Create M&A team that includes members from HR and risk management.
Whenever company A buys company B, there is always a chance the deal will not turn out to be as lucrative as the buyer intended. All sorts of issues can sour a deal, including unanticipated liabilities, incorrect valuations and poor integration of the acquired company into the operations of the buyer.
‘Any time you buy a company, you are potentially getting into bed with any number of situations,’ says Peter Flocos, partner at K&L Gates in Chicago. ‘You need to understand the good things you are facing and what liability problems you could be walking into.’
Of course, determining the good and the bad in any deal is often much more difficult than people think. There are the ‘known’ problems that must be uncovered during the due diligence process and through careful analysis of financial statements that take effort to find. But there are also unknown issues that may affect the future of the new entity and whether it is prepared to sustain itself during unanticipated market shifts and crisis situations that may be more difficult to unearth without knowing exactly what to look for.
While no company can prepare for every eventuality, there are several things corporations can do to decrease the risks involved when executing a merger or acquisition. Start with a comprehensive M&A team. While the tax, finance and operations functions of a company are seen as the core members of the M&A team, it is important for companies to also include members from the human resources and risk management areas of the company to add important perspective to negotiations.
Randy Nornes, executive vice president of Aon Risk Solutions, says it is important to have HR and risk on the team at the start of the process because ‘those people can offer a lot in terms of letting you know whether you are paying too much or too little for your target company.’ The HR function can let you know whether the company may be worth far less unless certain key employees are retained; the risk function can determine the cost of dealing with environmental or other risks that may not be top of mind at the start of negotiations.
‘Often, problems get generated because the right people were not engaged at the right stage,’ says Flocos. ‘Your due diligence process is only as good as you make it. I can extend the due diligence process as a buyer, but if I’m not asking the right questions and not looking into the right things and not involving the right people, I can spend all the time in the world and it won’t do me any good.’
Nornes says if you have a comprehensive team working together at the targeting stage, each function can come to the table with what it considers the strengths and weaknesses of each potential target, and then the group can negotiate which company makes the most sense to acquire. When the bid is made, each function can then help evaluate the negotiations with the seller. Is there some hidden value in the target that isn’t even on the table? Or are there some issues your company should get consideration for in order to complete the deal?
Watching for danger
Investigate acquisitions for hidden liabilities. If you buy a company or division of another firm before a problem comes to light, you inherit the problem, so it’s a case of buyer beware. Therefore, your search for risk and other problems must be as creative as it is thorough. ‘I always hone in on the unknown and off balance sheet liabilities,’ says Wally Brockhoff, M&A partner at Lathrop & Gage.
Brockhoff warns companies to take pains to find out whether their acquisition target is actually operating legally and truly complying with all aspects of the law in its industry. Although most purchase agreements talk about compliance with the law, you won’t really know whether a company is skirting the law unless you check.
‘This is where strategic buyers have an advantage,’ says Brockhoff. They generally have ‘a real, solid working knowledge of facts on the ground to understand whether or not what the target company is doing complies with best practices and what the law really requires.’ With a number of anti-corruption laws coming online along with Dodd-Frank, it is important to make sure you don’t buy a company that’s in violation of existing laws.
As part of the due diligence process, Brockhoff also believes it’s a good idea to project what the future company may be, by trying to determine how the newly combined entity may fare under changing regulatory and economic situations. ‘You have to assess what a company generally has looked like in terms of what it has done in the past, and then look at the future environment that it will have to operate in,’ he explains.
With new Dodd-Frank rules and healthcare reform legislation set to come into force over the next few years, it’s worth considering how these rule changes may affect the new company’s cost structure, the manner in which it operates or the financial performance of its business units. Projecting how the company would perform with increased personnel and a larger geographical footprint will also determine the value of a merger or acquisition.
‘We tend to focus on the piece we’re adding on instead of looking at what it looks like once it’s combined with the buyer,’ Brockhoff says.
Corporations should always seek to retain the rights of the insurance policies issued to the entity they are acquiring. Although you might think insurance policies in force would continue to apply upon the sale of a company or unit, there are many things that complicate the issue, and most often those rights must be negotiated during the sale.
Furthermore, according to Flocos, whether you can retain those rights depend on: the language used in the policies involved; whether the transaction is structured as a legal merger, a purchase of stock or as a purchase of assets; and the state the deal is done in and how that state’s courts and legislature have approached these issues. There is no one-size-fits-all answer to this issue, but it is important because retaining coverage under certain insurance policies can save you money on the purchase. Typically, buying insurance after the deal is completed will be more expensive.
‘If an insurance company is asked to insure a combined entity after the acquisition, many insurers will say, When two companies combine and become a new company, that really does change the risk so, as far as we’re concerned, this needs to be a new underwriting process,’ says Flocos.
Adding to the complications associated with retaining insurance rights, Nornes notes that if you are buying only a division of a larger company, or making an asset purchase, the existing insurance coverage isn’t meant only for the division you are acquiring – therefore, the seller will not relinquish its entire policy to you because it has other assets to protect, and negotiating away a portion of the coverage may not be possible for several reasons. ‘The company you have bought the division from may not want you to take away $100 million of its insurance because it has other businesses protected by that same policy,’ he explains.
Even with these difficulties, experts stress that it is worth the effort to obtain the rights. Some insurance policies spell out clearly that ‘you need our consent to transfer the ownership of the policy’. But you’ll need to negotiate for the sellers’ consent, and make sure those type of transfer clauses are honored in your state – some states contend such clauses are not enforceable.
There is always a risk when two entities combine that there will be a power struggle of sorts, so Leonard Gray, senior partner at Mercer, says it is important to create a cooperative environment between the leadership of the target company and the acquiring firm. This is particularly important at multinational corporations.
‘Remember that when going into a new geography, the leadership of the acquired company may be accustomed to making decisions in ways that are different from what you would anticipate,’ says Gray. ‘Decide where decisions will be made: locally, globally and nationally. Develop a framework everyone can agree on that defines what the new combined company will be in the future.’
Gray also warns that, in a global economy, familiarity and trust must be developed as the new company begins coming together. If not, he says there is a risk that ‘cultural differences might create barriers to running the company smoothly.’
Solve all legal problems before closing the deal. If a legal issue slips through the cracks, it becomes a much more expensive problem to deal with. Transaction documents must be sufficiently clear and applicable state laws must be adhered to – if they aren’t, the only recourse you have is litigation to help correct the issue. ‘It’s very difficult to solve a legal problem that got overlooked,’ explains Flocos. ‘You cannot go back and change the terms of the deal once it is signed.’
Once the deal is closed, the M&A team must come up with a plan to get the type of value out of it that everyone expects. The plan must be sure to maximize the resources acquired in the deal. ‘Sometimes you have to totally rethink your own business model based on what you’ve just decided to take on,’ says Nornes. Failing to be open-minded sometimes leads to internal decision making that can add to risk and hurt the deal’s chances of long-term success.
Nornes adds that companies often jump at the ‘false value’ of saving on salary by immediately cutting employees after a merger or acquisition. ‘They cut the people and lose the institutional knowledge that came with all of the issues that aren’t well documented around risk,’ he says.
A move like this could leave the buyer with no one to help solve the problems that were being put off or are yet to be resolved at the new acquisition. Such lingering issues could become a drag on the merged company’s balance sheet, tie up collateral or require undue expenses to resolve.