Managing Transactional Risk - Cassels Brock

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MANAGING TRANSACTIONAL RISKM&A is a risky process, and savvy buyers need to establish an effective risk management

framework encompassing everything from target identification right through to completion and post-deal integration. In 2010, as the markets slowly recover, more time and effort will

be spent on evaluating the viability of transactions.

M&A is a risky process, and savvy buyers need to establish an effective risk management framework encompassing everything from target identifi cation right through to completion and post-deal integration. In 2010, as the markets slowly recover, more time and effort will be spent on evaluating the viability of transactions. 8

M A N A G I N G T R A N S A C T I O N A L R I S K

R O U N D T A B L E

M A N A G I N G T R A N S A C T I O N A L R I S K

Andrew J. Nussbaum

Partner, Wachtell, Lipton, Rosen & Katz

T: +1 (212) 403 1269

E: [email protected]

www.wlrk.com

Andrew J. Nussbaum is a partner in the corporate department at Wachtell, Lipton, Rosen

& Katz, focused on domestic and cross-border mergers & acquisitions, divestitures,

carve-outs, joint ventures, spin-offs and other business combinations. He received his

J.D. from The University of Chicago Law School with high honours, was a Rhodes Scholar

at Oxford University and served as law clerk to Hon. Antonin Scalia, Supreme Court of

the United States.

Lorraine Lloyd-Thomas

Senior Vice President, Marsh Ltd

T: +44 (0)20 7357 1748


www.marsh.com

Lorraine Lloyd-Thomas heads up the Transactional Risk team in Marsh’s Private

Equity and M&A Practice in the UK. Ms Lloyd-Thomas is a non-practising solicitor of

the Supreme Court of England and Wales and, since joining the insurance industry

eight years ago, has built-up extensive experience of arranging Warranty & Indemnity

insurance policies and bespoke policies to cover identified issues in the due diligence

process.

Sanjay Thakkar

Executive Director, KPMG India Private Limited

T: +91 (0)22 3090 2319


www.kpmg.com

Sanjay Thakkar joined KPMG in the UK in 1991. He has worked in the US and Germany

and is currently head of Transactions & Restructuring in India. Mr Thakkar has worked

with major corporate clients, such as Bertelsmann, Virgin Media and BASF, as well as

with private equity clients, such as KKR and Goldman Sachs. He has led major buyouts

and disposals both in the West and now is helping a number of Indian companies

achieve their international expansion objectives.

Jeffrey Roy

Partner, Cassels Brock & Blackwell LLP

T: +1 (416) 860 6616


www.casselsbrock.com

Jeffrey Roy is a partner in the Securities Group at Cassels Brock & Blackwell LLP. His

practice focuses on corporate finance and public company mergers and acquisitions,

and he regularly advises clients on initial public offerings, private placements, takeover

bids and arrangements, including the international aspects of complex transactions. He

is also a former member of the Securities Advisory Committee of the Ontario Securities

Commission.

Brandon Farley

Global Director, Bowne SmartRoom, Bowne & Co.

T: +1 (404) 915 0438


www.bowne.com

Brandon Farley is the global director of SmartRoom, formerly known as Bowne Virtual

Dataroom, a leading provider of online due diligence solutions. Founded in 1775, Bowne

is the market leader in services for mergers and acquisitions worldwide. Prior to Bowne,

Brandon was a regional DataSite director for Merrill Corporation. His career has focused

on providing technology solutions to improve process. He holds a Bachelor of Arts in

English and Communications from Stanford University.

THE PANELLISTSTHE PANELLISTSTHE P

Todd Jirovec

Vice President, Booz & Company (N.A.) Inc.

T: +1 (214) 746 6525


www.booz.com

Todd Jirovec is a Dallas-based partner with Booz & Company, focused on the energy

sector. He has over 16 years of experience in strategy and operations consulting,

particularly with electric and gas utilities, energy trading and midstream gas companies.

During this period he has directed more than 75 merger or acquisition engagements

related to target screening and evaluation, competitor analysis, due diligence, cost

savings and revenue enhancement quantification, financial analysis, transaction

structuring, regulatory strategy, and merger integration.

Philip T. von Mehren

Partner, Baker & McKenzie LLP

T: +1 (212) 626 4818


www.bakermckenzie.com

Philip von Mehren routinely handles cross-border acquisitions and dispositions – for

strategic and financial buyers – including private equity and venture capital funds, often

in a distressed situation. Mr von Mehren has recently been appointed as a member of

the advisory committee of the firm’s Global Restructuring Focus Group. Mr von Mehren

received his J.D., cum laude, from Harvard Law School and M. Phil from Cambridge

University.

Kristina K. Faddoul

Partner, ASK Virtual Advantage LLP

T: +44 (0)20 3130 0295


www.ask-advantage.com

Kristina Faddoul is co-founding partner of ASK Advantage and heads the German

office. Kristina has 14 years experience in M&A and strategic planning, and has led

numerous projects in the US and Europe. As founder of ASK Advantage, a European

firm specialised in post-merger integration, culture and communication, she advises

mid-sized organisations to improve their M&A performance and success after the deal,

by providing organisational and cultural due diligence, integration planning as well as

integration execution and project management.

http://www.casselsbrock.com/People/Jeffrey_P__Roy

http://www.casselsbrock.com/index.cfm

mailto:[email protected]

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To what extent do buyers need to approach M&A with risk management as a key objective? How important is it to undertake effective and targeted due diligence as part of this process?

von Mehren: I think it is important to be aware not only of the effects that the global downturn has had on global M&A activity but also of the changing patterns of capital flows in the global economy. No longer are cross-border deals dominated by North-to-South or West-to-East transactions. The emergence of Chinese, Indian and, to a lesser extent, Brazilian as well as other emerging market companies means that capital is flowing in several direc-tions in the global economy. As a result, different legal and cul-tural issues are becoming increasingly important. These changing capital flows have a direct impact on due diligence issues, includ-ing risk management issues. Coupled with the lack of easily avail-able capital and the global downturn, many purchasers are placing greater emphasis on due diligence. Obviously, risk management is a – if not the – key objective of any due diligence process.

