Some interesting M&A Stats

I just took a look at a news item that arrived in my daily  PEHub Wire news roundup: Gotham Consulting Partners’ private equity survey on value creation.  While I’ve only had time for a quick read, three things jumped out at me immediately.

• 6% of the time spent on due diligence is spent on IT systems. This seems low, especially in light of what the rest of the survey says about value creation. A figure of at least 10% would make much more sense for PE firms that are serious about driving operational value creation initiatives.
• Post-merger integration does yield greater than expected results, according to survey respondents. A logical extension of this thought would be to begin integration planning early, to achieve those results as quickly as possible after the close.
• Most firms are relying on standard financial and operational reporting as tools for managing their portfolios.  However, among the more active methods of portfolio management cited, shared purchasing /shared services is the least used among the respondents.  However, a followup question listed shared purchasing/shared services as one of the two active management techniques that yielded better than expected results.

There is a lot of great information in this survey, but at a high level, it points to the need for further changes in approach both before and after deals close. More time spent vetting out risks at a deep level within operations and IT, rapid integration, and new approaches to active portfolio company management could drive these results in a different direction when the 2010 survey rolls around.

If you’re thinking of acquiring a software startup

IT due diligence on a software startup may seem unnecessary if the core product offering represents a significant new advancement.  It really can’t be overlooked, however, as there are many technology risks lurking within the product and within the company itself.

As far as the core technology offering(s), it’s important to conduct code reviews, architecture reviews, security audits, application performance assessments (especially in light of the projected growth in the business plan) and an assessment of the company’s software development lifecycle methodology.

There are other hidden risks, some of them far removed from the core product offering, that may impact your future acquisition’s ability to achieve its goals.  Many of them stem from the need to be both chief cook and bottle washer during the very earliest days of the company’s existence. Here are the top three:

1. Inappropriate software development practices: My favorite example here is a startup I was advising during its search for first round investors. They could not resist the urge to keep “improving” the code, so they never segmented or froze their brainchild into discrete releases. The night before I had scheduled a potential investor for a demo, they thought of four new “must-have” features to add, and were actually debugging during a demo that failed to execute.
2. Tendency to re-invent the wheel: Software entrepreneurs are often skeptical of packaged enterprise software to the extent that they will build their own backoffice, CRM, or other applications. The risk this imposes to potential investors is twofold: you are retaining dedicated staff to support those applications, and any migration off of these applications may be difficult because they are often built “on the side” without sufficient documentation.
3. Project management immaturity:  It’s unusual for a startup to hire real project managers very early on in their lifecycle. While PM discipline could certainly help them during the concept phase, it’s absolutely necessary as they are attempting their first deployments to clients.  Weaknesses in this area are easy to spot as you conduct due diligence interviews with their customers.

So even if the product has no competition in the market place, and you’re convinced it can sustain competitive advantage, please make sure you have qualified resources do some deep probing to help you understand where the hidden problems may lie.

“The Trouble with the Future…

…Is that it arrives before we are ready for it.”  A bit of plainspoken wisdom from American humorist Arnold H. Glasow. Thanks to the miracle of google, it becomes our intro quote for today’s topic of acquisition integration readiness.

In an earlier post, we talked about data integration readiness, but that’s only one task on a list of things you should be doing now if you plan to acquire a company in 09. Readiness is the word of the day, and the best way to sum it up is you have to have a documented platform to integrate with across the board, or you will lose time during your integration period. Lost time means revenue drag–you won’t hit your projections.

So, let’s make a list.

1. Data integration readiness, already covered in detail here.

2. Process readiness – are your procedures for key business areas up to date? You will need to walk through them with business team leads on the acquisition side to rapidly understand the gaps between the way they do business and the way you do business. Can you rapidly train the influx of people you will be onboarding with the acquisition? An effective training plan is a solid way to minimize post-close chaos.

3. Collaboration readiness – don’t underestimate the amount of time those new employees will take up with endless “How do I?” questions. Hopefully, you have a corporate knowledge portal in place already and you can give them access and a navigation walkthrough on Day 1. Make sure it includes discussion groups, so that the answers to their common questions can be searchable and institutionalized. There was a great post on this recently describing how IBM is using collaboration tools to help with acquisitions, and Edgewater’s Ori Fishler and Peter Mularien have posted extensively on Web 2.0 tools for corporate collaboration.

