Good news!

No numbers today!

Good news!

No numbers today!

Session 3 – Due Diligence

September - November 2011

Mark Okes-Voysey

September – November 2011Session 3 – Due Diligence Slide 3

Course outline 3rd week

1. Strategic overview – why deals?

2. Pricing and negotiating a deal – valuation methods and other key terms

3. Dealing with risk and the role of due diligence + integration planning

4. Tax – risks and planning aspects

5. Legal documents (+ presentation of team game)

6. Team game; your presentations

7. Test

8. Test feedback

September – November 2011Session 3 – Due Diligence Slide 4

Due diligence - the process through which a potential acquirer evaluates a target company for acquisition

What is due diligence?

• No strict definition• Not an audit• Not a valuation• Not legally/professionally defined• Can take many forms• Normally undertaken with help of professional advisors

September – November 2011Session 3 – Due Diligence Slide 5

Objective of due diligence

Provide objective evidence to support the underlying rationale for undertaking a transaction such as a merger or acquisition. Normally it involves access to the target company but the degree of access is sometimes limited significantly;

Can you think why access may be limited?

•Multiple buyers

•Commercial confidentiality

•Public company (hostile bid)

•Need for speed

September – November 2011Session 3 – Due Diligence Slide 6

What are the different types of due diligence

• Commercial• Operational• IT• Environmental• HR• Legal• Tax• Financial

September – November 2011Session 3 – Due Diligence Slide 7

Commercial due diligence

• A review of the commercial aspects of a business, typically including:- The market share and position of the company- Is market and market share growing or declining?- What is the company’s strategy?- Pricing of products compared to competitors- What do customers think of the products- Is forecast growth in revenues achievable?- Review of key costs assumptions- Review of forecast capital expenditure compared to growth plans

• Typically performed by specialist strategy consultants

September – November 2011Session 3 – Due Diligence Slide 8

Operational due diligence

• Review of a company’s operations:- Age and condition of machinery/equipment- Staffing levels compared to benchmarks- Efficiency- Use of KPIs- Efficiency of distribution- Bottlenecks – what is restricting growth?

• Typically performed by industry experts with a technical background

September – November 2011Session 3 – Due Diligence Slide 9

IT due diligence

• A review of a company’s IT systems, typically including:- What system does the company use?- Are they reliable?- Do they support the strategy of the business?- Are they “scalable” i.e. will they accommodate the growth in the

business?• Performed by IT specialists

September – November 2011Session 3 – Due Diligence Slide 10

Environmental due diligence

• A review to identify potential environmental risks, including:- Breach of environmental emissions/pollution permits, legislation- Potential liabilities to clean up e.g. soil contamination- Villages within the ‘sanitary protection zone’

• Performed by specialist staff with environmental qualification

September – November 2011Session 3 – Due Diligence Slide 11

HR due diligence

• A review of HR matters, including:- Compliance with labour laws- Staff turnover, average age- Shortage of key skills- Remuneration compared to market average- Bonus structure- Management experience and structure

September – November 2011Session 3 – Due Diligence Slide 12

Financial due diligence

• Historical trading results- What has been the driver of revenues and profits?- What are trends in volumes, prices, cost of sales, margins, overheads?- Why?

• Quality of earnings and financial condition- What is ‘true’, ‘normalised’, ‘sustainable’ profit (EBITDA)?- Eliminate the effect of e.g. tax optimisation schemes, release of

provisions, one-off events- Used as basis of valuation- Adequacy of working capital and financial situation

September – November 2011Session 3 – Due Diligence Slide 13

Financial due diligence

• Review of projections:- What are the assumptions behind growth in profits?- Is the projected growth achievable?- Link with commercial due diligence- ‘Hockey stick’- Are current results on budget?- Historical accuracy of budgeting- Link to valuation

