I recently had the chance to visit with Tom Pannell, Managing Director in K2 Integrity’s Investigations and Risk Advisory practice on the current M&A and deal making scene. We explored it from both the domestic and international perspective.
Pannell noted that initially the market took a big dip with the onset of the pandemic. The majority of deals were driven by economic distress. This was scene most glaringly with the consolidation within the energy industry. However, in the second half of 2020 things picked right back up where they were in 2019. Pannell said, “One would never expect to see that much activity during the second half of the year, but many big companies and private equity funds have huge amounts of cash and are looking to deploy it. People weren’t spending quite as much. They were probably investing it in places and gave the PE funds an extra boost as well.” This has led to the market currently being “extremely competitive”. It also means “valuations can be really high depending on the asset class that you are buying.” Companies which have demonstrated they could pivot during this time to a remote workforce and remain competitive “can really demand a premium from the deal market.”
Conversely, businesses which were negatively impacted by the pandemic “might be at a fire sale prices.” The bottom line is there are multiple ends of the spectrum in play at the same time. Pannell said, “you see sectors like technology and digital players with huge premiums and very high multiples; and other sectors more in distress, such as retail causing some low multiples. Also, Pannell said “there’s going to be an increased risk of fraud. What I would be most worried about from a deal perspective is fraudulent financial reporting, where you’re trying to prop up your results to demonstrate that the pandemic didn’t impact you as much, you’re still a valuable target.”
In May 2021, the market is at a point where there is a lot of pent-up demand. This could lead to literally “an explosion of deals as we move into the summer and things loosen up a little bit.” This situation presents new or perhaps different challenges around the lack of ability for site visits or in person interviews of key executives of a target. Data analysis is always critical and huge amounts of information is available electronically. It is typically “swimming in data in the data room.” It is critical to ascertain you have the right information to analyze. But even with the financial statements, the trial balances, sales registers, customer master files, and other information, you need to test and dig into select samples and push management to get you the information and look at the books and records from a support for the transaction.
Yet now, with a multitude of enforcement actions as diverse and anti-corruption, trade sanctions and data protection, other types of due diligence are needed in the M&A context. You need to look at corporate culture, cybersecurity, export controls and a wide variety of other areas which have traditionally been performed through in-person due diligence.
I asked Pannell, how do you think through the priority of these other, non-financial issues? He noted you would “want to take a step back and look at your deal. What is your target’s track record in these areas? Are there any sorts of red flags or any sort of operational questions that you might have? What is the full scope of the operations? Look at their customers, what do they do, what do they sell? Where do they sell it? How do they sell it? Are they using distributors and third parties, do they sell to governments? Things like that.”
We ended with a look at special purpose acquisition company’s (SPACs). Pannell began, “Historically, most SPAC deals have viewed warrants as an equity instrument but recently the Securities and Exchange Commission (SEC) has come out and said they might actually be a liability. From a fair value accounting perspective, it can have some impact on the overall view of the balance sheet and how you account for gains and losses of that liability when you fair value account for it. This is a complicated bleeding edge area right now that that is getting a lot of attention from the investor community and from those doing SPAC deals right now.”
International M&A presents both different and heightened risks. If an organization is going to enter into a multi-national global deal, it probably involves a fairly sophisticated buyer. However, the ultimate level of risk of the transaction is going to inform what you do. As the risk level could be both different and heightened, “I think doing a fulsome diligence is key and let the profile of the target drive the activities that you’re going to do. Look at the track of the target, look at what they actually do. If it’s slightly different than what you do as an acquirer, they might pose a little bit different risks than you’re used to.” Some of this might involve, who does the target sell to, where the customer’s located and what are their business operations? Does the target us a distributor model? Do they use third party sales agents and are foreign governments customers?
Another area for investigation and review is a target’s Supply Chain. Pannell said, “they really need to understand their supply chain and where the underlying goods are produced all the way through to the end customers.” This means an acquirer really needs to understand the risks around the underlying supply chain and what that can bring. But it also may require a physical look at their facilities to see what, if any, issues might arise from a physical inspection. Another area which is receiving a lot of attention right now is anti-money laundering (AML). An acquirer will need to review the target’s AML program. This is most particularly true for banks and other financial institutions which are expanding their global footprint. Pannell said, “you want to dig into their AML compliance programs. You will want to look at the governance. Finally, you are going to look at the customer due diligence and KYC policies and procedures and controls.”
A new area for background review in the international transaction arena is national security. The Committee for Foreign Investment in the United States (CFIUS) became much more prominent under the prior administration. That prominence will continue in the new administration as well. Pannell pointed to the abortive attempt by the Chinese company Alibaba to purchase MoneyGram as a key example.
We turned to some of Pannell’s thoughts on culture; why it is so important and why getting it right can be such a challenge in the international acquisition context. Pannell believes “Culture is critical. Largely because from a cultural norm perspective, people do not always do business the same way. Business in the US is very different than business in Sub-Saharan. Africa is very different than business in Asia. Looking at common practices is a key part of diligence in a global deal.”
From an anti-corruption and business ethics perspective, you need to review their overall compliance program. Is it a paper program and/or do they put it into practice? You need to review their policies and procedures, try to understand the tone from the top, is there a Code of Conduct and is there an overall tone of doing business ethically, these are all key questions you need to try and get a handle on in the pre-acquisition due diligence process. Pannell finds that a key is a target’s training program, which he said was “really, really important.” Such things as you as delivering the training and who is being trained are not only critical questions but can be key indicia of the culture of an organization.