Faddoul: Buyers ‘do deals’ for various reasons, from product, geographic and channel expansion, to increased operational ef-ficiency. Ultimately, though, their overriding objective is to in-crease financial results and shareholder value, while minimising risks. Admittedly, however, a great majority of deals diminish shareholder value. Our experience shows that the greater the em-phasis on identifying and mitigating risks during the due diligence phase, the greater the synergy realisation and value creation. If the primary objective of due diligence is to uncover risks, then due diligence should really go beyond the norm to reveal operational, structural, managerial and cultural risks. These are often after-thoughts, left on the back burner until after close, and frankly pose the most risk at integration.

Thakkar: In the current economic environment effective, target-ed due diligence remains critical. It is more important than ever to embed risk management as part of M&A strategy and we have seen potential buyers taking much longer to evaluate acquisition opportunities. Acquirers need to avoid ‘checklist myopia’. Their approach should be tailored around each deal’s unique value driv-ers and critical risks. It is important to approach each transaction with a tailored risk framework, dependent on the deal specifics, the market conditions and the prevailing economic environment.

Roy: From the legal point of view, risk management is a core objective. The identification and assessment of risks, be they legal, financial, operational or political, is a central part of the M&A process, as the identified risks may dictate deal structure and always impact documentation. While some risks can be iden-tified without due diligence, many deal specific risks can only be identified and assessed via due diligence. However, public M&A transactions are often negotiated on an extremely compressed timeline. The short timeframe in which legal and business due diligence must be completed frequently forces the acquiring party to narrow the focus of that due diligence. Therefore, a targeted due diligence process is essential as there may be insufficient time to explore each issue in detail. In addition, the process has to be flexible, shifting focus as preliminary investigation reveals areas of concern that may not have been known at the time the review commenced.

Jirovec: Effective due diligence by definition should illuminate transaction risks and provide for a complete consideration of

deal complexities. Materiality thresholds should be established at the outset to guide due diligence teams to focus on those risks that could have a meaningful impact on valuation. Leading practices include expanding due diligence to include not only financial considerations but also strategic, operational, legal, environmental, and people-related issues. The formation of a multi-disciplinary due diligence team can make a real difference to the quality of the results. A well-conceived and disciplined model for due diligence results in greater insight about the ac-quisition target and its assets, enhances target valuation, focuses the data analysis, provides a roadmap to synergy value capture opportunities, and accelerates integration planning.

Lloyd-Thomas: Focusing on risk and insurance issues pre-ac-quisition will enable buyers to better understand the risks and factor them into negotiations and the pricing of a transaction. A clear understanding of the target’s risks and their impact on the valuation, future performance and financial structure of the transaction can lower the level of uncertainty and reduce the risk of ‘surprises’ after the deal closes. Overlooking risk and insurance due diligence can result in overpayment, ambiguities in the sale agreement, delays and obstacles in integration, post-close surprises as well as incompatible risk profiles. Good risk management, however, goes further than thorough due diligence and, over the last 18 months in particular, we have seen many buyers really focusing on the protection received from the seller under the sale and purchase agreement.

Nussbaum: Even in the acquisition of a publicly listed company, it has always been essential for an acquirer to assess carefully potential risks – for both the known and unknown contingencies. Even a small transaction in relative size can have significant exposure concerns. While, on some level, it is true that there is no such thing as too much due diligence, the diligence exercise must be tailored to the business reality of the transaction nego-tiations.

Farley: We are currently seeing buyers approaching targets with an increased level of scrutiny, fuelled by an undercurrent of risk management, and demonstrated by significantly more due dili-gence information. Virtual data rooms have proven to be a lead-ing indicator of changes in transaction dynamics given their use early in the timeline of a process. Data room sizes have grown on average more than 30 percent since the onset of the financial crisis whether the transaction is distressed or healthy. This trend would suggest buyers are already undertaking a new level of

A well-conceived and disciplined model for due diligence results in greater insight about the acquisition target and its assets, enhances target valuation, focuses the data analysis, provides a roadmap to synergy value capture opportunities, and accelerates integration planning.

TODD JIROVEC

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targeted due diligence when evaluating whether or not to put capital to work.

Do buyers need to widen the scope of their due diligence to include areas of investigation beyond the traditional approach?

Farley: Prior to the end of 2008, traditional due diligence frame-works were encapsulated in a ‘documents request list’ that was focused on basic information presentment, such as general cor-porate information, financial performance, legal and contractual issues, intellectual property, customer contracts, etc. That frame-work has changed dramatically where the scope of information presented for review now goes to a level of granularity that was generally only reserved for the winning party of a competitive process. Now all potential suitors are requesting and receiving that information.

Thakkar: The traditional financial, tax and legal due diligence exercises are not always sufficient. In order to drive maximum value from a transaction, buyers need to understand the com-mercial, regulatory, technical, HR, operational and increasingly environmental risks in order to ensure that all bases are covered, that execution costs are clear, and that potential cost and revenue synergies are well understood. In addition to this, buyers must ensure comprehensive integrity due diligence is carried out to provide comfort on the individuals who have in the past and may continue to influence the target business. Given what has hap-pened over the last 18 months or so, recent history is no longer the best guide to future performance. Therefore, detailed com-mercial due diligence is required to challenge market growth as-sumptions and a target’s competitive position. This should high-light the target’s ability to exploit improving market conditions and therefore deliver additional value post transaction.

Roy: In an ideal situation, where there were no significant time pressures on the completion of the due diligence review, the process would be driven by the ongoing result of the investiga-tions. The identification of irregularities in internal processes or governance would lead to more wide ranging and non-standard investigations.

