Buyers Beware: Four Questions to Ask Before Approving a Buy-Side Deal

It’s no secret that acquisitions aren’t always successful. In fact, some studies suggest that as many as half don’t live up to management’s expectations. At the same time, M&A activity is an increasingly critical growth path for many large companies, which can gain innovative technology, market dominance, geographic expansion and other competitive edges from a well-planned strategic purchase.

To help management vet proposed acquisitions and ensure that purchases realize their full value-creation potential, boards must be hypervigilant in the review process—which means being willing to look beyond top-line numbers and deal conditionality. The following four questions can serve as a jumping off point for exploring the true costs, hidden risks and potential scenarios that could impact a board’s decision.

1. Are there any restrictions on the information available to us during the diligence process?
Business leaders are asked to make difficult decisions based on imperfect or incomplete information every day. That is especially true during due diligence, when essential information is often held back from decision makers just when they need it most. Pertinent information may be set aside to avoid a regulator’s antitrust concerns or restricted due to the seller’s caution, in case the deal ultimately collapses. Whatever the reason, more often than not, this hidden information tells an important story. To appreciate the risks of a proposal, boards must work twice as hard to understand and analyze the data they cannot see.

For example, during the due diligence phase of a recent deal between two competitors, the seller provided a client list to the buyer but was reluctant to share its backlog customer data. The seller rightly believed that the data would expose the significance or insignificance of each individual client relationship—a serious risk if the deal fell through. But the buy-side board argued that without such information, it could not justify the proposed valuation. After considerable negotiation, the parties agreed to aggregate sales figures and partially blind the seller’s customer data, which gave the buy-side board confidence in the valuation without revealing customer specifics.*

The Takeaway: To truly understand what they are seeing, boards must also know exactly what they are missing.

2. What factors make up the total cost of the transaction, and how might they change?
When recommending an acquisition, management often presents a single, top-line number to the board. “Our final purchase price is $3 billion,” for example, might sound like a reasonable firm position to take. Unfortunately, that headline number rarely tells the whole story and is more likely to obscure risk rather than illuminate financial variables, additional fees and structural costs—each of which can be significant.

In a recent proposal to its board, the C-suite recommended a $3 billion acquisition, partially paid through debt financing, and then quickly pivoted to discuss the conditionality of the deal. Focused on the M&A aspect of the deal, board members initially failed to ask the right questions about the cost of the debt financing, starting with fees and interest rates. Boards should explore both the restrictions the debt agreements would impose on the company going forward (such as restrictions on future acquisitions or payment of dividends) as well as the proposed method of supporting the new debt, especially if it is significant. Is management basing the repayment of the debt obligation on assumptions related to the transaction, such as synergies or revenue growth? Neither are guaranteed.

Regulatory fees and legal costs can also present expensive variables that are often overlooked. Payments to lawyers, consultants and accountants, among others, plus the cost of regulatory filing fees can quickly run into the millions, depending on the deal’s specifics. For example, a recent deal involving two strategic competitors required antitrust filings in four jurisdictions, which necessitated four filing fees and four separate counsels coordinating across international borders. Each prepared not only an initial filing relevant to their specific jurisdiction, but also answered follow-up requests and met with concerned regulators.

Finally, the board must consider the structural costs of the deal, including future costs that are being assumed as part of the acquisition. Will the buyer be paying for employee equity arrangements, severance or golden parachutes? What is the cost of supporting additional employees and facilities going forward? Does the seller have any community or charitable commitments that the buyer will be expected to continue? What costs will be incurred even if the deal doesn’t close? Any one of these items could be a material expense and in the aggregate could amount to tens of millions in additional costs.

The Takeaway: The headline price is rarely static, and many expensive items may not be presented clearly or may be excluded from the top-line purchase price.

3. If offering stock, what information are we sharing with the target? Do we have our own confidentiality agreement in place? Are we utilizing a standstill agreement?
Typically, sellers will require the buy side to sign a confidentiality agreement before sharing information as part of the due diligence process. Such agreements are often one-way, crafted to protect the seller.

Yet, when stock is offered as part of a transaction, due diligence quickly becomes a two-way street. Acquisition targets will seek confidential information about the buyer to reaffirm that the market price of the stock they are receiving is supported by the underlying fundamentals. To close such a deal, the buy side will often provide a presentation and supporting materials, including confidential business and client information. In addition, as transactions—whether involving cash or stock—move closer to the finish line and the two teams continue to interact, more information is likely to be shared through meetings and conference calls. None of the buyer’s information is protected by a standard confidentiality agreement offered by the seller. This represents a material risk to the buyer if the deal falls through.

Any board contemplating an acquisition should consider whether the confidentiality agreement should contain a standstill agreement. Consider a recent competitive process in which a seller was being courted by two firms: financial buyer (a nonstrategic acquirer) and strategic buyer (a strategic competitor), with financial buyer ultimately signing, and then closing, a deal with the seller. As a result, the seller and the financial buyer became a much larger and potentially more dangerous competitor to the strategic buyer.

The strategic buyer had wisely put in place a buy-side standstill agreement as part of the attempted acquisition. That document restricted the new competitor from certain activities, such as purchasing the strategic buyer’s stock or taking other actions that may have led to a change of control of the strategic buyer—unless the strategic buyer’s board approved the action and participated in the process. The strategic buyer not only protected its confidential information, but also protected itself in case the newly combined competitor was hoping to make further inroads and investments in the industry.

The Takeaway: Boards should inquire whether the appropriate documents are in place to protect their company from such downside risks.

4. Are there any restrictions on us while the transaction is pending?
The gap between signing and closing can sometimes run a year or more, most often due to regulatory inquiries. Particularly when stock is being offered as part of the transaction, the seller will place restrictions on the buyer during that period.

Commonly requested restrictions during pendency include freezing other M&A activity, halting the payment or declaration of dividends, restrictions on indebtedness and eliminating stock purchases, redemptions or buy-backs. These are routine business activities. As a result, boards must understand exactly how the proposed agreement will limit their ability to conduct business-during the pendency of the transaction. Some restrictions might be worth the trade-off for a high-value or strategic acquisition. But remember: not every deal will close, or close on the projected timetable.

The Takeaway: Boards would be wise to carefully weigh the opportunity costs of restrictions on routine business activities against the benefits of the proposed transaction.

When management brings an M&A opportunity to the board, the C-suite’s primary focus is almost always on the top-line cost and conditionality of the deal and on helping the board understand the necessary next steps required to take advantage of the opportunity. Certainly, conditionality and realization of the benefits of the opportunity are essential, first-order lines of discussion.

However, it’s critical that boards also explore the significant, material effects of the transaction and ensure protection against downside risks. These four questions can help launch that discussion.

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Kimberly C. Petillo-Decossard
Kimberly C. Petillo-Décossard is a partner at Cahill Gordon & Reindel who advises corporations, boards and private equity firms on domestic and cross-border public and private mergers and acquisitions and related financing transactions. She also advises domestic and foreign companies on governance, disclosure and compliance matters.