WHAT IS DUE DILIGENCE IN THE CHEMICAL INDUSTRY?

Due diligence is a familiar concept to most participants in the mergers and acquisitions markets these days but the concept of due diligence as we know it today is a surprisingly recent phenomenon.  Due diligence is all about understanding technology, production economics, customers and markets.  Technology and assets are obvious matters to investigate but the idea that acquirers should investigate the customers and markets of the companies they were buying only arose, surprisingly, in the early 1990s.  Since the value of any business is its future profits, which in turn depend on the strength of its market and its ability to sell to its customers, this lack of rigour is perhaps odd.  due diligence is a phrase widely used and abused by lawyers and accountants, especially in the USA, which has a long history of protecting investors from misleading information.

Surprisingly the US influence was less important to the chemical industry than the Ferranti story.  This cautionary tale was a key event in the evolution of due diligence work in the UK and illustrates some key aspects of the concept.  Ferranti was a reputable publicly quoted, UK defence electronics company with sales of about $800 million.

In 1987, Ferranti bought a US defence electronics company called ISC.   Soon after the completion of the transaction, it became obvious that ISC had fraudulently boosted its profits by creating $1 billion worth of fictitious contracts and transactions through offshore companies.   Eventually, Ferranti was destroyed by the weight of the $700 million that it had paid for a company with few real sales that was surviving primarily on illegal arms dealings.   Ferranti declared bankruptcy in 1991 and sued ISC's CEO, James Guerin.   Mr Guerin claimed that he had been working for the US government but was eventually convicted and sentenced to 15 years for defrauding Ferranti of $1.1 billion, money laundering and illegal arms exports.  

Ferranti also sued ISC's financial experts & auditors for negligence in the due diligence process but in vain.   An out of court settlement of a mere £40 million was reached.   This was small comfort to shareholders who had owned a company with a market capitalisation of £800 million before the ISC deal.

Even today, it is still surprising how little some acquirers know about the businesses they are buying. 

Tecnon OrbiChem has seen several examples of this in its chemical industry M&A work in the last five years. 

However, due diligence has evolved over the last decade and a half or so from customer referencing to more of a mini strategy review.  As the market for good company mergers tightened during the 1990s, so the need for professional third party due diligence became increasingly recognised as an essential part of the deal-making process.

To meet SEC regulations, acquirers are no longer content to listen only to "management's" assessment of the target company's market prospects.  With more and more of the deal value resting on growth and synergies, acquirers must understand the target in depth.

Unfortunately, most chemical industry M&A is often handled by "consultants" who are mostly lawyers and accountants.  Apart from their obvious lack of technical and commercial expertise in the chemicals and plastics industry, the philosophy of both professions is the avoidance of risk.  The lawyer is trained to see disaster around every corner and tries to get protection against everything that could go wrong, however remote and at what ever the cost in terms of his fees.  "Boiler plate" is a usual term for such attitudes.  One of the fundamental principles of accounting is prudence, which teaches us that losses should be recognised as soon as there is a possibility that they will arise. 

In our experience, the due diligence process is not dominated by the transactional risks that the lawyers and accountants tend to worry about.

A merger is a strategic tool and is a long-term proposition.   What happens after the deal is signed is much more important to a successful acquisition than what goes into getting the contract signed.  Buying a poorly positioned company in a market that is about to self-destruct will cost you a lot more than conservative stock policies or supply contracts.  Similarly, identifying process risks can tell the acquirer about where to bore holes to test for environmental liabilities as Tecnon OrbiChem was able to do in a €600 million acquisition.

A third-party industry expert hired early in the Merger process can save thousands on the due diligence process and millions on the overall deal.

FEAR AND GREED

The acquisition process, quickly presents two old bogies of human nature; fear and greed.  For example, rewarding the acquirer's staff (e.g.  Private equity buyer) according to the number of deals done in a year can propel acquirers into doing stupid things. 

The number of Chemical M&A deals is actually quite small in any given year so another common mistake is getting so seduced by an opportunity that common sense and strategy go out the window.  For example, the CEO falls in love and makes it plain that the deal is going to get done.  If the numbers do not quite work, the assumptions are stretched until they do.

USING DUE DILIGENCE TO REDUCE RISK

There is no dictionary definition of due diligence but there is no standard "legal" definition either.  Some would probably define technical and commercial due diligence roughly as follows:
A process of commercial investigation made by a prospective purchaser in order to confirm that it is buying what it thinks it is buying.

