Due diligence: delistings versus private transactions

Due to delistings

Due diligence: delistings versus private transactions

University: University of Groningen

Faculty: Faculty of Economics and Business Master: Msc Business Administration:

Finance: Corporate Financial Management Author: Robert Sturing

Student number: 1508687

Date: July, 2008

Supervisors University: Mr. W. Westerman and Mr W.W. Wijnbeek

Supervisors Ernst & Young: Mr. A. B. De Jong and Ms. C. Ramaker

Acknowledgements

With this thesis I finish my master Corporate Financial Management and as a result my study at the University of Groningen. During the four years I studied at this wonderful location I became a knowledgeable person in the field of Finance. However, the missing link in these four years was to put theory in practice. Ernst & Young offered me the opportunity to test my theoretical backgrounds and knowledge in practice. Therefore, the time I spent at Ernst & Young Transaction Advisory Services is one of the highlights of my academic career. As a result, first of all I would like to thank the company Ernst & Young for offering me an internship and the opportunity to write a thesis in cooperation with them. Moreover, I would like to thank a number of people for their assistance and feedback during writing this thesis. Of course, my supervisors form Ernst and Young, Chantal Ramaker and Aron de Jong, deserve a notification on this place.

Further, also my supervisor from the University of Groningen, Mr. W. Westerman deserves it to be mentioned here. Moreover, I would like to thank all the other people from Ernst & Young (and especially from TAS Apeldoorn) who helped, advised, supported, answered my questions and provided me with a considerable amount of information during this period.

There are several other people I would like to thank. Unfortunately, this people can not be named here. Because of confidentiality reasons this thesis is written on a no-name basis and therefore no names of companies and advisors are documented. I would like to thank the people and companies who cooperated in the thesis by this way and would like to notice that they are on my mind when writing these acknowledgements.

Apeldoorn, July 2008.

Robert Sturing

Abstract

From the literature it appears that acquisitions are not without risks and therefore a proper due diligence is relevant to trace these risks in advance. However, existing literature only documents about due diligence processes in private transactions. Nothing is known about these processes regarding delistings. This raises the important question if due diligence processes of delistings differ from that of private transactions. This thesis provides an explanation to this question by considering the influences of legal requirements and warranties, representations and indemnities in the process. To provide for a proper understanding of the legal requirements, also the acquisition processes of both transactions are under study. A case study is conducted where the acquisition and due diligence processes of listed companies and private transactions are compared to each other.

From the results it can be concluded that the acquisition process of delistings and private

transactions are different from each other and from the standard acquisition process specified in

the literature. Moreover, it appears that the influence of regulatory requirements in delistings is

significant and two-sided; it is assumed that corporate governance and listing requirements assure

that financial numbers and business are managed in a right way and that requirement influences

the acquisition process of delistings from start until closing. Furthermore, in delistings, no

representations, warranties and indemnities can be derived because there is no source for

indemnification. In private transactions, because of the controlled auctions, a trade-off has to be

found between price, conditions and warranties, representations and indemnities and speed of the

process.

Table of content

Acknowledgements…….…….……….1

Abstract……….………2

Table of content….……..………….………3

I Introduction…………. …..……….5

II Review of the literature………... 6

II.I Due diligence and objective of due diligence 6

II.II.I Position of due diligence in the acquisition process 7

II.II.II Due diligence methodology 8

II.III Level and scope of due diligence 9

II.III.I Level of due diligence 9

II.III.II Scope of due diligence 10

II.IV Due diligence from a legal perspective 11

II.V Types of acquisitions 15 II.VI Legal aspects in the processes 16

II.VI.I Current legal and regulatory requirements 17

II.VI.II Warranties, representations and indemnities 18

III Research objective, Methodology and Data………19

III.I Research objective and research question 19 III.II Methodology 20

III.II.I Case study research 20 III.II.II Case selection criteria 21

III.III Data 22 III.III.I Data sources 22 III.III.II Interviews 23

IV Results………..25

IV.I Delistings 25

IV.I.I The acquisition process 25

IV.I.II Legal and regulatory influences 28

IV.I.III Warranties, representations and indemnities 29

IV.II Private transactions 30

IV.II.I The acquisition process 31

IV.II.II Legal and regulatory influences 33

IV.II.III Warranties, representations and indemnities 35

IV.III Analysis of differences and similarities 35

V Conclusion and recommendations………...42 References...47 Appendices

Appendix I Figure delistings over the years 2004 - 2007 Appendix II Interview questions

Appendix III Detailed acquisition processes

Appendix IV Description of the regulatory requirements of the AFM Appendix V Summary description of cases: delistings

Appendix VI Summary description of cases: private transactions

I Introduction

Last year, an all-time high deal value of delistings of 27 billion euros was recorded at the Amsterdam stock exchange; Euronext Amsterdam.

