Investors are cautious about M&A transactions in the current business environment. Both Board directors and lenders are asking tougher questions, and demanding better answers about the merits of transactions.
Focusing on and objectively challenging the key assumptions that drive future results will build confidence in uncertain times.
According to Ernst & Young’s Capital Confidence Barometer, most organizations believe clarity of historical business performance and visibility of future cash flows, particularly revenue growth forecasts, are the key transaction value drivers.
Historically, investors may not have spent enough time focusing on current and historic trading, with valuations often based on multiples. But when business and economic performance are so volatile, this is no longer adequate as the degree of uncertainty around core business variables requires a fresh approach.
What do you consider most important for protecting the value of assets during divestment?
Increased scrutiny is prudent in these times. Act in haste, repent at leisure, is the adage.
Our recent survey of the private equity (PE) market highlights the correlation between the amount of time spent preparing an investment case and the likelihood of that investment achieving top quartile performance.
Many of the PE deals that worked out best were grounded in at least a year of scrutiny; many of those that did badly went through in six months or less.
But more preparation is not necessarily better preparation. Whether buying or selling, we believe it is critical to focus time and expert resource in order to identify and then challenge the key drivers on which expectations of future target performance are based.
Every forecast of future performance is based on a set of assumptions. Sometimes these assumptions are numerically expressed — “we expect our market to grow 15% over the next three years”; other times they are more subjective — “an injection of our technology will make this deal work.”
They may be stated explicitly, but often they are only implied. In either case, it is more important than ever that they are teased out and challenged — objectively and rigorously.
The focus of this challenge will vary from one transaction to another. But in our experience, four key questions will surface the core issues that drive future cash flow and value creation:
- Revenue: What core assumptions underpin the revenue forecasts and how realistic are they?
Revenue is almost always the starting point: it is connected to and shapes the rest of the forecast. A company cannot produce a revenue forecast without making a host of assumptions about the market, growth prospects, actions of customers, reactions of competitors and changes in the wider business environment.
These assumptions are even harder, and more important, to gauge when markets are in flux. Yet we find even experienced acquirers make these assumptions based on the past, and often on their own, rather than the target’s business.
For example, the investment thesis may be driven by a brand and premium pricing strategy, but research into the customer base can quickly expose any misplaced confidence. Having the time and expertise to deconstruct the revenue forecast is a key success factor in many M&A deals.
- Operating structure: How realistic and flexible are the company’s plans for leveraging and managing its cost base?
We are seeing companies coming up for sale that have had a great year in 2010. For many, that’s because they aggressively cut costs in the face of the global recession, and this year demand has come back, flowing straight through to the bottom line.
But is that level of profitability sustainable? Has management squeezed too much? If the company is operating at capacity, a marginal increase in demand might require a significant increase in fixed costs. Alternatively, if performance falters, is there scope to cut costs any further, or are they already sliced to the bone?
- Investment: Are all the investments needed to achieve growth targets and maintain cash flow projections identified and accounted for?
Challenging the production capacity needed to meet forecast output, for example, when will it be needed, how much will it cost, and is that cost in the free cash-flow forecast is only the starting point.
A company might require human resource investment, an increased advertising presence or an investment in IT and related infrastructure to achieve its goals. To what extent have those costs been taken into account?
- Change: Does the company have the management skills needed to deliver the expected synergies and operational improvements?
Investors often make unrealistic assumptions about the ability of their management to affect change. That is one reason why so many M&A deals fail to live up to expectations. Financial analysis might suggest that a combination of two businesses will deliver synergies, but making two entities worth more than the sum of their parts requires considerable management skill and planning.
A company might believe that it has this expertise in abundance, or that the target company will contribute. But this needs to be objectively challenged, especially if there is no track record of consistent business improvement or acquisition integration.
In today’s market, investors are right to be cautious in their M&A strategy. Getting increased certainty around the commercial aspects of a transaction can seem as difficult as it is desirable. The answer lies in a more rigorous and focused approach to challenging the key assumptions that drive future cash flows.
Some of these assumptions will be obvious, with others only implied or becoming clear from doing the hard work. Investors that understand the answers to the questions set out here, whether buying or selling, will increase the likelihood of a successful transaction.