The Philippine merger and acquisitions (M&A) landscape in 2017 spanned a variety of sectors, from digital payment platforms and convenience stores, to logistics, power and tobacco. But what drives M&A?
Let’s go back to the basics. Entrepreneurs form a company to engage in certain business activities for profit. So, management aims to create value to its shareholders by continuously growing revenues, profits and cash flows, which are either plowed back into the business or distributed as dividends.
When a business reaches a plateau, management considers M&A to accelerate and sustain its growth prospects. It can either grow horizontally by acquiring a competitor to increase market share, or vertically by merging its operations with a supplier to improve cost efficiencies. On the flip side, a company may also spin off its non-core operations and focus on growing its main business.
As M&A transactions involve huge amounts of money, management should conduct proper due diligence. While all areas should be covered, financial due diligence plays an important role in M&A deals. Take this acquisition of a software firm by an IT multinational company as an example. The buyer paid $11.1 billion – a 64 percent premium for a company with allegedly $1 billion revenues in 2010, consistent double-digit revenue growth, 87 percent gross margin and 43 percent operating margin. After more than a year, the buyer took an $8.8 billion write-down on its investment. Would a more extensive due diligence have revealed the red flags and avoided the huge write-down?
When you’re buying a business, financial due diligence provides you with:
• A better understanding of the company’s business
Through a quick industry scan, discussions with key management team and review of major contracts, a financial due diligence could give you a better understanding of the target’s business and growth prospects to see if the company fits into your strategy.
• A starting point for the company’s valuation
In the M&A world, businesses are often valued based on a multiple of EBITDA (earnings before interest, tax depreciation and amortization). With this financial key performance indicator, a financial due diligence analyzes a company’s historical financial performance and key drivers to estimate its sustainable earnings and identify potential synergies.
• An assessment of assets to support the business
Assets are assessed to verify if they are potentially overvalued or if there’s a need to replace fully depreciated assets. Capital expenditure costs are also highlighted to help you prepare funding, if needed.
• A company’s ability to generate cash flows
Cliché as it may sound, cash is king. After assessing a company’s earnings, it is equally important to check whether a company generates enough cash flows or resorts to outside financing to fund its day-to-day operations. This could help you estimate the amount of operating funds that you need to set up upon takeover.
• Protective mechanisms against potential undisclosed liabilities
In coordination with the legal and tax due diligence teams, financial due diligence can highlight undisclosed liabilities that could lead to outflow of resources. Financial due diligence gives you insights on how to address these potential undisclosed liabilities.
• Impact of related party transactions
A company may have assets used in the business and/or costs shared within a group of companies owned by existing shareholders that are either free of charge or charged below market rates. Financial due diligence helps you identify additional costs that could be charged to the company once the transaction is completed.
• Internal control risk areas to focus on
A financial due diligence provider must have a good understanding of how the systems are linked, the manual processes involved, and if checks and balances are in place. This puts him in a good position to give a view on the high-risk areas that the buyer needs to focus on during the first 100 days after acquisition. This, in turn, will allow the buyer to maximize the value of the acquired business by monetizing synergies from the acquisition.
• Insights on key management team’s competencies
Because a financial due diligence advisor talks with senior management members, he can gauge their competencies and commitment to achieving the company’s goals. This can help you assess the key management team members who are capable of implementing the company’s strategies.
Financial due diligence is done not only by buyers, but also by sellers. Both buyers and sellers can benefit from a vendor due diligence (VDD) report, which summarizes the key issues and financial analyses normally done in a financial due diligence. A financial due diligence advisor is engaged by the seller to do the VDD report but the duty of care is with the buyers. Below are the benefits of having a VDD report:
• Smoother and faster process
One can avoid nasty surprises as critical issues are identified earlier. Because of this, a seller can identify options to address these issues, and discuss these with the buyer right away.
• Cost savings
With fewer people on the ground, the seller can devote more time to growing its business than attending to the requirements of a financial due diligence. Similarly, the buyer can save on costs by performing top-up financial due diligence instead of performing a full-blown review.
• Improved valuation
Less disruption in the sale process captures the synergies from a deal early and optimizes valuation of a business.
Financial due diligence might seem expensive, but skipping it might eventually be more costly for the buyer—overpaying for a business and going through the trouble of untangling the wrong acquisition.
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Anna Marie G. Ordoñez is an executive director from the Deals and Corporate Finance department of Isla Lipana & Co., a member firm of the PwC network.
For more information, please email email@example.com. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.