Learn From the Leaders What Corporations Can Learn From the Success of Private Equity Firms and Their View of Risk

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by Geoffrey Clark & Eric Warner

The value of announced global mergers and acquisitions broke the $1 trillion mark in the first three months of 2007, setting a record for a single quarter¹. Growth was driven by strong equity markets, acquisitive managers, supportive investors and the apparently inexorable rise of private equity.

Private equity has participated in M&As for decades, but its influence has increased markedly in recent years. Today, private equity is a dominant force in the U.S. and in certain market sectors in Europe. It is succeeding due to talented advisers, extensive pre-deal preparation, risk assessment and proper valuation.

Think strategically about risk

Contrary to popular belief, private equity firms are not on a buying spree. They’re not overpaying with unlimited funds at their disposal. Rather, these firms are astute and sophisticated at evaluating the economics of their investments in underperforming companies. In this equation, both insurance costs and human capital risk figure largely. The effective management of risk becomes paramount due to the unique nature of the private equity business model: a proper valuation; clarity around the economics of a deal; requirements of debt providers; and the need for a “clean exit” on behalf of the limited partners to meet required returns on invested capital.

A clear understanding of the target’s risks and its impact on the valuation, future performance and financial structure of the transaction can lower the level of uncertainty and reduce the risk of “surprises” after the deal closes. More importantly, there are opportunities to deploy insurance capital strategically to reduce and mitigate these risks to the potential buyer. By viewing risk from the lens of a private equity professional, one can enhance deal negotiations and seize a competitive advantage.

Different perspectives

When corporate buyers consider the merits of a possible M&A transaction, they look at long-term benefits to their business. They are generally more strategic than financial. As such, they want to know how well the target company’s culture will mesh with their own, whether synergistic benefits can be obtained, and the extent to which a deal will be earnings-accretive. They also tend to pick business sectors with which they are familiar. However, there is also an increasing tendency to look for cross-border acquisitions, and to capture and diversify earnings in new industries or markets.

Private equity firms will generally seek businesses to which they can add value over a shorter timeframe. As the M&A sector has become more efficient in running deals, private equity firms can mobilize resources quickly, obtain expertise from advisers swiftly and access more information. When this is coupled with the volume and frequency at which private equity firms acquire and sell businesses, a narrow but important competitive edge becomes apparent.

In such an environment, staying ahead of rival bidders can be difficult, but private equity firms rise to the challenge better than most. They do so through a combination of in-house experience and external advisory expertise. In other words, they surround themselves with the best advisers, and this helps them move swiftly, decisively and confidently.

Their approach delivers a number of benefits. First, they are more likely to pay an appropriate price for a business rather than overpaying or discovering unfortunate postdeal surprises. Second, they are more likely to ensure that purchase-and-sale documentation is unambiguous and cannot be misinterpreted after the transaction. Third, the preparation they put in before a deal closes encourages a smoother and faster post-closing process.

Determine the right price; level of risk

For corporates, there are valuable lessons in private equity’s methodology. Rigorous pre-deal analysis can mean the difference between overestimating the synergistic benefits of a deal and making a realistic assessment of likely benefits. In essence, the disciplined approach of private equity can increase the chances that the right price is paid and that a business delivers the expected benefits after the deal closes.

Indeed, competitiveness can be enhanced throughout the M&A process if bidders do their homework properly – that means spending time and effort on comprehensive due diligence. In the context of M&A, due diligence is fundamentally a risk management activity. Yet risk and insurance reviews are frequently excluded from a bidder’s due diligence. This can be a dangerous oversight. As M&A practitioners know only too well, the business risks faced by target companies in various industries or geographies throughout the world can be significant.

Insuring or funding these risks can be costly, but effective insurance policies and good risk management practices should be viewed as quasi-assets of the target company. They protect the balance sheet and income statement and enhance the liquidity profile.

A rigorous approach is crucial, as every aspect of an M&A transaction can be affected by risk and insurance issues. Due diligence in this regard should involve: a comprehensive analysis of the risks inherent in the target company; accrual for self-insured risks; the quality and solvency of historical insurance policies; and outstanding litigation issues and environmental liabilities. Only after assessing these risks can an acquirer know whether or not to pursue the transaction. Management then can calculate whether it is worth signing a letter of intent and spending the time and money necessary to complete a transaction. Only then can managers determine whether the price reflects true asset value.