Among these deals was the acquisition of Numico by Danone. Given the fact that the probability a merger or acquisition fails is about 35%

to 75% (Pautler, 2001) it is remarkable that in this particular acquisition hardly any due diligence was conducted. Danone came up with a knock out bid and the deal was closed in 48 hours. This raises the important question raises if due diligence is still needed in the field of acquisitions.

Previous studies only give frameworks how to handle with the different phases in the acquisition and due diligence process in the case of a private transaction. As a consequence, hardly any literature regarding delistings is available. Delistings seems to be a new phenomenon and the acquisition and due diligence process of delistings might be different from private transactions.

This thesis is meant to provide a description of the differences and similarities in the acquisition and due diligence process of delistings and private transactions in view of legal influences into these processes. The legal influences that are examined are regulatory requirements and warranties, representations and indemnities.

One of the activities of Ernst & Young is to provide support and advice in mergers and acquisitions by her service line Transaction Advisory Services (TAS). For TAS it is relevant to get a clearer insight into different transactions because being informed about it provides for a better preparation before and anticipation during the particular transaction. In that way, better decisions in the acquisition process as well as in the due diligence process can be made.

The remainder of the thesis is structured as follows. In section II a review of the literature is given; the meaning, the level and the scope of due diligence is discussed. Furthermore, a description of the acquisition and due diligence process is given. Also possible transactions and the use of warranties, representations and indemnities in acquisitions are discussed. Section III contains the research question, the data and the methodology. The results are presented in section IV, whereas section V concludes and gives some recommendations.

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II Review of the literature

A general introduction to due diligence is given below. The exact meaning of due diligence and the objectives of due diligence are explained in section 2.1. The position of due diligence in the acquisition process and the methodology for conducting due diligence are mentioned in section 2.2 and the level and scope of due diligence is discussed in section 2.3. After that, in section 2.4 the study sheds light on due diligence from a legal perspective; the use of warranties, representations and indemnifications is explained. Section 2.5 provides a framework of types of acquisitions and section 2.6 relates this framework to legal influences with respect to regulatory requirements and warranties, representations and indemnities.

II.I Due diligence and objective of due diligence

Although due diligence is widely used in mergers and acquisitions, the academic world has not given much attention to this topic.

Goldberg (1999) describes due diligence as the process by which the purchaser challenges the representations made by the target company about its historical and current financial performance, financial condition, future prospects, and operational matters. It is also the process by which a buyer challenges its own understanding of the target company. This thesis uses the definition of Ernst & Young (2004). That definition describes due diligence as an investigation to financial, commercial, juridical, strategic and other aspects of the target. Besides that, the due diligence research is based on available information of the target supplemented with independent obtained information about the target.

Due diligence is intended to be an objective, independent examination of the acquisition

target (Angwin, 1995). To meet these goals, due diligence requires gathering information to

assess all risks associated with the transaction. This includes risks that may unreasonably increase

the overall cost of the transaction or that may result in the entire transaction being called off. By

uncovering these risks, the purchaser can decide whether to proceed, to modify the terms

(possibly a reduction in price), restructure the transaction, negotiate additional representation,

warranties and indemnities or abandon the transaction entirely (Goldberg, 1999, Ernst & Young, 2004).

Section 2.2.1 provides insight to where exactly in the acquisition process due diligence is/should be conducted.

II.II.I Position of due diligence in the acquisition process

Because every company and each transaction is different, there exists no one size fits all approach for an acquisition process. However, most steps involved in the process are quite similar, although timing and contents will differ. Ernst & Young Transaction Advisory Services (2004) has defined nine steps in the acquisition process (See figure 1)

, which is used in this thesis as the standard acquisition process.

