Early Due Diligence Case Studies

M&A Due Diligence: Family office kicks off fast-paced due diligence on a distressed asset

SITUATION

A family office put together a team of experts to evaluate a distressed energy company approaching bankruptcy. Distressed debt investors had taken positions in the company’s bonds, and the family office was evaluating a credit investment that would lead to eventual control of the business.

The company’s distressed financial situation was compounded further by the lowest oil price in decades, $25 a barrel. An accurate valuation of the company’s assets, and successful determination of the fulcrum security would be critical to their analysis. The family office had experience in “option style” investing, and was intrigued by the two forces at play: bonds trading at 30 cents on the dollar, and a possible oil price rebound that could increase the value of the target by multiples.

DETAILS

The market climate and fading health of the target contributed to a frenzied environment on the deal team. A general issue tree was developed with major branches of Asset Value and Operational Uplift. With long hours ahead, the senior expert in charge of Asset Value took a private office for three days to be undisturbed during his financial modeling. Starting with the data in the company’s latest annual report, he began working through two key assets: one in Texas, and one in Pennsylvania.

The team in charge of Operational Uplift took a conference room on a separate floor to review the companies G&A, operating expenses, and other key metrics. They began with the latest company filings, working backwards from the latest quarterly reports and conference calls, concluding that the company would be worth much more in the hands of a skilled operator.

When the team convened on day 4 to consolidate research, Asset Value was the first item on the agenda. As the senior expert presented his work based on an annual report now almost 9 months old, an uncomfortable discussion began about what the company actually owned. The latest investor presentation and conference call had detailed a distressed sale of all the company’s holdings in Pennsylvania, leaving its only operations in Texas.

While the team analyzing Operational Uplift had seen this, they focused on possible improved operations in Texas, which could in fact be meaningful. When the senior expert revised his valuation to focus only on the actual Texas holdings, the target no longer fit within the investor’s guidelines.

ANALYSIS

For a private equity firm or family office investing in a distressed situation, each day is critical, especially at key points in a market cycle. Expertise and industry specific valuation skills are paramount, but bringing a hands-on methodical approach are even more important.

The senior expert in this case had spent half of his time during the diligence modeling an asset that was sold in distress, leading to a major anomaly in resulting valuation. The latest company filings and press releases had detailed the recent sale of assets, but had not been reviewed, leading to wasted time on an asset already divested. The revised perspective of the company led to an end of the pursuit, a conclusion that could have been reached days earlier with proper process.

Regular and meaningful team check-ins, together with basic core punch lists could have led this team to their answer faster. Communication protocols are paramount during any M&A due diligence, but especially when time is of the essence.

M&A Due Diligence: Seasoned oil and gas investor looks to diversify into a new investment theme

SITUATION

An energy private equity firm looking to diversify into other natural resources evaluates a minority investment in a coal mining company.

DETAILS

The investment team was very excited about the company’s operational expertise, and end markets in Brazil, a country experiencing rapid growth at the time. Based on a minority investment to fund CAPEX, outsized returns were expected from increased revenues.

Following execution of the investment, proceeds were diverted to other entities and also used to satisfy past debts of the mining company.  After a series of legal actions, the private equity firm realized their expected downside protection didn’t in fact exist in this new asset class, leading to a total loss.

ANALYSIS

Minimal attention was given to the real downside, and possible low probability pitfalls by the due diligence team. Given the investment team’s decades of experience working with investments into existing oil and gas operations, they made a number of assumptions about the mine and lease they were buying into.

(Oil and gas leases are commonly subject to the special limitation that the lease continues only “so long as” gas is produced in paying quantities. Coal leases frequently contain special limitations, such as commencement of mining operations and, more commonly, exhaustion of the coal. Exhaustion occurs when all “mineable and merchantable coal”, terms subject to interpretation, has been mined. While they may appear similar on the surface, it is very rare for an oil and gas lease with significant reserves to terminate, while in the coal industry termination of a lease is much more common factoring in minimum royalty payments required from operators.)

The investors thought they had a perpetual royalty in the target coal mine, having never seen a lease with significant reserves expire. The mining company that received the investment never intended to continue operations of the mine, and the lease in question expired within a year, terminating the investors royalty along with it.

It’s critical to work with a team that has specific applicable experience. When M&A due diligence processes identify key pitfalls, risk can be properly assessed and downside action plans established.

M&A Due Diligence: Private equity backed software company attempts to stem losses by purchasing low cost competitor, seeing synergies

SITUATION

A private equity backed software company experiencing double digit growth over a 5 year period looks to purchase a low cost competitor.

DETAILS

While dominant in the past with over 80% market share in its information services business, a competitor selling products at half price had slowly captured nearly half the market. Compounding matters, a recent acquisition in their accounting software business supported by their new private equity partners had diverted attention away from the “boring” information services business to the new high growth accounting software group.

Two years prior the company had approached the low-cost competitor regarding an acquisition, but had been rebuffed due to the ease of takeaways the competitor was seeing. After losing almost 10% of top line in a year, the company proposed an offer representing a significant premium and negotiations for an acquisition began, supported by private equity backers.

Product pricing emerged as a key risk, given that many customers bought from both suppliers. Much attention was given to revenue synergies, with limited understanding around pricing dis-synergies. The CFO, GM, and Product executives each had a different approach to possible customer pricing proposals. Following the close, the team was surprised by customer unrest and the emergence of yet another low-cost competitor. The company saw erosion of combined top line.

ANALYSIS

Many times acquiring teams expect customers to act pragmatically, or believe that remaining competitors do not provide a real alternative. Surprises on both fronts can occur, with customers and competitors alike sometimes galvanized by consolidation in the space. Customers can pound the table when new terms are proposed, while competitors make promises with arms wide open.

Anticipating scenarios during the M&A due diligence process can help an investment team properly underwrite risk.

RETURN TO INSIGHTS