Perspective - Summer 2009

Consultants' Roundtable:
The Global State of Mergers and Acquisitions

Evolution of processes and deal opportunities

A consultants' round-table with Josephine Chow, Steven Dicker and Jim McKay

WATSON WYATT consultants from North America, Asia-Pacific and Europe recently joined together to assess the global state of mergers and acquisitions. They discussed how the current economic crisis has affected M&As and how companies can ride out — or even harness — the storm.

Q. How has the economic crisis affected corporate transactions globally?

McKay: Activity varies by industry. For example, the finance and pharmaceuticals industries have seen massive agreements signed lately — but for different reasons. Firms in the finance sector have been "rescued" by apparent white knights like Bank of America, which acquired Merrill Lynch and Countrywide Financial with considerable government support. On the other hand, the pharmaceutical sector has had significant deals in play, with Pfizer, Merck & Co., Roche and Abbott all being active.
 

At the same time, divestiture activity has increased among industrials and auto suppliers. But considering what's on the auction block, few deals have closed. Pricing the value of a business — now and in six months, or even a year — will continue to cause major problems for both buyers and sellers. Sellers are optimistic about the value of their business and growth projections, but buyers have trouble sharing such optimism.

Dicker: Deal processes and structures have evolved during this crisis, and major leveraged deals are disappearing. Average deal sizes are smaller and closer to the existing core business. Rather than responding to sellers' auction timetables and vendors' due diligence, potential buyers are spending more time on target selection and analyzing downside risks. In some cases, companies need to dispose of their "crown jewels." These may be the only assets attractive enough to tempt purchasers and bring in the cash required to support restructuring the rest of the business.

In other cases, joint ventures are formed with the parents each contributing assets and looking for synergies. In easier times, a company would achieve this by buying another's assets outright.

Q. When assessing a potential transaction, what are the key human capital issues, and how can companies address them?

McKay: The key issues are always the same: Where are the major liabilities and risks in employee plans and programs? Invariably, risk is found in retirement plans, executive contracts, severance plans and, especially in the United States, medical plans. Now, when planning for employee integration, companies are focused on how to get people "onboarded" and productive in the new firm as fast as possible.

Companies mitigate risk by doing a thorough due diligence on the people. They then manage the integration with as much focus, leadership and determination as they applied to buying the target in the first place. Companies that don't do the integration well are typically those that didn't have detailed integration discussions during due diligence. Or they didn't do a good job in their early talent and cultural assessments. If they did those at all.

Productivity typically drops immediately after an M&A announcement is made, and it's easy to understand why.  Employees are trying to figure out how their jobs or reporting relationships might change, while simultaneously being distracted by recruiters or competitors asking about their personal "contingency plans." It's difficult to maintain the same level of productivity in this environment. Smart acquirers know this will happen; it happens in all deals. They spend time and resources working through these issues as quickly as possible. It's at this stage where faster is better, in terms of decision-making and communicating with employees.

Chow: To add to Jim's [McKay] thought, companies also must look for hidden liabilities that could surface in the long run, as well as potential human capital risks. Take Asia, for example: There could be hidden liabilities in rising social benefit costs, gaps in reward philosophy, undisclosed top management compensation or soaring salary increases in different markets. At the same time, human capital risks lurk in the incompatibility of leadership styles, weak management capability, talent retention difficulty and talent shortage. It's also important to investigate the feasibility of a reduction in force, since it may be difficult to sever employees in some countries.

Asian companies also find it comparatively difficult to access people-related information due to the ambiguity in local labor laws, the unavailability of labor market data and poor human resource information systems at target companies.

Companies can mitigate these risks by scheduling more time for HR due diligence. Paper documentation, combined with meetings and interviews with different groups, will definitely help. They should identify the critical factors that can prevent the long-term success of a deal, and also build reps and warrants into purchase agreements. However, intangible risks such as culture will remain unresolved. So, when assessing a deal, companies should always incorporate local perspectives as much as possible.

Dicker: Also, regulatory issues are an increasing focus, particularly when employee benefit liabilities are large or significant layoffs are part of the deal.

