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Dispatches from the front

When to Fold ‘Em

February, 2006

“Deal making is glamorous; due diligence is not.” So begins a recent Harvard Business Review article that captures why some deals between operating companies shouldn’t get done. How do you know when to fold ‘em?

The piece, written by several Bain consultants, is based on a survey of 250 M&A executives, half of whom said that their due diligence failed to uncover major problems and half of whom said their targets had been dressed up for sale, Potemkin Village style.

The fault lies in superficial due diligence that typically focuses simply on verifying historical financial statements rather than looking closely at the deal’s strategic logic and the buyer’s ability to extract value from it. That, and the fact that once a deal gathers momentum, the train is real hard to stop.

The consultants propose four steps that successful acquirers move through to avoid M&A failure:
• Determine what you’re really buying;
• Calculate the target’s stand-alone value;
• Confirm practically realizable synergies;
• Establish a walk-away price.

You’re Buying… What?
Rather than rely on the target’s public image and its rosy forecasts, successful acquirers build a model of the target’s operations from the ground up by conducting research on its customers, suppliers and competitors. The emphasis is on getting into the field, interviewing key target “stakeholders” and gathering comprehensive information both from real people and from secondary sources like market studies and trade groups.

Doing so can reveal growth constraints like saturated markets, product pricing caps, limited economies of scale, the emergence of disruptive technologies, over-reliance on a handful of key clients, rising customer or supplier bargaining power, the requirement for substantial follow-on investments to remain cost-competitive (revealed through a benchmarking analysis), and post-close management team competencies, among other issues.

All Alone in the World
Next, the buyer creates a financial model of the target's stand-alone performance that reflects its findings from the field and industry research above. In this exercise you may obviously look toward the target’s internal operations and financial data for guidance, but retain your skepticism: some of the more common tricks used to inflate growth, profitability and cash flow are:
• Stuffing distribution channels;
• Proposing unrealistic sales or cost projections based on recent capital expenditures, including those for websites;
• Obscuring cost center costs by distributing them out into the field;
• Treating recurring expenses as extraordinary ones;
• Underfunding CAPEX or SGA costs to jack up cash flow; and,
• Boosting sales by discounting the price of later services.

The Search for Synergies
Now the buyer turns his gimlet eye toward where costs can be reduced and sales increased by combining his operations with those of the target. As a rule of thumb, cost economies represent more concrete and immediate sources of value generation than sales increases, which typically offer lower probabilities of realization. In fact, the authors advance the following synergy categories in declining order of probability and in increasing order of time to closure:
• Elimination of duplicated functions;
• Sharing of operations;
• Sharing of facilities;
• Selling existing products though new channels;
• Selling new products through new channels.

Needless to say, you must also consider the cost and time of pursuing these synergies as you calculate a net present value for them.

Walk-Away Price
After you add your probabilistically-weighted set of synergy cash flows to the target’s stand-alone value, you’ve got your walk-away price. One way to better assure the realism of this value is by linking the compensation of your key executives -- especially those who are championing the deal -- to realizing it.

But the key to this calculation is your willingness to live by it, avoiding the temptation to allow the deal’s momentum and the target’s demands or bidding environment to turn the process into a game of one-upmanship. A final advantage to knowing this number is its ability to extricate you from those ever-escalating demands: now, armed with your careful analysis, you can afford to tell the target what your top dollar is and welcome him to accept a superior one if he can find it. That’s your “walk-away” offer and in a surprising number of cases, targets accept it.

While this article has necessarily focused on the value of due diligence to avoid over-paying, the process can also increase your perception of value. More than once we have seen circumstances where all that analysis uncovers opportunities for value-creation that weren’t promoted by the seller and weren’t initially obvious to you.

Ryan Kuhn

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