In the West, "caveat emptor" (buyer beware) is central to the whole acquisition process.  Due diligence is the way that the acquirer makes sure it understands exactly what it is buying. 
Recently the SEC and debt syndicates will demand professional third party reliance letters, so an individual consultant report (or industry report) is de rigueur.

A professional dealmaker (like a private equity firm) would say that due diligence reduces transactional risk.  This usually means reducing the risk of paying too much.  The better the due diligence, the more an acquirer knows about a target and therefore the more it knows about the immediate risks it is taking or to identify points to negotiate a better price.  Therefore, due diligence allows an acquirer to:

• Identify issues relating price negotiations; the risk of paying too much.
• Identify areas where legal protection should be sought e.g.  environment, intellectual property and process costs.

What the buyer does with the assets after the deal is as critical to a deal's final success as profitable acquisition.  Some private equity buyers do not want to do very much and wait for the business cycle to turn up again.  Other buyers are more interventionist or positive and look for rates of return of 30% p.a.

Tecnon OrbiChem looks for the value in M&A as defined by:-

Value = Benefits - Costs x risk factor

POOR DUE DILIGENCE PRACTICES

In our experience, due diligence in the chemical industry is often done badly for the following reasons:-

• Due diligence takes time and costs money (but only a fraction of the total deal) and any costs are unrecoverable should a transaction fail.  Thus the process often starts when a transaction is more or less guaranteed and/or often when "exclusivity" is granted or two-party negotiation commences.
• The third party expert is commissioned after lawyers and accountants have been appointed, leading to duplication of effort, poor time-keeping and poor control of data.
• The vendor deliberately sets an unrealistic timetable for the sale, hoping to force the bidders into making high bids, or not to carry out a thorough due diligence (caveat emptor).  Such situations should be regarded as "hostile" and need special handling, often by specialist and educated third parties to put the vendor in his place, without being part of the negotiations.
• Due diligence is left to the last minute.  Following on from above, the acquirer is unsure of how to set up visits to the sites or to the data room and relies too much on the vendor's prepared "sales" material, such as the "Information Memorandum" (IM) and the "Management Presentation", until the contradictions in these materials emerge.
• The aims of the due diligence are poorly defined.  Due diligence can still be successful even if a transaction fails, especially if the acquirer finds an unacceptable "deal breaker".  In a Polystyrene Resin transaction, Tecnon OrbiChem saved a client a minimum of $20 million in advising its client to stop the deal.  In a PET acquisition, Tecnon OrbiChem saved $300 million in the eventual sales price by advising a "walk away".  Finally in a recent environmental review of a distressed asset, we saved our clients $40 million by reporting on major site liabilities.
• The acquirer may have staff whose remuneration depends on "deals done".  This is the most serious reason not to do poor deals in the chemical industry.  In one case, the acquirer hired a cheap local consultant with no direct experience in the industry concerned, in this case thermoset resins, and had a bonus tied to the overall value of the deal if it went through.  The result was an overpayment of $750 million, or 3 times the real business value.  The asset was sold three years later for a price in line with our evaluation.

The chemical industry has attracted the interest of a number of private equity firms in the last 10 years.  The image of chemicals is one of a mature even ossified industry ripe for "restructuring" by the bright dynamic private equity firms. 

There may be some truth in this but the days of a "cheap" purchase are largely over.  There are some examples left, such as the Celanese takeover by Blackstone, but these are rare.

SUMMARY

The Chemicals and Plastics M&A business is booming and it is possible to make a lot of money in acquiring the right target. 

It is also a fact that a lot of money has been lost by poor due diligence practice.  Identifying the true value of the business is one of Tecnon OrbiChem's special skills.  We prefer to examine all the assets including production, people and markets and are happy to discuss our experience with you.

Tecnon OrbiChem is actively assisting shareholders in the petrochemical industry with its "Due Diligence and Acquisition Support" practices.  We have three teams able to carry out work simultaneously on market/business, production/engineering and finance aspects. 

Acting as an independent third party industry expert, Tecnon OrbiChem provides assistance to banks, finance houses and other potential investors on key issues including:

• Asset Validation - Engineering/Technology
• Non Recourse Financing Support
• Market Leverage Opportunities
• Environmental Due diligence
• Production Efficiencies
• Price Forecasts

Tecnon OrbiChem has found that banks usually require all or part of the above.

Please contact the Tecnon OrbiChem Individual Project Studies Department regarding Mergers & Acquisitions assistance: 

Cressida Godfrey
Tecnon OrbiChem
12 Calico House
Plantation Wharf
London, SW11 3TN, UK

www.orbichem.com

Email:  cressida@orbichem.com
Tel:  +44 20 7924  3955
Fax:  +44 20 7978  5307