M&A: Three easily mitigated but commonly overlooked pitfalls
New Delhi lawyers LexCounsel explore three of the most common mistakes made when it comes to Mergers & Acquisitions and their straight-forward solutions.
Mergers and Acquisitions (“M&A”) are an incredibly popular way to grow business inorganically. However, a failed M&A can have far-reaching consequences for both businesses involved. New Delhi member law firm LexCounsel explains three common M&A pitfalls that are often overlooked but easily mitigated.
There are many reasons why an M&A deal might go wrong: over-enthusiasm about unquantifiable strategic benefits of the deal resulting in overvaluation of the acquired company; post-deal integration issues with systems, processes and human resources leading to a lack of synergy; a mismatch between the vision and operating strategies of the new and old managers; undisclosed/unexpected liabilities or claims causing a dent in the benefits of the M&A, etc.
The consequences for both parties are numerous: adverse effects on established systems and work processes, damage to the company’s reputation, erosion of goodwill and customer confidence, and a decrease in employee moral causing employees to exit. Needless to say, all failed M&As lead to the degradation of shareholder value.
While the legal experts usually focus on negotiating and capturing the critical provisions relating to commercial understanding, representations and warranties, indemnification liabilities, mitigation measures, limitation of liabilities, exit options and dispute resolution mechanisms, there are several other nuances to an M&A deal which may play a greater role in the potential failure of an M&A deal and the consequent loss of shareholder value. A few of these examples which highlight how things can go wrong in an M&A deal for reasons which could have been easily mitigated are discussed below:
1. Trust, but verify
The most basic rule of managing risks is to undertake a legal, commercial and financial due diligence exercise to assess the assets, debts and liabilities of the target entity. However, the danger is not that no due diligence is undertaken but that it is not done well, or that the risks flagged in the due diligence are ignored as the acquirer has ‘fallen in love with the deal’ and has chosen to ignore the identified risks. Worse still, the managers have trusted the assertions made by the promoters of the acquired group without conducting a physical asset/stock assessment.
Undertaking a physical asset/stock evaluation is particularly critical in cross-border acquisitions or in business transfer arrangements where assets being acquired are core to the transaction. For instance, not making an onsite visit to the factory of Ranbaxy was one of the key reasons for the failure of the Diachi and Ranbaxy deal. To elaborate, in acquisitions where a large part of the business' value is being ascribed to the assets being acquired, then conducting a physical inspection of the actual stock (e.g. checking for expiry dates or storage facilities on the ground) is a must to ensure that the acquirer knows exactly in real terms what it is acquiring and the valuation is fixed accordingly. Simply relying on excel sheet figures can be fatal to the deal and its future.
2. Mapping expectations
Often, minority acquisitions come with a majority mind-set and there are disconnects later on between the majority promoters and minority stakeholders, particularly when it comes to a say in the operations. If the acquirer is seeking minority stake/control, it needs to be clear on the role it envisages for itself i.e., is it satisfied with the exercise of affirmative consent/veto rights through board processes, or does it want a larger voice when it comes to operations and management? In the case of the latter, be very sure that the promoters of the investee entity are aware of these expectations and the same are mapped upfront both commercially and legally in the transaction documents.
3. Keep your advisors involved until the very end
An M&A deal can go wrong not just for the acquirer, but also for the target entity and its promoters. The common tendency of the promoters is to involve the advisors in the initial stage but as the closure compliances are being handled, the advisors are usually not involved. This can sometimes prove fatal, especially when there are multiple closing and post-closing compliances and obligations.
For example, in one cross border deal, a part of consideration was being withheld in an escrow arrangement, towards indemnification obligations of the sellers, for a particular period. The consideration was to be put in the escrow simultaneously with business transfer closure. While the transaction documents recorded the above understanding, the target entity, at the time of closing, did not keep the legal or financial advisors in the loop. This resulted in the offshore acquirer not transferring the balance consideration into the escrow account at the time of transfer (orally agreeing to transfer it within the next few days) and the share transfer deed was signed before remittance of such balance consideration. This was a case of 100% acquisition. It's been two years, but the balance consideration has still not been paid on the false pretext of indemnification liability – the cost of initiating an arbitration relating to the claim is now holding the promoters back. This situation however, could have been easily avoided, if the advisors had been kept on board until the very end so that all items on the closure checklist were ticked off. So it’s not enough to negotiate the documents; it is equally important to implement the understanding agreed under the documents.
A lot of time, cost and effort can be avoided if certain fundamentals are thoroughly evaluated and the over-enthusiasm and excitement of the managers looking to ‘close the deal at any cost’ are kept at bay. Otherwise the gap between expectations and actual performance can lead to a failed M&A deal and consequent erosion of shareholders’ wealth.