Thorough scrutiny can improve transaction deal capture
Enterprise-wide diligence has always been an important part of the mergers and acquisitions process, but it has become increasingly critical in the past three to five years.
Buyers are becoming more sophisticated in their analysis and scrutiny of their acquisition targets, and sellers have to be prepared for that rising level of inquiry. Buyers and sellers have come to understand that just performing financial diligence does not provide nearly the level of insight needed in a deal.
The effects of the COVID-19 pandemic brought into focus the need for close scrutiny of supply chains as well as workforce issues that include key talent retention and HR compliance. And as technology has become a differentiator for all kinds of businesses, buyers and sellers need insight on IT systems and capabilities — and cybersecurity risks and controls.
Lack of attention to culture often contributes to a deal’s failure to attain the expected value. And on the heels of the great resignation, which led to increased reliance on digitalization, buyers are considering more pricing issues related to deals.
“You don’t just buy the assets and earnings. You are buying an entire business…Pay attention to the people, processes, systems and operations.”
“The last three to five years have taught people that you don’t just buy the assets and earnings,” said Ben YoKell, Grant Thornton Transaction Advisory Principal. “You are buying an entire business. And sellers are trying to sell a business. They need to pay attention to the people, processes, systems and operations as part of a single, holistic look at the entire enterprise.”
Some buyers and sellers also learned difficult lessons during the transaction frenzy that occurred in 2021 and the early part of 2022. During this period, there was intense competition for available M&A targets that resulted in purchases made without thorough due diligence.
Buyers who overpaid during this time may want to perform more diligence as they pursue their next transactions.
“Doing diligence work that captures all these functional areas before deal close can substantially increase the probability that the buyer will achieve the value they’re anticipating.”
“Our clients learned that they needed to know more about people, systems and operations before they closed the deal,” said Angela Nalwa, Grant Thornton Transaction Advisory Managing Director. “Enterprise-wide diligence doesn’t usually prevent a deal from moving forward. But it raises awareness of potential risks and issues that companies need to be aware of as they’re integrating.”
Buyers who are seeking this kind of comprehensive diligence often need a third party with expertise in all these functional areas — IT, supply chain, human capital, financial and tax — to obtain a full understanding of the value of the acquisition. Sellers also often find they need outside expertise to get a complete view of the value of the assets they are selling.
“Doing diligence work that captures all these functional areas before deal close can substantially increase the probability that the buyer will achieve the value they’re anticipating in their investment thesis,” said Brent Johnson, Grant Thornton Transaction Advisory Partner.
Understanding systems and technology
An organization’s technology and systems play such a key role throughout operations that they need to be understood to get a full picture of an acquisition target’s capabilities.
“Technology is part of every single business process. It either enables or obstructs in some way everything that you’re trying to do”
“Technology is part of every single business process,” said Richard Sittema, Grant Thornton Transaction Advisory Principal. “It either enables or obstructs in some way everything that you’re trying to do, so it’s only natural to want to understand what risks your target’s technology is driving in the business and how those costs might change as a result of the transaction — both one-time and recurring spend.”
One important area that is often misunderstood is the extent to which the acquisition target’s technology systems can be integrated with those of the purchasing company. Merging IT can often introduce substantial savings based on reducing overlaps in capabilities, but the extent of those savings can vary greatly and requires a deep analysis to fully understand.
Meanwhile, the organization’s data provides the building blocks for all these systems and their value.
“A technology application is really just a defined business process that you purchase or license,” Sittema said. “The real asset is the company’s data. And so that’s what buyers and sellers need to understand. What data is there? How is it being stored? How is it being transmitted and how is it being protected?”
Data protection may be one of the most important risks of the whole transaction. A seller with lax cybersecurity controls poses a greater risk of introducing breaches to the merged organization’s systems when the technology is integrated after the close. The potential for harm is immense, so cybersecurity risks need to be fully understood during diligence, and solid cost estimates for the remediation of known gaps need to be developed.
Diligence on people factors
One critical factor for achieving full value in a deal is the organization’s ability to keep key talent. A 2019 study by a MIT Sloan Management School doctoral candidate showed that within the first year of a company’s acquisition, 33% of acquired workers left, compared with 12% of regular hires with similar skills and work experiences.
“Those are the people that you need to run the business to capture the value of the transaction,” Nalwa said.
That’s why it’s important to identify critical talent long before the transaction closes. Mergers and acquisitions are often unsettling for most employees at an organization — sometimes unnecessarily so. In many cases, the best employees are unaware that one key aspect of the deal is the contribution that they will bring to the reconfigured organization.
