Michael Calabrese is a managing director and global project leader with Aon’s mergers & acquisitions department. This group is comprised of 150 worldwide insurance and human capital risk specialists. They assist their clients, which include many private equity investors, through the deal negotiations process, anticipating and addressing obstacles, and often after deals have closed, acting as consultants. Collen Marie O’Connor, a senior editor at Buyouts, recently sat down with Calabresein his New York office to discuss trends in the due diligence and deal navigation process.
At what point are you brought in to the deal?
We have some firms who call us to strategize, saying Hey, we’re thinking of bidding on this what do you think?’ and we have some firms that call us only when they get to the LOI stage. If I could give you an average as far as time, I’d say that our lag from the call that we get vis-a-vis the accountants and attorneys, especially, would be from a few days to a few weeks before we get a call [from the actual investor].
So who are you usually dealing with once you get involved in a deal?
[We generally work] directly with the private equity team. They’ll be directing us and working with us and looking for deliverables just as they are from their other advisers. What we’ll do is work in concert with other advisers as issues arise, but the main source of our data and a lot of the interaction we have is not from talking with the CEO like a bank lender does because they care about interest coverage and those kinds of business issues. What we tend to do is deal with the CFO, and a risk manager and a human resources administrator. We’re looking at insurance risk management and human capital issues, so we’re not looking at loss of market share, etc.
Let’s talk about due diligence as it refers to these areas when you’re sitting down with CFOs and human resource department heads.
We have standard data requests and we go to data rooms just like other advisers to private equity firms do, and what we’re looking at is any issue that’s within our sphere of knowledge that could affect the people we’re advising. Virtually 95% of our financial sponsor transactions are buy-side due diligence transactions. We’re looking at anything that could help them in completely tightening up their valuations of their target company – what is it worth and why – and there are items in insurance and employee benefits that can help them with that. We’re looking at issues within those areas of competency that will help them tighten up their pro forma modeling so they can make assurances to banks on how they’re going to service their debt and sometimes there’s insurance issues or employee benefits issues , like whether there is going to be an escalation in costs or the liability they’re assuming isn’t adequately accrued for now, and it will come home to roost sometime in the next few years.
How deep do you go in?
When our employee benefits people look at things, and we have risk attorneys, we have pension actuaries, we have 401K experts, etc., so we look at the whole menu. The emphasis depends on what point in the due diligence it is. If we’re in an auction and it’s the second round and we want to bid on this thing, I don’t think too many people are worried about whether the vacation policy or the childcare is good. They want to close the deal and they want to construct a new program going forward.
Has anything changed since the economy seemed to cool off in 2000 in terms of due diligence issues? Are there some things that are higher on your radar screen than they used to be?
Because of Enron or Kmart, for example, companies have to post surety bonds. The entire insurance market has changed significantly. It was changing pre-9/11 and then 9/11 pushed it further into a very hardened market where there is less capacity, much higher pricing, much more restrictive coverage. But the big issues right now from an insurance perspective are the fact that most insurers do not cover sabotage or terrorism – a big issue particularly because most of our clients are going to go to banks for money to capitalize these companies, and a bank is going to want as much protection as they can get. So the fact that there is an absence of sabotage and terrorism insurance is an issue that has to be addressed and discussed. We look at does this target have that coverage or [doesn’t it]?’
The other issue because of the Enrons and Kmarts is the huge rash of bankruptcy, they were probably two of the most high profile ones, but the fact that a lot of surety bonds and surety underwriters were affected by those. They’re going to lose tens if not hundreds of millions of dollars and that market was already sort of tightening. So if a private equity firm is looking at a company that needs to post surety, they need to post surety for performance bonds or bid bonds.
What are some commonly overlooked or underestimated risks relating to private equity acquisitions?
I think they would all fall in the category of pre-closing liability adequacy accrual. That’s a big sweet spot. The other big thing is on corporate spinoffs where a division is being spun out of a Fortune 10 or a Fortune 1000 company, there’s a loss of economies of scale.
Are there any industries that seem to need more of your “alternative solutions” than others?
