IT directors are increasingly involved in due diligence
operations designed to ensure that everyone knows what they are
getting into when a bid is in the offing
Low borrowing costs and an abundance of cash-rich companies have
created the perfect climate for mergers and acquisitions.
According to the Financial Times, the volume of mergers
and acquisitions across Europe is set to reach £532bn this year.
And in the UK, the short-term mentality of shareholders, which lets
companies like Pilkington be snapped up by buyers half their size,
means overseas companies are queuing up to pick the low-hanging
fruit.
It is a business reality that more UK CIOs will find themselves
having a due diligence conversation, and for the majority, it will
be their first time. With no practice run, whether the CIO is on
the acquiring or the acquired side of the deal, pitfalls lurk
everywhere. Plus, there is the added knowledge that the job of
realising the benefits of a merger after the event often rests with
the IT team.
Angus Knowles-Cutler, corporate finance partner with consultant
firm, Deloitte, says about 70% of transactions fail to live up to
expectations. Simon Rawling, CEO of project management specialists
PIPC, agrees. "More and more, as acquisitions happen we are seeing
the value not realised as a result of poor or costly integration,"
he says.
The heart of the problem lies with the investment banks and
audit firms who are brought in and paid to do the deal, says
Rawling. "They are paid on the success of the deal and not on the
success of the business integration."
As a consequence, the majority of due diligence he sees focuses
on core financial details. "While they register IT assets they have
no idea which platform the new, merged company will run
on," Rawling says.
PIPC recommends that any deal aiming for an operational merger
should involve both integration specialists and the chief
technology officer within the due diligence team. Above all, the
team needs to keep the objective of the merger in view when
deciding the appropriate level of scrutiny of IT. While it may seem
obvious, focus can easily be blurred even after the deal has been
transacted and the company has moved onto the systems integration
stage.
Rawling advises: "Always think of integration before
optimisation, if that is your objective, even though it is tempting
to cut costs from day one."
Despite examples of difficult IT mergers, the prospect of
acquisition should not necessarily be a daunting one. This is
especially true if an M&A is designed to accomplish market
expansion rather than cost savings.
Ben Booth, chairman of user group Elite, was CIO of the market
research company Mori, when he found himself in takeover
discussions last summer as the French company Ipsos put in a bid
for Mori.
He has emerged from the acquisition with a promotion to European
chief technology officer for the Ipsos Group and an added role of
global chief security officer. His IT team was in a strong
position, explains Booth, because Mori had undertaken a rigorous
due diligence exercise in the previous year to secure extra
funding.
"The company was able to present detailed documents to the
bidder showing that the IT infrastructure was in good shape and
getting stronger."
In particular the "almost complete match" in applications used
for online survey, telephony and data processing in the two market
research companies assisted a friendly merger. Had big investment
been needed to strip out and replace one company's systems, costs
savings might have been sought elsewhere, acknowledges Booth.
The very thorough due diligence performed previously meant that
the process with Ipsos could be accomplished rapidly, which in turn
helped the eventual integration, Booth believes.
Different kinds of financial transactions call for different
levels of due diligence, says Chris Digby, IT and strategy adviser
for Deloitte's corporate transactions. "If it is financially driven
or is happening to prevent the degradation of a customer base, IT
due diligence need not be so heavy-duty." Likewise, a change of
ownership or purchase by a venture capitalist with plans to resell
the company may also warrant lighter investigation.
For these scenarios a quicker approach to due diligence is
possible, says Charlotte Walker-Osborn, an associate at Eversheds
law firm. "This might entail working out warranties for some key IT
components required for the deal and worrying about the rest
later," she explains. Such activity could take a couple of days of
being immersed in the data room.
A more detailed version, however, would entail a thorough
investigation. This is designed to nail-down ownership - or not -
of source code, existence of documentation to prove copyright and
the substance of third-party service agreements. The latter should
include termination and flex dates as well as service level
agreements.
Above all, due diligence is intended to flush out deal breakers
that could render integration so costly as to be prohibitive. Deal
breakers might consist of one party's IT operations being
outsourced or located offshore. This can cause enormous problems
because of the complexity and expense of extricating the company
from a contract.
Digby recounts one instance where the IT director was not
involved in his company's purchase of a small business. It was
discovered after the deal that the acquired company had outsourced
its IT to a third-party supplier with no SLAs, and even worse, no
termination date. The company was effectively tied into paying the
third-party charges. "Ultimately, the company had to buy the IT
supplier too," recalls Digby.
