M&A Value Plays: Fast, Deep and in Control

Charles Soranno, Managing Director Eastern Region Leader, Public Company Transformation
David Haufler, Managing Director Global M&A Practice Leader

M&A activity may spike favorably this year in the tech sector, and fintech may not be far behind.

Yes, but: It’s important to strike the right balance between deal-making speed and due-diligence depth due to increased board scrutiny and other factors.

 What’s next: While this is a decidedly abbreviated list, due diligence teams should:

  • Use sensitivity analyses and financial modeling to address inherent risk factors
  • Take a close look at the acquired talent pool, especially in the C-suite and among critical senior management roles
  • Assess IT issues such as cybersecurity risks, technical debt and more
  • Commit to specific and reasonable value milestones

 Go deeper: Read our insights below.

Now may be the time to strike – from a mergers and acquisitions (M&A) perspective – given some meaningful trends in play, albeit in a volatile environment. Recent data suggests tech M&A activity may spike favorably given a slowdown in that sector’s initial public offering (IPO) plans. Approximately 20% of the value of all 2022 M&A deals were attributed to technology, and that sector is expected to continue to drive M&A in 2023. And as one of our managing directors noted in a recent article for Forbes.com, certain companies have been very active in the M&A space in the past three years. Additionally, the financial technology (fintech) space has some available capital piling up on the sidelines, which suggests well-capitalized companies may be looking to invest this year in their core competencies.

It’s also time to strike the right balance between deal-making speed and due diligence depth now that boards are intensifying their scrutiny of proposed synergies along with numerous factors (including talent, technical debt, ESG and more) that determine whether a transaction generates its expected value on time. Add the specter of a looming recession, with differing opinions over length and depth, and uncertainty over interest rates that lower valuations in leveraged deals, and there is much to be concerned, and thus prudent, about.

Boards on both sides of a proposed deal are asking similarly discerning questions about divestitures and carve-outs, which come with their own set of concerns and considerations, including issues related to transition service agreements (TSAs) and associated costs to stand-up these activities posttransition.

As rate uncertainty persists and market valuations decline, more companies are circling potential acquisition targets, pressuring buyers to act quickly. At the same time, boards want transactions to produce their projected returns more quickly, driving buyers to conduct more exhaustive due diligence and to develop robust integration and value capture plans and realistic synergies aligned with the deal rationale. While these pressures are often oppositional, the following actions can help due diligence teams strike a balance that achieves both objectives:

  • Use sensitivity analyses and financial modeling to address inherent risk factors. High interest rates, inflation, looming recessionary worries and market volatility are driving an increased focus on valuations. Economists remain mixed on whether a U.S. recession will arrive this year – and, if it does, whether the slump will be brief and mild or protracted and severe. The combination of uncertainty and volatility means that a publicly listed target’s market capitalization could fluctuate by 10% or more in the weeks and months ahead, rendering current financial models inaccurate. This variability requires due diligence teams to strengthen their focus on sensitivity analyses while expanding financial modeling to address a wider range of scenarios and unknowns (e.g., what if intellectual property risks come to light after the deal closes?). These insights can be used to develop warranties, indemnifications and related mechanisms (e.g., earnouts, clawbacks, patent coverage) that mitigate downside risks.
  • Take a close look at the acquired talent pool, especially in the C-suite and among critical senior management roles. While it is crucial to scrutinize valuations in the current environment, this focus can inadvertently reduce attention on other factors that also determine a transaction’s value, including talent and cultural fit. This makes it pivotal to lock in key leadership talent with retention agreements while clarifying their postdeal roles and responsibilities. Further, the war for talent continues to rage at the C-suite and upper-management levels, and these leaders are more likely to jump ship amid uncertain economic conditions – especially when they are unsure of their roles following an integration.
  • Assess cybersecurity risks, technical debt and other information technology (IT) issues. A target company’s cybersecurity vulnerabilities can add substantial amounts of inherent risk to a transaction due to the threat those susceptibilities pose to intellectual property (IP) and other intangible assets. Cybersecurity should be top of mind for every due diligence team. Technical debt – the far-reaching costs associated with an organization’s overreliance on outdated IT infrastructure and applications – represents another significant risk, and one whose negative impacts escalate as digital transformations, cloud migrations and the adoption of advanced technologies advance. Protiviti’s 2023 Global Technology Executive Survey shows that technical debt represents a pervasive burden: Organizations invest more than 30% of their IT budgets and more than 20% of their overall resources to manage and address technical debt, and nearly 70% of organizations report that technical debt hinders their ability to innovate.
  • Commit to specific and reasonable value milestones. The cost-reduction and revenue-generation synergies contained within due diligence reports tend to be alluring – and, in many cases, too vague. High-level targets accompanied by insufficient analysis and context frequently cannot be achieved at the geographic, functional and/or divisional level in the face of operational realities. Boards are catching on to the fact that some due diligence reports resemble architectural blueprints that a seasoned contractor finds impossible to execute within budget. That 45% reduction in operating costs or the 30% cost reduction via application consolidation turns out to be overstated once the integration work begins. In these instances, integration teams must scramble to find synergies elsewhere to achieve the transaction’s projected returns on time. Due diligence teams can avoid this quandary by ensuring that revenue-generation and cost-reduction milestones are specific and reasonable. Many stakeholder groups, including the broader investment sponsorship community, have embraced a deep and lasting commitment to environmental, social and governance (ESG) initiatives, and thus ESG can no longer be overlooked in diligence activities. ESG-related synergies often benefit from greater specificity, as the protocols for accurate measurement and reporting are still being developed. This can be achieved by conducting materiality assessments of ESG risks and opportunities, recognizing the potential for greenwashing, and requesting a seller to provide specific warranties related to ESG factors. Similar forms of vigilance help diligence teams ensure that other synergies are reasonable, including grouping synergies into “achievable,” “reasonable” and “stretch” categories; performing bottom-up (vs. top-down) assessments of the cost to achieve milestones; and developing plans to implement and capture synergies within realistic time frames that account for employee transitions, other integration activities, and the ongoing effort of keeping the business running. Savvy acquirers sometimes tie the achievement of synergies to contingent considerations on the seller’s side.

Additional Measures to Help Strengthen Due Diligence

Buyers and sellers executing divestitures and carve-outs should ensure that their milestones contain similar levels of detail and planning while strengthening their due diligence in other ways. These actions include:

  • Detailing the processes and assets included or omitted in the transaction (e.g., revenue, procurement, payments, human capital, fixed assets, IT infrastructure).
  • Developing a comprehensive TSA that is buyer-led and supported by a TSA office, and that sidesteps common TSA pitfalls.
  • Analyzing whether to replicate existing business processes and systems in the new environment or create and stand up processes and systems independently.
  • Understanding the full cost associated with the TSA stand up and close down.
  • Defining and detailing the integration process and a path to roll off TSAs quickly, transitioning to business as usual.

That is a decidedly abbreviated version of a due diligence process that should be anything but abridged. A deep and comprehensive approach to M&A events, divestitures and carve-outs may tap the brakes on making an offer, but it will almost guarantee that the buyer achieves specific and realistic returns faster once the offer is accepted.

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