considerations for due diligence in mergers and acquisitions · considerations for due diligence in...
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BUSINESS – GENERAL ACTIVITIES TRACK TUESDAY, JUNE 13 | 9:00 A.M. – 9:50 A.M.
Considerations for Due Diligence in Mergers and Acquisitions
Performing due diligence is a necessary step in merger and acquisition activities. Karl Pearce, Global Director of Investment and Business Planning with Hatch, will examine the various aspects of due diligence, including assessing and managing risk, performing an economic analysis, conducting market studies, examining insurance coverage and identifying regulatory issues when reviewing assets or projects in development.
ABOUT THE SPEAKER Karl Pearce is Global Director of Hatch Advisory’s Investment and Business Planning Practice with experience in project execution and management consulting in the mining, energy and infrastructure industries. Pearce has specialist expertise in financial valuation, risk management and project management. His most recent consulting work focuses primarily on transaction advisory for investors, lenders and operators, where he leads teams of consultants on engagements including due diligence, project and technology valuations, market and competitive analyses, and risk assessments. Pearce holds a Bachelor of Science in Business Engineering and a Master of Science from Universidad Adolfo Ibanez in Chile, and a Master of Business Administration from the Kellogg School of Management, Northwestern University.
Considerations for Due Diligence in Mergers and Acquisitions
Karl PearceGlobal Director, Investment & Business Planning
Hatch Advisory
Introduction to due diligence for M&A
Risks
Valuation & Value at Risk
Key takeaways
Introduction to due diligence for M&A
Risks
Valuation & Value at Risk
Key takeaways
Due Diligence refers to the areas of technology, process and industry specific factors relevant to the acquisition target and its business model
“Reasonable steps taken by a person/entity in order to satisfy
legal or procedural requirements, especially in
buying or selling something”
“Process of investigation into the details of a potential
investment, such as examinations of operations and management and the
verification of material facts”
Due Diligence and deal execution capabilities are considered a differentiating factor for high-performing M&A companies
Source: McKinsey Quarterly, May 2015 survey
High performers: respondents who say the transactions their companies have completed in the past 5 years have either met or surpassed targets for both cost and revenue synergies
Low performers: respondents who say the transactions their companies have completed in the past 5 years have achieved neither their cost- nor their revenue-synergy targets
78
84
67
81
44
56
42
58
Integration
M&A operating model and organization
Due diligence and deal execution
M&A strategy and deal sourcing
High performers Low performers
% of respondents who agree that their companies have specific capabilities in the following areas of M&A
• Proven technology / asset conditionIs the asset real?
• Deviations from ‘normal’ / business risks• Recommendations for mitigation• Opportunity analysis
Fatal flaws and risk / opportunity evaluation
• Capital requirement and sustaining capital evaluation• Operating cost review and benchmarking• Opportunities for improvement / synergies
Cost considerations
• Representing output of the above into business model• Does offered price represent value investment?
