1. M&A TOOLKIT
Closing:
Due Diligence
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2. Poor due diligence is the fastest way to destroy a company
A CAUTIONARY TALE: THE DISTINGUISHED HISTORY OF FERRANTI
1882 Founded in London, championing AC power
1887 Designed the first modern power station in the world
1910 Amassed 176 patents in electronics
World War II Heavily involved in the early development of radar
1955 The first European company to produce a silicon diode
1987 Ferranti purchased International Signal and Control (ISC), a
Pennsylvania based defence contractor for $1.1 billion for cash
• Unknown to Ferranti, ISC's business primarily consisted of illegal arms sales started at the
behest of various US clandestine organizations
• On paper the company looked to be extremely profitable on sales of high-priced "above
board" items, but in fact these profits were essentially non-existent
• With the sale to Ferranti all illegal sales ended immediately, leaving the company with no
obvious cash flow
1993 The massive financial and legal difficulties that resulted
forced Ferranti into bankruptcy in December 1993
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3. More recently, Ken Lynch, CEO of Bank of America lost his job
after conducting due diligence on Merrill Lynch over a
weekend……
LYNCHED AT MERRILL
…Bank of America shareholders should be asking why their company's due diligence process allowed
it to undertake a takeover valued at $50bn last September for a business that made an operating loss
of $15.5bn in its first quarter of ownership.
….Now, not surprisingly, Bank of America’s shareholders are paying the price. Since Mr Lewis agreed
to the Merrill deal during the fateful weekend of September 15, Bank of America’s stock has crashed
to about $7 per share, down a whopping 80 per cent from the $34 a share the stock was trading at
the day before the Merrill deal was announced, and 40 per cent so far in 2009. Bank of America’s
total market value is now less than the $50bn it offered for Merrill’s stock last September.
….Mr Lewis defended his decision to complete the Merrill Lynch takeover on January 1 as being “in
the best interest of our company and our stockholders and the country to move forward with the
original terms and timing” of the deal. But it is going to be increasingly difficult for Mr Lewis to
continue to defend such a horrific failure of due diligence. Some are already calling for his head. “The
thing is unravelling so fast Mr Lewis may know his job is lost”
FT, January 28th
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4. Due diligence has three main purposes
THE PURPOSE OF DUE DILIGENCE
1) Confirm your “As Is” business value
• You understand the business/industry drivers
• Restate target P&L to get an accurate baseline
• Incorporate detailed analysis in your forecasts
2) Prove your Value Hypothesis
• Are your synergy assumptions realistic?
• Can you see how to realise them in merger integration?
3) Find “booby traps”
• What is the downside of all potential liabilities?
• Do assets exist and are owned?
• What don’t you know that you don’t know?
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5. You can use a checklist to conduct general due diligence
DUE DILIGENCE CHECKLIST
FINANCIAL P&L
Assets (e.g. cash position)
Liabilities (e.g. pensions)
Taxation
LEGAL Contracts and Commitments
Ownership and Control of the Company
IP (Patents, trademarks, licences, copyright)
Compliance
Litigation
Environmental
BUSINESS Operations
Reports
Organisation
Employees, Benefits, Pensions
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6. In addition, every business has different ways to “dress-up” a
business for sale that due diligence has to identify
WAYS TO DRESS A BUSINESS UP FOR SALE
Inflated revenues
•Stuffing distribution channels
•Sale-or-return agreements
•One-off sales classified as recurring
Depressed costs
•Cost taken outside the books
•Recurring costs classified as one-off
Underinvestment in the lead-up to sale
•Below maintenance capital expenditure
•Switching marketing spend from brand building into promotions
•Organisation under-invested (e.g. many vacancies)
Optimistic projections for new businesses, markets, products etc
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7. Ways to pump short term profits
INDUSTRY HOW TO PUMP
FMCG •Stuffing distribution channels
Finance •Extend depreciation period – change in accounting policy
Prof services •Booking profit before – revenue recognition
Airlines •Mothballing aircraft
•Change depreciation
•Release provisions
•Sell treasury bonds
•Acquisition goodwill/write-offs
Factoring •Selling receivables
•Vs Ownership
•Cost booking
Bank •Liabilities off balance sheet
•Lower provisions
•Non mark to market
•Reclassify assets
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8. There is a big difference between conducting due diligence on a
Western listed vs a Chinese private company
Buying a Western Listed Company Buying a Chinese Private company
Due Diligence starts Public Tender Offer Heads of Terms
after
Timescale Strict timetable: 2-3 weeks Flexible: Months
Access Dataroom only Whatever negotiated
Audited accounts Usually reliable Usually less reliable
Data availability Usually OK Target may need help
Key risks Embedded liabilities Compromised assets
(Contractual/Litigation/ Guanxi value
Pensions/Environmental) Lack of titles/contracts
Poor data/financials
Related parties
Indemnities and Listed: WYSIWYG Only effective with deferred
Warranties payment
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9. You can include Reps, Warranties and Indemnities in the SPA for
a private company if you find something unpleasant in due
diligence
ACTION AFTER DUE DILIGENCE
Listed target Continue bid
Reduce price
Walk away
Private target The above, plus include in the Share Purchase
Agreement:
• Representations (Reps) – Promises from the
seller about the situation today
• Warranties – Promises about the future
• Indemnities if promises breached (could be
10% of price held in ecsrow for 1 year)
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10. Key points on due diligence
• Poor due diligence is the fastest way to destroy a company…
……even a small deal can bankrupt a large company
• In due diligence you are looking to
- Confirm your “As Is” valuation
- Prove your value hypothesis
- Find and disarm booby traps
• For listed companies, WYSIWYG
• For private deals, use your full negotiation scope post-due
diligence
• Employ good local lawyers and accountants who know the
target business…..this is not a place to cut corners
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