Diligence Undone

What Mercury Finance Co. taught BankBoston and the rest of us about the perils of corporate horse-trading.

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When BankBoston announced last January 18 that it was buying a stake in Mercury Finance Co., the bank thought it was getting a great deal in return for all the shares of its own auto lender, Fidelity Acceptance Corp. After all, BankBoston’s investment banker, Merrill Lynch & Co., was pitching Mercury as a terrific investment, rating agencies had blessed its credit as investment grade, and KPMG Peat Marwick LLP had signed off on its financials.

At the time the deal was an-nounced, Mercury’s stock was trading at around $14–roughly 22 times Mercury’s most recently audited earnings. And no wonder. The company was touted far and wide as the best of a new breed of specialty finance companies racking up big profits in the booming business of auto lending (albeit to borrowers with poor credit histories). Mercury was said to be preparing to return to the capital markets for the first time since it went public in 1989.

Then the party came to a crashing halt. Barely three weeks after the announcement, Mercury disclosed that it had overstated earnings. BankBoston, the nation’s 15th largest, with $62 billion in assets, was caught completely off guard. At last count, the auto finance company had apparently overstated its earnings for 1996 and the previous three years by more than 100 percent, up to about $125 million. The stock is now almost all the way down to $2, as the company struggles to stay solvent.

What did the Boston bankers miss? An audit of the company’s 1996 results by Arthur Andersen LLP, which Mercury hired after firing KPMG, still isn’t complete; nor are the investigations reportedly under way by federal authorities. But at this point, the discrepancy appears to be based on inadequate loan loss reserves.

Granted, bankers say loan portfolios are especially difficult to examine because it’s impractical to determine the status of every account in the time frame required to complete a deal. But if anyone should be positioned to discover that a lender was playing accounting games with its loan losses, it would be another lender, especially one with the conservative credentials of BankBoston.

The irony is that BankBoston might not have needed much more information than was already available from Mercury to have detected trouble. One clear indication of Mercury’s woes, in fact, was in full public view several months before BankBoston announced its engagement. This took the form of a footnote to the consolidated financial statements in Mercury’s report to shareholders for the second quarter of 1996. In this footnote, Mercury admitted that it would have to restate its financial results for 1995 because of a mistake made during the fourth quarter of that year.

The problem: Reserves for losses in its life insurance business had been counted twice, once for that business and again as reserves for loan losses, which meant that Mercury had set aside less than it claimed it had. And the likely effect on the bottom line, Mercury said, was that its net income for 1995 would be about $12 million less than it had reported, or about 11 percent.

Some analysts contend it was understandable that BankBoston missed such an admission. “No one reads the footnotes,” says Howard Schilit, the president of the Center for Financial Research & Analysis Inc., a Rockville, Maryland, research firm for institutional investors.

Still, the report was a second, amended statement for the June quarter. A restatement is required by the Securities and Exchange Commission “immediately” after a company detects a problem with an earlier statement, explains John Heine, a commission spokesperson.

“If you see an amended 10-Q,” says Thomas Butler, a partner at Price Waterhouse LLP, “your eyes get wide.” Of course, restatements are required even for minor problems. But Butler notes that an amended 10- Q pointing to a problem involving more than 10 percent of net income could hardly be considered insignificant.

Actually, BankBoston was well aware of the restatement, but insists that it had nothing to do with the problems that KPMG discovered last January. “We thought the change in accounting was an improvement over what they’d done before,” says an insider familiar with the deal. So what does that say about Mercury’s previous practices? BankBoston seems to believe Mercury’s auditor should have done a better job detecting problems. KPMG won’t comment.

In any case, there were other, earlier signs that Mercury’s story was being oversold. Behind the Numbers, an investment advisory service based in Dallas, noted on May 3, 1996, that rising industry competition was hurting the finance company’s profit margins. And Westergaard Online, an investment research and strategic analysis firm in New York City, warned investors against Mercury as far back as early 1995.