When effective enterprise diligence is conducted, those people are identified early. Leadership can then communicate transparently with them and provide the incentives necessary to convince them to stay.
Meanwhile, diligence can uncover HR compliance issues that can have a critical impact on a deal. Workforce classification issues in particular can have a substantial effect on deals, as the thorny question of whether certain workers should be considered employees or independent contractors can cause significant compliance risks for the buyer in a deal.
“One of the biggest issues is making sure people don’t fall off payroll, and that they are on the payroll system on Day One.”
Enterprise diligence can uncover scenarios where the seller is classifying workers as independent contractors when they should be treated as employees. This can have a major effect on the value of a deal.
In preparation for the close of the deal, diligence can also enable Day One readiness, confirming that HR systems are being integrated properly, data is being handled and transferred appropriately, and that the combined organization will be able to sustain appropriate payroll and benefits procedures as soon as the combined entity is formed.
“You want to make sure that nobody is losing compensation and benefits — or if they are, that you’re aware of it and adjusting for it at the time of the closing of the deal,” Nalwa said. “One of the biggest issues is making sure people don’t fall off payroll, and that they are on the payroll system on Day One.”
What to look for in operations
Diligence in operations in a transaction generally focuses on the pillars that affect the value of a deal — service, cost, cash, and risk:
Service: The ability to deliver top-line revenue is contingent upon the delivery of a product, service or information. Anything that interferes with that service delivery will prevent the generation of the revenue that is part of the deal thesis.
Deficiencies or inefficiencies in the supply chain, production processes or delivery mechanisms pose a threat to revenue. In some cases, acquisitions are designed specifically to solve those deficiencies or inefficiencies. But it’s important during the transaction process to gain an understanding of these issues.
Cost: The margins achieved after a deal are affected negatively when costs exceed the expectations laid out in the deal thesis. Higher-than-expected people costs, system costs and operations costs can all lead to disappointment with the results of a transaction.
“Your ability to deliver EBITDA as expected is considerably reliant on the efficiency and effectiveness of your operations,” YoKell said.
Cash: The working capital and cash-to-cash cycle that result from the order-to-cash, procure-to-pay, and inventory management operational processes have direct financial implications that are included in financial due diligence. Taking a deeper dive into those key operational processes ahead of close can help de-risk cash flow barriers and obstacles that may need to be mitigated sooner rather than later.
Risk: Buyers need to enter deal negotiations with a robust understanding of the risks that may be encountered as a result of the transaction. Sellers also need to take stock of how shedding an asset might affect their risk profile.
A comprehensive approach
Some emerging trends in our culture create substantial risks that have the potential to create buyers’ remorse. Home buyers sometimes waive inspections that could reveal pricey defects in their new properties. It’s now possible to purchase used cars online without test driving the vehicle or having an independent mechanic search for flaws.
But parties in transactions are trending in the opposite direction and eager for more visibility into the fundamentals of their deals. In the same way that a home inspector or mechanic can protect buyers and sellers in the consumer world, a third party with all the relevant expertise in financials, tax, operations, HR and technology and systems can give buyers and sellers the insight they need to get the most out of a transaction.
“They’re seeking better insights into the company, the risk universe, supply chain challenges, the culture and the workforce,” Sittema said. “They’re getting a feel for what could blow up the deal outside of P&L and known risks. And that gives them comfort moving forward.”
Contacts:
Brent Johnson
Partner, Transaction Advisory
Brent is a Partner in our Transaction Advisory practice and has more than 20 years of business experience that includes assurance, financial advisory and interim management services
Minneapolis, Minnesota
Industries
- Construction & real estate
- Manufacturing, Transportation & Distribution
- Technology, media & telecommunications
- Transportation & distribution
Service Experience
- Advisory
- Transaction advisory
Angela Nalwa
Managing Director, Transaction Advisory Services
San Diego, California
Richard J. Sittema
Principal – Advisory Services, IT Transaction Advisory, Healthcare and Manufacturing Practices
Richard Sittema has more than 15 years of experience in business consulting. He started his career in business analyst roles on large-scale systems integration and IT-related consulting engagements for public, private and not-for-profit organizations.
Cleveland, Ohio
Industries
- Manufacturing, Transportation & Distribution
- Not-for-profit & higher education
- Healthcare
Service Experience
- Transaction advisory
- Technology modernization
- Risk advisory
Jonathan Eaton
Principal, Growth Advisory
Jonathan is best most recognized for his ability to help clients define their supply chain strategy in response to changing market conditions and other disruptive forces and subsequently helping
Charlotte, North Carolina
Industries
- Manufacturing, Transportation & Distribution
- Technology, media & telecommunications
- Energy
- Retail & consumer brands
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