“As most business people know, the best time to attack your competitor is when he is in the middle of a complex merger process. This is when his customers are neglected, his key employees are likely to leave, his key suppliers experience most uncertainty, and this is the time when he is least likely to be able to muster a coordinated response to any form of attack.”[1]
The list of failed mergers is not too short. The chances of unpleasant surprises making their way in can be predicted and minimized. Statistically, 70% of the M&A deals end up being a failure. The challenge for managers to opt for the mechanism of restructuring that reduces the value leakages to a minimum is difficult and continual in the entire process of effectuating the scheme. Scholars[2] have compared mergers and acquisition transactions to gambling in a casino. This analogy helps to understand that even in the best circumstances effectuating these schemes can be difficult and risky. In Chapters 24 to 29, we have seen what an M&A failure might look like. In this chapter, we will talk about some infamous mistakes that lead to such failures in merger schemes, the ways to identify such risks through the process, and focus our discussion upon mitigating these identified risks. The risks can be of various temperaments, they can be financial, operational, commercial or political in nature. We will move this discussion from risk mitigation that could be helpful in all kinds of M&A schemes to risk mitigation in schemes of specific nature, such as, schemes involving intangible assets, cross-border mergers, and schemes affecting human resources. We will also emphasize the significance of due diligence in the mitigation of various kinds of risks.
Identifying risks
The first step to minimizing risks in an M&A transaction is identifying them. Firstly, it is important to determine the various factors that can result in potential risk. Such risk factors can be identified by reviewing the literature, analyzing similar transactions, and taking opinions and suggestions from industry experts and relevant professionals. Thompson and Kim[3] provide three measures to understand if a potential risk factor should be accepted and identified as a relevant risk factor. The three measures are:
· If the potential risk factor diminishes stock performance? Elements like differences in industries of the parties involved in a scheme can have a negative impact on the stock performances of the entities as they will be subjected to elements not particular to their industry. Similarly, the composition of the acquirer’s leverage, acquired stock size and price, and his dependable resources can have an impact on the stock performance post the transaction.
· If the potential risk factor increases the probability of default in the transaction? For instance, the method of financing can significantly alter the chances of default after a merger transaction on behalf of the acquirer. If the charge is fixed on the assets and the liabilities are secured, the financing process becomes a little less risky.
· If the potential risk factor increases the likelihood of delisting due to poor performance? Even though, delisting in itself is not a negative impact as it can be induced by the venture capitalists in a cash-out situation or can be seen as an exit strategy. However, the mandatory delisting instances that are resulted out of a poor performance, bankruptcy, liquidation, are concerning. Again, a risky method of financing the transaction that only caters to the short-term financial needs can turn into long-term debt for the resultant entity and can be a risk factor that needs identification.
If any of the above questions are answered in a “YES”, the potential risk factor can be identified as a relevant risk to the scheme. Such identified risks can be ranked on the basis of the likelihood of their impact and prioritization must be made on these risks for moving forward. Further, mitigating strategies should be put in place. These strategies will be discussed in the next section of this chapter.
Some commonly identified risk factors are:
1. Overpaying for the target company: Overpaying for the target company or a business tends to act as a leakage to the value to the shareholders. Forbes notes that 70-90% of the times, the M&A transactions fail to create value for shareholders. The core to this risk can be pointed out to be the poor valuation practices undertaken by the parties involved. External personnel having expertise in corporate valuation can be appointed by the buyer to avoid such risk.
2. Overestimating synergies and failure to capture them: This is not to imply that synergies do not exist. But according to a survey by McKinsey (A management consulting firm), at least a quarter of all management tends to overestimate the synergies that would be resulted post-deal by almost 25%[4]. The projected combined ability of distribution chains, intellectual property, industry opportunities and workforce tend to be in overestimation of the actual numbers. The risk generates when there is misvalued optimism to create synergies everywhere, so much so, that there is no synergy in an inflow of money. The parties should remain conservative in assessing deal synergies. Once the conservative values are estimated, it is important to work in the direction of obtaining such results
3. Data privacy issues: In the present times, data is one of the most important assets of a business. it is important to ensure is confidentiality to retain the competitive advantage acquired over time. While engaging in transactions that require an exchange of classified documents virtual data rooms can be used to avoid security breaches. It should be ensured that such virtual data rooms have strong encryption and a two-step verification mechanism.