Due diligence normally occurs after the parties to a deal have decided the deal is financially feasible and after a preliminary understanding has been reached (or appears researchable), but before a binding contract is signed (Bing, 1996). In the Netherlands a

2

Ernst & Young (2004) further mention that it is also possible that targets approaches potential buyers by 1. Strategic considerations

2. Search for a target

3. First meetings and negotiations

4. Target selection based on criteria

5. Valuation

6. First negotiations about price, conditions and structure of

transaction

7. Letter of intent

8.1 Due diligence

8.2 Negotiations (adjustment transaction price and conditions)

Review of the balance sheet Closing audit of the balance sheet

9 Post transaction services 8.3 Buy agreement

Figure I

Nine steps in the acquisition process.

Source: Ernst & Young (2004)

letter of intent is binding and contains the negotiated transaction structure, transaction price and warranties and representations (Calkoen, 1992). Therefore, signing a letter of intent means that the buyer cannot walk away from the deal for a bad reason; this is only possible with new facts.

However, Raaijmakers (2002) mention that it depends on the content of the letter of intent if it is a binding agreement.

Due diligence thus takes place when negotiations are in an advanced stadium and starting-points are secured in a letter of intent. However, the possibility exists that this information is dressed up and does not meet the requirements secured in the letter of intent. The buyer wants a verification that the target is essentially what it seems to be (determining this, by means of interviews, document study and on-site inspections, is the fundamental objective of due diligence) and that the investment complies with investors criteria (Bing 1996).

Because the focus of this study is also on due diligence, section 2.2.2 zooms in on the due diligence methodology.

II.II.II Due diligence methodology

Ernst & Young (2004) introduced a methodology for their projects reflected in figure 2. The due diligence process (step 8) is split up in five phases, which are discussed briefly.

8.1.1; This phase includes insights and issues about the deal.

This includes background information and an examination into the market and the business the target company operates.

8.1.2; According to Bing (1996) due diligence can be accomplished successfully if it is preceded by careful planning.

Such planning includes the assessment of available resources, the estimation of risk, selection of management, the recognition of the consequences of failure, the identification of possible obstacles to the deal, the definition of the deal’s scope; all of which lead to the crucial decisions essential to produce the results one wants to achieve.

8.1.3; In this phase the due diligence investigation takes place, even so the accountant’s files can be reviewed.

Source: Ernst & Young (2004)

Figure II

8.1.5 Completion in the due diligence process

five phases 8.1.1 Preparation

8.1.2 Planning 8.1.3 Investigation

8.1.4 Reporting

8.1.4; The due diligence report is written and consists of findings and recommendations, specific subjects and quality of the information with analysis and specification.

8.1.5; This phase contains deal negotiation, signing of the sale and purchase agreement (SPA), making a closing audit and reviewing the acquisitions balance sheet and profit and loss account.

II.III Level and scope of due diligence

Section 2.2.2 mentioned the preparation and planning phase in the due diligence methodology. Two aspects that have to be taken into account regarding this phases are the level and scope of due diligence. These are discussed below.

II.III.I Level of due diligence

Harvey and Lusch (1995) argue that a variety of issues can directly impact the level of due diligence conducted during the acquisition process. They categorize them as time restrictions, cost constraints and situational factors.

Time restrictions may be an important factor in many deals. When this constraint is present, it is often the case that, beyond the major financial, legal, tax, and future sales projections, an effective examination of the target acquisition does not occur.

Cost constraints are usually a function of the size of the deal. If the deal is relatively small it will be viewed as uneconomic to invest a lot in due diligence because the personnel involved will have other things they can be doing that are more important. Furthermore, it has been quite often viewed as too expensive to bring in experts in every functional area of the target company (Hearne & Dean, 1989).

Cost and time constraints also need to be viewed in terms of using warranties and representations to remedy problems that are not uncovered during the due diligence process (Harmon, 1992).

A variety of situational factors, most notably foreign acquisitions and hostile takeovers, have

been said to warrant a shortcut to due diligence in the past. The competitive nature of bidding for

a company has required less than well-articulated due diligence.

In addition, Bing (2001) argues that the objectives and results one hopes to attain with due diligence must be equated with the number of people involved and the amount of money and other resources one has. Further, it depends on the amount of risk one would accept.

II.III.II Scope of due diligence

Due diligence is a concept from corporate law, therefore, traditional due diligence focused on the tangible, internal environment examined by lawyers and accountants (Harvey and Lusch, 1995). The attention of these auditors was primarily focused on verifying historical data and affixing value to the tangible assets of the company. Therefore, due diligence conducted in this way becomes an exercise in verifying the target's financial statements rather than conducting a fair analysis of the deal's strategic logic and the acquirer's ability to realize value from it (Cullinan et al., 2004).

