Risk and Threat Management – Presented by Greg George

Inside The Due Diligence Value Proposition: A panel of experts

Posted in Due Diligence by gtiadvisors on June 27, 2009

Useful information for both veterans and those new to the Mergers & Acquisitions game.

The information presented here, from a LinkedIn discussion string at the Private Equity Investment Group demonstrates the dimension, insight and multiple perspective views on the purpose and value (or contrary value) of completing due diligence as discussed by a participating group of experts.

This was too good not to share.  Another true example of awareness and educational value provided by social media forums that support professional collaboration.

Norman Mainer

Senior Information Technology and Services Manager and Consultant

“Due Diligence” value proposition?

What do you all think of the REAL value of “Due Diligence”? Think of “options pricing” for information and/or labor.

Example 1 – a two billion dollar deal:

Company X is investigating the purchase of Company Y for (about) $USD 2 billion, but the deal has to be closed in 30 days.  How much should X pay to investigate (or ” value”) Y?

Let’s assume the absurdly best case for X.  World-renowned (no matter the field – engineering, legal, medical, finance, etc) are somehow magically immediately available, uncommitted to any other projects, and will work the (moderately excessive amount) of 300 hours each for their services over those 30 days.

If 30 experts were paid $600/hour each, the total cost would be $5.4 million.  A large sum certainly.  But only really “noise” in terms of the overall deal.  X is thus paying about a 2.7% “insurance” commission to the experts.  Would it be worth it?  How would one know?

Example 2 – a half-million dollar deal:

X wants to buy Y’s popular restaurant in a small town.  It has been in business for many years.  X has eaten there often in the past.  X and Y have mutual friends.  No one in town has anything particularly bad to say about Y or the restaurant.  Everything seems on the “up and up.”

What should X explicitly pay to engage in formal due diligence?  And how would X know, if they hired a local accountant, lawyer, etc that such “agents” were competent, or had no unknown conflicts of interest etc.?

So, extending this to the recent “bail-outs” controversy, take example 1 above and reduce the time-frame to, say, 4 (not 30) days (I’m assuming that 72  hours, somehow secret notice, was possible) and would it truly make much difference what they charged over the next four days?

Anyway, just “throwing this out” (as it is said).

I’m working on on pricing/risk model for due diligence, and would very much like any feedback.

– Norman

Tommy Toy

Management Consultant, Strategic Marketing, Business Strategist

I would not consider making an offer that is not contingent on a due diligence.  Buyer beware is my motto.  You cannot place a value on due diligence, espicall on a $2 billion deal.  Deals fail all the time due to derogatory findings during the due diligence process.  I bill myself at $200 an hour.  A deal of $2 billion requires a lot of more due diligence work.  10 people at $500 per hour x 250 hours.  They you have travel expenses, out of pocket reimbursements, it adds up real quick.  You do the math.

Xavier Montero

Broadcast, Media and Advertising

Hi Norman,

You can do a “conditional purchase”

For the $2Bn case you say:

a) I (the buyer) will pay 500mm upfront to you (the seller) but you (the seller) will not be able to use it.  You (the seller) will have to put the money in to an “escrow-1.”  You cannot ‘spend’ it (This can be a warranty by selecting an escrow entity and paying the money to the escrow instead of to the seller).

b) During the 90 days, your team will make a “transference” to mine.

Conditionals:

If I see all OK and the value is foreseen +/- 30% within the original value, I will pay 500mm more and “escrow-1” will be released.

If I see things are so good (I will have to pay a higher price that expected, and also I will have options to create value, so the deal is less attractive to me as a buyer) or it is so bad (I will pay a less price, but in turn I will not be buying a money-making machine, but only burden) then I will be able to retire, cancel the operation, and you will have to return to me the 500m put in escrow-1.

c) In the case of the 90-day test is OK, then the operation is “definitively closed” (I will not be able to retire) but we will “condition” the final price.  I will put the remaining 1Bn in to “escrow-2”, to be paid in one year.

The more important condition to be written in some way:

“IN THE CASE THAT ALL YOU ARE TELLING ME IS TRUE AND THERE ARE NO HIDDEN “VALUE-DESTRUCTION” THING inside the company you are selling me” then I will release the “escrow-2.”

