Due Diligence for Global Deal Making

The Definitive Guide to Cross-Border Mergers and Acquisitions, Joint Ventures, Financings, and Strategic Alliances

Arthur H. Rosenbloom

• Publisher: Bloomberg Press
• Year: 2010
• Print ISBN: 9781576600924
• eBook ISBN: 9780470884744
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Companies of all sizes have been initiating international transactions--mergers and acquisitions, joint ventures, strategic alliances, and private placements--in record numbers. Targeted due diligence is crucial to effectively research, value, and complete these complex deals. With an evolving climate of uncertainty and new, unpredictable threats to business, it is more essential than ever before.

Due Diligence for Global Deal Making is an invaluable guidebook for companies trying to capitalize on the opportunities in both developed and emerging cross-border markets. All too often global transactions fail to meet the parties' expectations, and the leading culprit is inadequate due diligence. Especially when the target partner lacks a financial performance track record and significant assets, expanding businesses must answer difficult questions, such as: Why (if at all) do this deal? What are the rules going in, and what happens if things go wrong? Where are the tax, legal, financial, and operational traps, and what are the opportunities? This book provides what's needed to avoid devastating mistakes and to master the steps that ensure success:

• Expert analysis, insights, and strategies from experienced practitioners and leading authorities in cross-border matters
• In-depth coverage of critical topics decision makers need to understand in order to succeed in cross-border transactions--from corporate planning to operational, financial, legal, tax, accounting, and people/organizational considerations
• Best practices of corporate investors and professional advisers in conducting critical due diligence

Noted experts discuss critical topics corporate executives--and all those involved with their company's legal, operational, accounting, and tax matters--need to know to successfully complete complex global transactions today.

1

Due Diligence in the Global Economy

ARTHUR H. ROSENBLOOM

CROSS-BORDER TRANSACTIONS are an integral feature of business in the twenty-first century. Expansion in the Asia-Pacific region as well as in North America, with NAFTA-incentivized trade by and among the United States, Canada, and Mexico, continues apace. Much the same may be said for the salutary effects of the economic cooperation among countries in the European Union. Latin American cross-border transactions abound, and U.S. investors await the emergence of a post-Castro era and opportunities to join the Canadian and European companies already transforming Cuba’s trade. The trend is less pronounced in most of Africa, whose time for significant cross-border transactions is yet to come. On the whole, however, increasing numbers of cross-border transactions are likely to occur going forward. The purpose of this chapter and of the book itself is to suggest how effective due diligence can result in more thoughtfully planned and better executed transactions in an ever shrinking world.

These days, even small and middle-market firms regularly engage in cross-border transactions. As capital and technology move more frequently across borders and international trade agreements expand, cross-border deals are no longer the sole domain of corporate behemoths. Yet it’s a sad fact of life that many deals fail to live up to the parties’ expectations. Mergerstat reports that in the period 1992-2000, outbound mergers and acquisitions (those involving a U.S. buyer and a non-U.S. target) went from 403 to 1,400, a 247 percent jump, and their total dollar value (where reported) rose from $14.05 billion to $136.75 billion, an 872 percent increase. In that same period, inbound M&A transactions (those involving a non-U.S. buyer and a U.S. target) soared from 167 to 1,248, a 647 percent rise, and their total value (where reported) went from $9.3 billion to $299.2 billion, an unprecedented 2,217 percent increase. While the number of such transactions decreased in 2001 and 2002 (but only to about 1997 levels), one may confidently predict a rebound in such transactions when economies and capital markets turn upward.

Given the huge increase in the number of cross-border M&A transactions that has characterized much of the past ten years, one might expect to hear of boardroom bliss and satisfied stockholders. Quite the contrary has been the case. A 1995 Business Week/Mercer Management study that echoed the results of many prior and subsequent studies found, in examining 150 M&A transactions worth over $500 million in the period January 1990 to July 1995, only 17 percent resulted in substantial shareholder returns to the investing party, with 30 percent resulting in a substantial erosion of shareholder returns to the investor. Results in cross-border transactions have been especially unattractive. A 1999 KPMG study of the top 700 cross-border M&A deals between 1996 and 1998 concluded that over 53 percent diminished the buyer’s shareholder value.

