Before Michael Hagedorn, finance chief at $12.1 billion banking firm UMB Financial, pulls the trigger on a deal, he tests it using at least three sets of assumptions — optimistic, neutral, and pessimistic. Sometimes he uses five. Why? "So that management knows [just] how bad this thing could get if it were to go bad," he says.
Overcautious? Some CFOs might say so. After all, contemplating worst-case outcomes in a merger or acquisition is not something businesses are in the habit of doing. But in the current climate, more executives are allowing themselves to imagine the worst, gauging M&A risk by scenario planning, stress-testing discounted cash-flow models, or by just assuming that a merger will have negative side effects.
Global economic conditions have heightened overall M&A risk and are making buyers skittish: deal volumes cratered in the fourth quarter of 2011. "No one wanted to be the first to step out of line before there was a better sense of the economy's direction," says John Bogush, a partner at The Highland Group, an M&A consultancy.
This year, it seems, things won't get any easier. The margin of error for management is smaller because "shareholders and boards are much less willing to accept the risk of an M&A failure," Bogush says. Rich Jeanneret, Americas vice chair of transaction services at Ernst & Young, says, "Boards are very interested in top-line growth, and they are asking a lot more questions and demanding more accountability."
There is also less margin for error economically, points out Reeve Waud, managing partner at private-equity firm Waud Capital Partners. "The M&A market has become much more efficient," Waud says. "Many potential buyers review the asset or business that's up for sale, and the acquirer inevitably pays a very full price. That leaves it less room if it is wrong."
To raise the probability of a deal being successful, acquirers are rethinking how they underwrite risk, assess value, and perform due diligence on previously ignored aspects of transactions, like customer attrition. They are also trying to prevent their share price from getting slammed as a result of placing a fair value on the acquired assets. Below are some of the things acquirers will do to minimize acquisition risks this year.
Focus on What Drives the Business
When assessing an acquisition, the deal team needs to weed through copious amounts of data to focus on the three or four key things that are most important to creating value post-acquisition. "If you don't understand [those items], you don't understand the business well enough to buy it," says Waud.
In the home-alarm industry, for example, a sector in which Waud Capital has acquired 36 companies, the drivers are the percentage of customers a company loses every year; the cost to gain a new customer through the company's own marketing efforts; and the cost to acquire a customer in other ways, such as buying accounts from a competitor. It's no coincidence that all three drivers relate to retaining and gaining customers; in a low-growth economy, existing customers are gold.
Perhaps the greatest risks in M&A, in fact, involve the intangible assets of the seller — particularly its current customers, says Howard Johnson, managing director of Veracap Corporate Finance. "The question a buyer should ask is, 'What creates stickiness between a customer and the company as an organization, as opposed to a particular individual?'" says Johnson. "If there is no barrier to exit, that should send up a red flag."
Don't Rely on Revenue Growth
In a recent Ernst & Young survey, 40% of executives said that deals most often fell short of expectations because revenue gains didn't materialize. "Stakeholders are interested in the top line," says Jeanneret. Companies that meet earnings targets due to cost-cutting are often punished by the market.
Knowing that, however, may cause acquirers to overemphasize the potential revenue boost from a takeover. "Generally, I don't like to assume any revenue growth," says Waud, because that puts the success or failure of a deal at the mercy of something he can't control. "I would rather determine whether or not a deal was going to be good or bad based on flat revenue and how I can improve the business," he says.
Cheryl Beebe, CFO of Corn Products International, a $5 billion maker of sweeteners and starches, says cash flow and the value derived from cash flow are key. As a publicly traded company, Corn Products focuses on a deal's return on invested capital. "You can do a 'strategic acquisition' and get a boost in revenues and operating income, but that doesn't necessarily mean you get a return on invested capital that exceeds your cost of capital," Beebe says. "That's a little tougher criteria."
There are plenty of other criteria that companies should be using to guide the deals they invest in. For example, in 2010 UMB Financial diversified the revenue stream of its mutual-fund business by buying a fixed-income shop, Reams Capital Management. Reams's offerings complemented UMB's international and midcap equity products. "We saw what was happening with interest rates, and from a risk perspective decided that getting into the fixed-income business was something that made sense for us and our strategic plan," says CFO Hagedorn. "The revenue streams coming out of our Scout mutual funds are less risky because they're not dependent on equity markets."
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