Spotting the Holes in Due-Diligence Reviews

The NJBIZ Interview – Steven PinskyA crucial aspect of the red-hot mergers and acquisitions market is the due diligence that companies perform prior to inking deals. Yet a survey released last week by the Roseland-based accounting firm J.H. Cohn found that even as companies steam ahead with M&As, executives are worried about the quality of due-diligence reviews. The survey, conducted with the Association for Corporate Growth, covered nearly 100 middle-market executives in the Northeast. Steven Pinsky, a J.H. Cohn principal who heads the firm’s private-equity practice and works with companies on both sides of M&A deals, discussed the findings and implications with NJBIZ Staff Writer Martin C. Daks.

NJBIZ: J.H. Cohn’s survey indicates that more than a third of executives see serious shortcomings in due diligence when it comes to M&As. Are they taking steps to correct this?

Pinsky: They know about the deficiencies, but often it’s the M&A advisers, primarily CPAs and lawyers, who are doing the due diligence and who aren’t doing it right.

NJBIZ: What are some of the areas that advisers need to re-examine?

Pinsky: In some cases, they’re focusing on the wrong issues. For example, they’re spending time trying to validate the numbers [in the financial reports] and the quality of earnings. But instead they need to read between the lines to see what’s really going on.

NJBIZ: How can an outsider do that?

Pinsky: As a starting point, the M&A advisers need to gain an understanding of how the company’s numbers are calculated, and then see how the business uses the data to run operations and monitors the results.

NJBIZ: That’s almost like an audit. What sort of activities does it involve?

Pinsky: Consider something like gross margins [generally defined as the difference between sales in a particular period and the company’s cost to acquire or manufacture the goods that were sold in the same period]. Advisers need to look behind the reports and consider whether the gross margin is sustainable. Also, what kind of overhead is needed to support that level of gross margin.

NJBIZ: Can you offer an example?

Pinsky: In one case, a company thought it was structured to deliver a positive gross margin, but when we considered variable costs [which may not otherwise be included in a strict gross-margin calculation, but are still part of the costs incurred in a sales cycle] we discovered it was actually losing money on every sale. Other important issues include reviewing the profitability of contracts and specific product lines.

NJBIZ: Many companies use earnings before taxes, interest, taxes, depreciation and amortization (EBITDA) as a standard of comparison between similar firms. But how useful is it to strip out interest costs, especially if a company has heavy capital expenditures that may incur significant interest?

Pinsky: We’re often called upon to validate EBITDA, but I believe the metric is somewhat overrated. It’s really not a stand-in for a cash-flow calculation. On the other hand, a private equity fund that’s engaging in an M&A is likely to recapitalize the target company, so it may be appropriate to strip out the current interest-expense component.

NJBIZ: What else is important to a successful merger or acquisition?

Pinsky: Understanding the working capital [generally, the difference between current assets, including cash, and current liabilities, including accounts payable] needs of a company can make the difference between a success or a flop. For example, a company’s lack of cash may appear to be balanced out by a lack of debt at a particular point in time. But that may just be a lull in its operating cycle, and the business may quickly need to get cash in order to stock up on inventory in order to meet an upcoming sales cycle.

NJBIZ: Some of the survey respondents cited an over-emphasis on “legal concerns” as a problem with M&As. Do you agree with that?

Pinsky: I can’t read their minds, but I tend to believe that they’re not really disagreeing with legal due diligence so much as with the price of it. It’s vital to address representations and warranties, liability, environmental and other legal issues.

NJBIZ: Some private equity firms buy companies as long-term investments. Others plan on building up their acquisitions quickly and then selling them off within five years or less. Do these different models require different due-diligence models?

Pinsky: A long-term or strategic acquirer tends to focus on the assets being purchased, and how they can add incremental value to the acquirer’s existing business. So they can pay less attention to back office or SG&A [sales, general and administrative] expenses, since those functions can usually be rolled into their existing ones. But a financial or shorter-term investor usually wants to acquire the management team, in order to build on and improve the target company’s operations. So their due diligence is likely to focus on different areas, compared with the strategic investor. But it’s not always black and white, since more private equity firms are buying so-called “platform” companies that they can use a springboard to get into an industry. They may build on the platform company through buying other businesses, which involves taking a longer-term view.