The scope of due diligence is extended in last years; Cullinan et al. (2004) found that successful acquirers view due diligence as much more than an exercise in verifying data now.

While they go through the numbers deeply and thoroughly, they also put the broader, strategic rationale for their acquisitions under the microscope.

In order to be useful in valuing and negotiating deals and in line with effectively integrating and managing the acquired business, Harvey and Lusch (1995), Goldberg (1999), Kissin and Herrera (1990) and Angwin (1995), come to nine fields that need to be investigated in a comprehensive due diligence process (see table I). These fields are; macro-environment, legal, marketing, production, human resource, management, information system, financial and tax, and culture.

Source: Harvey and Lusch (1995)

Culture

Macro-environment Legal

Marketing Production Human resource Management Information system Financial and tax

infrastructure, organization structure complexity, comparability

cash management, tax liabilities, bank relationship accounting standards, control regulations

intellectual property rights, ownership of securities environment, system and functions review

technology, systems and processes

personnel, contracts, training, employee relations Table I

Fields that need to be investigated for a comprehensive due diligence Examples

management philosophy, impact on industry

Audit

.

Goldberg (1999) further suggests examining the ownership of the entity, any restrictions on the transfer of stock or assets, any consent required to transfer the business, outstanding stock options, and restrictions on dividend payments to shareholders. Moreover, one has to ensure that the representative of the target company has in fact been authorized to engage in negotiations. In addition, do determine whether the business is in good standing and lawfully

operating in all jurisdictions where it conducts business.

Harvey and Lusch (1995) mention that the due diligence process should be as comprehensive as time and money will allow. Therefore, it is recommended that the audits are conducted sequentially in a way like figure III. Each step in the sequence has to confirm the viability of the deal before subsequent audits are conducted. Ernst & Young (2004) argue that the elements a potential buyer wants to be included in the due diligence depend on the type of target and the risks involved.

This study investigates if the scope of due diligence differs between delistings and private deals. One aspect that might cause differences in this scope is the legal aspect. Therefore, in section 2.4 the legal perspective of due diligence is discussed.

II.IV Due diligence from a legal perspective

Practice shows that in a considerable amount of countries complex procedures of investigating information about target companies (due diligence) are being employed and that sale and purchase agreements (SPA) contain even more detailed warranties (Calkoen, 1992). In the discussion that follows, warranties are defined as warranties, representations and indemnities (in Dutch: garanties, borgstellingen en vrijwaringen).

Failure to use warranties could lead to implications such as liability to third parties or criminal liability. Examples of type of liabilities that purchasers of business unknowingly assume are; environmental liabilities, employee benefit plan liabilities and product liabilities (Bing, 1996).

1.Financial audit

2.Legal audit

3.Macro- environment audit

4.Marketing/manage ment audit

5.Information systems audit

Figure III Due diligence audit

sequence

Source: Harvey and

Lusch (1995)

Therefore, to protect investors, part of the due diligence process in many transactions includes the drafting of contracts and other documents (like the letter of intent and the SPA) that contain appropriate representations and warranties that elicit information and identify and address the transaction’s risk (Calkoen 1992). Proper due diligence may serve as a legal defense to third party claims after closing of the transaction and should therefore also identify unwanted liabilities and obligations and any unexpected or unforeseen risks or business problems. A complete lack of due diligence, or only a cursory due diligence if there are obvious purchaser concerns, could be viewed as reckless. Furthermore, a thorough due diligence will serve as sound evidence against any claim or defense the seller could rise about the investor’s due diligence (Bing, 2001).

However, as Calkoen (1992) argues, the due diligence researcher has to become acquainted with all ins and outs of the target company in a very short time. The researcher has to identify the risks based on limited information, made available by the seller. The investigation of the buyer therefore extends to a verification of the information disclosed by the seller. In contrast, the seller does not want a broad and thorough due diligence given the risks of a downwards price adjustment.

Therefore, a contradiction between seller and buyer arises. Because the advisor in this thesis represents the buyer, the researcher is confronted with this contradiction. In such cases, the researcher has limited access to information and to people of the target (Ernst & Young, 2004).

As a result, it is impossible to investigate everything and to establish the accuracy of all the information obtained in the due diligence process. Therefore, the final step in the acquisition process consists of the warranties given by the seller to the buyer for all those cases in which the buyer suffers damage as a result of any inaccuracies in the information disclosed or of any information withheld, unless the buyer was acquainted, or should haven been acquainted with such information through his own investigations (Calkoen, 1992).