September – November 2011Session 3 – Due Diligence Slide 14

Legal due diligence

• A comprehensive legal review of the targeted business, typically including:- Company’s incorporation (covering, if applicable, privatization process and any

corporate reorganizations);- Title of the seller(s) to the company’s shares, including historical share transfers,

encumbrances (pledge etc.) over the shares or other transfer restrictions; shareholders’ or other agreements among the shareholders of the company;

- Company’s ownership, leasehold or other title to material real estate (buildings etc) and movable property (equipment etc), encumbrances (pledge etc.) and other restrictions;

- Material commercial contracts (sale/purchase, distribution, service, agency etc);- Material credit/loan agreements and other financial liabilities;- Guarantees, indemnities issued by the company in favour of third parties;- Intellectual property (trade marks, patents, know-how etc);- Status and compliance with regulatory approvals, licenses, authorizations,

registrations, consents, permits and certificates, necessary to carry on the company’s business;

- Material litigation and administrative proceedings;- Directors and employees (employment contracts and policies, trade unions,

collective bargaining agreements, additional guarantees etc).

• Performed by lawyers

September – November 2011Session 3 – Due Diligence Slide 15

Legal due diligence(continued)

• Main objective - indentify material legal risks and areas of concern, therefore:- Obtain leverage to renegotiate initial transaction structure, purchase price

or other material terms;- Figure out specific conditions precedent to be satisfied by the seller(s)

before completion of the transaction (e.g. waivers from key clients/customers for change in control, mitigation of certain legal risks revealed during the legal due diligence etc);

- Capture the scope of representations and warranties to be agreed in the SPA;

- Indentify risk factors to be covered by specific indemnities and other remedies in the SPA (e.g. ongoing litigation, breach of material contracts etc);

- Understand the areas of potential post-completion work (e.g. integration of the acquired business within buyer’s group structure or business model).

September – November 2011Session 3 – Due Diligence Slide 16

Tax due diligence

• Look for possible tax exposures related to trade flows

- Sales structure

- Relationship with, and functions of, suppliers

- Import and export operations

- Related party transactions

- Use of intellectual property and license rights

• Look at tax function effectiveness

- tax filings

- tax audits and litigation

- Quality of staff

• Look at one-off events

- sale or acquisition of a major assets

September – November 2011Session 3 – Due Diligence Slide 17

Vendor due diligence

• An independent due diligence, commissioned by the vendor• Made available to bidders on a no-reliance basis• A contractual duty of care is assumed to the ultimate buyer• Not a sales document• Saves the target business being subject to due diligence by multiple bidder

teams• Common in western Europe, starting to be seen more often in Russia

September – November 2011Session 3 – Due Diligence Slide 18

Case study – read through the text and highlight how you think you would react to the information you receive after the due diligence

Use the following key:

DB = Matter so important that may be a deal breaker unless a solution can be found

V = Try and negotiate a modification in price

GN = Good news. This makes the deal more attractive than you thought

R = Representation and warranty required. Consider need for escrow account.

September – November 2011Session 3 – Due Diligence Slide 19

Case Study

• The Russian Company “Mashina Century 21” makes equipment for the oil and gas industry. Its technology works well and is well known for being relatively low cost to buy but with high subsequent maintenance costs. It has signed a letter of intent to purchase 75% of the shares for $125 million in the German engineering company “DeutcheEquip” (“DE”) in order to access its more up to date technology and enable it to address international markets outside Russia and the CIS. They are planning to buy these from the shareholder who currently owns 100% of the shares and is the CEO. The due diligence process finds the following;

- DE buys its steel from a German steel producer at prices which are 5% higher than the price at which MC21 can purchase the steel. Its market position is exactly as expected and it is growing with the market. The due diligence findings suggest that the CEO is responsible for the relationships with 40% clients accounting for 40 % of DE’s client base by revenues.

- The company owns land in a large industrial estate and it has around 10,000 square metres of warehouse which it built several years ago which is surplus to its current and future needs. It also owns a factory which is operating at 75% of capacity. The remaining 25% capacity will be sufficient to allow for expected growth in the coming years. Engineers have found that regular maintenance has not been carried, and approximately $5 million has been “saved” in each of the last two years.

