Borrowers are violating covenants and committing payment defaults and their businesses are being adversely affected by the slow-down in the economy.
As a result, lenders have been taking longer to commit to new deals, reducing the amount of their exposure and being more careful about which companies they lend to and which private equity sponsors they will rely on. The due diligence process has not only been taking longer but has become much more important to all concerned. Senior lenders are more frequently insisting on receiving a full blown “Due Diligence Memorandum” in lieu of assurances from equity sponsors.
Members of a group or syndicate are no longer content to have one counsel take the diligence lead but are insisting that their own counsel become more active in the diligence process and drill down into the assumptions and projections. Financial due diligence conducted by Big 4 and regional accounting firms and environmental reports from experts are commonplace. Fifty-page reports which cost tens of thousands of dollars are being demanded by investment committees across the board, some of it to insulate themselves from criticism if the deal fails and much of it because of recent write-off experience. All of this activity has resulted in increasing the time and the cost of closing a transaction but buyers and lenders have required more and more comfort given the continuing uncertainty in the market. The allocation of these costs has become another item of negotiation between and among the various parties.
What are buyers and lenders looking for? The purpose of due diligence, going back to basics, is to determine the risks and rewards of a potential investment and to shine a light on issues, early in the process, that require resolution in order to successfully close a transaction. Meaningful diligence is more than collecting random pieces of information and checking boxes on a form. Although it is necessary to understand the nature of the assets being acquired and the liabilities being assumed, most acquisitions are based on the value of future cash flows and particular attention should be paid to those issues which affect this important metric.
Often the impact of negative items discovered in due diligence can be addressed by adjustments to purchase price and increasing indemnities and escrows. Unfortunately, sellers frequently remain reluctant to alter the amounts agreed upon in the Letter of Intent, which is typically executed prior to conducting any meaningful due diligence. The perspective of the due diligence lens also affects the outcome. For example, counsel may see an issue which it thinks will affect the viability of the transaction whereas the business people may see an opportunity to negotiate a better price or terms.
No target is completely clean especially since most middle market businesses have been privately held, often in the same family, for years, often absent an institutional investor and management has often kept books and records in less than pristine condition. The focus has been on growing the business, not legal niceties or tax efficiencies. Professional advisors have usually been local family friends who are not experienced in buyout transactions, who are reluctant to provide requested opinions, and who are generally inadequate to the task of providing access to meaningful data rooms and appropriate schedules to the purchase documents.
These factors add to the complexity of the diligence process and require the due diligence team to focus on what is really important, to prioritize and to expeditiously move the process forward in a cost-effective manner. Of crucial importance are the interviews with company management. Senior executives of the target often provide guidance as to its current strategic direction while middle management can offer information about day to day operations. Our experience shows, not surprisingly, that one or more offsite dinners or meetings with the owners, the CEO or other key executives, often with their spouse, can be most revealing and rewarding in terms of information-gathering and personnel dynamics, which are crucial to a successful business.
To illustrate the kinds of items discovered in the due diligence process, set forth below are actual items gleaned from the reports of a Big 4 accounting firm tasked to provide financial due diligence in connection with three separate potential acquisitions. Two of these transactions were consummated: one of the targets is doing well, the second filed for Chapter 7 and the third transaction was abandoned as a result of the diligence process:
Deal Number 1
1. Ownership of the target was not documented. The patriarch always told his relatives that they were owners but never documented the ownership and such ownership was not reflected on tax returns.
2. Receivables of the target had been diverted to a related company but the cost of sales was recorded on the target’s books.
3. Agreements with suppliers (120 day terms) were based on a handshake.
4. The target paid rent on apartments for several years, purchased cars and leased others and the amounts were not included in the employee W-2s and thus not subject to payroll taxes or income taxes. Although these amounts represented personal income tax for the employees, since the W-2s were inaccurate the target could have been responsible for the amounts due.
5. Laborers were paid significant amounts in cash absent any W-2 or 1099 reporting thus representing an unpaid federal income tax liability and the amounts were labeled as “miscellaneous factory costs” on income tax returns and target financial statements.
6. Payroll tax returns and payroll reported on the federal income tax return showed significant discrepancies not reconciled.
7. Target CFO owed past due income taxes to IRS and in order to avoid garnishment of wages the target improperly paid the CFO as an independent contractor creating potential liability for the target.
8. The location of distributors in a variety of states (e.g. Washington and Michigan) triggered those states to aggressively argue that such activity was sufficient to subject the target to the business taxes of those states.
9. Last, but not least, the CEO had been engaged in fighting with the IRS for nearly 20 years over $40,000 in taxes due and refused to settle by paying amounts offered to be supplied by buyer at closing.
This transaction was abandoned by the buyer despite strong growth, good prospects and talented management.
Deal Number 2
1. Target revenue was highly concentrated, with the top five customers accounting for 85 percent, 90 percent and 84 percent of revenue for the past three fiscal years.
2. Target books and records were not prepared in accordance with GAAP (did not make required GAAP accruals) and this was a potential issue for lenders.
3. The target became self-insured for health claims to avoid a significant increase in premiums. The issue examined was whether employees were pressured not to make claims and whether bonus amounts were impacted by employee medical expense claims in violation of applicable labor and employment laws.
4. The target’s low-cost financing from a state agency was adversely affected by the change of control.
5. The target’s revenue recognition policies were improper because it recognized revenue when goods were shipped even though it maintained “risk of loss” until the goods were accepted by the customer. This required an analysis of historical revenue recognition and the impact on covenant ratios for lenders.
6. The target verbally modified many of its material contracts and it was difficult to obtain independent confirmation of the terms thereof.
This transaction was completed and the target is performing well.
Deal Number 3
1. Related party leases were above market rates.
2. The target outsourced an interim controller and did not have a strong accounting department.
3. This was an earnout transaction and it was necessary to monitor operations to assure that the performance of contracts was not pushed into the subsequent fiscal year, which would lower the amount for the base year computation and thus increase the amount of the earned bonus.
4. The target had EBITDA margins in excess of 20 percent for the past several years.
5. The target had strong customer relationships with significant retention rates and only a few competitors.
6. The target had significant growth opportunities.
7. The sellers were rolling over several million dollars to purchase a 25 percent interest in the buyer.
8. The buyer conducted market studies, industrial engineering studies, prepared environmental reports, financial due diligence reports and did extensive background checks.
This transaction was completed and resulted in a Chapter 7 filing. Lawsuits are imminent and will allege breach of contract, fraud and fraud in the inducement.
Lessons learned: Irrespective of the market, the growth opportunities, the industry, the numbers or the competition, it always comes down to the quality and integrity of the people with whom you do business.
Stephen M. Fields is a partner in the corporate practice of McCarter & English’s New York office. He concentrates his practice in the formation of funds and in investment transactions on behalf of fund managers engaged in LBOs, mezzanine investing and venture capital investing across a wide variety of industries. He can be reached at 212-609-6803 or sfields@mccarter.com.
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