Why do deals go bad?

Insight /  30 September 2024

Danny Malone, Corporate Finance Senior Manager at UNW, outlines common deal busters identified during financial due diligence and how to respond to them.

In the world of M&A transactions, deals can abort at any time due to a wide variety of reasons. Reasons ranging from the more familiar (e.g. poor recent trading results, sudden economic downturn, loss of a key customer, etc.) to the more esoteric (e.g. a legacy tax compliance point, poor outlook on run-rate earnings, bun fights about working capital and cash/debt definitions, etc.).

With some deal breakers, particularly those driven by macroeconomic variables or changes in the tax regime, it is largely a matter of fortunate (or unfortunate) timing. However, for red flags we can respond to, it is best to identify these as early as possible in the deal process. Financial due diligence is, after all, designed to find those skeletons hiding in the closet which a savvy buyer would view as game-changing pieces of information that they were not aware of when entering a negotiation and leverage accordingly!

Listed below are some of the more common deal breakers across two key categories, assets and people, and how to respond to them in order to maximise value and avoid a bad deal.

Assets

For capital-intensive businesses, the fixed asset base is inherently critical to the ongoing operations and effectiveness of the business. These assets – whether they refer to a fleet of vehicles, specialist machinery, property, facilities, etc. – require routine levels of repairs, maintenance and replenishment to remain effective and avoid unnecessary business downtime.

When due diligence uncovers fixed asset deficiencies, several responses are possible. These may include retrospective catch-up capex being treated as a debt-like deduction off the headline price, or a true-up adjustment in repairs and maintenance expense line as part of the quality of earnings assessment or forecast capex deductions from the future cash flows (which may impact earn-outs and cash flows available for debt servicing). In some cases, a straightforward reduction in the headline price may also be warranted.

Deal breakers on the asset base are not just limited to those tangible assets; increasingly it is the assets you cannot see and feel that are a cause for concern. Due diligence across the legal, financial, tax and technology workstreams can identify serious issues regarding the underlying IP ownership (e.g. outside the transaction perimeter), technical know-how, the uniqueness and scalability of the tech-stack, and the nature of capitalised development costs – this latter point being of increased interest to HMRC.

When it comes to intangible assets, this is where the thoroughness of the due diligence Q&A process and the follow-up advice on suitable SPA protections and disclosures are of the utmost importance.

People

Another core area of financial due diligence is an assessment of a target company’s personnel, particularly its management team. Any assessment would include a review of staff composition by roles, shareholder involvement, key personnel, top fee earners / relationship holders, joiners and leavers, average length of service and number of live vacancies.

A holistic view is required, but any review should aim to identify the current team’s capabilities, capacity and where additional headcount is required. Common issues include challenges with recruitment, which may hinder growth plans, staff retention and a lack of succession planning.

By the due diligence phase, any succession issues should already be ironed out. However, recruitment and retention concerns may require post-deal Day 1 actions in the form of parent company support, interim placements, incentives to key personnel, contractors bridging the gap, etc.

These responses will either adversely affect the earnings profile via increased staff costs or management charges, or result in a negotiated debt-like adjustment such as the seller contributing to post-deal bonus payments, recruitment fees and training costs. A common approach for owner-managed target companies is the continued involvement of the outgoing shareholders over an earnout period, this can greatly mitigate against post-deal concerns in relation to staff and management.

Key takeaways

Unfortunately, not all deals complete and even ones that do can ‘go bad’ post completion. Deal breakers and red flags are a normal part of M&A activity. The best approach is to prepare for them and identify them as early as possible in the deal process. Once identified, advisers can work on pragmatic and value-driving solutions. Getting good deals done and avoiding bad deals is ultimately about asking the right questions, working flexibly and adapting quickly to unknowns.

If you would like more information about the topics discussed in this article, or any other due diligence related matters, please get in touch with dannymalone@unw.co.uk.