“Two things were screwy,” John Westergaard, president of the service, recalled in a newsletter dated January 31, 1997, that reminded subscribers of its prescience. First, Westergaard noted, the company was paying out more than 40 percent of its earnings in dividends, although it was heavily leveraged and purportedly earning more than 30 percent on equity. “Why pay it out when you’re making that kind of a return?” he asked.

Second, at a point when Mercury’s stock was at its highest, selling for 40 times earnings, the company failed to pursue equity financing even though it could have raised a lot for a pittance. “Maybe they were afraid back then of undergoing the scrutiny of due diligence,” Westergaard offered. Given the lack of scrutiny Mercury got from everyone from Merrill Lynch to BankBoston, the auto lender may have had less to fear from the process than it thought.

The bank claims it did thorough due diligence. “If someone’s trying to perpetrate a fraud, chances are they’ll be successful,” says a knowledgeable source. “And the higher up in the company they are, the greater their chances of success.”

But clearly BankBoston could have investigated Mercury Finance more clearly than it did. The fact that the conservative bank and its blue- chip allies made such an embarrassing mistake reflects how often companies stumble in conducting due diligence. Indeed, the news is full of companies with sterling reputations slipping up in their eagerness to close a deal.

With stock prices at an all-time high, such errors are hugely expensive for shareholders. Yet a look at some of the worst experiences suggests a number of practical steps companies can take to make sure that flawed due diligence doesn’t come back to haunt them.

Discount the Hype

For starters, recognize that a high-flying company can be grossly overvalued even if its numbers aren’t fraudulent. Consider Eli Lilly and Co.’s acquisition of PCS Health Systems Inc., a drug discounter, in 1994. At the time, Lilly had great hopes that PCS would benefit from the health-care-reform legislation being pushed by the Clinton Administration.

So did investors. Stock in PCS’s parent company, McKesson Corp., soared from 73.25 to 98 when the deal was announced in July 1994. But in mid-1995, the proposal’s prospects in Congress dimmed and the Federal Trade Commission warned that it would break up such mergers if drugmakers used prescription services to gain an unfair advantage.

In June, Lilly took a $2.4 billion charge to write down its purchase. Observes Thomas Burnett, director of research for Merger Insight, a New York research service for institutional investors: “Perhaps the due diligence was not as skeptical as it might have been.” You can say that again. Lilly, along with PCS investors, vastly overestimated how quickly pharmacies would turn to distributors like PCS to cut costs. “It’s happening,” says Ed West, a Lilly spokesperson. “It’s just taking longer than we expected.”

Sometimes companies mistake glamour for fundamentals. Consider the cases of Sony Corp. hankering after Columbia Pictures Entertainment Inc. in 1989 and Mitsubishi Estate Co. buying Rockefeller Center around the same time. Sony took a big writedown five years later, and Mitsubishi went bankrupt in 1995 as a result of a bad real estate market. More recently, the most common error has seemed to lie in expecting too much from compelling but abstract concepts like “synergy.” Witness the fading hopes for financial magic to be produced by such mergers as Disney/Cap Cities­ABC, Westinghouse/CBS, and British Telecom/MCI.

The frequency of such cases leads Susan Hershman, a principal in the Toronto office of Mercer Management Consulting Ltd., to doubt that acquirers are doing enough financial homework after making an initial offer. While acquirers commonly project increased cash flow from such deals, she says the typical model they employ “doesn’t have the analytical rigor or detailed comprehensive analysis required.” As a result, their valuation process too often amounts to “a quick and dirty guesstimate of how many people you can cut and how many plants you can close.”

On the other hand, no one’s got a crystal ball. “You can’t really project beyond a couple of years with a high degree of accuracy,” says Michael P. Monaco, vice chairman and chief financial officer of HFS Inc., a $2 billion (in revenues) real estate and travel-services conglomerate based in Parsippany, New Jersey. “And you want to win,” says Monaco, “so you have to take some informed risks.” But the operative word here is “informed.”

