Before Michael Hagedorn, finance chief at $12.1 billion banking firm UMB Financial, pulls the trigger on a deal, he tests it using at least three sets of assumptions — optimistic, neutral, and pessimistic. Sometimes he uses five. Why? “So that management knows [just] how bad this thing could get if it were to go bad,” he says.
Overcautious? Some CFOs might say so. After all, contemplating worst-case outcomes in a merger or acquisition is not something businesses are in the habit of doing. But in the current climate, more executives are allowing themselves to imagine the worst, gauging M&A risk by scenario planning, stress-testing discounted cash-flow models, or by just assuming that a merger will have negative side effects.
Global economic conditions have heightened overall M&A risk and are making buyers skittish: deal volumes cratered in the fourth quarter of 2011. “No one wanted to be the first to step out of line before there was a better sense of the economy’s direction,” says John Bogush, a partner at The Highland Group, an M&A consultancy.
This year, it seems, things won’t get any easier. The margin of error for management is smaller because “shareholders and boards are much less willing to accept the risk of an M&A failure,” Bogush says. Rich Jeanneret, Americas vice chair of transaction services at Ernst & Young, says, “Boards are very interested in top-line growth, and they are asking a lot more questions and demanding more accountability.”
There is also less margin for error economically, points out Reeve Waud, managing partner at private-equity firm Waud Capital Partners. “The M&A market has become much more efficient,” Waud says. “Many potential buyers review the asset or business that’s up for sale, and the acquirer inevitably pays a very full price. That leaves it less room if it is wrong.”
To raise the probability of a deal being successful, acquirers are rethinking how they underwrite risk, assess value, and perform due diligence on previously ignored aspects of transactions, like customer attrition. They are also trying to prevent their share price from getting slammed as a result of placing a fair value on the acquired assets. Below are some of the things acquirers will do to minimize acquisition risks this year.
Focus on What Drives the Business
When assessing an acquisition, the deal team needs to weed through copious amounts of data to focus on the three or four key things that are most important to creating value post-acquisition. “If you don’t understand [those items], you don’t understand the business well enough to buy it,” says Waud.
In the home-alarm industry, for example, a sector in which Waud Capital has acquired 36 companies, the drivers are the percentage of customers a company loses every year; the cost to gain a new customer through the company’s own marketing efforts; and the cost to acquire a customer in other ways, such as buying accounts from a competitor. It’s no coincidence that all three drivers relate to retaining and gaining customers; in a low-growth economy, existing customers are gold.
Perhaps the greatest risks in M&A, in fact, involve the intangible assets of the seller — particularly its current customers, says Howard Johnson, managing director of Veracap Corporate Finance. “The question a buyer should ask is, ‘What creates stickiness between a customer and the company as an organization, as opposed to a particular individual?’” says Johnson. “If there is no barrier to exit, that should send up a red flag.”
Don’t Rely on Revenue Growth
In a recent Ernst & Young survey, 40% of executives said that deals most often fell short of expectations because revenue gains didn’t materialize. “Stakeholders are interested in the top line,” says Jeanneret. Companies that meet earnings targets due to cost-cutting are often punished by the market.
Knowing that, however, may cause acquirers to overemphasize the potential revenue boost from a takeover. “Generally, I don’t like to assume any revenue growth,” says Waud, because that puts the success or failure of a deal at the mercy of something he can’t control. “I would rather determine whether or not a deal was going to be good or bad based on flat revenue and how I can improve the business,” he says.
Cheryl Beebe, CFO of Corn Products International, a $5 billion maker of sweeteners and starches, says cash flow and the value derived from cash flow are key. As a publicly traded company, Corn Products focuses on a deal’s return on invested capital. “You can do a ‘strategic acquisition’ and get a boost in revenues and operating income, but that doesn’t necessarily mean you get a return on invested capital that exceeds your cost of capital,” Beebe says. “That’s a little tougher criteria.”