“In the case you have “lied to me” and there are hidden destructive things” then I will release only the proportional part of the escrow (if final price is 1.7Bn instead of 2.0Bn, I will release 0.7 and the remaining 0.3 will not be paid.

For this to be clear, you must request the seller to write in a paper the “list of OBJECTIVE things that hte seller is warrantying” (for example “staff will not refuse to continue working” or “we have sales pre-closed for X dollars, you can count them inside the value” or “customer non-payment ratio is 2%”).

This list can also be done in the 90-day trial period. No need to do it upfront.

Then you have 1 full year to do the your “internal due-diligence” and you will really discover “hidden things”.

The same applies to the local restaurant. Let’s say it is valued $300. Pay $100 upfront, $100 in 60 days and $100 in one year always CONDITIONED to your friend writing a “list of objectively measurable things” like for example “There is no hidden debt to providers” or “staff is not getting ‘black money’ appart from that on the accountability”. You pay $100 and you put $200 into escrow to ensure him that even if you are a “bad manager” if he told the truth he is going to get all the full amount, but if he lies, he is gonna get less.

“Conditionals” in the deals are much more powerful than people often think.

Does this work?

Scott Shalom

Principal at Dowser Management

Norman,

One thing to consider in constructing such a price/risk model that comes to mind in the case of a fund that is compensated for managing money is that much of the cost of due diligence is really a “sunk cost” for investors. There are additional deal expenses (i.e., legal, IP, etc) that get paid by investors in addition to typical management expenses, but these are typically not material relative to the quarterly management fee that is paid. I can see where you are going on independent/one-off deals that an investor is looking to do, but your model might be skewed by the fact that many deals are done under a fund scenario where cost is relatively fixed.

Michael Rosenbaum

Market Value Enhancement Advisor

Norman, Due diligence is a very poor value for most investors. It’s a requirement, if only to make sure there really is a machine on the plant floor, but its true effectiveness is/shouldbe fraud avoidance. The major limitation of due diligence is lack of access to customers, employees and other market participants who create the real value of the company. The sustainability of customer relationships and the loyalty of current employees cannot be determined accurately in the due diligence process. Insurance premiums aren’t a great analogy here, because there is no pool of funds to repay in the case of a bad deal and there are too many sources of failure anyway. In your restaurant example, the due diligence process should include sitting in the restaurant at breakfast, lunch and dinner and watching how many people come in. Sit close to the cashier so you can hear any complaints. Confirm the tax returns and the bank statements, but that’s about all you can do. (Yeah, I know, every restaurant owner tells you he’s making lots more than he reports to the IRS, but if he’s willing to lie to the IRS about the real number, he’ll lie to the buyer as well.)

Greg George

Managing Partner, GTI Advisors Threat Management Practice Group

Great subject to explore Norman; and valuable input so far – I would be very interested in seeing the results of your model when finished.

I do agree with Michael; “DD a poor value for most investors” – and the true effectiveness should be fraud avoidance, which is where our focus remains on behalf of clients.

Randy Lewis, CFA, MBA

The GSL Group, LLC

Michael, that is a great answer… It is the same logic with the SEC and other regulatory bodies. In teaching business, I always use the home security system example. There is a clear distinction between deterrence and prevention. Will a security system deter a thief? Certainly in some cases, yes. Will it prevent a breakin? Certainly in some cases no.

Same with the SEC. Does SOX deter fraud? Sure. Does it prevent fraud? Absolutely not.

I think it is also the same with DD. The process will likely not catch a “thief” bent on deception, but for myself, I would kick myself in the you-know-what if I didn’t try…

Sunny J. Barkats, Esq.

Chair of Capital Markets/Securities Group at Herzfeld & Rubin, P.C

A well-run due diligence program cannot guarantee that a business transaction will be successful. It can only improve the odds. Risk cannot be totally eliminated through due diligence and success can never be guaranteed.