Give Yourself Enough Time

Start due diligence as early as possible and move efficiently–but not too hastily. The desire to make a deal work puts pressure on the due diligence process. BankBoston announced its deal with Mercury Finance early because it expected the value of the deal to its shareholders to increase as a result. Such a strategy has value, but it puts a crimp on the time spent on due diligence.

Here, so-called strategic buyers may have an advantage, simply because they are usually buying companies that are in allied if not the same businesses, whereas financial buyers– typically buyout firms and other investment companies–have to go to greater lengths to understand a target’s business. “We do less market-related due diligence than a financial buyer would, or than if we were diversifying,” says Frank Sullivan, chief financial officer of RPM Inc., a $1.3 billion (in revenues) maker of specialty chemicals and coatings, based in Medina, Ohio.

It’s possible to spend too long on due diligence. Dragging out the process can undermine an otherwise desirable deal. For one thing, the longer it takes to close, the greater the chance that word will leak. That may lead valuable employees to leave for more secure pastures. If the acquisition target is a public company, leaks may prompt a bid-up of its stock price, raising the cost of the deal to a prohibitive level. If the stock does move in either direction as a result of rumors, the SEC requires the parties to announce that a deal is being contemplated, which may make it harder to keep the price from getting out of hand.

For Sullivan, “speed is an advantage.” A little more than half of RPM’s revenue growth is the result of the 60 acquisitions it has completed since 1971, which work out to more than two a year, with most taking no more than two to three months to complete. “You don’t want to tip your hand to the competition,” says Sullivan.

Although that logically applies in private deals in which a company is being auctioned off by an investment bank, speed is even advantageous when dealing one-on-one with a buyer. “If employees lose interest, companies lose value,” says Butler of Price Waterhouse.

Companies also lose if they move too fast. Even RPM slows down sometimes, particularly when an acquisition candidate raises possible product or environmental liability issues. The potential scope of these liabilities requires a buyer to be extra cautious. “They can bear no relation to the size or profitability of the business, but if a $10 million deal has a $5 million problem, that will kill it,” Sullivan says. “Look at what asbestos has done to multibillion-dollar companies.”

Or consider RPM’s recent acquisition of Tremco, a sealant and coatings company, from The BFGoodrich Co. for $236 million in cash. The deal took six months to close (a long time for RPM), largely because of environmental concerns and product-liability issues. “We got a few things changed,” Sullivan explains, declining to be more specific. “You can’t practice speed to a fault.”

Do Your Own Audit

Unless you’re gambling, don’t rely on audited financial statements alone. As Mercury Finance shows, even Big Six accounting firms can fall down on the job. Some analysts agree that fraud is difficult if not impossible to detect if you take what’s delivered to the SEC at face value. Yet the kind of accounting that skeptical dealmakers routinely employ could have revealed something amiss at Mercury Finance.

These buyers do not rely on a seller’s audited financials, but bring in their own auditors to do what’s known as a technical review of the work papers of the seller’s accountants. This will tell the buyer’s auditors how accurately the seller’s accounting reflects its revenues, expenses, assets, and liabilities. Even so, this still amounts to only a confirmation that the numbers are basically in compliance with GAAP, says Arthur Rosenbloom, a partner in the New York M&A firm of Patricof & Co. Capital Corp. Says Rosenbloom: “As we all know, accounting is an art and not a science.”

So he says it’s imperative to do a “substantive” review to determine the seller’s quality of earnings. The basic question here, he says, is, “Have the earnings been massaged?” After all, it is a not- uncommon practice to accelerate receivables and delay payables or cut back on research and development and “beggar future earnings,” says Rosenbloom. “If I want to show a greater profit for a current period, I can play some games that are consistent with GAAP,” he notes. “Eventually, they catch up with you, but by then you’re past the closing.”