Business Case
We take a systematic approach to Due Diligence
Some basic considerations are critical for due diligence success…
Balance transparency and confidentiality; efficiency and building a shared vision
Correct team
Unencumbered access to all data requestedData provision
Schedule must reflect required level of detail and allow for required approvals and buy-in
Adequate timing
Experts need to review and evaluateAdequate analysis
Brainstorming final risk matrix as complete teamRisk review
Must ensure realistic, but optimized business modeling
Financial optimization
0
5
10
15
20
25
30
<2 2-3 3-4 4-6 5-6 >6
% o
f res
pond
ents
Number of months from nondisclosure agreement to binding offer
High performers Low performers
…However, high-performers move faster than low performers through deal execution
Source: McKinsey Quarterly, May 2015 survey
High performers: respondents who say the transactions their companies have completed in the past 5 years have either met or surpassed targets for both cost and revenue synergies
Low performers: respondents who say the transactions their companies have completed in the past 5 years have achieved neither their cost- nor their revenue-synergy targets
Introduction to due diligence for M&A
Risks
Valuation & Value at Risk
Key takeaways
Risk is difficult to talk about and the due diligence team needs to be aware of cognitive biases
Effective risk management
processes must
counteract these biases
When events depart from our expectations, we tend to escalate commitment, irrationally directing even more resources to our failed course of action – throwing good money after bad
We tend to be overconfident about the accuracy of our forecasts and risk assessments and far too narrow in our assessment of the range of outcomes that may occur
Teams facing uncertain conditions often engage in groupthink: Once a course of action has gathered support, those not yet on board tend to suppress their objections –however valid – and fall in line
These biases explain why so many companies overlook or misread threats. Rather than mitigating risk, firms actually incubate risk through the normalization of deviance
We also anchor our estimates to readily available evidence despite the known danger of making linear extrapolations from recent history to a highly uncertain future
We often compound this problem with a confirmation bias, which drives us to favour information that supports our positions (typically successes) and suppress information that contradicts them
Risk Risk description
Market risk • Reduction in sales (demand risk)• Change in product price (price risk)• Availability of raw materials/primary products (supply risk)• Cost increase of production (price risk)
Interest rate risk • Changes in interest rates via variable rate agreements
Exchange rate risk • Changes in exchange rate between local currency generated by project and currency in which project costs/loans are denominated
Environmental, social and governance (ESG) risk
• Environmental: climate change, resource scarcity, environmental degradation, changes in regulations, etc.
• Social: human rights, labour rights, health and safety risks for employees and local communities, consumer protection, public resistance to project, etc.
• Governance: corrupt business practices, weak public and corporate governance structures, government and stakeholder relations
Political, legal and regulatory risk
• Changes in legislation/(de)regulation• Nationalization/Expropriation• Breach of contract/concession• Changes in tax rates and tax legislation• Public acceptance
Force majeure • Strikes• War/terrorism• Earthquakes and other natural disasters
A systematic approach for identifying and assessing risks should be applied through due diligence – General Risks
Risk Risk description
Planning, construction and completion risk
• Planning amendments by principal• Excess costs owing to delays in planning or construction phase• Construction overruns not attributable to planning errors• Existence of transport/infrastructure
Technical and performance risk
• Use of tried-and-tested technology from known manufacturers, that is adequate for the operating process
• Suitable climate or soil quality (for construction of large facilities)
Financial risk • Changes in contractual conditions between signature date and provision of financing
Syndication risk • Ability to syndicate/place loans
Operational risk • Excess operating/maintenance costs• Interruption of operation• Selection of operator/partner
Contractual and counterparty risk
• Failure to receive approvals, licenses and concessions• Effectiveness and enforceability of contracts and agreements• Poor functionality of the judicial system• Ability of contractual partners to provide products, services and payments
Realization risk • For projects to be transferred back to the principal
A systematic approach for identifying and assessing risks should be applied through due diligence – Asset-Specific Risks
38%
38%
17%
8%
8%
4%
54%
21%
8%
4%
Stakeholder opposition
Permitting issues