However, other smaller-scale oversights can cause significant
disruption too, and it is better to know about these up front,
advises Walker-Osborn. "Common mistakes include selling off a group
company, which then loses access to corporate IT licences. In this
scenario a solution may be to draw up a bespoke agreement for the
ex-parent company to continue providing the IT services for a set
period."
It is worth remembering too that licences may exist not just for
hardware and software, but also for embedded software in hardware.
"If the software was licensed by Microsoft, then it is unlikely to
be a problem to get a new licence. But with embedded software -
often bespoke for a particular hardware device - there is the
danger that companies are flouting copyright rules or intellectual
copyright law without realising it," says Walker-Osborn.
Due diligence is designed to flush out these issues, but unless
the company is technology-focused, it could be the last issue on
their mind. "They're busy thinking about questions like 'how much
can we save in tax?' and 'what is the core proposition?'," explains
Walker-Osborn. However, she believes that companies are getting
savvier about the IT aspects.
Due diligence veteran Booth says what happens before is as
important as what happens during any merger fact find. "If your
house is in good order and you have good, but not extravagant
technology and a good team, then the acquiring team will see this
as a plus."
Case study: Littlewoods homes in on systems
integration
Littlewoods home shopping acquired Shop Direct in 2005 with the
aim of increasing its lead in the mail order business and winning
custom from the high street. Chairman David Simons has predicted
big advantages can be gained from an integrated IT infrastructure:
"Provided we get the infrastructure right, we have the opportunity
to dominate the UK home shopping market," he says.
Limited due diligence performed on the IT before the deal has
called for extra flexibility at the systems integration stage,
explain the integrators hired to do the job. Jason Knight,
integration director of project management specialists PIPC, got a
call from the owners of the Littlewoods home shopping operation,
the Barclay Brothers, as the acquisition of Shop Direct was cleared
by the Competition Commission. He became the interim CIO with a
remit to deliver an integrated and more stable IT platform with a
lower cost of service.
Knight was not part of any pre-deal due diligence and reveals
that little had been performed. "This was an entrepreneurial
acquisition. They [Littlewoods and Shop Direct] were similar
businesses based in the North West of England, with the potential
to share headquarters and services. In-depth due diligence of IT
was not considered to be a crucial aspect in realising profits from
this acquisition", he says.
Nonetheless, the cursory nod to the IT component did result in
some surprises early on in the integration exercise. Chief of these
were discovering licences that had not expired and which could not
be terminated without paying large penalties. "These were
contractual obligations that impacted our ability to realise some
of the anticipated savings," says Knight.
While the penalties did not interfere with building a more
efficient infrastructure long term, they did have to be written
off. Fortunately, minimal due diligence also had its upside as the
pre-deal team had calculated the labour cost of integration on the
basis of hiring individual contractors. Instead, PIPC recommended
that Littlewoods purchase its IT manpower from a small number of
niche suppliers.
There was never any danger that the purchase of Shop Direct
would incur large integration costs that could not be offset by
business benefits. Clear direction from shareholders at the outset
stated that integration had to pay for itself within a year. This
direction trained attention on accruing business benefit first,
which could then be reinvested into IT integration. Larger-scale
procurement brought discounts, for example, while changing terms
and conditions from 30 days to 60 days also had a very liberating
effect on cash flow.
There were, however, some high-level assumptions made pre-deal
that had to be validated in the first 30 days after acquisition.
This was a slightly messy period of "lifting up stones and seeing
what was underneath" as Knight puts it. As a result of the
validation, bits of the integration jigsaw had to be moved.
"However," he says, "PIPC is still committed to completing its work
by January 2007".
Knight maintains that due diligence is always a good thing, and
in particular recommends that an integration expert be included in
the pre-deal team. "It is never a good idea to have a serial
handover, and it is better to include the person responsible for
post-deal integration within the deal team. This person can
influence the debate about costs and the benefits that can accrue
from streamlining. And if they are not included there is always the
danger that issues will surface and bite from a cost or time
perspective."
What is IT due diligence?
The detailed investigation of the IT operations of a potential
acquisition to verify exactly what the assets and liabilities are
in terms of hardware and software, contractual obligations,
processes, management and staff. Vendor due diligence is where the
company which may be acquired carries out this exercise itself.