To ferret out such games, says Rosenbloom, you have to look at the historical patterns of a company’s results. HFS, for example, will routinely sample a week’s worth of a target’s book entries just to see how many adjustments the numbers undergo as they’re accounted for.

Of course, you aren’t just looking for problems. “You’re trying to validate the strategic premise of the deal,” says CFO Monaco. To see just how profitable a company is, he says, you need to see how efficient it is, and “the less human intervention you see in the accounting, the better.”

If HFS suspects there’s so much “intervention” that fraud may be involved, it will enlarge the scope of its review of book entries to cover a greater period. What about including a forensic accountant from the start? There’s a downside here. “You can’t go in like you’re a prosecutor in a criminal case,” says Stephan Haimo, a partner in the New York law firm of Stroock & Stroock & Lavan LLP. “You don’t want to cross-examine people to the point where they’re angry about being called onto the carpet.” Of course, that assumes you aren’t dealing with another Mercury Finance.

Accounting gamesmanship won’t necessarily drive HFS away. If a company’s fundamentals are still attractive, HFS may try to renegotiate the price, seek protection against surprises through contractual “representations and warranties,” or put part of the purchase price into escrow. But to do that, it must still be satisfied that a deal is cash-flow positive and immediately additive to earnings. Otherwise, HFS will walk away, as it did earlier this year after initially agreeing to acquire Value Rent-A-Car for $175 million from Mitsubishi Motors of America Inc.

While substantive reviews are standard operating procedure for HFS, BankBoston evidently didn’t undertake anything close to one in the case of Mercury Finance.

Beware of Overconfidence

It’s easy to dismiss the need for due diligence if you’re confident of your own talents for making a deal work. But hubris is dangerous, says Haimo, particularly when it comes to assessing the potential of new products. He cites the case of a client that wanted to divest itself of a high-tech defense business based on hand-held devices that pinpoint an object’s location, technology that U.S. and allied troops used to devastating effect during the Gulf War. Although the company saw significant commercial potential in the technology, it could not get a firm enough handle on development costs, so it decided to sell it off. Luckily, it found a buyer with no such doubts. “They came in with a great degree of arrogance about their ability to get control of the costs,” says Haimo. “But they miscalculated,” and now all they have is “a bundle of assets and liabilities” that produce no profit. In other words, he says, “we sold well.”

Hire Good Lawyers

Insurance companies are happy enough to sell products designed to protect against many surprises that have little or nothing to do with the basic business. These include not only potential court damages for environmental and product liability but also underaccruals for workers’ compensation, pensions, and postretirement health coverage (see “Just in Case,” page 43).

But some potential buyers believe that insurers themselves are so risk adverse, especially in product liability, that coverage isn’t worth the cost of the premiums. Yet to live without such coverage requires buyers to have enough legal and actuarial expertise to assess the extent of such liabilities on their own. Consider Johnson & Johnson Inc.’s extensive courtship of Cordis Corp., a cardiovascular-device maker that J&J bought in February 1996. J&J worried about potential liability stemming from lawsuits involving a pacemaker business that Cordis once owned. While it considered insurance, J&J in the end satisfied itself that the worst-case scenario was something it could handle. How? Its lawyers examined such variables as the potential failure rate based on the number of products sold by Cordis that had exhibited the problem, the number of lawsuits Cordis had faced, and the average cost of settlements or jury awards. That assured Robert Darretta, J&J’s vice president of finance and CFO, that the risk was “tolerable” at the price of $109 a share that J&J agreed to pay for Cordis. “You’ll always uncover surprises in the course of due diligence,” Darretta notes. “The question is how material they are.”

Don’t Shoot The Messenger

Yet another obstacle to effective due diligence, says Haimo, is a natural tendency for a due diligence team to confirm rather than contradict management’s expectations. “You’re not necessarily looking for something to be wrong,” he says. That’s why it’s critical that senior management closely oversee the due diligence team. Sullivan stresses that he’s involved in every due diligence review that RPM conducts.

