Integrity Due Diligence

Since 2015, UQ have been asked to undertake a range of reports and projects to help customers understand the landscape ahead of them. This is due to a change of circumstances, a change of strategy or a willingness to grow. Over the last 2 years, this type of research and support has been classified by a number of global consultancies as “Integrity Due Diligence”

Within UQ, we view Integrity Due Diligence (IDD) as all non-financial areas of insights and intelligence that add value into a companies’ growth strategy. This could be relative to M&A activity but also route to market strategy, recruitment and retention of talent and successful bid management.

IDD includes available public records sources such as corporate and compliance databases, subscriptions, journals, and media. In addition, UQ undertake third party interviews and reviews with key individuals and supplier’s past and present, to look to add depth and context to the insight.

Within this service, UQ identify and profile across a range of topics. Such as: –

Beneficial ownership: direct and indirect shareholdings, illustrated through a corporate structure diagram
Financial Overview relating to most recent financial submissions
Corporate activities: operations, media profile and identifier information
Key personnel: professional history, directorships, affiliations and management style
Supplier Relationships: How valued and rated are they within their desired supplier base.
Recruitment Strategy: How do they go about attracting talent to join/ remain within the organization.
Key Customers: Big wins or loses linked to reliance on top 20% of customer base in terms of annual revenue.
Ongoing Issues: Any insights or chatter from within the sector that may have relevance.

Reports are usually bespoke to each customer but link a number of the above areas of interest within the research phase.

Integrity Due Diligence (IDD) service is now essential in doing business as to ensure the correct resource and investment package is allocated to each and every opportunity.

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UQ Merger & Acquisition Support

In considering whether M&A is the appropriate method to improve shareholder value, performance and market competitiveness, a company should first review its corporate strategy

Target Sourcing & Selection

Once the company has determined that an acquisition fits with its wider corporate strategy, the next phase is to identify potential targets, synergy opportunities and to arrive at a valuation.

Defining Screening Criteria

Affordability – potential acquisition targets are reviewed in terms of market capitalisation, revenues, net assets value

Synergy Expectations

The synergies available can be significant and are often the reason for the acquisition. Synergies can be difficult to quantify and their capture is uncertain. It is therefore essential that they are considered carefully throughout the M&A process.

Executing the Deal

Having determined that M&A is consistent with the corporate strategy, identified and valued the target, the deal must then be executed. At this stage, identification of key issues within the target business can make the difference between a successful deal at the right price and an expensive failure.

M&A strategy

In considering whether M&A is the appropriate method to improve shareholder value, performance and market competitiveness, a company should first review its corporate strategy.

Corporate strategy makes the company greater than the sum of its business units, and sets out the organisation’s direction and goals, business portfolio, resource allocation and growth plans.

A corporate strategy review is critical for success. However, it is often neglected by executives under pressure to achieve short term results. One of the primary causes for acquisition failures is a lack of insight into the target company, its core competencies and limitations, and changing market conditions.

The rigorous analysis conducted in a strategy review enables a company to understand its internal strengths and external market conditions over the coming few years. This analysis helps to develop a set of prioritised options, such as an acquisition or divestment, to achieve its objectives.

As challenges and opportunities for growth are defined, options to defend, grow, fix or exit can be assessed and prioritised based on the company’s goals, capabilities and financial position. Generally, companies can choose from a myriad of strategic objectives such as:

profitable growth– to increase business breadth or depth through revenue growth, market share capture, margin enhancement or improved asset utilisation;
skill strengthening– to acquire the necessary talent to remain competitive (e.g. personnel, technology, capability, geographies, etc.);
defensive action– to ward off potential take-over attempts or fix existing business/operational problems;
opportunistic posture– to capitalise on a unique market/competitive opportunity or a developing business formula;

Depending on a company’s strategy, acquisitions may serve as a way to quickly achieve strategic and financial objectives.

TARGET SOURCING & SELECTION

Once the company has determined that an acquisition fits with its wider corporate strategy, the next phase is to identify potential targets, synergy opportunities and to arrive at a valuation.