Environmental concerns
Land Access
Health and Safety
Extreme weather
Comercial issues
Technical challenges
Revenue sharing
No details available
57%
38%
5%
Delayed orabandoned
No delays;delivered on
schedule
No delays; not yetdelivered
Source: ERM; Survey of capital projects (2013-2016)
Non-technical issues
Technical & Commercial issues
Nearly 50% of projects are delayed and related to one or more ESG issues
Mean Median
FEL 1 71% 38%
FEL 2 15% 5%
FEL 3 8% 2%
Capital cost overruns are a significant source of risk, which can be mitigated through proper engineering staging
Source: Cost Engineering Journal, Quantifying Estimate Accuracy and Precision for the Process Industries, Nov-Dec 2012
Introduction to due diligence for M&A
Risks
Valuation & Value at Risk
Key takeaways
A number of techniques can be used to quantify the economic impact of project risk and opportunity
Qualitative Risk Assessment
Risk Adjusted Discount Rate
Real Options Valuation
Simulation Modeling
Cons
• Simplicity of application
• Simplicity ofapplication
• Unlocks value of management flexibility
• Quantifies both variability and riskevents, provides valuation range
• Subjective ranking of risks
• Impact on project value not quantified
• Applies the same penalty/advantage to all cash flows
• Difficulty in modeling management decisions
• Requires multi‐disciplinary inputs for meaningful risk profile
Industry Standard Good Practice Flexible and PracticalInsufficient
Pros
Deterministic
Pricing
Deterministic DCF
NPV
Operating Cost
Capital Cost
Discount Rate
Schedule
Technical Parameters
Probabilistic
Pricing
Quantitative Risk Model
Operating Cost
Capital Cost
Discount Rate
Schedule
Technical Parameters
NPV
Risk Events
Sin
gle
Inpu
ts
A quantitative risk model is developed to assess impact of project risk
123
Develop deterministic Discounted Cash Flow
Determine probabilities and impact ranges
Apply quantitative risk tools and evaluate
• Sufficient granularity required for meaningful risk analysis using discount rate
• Engage those most familiar with the project: PM, engineering, estimators and outside experts
• Data driven process for reliable results
• Monte Carlo “executes” the project many times and tracks results with defined correlations between inputs
Systematic 3-step process requiring the input of project team and external advisors
Case study: Greenfield liquid terminal project. Should we invest in this asset?
INFRASTRUCTURE‒ Upgrades to existing pipeline
required, greenfield facility
‒ CAPEX: $3 billion
‒ OPEX: $8/barrel (incl. pipeline transportation)
COMPLEXITIES
COSTS
‒ Environmentally sensitive area, policies and agreements under development
Key Client Questions
1. What is the risk adjusted NPV and IRR?
2. What is the probability of achieving the hurdle rate?
3. What is the value at risk?
4. How much should we pay?
(6,000) (4,000) (2,000) - 2,000 4,000 6,000NPV (US$ millions)
0
Increasing risk results in a wider distribution
76%Variability + Discrete Risks2
55%Variability + Discrete Risks + Pricing Risks3
70%All Risks + Mitigations + Opportunities4
Expected NPV
95%Variability1 1,241
892
1,012
892
Probability of Achieving NPV > 0
Deterministic ($1,597 million)
(6,000) (4,000) (2,000) - 2,000 4,000 6,000
How do we interpret the results?Baseline Metrics
Risk Adjusted
Capital costs,US$ millions
3,050 3,250
Operating costs,US$/barrel 8.0 9.5
Expected NPV,US$ millions 1,597 1,012
Probability of Breakeven ? 70 %
Internal Rate of Return, % 15% 13 %
Expected NPV
1,012
5th percentile
(721)
Deterministic
1,597
35% probability of meeting deterministic
Breakeven Point
0
70% probability of breaking even
Value at Risk: $1,733 million
?
Practical implications for decision makers
• Supports more robust investment decision making
• Provides insight into the risk adjusted asset value
• Supports more robust investment decision making
• Provides insight into the risk adjusted asset value
• Performs more comprehensive stress testing
• Evaluates a project’s ability to pay back interest
• Performs more comprehensive stress testing
• Evaluates a project’s ability to pay back interest
• Prioritizes development and de-risking efforts
• Assists with portfolio optimization and strategy
• Prioritizes development and de-risking efforts
• Assists with portfolio optimization and strategy
LENDERSINVESTORS OWNERS
Introduction to due diligence for M&A
Risks
Valuation & Value at Risk
Key takeaways
Key takeaways• Due Diligence and deal execution capabilities are considered a
differentiating factor for high-performing M&A companies.
• Balancing transparency and confidentiality; efficiency and building a shared vision are key to successful due diligence.
• Risk is difficult to talk about and the due diligence team needs to be aware of cognitive biases and, at the same time, implement a systematic approach for identifying and assessing risks.
• Building a base case valuation model is not enough. More advanced techniques, including simulation analysis, allow identifying key drivers and quantifying the value at risk on a particular transaction.
