(TMA International Headquarters)
The use of the word “art” in discussing pre-acquisition due diligence may seem confusing, even odd, to some readers. But just as with constructing an investment thesis and execution plan for a special situations acquisition, there’s an art to executing effective pre-acquisition due diligence.
Every special situations investment opportunity is unique, posing particular transactional, financial, integration, and human behavioral challenges. As such, the art lies in taking a comprehensive due diligence template and effectively and efficiently customizing it to fit a particular special situations transaction.
Although this article discusses certain technical and technological aspects of executing effective pre-acquisition due diligence, it can’t pretend to teach the art of the process. The art manifests itself when discussing the theoretical objectives of performing effective due diligence in combination with providing practical examples of certain procedures that result in successful investment decisions.
Theoretically, the fundamental objective of pre-acquisition due diligence is to validate the investment thesis of a particular acquisition or transaction. However, a more comprehensive objective of pre-acquisition diligence exists. Utilized by certain special situations equity sponsors, these best practice due diligence procedures include investigations, analyses, strategies, and tactics relevant to the people and process decisions necessary to predictably close the transaction and integrate the post-acquisition 90-day business plan.
Although more difficult to execute, especially in scenarios involving uncertain outcomes (e.g., a Chapter 11 Section 363 auction sale), these procedures are essential to forecasting the likelihood of a successful return on investment. An acquisition that integrates pre-acquisition due diligence with a transaction’s closing and initial post-acquisition integration plan has higher levels of predictability and probability of success. To achieve this requires a distressed investor to develop a comprehensive understanding of the key qualitative and quantitative elements of an acquisition target—past, present, and future—especially as these elements relate to people, products, processes, trends, and markets.
Accurately predicting post-acquisition revenues and variable and fixed costs on both an accrual and cash-flow basis is one of the expected outcomes of executing best practice due diligence procedures. Achieving predictability is much easier said than done, but experienced special situations investors understand what factors addressed through due diligence drive a post-acquisition forecast.
What are the target’s distinctive capabilities in relation to its competition (e.g., its hedgehog)? Which products and customers, suppliers, internal processes, and people are critical to executing the post-acquisition integration plan? If the investment is an add-on acquisition to an existing industry or product platform, what synergies does it bring to the existing platform? Understanding key elements enables the acquirer to successfully flex the post-acquisition business plan to predictably exploit economic opportunities, including exit strategies, in both expansion and recessionary scenarios.
Of course, achieving high levels of predictability is impossible unless the numerous people decisions essential to identifying and underwriting the target, closing the transaction, and integrating the acquired asset are properly executed. What should the decision criteria be for who is on the pre-acquisition team? The transaction closing team? The post-acquisition board of directors and senior leadership team? What should the composition be between the acquiring sponsor’s investment partners vs. operating partners vs. the target’s management team vs. outside professional advisors vs. other players? These decisions have profound long-term effects on the predictability of an investment’s operational and financial performance, and thus investment values, under a variety of scenarios.
Understanding the respective performance goals for each of these positions; creating criteria and processes for deciding the initial who, what, when, where, and at what price questions; and establishing criteria to score and evaluate the respective performances of the people chosen should be established during the pre-acquisition due diligence processes. That there is an art to the making these critical people decisions is evidenced by the number of private equity sponsors that engage outside professionals to advise them on these matters.
For a special situations investor, the back office effectiveness of a company does not normally factor into whether the acquisition target is a valid prospect. However, the back office operations do affect an investor’s ability to retrieve and analyze core business data, the predictability of integration costs, and the organizational overhead costs. An investor can retrieve information regarding staff, software, hardware, and processes in cooperation with the target acquisition’s leadership during the pre-acquisition due diligence process. Performing a back office assessment is fairly straightforward as well, but getting the answers an investor needs from back office employees can be much more difficult during pre-acquisition stages.
What are the core elements of pre-acquisition due diligence an investor needs to understand from the business? Collecting key information to quickly gain control of the financials, cash flow, and operational costs [accounts payable (AP), accounts receivable (AR), general ledger (GL), and payroll] is paramount to making an investment perform.
Moreover, there are additional risks from an IT perspective that an acquisition investor should always be aware of, such as:
Collecting this information requires interviews with back office staff and up-to-date technical documentation that the investing team can review and analyze. The post-acquisition plan will call for either merging or optimizing back office operations, which could require the consolidation of software, hardware, staff, and processes. Determining what stays, what goes, and what will be “merged” is unique to each merger, and the special situations investor is right in the middle of that decision-making process.
The information that is gathered is very important to special situations investors because it enables them to take control of the company once the transaction is complete. Being able to control AR, AP, and GL within the first 30 days after completing a transaction allows an investor to control the cash flow and therefore the company.
Accessing information regarding a target acquisition is imperative to due diligence and post-integration processes, but special situations investor often approach these tasks differently. The amount of information that an investor receives and how easily it is obtained often depend on the “likability” of the investor and his or her willingness to work together with the target acquisition. Analyzing information is a straightforward process, but requesting and receiving necessary information is an art form that requires a deft touch by an investor.
Every special situations investor has a bucket list of key activities and business elements that should be evaluated during a due diligence period, along with a set of methodologies to execute against. These are great to have in place. However, time, budget, and resource constraints during a distressed acquisition do not always allow for performing ideal due diligence. An investor often has no choice but to go off-script and make executive decisions based on his or her experience in the industry rather than using the defined methodologies for a particular task.
Every acquisition is unique, posing its own challenges. Other uncontrollable elements, such as current and future economic conditions and cultural differences between merging companies, also may contribute the challenges of an acquisition.
As an example, accurately predicting revenue of a target acquisition depends heavily on a three-year historical review. Ideal due diligence would dictate that an investor review changes in ownership, acquisitions, divestitures, restructurings, key account wins/losses, and litigation history. However, a distressed acquisition in which the target has only 30 days before it runs out of cash doesn’t provide enough time for an investor to a complete a full historical review. Does the special situations investor do no historical review at all? Alternatively, which elements of a review do they perform considering the time constraints?
When time, resource, and budget constraints are significant in a distressed acquisition, a special situations consulting firm that specializes in the relevant industry can assist in the process. A consulting firm can help an investor retrieve specific information and provide guidance regarding the pre-acquisition process when time is short.
Making Informed Decisions
A distressed acquisition will almost always contain constraints with no real active solution in place to prevent inevitable failure. Whether a company is hemorrhaging money at an alarming rate or customers are leaving because of product dissatisfaction, there are always problems that must be solved immediately. Ultimately, making a decision under ideal circumstances, when all information is readily available, is fairly straightforward. The art of due diligence lies in an investor’s ability to retrieve enough necessary information to make executive decisions regarding next steps in the process in a timely manner when the situation is less than ideal.
Due diligence should be performed pre-acquisition/merger of a company, not just post-close. It is a good predictor of the potential for success of a company, allows an investor to make more-informed decisions on the fate of the acquisition, and jump-starts the execution of the post-acquisition plan.
There is an art to executing a due diligence process. While the end goal is clear for most investors, the art of executing identified business elements in a timely manner requires a deft touch from an investor and a proper post-acquisition plan against which to execute.