The observation, ?Anything that can go wrong, will go wrong,? is the very underpinning of pre-deal due diligence. But as the world evolves, and as private equity's role within the world evolves, the list of things that can go wrong has lengthened.
Correspondingly, due diligence specialists have arisen to help acquirers identify potential problems in the many emerging categories of risk. In this article, we present three specialized forms of due diligence that are increasingly being employed by risk-aware private equity firms.
?Recently GPs have faced a range of labor and employment issues that they're not used to having.?
Due diligence into the potential liabilities tied to organized labor is a growing area, thanks in part to the growing sophistication of labor unions in identifying the ultimate owners of companies, aka private equity firms. Likewise, information technology systems is an area that many GPs know is important but lack the wherewithal to judge weak systems from strong systems.
Finally, where traditional due diligence seeks to confirm the numbers presented by the seller, some firms are resorting to forensic accounting and management investigations with the goal of sniffing out fraud, remote as that possibility may be.
The labor factor
A failure to understand the dynamics of a portfolio company's organized labor force can result not only in lawsuits but also in a particular form of scorched-earth labor activism called the ?corporate campaign,? which can and has involved (but is not limited to) giant, inflatable rats perched by organized labor outside a private equity firm's headquarters.
Increasingly, labor unions are on to private equity. Union leadership has become ?very sophisticated? at identifying the ultimate owners of unionized companies, says Michael Album, a partner in the New York office of law firm Proskauer Rose, which specializes in representing management in labor and employment matters. Unfortunately, most private equity firms are not on to labor risk. ?Recently GPs have faced a range of labor and employment issues that they're not used to having,? notes Album.
Firms as advanced as Kohlberg Kravis Roberts, Texas Pacific Group, MatlinPatterson, Permira and CVC have learned that unions are becoming very thorough and even creative in applying pressure on GPs when negotiations or other points of dispute are not moving in the direction of the union. Private equity firms now must be wary of the corporate campaign, by which the union attempts to blast its message to each constituent of the company's owner. For private equity firms, this means limited partners, the board members of LPs, lenders, the private family members of general partners and, in the case of Permira head Damon Buffini, his church members, who were recently treated to the spectacle of a camel being paraded in front of the congregation by union members in a symbolic effort to battle the supposed greed of private equity owners (it is easier for a camel to get through the eye of a needle, etc.)
The ability to identify the potential for embarrassing or franchise-harming corporate campaigns is essential where investments come with a labor component.
For general partners in the US, the changing labor market means new and often wholly unfamiliar risks. A case in point is the relatively new tactic of unions seeking ?neutrality and recognition? agreements with company owners prior to organizing a labor movement within the portfolio company.
In brief, US unions are now less inclined to attempt to unionize a company the old-fashioned way, through contested secret elections conducted by the National Labor Relations Board in which the company can campaign against the union. Instead, many now favor a ?top-down? approach in the form of a neutrality and recognition agreement. This typically means that owners and union representatives agree on a framework that permits the union to organize workers by collecting signed authorization cards, and to do so while the employer foregoes opposing the campaign and maintains a ?neutral? stance.
The legality of this approach has been under attack by the National Right to Work Foundation and as this article goes to print there are cases pending before the National Labor Relations Board where that agency has pursued litigation addressing various aspects of the approach. The approach was also recently tested in Patterson v. Heartland Industrial Partners, a suit brought against buyout firm Heartland in connection with its 2003 acquisition of Collins & Aikman. The GPs of Heartland had, prior to the closing of the deal, agreed with the United Steelworkers union to cooperate on the union's membership drive. The agreement included Heartland's supplying contact information for all Collins & Aikman employees and, in return, the union's commitment to not extend its organizing drive past 90 days, as well as to not speak critically of the company during that time. Instead of a secret election, the union used a ?card check? process, by which union representatives collected signed authorization cards from employees
Several employees of Collins & Aikman filed suit against the buyout firm, claiming the GPs had illegally transferred a ?thing of value? to the union in violation of federal labor law. A court dismissed this complaint and its challenge to this neutrality approach in dealing with unions.
While the trend toward neutrality may mean fewer corporate campaigns in the future, there may be more lawsuits related to this approach, and as mentioned above, there are currently important cases pending before the National Labor Relations Board that may provide further guidance, and even cutbacks, regarding this strategy.
Album says his firm has a specialized due diligence service for assessing the risk to a buyer related to these and other labor issues. Proskauer Rose's Transactional Business Labor Group will comb through the history of a potential portfolio company's unfair labor practice filings, its arbitration and grievance records, talk to human resources professionals, size up collective bargaining agreements and sometimes conduct statistical surveys in an attempt to ?provide a roadmap? for operational issues down the road, says Album.
Pricing for this service can vary from a blended hourly rate to a fee basis.
Album says his firm's findings in the labor due diligence area have not often killed deals, but have more often identified risks that a GP can take into account in pricing a deal and preparing for operations once the deal is consummated.
Paying IT forward
On January 25, 2003 – ironically, the day after the new US Department of Homeland Security started operations – computer systems all over the United States, Europe, and Asia were attacked by a computer ?worm? program called ?SQL Slammer.? As a result, thousands of government and business computer systems were slowed down to the point of complete inaccessibility. The financial titan Bank of America, for example, saw its vast network of 13,000 ATMs rendered unusable for an entire day. The reason? The worm – only 376 bytes of computer code created by an anonymous computer hacker – exploited a tiny vulnerability in a Windows program installed on all of the computers it affected.
