Some years ago a major US based shareholder of a business for which I was responsible took a very active interest in various transactions we were conducting and his legal adviser and I got to know each other well through the course of some regular conference calls. I was therefore delighted when I heard from him recently that he and his wife would be attending a black tie dinner featuring Supreme Court Justices Sonia Sotomayor and Stephen Breyer at the Library of Congress in Washington, DC. The dinner was in honour of the 2011 Burton Awards. The Burton Awards for Legal Achievement encourage and reward effective legal writing by honouring authors who use “plain, clear and concise language and avoid archaic, stilted legalese.”
Jeffrey M. Weiner is a partner in Steptoe & Johnson LLP based in Los Angeles. He was one of 30 recipients to be selected from the submissions from the 1,000 largest law firms in the US. He was chosen based on a chapter he wrote on due diligence for a Thomson Reuters book, Business Due Diligence Strategies, published last year.
Jeff believes that a good M&A lawyer is not just working on the legal aspects of a deal but is helping his client to
• Minimise risk
• Allocate risk
• Maximise shareholder value
These three goals are party neutral—it does not matter whether he is representing the buyer or the seller. The business school literature first looks at the combined returns to bidder and target shareholders, to see whether they are positive or negative. In other words, are mergers positive net present value investments? Target returns are, not surprisingly, nearly always substantially positive. Most critical, however, are the bidder-only returns, which the studies generally find to be negative, including post-merger operating performance. In other words, most mergers either destroy value for the bidder’s shareholders or create no incremental value. It is the relatively poor track record of mergers and acquisitions that creates the impetus for trying to do them better and improve one’s “hit rate.”
Jeff then asks the question what “due diligence” actually means. He finds the text book definitions less than helpful so he offers his own definition:
“A future-oriented super audit to help minimize the risk and maximize the shareholder value of an M&A transaction.”
Parsing this he shows that it covers what is required. First, it is “future oriented.” It is difficult to imagine why anyone would buy a business for what it did in the past.
Next, it is a “super audit.” Rather than an accountant’s audit which has been demonstrated many times, not least in the Enron case, is not a complete examination of anything, and certainly is not designed to detect fraud. All an “audit” is designed to do is furnish a sufficient basis for them to express the opinion that the financial statements of management are presented in accordance with generally accepted accounting principles. A full “super audit” would take too long and cost too much, so what is required is to focus on the particular value drivers in any particular deal. The rest of the definition is consistent with Jeff’s rationale of his three goals.
So why is due diligence necessary? There is no law requiring “due diligence” but there are fiduciary duties of directors. One such basic fiduciary duty is the duty of care. It is clear that a buyer’s Board of directors would be in breach of its fiduciary duty of care if it did not perform due diligence on a target company prior to acquisition, though this duty can be delegated to outside professionals.
But is it is not just for legal reasons that due diligence is required. It also helps the process of minimising risk and maximising shareholder value. In the process we gain knowledge and that will inform enhanced negotiation over terms. Jeff quotes examples which point to the significant conclusion that due diligence, performed well, is the buyer’s last chance to avoid a disastrous deal, and the greatest opportunity to help ensure an acquisition’s success. The chances for maximising deal value are increased if, prior to closing, the integration plan has already been designed, and is ready to be implemented commencing immediately after closing. And it is the due diligence team that is gathering the information necessary to design the integration plan.
We know from considerable research on both sides of the Atlantic that at least 50% and even up to 80% of acquisitions fail to deliver shareholder value to the acquirer. Jeff has developed his due diligence hypothesis, which states:
“If your M&A transaction “fails,” and the world has not materially and unforeseeably changed, then either (1) your corporate and M&A strategy was defective or defectively executed, or (2) you had a failure of due diligence.”
Breaking this down we see that first the acquirer must have a sufficiently developed strategy so that it can tell us how it plans to measure the “success” or “failure” of the deal.
Second, we must accept that if circumstances materially change the subsequent failure cannot be blamed on a failure of due diligence.
Third, the lawyers or other advisers cannot be blamed if the strategy or its execution is defective.
But the fourth point shows again the importance of due diligence and Jeff believes that more M&A failures are probably due to due diligence failures than to anything else. As well as writing, Jeff also teaches an annual M & A programme at UCLA Business School. He encourages the executives attending the programme to swap due diligence “war stories.” The challenge is to learn from the mistakes of others, not just our own mistakes.
Another concern Jeff addresses is that often the actual practice of due diligence is conducted by the more junior, less experienced lawyers. It is therefore important that the senior lawyers brief them well and direct them to salutary examples of due diligence failures. Perhaps the client too should ask what preparation a lawyer conducting due diligence has had.
Time is a key factor. In my own experience deals done in haste often go wrong while deals conducted over time have a greater chance of success. This is not only about due diligence in the technical sense but also about the parties gaining a better understanding of each other. So in recruitment my better hires and the jobs that have worked out better for me have usually involved a longer period of courtship. But time is the enemy and many deals fall through because circumstances change on one side or other.
Jeff warns us of “deal heat” where the client gets too keen to do a deal without the necessary caution.
In the rest of his excellent chapter Jeff Weiner goes on to the more technical though still important questions of who will conduct the due diligence and on whom; the different kinds of due diligence, both legal and business; the ways to prioritise if fees are limited; the issues over confidentiality; the need for the right kind of person to be involved; the importance of cultural due diligence to ensure a good fit between two organisations; the process for dealing with the information gained; and the timetable for conducting due diligence.
If representing a seller there may still be requirements for due diligence if, for example, part of the consideration is in stock. There is also the issue of readiness for sale. Jeff advises, and I have always believed, every business should be operated as if it were going to be sold or taken public. If you do decide to sell your business it will take time to prepare it for sale and so it is better if this has already been done. Even if you never sell it is a good discipline to think what an acquiring company would do to save costs and then do it.
By coincidence last week I participated in a seminar on global expansion through partnership. The participants were all British based senior executives with interests in expanding their business through overseas partnerships. But for most of them the preferred strategies were more conservative. Few had an appetite for outright acquisition as they were concerned with the high risk of failure which, if anything, is increased in overseas markets. Most preferred direct operations or alliances with partners. One had developed a successful licensing model where after the initial investment of finding a suitable partner he had virtually no running cost and only income.
But in all such cases a process of due diligence is still required and I am grateful to Jeff Weiner for pointing me to his valuable article. For the full chapter Due Diligence in M&A Transactions: A Conceptual Framework,” which includes further detailed references please go to http://www.steptoe.com/publications-6953.html
Copyright David C Pearson 2011 All rights reserved