Jirovec: The power industry’s uncertain future – for example, volatile input prices, declining loads, carbon threat, grid mod-ernisation, etc. – suggests that following a traditional approach

threatens a thorough analysis of a transaction’s potential and too often results in ad hoc M&A processes, uneven due diligence, and a lost opportunity for enhanced integration planning once a negotiated agreement has been reached. Due diligence planning should be elevated to address more strategic considerations. The due diligence work plan should embed steps to confirm or disprove the strategic rationale for the transaction. This type of approach suggests due diligence leadership must consider how assets are positioned within markets, how products or services can be more effectively marketed, how capital can be deployed in a more efficient manner, and how the uncertain regulatory environment impacts investment and operating practices.

von Mehren: Due diligence is always a process that must be customised to the particular transaction, paying close attention to the types of assets involved, the level of incumbent manage-ment’s skills, the legal context in which the target has operat-ed and the legal context in which the purchaser operates. The changing patterns of global capital flows coupled with global economic uncertainty requires a more rigorous examination of certain issues based on the specific context of the given transac-tion. Whether this is a fundamental change in how due diligence is done or merely an evolution of traditional approaches is open to debate. Although the same principles continue to apply, new areas are emerging as relatively more significant depending on the factors listed above.

Faddoul: In light of increased pressures to create success-ful mergers and acquisitions, companies must indeed perform deeper levels of due diligence and include non-traditional due diligence techniques. It’s true that companies have gotten bet-ter at managing deals and outcomes, but a failure to address the human aspects of companies not only limits the effectiveness of the deal and desired outcomes but, in many cases, can contribute to its demise. Due diligence must not merely be seen as a tick-the-box exercise, but as a vital tool to identifying the appropri-ate deal, engaging all stakeholders and is key to understanding the cultures, personalities and values of the merging entities. By staffing the pre-close due diligence team and execution teams in the beginning of the transaction, companies can maintain con-sistency, knowledge transfer and ensure success. We are seeing this shift beginning to happen.

Lloyd-Thomas: Buyers have narrowed their approach, be-coming very much focused on the scope of diligence they now require, and rightly so. Gone are the days where chapter and verse were required on the details of a target company’s risk and insurance arrangements. The priority issues many buyers now address typically consist of cost differentials as a result of a transaction, gaps in insurance coverage –current or historical – that could impact on future revenue projections, as well as trends in a company’s claims history that may indicate an under-lying problem or trend.

Nussbaum: Buyers too often ignore the ‘culture and policies’ element of diligence. Discussing with senior management the approach to risk and compliance, and with internal legal de-partment employees how risk management and compliance are implemented organisation-wide, will be as useful as reading a compliance policy or studying pending litigation.

In your opinion, can transaction planning make the differ-ence between success and failure in M&A? In this regard, 8

Due diligence is always a process that must be customised to the particular transaction, paying close attention to

the types of assets involved, the level of incumbent management’s skills, the

legal context in which the target has operated and the legal context in which

the purchaser operates.

PHILIP T. VON MEHREN



is it important for companies to think about balancing the needs of all stakeholders from the outset?

Faddoul: A formula for failure is to identify all the synergies and opportunities for a successful transaction and then to poorly plan, staff, monitor and oversee the integration after close. The then ensuing loss of momentum and chaos is a deal-killer. Lack of structure, discipline and transparency, difficulties in cross-team communications, inability to cope with unforeseen events, unclear decision-making protocols and lack of integration team coordination all contribute to deal-eroding delays and synergy leakage – an environment that makes success a rare and difficult feat. It is vital, at the outset of any deal, that CEOs approach the M&A transaction as a lifecycle that begins with a compelling strategic rationale for growth and continues into the post-merger integration phase, maintaining all stakeholders in mind. Deal capturing and closing, although exhilarating, is but a small piece of the lifecycle. I believe we have lost sight of this.

Jirovec: Transactions which fail, fail for two primary reasons – failure in logic or failure in execution. Robust transaction planning can mitigate both these risks. A well-designed due dili-gence process should answer the logic question through evalu-ation of strategic, not just financial, fit. In regulated industries, this logic test extends to stakeholders other than shareholders – for example, customers. Value from the deal must be suffi-cient to share between both shareholders and customers through a well-designed regulatory plan that recognises both the risks shareholders are taking on in capturing value from the trans-action, while providing for a level of benefits for customers. Mitigating the risk of execution failure starts with due diligence. Diligence should provide the foundation for transaction execu-tion, as well as readiness for post-close operation. The due dili-gence process should identify the post-merger operating model, material risks, and functional synergy targets that can be used during the integration planning process.

Nussbaum: I do believe that effective transaction planning – both pre-agreement and for the critical days following an-nouncement – is essential. A buyer who has not organised its advisory team, and prioritised its diligence needs, will find the seller growing increasingly frustrated, and less forthcoming, as the process lacks direction. The importance of stakeholders var-ies greatly from jurisdiction to jurisdiction; it clearly is essential to understand the key interested parties who will affect the suc-cess of the transaction, and to have a game plan to win their support early.

Lloyd-Thomas: Transactions that lack sufficient planning may often be delayed or could even fail. The transactions we work on can be clearly divided between the last minute telephone calls where the warranty cap has been parked as an issue and simply cannot be agreed upon by the stakeholders, and those where we have been involved from a very early stage before a company has even gone to auction. Although both can result in successful usages of warranty and indemnity insurance, I think the latter are the ones where the real benefits of the insurance can really come to the fore, as the insurance is structured into the transac-tion and becomes an integral part of its success.

von Mehren: Transaction planning is an increasingly important driver in the new context for M&A transactions in the wake of the Great Recession. Transaction planning is not only about en-

suring success – which, at times, is advising the client not to proceed with a transaction – but also is increasingly demanded by clients as a manner to control costs, especially as the number of blown deals are likely to be higher than historic norms. Deal management skills are extremely valuable attributes for select-ing a counsel and for increasing the odds of a smooth transac-tion. Issues, such as the sequencing of due diligence and con-tract negotiation, ensuring an efficient tax structure will exist post-closing and analysing integration issues, should require more assertive and effective input from deal counsel.

Farley: M&A market findings suggest that despite all of the advancements in technology and sharing of best practices over the last 40 years, the success rate of transactions has stayed rela-tively constant with only approximately 3 in 10 deals achieving the assumed synergistic value. The combination of competent information management, transaction planning, and leverag-ing technology to improve process should allow the acquirer to recognise the needs of all stakeholders and create the best platform for success. To that end, the integration of the business critical information cannot be made a secondary priority once the deal closes. Ongoing presentment of the due diligence infor-mation will allow for the combined entity to recognise problem areas faster and craft more comprehensive integration strategies and tactics.