Developing a pool of targets

In assessing investment opportunities, a company should evaluate the attractiveness of the sector in which it plans to conduct an acquisition by:

understanding the industry structure and leverage points, where value can be captured;
appreciating the market scale, and growth potentials;
understanding the key players, both domestic and foreign-owned, along with competitive dynamics;
envisaging any technological trend; and
identifying entry barriers.

Once the decision is made to pursue opportunities in a sector, the company can begin its preliminary research on potential acquisition candidates.

Developing the acquisition candidate pool

The first step in a target selection process is to develop a long list of potential acquisition candidates. This involves a high-level search based on criteria such as:

Sector/industry.
Competitive position within the industry/product mix.
Revenue/size.
Market capitalisation.
Location of operations.

Often a search will come up with more than 100 potential candidates in the long list. These potential candidates will be further screened and profiled.

Sourcing potential acquisition candidates

Finding the right candidate, a buyer or a seller, requires time and patience. A search for a target requires an extensive review of potential candidates before finding one that fits a company’s strategic needs, whilst being fairly priced.

A company could identify potential acquisition targets by conducting internal analysis or using its own network. Some business owners would search openly for a buyer whilst others would identify potential candidates through:

examining the financial position of potential companies. Financial problems such as cash shortages or excessive debt may indicate that a sale may be necessary; and
investigating the potential company’s shareholding and management. Indications of possible future sales include an owner nearing retirement with no heirs in key management positions, absentee owners, or financial investors potentially interested in an exit strategy.

Affordability – potential acquisition targets are reviewed in terms of market capitalisation, revenues, net assets value;

profitability – i.e. targets’ EBITDA/EBIT, net margin and free cashflow;

shareholding preferences – i.e. determining the desired level of control over the target and defining a criteria for either a majority or a minority shareholding;

transaction structure preferences – i.e. acquisition of shares against assets; and
management requirements – i.e. taking into consideration leadership style, expertise, receptivity to change, compatibility of culture, and modality of management after the completion of the transaction.

Operational

marketing criteria: product lines, customer base, brand reputation, geographic area, distribution channels;
research & development requirements: e.g. licences, patents, research & development centres, product pipeline, research & development expenses; and
production criteria, such as facilities, labour supply, production techniques and capacity. Short-listed targets should be further screened to determine:
their fit into the buyer’s current business portfolio; • their competitive position and future prospects; and
the value they create for the buyer.

Collecting target data

Availability of target data in the UK is generally good. UK companies have to file publicly available financial statements on an annual basis. These must be audited wherever a company exceeds certain size limits. For listed or quoted companies, more regular reporting is required and information may be available from investment analyst coverage.

Prioritising targets

Buyers should prioritise potential targets according to the number of screening criteria the target companies fulfil. This is also an opportunity to establish under what circumstances the company would walk away from one target and move on to the next.

Prior to approaching the target company, additional research and information gathering should be conducted by a financial advisor to provide a more complete picture of the candidate. This would include information on ownership and management teams in the target companies, and include subjective elements such as family situations and succession plans (e.g. the willingness of children to take over the business). Very often, negotiation levers are identified during this process.

An experienced lead advisor will:

assist in prioritising the targets;
develop appropriate strategies and tactics to approach the targets;
prepare appropriate Confidentiality and Exclusivity Agreements; and
develop the right time frame for negotiations and due diligence.

An initial part of due diligence is identifying potential synergy opportunities between targets and the buyer. Only targets that bring additional value to a company should be considered in an M&A exercise.

A synergy may be defined as the increase in performance of the combined company over what the two companies are already expected or required to accomplish as independent companies. Put simply, synergy is either the revenue enhancing or cost savings achieved by integrating.