Though the crisis was resolved quickly and did little lasting damage, it put businesses worldwide on notice. Meanwhile, fund managers involved with mergers and acquisitions also took note of the crisis and its meaning. In short, a security lapse like this could cost a company millions, and a responsible manager needs to get ahead of all potential IT pitfalls in any target company. Thorough and careful IT due diligence can not only stop security problems, but also efficiency and even potential legal problems before they start. ?Most of it comes down to dollars, although sometimes it comes down to liability,? says Harwell Thrasher, an IT consultant who runs the website MakingITClear.com.
Thrasher says that when evaluating a target company's IT, it pays to start with the basics. ?They say they own the licenses to all this [software], and they say they own all this hardware; do they really? It's just verifying assets,? says Thrasher. Furthermore, is the company management representing itself accurately? That is: are they who they say they are? ?You want some reassurance, even if they're going to be arm's-length, that they will continue to do what they say they will do,? says Thrasher. ?But there I don't think IT is any different than anything else. You want to look at their strategy, and then see what the critical aspects of that strategy are – and if IT is a critical part of that strategy, then you want to know about it.?
This sort of IT forecasting is especially useful when one particular IT aspect of a company's IT is especially prized – say, its customer-service system. ?They have maybe 100 people using this customer service system; you want to use 1,000. Will it scale?? asks Thrasher. ?You want to be able to tie it in with your existing systems and so that looks at architecture and interfaces. So you get into a lot of those kinds of things.?
Future problems can be predicted in some cases; for example, if a company's IT systems are made up of a jigsaw puzzle of discrete individual modules, or ?point solutions.? ?Is a company essentially running the business with a set of point solutions where each area, each issue, each process has its own application?? says James Senn, managing director of the Center for Global Business Leadership at Georgia State University. ?Now, point solutions on their own are not bad. They do solve the problem. But over time, these individual solutions start to become issues because a company says: ?Wait a minute. We need to integrate across inventory and manufacturing and customer orders and so on, and we've got these stand-alone applications.?? Such a web of stopgaps can mean an upgrading and conversion nightmare down the road, when a business wants to scale up its operations.
That said, an acquirer should resist the temptation to take the easy way out and start from scratch, says Senn. ?I've seen a number of situations where acquisition managers come in and they look at the existing technology of the company they're buying, they look at the applications and say: ?How can we convert all this to what we're already doing??? he says. ?In the process, I've seen some cases where they've thrown out some extremely good and highly valuable applications. They've thrown out major applications – ?business-building applications,? I call them-that would have actually moved their company ahead if they'd integrated them.? And higher-ups in the company are frequently unaware of what it's lost until it's too late, says Senn. ?It comes up to them as a new issue – ?How do we build this capability?? – when in fact they acquired it, and tossed money out.?
Thrasher mentions a case of a buyer ignoring IT due diligence-and incurring massive IT conversion costs as a result. ?And ultimately the acquisition – well, it didn't so much fall through because they actually did acquire the company, but they ended up divesting it afterwards,? says Thrasher. ?It just wasn't worth keeping. They underestimated the difficulty, and it all translates to dollars.?
As the seller of a company, you will quickly become aware that private equity bidders are keen to subject you to the most thorough of investigations as various teams of due diligence experts probe all aspects of your firm's activities. But there is one investigation going on that you are likely to know nothing about, because it is being conducted very much on the quiet.
?The more information you have on the people sitting on the other side of the table, the better the price you'll get.?
Forensic due diligence is a growing area of the overall private equity due diligence market. In light of various accounting scandals such as Enron, together with increasingly stringent regulatory burdens like Sarbanes Oxley and new antimoney laundering rules, the need to make sure that a target company has all its ducks in row compliance-wise is perhaps more pressing than ever before.
London-based risk consultancy Control Risks Group has been conducting forensic due diligence work on behalf of private equity clients for the last ten years, but Ben Wootliff, head of the firm's financial institutions group, says it has seen a marked increase in such mandates recently to around two or three new assignments a week.
While the compliance aspect of such work is important, Wootliff stresses that Control Risks focuses as much on a company's management as its books. ?We look at the relationship of the management with the company, because people are buying into the management as much as the assets,? he says.
The importance of examining this relationship between management and company can become all too apparent, says Wootliff, in cases where it transpires that the management is not even in a position to sell the firm. Such horror stories, he says, have arisen more frequently as private equity has made a greater push into emerging markets.
Studies will also focus on whether management are who they say they are and whether they have the qualifications they claim, whether they have outside interests that have not been declared, and how they are perceived by third-parties such as clients and suppliers. Adding to the glamour of such detective work is that, under normal circumstances, the management team in question will not be told that it's under the spotlight.
Of course, one clear motivation for undertaking such due diligence is to determine that no fraud is being committed. But, in the generally highly competitive deal environment of today, another reason is to try and gain a better understanding of the potential value of the asset than you would otherwise have. Wootliff claims: ?The more information you have on the people sitting on the other side of the table, the better the price you'll get.?
Wootliff stresses that, in around two-thirds of cases, nothing unusual is discovered by his firm. In that case, the value of the investigation is perhaps simply to confirm that the business is exactly what you thought it was. But quite often, interesting dynamics might be at play, which are not apparent from the outside. Areas that Control Risks often investigates include: Is the relationship between CEO and CFO is healthy? Does the owner need to cash in quick? Is the owner motivated only by price, or does he feel a social obligation to identify the right buyer? How will the management react to having a new major shareholder on board?
As private equity firms increasingly target larger and more complex deals, often of a cross-border nature, so the mandates handed to Control Risks have become increasingly challenging, says Wootliff. From a financial point of view, this is good news for the firm. He says a basic investigation can cost as little as £5,000 ($9,200), whereas the most demanding command up to £100,000 ($183,900).
The work of private equity's private eyes appears to be growing in both popularity and lucrativeness.