Acquisition pitfalls: Colin Oldfield on the dangers of making acquisitions without proper due diligence
By Colin Oldfield09 May 2012
Colin Oldfield, an experienced rental manager who has been involved in many acquisitions throughout his career, highlights some of the things to look out for during the due diligence period.
During my own career in the rental business I have been involved or responsible for many acquisitions since 1975. I have seen many mistakes made when buying companies, and when planning future strategies, and I have also made some myself.
Many acquisitions will of course prove to be successful, but others will be disappointing, and some, regrettably, will prove catastrophic for the companies involved.
There are many good reasons to take the acquisition route to accelerate expansion: they could be strategic, geographic, opportunistic, or even political, with a small ‘p', and it is true that ultimately the value of a business is what someone is prepared to pay for it.
It may well be acceptable to pay a premium over book value for a company; however, it is obviously critically important, and in fact essential, to determine the likely ‘true book value' of the company prior to formalising the final offer.
If a company is privately owned, one would normally expect it to be conservatively managed, whereas a listed company may well have a more aggressive accounts' policy, which will help to impress bankers, shareholders, analysts and potential investors.
The result, unfortunately, is that there is quite often a wide disparity in the way that individual companies determine the reported data in their audited published accounts. This means that companies which are operating similarly to peer operations appear to be more or less profitable and valuable than other companies in their sector, purely due to the way they report their published accounts.
Nearly all initial offers to effect a purchase are invariably made ‘subject to due diligence', when the books, operating procedures and assets will be open to scrutiny and interrogation. These, sometimes complicated, procedures will be carried out by an experienced financial accounts team.
However, before consideration is given to what premium should be paid over the book value, it is absolutely essential, at this stage, that an industry-specific expert be employed to ensure that the ultimate data provided to the target company does truly reflect its likely real value.
There are many ways that accounting policies can significantly enhance accounts, and here are but a few:
In the ‘Notes to the Accounts' all companies will indicate the parameters used when analysing charges for depreciation, typically indicating periods of operating life in years, or by applying annual percentage charges. These will invariably vary from one company to another.
Clearly, therefore, if company (a) depreciates units over 5 years, and (b) depreciates similar assets, say over 8 years, then at any one time the performance of company (b) will appear markedly better than company (a) in terms of earnings, and of course net asset value.
Instead of writing-off repair costs to the current account, some companies will sometimes actually capitalise the cost by adding the repair cost to the current written-down value of the equipment, resulting in an upwardly revised valuation, which bears little or no relationship to the real value.
There are occasions when this procedure can be genuinely justified, but it does require disciplined vigilance to ensure that the asset value is not being corrupted.
Over-optimistic depreciation policy, or poor maintenance, will ultimately result in serious over-valuation of equipment that is scheduled for disposal. However, by using discounts from new replacement, or additional equipment, and allocating these to the disposed equipment, it is possible to mitigate any losses that should really have been generated when the assets were disposed of.
This does, of course, mean that the newly acquired assets are now, in their turn, scheduled on the asset register at values higher than they actually cost. In other cases, where assets are in fact only worth scrap value, they continue to languish on the asset register instead of being written off as a loss.
Extended Payment Terms
When buying new equipment it is not unusual to negotiate ‘extended payment terms'. Obviously, there is a cost involved, in effect reflecting the cost of interest for the period of extension.
Some companies will, in effect, capitalise the interest by adding it to the capital cost. This, of course, has the effect of taking the interest charge out of the current account and writing it off over the life of the asset, thus improving profits and enhancing fixed asset valuations. A further benefit accrued from this procedure is improved cash-flow, as the equipment will earn revenue for the period of extension, without any cash being expended.
Obsolescence, health and safety
New technology and continuously rigorous safety regulations are particularly influential in the design and development of heavy equipment, such a truck-mounted cranes and mechanised access equipment, such as telescopic booms and scissor lifts.
The result of which is that in many cases the equipment at only just over half its working life could, in fact, be over-valued, or may not be able to demand the hire or rental rates expected when the equipment was initially commissioned. Consequently, the book value of these machines, which has been depreciated for periods of from between eight and, on occasions, twenty years, could be dangerously over-valued.
It should be noted that in times, not long past, when inflation was a major factor, it was quite possible to relate book value to market value; however, current inflation rates sustained for the last few years, together with forecast low rates for the future, make this an area for specific investigation.
In the last twenty years or so we have witnessed frenetic activity related to domestic gas, cable TV and fibre optic cable installation. The specialist contractors providing the installation services operated in some cases for twelve hours a day, seven days a week, on continuous contracts spanning many years.
The rental companies entered into supply contracts with the contractors, without sufficiently taking into account the excessive wear and tear being sustained by the hired equipment. These contracts are on-going, but it would be no exaggeration to say that, in effect, the apparent profits being made on these hire contracts should be mitigated by additional depreciation reserves, because in real terms the plant will have aged at twice its normal rate. This is unlikely to occur, the result of which is invariably early plant graveyards for some companies.
When assessing some balance sheets, it appears that goodwill, on occasions, is valued out of all proportion to its real value. It does seem somewhat unreal to apportion value to a trading name that is no longer recognised, and what is more is not being used.
There are, of course, many other areas of evaluation that need assessing. However, it should be noted that proper due diligence has, on quite a few occasions, resulted in a scheduled acquisition being aborted and, as things are not always as they seem, this will doubtless occur in the future. Caveat emptor indeed.
The author: Colin Oldfield has a lifetime's experience of construction and equipment rental. He started is plant career with crane company Grayston Crane Hire and subsequently worked for BET Plant Services in South Africa and the Middle East, Dell Plant, TNT Nationwide Transport and LPH (Lovell). He has also advised companies including Power Plant Hire, First National Rental, Osborne Construction and Andrews Sykes. Since 2006 he has advised construction companies on their rental divisions and equipment procurement .