While we are on the subject of collaboration tools, let me tip you off to an important secondary benefit. The people that use them and participate actively in discussions are your change agents, the people that can help lead the rest of the acquired workforce through the integration. The people that don’t participate, well, they are your change resistors. They need to be watched, because they may have emotionally detached from this whole acquisition thing. If they are key employees, you want to make sure they don’t have one foot out the door.

4. System integration readiness – It’s oh-so-much-more-challenging (meaning time consuming and costly) to integrate into an undocumented or underdocumented architecture. Get your data flow diagrams and infrastructure diagrams, as well as your hardware and software inventories up to date before you close.

That first quarter after you close will still be a wild ride, but you can be sure you’ve cut the stress level down significantly if you make these readiness tasks a priority before closing day.

Designed to Sell, Corporate Edition

When contemplating which business units or product lines to put up for sale in today’s challenging market, it might be wise to borrow some tactics from  the real estate market. It really comes down to three important guiding principles in planning a divestiture as part of your deleveraging strategy:

1. Know your market – cultivate target buyers to avoid a fire sale. Identify players looking for complementiarity in products, services or customer base.

2. Model the outcome on your going-forward financials – freeing up cash may be top of mind for everyone, but we all need to think past the current crisis and understand what the impact will be on sales and profitability going forward. If you don’t have a business intelligence toolset in place already, you may have difficulty in achieving the type of agile scenario modelling that is necessary here. Infoworld is reporting BI as a key spending area in the recession, specifically for determining profitability.

3. Know where to invest, or “design to sell.” – there may be secondary benefits, above and beyond a divestiture’s products, services, and customer base. Specifically in the technology architecture, especially if the business unit is on its own (instead of shared corporate) platforms. Ancient mainframe technology is like the walnut panelling and avocado shag carpeting lurking in the basement. Customized applications with their big in-house support teams are like the pink stucco patio and poolhouse a proud homeowner showcases, causing the buyer to race down the road to the next listing. Call in the design team, these could be good spots to begin a corporate makeover, as they are very likely to increase the value of the sale.

On the flip side, things like collaboration tools and  business process management suites are like the well-appointed master suites and media rooms that can help a buyer warm up to the sale. In addition to things like a lean operating architecture, these technologies help make a divestiture an attractive asset for buyers looking to build out a platform company.

Is this the end of M&A as we know it?

Part of me says, “Oh please, let’s hope so!” — for more than a decade we’ve heard constant complaints about deals that don’t reach their full potential, and watched the same sort of mistakes being made over and over:

• the hoped-for synergies that are never really defined
• the integration or transition plan that’s 3000 lines long but gives no one a clue about where the effort actually stands
• no coordination of business and technology plans during integration or transition
• the blanket assumption that a move of the acquiree’s business to the acquirer’s systems and processes are always the right choice

There’s no doubt about it—deal volume and total deal value is down year over year from 2007. Credit market woes are pushing buyers to move away from senior debt toward riskier mezzanine capital. Common sense would tell you that if you’re taking on more risk, you’d better be vetting out risks earlier in the deal timeline, yes? Valuations are coming into line due to market conditions, so there’s not so much need to use due diligence to position for negotiating advantage during valuation discussions (but hey, it never hurts to strengthen your position during negotiations, right?) But, given the additional risk you’re taking on with the mezz financing, you’d better have a clear idea about what your IT spend needs to be in year 1. Pre-close is the time to ferret out those orphaned releases, costly overly-customized environments and low-productivity in-house custom IT development shops. Find them, redefine them, and build a tight cost model so you don’t take on any more risky debt than necessary.

Gloom and doom, we can’t shake it these days—it feels a little like we’re living through Ragnarok or at least Fimbulvetr, the winter of winters that precedes that Destruction of the Powers, doesn’t it? Many assets are being put on the block these days as part of a vast global deleveraging battle. Who couldn’t use a few valkyries on the team, to help choose among these slain assets the most worthy and heroic and carry them off to the Valhalla of value creation?

Difficult days for all of us, these. Let’s remember the great Norse legend does end on an up-note, though — after the great battle, the world resurfaces anew, fertile, with a bright future. Even in these uncertain times, there’s much you can do to either position the assets you plan to put on the block, or to prepare for the success of future acquisitions. More about both topics in future posts.

Keys to Successful Divestitures

There’s no doubt about it. A well-crafted TSA (Transition Services Agreement) can make or break a divestiture. In a recent review, Deloitte describes some of the key elements of making a fast break. Shrinking the interval between Day 1 (Financial Close) and Day 2 (Full Separation) is a priority goal of a successful transition. To achieve a short timeline, it’s crucial that IT decisions be made as soon as possible, even before Day Zero (the day the deal is publically announced).

