Source: Control Risks from Forbes
McKinsey & Company estimates that more than 70% of global merger and acquisition deals fail … but why is this? We believe it is due, in great part, to a lack of information (or poor information) on the target and the deal. What might be blamed on a poor integration process might actually be more related to not knowing enough about the target and opportunity. Too often, particularly in emerging markets, integration teams are left to deal with legacy problems that are not identified within the traditional pre-transaction due diligence: inflated books and stock; non-existent distributors and customers; business-critical political connections; facilitation payments; and conflicts of interest with competitors. The result is companies find they have overpaid for assets that cannot deliver the market-share and growth trajectory that formed the basis of the acquisition strategy in the first place.
Black Hat teams
At Control Risks, we support executives to make good decisions by helping them assess risk and mitigate its impact, particularly in emerging markets. In our experience, although most companies will conduct standard legal, financial and commercial due diligence on deals, the high failure rate in M&A suggests there are still “unknown unknowns” that could threaten a deal.
In the world of cyber security, security firms will establish mock “black hat” teams to attempt to penetrate their clients’ network and systems. The lessons learned from the friendly “attacks” ensure a stronger, more robust IT security is established based on real-world scenarios.
In the same way, we advocate forming a black hat team as part of a company’s deal team to aggressively test assumptions on deals as they progress, from the initial strategy stages through to integration. A black hat team comprised of strategy, risk management and forensic specialists will take the standard due diligence and push harder on some of the traditional failure points in deals.
Common failure points in emerging market M&A
In our China practice we are often called in by management to help with an M&A deal that was done recently, providing investigative and crisis management support to “unwind” it. There are some common post-transaction issues we often see, which could (and should) have been discovered before the deal was done. These include:
- Not having a full picture of related parties – Too often a company finds, post-acquisition, that the target’s principals have undisclosed relationships that have a direct impact on the success of the deal. We’ve seen many cases where the target’s owners had equity relationships with suppliers, distributors and, in some situations, direct competitors. The standard due diligence process often does not dig deep enough into the backgrounds of the principals and related third parties.
- The real reasons for a target’s success – When we conduct a deeper post-transaction investigation and expose the background and connections of the target principals, we often find a target’s connections have a lot to do with its profitability and growth. For example, one of our clients acquired a company whose general manager had very good relationships with the local tax authorities who gave them big tax breaks, a healthy contribution to the company’s bottom line. However, after the acquisition, the tax authorities were not willing to extend those same breaks to the new, now “foreign” entity, and the target’s financial picture completely changed.
- Corporate culture issues – Some local company bosses put an immense amount of pressure on their salespeople to reach targets, but they don’t have internal governance processes to validate whether reported sales are true. A client of ours in the consumer products sector discovered, nine months after its acquisition of a Chinese competitor, that nearly 20% of sales were falsely reported, a fact not caught by the pre-transaction audit (see below). When our client factored in the false sales, it found it greatly overpaid on the acquisition and would have a more difficult time justifying the additional investments needed because its hurdle-rates changed.
- Inflated market access – A client of ours recently acquired a company in China because it wanted to add its product portfolio to the target’s multiple manufacturing locations and broad distribution structure. As part of the due diligence process, our client conducted a traditional pre-transaction audit, looking at the books and confirming there were 1,600 distributors of the target’s products and each had transactions against their names (with the appropriate paper trail for each transaction). However, nine months after the deal was completed, our client discovered nearly half of the distributors had “paper-only” transactions and one-quarter of the distributors were actually owned by relatives of key employees of the target. The value of the deal automatically dropped to half of what was expected.
Investigate, don’t just audit
In all of these cases, when we are asked post-transaction to dig deeper, it is actually very easy to go into the market to identify many of these problems … but it would have been equally easy to do so before the transaction. A basic audit will not reveal all the exposures companies face in an emerging market M&A rather, you need to investigate, getting beyond the four walls of the target and out into the market to talk to distributors, customers, competitors, former employees, etc. Act like you’re gathering intelligence on your biggest competitor … because that’s what they will become if the deal collapses. Control Risks estimates that over half of the bad deals in emerging markets could be avoided by spending the time and effort to do a proper investigation (not just an audit) up front.
Pre-transaction stress vs post-transaction pain
Some companies are, strangely, nervous about taking too deep of a look at a target for fear of finding something that will kill a deal. In our experience, if the company has put a decent amount of thought into target selection, rarely do we find anything that actually prevents a deal from happening. However, well over 60% of the time we find information during a deep-dive that enables the client to restructure and renegotiate the agreement to make for a much better deal. This is not always easy for a deal team to handle, but with patience and an open and enquiring mind, we find the front-end work well worth the effort.
Crashing a new acquisition is brutal – money is lost, stock prices plummet and reputations are damaged. Instead of waiting for the pain to hit, we advocate companies take an aggressively investigative stand from the beginning and “pressure-test” everything about their deals. A black hat deal team is an excellent way to help ensure we do not believe our own hype and really are doing the right deals in the right way.