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.
This was first published in April 2006