But that isn’t always possible. William Shea, BankBoston’s former CFO and vice chairman, was excluded from its review of Mercury, even though he was in charge of Fidelity Acceptance, which was finally unloaded to Norwest Corp. of Minneapolis in late June. Shea’s exclusion was designed to make sure the due diligence review was objective, says Karen Schwartzman, a spokesperson for BankBoston. “Shea was specifically not involved, so as to have this be an arm’s length deal,” Schwartzman explains. Shea resigned a few weeks after Fidelity Acceptance was sold. Having seen that deal to completion, along with the integration of BayBanks Inc., which BankBoston acquired last year, Shea left to pursue an “entrepreneurial” opportunity that he had long coveted, says the spokesperson.

Know What You Know

Ultimately, due diligence is a proxy for price, and vice versa. Asked how he would perform due diligence on a company whose numbers were hard to penetrate, one CFO advises, “Buy it cheap.”

Some analysts thought British Telecom (BT) was doing precisely that when it agreed to buy MCI last November for $22 billion in cash and stock. They applauded the deal as a great “strategic” move by the British telecommunications company. After all, it should be able to deploy its capital more effectively in MCI’s markets than in the United Kingdom, where BT is steadily losing market share as its erstwhile monopoly is picked apart.

A few weeks ago, however, MCI disclosed that it will have to spend about twice as much as anticipated to meet its own growth projections in local service. Furthermore, its core long- distance business is growing at a clip of less than 5 percent, not the 8 percent or better that BT anticipated. But the deal hasn’t closed, and with the value of MCI’s stock falling, it’s now about 25 percent more expensive for BT than it was when it was announced.

So perhaps calling a deal “strategic” is just an excuse for overpaying. After all, financial buyers are able to live with a greater degree of uncertainty only because they insist on paying less for the same company than a strategic buyer would. In any case, the bottom line for finance executives is this: The more you know about the company, your industry, and the market, the better you can bid. If you can’t know everything you’d like, at least know what you don’t know. Otherwise, the risks you take will be anything but “informed.”

JUST IN CASE

If due diligence leaves you with doubts about a company’s liabilities but you still want to do a deal, insurance is often available. It may even be worthwhile. Indeed, the average deal is completed at a price that fails to take into account roughly $6 million in underestimated liabilities, says Neil Krauter, vice chairman of Aon Risk Services Inc., a Chicago-based insurance broker.

But Krauter says most of the causes of underaccruals involving workers’ compensation or other benefits are easy enough to quantify and cover. And, he says, many accounting problems can be covered under a standard policy dealing with the “representations and warranties” of a contract.

The typical premium for such coverage, says Krauter, is 80 percent of the anticipated underaccrual. If, for instance, due diligence uncovers $10 million in underaccrued liabilities for workers’ compensation, Aon would “buy it out” for about $8 million, says Krauter. But the cost varies with the type of risk. With environmental liability, for example, the premium usually depends on how much upside protection is actually needed. If, for example, the insurance covers any amount of liability up to $15 million, the premium would run anywhere from several hundred thousand dollars to as much as $1 million, depending on how far short of the $15 million cap the liability falls.

Policies that cover underaccruals arising from pension plans and postretirement health coverage are harder to design, says Krauter, because cost projections are so iffy. But Aon is working on a product designed to cover such a liability that would prevent a deal from going through unless Aon could get rid of it. The hang-up is matching the right type of investment product with insurance, he says.

While coverage for fraud and other malfeasance is more straightforward, such policies are hard to price in the United States, “because we’re such a litigious society,” says Krauter, noting, “It’s deal by deal by deal.” As a result, such coverage is more widely available abroad, largely from Lloyd’s of London. Yet fraud policies are increasingly available in this country as well, with American International Group Inc. the primary underwriter.

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