There are many reasons for conducting due diligence, such as a confirmation that the business is what it appears to be; identify potential “deal killer” defects in the target and avoid a bad business transaction;
and obtain proper information that will be useful for valuing assets, defining representations and warranties, and/or negotiating price concessions; and the verification that the transaction complies with investment or acquisition criteria.

The amount of due diligence you conduct is based on many factors, including prior experiences, the size of the transaction, the likelihood of closing a transaction, tolerance for risk, time constraints, cost factors, and resource availability. It is impossible to learn everything about a business but it is important to learn enough such that you lower your risks to the appropriate level and make good, informed business decisions. On the other hand, too much due diligence can offend a target company to the point where they walk away from a deal. It can also result in “analysis paralysis” that prevents you from completing a transaction or provides time for a better competing offer to emerge. Accordingly, it is important that due diligence be prioritized and executed expeditiously.

Michael Rosenbaum

Market Value Enhancement Advisor

I’m glad you mentioned SOX, Randy, as this is a good example of the ways in which focus in one area leaves us vulnerable in another. When SOX was created, I was running the country’s largest Investor Relations/Financial PR firm. We had an avalanche of experience with the costs of SOX and the checklist mentality that it created.

Here is the real problem, however. Fraud is only one of many sources of corporate failure. When you direct a disproportionate amount of funds and management bandwidth to fraud, you underfund and underfocus in other areas, like marketing and R&D. The unintended consequence is that business failures might actually increase due to management distraction, even though fraud declines as a source of that failure.

My partner and I have had a lot of experience with clients making acquisitions and, despite millions spent on due diligence, not knowing what they just bought. Now, one of our services is a post-closing assessment that measures all the things that can’t be reviewed in the DD process. It’s an eye-opener in many cases.

Norman Mainer

Senior Information Technology and Services Manager and Consultant

I have found all of these remarks quite useful. Thanks.

But I was also attempting to question how/when DD is often useless, and/or pointless, as I alluded to in the last portion of my initial message (“extending this to the recent “bail-outs” controversy …”). Good “traditional” business DD was, to my mind at least, essentially irrelevant to whether some large financial institution bought another distressed financial institution, or if billions were authorized in just a few days to “save” an insurance, car or other major company. The DD in many of these big deals had little to do with classical valuation of assets, liabilities, IP, products-in-development, etc.

Deals were done in a few days because of factors which are not commonly associated with classical DD. e.g. 1) Government tells X that they had better buy Y if they know what’s good for them, or 2) X buys Y just to vacuum up dominant market share at a time when anti-trust considerations are of little immediate concern, or 3) X buys Y to make X even bigger to assure a future bail-out if then needed by X, or 4) for the good PR of X being a white knight (save jobs! – save our communities!), or 5) to enable X to kill some annoyingly superior products/services of Y, or 6) X gets special tax breaks, or etc., etc.

I have serious doubts that even a devastatingly negative DD report would really have prevented BOA from acquiring Merrill Lynch, or Chase buying WaMu.

In these cases DD is pretty much “short-circuited”. 100+ billion portfolios, examination of the overlap/integration/layoffs of new 5 or 6-figure staff counts, foreign operations, company property ownership/leases/rentals, pending lawsuits, R&D, trade secrets, risk exposures, etc. just can’t be clearly identified, much less valued, in a couple of months, much less days.

Xaiver makes excellent “classical” points – but in a really big, quick, deal, who in the world is going to offer a 90-day trial period, and who will make good if things don’t work out? A lot of deals are “garage sales”. You look and you buy (or not) FAST. If the lawn mower you bought one afternoon turns out to be unrepairable junk in week, you have little recourse. If the regional bank you bought over the weekend goes insolvent tomorrow, you are pretty much in the same boat.

Anupam Kumar

Associate Director – Privately Held Business Solutions

Do we know how many billions of $$ in fraud was prevented due to SOX? (All of us know how many billion $$ were spent in implementing SOX!) Similarly, we can probably never really know the REAL value of Due Diligence.

