This is part 2 of the five-part series “Compliance, Diligence, and M&A” with Tom Fox and the FCPA Compliance Report. During the series, Tom was joined by K2 Integrity experts Hannah Coleman and Tom Pannell for a discussion on due diligence’s role in the M&A process, and how it can create a more successful environment for integration. Listen to the series from the beginning.
Deal making experienced a big dip with the onset of the pandemic, with the majority of deals that did happen driven by economic distress. This was seen most glaringly in the consolidation that occurred within the energy industry. However, in the second half of 2020, things picked right back up to where they were in 2019. That much activity is unusual during the second half of the year, but many big companies and private equity funds had huge amounts of cash and were looking to deploy it. This has led to the market currently being extremely competitive—and it also means valuations can change depending on the asset class or industry to which the company belongs.
For example, companies that 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 that were negatively impacted by the pandemic might be at a fire sale prices. The bottom line is that there are multiple ends of the spectrum in play at the same time, with 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.
Due Diligence in the Current Deal Environment
With all the deal activity, there also comes an increased risk of fraud. Experience says that companies looking to acquire should be on the alert for fraudulent financial reporting, where companies attempt to prop up their results to demonstrate that they are still a valuable target.
Presently, the market is at a point where there is a lot of pent-up demand. 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, always critical, is now even more so, a job not made easier by the huge amounts of information available electronically. It is critical that companies looking to acquire ascertain that they have the right information to analyze—over and above the financial statements, the trial balances, sales registers, customer master files, and other information, companies need to test and dig into select samples and push management to supply the information in order that they can look at the books and records that support the transaction.
However, it’s not enough to perform financial due diligence in this M&A context. With the current and former administrations turning their attention to a multitude of enforcement actions as diverse as anti-corruption, trade sanctions, and data protection, other types of due diligence are needed. Acquirers need to look at corporate culture, cybersecurity, export controls, and a wide variety of other areas that have traditionally been performed through in-person due diligence.
How do you think through the priority of these other, nonfinancial issues? A few key questions to ask when considering acquiring a target company: What is your target’s track record in these areas? Are there any sorts of red flags or any sort of operational questions that remain unanswered? What is the full scope of the operations? Who are 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?
One type of transaction that especially needs due diligence is the special purpose acquisition company (SPAC). Historically, most SPAC deals have viewed warrants as an equity instrument, but recently the Securities and Exchange Commission (SEC) has come out and said SPACs 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 a company would account for gains and losses of that liability. This is a complicated bleeding-edge area that that is getting a lot of attention from the investor community and from those doing SPAC deals right now.
Join us for Part 3, where we discuss how to identify potential reputational issues.