Historically, when you look at ingestible products – you know food or pharmaceuticals – their insurance is historically pretty high priced so they may want to look at absorbing some of that risk themselves before they transfer it. On the workers compensation side, there’s certain industries like mining where there’s high hazard but as you may know, mining deals have been done by leveraged buyout firms. Look at Peabody Coal. They’re doable. There’s always some industries that have higher hazards than others, but I go back to my original foundational answer that there’s some way to transfer that risk. I don’t know of any industry that’s raising its hands saying that we’d love to provide that service or that product but we can’t. We’re being bankrupted by the fact that we can’t transfer or layoff any of that risk.
Any examples you can cite where due diligence yielded something that a transaction didn’t already show?
We’ve been involved in transactions where our discovery helped or did kill the deal.
The best example I can give you, but yet still be fairly general, is a case where the company did not have adequate accruals on their balance sheet for a self insured liability, and it was fairly significant. I mean I don’t even know how they got a sign off on the balance sheet because they had little accrual on a $70 million liability. The whole transaction’s a few hundred million so how do you make up a $70 million dollar gap? They didn’t.
Do you go in with the hopes of finding gray areas like this that drive the price down?
We’re our clients’ advocate and we take a conservative approach on these funding issues on what steps they’ve taken, arrangements they’ve made prior to deal with their risks. But what we’re looking for is finding what’s there. In the hundreds of transactions, we inevitably find a deal point or two that post transaction is going to be more expensive. We sort of stick to a top-down approach: Is there anything in the transaction that would affect their strategy to buy based upon the areas that we’re studying? Is there anything in the transaction that they should know about and that affects the purchase price? Is there anything that we can provide them that gives them a better feel for the cash flow assumptions that they’re making?
There’s one area where insurers have developed a couple of products that are very helpful in transacting business which we call our deal solutions toolbox. You can get reps and warranty insurance, tax opinion liability, so you can even protect yourself if you’re expecting a certain tax treatment based upon the structure of the transaction, loss mitigation insurance , insurance on a known litigation or a known claim.
Loss mitigation helps facilitate the close of a transaction because in some cases if the bank is aware of this it says, “Gee, how can I be confident you’re going to service my debt? I think I can, out of your normal operations, but if you hit this speed bump that comes in and you needed to write a $20 million check, wouldn’t that sort of interrupt your cash-flow schedule?”
How much has your business been affected by the slowdown in M&A activity?
I think that we were fortunate last year because statistics show there was a significant slowdown in M&A and in private equity deals. What happened with us is that we didn’t suffer from that. Our revenues actually grew and I think that there were three main reasons why they did: we were fortunate enough, because of our market share, to work on a lot of large transactions. We worked in eight of the 10 largest transactions done worldwide.
Secondly, the fruition of our strategy to get dual assignments, where we’re asked to look at the insurance and the human capital/human risk side . And the third reason is because we do have a global footprint. Yes, M&A activity slowed down throughout the world but, prior to a year ago and two years ago, in Asia we weren’t collecting any of that activity. So even though Asia might have been down, our Asia number, because we didn’t have a practice there, was zero three or four years ago. So there was growth there no matter how you look at it as there will be this year in Latin America.
Is deal flow as slow this past quarter as it was this time last year? How would you judge it?
What we saw towards the end of 2001 kind of looked encouraging. There seemed to be a bit of a pickup and it trickled over into January but February and March, now, slowed up again as far as deal flow. February and March look more like February and March of last year. Through the middle of last year, up to that, pickup was noticeably slower than years prior.
Any positive aspects to the slowdown? Does it give you more time to focus in on particulars?
I think it’s given us more time with our global build out to work on standardization, make sure everybody is on the same page, and do things you didn’t have time to do in years prior when deal flow was very robust and you were running to keep all your clients and all the assignments and projects going.
Projects tend to have a life and each deal is different. If our project manager is just juggling three projects instead of six, those three are still running on the same kind of timeline that in years past the other six were. But some deals are taking longer to get done. Particularly the larger ones we worked on last year where sometimes it took months to get things done.