Also, I believe Due Diligence should not be looked upon as an insurance policy for ensuring the success of M&A activities. Anyways, M&A are known to be value destroyers (Unless you do it the way Cisco carries out their M&A)

If you are building a model, I think some weightage should be given to international transactions because such transactions are growing. Recent research / survey cites ‘looking for new markets’ as one of the top most reasons for international M&A. Typically, the lawyers, accountants and experts help de-mystify the unfamiliarity with local laws/ regulations in another country. In my experience, post diligence, the transaction value is almost always revised in international M&A.

Norman Mainer

Senior Information Technology and Services Manager and Consultant

In response to Anupam Kumar:

Several excellent points, sir.

1) “Also, I believe Due Diligence should not be looked upon as an insurance policy for ensuring the success of M&A activities.”

If it “should not be looked upon” as at least some sort of “insurance” policy, why bother at all? DD costs something. Maybe a lot, may be a little, but at least some amount of time and money is spent on it constantly. My original inquiry was what people thought was ROI on DD. Just pointless DD exercises done primarily because of legal or “customary” expectations?

The Cisco reference is good – I have a (little) bit of knowledge about this myself. But Boeing bought Rockwell NA and McDonnell Douglas. Was this done to get their IP, or staff, or manufacturing capacity/cash/property/equipment, or to just clear out some of the competitive space?

2) Re: SOX. Ah, yes! Who knows? And even if it could be valued, would it A) be strengthened if proved highly useful, or B) weakened/eliminated if proved highly dubious? SOX may just be one the many things that exist because of politics rather than proper engineering.

3) > “If you are building a model, I think some weightage should be given to international transactions because such transactions are growing.” and “help de-mystify the unfamiliarity with local laws/ regulations in another country”

Absolutely! One of my other projects is related to “velocity” and “friction”. What does is cost to get some basket of business transactions done from one jurisdiction to another (even within a single country, much less between countries)? How long does it take? What are the exposures (Forex, permits, taxes, corruption, physical risks, stability in rule of laws, etc.), and “betas” for all of the factors?

There are “corruption”, beer and “Big-Mac” indices (see The Economist magazine – grin), and a good deal of research has been done on “costs of starting a business”, but I believe much more could be done. When should a firm out-source? Well, depends where they are, where they could potentially go, what risk exposures they would have. Can they hedge? Could insurance be purchased on the likelihood that my new mining permit would be issued in Peru? Could there be an options market on light-manufacturing permits in Taiwan (products yet to be determined)?

Sanjay Thakkar

Head of Transaction Services India at KPMG

The origins of the term due diligence i think comes from the regulatory requirement in the UK where stock exchange rules require the directors of a company and their sponsors to make certain statements to the exchange having made “due and careful enquires”. If you use this as a baseline due diligence is about making sure you enter into a transaction having carefully thought about it. In a world with Caveat Emptor, you need due diligence as the natural opposite to bring equilibrium to the economic equation whereby buyers and sellers come together.

Due diligence is therefore absolutely necessary in any transaction. When you buy groceries at a store, you check to see the sell buy date – due diligence; when you buy a house you get a surveyors report because unlike the grocery store, you are not a expert and therefore have to outsource your due and careful enquiry.

Therefore when building a risk model, you would need to differentiate between what is the overall due diligence effort and what is the amount that is laid off or outsourced to advisors.

In an emotionless world where rationale behaviour exists, a due diligence pricing model could be developed (i’m not a mathematician but its amazing what you can do with numbers!). However for this to be effective and applicable in the real world, variables such as human emotion and egos would need to come into play.

Just as I may ignore the advise of those around me when i buy a fancy sports car ( high maintenance costs, high fuel consumption, insurance etc) because of my pent up desire to have that Italian sports car as a trophy acquisition, so too many purchasers ignore or limit the scope of due diligence because they want a deal too badly.

So ultimately, is due diligence worthwhile? Yes of course it is. It is how we make choices. Is it effective and can it be priced? This I’m afraid is where the variables kick in such as human emotion and egos.

Norman Mainer

Senior Information Technology and Services Manager and Consultant

In response to Sanjay Thakkar:

Coincidentally, some of what he says is quite closely aligned with comments I have made in other contexts. In those cases I was exploring “perceived utility”, and used a sports car as one example as well!