There is a certain relationship between these three elements (investigation, disclosure,

warranties) on which the negotiating parties must try and reach agreement. The more information

the seller has supplied and the more opportunities the buyer has been offered to carry out his own

investigations, the less reason or willingness there will be on the part of the seller to give

warranties to the buyer, and vice versa (Raaijmakers, 2002).

In the Netherlands, warranties and indemnities are included in the SPA (Calkoen, 1992). It is common experience that the combination of investigations and warranties does not cover everything and can never be entirely watertight. Dutch law prescribes that the parties to an agreement must act in good faith towards each other. This good faith doctrine has two elements.

The first is that it can fill gaps in the agreement. On the other hand, the good faith doctrine may provide the basis for liability if it should emerge that the seller has withheld essential information from the buyer.

In view of the representations and warranties included in the acquisition agreement, it is often agreed that in the event of a breach of any representation, warranty, covenant or commitment made to the buyer in the agreement, the seller shall, on demand, pay to the buyer the amount of damage suffered by the buyer as a result of the breach, without prejudice to any other remedy which he may otherwise have. If the seller fails to pay, the buyer shall be entitled to deduct such amount from any payment made under the agreement. When the parties complete the agreement, it is not unusual to keep part of the purchase price in escrow for a specified period as security for warranties (Calkoen, 1992).

According to Hutchison and Mason (2004), regardless of the structure of the transaction, acquisition agreements have the following four common and very important characteristics;

representations and warranties, pre-closing covenants, conditions precedent to closing and indemnification. Indemnification is examined in detail here, whereas pre-closing covenants and conditions to closing are discussed briefly. The discussion about warranties and representations above should be sufficient to understand the relevance of this concept.

Pre-closing covenants

There are two types of covenants: negative covenants and affirmative covenants. The former

restrict the seller from taking actions prior to the closing without the buyer’s prior consent. This

protects the buyer from the seller taking actions prior to the closing that change the business that

the buyer expects to buy at the closing. A typical covenant is to not paying dividends or making

any other distributions to shareholders. Affirmative covenants obligate the seller or buyer to take

certain actions prior to the closing. A typical affirmative covenant is to allow the buyer full access to the seller’s books, records, and other properties.

Conditions to closing

Conditions to closing are certain obligations that must be fulfilled in order to legally require the other party to close the transaction. Common closing conditions are that the representations and warranties of the parties must be true and correct, and that the pre-closing covenants have been performed or fulfilled prior to the closing.

Indemnification

The last major feature of a typical merger and acquisition agreement is indemnification.

Indemnification provisions protect the parties from certain matters that occur after the closing and allocate the risks and responsibilities for the occurrences between the buyer and the seller. It typically addresses breaches of covenants or representations and warranties that are discovered after the closing. Typical request for indemnification, beyond representations and warranties, are for environmental, pending litigation and tax liabilities. Such provisions are generally heavily negotiated and the seller will seek to limit its post-closing indemnification obligations in several ways.

Firstly, the seller will try to limit the time period after the closing for which it has obligations.

In theory, this time period should be based upon a reasonable period within which the buyer, through reasonable due diligence, should have discovered the breach and/or misinterpretation.

Secondly, the seller will try to impose a cap on the total amount of its indemnification liability. Many sellers try to cap their liability at an amount less than the total purchase price. The buyer mostly agrees to a cap equal to the total purchase price. However, if the seller’s business is

‘clean’, the risk to the buyer in agreeing to an indemnification may be small.

Thirdly, the seller will try to negotiate a basket on its indemnification obligations in order to

eliminate small claims. This provides that the seller does not have liability to the buyer until the

amount of the buyers’ losses exceeds a certain amount.

In order to ensure that there are funds available to satisfy the seller’s indemnification obligations, the buyer may require that a portion of the purchase price be held in escrow by a third party for a period of time after closing. Alternatively, the buyer may hold back a portion of the purchase price and give the seller a promissory note for that portion but retain the right to offset the promissory note to satisfy its indemnification problem.

However, indemnification provisions are unusual in agreements for acquisition of a public company, because in principle the shareholders are anonymous there is usually no source of indemnification after a publicly quoted target is acquired (Lehrer, 2006). A delisting is a form of an acquisition of a publicly quoted company and is discussed in the next section as well as other forms of acquisitions.