Thakkar: It is important to ensure that all relevant business units within the acquiring business have had the opportunity to under-stand the transaction and related implications to them. Commit-ted senior representation, with sufficient available bandwidth, from each business unit must be involved at the planning stage, during the transaction and critically after signing. Involvement must be prioritised based on value impact and degree of com-plexity and change required. From our experience, the winners in a transaction scenario are those that do a better job of using business unit managers and leveraging their managers’ unique operational knowledge. Further, the winners are those who are better at using data sources outside of the data room and their own organisations. This superior understanding results in more accurate valuations, more detailed integration budgets, and an earlier ‘buy-in’ from all relevant stakeholder groups.

Roy: The recent decision of the Supreme Court of Canada in the BCE case requires that boards of target companies carefully consider the impact of negotiated change of control transac-tions effected by way of a court-supervised ‘arrangement’ on a

The importance of stakeholders varies greatly from jurisdiction to jurisdiction; it clearly is essential to understand the key interested parties who will affect the success of the transaction, and to have a game plan to win their support early.

ANDREW J. NUSSBAUM

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number of constituencies that previously would not have been regarded as having legal rights in the transaction. The arrange-ment procedures under Canadian federal and provincial corpo-rate laws have been heavily relied on by the M&A community, as they provide an extremely flexible means of accomplishing change of control transactions. However, the corporate statutes require that the court, in determining whether to approve the transaction, considers the overall fairness of the arrangement to debt and equity holders of the corporation. As a consequence, it has become increasingly important to identify and assess the expectations of a number of constituencies in the context of a proposed change of control transaction, as failure to adequately address their expectations may significantly increase the execu-tion risk associated with the transaction.

Why is it crucial for buyers to fully understand the legal is-sues surrounding the target, including its regulatory compli-ance program and potential liabilities?

Roy: An understanding of the legal environment, within which the target corporation operates, is crucial. Much of the value of the target may depend on the continued effectiveness of its network of contractual relationships, as well as the governmen-tal licences under which it operates. A failure to completely un-derstand the effect of a change of control transaction on these contractual and governmental relationships may make it impos-sible for the acquirer to fully realise the practical benefits of the transaction. A regulatory compliance audit is essential in cases where the continued operation of the target, in a particular juris-diction, depends on ongoing compliance with licensing require-ments. These requirements often include reporting as well as use of local suppliers, and non-compliance may lead to termination of the licence or similar right.

Jirovec: The ability to deploy capital to higher growth oppor-tunities as a merged company is one of the key value drivers in today’s energy M&A environment. Identifying regulatory commitments and related capital requirements is critical to un-derstanding the constraints that must be managed as a merged entity. The financial returns associated with these regulatory commitments must also be fully understood to assess the overall attractiveness of the target. Reprioritising capital projects, based on the buyer’s own risk management philosophy, can provide for enhanced returns while still meeting legal and regulatory commitments.

Thakkar: Buyers need to understand the maximum potential future cash outflows as a result of all legal issues, regulatory non-compliance and other potential liabilities. This is critical for negotiation on price, to ensure the sale and purchase agreement documentation is all-encompassing, and to understand the likely future funding requirements of the business being acquired.

von Mehren: The focus of creating a solid acquisition document must be on integrating due diligence with the specific language of the representations and warranties and indemnity sections. Merely relying on boilerplate contractual language with the hope that it covers post-closing liabilities is a dangerous approach. A far better approach is to identify potential liabilities and either provide the purchaser with the opportunity to renegotiate price, restructure the acquisition to exclude the asset or business seg-ment generating the liability, or create a special indemnity that specifically addresses the uncovered liability.

Farley: Given the small percentage of transactions that accom-plish a minimal value gap between assumed and actual syner-gies, the probability of post-close disclosure issues is rather high. If buyers do not fully understand the landscape of risk, they are opening the door to not only shareholder and board of director criticism, but may potentially find their only path of resolution is to litigate with the target for lack of disclosure. Im-proved due diligence practices and easy access to transactional information, even well after the deal closes, are imperative for buyer risk mitigation and cost management.

Lloyd-Thomas: If a buyer agrees to accept liability in a trans-action for a contingent issue which, post-sale then, crystallises, this could have a serious effect on the profitability and success of the transaction. Many private equity sellers, who have taken a portfolio company through tax planning to release cash, will often be reluctant to provide an indemnity to the buyer of that portfolio business should the taxation authorities challenge the planning in the future. Specific tax policies can be put in place to stand behind an indemnity being given by the seller or, if no indemnity is forthcoming, to simply ring-fence the tax issue with a policy in favour of the target company which is inherited by the buyer on completion of the transaction. In addition, com-panies need to be aware of the consequences of non-adherence to insurance and premium tax compliance regulations. This is of increasing importance, as a number of tax authorities in the EU have recently increased their efforts in auditing the global programs of a number of multinational companies.

Faddoul: After all these years, the ability of most organisa-tions to quickly and effectively digest mergers and acquisitions remains fragile, and when faced with having to comply with regulatory demands, the challenge can be herculean. Therefore, identifying and taking steps to understand the regulatory and compliance landscape, keeping up to date and in line with ever changing regulations is for the newly formed company a key post-merger element. In our experience, bringing two entities to-gether as quickly as possible is a good thing, yet loss of knowl-edge, especially relating to compliance and legal issues at the expense of speed can be avoided. Implementing and establishing the right tools and processes in the beginning, to help capture the vast amount of internal knowledge, can be addressed with standardised processes, thorough analysis of the issues, strong project management and a robust data management system to capture the information. 8

An understanding of the legal environment, within which the target

corporation operates, is crucial. Much of the value of the target may depend on the continued effectiveness of its

network of contractual relationships, as well as the governmental licences under

which it operates.

