FINANCING A BUYOUT, MERGER OR ACQUISITION

FINANCING A BUYOUT, MERGER OR ACQUISITION

Karpenko, Steve

This year is shaping up as a record setter for leveraged buyouts, mergers and acquisitions, financed in large part by debt. Indeed, The Wall ‘Street Journal reports that $100 billion in leveraged buyouts were announced in the first quarter of 2007. With record multiples and more accommodating credit structures such as “covenant-lite” loans, lenders may need to monitor credits closely to make sure that problems don’t surface in the postmerger or acquisition integration period. A key aspect of the risk-management process is for the lender to review the company’s integration/merger plan before committing to the financing.

In the blur of activity when a buyout, acquisition or a merger gets financed, it’s important to keep in mind the common problems that can crop up after a merger or an acquisition. Here are some common questions to ask:

Do people matter if the two companies have great products?

If you have to choose between a company with a strong management team and mediocre products versus a mediocre management team and good products, take the strong management team. What if one of the companies is in bankruptcy or is distressed? It is important for the lender to know whether the acquired company has one major flaw and is limping back to home base or is suffering scores of lesser problems. These two scenarios require radically different repairs. If you’re financing the acquisition of an “orphan” product acquired from a multinational, be prepared for some heavy spending on marketing and sales channel development. If you’re financing the acquisition of a “sunset” business, maintain a close eye.

Leadership: Can two strong leaders co-exist after a merger? Rarely, unless the operating units are kept completely separate, which usually defeats synergy opportunities. Two cooks usually spoil the broth. Investors and lenders should demand very specific integration plans if both CEOs intend to stay on.

When an entrepreneur sells his company to a private equity group as part of an industry consolidation play (a rollup), how can he be kept productive?

We’ve all seen many situations where the selling entrepreneur has a wad of cash in the bank, and there’s concern that he won’t be focused on the future. In these cases, the lender needs to know how the selling entrepreneur is going to be transitioned out. Questions need to be asked: How will customers react? Will the company’s suppliers be upset? What are the non-compete provisions in the buyout? Will he or she be replaced by people who have the right background to drive growth and help the new company meet its goals? If the borrower replies that the transition will be done “on-the-fly”, the lender should underwrite the risk for a higher level.

It’s not only a productivity issue with the entrepreneur; the second, key question is “does the leader of the rollup have the leadership skills to ensure that synergies are realized?” Even when both companies have similar cultures, unclear transition plans will trigger short-term chaos, causing the best people to leave.

Private equity oversight: What happens when a private equity group interferes with management? Private equity sponsors can bring good disciplines and rigor to a buyout or a merger – often, they insist on a high degree of accountability, organizational structure and succession plans that may have been lacking under entrepreneurial ownership. Such sponsors often have access to superior industry information and analysis that can broaden the perspective of management in the company. Many private equity sponsors have integration specialists, which is a skill set to which few middle-market borrowers have ready access. Lenders need to ask the private equity sponsor how much it will be involved with the company, and where the lines will be drawn between the company’s management and the sponsor.

When you are getting to know a new private equity sponsor, make sure it has a good track record of integrating rollups. Ask how its deals have performed (make sure you ask about disappointments), how it has dealt with problems and surprises, and what keeps the sponsor up at night once it has bought a new company. Ask whether it’s a hands-on sponsor, or if it leaves management alone.

We’ve seen instances where the private equity sponsor overmanages a company to the point where senior management loses their credibility with employees. Most private equity sponsors are staffed with smart MBA types who can spot good value propositions and negotiate favorable deals; however, some continue to be assertive beyond their areas of expertise into the realm of operations. They can intimidate the people who are supposed to be running the company, so the ship becomes rudderless.

Management style: Casual vs. formal management styles can be a source of conflict in the merged company or rollup if this issue is not properly managed. The lender needs to ask if this will thus be a merger between an “oilbased” corporate culture and a “water-based” corporate culture.

Take stock of differences in culture between the acquirer and the acquired company. These differences can be driven by geography (especially when buyers are from other regions of the country or are foreign-based), maturity of the companies, differences in affinity for technology, and whether they have finance-driven vs. sales-driven vs. operations-driven cultures. Huge differences can exist even when companies are in different parts of the same industry and come from the same part of the country, especially entrepreneur-led firms.

The leader of a company usually sets the overall management style, but good M&A leaders listen, especially during times of transition. They take the time to understand the culture of the other companies joining the mix, and create conditions that help everyone succeed.