Revenue enhancing synergies. A revenue enhancing synergy results in additional revenue above and beyond what the two companies are expected to accomplish independently. Revenue enhancements promote higher returns and facilitate long-term growth more than cost savings, but they tend to be difficult to quantify. Most initiatives that can enhance revenue can be grouped into:

market expansion: Entering new markets and expanding market share;
margin improvement , by implementing a better pricing strategy;
asset utilisation: Enhanced performance through better and more efficient use of existing assets;
investments: Better return on investment (ROI) on existing investments. For example, the acquiring company has an extensive IT infrastructure which the target company can also access; and
products and services: Increasing product portfolios and service portfolios by creating better product mixes, or removing a potential substitution option. Cost saving synergies. Cost saving synergies can generally be categorised into:
duplication avoidance: Avoidance by consolidating functions on a centralised basis, i.e. shared services, or by combining similar expenditures, e.g. licenses;
economies of scale: Increased purchasing power, e.g. improved pricing on contract services;
expenditure avoidance: For instance, avoiding the expense of new distributor relationships or the duplication of existing capacities such as IT systems;
operational efficiency: Increasing your control of processes, e.g. maintenance scheduling;
practices adoption: Using technology from the target company, i.e. technology transfer;
organisational streamlining: Reducing organisational layers and breadth, e.g. spans of control, substitution of external/internal sources; and
performance realignment: Considering more efficient structures, e.g. centralising certain departments or outsourcing.

Identifying and reviewing synergy opportunities is critical to determining whether a candidate company should be further considered as an acquisition target. Selecting the appropriate target will enhance the performance of the buyer after integrating the entity

Evaluating the target

It is critical for the company Directors to consider both the risks and rewards associated with a prospective acquisition. In broad terms the due diligence would seek to understand the underlying profitability of the business, the identification of potential liabilities and exposures, and any matters to be addressed in the integration of the target’s operations into those of the acquirer.

The scope and depth of the review will depend on many factors, including the complexity, size and geographical spread of the target’s operations. It is important that the due diligence is performed by professionals with a balance of financial and sector knowledge.

Due diligence would normally include a commercial review of the market and competitors, a detailed review of the historical financial performance of the business, a review of the target’s tax affairs to identify potential exposures and tax compliance, and a robust review of the target’s business plans. The due diligence would also cover an assessment of the target’s financial reporting procedures and management capabilities. The negotiation of the sale and purchase agreement (SPA, see 6.4 ‘Finalising the transaction’) is a critical part of the process – contractual provisions are built into the SPA to protect the acquirer from the impact of potential exposures identified as part of the due diligence process.

Investigating management

In recent years it has become commonplace for acquirers of UK companies to conduct background checks on the target and senior management (the Subjects) – frequently referred to as Integrity Due Diligence (IDD). These checks seek to identify information that can assist the acquirer both with better understanding the Subjects and identifying ‘red flag’ information that may be found on public records.

IDD checks on UK targets involve searches through a wealth of UK public record information. Companies House not only holds a company’s filings (such as Financial Statements and Annual Returns), but also a list of those individuals who have been disqualified from holding UK directorships. A wealth of information is also held in media databases, which cover both specialist and national press, with some articles even dating back to the late 1980s. Litigation databases are also accessible and, whilst they don’t cover criminal records (which are not a matter of public record in the UK), they do cover certain criminal cases heard by the Court of Appeal. Also available to the public are records covering insolvency or bankruptcy and civil debt judgements awarded against a company or individual by a County court.

Assessing the target’s operations

In most cases the deal execution starts with an initial understanding of the target via an Information Memorandum (IM). However, the operational due diligence will provide a broader insight into the target’s operations as it will allow the acquirer to compare the target’s operational performance relative to its industry competitors.

Operational due diligence is increasingly being used by corporations and private equity firms to help identify operational risks and/or opportunities in a target. Typical operational risks might include separating a division from its parent company or the successful delivery of a planned operational restructuring/performance improvement initiative, which often support forecast EBIT growth (Earnings Before Interest and Tax). Operational opportunities identified during a due diligence typically include cost synergies from the post merger integration, or the identification of potential opportunities to deliver performance improvement/cost reduction within the target.