Unsuccessful transactions, like dysfunctional families, go sour for many reasons, but high on the list in most surveys is the absence of thorough due diligence. Some experts argue that merger failure is not as pronounced among middle-market and small companies as in large ones (see the Business Week/Mercer Management study cited above), or, as Peter Peckar of international investment banking firm Houlihan Lokey Howard & Zukin asserts, that strategic alliances or joint ventures are likely to produce more attractive results than mergers.¹ What is crystal clear, however, is that good due diligence will cause thoughtful parties to back away from what are likely to be ill-starred unions or to identify, early on, problems in attractive deals so that they can be dealt with before or soon after the closing.

Sound transactional due diligence is a prerequisite to successful business deals in good times of rising expectations and in bad times when success may be more elusive. And it is particularly necessary in this postmillennial deal period, in which cyberspace, biotech, and other kinds of technology-driven companies are, more than ever, subjects of the transactional process. Determining the value and use of the intellectual property of postindustrial-era companies is dramatically more difficult than determining the value of the real property and hard assets of industrial-era companies. Many of the tried-and-true valuation yardsticks just don’t apply to intellectual property.

What Is Due Diligence?

Transactional due diligence is the investigation by an investor or its advisers of the accurate and complete character of the target company’s business. The target may be an acquisition candidate, a joint venture or strategic alliance partner, a prospective public offering registrant, or a company the investor is considering for minority interest private placement purposes. Due diligence must be linked to the investor’s corporate strategy; in fact, the goal of much of the legal, financial, and operational due diligence is to determine whether a transaction with a given target is in the service of that strategy. Due diligence also includes investigating the target’s legal status, from its proper legal authorization to do business to its actual or contingent liabilities and all points between. In addition, it includes analyzing the target’s historical, current, and projected financial statements. It involves scrutinizing the target as a whole and its corporate, divisional, or subsidiary affiliates. When the investor and the target are in the same industry, transactional due diligence explores financial, operational, or managerial synergies between the investor and the target.

Transactional due diligence is not the exclusive province of the investor. Target companies should perform transactional due diligence on the investor, especially if the investor is offering consideration other than cash. Even in an all-cash transaction, a thoughtful target investigates the extent to which an alliance with the investor will assist it in growing its business, not to mention the critical question of whether, in an M&A or joint venture situation, corporate cultures can mesh. History’s lesson is that transactions resulting in personality clashes or dramatically different styles of doing business (entrepreneurial versus highly structured companies, centralized versus decentralized, or the special culture wars that sometimes arise in cross-border deals) seldom produce attractive post-transaction outcomes.

No two due diligence efforts are alike, and for the practitioner each transaction presents novel issues. Due diligence may reveal that a Native American tribe claims title to the land under the target’s principal facility, disclose questionable transfer payments between the target and its corporate affiliates, or unearth unfavorable information on the target’s CEO. However, no solution can be provided unless the fundamental facts are discovered in due diligence.

Types of Due Diligence

Although due diligence practices are far from uniform around the world, they can be categorized roughly in two forms. What has been characterized as the “Anglo-Saxon” practice involves comprehensive legal and financial due diligence and significant disclosure before the signing of an agreement. The deal is embodied entirely in the documents, which set out in detail the rules governing the parties’ rights and obligations. Contrast this with the practice in much of the rest of the world, which involves more modest preliminary legal and financial due diligence with correspondingly limited disclosure.

