Know when to quit a job -Sri Rajan,Partner,Bain & CompanyNews | Knowledge Seeker | April 20, 2009 at 5:38 pm
An interesting article highlighting the due diligence process
Hindalco industries, which paid $6 billion for Canada’s Novelis in 2007, is scouting for copper mines in South America while pharmaceutical producer, Biocon, is targeting overseas acquisitions.
A newly confident India Inc is using its muscle to expand abroad. A recent Bain & Company study shows that Indian outbound deals in January-October 2007 touched a record $34 billion, more than a three-fold jump over 2006, and greater than the combined value of the outward M&A from Russia and China during this same period.
Globally, the total value of announced M&A deals in 2007 rose to an all-time high of $4.3 trillion. This surpassed the 2006 figure by around 20 %, despite concerns about the stability of the credit markets.
For Indian companies, the strong rupee is also making overseas acquisitions more affordable. As your company gains more confidence in competing for overseas targets, having an excellent idea of your investment thesis and what will happen after a deal closes tells you whether to pursue a bidding war.
Indeed, making the right calls about acquisition targets is a challenge that more and more top executives face, and it’s getting harder. When Bain & Company recently surveyed 250 senior managers with M&A responsibilities, half of them said their due diligence process had overlooked major problems, and half also found that targets had been dressed up to look better for deals.
Overall, only 30 % of executives were satisfied with their due diligence processes. A third acknowledged they hadn’t walked away from deals despite nagging doubts.
What can companies do to address these common shortcomings? For a start, they can rid themselves of their assumptions. Private equity firms tell us their acquirers’ advantage lies in being industry outsiders: they force themselves to ask basic questions about how an acquisition will truly make money for investors. Indeed, such coldly realistic calculations lie beneath a rising tide of private equity backed mergers and acquisitions across many parts of the world, including in India where our analysis shows the PE market has more than doubled from 2006 to 2007 and is likely to grow at a very healthy pace going forward.
Top corporate buyers take a similarly rigorous approach: “When I see an expensive deal, and they say it was a ‘strategic’ deal,” says Craig Tall, vice-chairman of corporate development at US mortgage firm Washington Mutual, “it’s a code for me that somebody paid too much.”
Develop your investment thesis
Due diligence starts with verifying the cost economics of the proposed deal. Buyers must ask such questions as: Do the target’s competitors have cost advantages? Why is the target performing above or below expectations? To arrive at a business’s true standalone value, all accounting idiosyncrasies must be stripped away.
To put these questions in the right context, potential acquirers need to be clear about the deal’s strategic rationale — its investment thesis. Is the deal intended to be an active investment of the type that PE firms specialise in? Then the attention should be on the stand-alone cash flow.
If it’s a scale deal, then the due diligence teams should zero in on the integration costs and the question of scale economy as well, to help decide if a target is worth pursuing. For an acquisition aimed at increasing scope, the analysis should also include revenue and customer synergies.
This all sounds obvious but many acquirers have seen deals fail because of a vague investment thesis developed late in the process.
Our survey of senior managers showed around 50 % of failed deals did not have an early and well-developed investment thesis while over 90 % of successful ones did. The survey also noted a clear co-relation between a lucid and well-developed investment thesis and the ability to accurately estimate synergies: 80% of respondents who accurately calculated synergies of a proposed deal had a very clear investment thesis. Those with a vague strategic rationale fared badly in comparison: only 20 % were able to make a precise assessment of synergies.
Acquirers need to hammer out their investment thesis first and then send out due diligence teams to look beyond the reported numbers and test the target’s fitness: whether it will live up to the objectives of the investment thesis.
Use the fine comb
That’s what Cinven, a leading European PE player, did before acquiring UK theatre chain Odeon Cinemas. Rather than simply reviewing aggregate revenues and costs, Cinven’s analysts combed through the numbers of each cinema. They painted a rich picture of local demand patterns and competitor activities, including data on attendance, operating costs and likely capital expenditures. That microexamination revealed that estimates of sales growth at the national level weren’t justified by local trends. Armed with the findings, Cinven negotiated to pay £45 million less than the original asking price.
Indeed, successful acquirers create a detailed picture of their target’s customers. They begin by drawing a map of the target’s market—its size, its growth rate and how it breaks down by geography, product and customer segment.
Bridgepoint, another European private equity firm, is particularly adept at this kind of strategic due diligence. In 2000, Bridgepoint was considering buying a fruit-processing business that we’ll call FruitCo. As the leading producer of the fruit mixtures in yoghurt, it seemed a good bet. Western consumers had been spending between 5 %t and 10 % more each year on yoghurt, and the market was growing faster still in the developing world, particularly in Latin America and Asia. FruitCo looked like a winner to Benoît Bassi, the managing director of Bridgepoint. Yet, just four weeks later, Bassi killed the deal.
What happened? During those four weeks, the due diligence team had discovered many figurative worms in the FruitCo apple. For instance, when the team tested Fruit-Co’s price and revenue forecasts, they found that although the market for fruit yoghurt was indeed growing, profitability in many markets was falling rapidly. Further, consumers told Bridgepoint’s researchers that they were unlikely to tolerate increased prices.
Next, the team examined the capabilities of competitors. They found that while FruitCo boasted considerable global scale, regional scale turned out to be the more relevant driver of costs. That was because the economics of transportation and purchasing made the global sourcing of fruit—a major cost component—unfeasible. At the same time, advanced processing technologies enabled FruitCo’s competitors to achieve competitive economics at the country level.
By performing painstaking due diligence, Bassi said he came to recognise that, “What we thought we knew turned out to be wrong.”
What Bassi and other successful acquirers realise is that the ultimate goal of due diligence is to determine a walk-away price. And, for this price to have meaning, it can’t be academic. Successful deal makers are willing to walk away and often do. In the end, effective due diligence is about balancing opportunity with informed scepticism. It’s about testing every assumption. It’s about not falling into the trap of thinking you’ll be able to fix problems after the fact. By then, it’s usually too late.
Sri Rajan is a partner with Bain & Company and leads its M&A and private equity practices in India. Karan Singh is a partner in the Bain India office.
This article was published on 15 Feb 2008 in Economic Times
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