The need for speed: Patience is not a virtue in postmerger integration. The plan and key players must be in place before the transaction closes and communication should begin on the first day of the new entity. If the integration is poorly communicated and slowly deployed, people will blame the merger for other problems. The result: often lost or delayed synergies and sloppy work habits.

Conflict resolution: Lenders need to ask if the merged company has a formal conflict resolution mechanism in place to deal with the inevitable clashes. Conflicts are inevitable, and a transparent conflict resolution mechanism goes a long way towards making people comfortable that the playing field will be level. There’s nothing worse than a rumor mill with lots of closed-door meetings which make people worry and think that favorites are getting the best deal.

Compensation: Are there some “stars” whose pay will create jealousy? Lenders need to know that the borrower’s management has given a lot of thought to compensation for the new merged company. A poorly conceived compensation plan means that some of the best people will leave. If the compensation plan is pay-for-performance, ask if measurements are in place so the staff members feel their efforts will be recognized and rewarded.

Training, professional development: Does the merged company face some challenges of upgrading staff skills in one of the companies to be acquired?

A common instance of this is when a larger company swallows up a smaller entrepreneurial venture whose staff had been trained “on-the-fly”. In those cases, the entrepreneurial staffers may feel like they’re being “bureaucratized”. There are instances where fast-moving rollups are acquiring “orphaned”, cast-off divisions of corporations, and sometimes the acquired company has better skills and training than the acquirer. But it can succumb to the turbulent, on-the-fly culture of the acquirer, leading to a disruptive merger and lost value.

Poorly handled, these issues can result in higher turnover, with the best people leaving.

Management information systems

Legacy systems that won ? talk: Lenders need to ask if the computer systems of the various merged entities are compatible.

It’s unlikely that the compressed timeline of a rollup would permit the extended timeframe required to do a thorough analysis of the compatibility issues. Even two companies running similar systems like SAP or People Soft could experience drawn out integrations that can be costly and are easily underestimated, even by the most experienced practitioners.

New technology costs: Lenders should ask what dollar amount is allocated in the merger plan for upgrading technology. If a massive system upgrade is planned, will the legacy systems run parallel until the new system is running smoothly? Are the risks of the technology expenditures clearly laid out and thought through?

It’s likely that significant work will be required to integrate the systems of any two companies. Even in an operating niche (e.g., transportation) with the same computer systems, there are still process execution and data integration steps that must be accounted for in any integration plan. Typically, the costs and risks expand exponentially with the number of points of dissimilarity and affected processes.

Accounting and financial systems: Ask if the computer systems deliver accurate profitability and financial control information in a format that management and the lenders need. This must be a short-term priority, even if adhoc patches or outside contractors are required to accelerate the integration, since these systems are at the heart of decision-making.

Supply chain systems: Do the companies’ supply chain systems complement each other? In industries with highly sophisticated supply chain requirements (like global retailing), this should be a front-end consideration, and flagged as a principal risk in the acquisition equation, as significant costs and timelines will be involved. An alternative to reducing MIS risk is to run parallel, separate systems until the supply chain integration can be completed properly. This may increase overall integration project costs, but the reduction in business risk could be worth it. Smaller companies can possibly reduce integration risk by outsourcing their supply chain needs.

Products

Who’s responsible for what customer after the merger! Lenders need to ask if there will be overlapping sales territories which can cause turf battles between sales reps. What happens if one sales rep has a great customer that becomes a “house” account which pays no commission? Is management preparing for some amount of customer confusion and the reaction of competitors who will try to take advantage of customer disruption?

This is the fastest way to lose customers after a merger. Customers can accept change, but are loath to accept uncertainty. Customers usually have no obligation to hang in while their supplier gets its act together. Lenders must be certain that a crisp customer transition plan has two key elements: commission rates and responsibilities should be optimized from the start and customers should be clearly informed (preferably consulted) as to any changes in service or personnel.

Differences in quality: Find out if one of the merged companies has products whose quality or reputation can harm the reputation or perceived value of products offered by the other merged company.

If the acquired company is to become part of the acquirer’s entity, rather than operated separately, incompatible products or services must be sold or discontinued. This is a crucial part of the valuation process during diligence. If the borrower is buying a company for one product, process or access to a customer, the borrower may have to discount the value of noncompatible assets, but also the costs and delays associated with selling or discontinuing them, including the impact that severances will have on morale.

New product development: Does one merged company have a great product-development process that can be used in the other merged company?

