In his book Big Deal, Bruce Wasserstein identified multiple forces driving organizations to pursue a growth through acquisition strategy. Wasserstein’s list included regulatory and political change, technological change, financial change [at the macro and micro levels], leadership, and economies of scale1. However, despite the continued pursuit of corporate growth through acquisitions, many academic studies have documented how merger and acquisitions often appear to destroy shareholder value. But why? Is it that acquiring other companies is an inherently flawed strategy or is it simply a poor execution of a good idea? Additionally, if so many transactions fail to meet expectations and the root cause is not the concept of mergers and acquisitions in itself, but merely the execution, why is poor execution so prevalent in the business community? In their paper, “Why Do Mergers and Acquisitions Quite Often Fail?” T. Mallikarjunappa and Panduranga Nayak identify more than 20 common reasons for poor results from pursuing an acquisition strategy.2 These causes can be summarized into four broad categories: Strategy flaws, poor internal transaction process and execution, inappropriate price and structure, and an incomplete due diligence on the target company. Baker Tilly’s experience has led us to believe that, assuming the strategy was not flawed from the outset, the transactions with the most thorough due diligence have ultimately had the most success. The utilization of information gathered from due diligence can not only verify the target company’s economic earnings but also validate the investment thesis as a whole and lead to a more robust post-transaction plan that, when vigorously executed, can significantly increase shareholder value.
More often than not, financial and accounting due diligence is executed to verify the quality of earnings. In addition to the audit-like procedures that an accountant may perform as part of the confirmatory due diligence process, analytical procedures are often applied, which are designed to raise questions challenging the quality of the earnings of the target company.
The quality of earnings is measured by how closely the chosen earnings metrics reflect the sustainable cash flows that are generated from continuing operations that become available to relevant stakeholders. Earnings before interest, tax, depreciation, and amortization (EBITDA) is frequently utilized as a primary measure of economic earnings. EBITDA, while easy to calculate, has some inherent flaws. Unless the company has no working capital, no fixed assets, and does not need to pay income taxes, it may not reflect the cash flows that will be available to service debt or distributed to equity holders.
The quality of earnings analysis usually starts with a top-down study of the income statement. An investigation of sales includes the following: proper revenue recognition, the risk of sales, volatility of sales, verification of the revenues, and sustainability. The gross margins, operating margins, and the operating risks are investigated next by analyzing the utilization of standard costs, an analysis of excess and obsolete inventory, an analysis of the cost structure of the company, and the trends and relative relationships to operating activities in the sales, general, and administrative expenses. A “bridge” analysis is often utilized to determine how sales, gross profit, and EBITDA changed between periods and why.
In the case of a closely held business, a seller will often want to extract value from the purchaser for “discretionary” expenses that a potential buyer would not need in the post-transaction company. As part of the quality of earnings process, these “add backs” are analyzed to determine if they truly merit being added back to the reported EBITDA. However, the financial analysis should not stop there as a significant portion of the cash earnings from operations can be tied up in working capital or committed to funding the necessary replacement of fixed assets. To capture these significant components in cash flow, EBITDA should be compared to free cash flows. Free cash flows is calculated as EBITDA, plus or minus the change in net working capital, less net capital expenditures, less cash taxes paid.3
FCF=EBITDA±NWC-Net Capex-Cash Taxes Paid
For our purposes, net working capital would not include cash or funded debt. Capital expenditures should only represent normal replacement of fixed assets. Additionally, capital expenditures should also be presented net of the cash proceeds from retired assets.4 EBITDA, free cash flows, net income, and cash flows from operations are then compared over a reasonable period. If these earnings metrics move together over time, the company’s earnings may be considered to be of high quality. If however, there appears to be no or a low correlation between these metrics then the earnings are often considered to be of low quality and further investigation is usually required to determine the root cause of the deviation.
Often confirmatory due diligence exposes issues such as obsolete and excess inventory. While the presence of excess and obsolete inventory may result in a purchase price adjustment, confirmatory due diligence does not necessarily address the flaws in the systems, policies, or procedures that allowed the problem to exist. Many of these causes would be uncovered in an operational due diligence.
Information technology, as another example, is a critical strategic element of any operation. Unfortunately, many entrepreneurs view systems as an unproductive overhead. The ability to obtain accurate and timely data on any operational aspect of an organization is necessary for management to make timely and informed decisions and is, therefore, a critical strategic asset. Ineffectual reporting systems will reflect poorly on the management team.
Information technology due diligence should include an assessment of the current system’s capacity, security, and the capabilities of the administrator and any outside consultants. This sort of analysis can lead to the discovery of issues such as limited capacity and subsequently the need to make a significant investment in an upgraded system.
Yet another example of an operational issue is the marketing, sales, distribution, and customer service effort. A voice of the client survey can measure the customer’s purchasing decision-making process, the perception of the company relative to the market, loyalty of the customer, and the anticipated future purchases of the customer. This sort of analysis may highlight shortcomings in the company’s current sales and marketing effort or uncover a heretofore-unexploited opportunity.
Once the buyer has gathered all of its confirmatory and operational due diligence, they need to synthesize this information with knowledge of their own organization and the industry in which they operate. Put quite simply, if an organization does not know what they are going to do with an acquired company on day one, then why did they buy it? The post-transaction plan should include near-term, intermediate, and long-term objectives; capital needs; human recourse needs; technology needs; and operational needs, including leveraging the respective capabilities and competencies.5 The plan should include an operational and capital budget and a timeline with milestones. The plan should also address how policy and procedures will be integrated. Senior management should assume responsibility for coordinating and resolving any conflicts of the different managers’ perspectives within the context of available resources.
A successful transaction has many critical aspects. It is essential to take a comprehensive approach to due diligence and respond appropriately to the results. By coordinating the confirmatory and operational due diligence and actively involving the management teams of both the buyer and the seller a company can develop a post-transaction plan that provides the best opportunity to fulfill the promise of the deal.
For more information on this topic, or to learn how Baker Tilly transaction specialists can help, contact our team.
1Big Deal: The Battle for Control of America’s Leading Corporations; Bruce Wasserstein; Warner Books, Inc.: 1998; Page 2- 6.
2“Why do Merger and Acquisitions Quite Often Fail?”; T. Mallikarjunappa and P. Nayak; AIMS International; Vol. 1, No. 1; January 2001; Page 53-69
3Valuation: Avoiding the Winner’s Curse; Kenneth R Ferris and Barbara S Pecherot-Petitt; Financial Times / Prentice Hall; 2002; Page 76 – 77.
4Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance; Charles W Mulford and Eugene E Comiskey; John Wiley & Sons, Inc.; 2005; page 370 – 372.
5 Managing Acquisitions: Creating Value Through Corporate Renewal; Philippe Haspeslagh and David Jemsion; The Free Press, 1991.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.