4. Integration risk: Post-merger integration is a renowned challenge. The challenge to manage audits, integrate salesforce and all other aspects of operation is all the more, when the parties involved belong to different industries. There always runs the risk of employee dissatisfaction, failure to secure synergies and eventually, loss of value to the shareholders. In the case of cross-border mergers, there also is a need to integrate cultures – which cannot always be defined in numeric goals. To make the integration process easier, it is important to include the members of due diligence teams in the practice. The focus should ultimately be value creations. Sometimes it is imperative to include the human resource management team in the integration process to ensure smooth transition or incorporation of employees into the new or restructured entity. Failing to consider culture and change in management in the integration process can be disastrous for the acquirer firm. It is important to ensure the high morale of employees and maintain their satisfaction to keep them in the company. The acquirer party must be very diligent in collecting and processing information on the target company’s culture and ways of operation to give effect to the projected synergies.
5. Unexpected costs of the transaction: there can be multiple kinds of fees involved in effectuating the deal, which might have been overlooked while planning for the expenses of the transaction. Some of the costs that are necessarily part of all transactions and must not be neglected while planning the transactions are the cost of due diligence, legal fees, valuation expert fees, cost of integration practices, like training of employees, rebranding cost, and cost to retain the employees. To avoid the element of surprise (or shock), the best practice is to settle on flat rates and pricing methods for such estimated costs. It is important to note that this risk borders on being inevitable and can only be reduced and not avoided altogether.
6. Litigation risks: Even some of the most negotiated and well drafted M&A deals end up in courts. The failure lies in not paying enough attention to the dispute resolution mechanisms governing the deal. Disputes can arise in the deal in case of breach of representations and warranties, or differential calculation of the working capital by the target company and the acquirer. Shareholders can also initiate litigations upon firms with claims of oppression, mismanagement and prejudicial conduct, Class actions, breaches of contract or statutory duties, or acts of misconduct on the part of management. Litigation is known to a be a lengthy and expensive process. Apart from the direct costs of court fees and legal fees, it results in overbearing and lasting cost on the reputation of the firms involved. As it is for other risks, there is no way litigation risk can be avoided altogether, it can only my minimized. The most effective way to minimize litigation is instilling a comprehensive dispute resolution mechanism in the deal. The dispute resolution mechanism should be expansive enough to bind all parties that can institute suits against the deal. Dispute resolution mechanisms in context of pre and post transaction are discussed in more detail in later chapters.
7. Fraud risks: Fraudsters never seem to be underequipped in their means, and they are not shy to make use of them. Any fraud in the financial statement, revenues, or disbursements directly affects the valuation of the target company. Buyers tend to ignore the existence of minor misrepresentations, corruption or bribery. However, the buyer is likely to become liable for such actions of the target company that continue to (wrongly) benefit the entities. If the buyer is not careful, he might become liable to pay concealed liabilities or expenses. It is important to note, that this risk cannot be minimized post-acquisition. Thus, it is advisable to conduct forensic due diligence focused on the proposed transaction, so that the acquirer can analyse his future liabilities in a more realistic sense. In case any questionable activity is found in the records of the target company, or is apparent off record, then the acquirer may analyse the risk and proceed with caution or walk away from the deal altogether.
8. Market volatilities and force majeure: there are certain risks that cannot be identified beforehand, even if they fall under all the categories mentioned above. The covid 19 pandemic is testimony to this. It has created unforeseen failures and delays in the M&A settings around the world. Where this is almost nothing that can be done to mitigate such risks, taking part in continuous research and discussions, engaging with field experts and professionals can help the parties pass through such risk passages. There can be no solutions to his, just good business decisions from time to time to minimize the risks.
[1] Christine Benedichte Meyer, Value Leakages in Mergers and Acquisitions: Why they occur and how they can be addressed, 41 Long Range Planning 211 (2008).
[2] Michael A. Hitt, Jeffrey S. Harrison & R. Duane Ireland, Mergers and Acquisitions: A Guide to Creating Value for the Shareholders 178 (Oxford University Press, 2001).
[3] Ephraim Kwashie Thompson & Changki Kim, Post-Merger and Acquisition Performance and Risk Factors: An International Study, 31(3) The Journal of Risk Management 29, 40-41 (2020).
[4] Scott A. Christofferson, Robert S. McNish & Diane L. Sias, Where Mergers go Wrong, McKinsey & Company, https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/where-mergers-go-wrong
