Go on the offence, sometimes using your defence

By Rajesh U. Kothari, Cascade Partners
due dil·i·gence – n. reasonable steps taken by a person in order to satisfy a legal requirement, especially in buying or selling something - As part of the process of preparing for the sale of a company, most investment bankers perform a level of due diligence on their client's business before they go to market. This diligence not only helps protect the investment banker but it can also be an essential exercise to preserve and, in some cases, even drive value. 
As is often the case, we believe the best defence is a strong offence. 

Retain value, deal with issues upfront

Recently, we evaluated a client to prepare for the sales process and discovered their financial system was significantly outdated. We highlighted the potential issue to the client and ensured it was explicitly pointed out as an area that may need attention from a new acquirer. We again made it a minor point of discussion during management presentations.
In flagging this issue, we were able to leverage the competitive process to drive valuation, despite this potential shortcoming. Typically, in a competitive process, buyers will either read past modest operational issues, or note the concern but focus on the competitive dynamic of losing a deal over an operational issue that can be easily addressed. 
Now, that didn’t stop the buyer from coming back to us during due diligence and proposing a purchase price reduction because of the investment they felt was necessary to upgrade to a new system. 
Because of the approach we took, we had the advantage. 
We countered that the buyer had the information when they created their valuation, and no new information was revealed. The ability to cite the reference pre-indication of interest, and pre-letter of intent, refuted this rationale, and the purchase price remained unchanged.
A good offence is often the best defence. 
Revealing the company’s potential need for an upgrade to its financial system early in the process put us in a position of having facts on our side as we entered the final negotiations. We held our ground and are pleased to say that our client was happy with the result.

Don’t let it ride

Many would have let the outdated financial system ride, and waited to see if the buyer even determined there was an issue.  
In our opinion, these issues are almost always discovered.
Isn’t it better to be in a position of strength when working on potential issues, rather than when you are down to only one or two buyers, and can no longer drive the deal dynamics?
Presenting potential issues, challenges, and value detractors early in the process also helps build credibility with potential buyers.
We all recognise that buyers worry about what is not being disclosed, or glossed over, by sellers. When you address issues upfront, you take a more balanced approach to presenting the business even as you highlight the positives.
How would you feel if something was hidden and not shared with you if you were the buyer? 
You might feel distrustful, and the process could become tainted. 
On the other hand, if you are the buyer and the seller revealed potential issues upfront, you are more likely to feel they are sincere and that the process is balanced. These positive feelings towards disclosure help increase the buyer's likelihood of believing more about what you are forecasting or predicting about the future. 

Environmental risks

Another area where upfront work can pay significant dividends relates to environmental matters. Environmental issues are not well understood in the US, and regulations can differ significantly from state to state. A lack of understanding can frighten buyers or push them into taking an unnecessarily conservative position when bidding.
We regularly work to identify the scale and scope of environmental issues long before going to market.
We are based in the Midwest United States, where environmental issues are common. Because of this, the process is well understood by locals. When we attract buyers from outside the Midwest or internationally, their understanding can be more limited, which can cause some potential buyers to pass or lower valuations.
While you may not lay out all the nitty-gritty details in the beginning, we often present environmental information during the indication of interest due diligence process.
Beyond presenting the environmental dynamics, we often provide information on the scope of environmental issues relevant to the sale. We describe the regulatory process for managing any environmental legal exposure for the buyer. The concept of a Baseline Environmental Assessment ("BEA") and the unique structuring required to preserve this protection are unique to only a few markets. Since most buyers do not have this insight, many may pass on the opportunity without this information, not realising there is an easy resolution. 
If the problem is severe enough, we often encourage sellers to have their own environmental consultant perform an upfront assessment and identify potential remediation costs. On a side note, this is typically contracted with legal counsel to preserve attorney-client privilege.
Hiring an environmental consultant addresses two issues:
  • First, you gain a sense of the order of magnitude and soon have a clear understanding of the problem to counter any expected conflicting point of view presented by the buyer’s environmental consultant. You are also able to develop a case to manage the risk, and prepare to educate the buyer on potential solutions, rather than forcing them to figure out how to handle the problem without guidance.

