The U.S. mergers and acquisitions (M&A) market is at an all-time high. The competition between buyers for attractive acquisition candidates is driving up valuations. In fact, transaction multiples of 10 or more are now considered common. However, there is also a dark side to a hot M&A market, which includes the use or creative deal structures. These structures often include items, such as seller financing and earn-outs, which are used to bridge gaps in the capital structure.
Sellers naturally want to present their businesses in the best possible light, since they are often valued based on multiple earnings before interest, income taxes, depreciation and amortization (EBITDA). In a market with heavy M&A activity and high valuation multiples, private equity (PE) firms actively seek strategic and synergistic investments. However, in this atmosphere, there are inherent risks to buyers, who may potentially pay a premium for their target or assume unexpected risks.
Buyers and sellers frequently find themselves involved in post-closing disputes involving matters such as working capital adjustments and earn-out calculations. Because of complexities associated with many transactions, working capital and earn-out disputes often occur due to vague language and undefined terminology. That’s why it’s important to clearly define how the post-closing adjustments and measurements will be calculated and what sources of data will be used. Forensic accountants are frequently used to resolve post-close accounting disputes between a buyer and a seller.
Courts have basically said that while sellers must be truthful and transparent in their M&A dealings, ultimately buyers must be diligent in their investigations and cannot rely solely on sellers’ representations and warranties. This creates danger on both sides. Sellers are at risk if their financial statements are misstated or they accidentally misrepresent information, just as buyers are at risk if they don’t thoroughly examine their investment target before finalizing the transaction.
The due diligence environment has become increasingly complex. Historically, the buyer would focus on financial results and trends of a target. Today, the due diligence process frequently extents to areas such as tax matters, cybersecurity, information technology and customer assessments.
“Many investors downplay the critical role comprehensive due diligence plays in M&A transactions,” says Scott Moss, CPA, Cherry Bekaert’s Managing Partner of Advisory Services. “There are many ways to window dress a company to artificially inflate the EBITDA and corresponding valuation. Equally important is assessing a target’s cybersecurity and evaluating the overall information technology environment. Without an extensive assessment of the IT and cyber environment, a buyer may only see the tip of the iceberg and not fully comprehend what lies below the surface.”
Including these three specific examinations during the analysis and valuation period of your M&A transaction can reduce the likelihood of a post-closing transaction dispute. If you’re the seller, this checklist can help you know what to focus on to get your house in order before the sale. If you’re the buyer, include these steps in your due diligence.
- Assess your target’s information technology environment – IT and systems due diligence is a critical aspect of any deal. Technology infrastructure often doesn’t receive the level of investment it needs to ensure that the technology is up to date and that a potential future buyer won’t find themselves owning a business that unexpectedly requires hundreds of thousands of dollars in system upgrades to process basic transactions.
- Assess your target’s cyber risks – Hardly a day goes by that major headlines don’t include news about cyberattacks or data breaches. These issues aren’t just challenges for large companies. In fact, many middle market companies are targeted and affected more by cyberattacks, because they aren’t always able or willing to make the investment in data protection and cyber risk best practices that are required to run a world-class business.
- Understand the sustainability of positive trends in a business – A potential buyer’s ability to effectively evaluate the sustainability of positive growth and financial performance trends in a business is a critical differentiator between a successful long-term deal and an unsuccessful one.
Johnathan Robertson, president and managing director at TG Capital, a PE firm, affirms the importance of M&A due diligence. “Especially in active markets where there are price and time pressures, investors should uphold their diligence standards. Done well, a robust diligence process makes an investor smarter on risks and often reveals unexpected upside avenues. Given that a bad deal can take up more time and resources than five good ones, thorough and expert diligence actually saves time and money over the long term.”
Another recent advent in the M&A market is the use of representation and warranties insurance. These polices shift the potential liability for unintentional and unknown breaches of representation and warranties to an insurer for a fixed cost. According to Kyle Frigon, a director at Cherry Bekaert Benefits Consulting, “Buyers and sellers will frequently agree to use rep and warranty policies as a bridge to close gaps over escrows, deductibles and caps on claims. These policies are being utilized more and more frequently and can act to speed up the time needed to close a transaction.”
Adding these actions to your M&A checklist, as well as working with a qualified due diligence team, will help increase your satisfaction with your M&A transaction and should decrease the risk of the transaction going sideways.
Steven A. Wolf is a partner with Cherry Bekaert’s South Florida office who specializes in forensic accounting, economic damages, fraud investigation and valuation services. He has extensive expertise on matters involving complex commercial contract disputes, internal investigations, partnership and shareholder disputes, construction default and delay claims, post-acquisition disputes, economic damages and earning loss calculations, professional liability claims and bankruptcy matters.