The goal among many non-Western transactors, for example, is to build trust between the parties, leading to provisional agreements. These provisional agreements are followed by more intensive due diligence, culminating in a final agreement embodying a business relationship in which the contractual documents form one of the constituent parts. Thus, U.S. parties involved in outbound transactions with companies in countries in which Anglo-Saxon-style due diligence is not practiced often must obtain the necessary information and assurances by means other than the highly documented, full-disclosure process to which they are accustomed in their home market. International deal makers must be flexible and sensitive to the differences between what is acceptable in a domestic deal and what is acceptable in certain cross-border deals.

Who Is Involved in Due Diligence?

The cast of characters in most due diligence efforts is likely to include company employees, the company’s traditional professional advisers, and those hired for their expertise in certain legal, tax, accounting, and operational issues present in the target’s home country. They include legal, financial, and operational professionals.

Legal pros. Because law has become highly specialized, today even midsized deals involve armies of corporate, tax, real estate, environmental, employee benefits, insurance, and other kinds of legal specialists. Although some of the due diligence legal work may be done in-house if the companies have sufficient legal staff, outside counsel is likely to be engaged in larger and more complex transactions. Over the years, business has been regulated increasingly by local and national governments as well as by treaty-created organizations like the European Union. As a result, regulatory resistance outside the United States can cause problems in what is, at least nominally, a purely domestic deal. These facts make lawyering an increasingly important part of the transactional due diligence scene.

Financial pros. In M&A and private placement due diligence, both the investor and the target typically rely on in-house personnel (CFOs and controllers) as well as their outside auditors. The underwriters and registrant in a cross-border public offering also use both in-house CPAs and outside CPA firms. One or both sides may use investment bankers and commercial banks, and other institutional personnel are certain to perform their own due diligence on the issuance of any debt required to fund the transaction.

Operational pros. The buyer must evaluate every material aspect of the target’s business. Key operating personnel (in-house managers or outside consultants) must scrutinize the target’s business and report their findings to the decision makers. The target’s prospective ability to help the investor execute its strategy should infuse every aspect of the operational due diligence process. Operational due diligence includes investigating the target’s intellectual property, its production (if a manufacturer), its sales and marketing efforts, its human resources, and the other operational issues described below. For financial investors, the problem of valuing these operations is magnified if the transaction represents the investor’s first foray into the target’s industry. Financial investors tend to be especially meticulous in their collection of independent financial data on the target’s industry. They generate some of it internally and rely on outside advisers for the rest.

What Constitutes Legal Due Diligence?

Whether the transaction is domestic or international, due diligence must address certain fundamental legal issues. Among the basic corporate law issues are whether the target’s debt and equity securities identified in the target’s Certificate of Designation have been validly issued and whether the target is in good standing in the places in which it does business. Its tax compliance status in all such jurisdictions and whether it has good title to all of its assets should also be examined. Although the bona fides of all of these will surface as the target’s representations and warranties and covenants in the purchase agreement, the ability to sue for breach of the agreement is cold comfort after the deal is done, when the funds have been expended and when the parties, comfortably or otherwise, must join as one to accomplish the common goals that brought them together in the first place.

Tax attorneys and accountants examine the target’s tax practices, undertake the tax planning for the transaction itself, and consider postdeal tax planning. Lawyers also investigate whether the deal will raise antitrust questions. In this respect the cross-border deal may present interesting challenges, such as those the European Union’s anti-monopoly group posed to the GE-Honeywell transaction, a nominally domestic U.S. transaction.

Legal due diligence requires careful attention to actual and threatened litigation. Such litigation can come from debt or equity security holders, tax authorities, customers, or suppliers, in the form of breach of contract, product liability, or breach of warranty claims, and the liability exposure and damage implications of all such matters should be carefully investigated. Due diligence of so-called lawyer’s representation letters that describe such litigation is a must.