    Without this, you have no basis to argue your position other than you don’t like their proposal.

    Not a good defence.

  • Secondly, this information allows you to assess whether you will address the problem upfront or leave it to the buyer.   
Having information in advance provides an opportunity to determine if the environmental issue is a value degrader or not. In most cases, we remind clients that this is a liability they already have. Why make it a detractor to the overall business?

Representation and warranty insurance

In some cases, despite your best efforts and planning, there is no way to know the unknown for either the seller or the buyer. While buyers worry about this acutely, sellers also do not like unknown, potential liability hovering over their heads. They want certainty on how much of their profit remains at risk.
On nearly every transaction, we turn to representation and warranty insurance as a tool to ease purchase agreement negotiations, put more proceeds in the pocket of the seller upfront, and give the buyer a more straightforward approach to making an indemnity claim, if necessary.
Engaging representation and obtaining warranty insurance in advance allows the market to assess the potential support needed, and provide a high-level cost estimate for a policy to support a transaction. We speed up this process by sharing a confidential information memorandum and quality of earnings report with our insurance advisor. This allows them to vet the level of interest, identify unique issues with the target company that they can work to address in advance, and get a sense of pricing. We share the feedback on interest from underwriters and pricing as part of the Letter of Intent due diligence process. In this way, we can dictate the use of representation and warranty insurance while adding to the buyer’s confidence that an insurer is open to supporting a transaction.
With a total cost of 2% to 3% of the indemnity limit, this can be a very attractive alternative to escrowing 7% to 10% of the transaction value for 18 to 24 months to support representations and warranties. This is a trade-off sellers are happy to make.
For buyers, the ability to pursue a potential indemnity claim with an insurance institution, rather than individual sellers, provides a sense of comfort to the objective discussion that will likely ensue. There will be no seller emotion to deal with, or the need to chase down multiple individual owners. This can be an even more acute problem when the seller continues to be a shareholder, and the buyer is trying to make a claim against their “partner” in the company. Also, with insurance in place, buyers are often able to secure more robust representation and warranty language in the purchase agreement as the seller’s liability is limited by the insurance. 
Simply by being proactive, we can address potential issues upfront, taking the offensive and getting in front of the game instead of on our heels reacting to a situation.

Leading from the front

More than ever before, sellers are conducting their own due diligence before they go to market to identify potential issues and address them before a potential buyer does. One of the most common tools used is a sell-side quality of earnings ("QoE"). We use this in nearly all our transactions to provide third-party validation of our financial reports. In many cases, we include pro forma projections in this analysis, along with more standard EBITDA adjustments. All this becomes evidence we use to validate our position.
We use the QoE analysis to drive the tempo of the transaction process. With a credible organisation producing the QoE, a detailed data book and organised data allow us to push the buyer to expedite their own QoE process.
Most importantly, this tool helps identify any account anomalies or mistakes before a potential buyer finds them. If there is an error that negatively reduces EBITDA, we can recalibrate expectations with the sellers before we go to market. This is far better than dealing with a proposed purchase price reduction by a buyer, under exclusivity, after finding a mistake in the EBITDA presented. It’s really hard to argue when you’re in a reactive position.

Cash to accrual: hidden dangers

When a seller operates on a cash basis, we always adjust the financial results to report data on an accrual accounting basis. Not only is this what buyers expect, but it can help ensure we define the process and identify errors rather than the buyer. 
When we converted to accrual accounting for one client, we flushed out a critical inventory issue and identified a USD 500,000 error. We couldn't change this once this was discovered, but we could recalibrate our seller’s expectations. 
We were in a very competitive process and able to drive an above-market valuation of the business as nearly every aspect of the business matched up with what was initially presented. Had we left it to the buyer to do the cash to accrual adjustment, we would have been against the wall. It was clear the buyer would have used this to reduce their purchase price, and likely disproportionately, given we were under exclusivity.