JEFFREY ROY



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Nussbaum: The legal and compliance structure of the target have the potential to greatly impact both transaction value and deal terms. For example, a company undergoing a substantial, or potential, price-fixing investigation may be an unacceptable target, or in fact quite desirable if either a proper indemnity ar-rangement can be agreed, or the risk can be well-understood. Companies with significant environmental problems often engage in M&A on both the buy and sell-sides. But failure to evaluate and value those liabilities may well be the difference between a good deal and a bad/awful one.

In the current financial climate, have merger parties grown more risk-averse and therefore more likely to conduct detailed risk and insurance due diligence? What are the key focus areas for buyers and sellers?

Nussbaum: There is no doubt that the post-economic down-turn has caused buyers, and sellers, to be more risk-averse. On the buyer side, diligence is more extensive and more detailed, though often a checklist mentality still pervades. Key areas of focus are legal compliance, any regulatory issues, tax concerns such as transfer pricing, as well as a look at the compliance in-frastructure of the firm. Insurance diligence is in my experience still somewhat limited, absent a history of failed claims.

Faddoul: Companies have become more risk-averse and rightly so. Shareholders are more sophisticated and want to avoid mis-takes. They want as much assurance as possible that the deal will be a success. In today’s financial climate, it is important that companies look closely at the rationale of their deals and properly evaluate their ability to absorb and integrate acquisi-tions. So before a company embarks on an expansion strategy, it must first assess its ability to acquire and its operational readi-ness, to critically select and assess the right targets. Sellers, too, need to fully explore their rationale for selling and weigh their options carefully: do you sell to the highest bidder? Or do you sell to the best long-term partner for your employees, customers and brand? We know the reality, but there is a good argument in favour of the latter.

von Mehren: Everyone is more risk-averse in the current envi-ronment. Purchasers want to make sure that the financial num-bers are real and that no other material risks or liabilities are part of the transaction. Sellers are concerned about whether the purchasers have access to capital and do not want to tie them-selves up in a transaction with a purchaser that cannot complete the transaction. Pricing is tricky because of the volatility of the 12 month trailing EBITDA matrix – sellers are arguing that EBITDA levels are bouncing back and, absent a distress context or other factors, that they should get credit for projections in EBITDA growth as the global economy recovers.

Jirovec: There is definitely more emphasis today on evaluating and modelling the ‘downside’ case, while being very cautious in valuing any potential upside, for example, revenue enhance-ment opportunities. While identifying and capturing value is paramount to a transaction’s success, early risk identification during due diligence is a close second. Understanding the target company’s asset condition, plant performance levels, regulatory commitments, price forecasts, trading positions, environmental program, capex levels, and pension funding are a few of the parameters that inherently embed significant risks. Conversely, sellers today are placing increased value on the financial strength

of the buyer when evaluating multiple offers. A robust bid price must also be coupled with a strong balance sheet, sufficient ac-cess to capital, ample liquidity, and a constructive regulatory environment.

Roy: While parties may not have become more risk averse, they are more likely to focus on areas of risk that previously were not thought to be significant. Key focus areas for risk analysis on the sell side are those associated with deal certainty: the availability and conditionality of financing, the risk of shareholder approval of a transaction, when required on the buy side, and the risks as-sociated with obtaining required governmental approvals and/or the conditions that might be attached to such approvals when given. For example, the Toronto Stock Exchange has fundamen-tally altered its approach to the requirement for buy-side share-holders to approve transactions involving significant dilution. Where previously buyers could issue almost unlimited amounts of stock in connection with the acquisition of other public enti-ties without shareholder approval, the TSX now requires buy-side shareholder approval for dilution in excess of 25 percent. This has significantly increased execution risk on the sell side. On the buy side, risk analysis focuses, as it always has, on issues related to fundamental value.

Farley: I believe we are in a ‘buyers market’, creating more opportunities for companies and financial sponsors to strategi-cally put capital to work in the form of ‘bolt-on’, ‘tuck-in’ or industry sector consolidation acquisitions. Given that technol-ogy enables acquirers to look at more targets, and targets to at-tract more acquirers, by default they can become more selective, which breeds risk aversion and more detailed due diligence. The current macroeconomic factors create a desire for immediate positive financial results so merger parties will gravitate to the entities that can be material to improved performance and de-liver a compelling competitive advantage in the market.

Lloyd-Thomas: Over the past 12 months, we have seen an in-crease both in sellers putting more focus on their disposal pro-cess and buyers becoming more risk-averse. The key focus for sellers is to present the asset in the best light thereby reducing or removing issues which provide buyers with ammunition for price reductions or the ability to ‘walk away’ from the deal. Typ-ical issues from a risk and insurance perspective include quanti-fying expected liabilities in respect of retained insurance losses, so that the seller can make the best decision on whether to retain the liabilities or sell them for the right price; and developing

Before a company embarks on an expansion strategy, it must first assess its ability to acquire and its operational readiness, to critically select and assess the right targets. Sellers, too, need to fully explore their rationale for selling and weigh their options carefully.

KRISTINA K. FADDOUL

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stand-alone cost estimates so that the seller can question any increases the buyer may build into their business model, which they might use to negotiate on the purchase price, and looking at using insurance capital to remove transaction obstacles. The key focus for buyers is identifying whether pre-transaction in-surance policies will protect the buyer against post-transaction liabilities and whether competing interests adversely impact the policies’ value.

Thakkar: We have not seen any significant increase in the level of insurance due diligence being carried out as a result of the economic crisis. In relation to risk due diligence, this is a very broad term and in our view incorporates the above mentioned insurance, legal, commercial, financial, tax, regulatory, com-mercial, environmental, technical, HR and operational diligence processes.

In terms of risk transfer and insurance solutions, what tools are available and how have their structures evolved since the beginning of the financial crisis?