While the Deloitte approach provides a reasonable framework, I think we can add some additional perspective based on our own experience in this area.

1. The acquiring company or PE firm should recognize the fact that the IT resources within the business unit to be carved out are not likely to possess the strategic vision and leadership to create a target architecture and craft an accelerated transition plan.

2. The internal transition team needs skilled coaching and leadership to effectively “turn the tables” on the former parent organization. Think  about it: the IT resources you are bringing over with the divestiture have been taking orders from corporate IT. During the transition they must quickly change the dynamic of power and manage their former bosses as service providers.

3. SLAs are important. The Deloitte article minimizes the need for formal SLAs, but it only stands to reason that service requests from divested assets will fall to the bottom of the priority list when there are more pressing internal service requests.

4. Make sure that the agreement specifies the level of involvement from the parent organization’s resources and access to data and information that you can expect during the transition.

5. Don’t pay for what you don’t need, and scrutinize TSA cost drivers diligently. For example, if the parent organization is making an allocation to maintain a highly customized, automated environment that you will not fully use during the transition period, you should negotiate for discounted fees for that particular TSA area.

6. Manage expectations within the carved out business appropriately. Sometimes a little more chaos and pain in the short term is worth it to achieve full separation and transition to a more efficient operating platform.

Experience, negotiation, coaching, strategic vision are all key elements of a successful transition team leader. If you can’t find the right combination of skills within the acquired asset, it’s well worth it to bring in an expert to lead the team during the short but intense transition team.

Reducing IT Costs for New Acquisitions

Over at CIO magazine, Bernard Golden recently published an update on Cloud Computing. In his list of the types of companies that can benefit substantially from computing in the cloud, he left off one situation that can reap tremendous benefits from this approach: newly acquired private equity portfolio companies that are being carved out from larger businesses.

For these companies, cloud computing offers the following benefits:

• Accelerated implementation timeline that dramatically reduces implementation costs
• Significant savings on support costs, which typically represent 60% of the IT budget
• Eliminates the dependency on staffing and retaining IT support staff
• Costs scale with number of users
• Repeatable implementation playbook
• Easily extensible for tuck-in acquisition

One of our senior architects, Martin Sizemore, has laid out the broad strokes of this approach in a short slide show.

It’s an especially attractive M&A technology approach in the middle market, where it can help drive annual IT budgets down under 4% of revenue. While it is most advantageous for creating a new operating platform to accelerate transition services (TSA) migrations, the transition to cloud computing makes sense as a value driver at any point in the asset lifecycle.

Recession proof approach to managing IT spending

InfoWorld is listing five outside-the-box ways to cut IT costs, a topic which is sure to resonate in this week’s economic climate. While the recommendations make sense, their approach perpetuates an outdated and problematic relationship between the CFO and IT. Instead of focusing on across the board budget cuts, placing IT on a level playing field with other business functional areas, it might make more sense to look hard for savings opportunities within the core business functions and evaluate the total costs of operations for finance, HR, Marketing, etc. IT capital expenditures and support costs would be modeled into the total cost of ownership.

We’ve seen this TCO analysis work well for our private equity clients, who have varying tolerances for capital expenses versus ongoing costs, so we typically provide them with a month by month CAPEX projection for the transition period, and an estimated monthly operating cost model that includes IT, BPO monthly fees, and FTE costs for running a particular segment of the business.

When business decisions are made within the framework described above, strong leadership is required to align competing stakeholder needs. Instead of IT project teams, we pull together business transformation teams that serve up the necessary information (costs, risks, organization impact, business process impact, regulatory concerns, etc.) so that major business initiatives can be evaluated from multiple perspectives:

Business Architecture perspective: How does the proposed project impact the organization structure and the business processes? This perspective is owned and represented by the COO and the executive leadership of the affected business functions (e.g., HR, Marketing, Sales, Product Development)

IT Architecture perspective: What are the impacts on our enterprise IT architecture and its interfaces with third parties? This perspective is owned and represented by the CIO.

Financial perspective: What are the CAPEX and ongoing costs? What is the estimated impact on revenue? This perspective is owned and represented by the CFO.

