By Bill Vinck, Excendio Advisors
Background
It is sadly commonplace to notice that many M&A endeavors fail to achieve the results sought. Often the integration of the acquired firm is mentioned as a cause of the failure. The integration may have been poorly planned or poorly executed. Perhaps the synergies believed to be available proved illusory. The imagined expense savings presumed a rapid and successful integration and, failing that, savings became overruns. Short time horizons to realize benefits became longer and longer. Executives touting synergies found other subjects to discuss.
Before the transaction is completed, the executive team advocating an M&A transaction may be asked by their board, their investors or their bankers to comment on the risk of the deal. How do they typically respond? They can say that they have a very detailed due diligence process implemented by a highly experienced team. They may compare this transaction with a similar ones in their experience. Their attitude is confident. Risk is under control and major concern is inappropriate.
These are standard types of responses. They are also deceptively subjective and are versions of “trust me”. This article suggests that one can look at business integration disappointments and often find a basis for that disappointment in an incomplete due diligence attitude. The word “attitude” is used rather than “process” because we’ll argue that the process may be adequate, but it was implemented with an inappropriate understanding of what due diligence is and how it should be conducted. The attitude can be seen as compliance oriented and drawing comfort from completed check lists. The answer to the “risk of the deal” question is that the due diligence checklist was completed. The unarticulated premise is that completed due diligence checklists move risk to unspecified but acceptable levels. But is that unarticulated premise true?
This article suggests that the premise in question is neither true nor relevant. What is needed is an approach that is quantitative and objective. This approach, properly implemented, gives the acquiring firm the ability to quantify the risk they are assuming and, therefore, draw the appropriate conclusions about the risk they are assuming.
What is Due Diligence?
The typical approach to due diligence can be seen as a compliance-based approach. It is an exhaustive roster of items to check. An example would be the company accounting policy manual. The due diligence check list tells the analyst to see if such a manual exists and to request a copy. At that point, this item may be considered complete. Perhaps someone will read it; perhaps not. This topic may be considered closed because the acquiring firm plans on only using their policy manual and approach.
Dropping down a level or so of detail may additionally require a review of specific accounting policies such as the bad debt policy or the cash vs accrual accounting policy. This review may result in a similar conclusion to adopt the acquiring firm’s policies.
The integration plan has a line item added to “adopt the acquiring firm’s accounting policies in the acquired firm”.
A Different Approach
Consider adopting the idea that due diligence is better termed M&A Risk Management. On this view, one looks at the relationship between items on the due diligence checklist and their occurrence and importance during business integration. In the process of so doing, several sets of questions are asked:
Timing:
How will this topic impact the integration schedule? The plan has probably specified a date by which both firms are following the same accounting policies. If the date is missed, how are operations conducted? What will be the customer impact? The client impact? in terms of timing and expense? In this accounting policy example, we make assumptions about the ease of transition. What if we are wrong? What are the major sources of error in our assumptions? How likely are they to occur? How can we predict their occurrence? How probable are they?
For example, are there clients who would object strenuously to a change in accounting policy? How strenuously? Would we be forced or encouraged to maintain two different policies rather than risk losing this client?
Expense:
Delays in timing add additional expense. The transaction is built on a set of, among other things, financial assumptions. Integration timing and expense disappointments threaten the investment thesis. How much of a threat can be tolerated?
Impact:
Having discovered the possibility our assumptions have a greater than zero probability of error, we must consider the magnitude of that probability. We must develop a data driven analysis of various risk scenarios with an associated probability.
As important as probability is, the magnitude that error is as important. A 10% probability of a $20,000,000 error gives anyone pause.
Risk Quantification
In our example above, we have made a major change in our approach to the accounting policy manual due diligence task. We have added a review of potential risk scenarios and developed a data driven set of probabilities with associated financial impacts. We have looked at impacts for all due diligence items in terms of time, expense and probability. Our risk can now be specified in total. This review has given us a number (or a set of numbers) to review with those who ask us about risk. We have moved beyond a compliance based “trust me” model to an objective analysis measured in dollars and time. By so doing, we have added muscle to due diligence and probably have a new perspective on the wisdom of the proposed transaction.
Now take every item on the due diligence check list and perform the same analysis. Time consuming? Yes. But at the end you can tell stakeholders in mathematical terms the risk they are assuming. That’s the managerially responsible thing to do. It may even prevent a problem.