Putting on your buyer’s hat

As advisors, we spend a significant amount of time setting expectations or recalibrating sellers' expectations – helping them understand how potential acquirers will evaluate their business and what they consider important. We know what a challenge it can be for sellers to see the buyer's perspective. 
While we are constantly working to identify points of value, synergy or benefit that a buyer might find in our client, there is additional value to be gained by proactively looking at what could be an issue, challenge, or value detractor as you begin to position the company. By preparing for and positioning these issues upfront in a proactive manner, you can help sellers realise more value through the entire process.
In addition, when we work through the process, we are always looking to see what the company is working on that may materially change value with a bit of time or accelerated action. Often, the seller doesn’t realise how much this can drive value.
A common occurrence is when the key shareholder(s) seek to slow down or play a smaller role moving forward, and they work on seasoning or complimenting the management talent by promoting key staff or hiring from the outside. 
We have also worked with companies to make a small acquisition that will fill an identified gap or demonstrate the organisation's ability to digest an acquisition. 

Seasoned team

We are often called in when a key CEO/founder of an organisation is ready to step back and retire while realising the value of their life’s work. In one situation, the CEO was planning in advance and made his first hire from the outside into a leadership role, the COO.
It was great that he was looking forward, but the COO was new and didn’t have an established track record of success, something many buyers are looking for. 
The company had been approached with an initial offer that had an attractive valuation, but we helped them understand that they could materially change the value with just a little bit of effort. 
First, we helped them establish a board of directors that included outsiders to hold the COO truly accountable and force the founder to let go. 
We then completed a successful, small tuck-in acquisition to demonstrate the ability to scale, acquire and successfully integrate. 
Less than a year and a half later, we ran a managed process and secured a multiple that was 25% higher on a larger EBITDA, and generated a much more significant sale for the shareholder. 
By putting on our buyer’s hat, we were able to recognise that buyers would question the new COO and his abilities. We saw this as an opportunity to drive additional value and check all the boxes private equity buyers find valuable, including:
  • Market Leadership;
  • Management executive in place to drive the business post-close;
  • A demonstrated ability to grow through acquisitions and successfully integrate them into the company;
  • Proof there was a plan to grow.

Actions to drive value

A firm looking to sell had a second entity that was a joint venture with another organisation. While these two organisations were complementary, it was going to be impossible to sell without the buy-in of the other organisation.
This was a complicated transaction on its own, and we realised that the added complexity of the second organisation would encourage buyers to downgrade their valuations or walk away from the process because it was going to be too much of a headache. 
We encouraged our client to merge the two organisations. The merger made them much stronger competitively, the scale of the merged entity was able to generate a higher value, and we were able to show their ability to successfully integrate a merger. 
By looking at this situation from the buyer's perspective, we were able to achieve a higher multiple for the organisation, with some small changes along the way. 

The best defence is a good offence

No matter the client or the situation, you need to understand all the potential pitfalls, value detractors and potential red flags for prospective buyers. And, in some cases, you have to look at where opportunity can be developed.
Only when you understand these issues can you create plans to either drive value or preserve value proactively from a position of negotiating strength.
If you are left in a reactionary position, you will almost always lose. We are in this to drive value and retain value for our clients. Our upfront due diligence has saved the day more than once and even resulted in actions we could take to drive additional value. 
So, be upfront, don't hide any ticking time bombs from prospective buyers and work with your client to manage expectations and drive value wherever possible. 

Rajesh U. Kothari

Rajesh U. Kothari

GCG member firm
Cascade Partners LLC
M&A Advisory, Corporate Finance
Cleveland (OH), Detroit (MI), USA
T: +1 248 430 6266
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Cascade Partners is an investment banking and private investment firm serving entrepreneurs, businesses, and investors active in the middle market. Drawing on the deep management, investment and transaction experience of its principals, Cascade Partners provides the guidance and resources necessary to navigate the complexities of managing growth as well as acquisitions, divestitures, financing, and other strategic initiatives.
Rajesh U. Kothari draws on his over thirty years of experience as an investor, financial advisor, and entrepreneur to assist companies with mergers, acquisitions, divestitures, and other corporate finance strategic initiatives. Rajesh is the founder and a Managing Director of Cascade Partners, a private investment and investment banking firm.

Published: M & A Newsletter, No. 02 Spring 2022 l Photo: BGStock72 - stock.adobe.com

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