not only the target’s product market but also its customers’ product markets, he notes. “This is similar to what people were looking at with the Y2K issue when they were saying, If my customers aren’t being directly impacted, are their customers being directly impacted?’ Revenue and customer due diligence exercise is at a whole new level now,” he says. Instead of just looking at the target’s relationships with its suppliers and customers, buyers are more closely examining the target’s customers and suppliers themselves. “Where due diligence used to occur at 10,000 feet it is now occurring at 30,000 feet. Buyers are looking at more macroeconomic issues as they relate to how the companies’ suppliers and customers are positioned relative to the competition,” says Alley. Especially in a down economy, dealmakers note, it is essential that buyers keep in mind that the target’s customers and their contributions to the target company’s revenues are critical elements of value in a deal. In addition to checking out the financial health and market positioning of the target’s customers they suggest that buyers interview the target’s larger customers and determine their levels of satisfaction with the target’s products and services. Also, determine whether any of the target’s products or services do not meet their expectations and ask for suggestions for improving them. It is also essential for acquirers to check out the viability of the target’s vendors, dealmakers say. In particular, buyers should investigate the most critical vendors’ access to the raw materials and check out vendors’ pricing and procedures, they say. It is also important to look for compliance with government regulations, negative union actions, and pending litigation that could affect productivity or cause liability in the future. Another item that may have gotten only a cursory glance during due diligence before September 11 is the target’s insurance coverage. Not so anymore, m&a pros say. Saddled with huge losses from the September 11 attacks, many U.S. insurance companies cancelled terrorism-risk coverage on January 1. They had said they could pay the $40 billion or so in expected claims from the attacks but would not be able to support additional losses of that size without help. Government officials have been working toward passage of legislation to continue to provide terrorism-risk insurance for U.S. companies. Until a deal on terror insurance is reached, however, companies that were previously insured for damages resulting from acts of terrorism could find themselves with gaps in their coverage, notes Michael Calabrese, a managing director and global practice leader of the mergers and acquisitions group at Aon Corp. What was a “normal, covered event” in property insurance is no longer viewed by insurers as a normal, covered event, he says. Firms in high-risk industries or those with facilities in high-profile buildings or in volatile countries could be especially vulnerable to attack, and buyers need to keep that in mind when negotiating the deal details. If such a company with inadequate or no coverage were to be acquired, the buyer would be left to pick up the tab for any terrorist-induced damages that would occur after the deal closes. For any company that was severely impacted by the attacks, or could be affected by future events, its ability to collect on its insurance is a significant due diligence matter, says Bill Chrnelich, a partner in the transactions services group at PricewaterhouseCoo-pers who specializes in financial services. A target’s lack of coverage is particularly an issue in LBOs and other types of transactions in which the acquirer has financed the deal with some form of debt, Calabrese adds. “Banks normally require protection of the company and its assets in their loan agreements, so there could be issues with that,” he says. Terry Brown, a managing di-rector at Anderson Corporate Finance LLC, agrees, noting that people are much more focused on companies’ catastrophic insurance coverage. “Lenders are just not going to take the risk that there isn’t insurance coverage to protect the company. Determining whether the target’s assets are going to be covered for the duration of a loan or the duration of investment has been a critical issue that people are now focusing on,” he says. Yet, as important as the discussion of insurance coverage is, dealmakers warn that insurance can be cold comfort for companies faced with business disruption. They say that buyers should thoroughly examine the nature and extent of the target’s risks and determine whether the company has taken actions to safeguard against those risks. “As due diligence takes place in a post-September 11 environment, buyers are looking at business continuity and security of employees, facilities, computer networks, technology, and information with added vigor,” says Nick Galambos, head of the m&a practice in the automotive group at A.T. Kearney Inc. Colleague John Hoffecker, head of the global automotive practice at the firm, notes that in the past, “people tended to view security on kind of a point solution basis, but now they are looking at it on a more holistic basis.” Where before buyers may have focused on a certain facility of a target now they are scrutinizing a target’s entire security system and disaster recovery plan. Greg Peterson, leader of the private equity practice in the transaction services group at Pricewaterhouse-Coopers, says that he has noticed a heightened focus on security among his clients in recent months. “Before September 11, people weren’t too interested in security, unless they were dealing with companies in regulated industries or companies with trade secrets,” he says. “Now, if an acquirer determines that it likes a target’s business plan, it is opting to have the security checked out.” Peterson says he also has noticed that buyers are contemplating what the “next level” of terrorism might be and what the next weapon of mass destruction might be. Additionally, says Peterson, corporate kidnap and ransom (K&R) insurance has taken on new importance. Although most companies, as a matter of course, have long covered their higher-level executives against the risk of abduction, some firms are looking into expanding their coverage. Since September 11, companies seem to be taking their responsibility toward their employees much more seriously, dealmakers say. Over the past couple of years, underwriters have reported a sharp increase in claims related to abductions of corporate officers and other key personnel. Bill Nugent, a managing director in Kroll Inc.’s intelligence and investigative practice in Philadelphia, says that his firm, which has a robust transactional due diligence practice, has seen a tremendous surge in business in the past few months. He says that historically, companies have tended to look at security as a “cost center within a business.” Now he is seeing a shift in attitude among his clients, who increasingly are recognizing that lack of proper security can lead to potentially devastating business interruption. Colleague Howard Silverstone, a principal responsible for the forensic accounting practice in Kroll’s Philadelphia office, notes that companies are realizing that they are operating in a new environment and that they now must establish comprehensive contingency plans and consider new risks when making operational decisions. “It is clear, from the inquiries we have had since September 11, that what people really didn’t think about in the past when buying a company was security. Now it’s definitely part of the checklist when acquiring a company,” Silverstone states. Additionally, buyers should ascertain that the target has done complete background checks on its employees, Nugent says. During the last several years, when the unemployment rate was low, some companies hired almost anyone who appeared to be qualified, he notes. Few companies did full background checks on new employees, and often those new hires were given access to sensitive corporate information. Larger companies generally have in place comprehensive security and disaster recovery programs which include extensive background checks of employees but many mid-size and smaller companies have not implemented adequate programs, Silverstone says. “Take for example the recent mass shooting by an employee of Nu-Wood Decorative Millwork in Indiana. If I were buying that company three months ago I would have wondered if they had security in place and whether the company checks the backgrounds of all employees. It has taken these kinds of incidents for companies to realize that they should have a plan in place so that when they lay off 1,000 people, they have controls in place to deal with disgruntled workers. Acquirers that intend to lay off workers after deal closing especially need to consider this,” he adds. While many companies’ contingency plans focus on data recovery following an accident or natural disaster, businesses today will need to include in their disaster recovery programs procedures for recovering from an act of terrorism, including plans for business relocation, communication with employees, and other business continuity issues, Nugent says. Companies will have to regularly test and update their business recovery plans and be more cautious in their decisionmaking and due diligence, he says. The risks associated with physical and cyber attacks could easily become dealmakers or deal-breakers, says Galambos, depending on how the buyer views the security of the target’s assets and what levels of security the buyer expects. Though, as important as the topic of security is, Hoffecker believes that it’s mainly a negotiating point in dealmaking. “There are very few things that can’t be fixed from a security standpoint, but inadequate security may be reflected in the price paid for a company,” Galambos says. “Whether the issue becomes a deal-breaker depends on how tight the deal is. If it’s tight and you add on top of that the cost of installing a security system at the target or improving an existing one, that could be enough to break a deal.”