In the United Kingdom, pension plan trustees or fiduciaries now expect to be active players in deal negotiations. Some high-profile transactions have foundered when companies couldn't agree on funding ballooning pension deficits. The pensions regulator's power has also been enhanced.  If a pension plan loses employer support as a result of a deal, it can pursue cases up to six years after the deal is struck and compel deal participants to contribute to the pension plan.

Elsewhere in Europe, social legislation and political reaction to the economic environment make it difficult and/or expensive to lay off workers. This can delay integration and deny purchasers the synergies required for deal success.

Building these factors into the process can lengthen the timeline and complicate negotiations. If they aren't handled effectively upfront, there is a real risk of significant post-deal value erosion.

Q. Once a merger has been completed, what are some potential pitfalls?

Dicker: The way two companies adjust to different systems, such as pension plans or pay structures, will depend on the type of deal being struck. Research shows that deals done in difficult times are more likely to pay off in the long term than those done in bull markets. A key challenge is finding the resources to fund an acquisition with credit currently being very tight. If a company has the funds, there are bargains to be had. For those with limited cash or credit, true mergers or joint ventures can provide a way forward. While these options present different challenges from the integration or assimilation of an acquisition, they also offer the potential to establish a completely different culture and reward system. One that's appropriate for the new entity rather than reflecting either parent's legacy arrangements — such as DB pensions, for instance.

McKay: With executive pay, the buyer largely has to go with what's already there. The real problems come with integration. One big problem arises when the target executives get paid more than the buyer's counterparts.

Regarding DB plans, the trend is to try and leave them behind with the seller or to take over and freeze the plan if possible. During a transaction, participants should identify and quantify DB deficits, then factor them into the deal bid as a "net debt," just as a firm quantifies all its debts.

Q. As corporate transactions become more global in scope, do companies need to consider any new governance issues? What has changed for emerging markets, particularly India and China?

McKay: Governance really comes into play as a discussion item during integration. And it is executed once the company returns to normal operations,

when the formal integration teams have disbanded. Governance issuesbecom cultural issues when you consider pre-deal governance models for each firm versus the needed post-deal model. A predominantly US-focused company might have sophisticated, detailed systems that are "best in class" for a US firm, but those systems might not work for new employees from India, China, Japan, Germany or other countries.

Dicker: In terms of the employment deal, perspectives can differ by country. For example, compensation that is significantly performance-based can be counter-cultural in some territories. Also, the balance between employer and state provision of pension and health care benefits varies widely, even within Europe. And all of this is compounded by the current economic environment, which is causing significant changes in all territories. The key for effective deal management is having a core team — whether in-house or with a consultancy — that has complete oversight, as well as access to relevant, up-to-date local knowledge.

Chow: In the past, emerging markets like China and India were hot spots for foreign investment. Today, there are an increasing number of outbound acquisitions originating from those same places.

In China, it's becoming clear that the government will take action to protect well-regarded domestic companies. Such protective practices should not be taken lightly, as we saw in the recently failed deal between Coca-Cola and Huiyuan. Companies must evaluate how the Chinese government will react, since it will judge deals from a commerce-trade perspective and from a national security point of view. That's why it's even more critical for companies seeking to enter the Chinese market to understand the multitude of concerns they face. Multinationals, state-owned enterprises and private Chinese companies all face different issues during M&A.

In India, the Satyam corruption case shows that there are loopholes in Indian corporate governance, as well as problems with government supervision. India's traditional family-business form of management can engender a real danger of corruption. Companies need to understand the intricacies of running a business in India and identify the dangers.

Q. How can companies prepare for the next 12 months?

Chow: From some recently announced mega-mergers, we can tell that companies with resources are still on the lookout for deals that make sense. For these companies, M&A should be regarded as a regular part of business — not as an uncommon phenomenon. Companies can benefit by having a flexible workforce that’s capable of quick integration. This can be achieved by having a dedicated M&A team, building up senior management with significant M&A experience or developing management’s understanding of M&A integration.

Dicker: Companies can conserve cash and maintain access to credit to ensure survival. Most companies are looking to sustain existing market share, even if the market is smaller overall. But that might mean significant restructuring or disposal. For those that are more secure, there are opportunities to capture a bargain. It makes sense to start identifying where the best deal can be struck. In either case, it’s important to ensure that people issues are considered at an early stage since they can make the difference between success and failure.