A project execution framework should allow for multiple checkpoints for these key stakeholders to approve the scope and direction of the project over the course of its full lifecycle.  The approach makes sense for any business, but within the private equity portfolio, it can be the key to driving asset value in ways that pure financial engineering approaches are unlikely to attain.

M&A Transition Services: Pitfalls and Opportunities

Deals that involve Transition Services Agreements (TSAs) turn into our most challenging and satisfying M&A projects. Over the years, we’ve seen (and helped our clients avoid) many pitfalls unique to the TSA situation. Right now, we’re also really excited about the opportunities for creating a lean IT organization and architecture when planning out the strategy for getting acquisitions off of their TSAs.

TSAs: The Dangers

It’s important to begin vetting out the hidden risks of the TSA during the M&A IT due diligence phase.

1. Assuming that the IT staff of the carved out business unit can evaluate, negotiate and manage the relationship with the former owner during the transition period. Think about this: these are the people who used to take their orders from the parent company. They are good at executing to orders, and they are rarely quick enough to realize that they must now relate to their former bosses as service providers during the transition period. We have seldom seen the right mindset and leadership skills in an acquired company to radically and rapidly turn the tables on working relationships that may go back for decades. If a TSA is on the table, it’s an important component of our IT management evaluation during IT due diligence.

2. Failure to insist on the following key components of a comprehensive M&A TSA  during the evaluation and negotiation phases:

• Service Level Agreements (SLAs) – treat the seller as an outsourced service provider, and demand adequate performance. Ask yourself about the quality of service you have received as a PART of the parent company, and assume that they will deprioritize your needs over their own once the deal has closed. You need SLAs and performance monitoring to safeguard against that. 
• Definition of Termination Notice windows on a service by service basis.
• Appropriate cost basis for each service offered under the TSA. Caveat emptor - I can’t tell you how many times we’ve seen cost allocations that made no sense in terms of the going-forward business model of the acquired company.

3. Failure to fully plan out Day 1 (day of close) operations. For each business functional area (including core IT services like email and help desk support) make sure there is either an included TSA service offering or a viable internal process and technology component that will be ready on Day 1.

TSAs: The Opportunity

Because a carve-out and the subsequent TSA migration offer the opportunity to create a new operating platform (process+technology+organization) for the stand-alone business, leveraging new technology approaches can result in significant run-time IT cost savings. By relying heavily on Software as a Service (SaaS) solution providers, outsourced hosting and support, and interim strategic IT advisory services, the run-time IT department can be kept quite small, and there is often a reduced need for big-ticket IT leadership resources as the helm.  Outside of IT itself, we can design the technology platform to support significant business process outsourcing of non-strategic, non-customer facing transaction processing to reduce other operating costs as well.

We’re excited about this approach because it provides a viable path for driving IT spending down below the current industry average of about 7% of revenue. In addition, it represents the quickest approach to getting off of the TSA. We’ll be laying out the broad strokes of a generalized virtual operating platform in future posts.

Platform Company Integration Pitfalls

Cookie-cutter approaches to integrating platform companies are a surefire way to limit your abilities to achieve acquisition goals. There are many ways to do it wrong, and no single, one-size-fits-all approach to doing it right. Some of the more common mistakes include:

1. Letting earnout terms play out in the operating infrastructure for too long. If it’s hands-off during the earnout period, you need to evaluate whether keeping the acquisition on a separate P&L really makes sense after the earnout ends. Too often, these structures persist and limit the company’s ability to achieve full economies of scale by centralizing key functions such as accounting or call centers.  Instead of compensating former owners on full P&L, it may actually make more sense to move key functions such as AR and collections into a centralized service model before the earnout ends. It’s important to get these considerations on the table during IT due diligence.
2. Assuming that it always makes sense to integrate all of the acquisition’s business functions into the parent company’s model. Evaluate each functional area on a case by case basis. Leverage better and newer technology and business processes within the acquisition. Remember that the most successful mergers are transformative of both the acquirer and the acquired company.
3. Assuming that you can just dust off the m&a integration plan for your last acquisition, adjust the dates, and march to the same tune. Every acquisition is unique, and while it makes sense to follow a common integration approach and methodology, flexibility and agility are keys to success.
   
4. On the tactical level, one big mistake we often see is trying to integrate a new business into a business operating architecture that is not adequately documented. Every implementation or transition date for a particular business function/system has impacts that must be defined and communicated to multiple stakeholder groups within and outside the company. Put your entire business platform (people+process+technology) under change control and understand and communicate the changes appropriately.