Scenario Planning Can Help Buyers Nail a Good Price: The exercise forces acquirers to consider various “what-ifs” and the value implications of those scenarios

Buyers’ acute sensitivity to deal overpayment has led many to dig deeper in due diligence and take more time crunching the numbers. Acquirers want to make sure they have realistic expectations of synergy benefits, a good handle on anticipated revenue streams at the target, and a solid estimation of the value of the target’s assets. A buyer may be able to estimate these values quite accurately, but even the savviest dealmakers can’t predict the future with 100% precision. Unforeseen events like a changing regulatory environment, competitive responses to the deal, and technological advances in the target’s industry could ruin even the best-priced deals. But just because certain events may be beyond a buyer’s control doesn’t mean that it shouldn’t consider how market and business dynamics could impact the target’s future performance and results. Acquirers may find “scenario planning” – an exercise that considers a series of possible outcomes by taking into account a wide range of potential future developments and forecasting their effects on performance – useful in deal valuation. Everything from competitive reactions to the deal to industry innovations can be incorporated into pricing models to generate possible post-closing scenarios, helping buyers to better price their deals by making them consider various “what-ifs” and the value implications of those scenarios. The mechanics of scenario planning are straightforward. The buyer would sketch out each possible scenario, forecast the cash flows associated with each scenario, value each scenario, assign a probability to each scenario based on the likelihood of it happening, and then multiply the value by the probability for each scenario. The buyer can identify the most likely outcome and price the deal accordingly. Relying too heavily on the assumption that history tends to repeat itself and making projections based on a target’s recent growth levels is one of the biggest errors in judgment buyers make, notes Pat Donoghue, a Managing Director in the New York office of Standard & Poor’s Corporate Value Consulting. Considering future dynamics and pinpointing the most likely deal paths is very helpful in acquisition planning and pricing; in valuing deals in emerging industries, in which technology may be evolving rapidly, distribution channels may not be fully established, and revenue flows may be inconstant, it can be critical. Some degree of scenario planning should be – but often is not – a normal part of the deal valuation process, notes Michael Kollender, EVP of Ryan Beck & Co.’s middle-market banking group. In some cases, buyers do consider different scenarios, but they’re less likely to place probabilities against each scenario and then value them on the basis of those probabilities, says Ian Cookson, Corporate Finance Director at Grant Thornton. Keeping the deal process flowing often precludes elaborate scenario planning, which can result in “analysis paralysis” if taken too far. “In going through a Monte Carlo simulation, you end up valuing an amalgamation of scenarios, and aggregating them into one outcome that will not actually occur,” says Cookson. Therefore, he adds, it “makes sense to look at the possible outcomes and think of them in terms of: * Placing bets: If you can buy the business at the value of the most likely scenario and the downside risk below that is low but the upside potential is substantial, with a reasonable chance of success, this may be a bet you are prepared to make. * What you can do to change the probabilities: What actions can you take as a future owner to improve the level of cash flows or increase the likelihood of success? * Deal structuring: Can you structure the deal so that you pay one price in the event that one scenario occurs and a different price in the event of another scenario taking place, e.g., by negotiating an earn-out or deferred consideration?” Copyright 2004 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com