The due diligence process for target acquisitions should extend beyond what’s evident — financial performance, tax liabilities — and cover those elements of business operations and holdings that present tangible implications for the post-integration entity. This section considers three critical, though often overlooked, areas fraught with risk:
- Real estate
- Employee benefits
- Post-merger integration
Real estate
With so much attention directed to your target’s finances and performance trends, you must not overlook the land and buildings involved in any prospective deal, as property can have a substantial impact on the performance of the post-integration entity.
As part of the initial due diligence stage, assess the target company’s real estate portfolio. Will you be inheriting a lease agreement or purchasing real estate as part of the transaction?
If you stand to inherit the lease, there are a number of items to factor into your valuation. Determine your rights and duties versus the landlord’s rights and duties, including any obligations regarding maintaining mechanical systems, parking lots, or restoring the facility back to its “original” state. Include scheduled rent escalations into your ROI projections, and don’t forget details regarding termination provisions or renewal options, including the timing of notice provisions. The type of lease (triple net, absolute net, modified gross, gross, etc.) may also carry unique financial considerations. Finally, perform a mark-to-market assessment of the real estate, categorizing them as above, below, or at market.
If you’re inheriting the real estate portfolio as part of the acquisition, consider a facility condition assessment to uncover deferred maintenance or deficiencies of the facility. Additionally, as you consider the growth potential of the post-integration company, consider a sale-leaseback arrangement of real estate. Such a vehicle can generate immediate funds to pay down debt or expand operations, while affording you the opportunity to reposition the asset.
Whether you inherit a lease or the actual facility, investigate existing incentive agreements on a state and local level. These agreements can exert a tremendous liability on the post-integration entity, necessitating an exhaustive due diligence review. If they exist, review any clawback provisions of the agreement. Does the incentive agreement coincide with your long-term vision? Will the facility location need to be consolidated or relocated? If so, determine whether you can rework the incentive agreement prior to closing as you may lose leverage to modify it afterward.
Employee benefits
According to the U.S. Bureau of Labor Statistics, employee benefits average in excess of 30% of the total costs for employee compensation for the private sector, with costs in some industries averaging much higher. Therefore, it’s easy to see the importance of conducting a thorough review of employee benefits costs for your target company.
The impact of employee benefits on future earnings can be considerable, especially for major legacy expense items such as pension obligations and OPEB (other [than pension] post-employment benefits) liabilities such as healthcare benefits, life insurance, and disability. These liabilities can extend beyond the target company following a deal. In fact, a recent court ruling found multiple private equity funds managed by a major private equity firm to be jointly and severally liable for unfunded pension liabilities owed by a bankrupt portfolio company. When looking at a financial statement, review its long-term liabilities carefully, as the actuarial assumptions and methods prescribed to establish OPEB financial statement liabilities do not provide an accurate reflection of the actual long-term impact on cash flow.
Finally, evaluate other employee benefits-related items, including those tied to IRS and/or DOL compliance, employee reactions to anticipated benefits changes, potential need for preemptive negotiations with union representatives, and potential union pension withdrawal liability. Additionally, assess executive compensation agreements to ensure compliance with IRC 409A and 280G as appropriate. All of these can impact the performance of the post-integration company, which must be addressed prior to finalizing the purchase.
Post-merger integration
With its strong focus on quality of earnings, the due diligence process for target acquisitions typically doesn’t include identifying potential post-merger integration risks. Target companies may lack sufficient resources, technical expertise, or find themselves unprepared for the rigors and new demands of the purchase process, and these factors make them more susceptible to post-merger integration pitfalls.
The delivery of accurate and timely financial information is critical for making relevant and strategic business decisions, and to avoid becoming reactive. Private equity groups should be proactive in identifying and addressing the common integration risks. The following should be considered when considering post-merger risks:
1. Lack of a post-merger integration plan
Companies face many risks during and immediately after the closing of an acquisition: turnover of key talent, incompatible systems, potential sales losses, month-end financial close inefficiencies, productivity declines, and cultural friction, to name only a few. It’s critical to put a plan in place to identify and address them and provide structure to the integration process to meet major milestones.
2. Not conducting thorough diligence on financial records and data
As part of the process of developing your post-merger integration plan, it’s important to perform additional due diligence on the company’s financial records to ensure the data are clean, reliable, and usable to meet your performance-monitoring and value-creation goals. Several factors are at stake during this process, including investor expectations. You also don’t want to risk leaving money on the table when determining any purchase price adjustments if post-merger risks are not addressed in a timely manner.
3. Not evaluating talent capabilities
As you evaluate your target’s potential post-merger integration risks, the capabilities of your target’s existing finance and accounting team should also be assessed. Is the current finance team capable of handling higher expectations around financial reporting? Is the company’s existing accounting and finance department sophisticated enough to keep up with the financial performance expectations of their new owner? Do additional accounting and finance personnel with the requisite skillsets and experience need to be identified? By addressing these gaps early on, not only will you proactively minimize risk — you’ll ultimately maximize the operational efficiency (and thus, profitability) of your target.
4. Not assessing the systems to determine if they are adequate
During the post-integration plan development process, you might discover that your target lacks the systems to provide accurate financial information. Consider what resources are readily available to provide to the target at a moment’s notice. The business’s day-to-day operations don’t stop just because they’ve recently gone through an acquisition — sustained operational efficiency during the transition period is no less critical to the acquisition process.
Have you assessed the target’s reporting systems, methodology, and efficiency? Does the company need to implement a new financial reporting system or consolidate systems with another company in the portfolio?
Assessing the finance department — both systems and talent — may reveal the need to revamp your target’s financial reporting framework. As you consider the proper forward-looking strategy for your target, a solid financial reporting function is key to navigating significant changes, mitigating risks, and creating value.
Avoid risks through transparency and deliberate planning
Often, hard conversations around company culture, leadership changes, inefficiencies, and many other topics are avoided prior to acquisition, or they’re simply overlooked because no integration plan exists. As these types of issues are common, both acquirers and acquirees should strive to be over-prepared for these pain points. Don’t let these common risks derail the work to achieve your post-integration performance goals and financial targets. Addressing these post-merger risks early will help drive value creation, growth, and your target company’s future success.