Jirovec: From a more strategic perspective, companies are con-sidering alternative deal structures to traditional M&A to ad-dress risk transfer issues. For example, joint ventures and alli-ances can be used to capitalise on market opportunities. These structures can combine or chain together complementary sets of capabilities – operational, regulatory, innovation, marketing, fi-nancial, etc. – and can be effected much quicker than traditional M&A, which can often have a protracted approval process. JVs can provide more flexibility than acquisitions and allow com-panies to modulate their commitment or exposure as they learn from each other and scan the environment. Compared to ac-quisitions, JVs act as real options by providing a firm with the flexibility to increase or decrease investment depending upon on how conditions develop. These formats have their own set of governance challenges and should be carefully structured from the outset. While more commonly used in the oil and gas sec-tor, we’re now seeing these type structures in nuclear generation development and wholesale trading and marketing.

Lloyd-Thomas: M&A insurance solutions, such as warranty and indemnity insurance, have been available for over a decade. However, the motivation for clients using these solutions over the last two years has changed. Back in 2006/2007, many sell-ers were selling assets via a competitive auction process. They

were capping their warranty exposure often at just 1 percent of the transaction value and were offering the bidders a buyer-side warranty and indemnity insurance policy to provide the success-ful bidder with additional financial recourse above this 1 percent cap. This enabled the sellers to exit the transaction with very limited contingent liabilities. Recently, we have seen a more bal-anced approach to share purchase agreement negotiations and the motivations for purchasing the insurance have largely been buyers’ concern over the strength of financial covenant of the sellers giving the warranties and good corporate governance, with corporate sellers giving warranties but taking out insurance to mitigate their liability. We have also seen an uptake in the number of policies that are being placed to ring-fence identified issues in the due diligence, such as target company tax plan-ning.

Nussbaum: There are a number of third-party insurance prod-ucts available for buyers, and sellers, to insure against post-clos-ing contingencies. These include policies to provide insurance for representations and warranties made by the seller, or to in-sure against a specific outstanding litigation or tax matter. While these products pre-date the crisis, they still exist and can help solve critical deal issues between buyer and seller – for example, where a seller will not, or cannot, due to its public company na-ture, provide post-closing protection. The products are not per-fect, though many would argue that neither is a seller indemnity, which is likely limited in cap and scope and time period, among other things.

Faddoul: Companies and investors are always looking for dif-ferent ways to transform risk and to hedge their bets. Thanks to sophisticated financial products and global markets, there is a product to fit everyone. It’s about finding a balance between financial hedging instruments, the right level of insurance cov-erage, internal scrutiny and proper evaluation. But at the end of the day, whether the deal is large or small, global or local, prudence should dictate due diligence and strategic logic should prevail. By paying carefully attention to the intangible, tacit characteristics of the acquisition target, much can be revealed about its personality, reputation and culture, providing ample insight into its viability and fit.

Farley: In terms of minimising risk through virtual data rooms, the documents and files are assets that reside in a secure data-base, which will allow the target to follow the footprint of all buyers. This audit trail enables sellers to mitigate their risk on post-close disclosure claims since they will know exactly when data is uploaded, viewed, printed and saved. Since the begin-ning of the financial crisis, the reporting available in virtual data rooms has transformed from surface level activity reporting to detailed business intelligence tools.

In your experience, do buyers place enough emphasis on evaluating the strategic fit of the merging entities and understanding how to realise synergies in the post-deal phase? What challenges do they face and what techniques can they use to generate such value?

Thakkar: More and more, we are seeing that the focus of ac-quirers is moving from looking at a target as a standalone en-tity, to the potential of the merged group. We believe that more could still be done, in particular in giving more thought to the ability of the team to execute the integration plan and to iden-

Recently, we have seen a more balanced approach to share purchase agreement

negotiations and the motivations for purchasing the insurance have largely

been buyers’ concern over the strength of financial covenant of the sellers giving the

warranties and good corporate governance.

LORRAINE LLOYD-THOMAS



8

tify the key areas of synergistic benefit during the transaction. This ‘merged group’ approach is most effective when all the key stakeholders are focused on the deal and when sufficient work is carried out to understand the transaction in the broader market context from an internal company and also a competitive en-vironment perspective. Another notable attribute of successful M&A teams is the amount of time spent on downstream imple-mentation activities. This typically results from including M&A team members, the people who validated the key assumptions in the original financial model, playing a major role in tracking the progress of the integration teams and the results of the newly-acquired business.

Nussbaum: The difficulty in the synergy discussion pre-sign-ing is that many sellers will resist substantial digging into the company’s operations, which makes specific numbers somewhat more difficult to obtain. I think the most difficult challenge post-completion is that many buyers do not implement the required changes promptly. The first 100 days are critical to implement-ing the synergy plan, and thus pre-completion planning is nec-essary so that the buyer can take the necessary measures while absorbing the target, not after.

Lloyd-Thomas: The emphasis that buyers place on achieving strategic and operational goals and synergies differs greatly. Cor-porates need to identify, early on, how the target will be integrated with their operations and internal processes. For instance, will the target continue to operate independently or will it be fully inte-grated at closing? If it’s not fully integrated at closing, will that change over time? This will ensure faster, smoother integration and enable synergies to be realised more quickly. To generate val-ue quickly, post-merger integration issues need to be considered at the beginning of a deal, not after the deal closes. Performing a thorough risk and insurance due diligence review will form the basis for planning the integration, developing pro-forma cost pro-jections, and identifying and implementing synergies.

Faddoul: In general, we tend to see greater focus on cost syner-gies than on revenue synergies. This is because it is much easier to eliminate jobs or merge cost centres, move a factory to a low-cost producing country than it is to innovate or to get previously competing sales teams, often with different cultures, to work to-gether. But by creating the appropriate integration structures and by pre-planning all details of the integration well in advance of close, companies are able to quickly capture synergies and stabi-lise the organisation, vendors and customers and thereby create and capture the expected value. Although strategic fit is an es-sential element of any merger, the processes and methodologies of integration, combined with financial alignment and detailed plans prior to close, can cut the integration time in half and generate a considerable impact to cash flow, thus exceeding expectations.

von Mehren: In my experience, which is supported by histori-cal studies, purchasers tend to over-estimate synergies with the target. Part of the reason for this failure is that too little attention is paid to post-closing integration issues, including rationalising the global corporate structure from a tax perspective, integrating workforce effectively, examining IP portfolios for synergies and generally following through with a meticulous process to ensure an effective post-acquisition integration.

