Deal breakers

Merger and Acquisition (M&A) transactions have been commonplace in the past decade. According to one study, worldwide M&A activity increased by over 40% from the year 2000, resulting in the highest M&A activity levels since then. M&A transactions are also responsible for spurring the growth of organizations worldwide. In the Philippines, the 2006 merger of Banco de Oro Universal Bank, the fifth largest bank at that time, and third largest Equitable PCI Bank was heralded as the biggest bank merger in the nation’s history, and the surviving entity – Banco de Oro Unibank, Inc. – is now the country’s largest bank. Globally, the largest acquisition happened in 2000 when Vodafone AirTouch, a telecommunication company, acquired Mannesmann for $202.8 billion.

In M&A transactions, the parties involved face the risk of assuming unknown exposures stemming from the entity consolidation. To manage this risk, a due diligence study may be conducted before the acquisition or merger takes place. Through due diligence, several potential deal breakers can be uncovered before commitments are made and papers are signed.

Below are some key features to watch out for when searching for the perfect match for your organization.

Search for skeletons

Conducting a thorough background check is crucial to cementing your decision when pursuing an M&A transaction. And when gathering all the details you need, you can never have too much information.

Motivations and management. As the acquirer, you should learn why the owner is selling the business. Does the business have good management? Does it have the same cultural values as your company? Would you be able to work with the people in the organization? What are the competitive and comparative strengths and weaknesses of the company? If bankruptcy is the main reason for the M&A, you must be ready to assume the liabilities and continue operating while reorganizing the company.

Accounting, compliance and legal considerations. In addition to looking at the target company’s motivations and management, financial and accounting practices, regulatory compliance, legal entanglements, and contingent events should also be thoroughly inspected. When you are looking at accounting practices, specifically check on how the target company records its liabilities. Be wary of creative accounting practices. For example, when there are downturns in sales, deferred revenue liabilities may be recorded to pad sales performance.

Watch out for omissions in recording and outstanding obligations as they may be disruptive when negotiations commence. Conduct thorough research on probable underfunded pension plans or self-insurance reserves, neglected capital expenditures, pending litigations, outstanding tax settlements, and lease commitments. These transactions should be uncovered as early as possible to help you decide whether the M&A transaction is worth your while.

Product profile. The target’s product profile should also be considered to assess the strategies required to sustain or improve profitability. Extensive research on the profitability of each of the major products should be performed. If the profits come from a number of products, will the business perform better if they focus on the more profitable items? In addition, the acquirer should determine if a target’s products are being purchased by only a handful of key customers, and whether the relationship with these key customers would be affected by the transaction.

Industry and competitor profile. Apart from gathering information about the company, you should also look at competitor products or services and how the company fares in relation to them. At the same time, you should also know the market share of the company and its competitors. How do competitors interact with each other? Is the intensity of the competition fierce, moderate, or passive? Obtaining competitor credit reports or any other available information is necessary to understanding the dynamics of the market where the target company operates.

Nothing but the truth

It goes without saying that as with any undertaking, deceit is always a deal breaker. For M&A transactions, both parties should be truthful in all their representations. Information should not be withheld - from the simplest detail regarding organizational structure, to the crucial matters on financial information. While it is assumed that both parties come to the negotiating table in good faith, it would be wise to do your own research and to corroborate facts especially on items that could materially affect your decision to proceed with the transaction. If you find inconsistencies, make sure you are satisfied with the justification for the deviations. What may seem to be a small aberration can be a symptom of a larger problem that you might not be prepared to assume.

Three is a crowd

For M&A transactions to work, both parties must be equally devoted to the success of the deal. Uncovering that the target company is working on a deal is with another potential acquirer while you are in the middle of a due diligence process indicates that the other party may not be fully committed to the consolidation. As M&A proceedings require extensive resources and time, both parties must be upfront and forthcoming as to the extent of their investment in the transaction. Knowing whether your prospective partner organization is ready to buy/sell or is just window shopping is crucial to your decision in seeing the whole deal through.

Value for money

In M&A transactions, the asking price is a determining factor whether to continue the deal or not. The acquirer must specify what is for sale, e.g., assets, stock, real estate, the price, and terms. Establishing a price is never an easy task as the acquirer should consider the four major elements of pricing:

• shareholders’ equity

• current book value of the business as projected over the long term

• value of its market franchise, distribution network, its administrative systems, and other intangibles

• synergistic value that the company will bring to its acquirer

Once the abovementioned elements have been considered, a fair price can be established and agreed on by both parties.

From the conception of an idea to acquire or merge with another company, potential deal breakers should be carefully sought out.

Managing the risks surrounding the prospect of being associated with another company is paramount.

Knowing where to begin and what to look out for can help you assess whether consolidating with another company is best for your company’s growth.

Kristee Loraine Marenciano CPA is a Lead Consultant with the Advisory Services Division of Punongbayan & Araullo.

Executive Brief – October 2012

Punongbayan and Araullo