In this post-Enron age of increasing regulatory and judicial scrutiny, issues like allegations of improper behavior by corporate officers, directors, and employees (as in accusations in 2002 concerning misuse of company funds by executives of Tyco International Ltd., for example); workplace safety matters; employee benefits; potential equal opportunity violations; and increasingly significant, environmental regulations, may loom large. Second perhaps only to environmental concerns, pension and related issues have, over the past three decades, become an item of ever greater concern. Thus, ERISA lawyers are inevitably involved in due diligence. The list of legal specialists the above discussion presupposes is far from exhaustive.

Lawyering in cross-border due diligence involves considering all of the matters found in purely domestic transactions as well as those that arise from different or conflicting legal regimes operating in the countries in which the parties are domiciled. Selected examples in developed markets include rules that require minimum amounts of capital to be invested, requirements to purchase or manufacture in the target’s country, and restrictions on acquiring assets in certain types of “national interest” industries (such as defense, telecommunications, or broadcasting). Many countries have foreign investment control laws, impose limits on foreign ownership, require restrictions on share transfers, or regulate the prices that companies can charge. Tariffs, duties, required government or workers’ counsel approvals, and bilateral or multinational tax treaty implications are but a few of the elements involved in legal due diligence.

To this daunting list, add the legal issues that arise when targets are in emerging markets. These issues include questions about the enforceability of judgments and creditors’ rights. Indeed, one investor recently abandoned a cross-border transaction because it was not able to obtain a security interest in the target’s assets given the absence of a Uniform Commercial Code-type procedure in the target’s home country. Contradictory laws and regulations as well as new laws (such as environmental ones) might affect how future business is conducted in an emerging market.

What Constitutes Financial Due Diligence?

Financial due diligence (leaving aside, for the purposes of this general overview discussion, the important related area of tax due diligence) involves considering a company’s historical, current, and prospective operating results as disclosed in its historical, current, and projected financial statements, tax returns, backlog data, and other information. From these data, an income statement review can establish trends in revenues and profits, investor returns, and compound growth rates. Examination of the cost of sales; selling, general, and administrative (SG&A); extraordinary and nonrecurring expenses; interest; and other fixed charges and taxes can lead to a thoughtful profit margin analysis.

Financial due diligence also involves a balance sheet review, from cash to marketable securities, receivables, inventory, prepaid expenses, and other current assets, as well as the value of fixed assets. On the liability side, accounts payable, taxes, and debt obligations must be closely examined. Contingent liabilities such as those from special-purpose partnerships and the like that are usually “off balance sheet” require particular attention in due diligence. Price redetermination issues in government contracts, warranty or service guarantees, product liability issues, unfunded pension plans, equal opportunity employment issues, and the ubiquitous environmental issues require careful attention.

A review of the target firm’s financing and capital structure is de rigueur. Issues to analyze include details of short-term and long-term borrowings, including maturities and acceleration clauses in debt agreements, the terms and conditions of equity securities (common and preferred), the percentages of debt and equity in the company’s balance sheet, interest and fixed charges coverage ratios, and so on.

In many companies, cash flow is king. Therefore the target’s sources-and-applications statement demands serious review to determine the ability of internally generated cash to finance the company’s future growth. The company’s capital budget and its projections require thoughtful scrutiny as well.

On “softer” but no less critical issues, financial due diligence involves examining the quality of the company’s relationships with its lenders and an ultimate opinion concerning the reliability and credibility of its financial state...

Table of contents

• Due Diligence for Global Deal Making
• Praise
• Title Page
• Copyright Page
• Preface
• Acknowledgements
• About the Contributors
• Chapter 1 - Due Diligence in the Global Economy
• Chapter 2 - Strategic Due Diligence
• Chapter 3 - Operational Due Diligence
• Chapter 4 - Financial and Accounting Due Diligence
• Chapter 5 - Legal Due Diligence
• Chapter 6 - Tax Due Diligence
• Chapter 7 - People and Organizational Due Diligence
• Chapter 8 - Due Diligence Investigative Technology and Know-How
• APPENDIX: Cross-Border Due Diligence in an Age of International Terrorism
• Index
• About Bloomberg