Jirovec: Often times, the transition between the due diligence phase, where synergies are estimated, to the post-deal integration

planning phase, where synergies are expected to be captured, is not synchronised. Leading companies use a more integrated deal planning process that aligns the leaders accountable for deliver-ing the value in the transaction with the early phases of the trans-action lifecycle. A consistent leadership team involved from the outset has the benefit of understanding the shared learnings, as the transaction has evolved, and this team can quickly transi-tion to developing synergy capture plans when the integration planning begins. The integration design principles should build on the momentum gained during due diligence with a focus on value capture. Due diligence reports should serve as the founda-tion for this planning and provide the context for where integra-tion emphasis is needed.

Farley: It always amazes me that the majority of virtual data room projects archive the information to DVD upon close when they have the opportunity to leverage the information through-out the post-deal phase. According to the global financial advis-ers and legal counsel with whom we work, the single biggest challenge facing a company before and after a transaction is the management of business critical information. I think immediate cost savings cloud the value proposition of having a dynamic li-brary of detailed due diligence information to enable the parties to expedite the realisation of synergies.

Roy: Much of our M&A experience has been in the natural re-source sector. One of the most difficult issues facing acquirers is effectively managing acquisitions in jurisdictions in which they have not previously conducted business. While the strate-gic rationale for such acquisitions may be compelling, often the difficulties of conducting business in new and unfamiliar juris-dictions are underestimated. The primary technique for ensuring that value can be generated is to understand, as fully as possible prior to completing the transaction, the operational and cultural challenges associated with moving into a particular jurisdiction. This can be accomplished through comprehensive due diligence and establishing strong local relationships prior to completing the transaction. The due diligence phase can be used to build alliances with local service providers who know and understand the business and political environment. A comprehensive due diligence review that identifies issues of local importance can be the foundation of an effective transition plan.

How can a buyer use the due diligence phase to lay the groundwork for integrating business operations smoothly, with minimal value leakage?

According to the global financial advisers and legal counsel with whom we work, the single biggest challenge facing a company before and after a transaction is the management of business critical information.

BRANDON FARLEY

ROUNDtable


Lloyd-Thomas: Due diligence provides information which can be used at an early stage to develop potential upsides and mini-mise value erosion. This can include determining the structure of the insurance programme, with particular consideration given to: insurance regulatory and premium related tax implications of the insurance programme; compliance with compulsory in-surance requirements; the optimum program for financing risk – for example, the most cost-effective blend of retained risk and transferred risk; ensuring risk management budgets are not under-estimated; and establishing local policy terms and con-ditions – tacit renewal is standard in many countries, with 60-90 days advance notice required to cancel. Due diligence also provides sufficient time to analyse and address potential deal issues, minimising value leakage.

von Mehren: The corporate lawyers and other legal special-ists should work closely with the internal business team of the purchaser so that the resulting due diligence report will identify both potential liabilities and structural and business efficiencies. Indeed, in my experience, often purchasers may be better served by taking certain reorganisation steps either before or during the acquisition process to ensure a smoother post-acquisition inte-gration. For global M&A deals, in particular, in order to effi-ciently implement such a process, it is crucial for the corporate lawyers representing the purchaser to have both a money centre savvy and a real local knowledge of the intricate requirements of many specialist areas. Unfortunately, many clients do not recog-nise the value of this approach.

Farley: The most successful transactions on which we have worked employ a methodology of involving the strategic business stakeholders across the buyer enterprise. Key constituents should be allowed to focus on just their area of expertise and to execute a proactive strategic plan of integration rather than reacting to a tactical list of deliverables after the close of a transaction.

Faddoul: Once the target qualifies as both a strategic and finan-cial fit, a buyer must go further and begin to plan meticulously how the two entities will effectively blend their operations. The experienced and best performing acquirers purposefully incor-porate culture and integration planning into their due diligence. Culture, often cited as the prime barrier to successful M&A, must be intensively assessed and examined and go beyond ca-sual dinner banter. Integration planning, too, must go beyond informal and casual drafting by individual business divisions,

to become a top-down, mission critical element of the due dili-gence team. Leaders must refrain from tossing planning to their managers and create concise, detailed integration strategies to-gether with pre-deal training and dedicated integration teams. Only in this way can synergies and value be fully realised. In fact, a longer pre-close phase helps companies to act swiftly and efficiently after the deal has closed.

Nussbaum: A prong of the buyer diligence exercise must be the confirmation of potential synergies. If the synergies are primar-ily cost-savings in nature, diligence should focus on infrastruc-ture and the ability to reduce those costs. If the synergies are more revenue-oriented, or opportunistic, diligence should focus on the growth plan and ability to cross-sell products, etc. Inte-gration planning almost always has to occur at least post-sign-ing. A seller will rarely permit the buyer that level of discussion with management, as it can be very destabilising for the target’s business.

Jirovec: Integration teams should take advantage of the time between transaction announcement and transaction closing to develop plans to realise synergies as quickly as practical. While not all synergies will be captured in the exact categories initially identified, we have found that integration teams typically per-form well when provided a synergy target. In fact, in many cas-es, integration teams can deliver more than the anticipated sav-ings as those individuals, most closely aligned to the work, can find ways to transfer best practices across organisations to de-liver additional value. To capture this upside the use of ‘stretch’ targets for integration teams is a useful concept to embed in the functional target setting process.

Thakkar: Critical items, here, are placing enough emphasis during the diligence phase on how the merged entity will be stabilised as quickly as possible, thinking early about the right people who are going to be part of the integration team (with the right commitment) and how to manage cross-functional interde-pendencies post deal. We have seen that the natural tendency is for groups to handle different parts of the integration process in isolation, which leads to suboptimal results.

Can you describe how cultural issues might undermine a merger? What methods can companies use to address this problem throughout the transaction process, such as establishing strong leadership to guide the deal?