II.V Types of acquisitions

Table II illustrates a basic overview of possible transactions according to delistings and private transactions.

The table shows that acquisitions of publicly traded companies listed on a stock exchange (defined here as a public company) and acquisitions of private companies by

another party results in four different types of transactions. A delisting can be described as one listed company that acquires another listed company or when a private company acquires a public company. The other two are transactions in which a private company is acquired; a private company that acquires another private company and a public company that acquires a private company. This thesis focuses on the middle two transactions in the shaded area of table II (section 2.6 provide the rationale behind this choice).

However, table II is a simplified version of the complex world of acquisitions with respect to buyers and targets. Because the sale of a company can take many forms, one important distinction exists between strategic and financial buyers. For public companies these forms include going private-transactions, public take-out transactions and public mergers (PiperJaffray, 2007). A going-private transaction is defined here as the sale of a public company to a private equity group in an all-cash transaction. Similarly, a public take-out is defined as a transaction in

Buyer Target Delisting

Public acquires Public yes Private acquires Public yes Private acquires Private no Public acquires Private no

Table II

Overview of possible transactions

which the acquired (target) company’s shareholders receive cash as the form of consideration in a sale to a strategic buyer. Conversely, public mergers are defined as stock-for-stock transactions in the public market. This focus of this thesis is on the category where a company is delisted because of an acquisition by private equity parties in a so-called buyout. However, the purpose of this thesis is to analyze the differences with private transactions. Therefore, also buy-outs of private transactions are considered.

Van der Wurf and Mertens (2001) make a distinction between buy-outs of private and public companies. A delisting is named a public-to-private transaction and described as a special form of a buy-out. According to De Jong et al. (2007) the market for buy-outs includes three types of transactions, (i) the acquisition of an publicly traded company (public-to-private), (ii) divestment of a division of a publicly traded company (unit buy-out), and (iii) (management) buyouts of non- publicly traded companies (private-to-private).

As table 2 illustrates, the focus of this thesis is on public-to-private transactions (delistings) and private-to-private transactions (private transactions).

II.VI Legal aspects in the processes

Based on the literature above, two variables have not got the attention in the literature they deserve in explaining the differences between delistings and private transactions in the acquisition and due diligence process. These two are legal and regulatory requirements and warranties, representations and indemnities. Table 3 provides an overview of the legal influences in the type of acquisitions described in section 2.5 as well as the possibility to negotiate representations, warranties and indemnities. It shows that the legal and regulatory influences

Table III

Overview of the influence of legal and regulatory requirements and the possiblity to negotiate representations, warranties and indem nities for the different types of transactions

Buyer Target

Influence of legal and regulatory requirements

Possibility to negotiate reps.,warr. and indemn.

Public acquires Public high no

Private acquires Public high no

Private acquires Private low yes

Public acquires Private m iddle yes

differs the most between the middle two acquisitions. Furthermore, it shows that when a public target is acquired there are no possibilities to negotiate representations, warranties and indemnities and this differs when a private company is acquired. This might cause important differences between the due diligence and acquisition processes in the different acquisitions and is therefore an interesting aspect to investigate. From the literature above it appears that representations, warranties and indemnities are already specified in the letter of intent and in the final SPA new guarantees are derived. For this reason and to provide for a proper understanding of the legal requirements, also the acquisition processes (also specified in the literature above) of both transactions are under study.

Section 2.4.1 provides a discussion about the current legal and regulatory requirements whereas section 2.4.2 relates warranties, representations and indemnities to the acquisition and due diligence process.

II.VI.I Current legal and regulatory requirements

PiperJaffray (2007) studied delistings from the perspective of the management of the selling firm. They mention the following internal motivations for public companies pursuing a delisting;

increased corporate governance requirements (e.g. due to Sarbanes-Oxley), increased costs associated with operating as a public company, heightened emphasis by boards of directors to seek the value maximizing strategy and, substantial strain on management resources, including:

reporting and investor relation requirements (quarterly and annual reports, press release issuances, research analyst discussions, shareholder discussions and investor conferences) and business and operating strategy diversion resulting from being public (near term focus, such as managing quarterly results).