There are plenty of other criteria that companies should be using to guide the deals they invest in. For example, in 2010 UMB Financial diversified the revenue stream of its mutual-fund business by buying a fixed-income shop, Reams Capital Management. Reams’s offerings complemented UMB’s international and midcap equity products. “We saw what was happening with interest rates, and from a risk perspective decided that getting into the fixed-income business was something that made sense for us and our strategic plan,” says CFO Hagedorn. “The revenue streams coming out of our Scout mutual funds are less risky because they’re not dependent on equity markets.”
Make Risk Mitigation Central to the Deal
Hagedorn does something that can make his business managers scowl. He runs different hurdle rates depending on the riskiness of the investment. The lower the hurdle rate, of course, the more likely a given deal will get done. “Certain businesses just present more risk. A pure banking franchise with a balance sheet has a lower hurdle rate than a fee-income business,” he says. While a fee-income business is completely dependent upon continuing to perform a certain activity to get a fee- income stream, a banking business provides “more levers to pull,” like the ability to raise or lower deposit pricing and loan rates.
Risk management also can be integrated into other aspects of deal assessment and execution, like the calculation of proposed synergies. Corn Products has found a way to manage and minimize the risk associated with delivering on a specific dollar amount of synergies. For cost-savings synergies, the company’s management has to be able to define the action associated with a cost savings. Process owners, not just the corporate-development staff, have to agree to the number.
So if Corn Products promises a $5 million savings in IT, the chief information officer has to document how that $5 million target will be achieved, Beebe says. That contrasts with the more common approach, in which a top-level modeling assumption is made that savings will amount to “x%” of projected revenues.
A third way to incorporate M&A risk mitigation is to put more structure into a deal, which is especially useful in purchases of private companies. “Give the sellers the price they want, but structure the deal in a way that helps to mitigate the risk,” Veracap’s Johnson advises.
More buyers are using instruments like promissory notes attached to liability and performance conditions. They are also spending more time on postacquisition contracts that keep sellers engaged in the business. UMB’s Hagedorn says that five years ago buyers couldn’t get earn-outs, but UMB has recently negotiated some that last as long as five years.
Forecast the Accounting
With management on the hook for delivering tangible results that boost earnings per share, acquirers are more aware of a deal’s “accounting risk”: How will the transaction affect the buyer’s financial statements, and in particular will it be accretive to earnings per share after the close?
“We look at both cash flow and the accounting,” says UMB’s Hagedorn, “because oftentimes in the accounting you have to record certain transactions that have no bearing on the cash of the company. Even though cash is king in my mind, it is important to know what is going to happen to our financial statements as the public sees them.”
Foreseeing how the amortization of intangible assets will play out in future earnings periods and whether yearly impairment tests will cause goodwill to be marked up or down is difficult. Investment bankers don’t look at the accounting consequences of a deal, for one. And much of the determination of how to allocate the purchase price among tangible and intangible assets, as well as goodwill, is reviewed by auditors only after a deal closes, points out Veracap’s Johnson. Says CFO Beebe: “Even though you paid a certain price, you still have to go through all of the discounted cash flows for all of the entities. There are many unknowns until you get down to the books and records, which you don’t typically get in due diligence.”
With Corn Products International’s $1.4 billion acquisition of National Starch and Chemical Co. in 2010, Beebe and her team estimated the company’s EBITDA before and after purchase price allocation and presented the numbers in the first earnings report after the deal was announced.
If there is a final risk-mitigation technique that might be especially important in 2012, it’s patience. Companies that rush into deals are rarely glad they did. National Starch and Chemical was put on the block by its owner, AkzoNobel, in 2008. Corn Products considered buying the food-ingredients business but thought the property was overvalued, and the financial crisis forced AkzoNobel to pull National Starch from the market. Corn Products bided its time until 2010, when AkzoNobel was in a selling mood again and the price fell within the range that Corn Products had determined it would pay.
It takes discipline, but it’s important to “know how much you’re going to pay and how much you’re not going to pay,” says Beebe. “And it helps a tremendous amount to really know what you’re buying. That minimizes the risks and the surprises.”
Vincent Ryan is senior editor for banking & capital markets at CFO.