Lloyd-Thomas: Organisational cultural differences and people integration issues consistently top the list of significant chal-lenges in conducting successful transactions. To achieve signifi-cantly greater and accelerated value, buyers should effectively and aggressively manage the people risks and opportunities, which are critical to the deal’s success. Failure to accurately as-sess and effectively manage these issues can result in lost time, missed synergies and diminished value. Some themes do con-sistently emerge such as aligning leaders and identifying the de-sired cultures early, deliberately driving behaviour by selecting those drivers that will have the greatest impact on the culture change needed and choosing words carefully – the language used in a transaction surfaces as a key to ensuring alignment of effort. Finally, track and celebrate progress showing that your organisation is changing in the ways intended. Those achieve-ments should be celebrated during integration, and at the six month and one-year anniversaries. 8

Placing enough emphasis during the diligence phase on how the merged entity

will be stabilised as quickly as possible, thinking early about the right people who

are going to be part of the integration team and how to manage cross-functional

interdependencies post deal are critical.

SANJAY THAKKAR

This article first appeared in Financier Worldwide’s April Issue April Issue April 2010© 2010 Financier Worldwide Limited. Permission to use this reprint has been granted by the publisher. For further information on Financier Worldwide and its publications, please contact James Lowe on+44 (0)845 345 0456 or by email: [email protected]



Faddoul: Mastering M&A requires that acquirers break from traditional business practices and tenets and provide their or-ganisation with the training, discipline and tools to succeed. It is not a time for ‘business as usual’. Many mergers fail to realise the results originally identified by management. Unquestion-ably, there are many reasons for this, but culture is often an easy ‘fall guy’ when the deal goes sour. Culture may be a so-called ‘soft issue’, but its effects can truly be felt to the bottom line and it should not be underestimated. Those companies, with strong leadership and integration teams who choose to acknowledge, understand and actively manage culture – not change it – dur-ing the transition, not only reduce their company’s exposure to unquantifiable and unforeseen risks but are instrumental in the deal’s success.

von Mehren: Cultural issues are becoming more important in M&A, as the changing patterns of capital flows become more prevalent. From a legal perspective, it is important to be willing to explain issues in a clear and concise manner to foreign clients. It is also important to attempt to link the legal team with decision makers in the client. This point may seem obvious but, in some cultures, lawyers are seen in a very different light than in Western cultures – more as mere scribers than counsellors. Developing the role as counsellor requires experience in a cross-border context as well as sensitivity to cultural and internal political issues.

Farley: Dealmakers often describe virtual data rooms as bitter-sweet. Stakeholders conducting due diligence, while sitting in a conference room of a target, don’t miss the inconvenience of on-site assignments, but they cannot overlook the critical exposure to the invaluable element of company culture. One due diligence team with whom I worked used to sit in the parking lot of a tar-get to determine when a company’s day started. If it was after 7:30am, they knew there wouldn’t be a fit. Targets should also be aware that the way they disclose information could portray their company’s culture. Do they make it difficult to locate busi-ness critical data? Are they responsive to buyer questions and deliver an intuitive due diligence framework? Strong leadership can identify and address problems in a process; however, they also need to be a catalyst in recognising and appreciating the culture and valuing that component as much, if not more, than the material results the merger could deliver.

Roy: There are at least two types of cultural issues that may undermine a merger: internal and external. Internal cultural is-sues relate to the difficulty of integrating diverse corporate cul-tures. While these issues cannot be eliminated, it should be made clear, from the outset, who will be the senior management of the merged entity and who, from each of the merging compa-nies, will have responsibility over the major operational areas of the merged entity. External cultural issues can be managed by identification of, and liaison with major stakeholders in each of the jurisdictions in which the merged entity will operate. In the case of both internal and external cultural issues, a communica-tions strategy should be developed and implemented. The goal of the communication strategy should be to identify the major internal and external political issues and to articulate the merged

company’s approach to them. The messaging should be consis-tent between the acquirer and the target. Strong leadership is important and should focus on a clear and consistent articulation of the rationale of the merger.

Thakkar: Deals often fail because insufficient thought is given to the softer, more intangible, people, and change and culture is-sues during the deal process. From our experience, it is often the case that when these issues are eventually addressed, it is too late to impact hearts and minds in the right way to ensure the union is effective. The key to tackling this, as with so many other issues during a transaction, is careful planning and preparation. Other than strong leadership, clear definition and sharing of key roles between the two joining entities, one area where we have seen significant benefit throughout the transaction process is when business-unit managers have shared industry-specific knowl-edge with corporate development teams, along with insights into the company’s culture and key organisational relationships. In addition, a focus on people, change and culture throughout the diligence process assists in ensuring that the right direction, strategy and consistent HR policies and procedures are followed from day one. This is particularly important when addressing the issue of merged entity ‘pay and rations’.

Nussbaum: Human capital is nearly always an essential ingre-dient in M&A deals. Very few targets are only attractive for their physical or intellectual property assets. Further, the culture of the target enterprise will affect its willingness to be combined with another business. Methods to address culture issues include the following. Reach out to the target employee base immediate-ly following deal announcement – it is more important to settle them than to speak to your own employee base, and stay con-nected with them during the interim period before completion. Implement fair and disclosed compensation and benefits poli-cies for the target employees for the transition period, to reduce anxiety and even promote enthusiasm. The same can be said for retention bonuses. Finally, give senior management at the target a fair shot at positions of equal or greater responsibility in the combined business – many leaders have strong followings.

Jirovec: Strong leadership from the outset is necessary for an effective integration. Our experience has been that a single indi-vidual accountable for leading the integration effort is required to elevate the importance of delivering on the transaction ben-efits. Cultural differences should be expected and identified early in the integration process. Several tools are available to measure the cultural differences between companies; howev-er, many struggle with what to do with that information. Sig-nificant cultural differences in how performance is measured, employees are developed and rewarded, or how decisions are reached can have a profound impact on the ultimate value re-alised from a deal. Consistent messaging during the integration process regarding the strategic rationale for the transaction, and the values the merged company expects and rewards, will help reinforce the desired cultural end state. Don’t expect a new, merged culture to appear overnight – this part of the merger process takes time.

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Managing Transactional Risk - Cassels Brock

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