The target’s operations are assessed for their ability to support the forecast assumptions that underpin the target’s valuation: outputs, costs, quality, delivery, cost savings, management structure and capabilities. The diligence can then be refined and enhanced as access to the target and further information become available.

Deal structuring

A buyer should generally structure the transaction by taking into account the needs expressed by the seller as well as their own requirements. There are many ways to structure and specify terms for a transaction. Essential to formulating the optimal transaction structure, the buyer (with the assistance of a financial advisor) should:

conduct a scenario analysis on different possible transactional structures;
evaluate the financial impact on the company for each scenario; and
identify and determine the appropriate deal structure.

A buyer can either buy the shares from existing shareholders or directly acquire the assets from the target company. Acquiring shares tends to be more popular than acquiring assets because:

all shareholders of the acquired entity will share the risks of the merger;
an asset acquisition may require consent from third parties not directly involved in the transaction; and
tax considerations (see section ‘Tax Structuring’ below).

In addition to the financial structure of the deal, buyers may also consider management, assets, tax and financing issues, in order to structure the transaction in a way that suits all parties involved

Continuity in management

The continued employment of management is often subject to considerable negotiation. A buyer often considers the management team as a key asset in an acquisition, particularly if the buyer is a financial investor. Under such circumstances, employment agreements are often negotiated with key people, specifying terms, responsibilities, remuneration, and equity participation. Buyers should recognise that retaining existing management would provide continuity in business operations while slowing down cultural integration.

Consideration

The consideration a prospective buyer can offer may be in the form of cash, notes, stocks, shareholders loans, or a combination of the above. Since each form of consideration has different implications and liquidity, the transaction price may be subject to further negotiation depending on the form of consideration offered. The two most common forms of consideration are cash and stock. Figure 11 summarises the characteristics of each.

Contingent payouts

During price negotiations, points of view may diverge on business forecasts. The buyer may believe the growth rate will be lower than what the seller presents. Considering that the price might be based on forecasts provided by management, it is critical to make sure that the figures are as accurate and achievable as possible. One way to break the impasse may be a contingent payment agreement, where additional payments will be made only if the company meets certain pre-defined goals after the transaction is completed.

Before signing any Sales & Purchase Agreement, both parties should understand that there is a chance the deal may not happen for the following types of reasons:

a potential candidate may receive a better offer after the exclusivity period ends;
the shareholders of the target company may ask for a higher price; or
findings from due diligence may reveal new issues or may not meet expectations.

There are many factors that may halt the M&A process. Whether a company will want to search and pursue another target will depend on a number of factors – strategic need, business conditions, morale of the M&A team, and time already spent.

Advice on integrating the target into any existing group (which often results in ideas for a post -acquisition 100 day plan), for example a review of the new group’s transfer pricing policies, tax efficient supply chain management, cash pooling and group treasury functions, planning around intangible assets (egg intellectual property), effective tax consolidation, opportunities for tax credits (egg research & development credits available in many countries) and key compliance/tax risk management features of the new structure.
Advice regarding financing the acquisition tax efficiently, including issuing stock as consideration to sellers and/or taking on third party acquisition debt. Where there are third party lenders, they sometimes require reports
Mitigating acquisition costs, including VAT on transaction costs, tax deductibility of transaction costs, transfer taxes (shares & real estate) and capital duty.
Anticipated exit strategies and sales of non-core businesses. Often, a client’s strategy includes selling off non-core businesses in the target group in the months following an acquisition.
On multi-jurisdictional transactions (egg for European groups), taking responsibility for integrating advice from tax advisers across multiple jurisdictions to ensure that the end product is complete and covers all of the areas necessary.

Overall, tax considerations must be integrated into other areas of the deal. For example, all of the above structuring has to be achievable within the legal framework of the jurisdictions involved, so ensuring that tax and legal advisers work closely together enables a complete and workable solution, as opposed to one that works for tax but which is not capable of being implemented for legal reasons.

Growth Through Intelligence

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