Companies lacking new product or service development track records often need to buy the expertise. Acquisition is a legitimate way to address that need. However, a new product development culture often conflicts with a “status quo”, business maintenance culture, especially in the operations and sales functions. Some companies are great at developing new products, others are lousy. We know about one company in a hotly competitive consumer products category – vinyl cases for CDs etc. – where 20 percent of its sales each year come from new products developed annually.

Sales channels and competing against your own customers or suppliers through vertical integration: Do both companies serve the same markets (mass merchants versus specialty stores)? If the strategy is to serve both channels, lenders need to see a coherent plan to manage these distinct customers. As an example, some consumer product companies develop a higher-end line of products available only to their specialty retailer channel, while the mass merchants get a different, less feature-rich line from the same company.

If one merged company is further downstream than the other merged company (such as a distributor), will they end up competing against some of their customers? It’s surprising how many companies ignore this, or think that it won’t matter.

As mentioned earlier, this should be part of a competent operational diligence process. “We’ll know how to handle that once we get inside” is a lazy answer to your question. Incompatible customer strategies can lead to customer defections if they think the supplier is confused, has introduced new competition to them or relegated them to lower customer status behind the merged company’s customers.

Operations

Differing service levels: If one of the merged companies excels at logistics requiring “split second” deliveries, while the other does not, the poor performer can drag down the efficient operator.

It’s easier for a well-honed supply chain to absorb a lesser execution-sensitive one. The better-performing supply chain will have skills that can handle the complexity and scope. The reverse is rarely true. Also, you can’t overlook differences in bulk package sizes, location factors, customer size and costs that may not be in sync.

Too many factories: Lenders need to ask who wins out in a geographic rationalization. Will there be a stalemate, with no action taken (in mergers, there is often reluctance to slaughter sacred cows)? Rationalization decisions about factories can be more obvious than decisions about distribution centers.

Does the buyout or merger plan spell out offshore sourcing issues? It must. Today’s reality is that it’s impossible to compete with the offshore economies of scale unless the product is too expensive to ship or is proprietary. In the long term, much manufacturing may come back onshore as we start to understand the total costs from offshoring in the life cycle of a product and company. In the short term, synergies must be realized and all cost advantages acted upon. Most markets are far too competitive to leave money on the table. Highly leveraged buyouts have even less room for inefficiency.

Supply chains: Lenders should ask whether the buyout or merged company is better off outsourcing its supply chain in the short term, then bring it back in-house in the longer term. The integration of supply chains can be expensive and time-consuming, and easy to underestimate.

Corporate financing

Dividends to the private equity group: Does the buyout or merger plan contemplate dividends that will limit liquidity? In today’s liquid marketplace, some private equity groups are taking dividends seven to ten months after a deal gets closed. Once the dividend money is in the hands of a private equity sponsor, it can be painful getting it put back in.

Cross-border loans are exciting to book when the economy is on the upswing, but the opposite can be the case when the company gets into trouble. Find out if the individual jurisdictions in foreign countries will hinder reorganizations.

The most obvious come to mind: the unpredictability of the courts in France, the heavy employee severance obligations in the Netherlands, and the lack of intellectual property protection in China. The European insolvency laws are a patchwork quilt, which can significantly delay restructuring and reorganization. The unpleasant result can be that both your collateral and the enterprise value of the borrower erode, while stakeholders duke it out across multiple legal jurisdictions. Comparing the U.S. restructuring and insolvency to the European landscape is like comparing the Sibley portrait of George Washington in The National Gallery in Washington to a Picasso.

The danger of addbacks: Addbacks are a hotly debated point between lenders and private equity sponsors. The natural tendency is for private equity sponsors to try to classify as many costs as nonrecurring in order to spur up EBITDA. In today’s market, addbacks can be as much as 50 percent of TTM EBITDA.

An increasingly fractious point of debate between buyers and sellers is the distinction between “hard addbacks” and “soft addbacks”. A good example: when a private equity sponsor says that its portfolio company is making an acquisition solely for the products owned by the target company, it is saying that the acquisition should be strictly judged on the contribution margin that’s generated by the new products. Therefore, overhead, sales, general and administrative expenses won’t increase as results of the acquisition. Are these addbacks soft or hard?

One thing is for sure: financings loaded with soft addbacks may run into trouble at the syndication desk.

Steve Karpenko is a managing director in Trimingham Inc.’s New York office.

Hugh Larratt-Smith is a managing director in Trimingham ‘s New York office. He is an Advisory Board member of CFA ‘s Education Foundation, and was a director of The Turnaround Management Association from 1999 to 2006.

Copyright Commercial Finance Association Jul/Aug 2007

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