- Included in the financial statements was a one-off transaction, profit on the sale of a subsidiary, of $1 million. The buyer had not been made aware of this previously. Implicit in the $125 million price is a price multiple of 5 X EBITDA. We also find that year on year salaries have been going up by more than inflation. This was a known fact to the buyer.

- The Company has a plan to move its headquarters to a new building which is owned by the wife of the shareholder. A commitment for 10 years has already been signed at a price per square metre which is 20% above the current price paid. The total number of square metres being taken is 50% more than currently rented. The shareholder explains that this is to allow for growth of the business.

- The company has bank debt of $20 million which is less than the buyer originally thought by $5 million. The company has also started to pay its suppliers slower than it used and it owes its suppliers $10 million rather than the $4 million that had been the norm historically. This has happened over the last two months and there is no suggestion that the suppliers are unhappy about this.

- The buyer finds that following an inspection by the tax authorities there is a claim relating to the business from three years ago. The claim is for $5 million and relates to the way that the company pays taxes on its employees. DE has been applying the same method for many years. The buyers tax advisors and lawyers think that there is a 50:50 chance that DE’s views will prevail in the upcoming court process.

September – November 2011Session 3 – Due Diligence Slide 20

It is typical for sellers to try and “manage” the business differently when they are near to closing a deal…the key is sustainability of what they are doing

The company has bank debt of $20 million which is less than the buyer originally thought by $5 million. The company has also started to pay its suppliers slower than it used and it owes its suppliers $10 million rather than the $4 million that had been the norm historically. This has happened over the last two months and there is no suggestion that the suppliers are unhappy about this.

September – November 2011Session 3 – Due Diligence Slide 21

Related party transactions are always a complex and often delicate area…and sometimes difficult to find!

The Company has a plan to move its headquarters to a new building which is owned by the wife of the shareholder. A commitment for 10 years has already been signed at a price per square metre which is 20% above the current price paid. The total number of square metres being taken is 50% more than currently rented. The shareholder explains that this is to allow for growth of the business. The annual rental today is $3 million a year.

September – November 2011Session 3 – Due Diligence Slide 22

How do we keep these relationships after the CEO has $125 million in the bank?

DE buys its steel from a German steel producer at prices which are 5% higher than the price at which MC21 can purchase the steel. Its market position is exactly as expected and it is growing with the market. The due diligence findings suggest that the CEO is responsible for the relationships with 40% clients accounting for 40 % of DE’s client base by revenues.

September – November 2011Session 3 – Due Diligence Slide 23

Watch out for assets not used in the business....they can be sold and represent an effective reduction in the acquisition price

The company owns land in a large industrial estate and it has around 10,000 square metres of warehouse which it built several years ago which is surplus to its current and future needs. It also owns a factory which is operating at 75% of capacity. The remaining 25% capacity will be sufficient to allow for expected growth in the coming years. Engineers have found that regular maintenance has not been carried, and approximately $5 million has been “saved” in each of the last two years.

September – November 2011Session 3 – Due Diligence Slide 24

Remember we should exclude one-off transactions when arriving at a valuation of the business

Included in the financial statements was a one-off transaction, profit on the sale of a subsidiary, of $1 million. The buyer had not been made aware of this previously. Implicit in the $125 million price is a price multiple of 5 X EBITDA. We also find that year on year salaries have been going up by more than inflation. This was a known fact to the buyer.

September – November 2011Session 3 – Due Diligence Slide 25

Tax is often an area requiring reps and warranties

The buyer finds that following an inspection by the tax authorities there is a claim relating to the business from three years ago. The claim is for $5 million and relates to the way that the company pays taxes on its employees. DE has been applying the same method for many years. The buyers tax advisors and lawyers think that there is a 50:50 chance that DE’s views will prevail in the upcoming court process.

Thank you!