In one recent case, the income of a target company was overvalued by nearly 34% as a result of inadequate reserves for self-funded losses and some insolvent insurers. The bid price was subsequently lowered by almost a third.

Understanding the risks beneath the surface of a bid target can influence the wording of the purchase and sale agreements. Outstanding litigation or environmental concerns, for example, can have a substantial impact once a deal is completed. With proper advice, these issues can be handled by the insurance market in such a way that they move from an unknown to a known quantity. Again, this encourages acquiring companies to offer an appropriate price for a bid target, and it reduces the likelihood of future unpleasant surprises.

Human capital risk

Risk involves much more than inanimate assets, and human capital is another area where effective risk management can prove beneficial. Many deals succeed or fail due to the people involved, from the most senior to the most junior. The costs associated with human capital account for nearly 40% of corporate revenues, and the first step toward managing this expense is to understand the magnitude and sources of the cost base.

Human capital risks include liabilities of various benefits programs; questions of incumbent managers’ capabilities to take on more demanding roles; and unknowns about whether business or national cultures will blend.

Pension and benefit liabilities have become an acute human capital issue, particularly as practices vary widely from one market to another. In Italy, for example, the state provides pension rights, which lessens the M&A focus. In the U.K., however, defined benefit plans are the norm, and many now face substantial funding deficits. Ensuring that a proper valuation is placed on pension liabilities is a crucial part of assessing the value of a bid target, and the results can be a deal breaker.

For North American acquirers, European workforce protection can be a minefield. Works councils, unions and government protection are common in Europe, and can present significant obstacles to restructuring or downsizing plans. In the U.S., severance and retention bonus programs can create significant liabilities.

Private equity firms usually assign great importance to thorough due diligence around human capital issues. They analyze pension and healthcare plans, medical and life benefits, collective bargaining contracts, and change-incontrol agreements. They then work quickly to adapt those plans so the target business can produce a healthy and sustainable profit.

Corporate buyers, meanwhile, may be more willing to live with legacy issues and try to offset them by cutting costs or growing revenue over the long term. But they could benefit from the start by determining how to reduce or eliminate legacy costs by buying them out, converting them, or bargaining with unions/employees.

Risk management continues after the deal

External advice can facilitate the integration process by examining the risk management processes of the new entity to identify opportunities for cost-savings and realignment of resources. Ideally, an organization should conduct an in-depth analysis of loss and risk data to promote the most effective deployment of resources and the implementation of strategies that reduce the chance of accidents and loss.

Private equity firms will frequently call on external advisers to drive risk management improvements and reduce the total cost of risk. Support is often provided to develop and execute an appropriate integration strategy. In fact, there are many areas in which risk management best practice can enhance a deal’s success. Advisers help acquirers integrate loss-control processes, datacollection procedures, and past and future resources and claims. Assistance also can be provided in respect to the transference of new exposures to risk.

On the human capital side of the business, private equity firms devote considerable time to assessing whether to replace inherited management with new, improved leaders. Firms often complement their instinctual assessment with competency-based analyses of both individuals and the team dynamic. Hiring and firing staff at any level of the organization can be contentious, but rigorous assessment of senior management can really contribute to the success of a deal.

Private equity compensates managers in such a way to ensure alignment between performance and pay. Firms normally ask senior managers to take substantial stakes in the business, which means they will share in the upside of success. Managers know they can participate in substantial wealth creation through private equity, and they know their compensation will escape scrutiny found in public markets, particularly in Europe.

Follow the leaders

In certain respects, private equity firms have the upper hand in the M&A world. They do it all the time. They have ready access to debt. And, they can offer superior remuneration to top talent. Corporations, however, know their markets better, which should accelerate deals. They also can look at synergies and cost them accordingly. Corporations can enhance their competitive edge by adopting the due diligence and risk management tools used by the private equity industry.

Buyers cite a number of challenges to a successful deal. Though they lament the tight timeframes, limited access to high quality information, and the failure to integrate information from the data room, comprehensive preparation and planning can help them manage these issues far more effectively.

Proper risk management allows potential purchasers to better analyze, assess, price, and stay ahead of the competition. Private equity firms understand this well, which makes them a perfect knowledge base for those corporations that are prepared to listen and learn from the M&A professionals.

 ¹ Source: Dealogic