Sanjay is pointing out how the GOALS of DD affect the volume, speed, costs, maturity, etc. and thus the “perceived value” of DD. Others in this forum have, quite appropriately, identified reduction of fraud risk as both a common and an important goal of DD.

But the bigger truth of a perception of DD utility may seem to you, or to me, in one case logical, in a second case debatable, and in a third case, virtually worthless.

Aspects such as price, aesthetics, safety, reliability, prestige, convenience, peer pressure, legal requirement, lack of alternatives, and others.

Consider:

1) Where utility is rather fundamental and apparently self-evident to most people. Food, clothing, shelter, etc. Let’s take utility-supplied water, as one example. I hazard that DD for investment in a water firm is more fraud-avoidance then exotic analysis of IP or fickle consumer aspirations. Are the firm’s asset/debt positions and cash flow numbers reliable? Is the water safe?

2) Where perceived utility seems far more artificial – a new exclusive golf-club; a fashion house; a chunk of Lamborghini stock. Yet these kinds of investment vehicles (yes, a bit of a pun is intended here…) wouldn’t usually be purchased unless they appeared to provide utility of some sort based on much more capricious, less price-sensitive factors like prestige. An investment to exploit consumer’s improved social status, or their atavistic desire to drive really fast, or get revenge on people who once thought they would never be successful? DD in these cases appear to me to be more “where the variables kick in such as human emotion and egos”.

Mukesh Bajaj

Risk Management Specialist (Non-Financial)

Great points gentlemen. I have done extensive work in the due diligence field and have assisted a number of M&A transactions. I operate in the reputation due diligence field which is quite different from legal due diligence or operations due diligence and accounting due diligence. Reputation DD is undertaken with the objective of verifying the facts from a third party perspective and to unearth the unknown specially when you operate in the not-so-transparent emerging market economies, like China, India, Russia, Brazil etc. The objective of the assignment is not to break the deal but to verify what has alredy been shared and to identify hidden facts which will help the buyer take an informed decision.

More than 9 times out of 10 you will find issues with the target companies, information that if not known before would have caused lots of problem post transaction. In such events the value of the DD is priceless. On the other hand, the DD does not guarantee that all issues relating to the company will be highlighted. Lets say that the DD was conducted and there were still problems that were hidden. The transaction is concluded and a year later the buyer is faced with a major liability. The shareholders of the buyer company sue the company for negligence. Here the buyer presents the DD report to the relevant authorities to demonstrate that he has been diligent and has taken all precautions required before concluding the transaction and that the issues was impossible to detect before signing the deal. The authorities will take cognizance of the DD and the penalties or actions taken will be less stringent than in the case there was no DD conducted. In such a scenario, once again the value of DD is priceless.

DD can be categorized as a fraud management tool, an information gathering exercise or just a shield that will provide some value in case something goes wrong. It is important to undertake a DD for all transaction irrespective of the value. You cannot evaluate it in terms of ROI. Consider it as a cost just like a premium paid for insurance.

Greg George

Managing Partner, GTI Advisors Threat Management Practice Group

Well done Mukesh…

And, exceptional input from all – my thanks to Norman for starting this discussion string.. it has become a valuable awareness tool; for us in the trenches each day, and to foster education for our clients – sometimes they don’t get it, especially when the “human emotion” of the deal begins to accelerate.

Benjamin R. Preston

Member at Womble Carlyle Sandridge & Rice PLLC

Let’s not forget the age-old maxim that “sometimes the best deal is the one you don’t do.” I would suggest that any pricing/value model around DD take into account losses avoided (and thus, value “created”) when due diligence efforts reveal problems that cause parties not to enter into a deal in the first place.

Please check the Private Equity Investment Group for any further comments…

_______________________________________________________________________

Greg George is Managing Partner of GTI Advisors; Threat Management Practice Group, a firm dedicated to protecting decision makers from the “dark side” since 1962.  Greg works with clients to develop practices and strategies to best protect their organization including threat analysis, multi-disciplined due diligence review, and training.  For more information, please visit www.gti-advisors.com or contact Greg: greg@gti-advisors.com

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