Reed Lajoux and Elson (2000) mention that any company that has issued securities has

already been subject to a due diligence study by underwriters and their counsel in preparing the

company’s original prospectus. Acquirers, then, can use the company’s prospectus as a guide,

and can rely to some extent on the due diligence that the prospectus required. The extent of this

due diligence will depend on the size of the offering and the history of the company’s previous

security registrations. However, in the Netherlands, for a listing on the stock exchange, no

specifications about due diligence are prescribed by the Netherlands Authority for the Financial

Markets (AFM), which is the institution that monitors the open market (Euronext Amsterdam) in the Netherlands.

Public companies in the Netherlands are subject to regulatory requirements rules stated by the AFM in the Dutch Securities Trade Supervision Decree 1995 (in Dutch: Besluit toezicht effectenverkeer 1995 (Ministry of Finance, 2005)) (Raaijmakers, 2002).

In addition, the AFM has specified rules about news announcements with reference to confidentiality. The more people know about the transaction, the greater the chance that someone will leak confidential information to the press. Public acquaintance about the sale of the company can cause negative effects for business operations because of the uncertain situation for employees, trade creditors and other involved third parties (Raaijmakers, 2002). Therefore, a confidentiality statement is signed before the first negotiations start (Raaijmakers, 2002).

In contrary, private companies in principle are not subject to these stringent rules. For example, the Sarbanes-Oxley Act of 2002 directly applies to SEC reporting public companies only and therefore less information is public available (Donahue, 2006).

Furthermore, Donahue (2006) reveals that these rules have effect in public company acquirers of extending due diligence periods, increasing deal costs and even impacting deal pricing. Therefore, public companies may find themselves at a disadvantage when negotiating against buy-out funds and private bidders.

II.IV.II Warranties, representations and indemnities

Harmon (1992) mentioned that cost and time constraints also need to be viewed in terms of using warranties and representations to remedy problems that are not uncovered during the due diligence process. However, whereas in private transactions it is in principle possible to derive detailed agreements about pricing mechanisms, warranties, representations and indemnities in public deals these cannot be used because there is usually no source of indemnification after a publicly quoted target is acquired (Lehrer, 2006). This is because in principle the shareholders are anonymous.

As a result, in a delisting, realistic estimates have to be made about current and future risks

about, for example, a potential claim. This should be discounted into the purchase price

(Raaijmakers, 2002). However, to justify that the purchase price is lower than the market price,

shareholders should be informed about the value of the discounted claim. This can cause problems because in theory new information is not possible. According to Capron and Shen (2007) the market of corporate control for public targets already serves as an information- processing and asset valuation mechanism for all potential bidders. In addition, negative information provides for a signal of an overvalued company (Grinblatt and Titman, 2002).

In private transactions the due diligence process also has to provide insights and realistic estimates about the future risks of the business because warranties and representations have a limited duration after the closing (Raaijmakers, 2002). Another important aspect that has to be considered is that the buyer has a ‘duty to investigate’; therefore the buyer cannot rely on warranties entirely. On the other side, the seller is responsible to disclose information; ‘duty to disclose’ (Ernst & Young, 2004). As a result, not everything can be reckless secured into representations, warranties and indemnities. As Bing (1996) notes, such provisions are no substitute for careful due diligence.

III Research objective, Methodology and Data

In this section the research design, methodology and data used in this thesis are described.

The first section mentions the research objective, the research question and investigative questions, whereas in the second section the case study methodology is explained. Also the case selection criteria are formulated in this section. The third section provides a description of the data and discusses how it is collected and how it is used with an important role of the use of interviews in this context.

III.I Research objective and research question

The research objective is stated below; it is established in dialogue with Ernst & Young.

After analysing relevant academic literature the research question and investigative questions are derived.

Research objectives

The objective of this research is to analyse the utilisation of due diligence in a delisting as

opposed to a private transaction. In addition, the objective is to come up with differences and

similarities in the acquisition and due diligence process used in public deals against the same processes in private deals. Therefore, the focus of this thesis centres on the following question.

Research question

What are the differences and similarities between the acquisition and due diligence process in private transactions in comparison with public transactions (delistings)?

To find an answer to this question, the use of warranties, representations and indemnities and the role of legal and regulatory requirements are examined. To support the research question the following investigative questions are developed.

Investigative questions:

· How can the acquisition process be described?

· Does the current legal and regulatory requirements influences the acquisitions and due diligence process of a delisting in comparison to a private transaction?

· Does the use of warranties, representations and indemnities lead to differences between a delisting and a private transaction?

III.II Methodology

After analysing the literature, which purpose is to become a guide for defining the case and the unit of analysis, more focus is needed to get more insight into the process of acquisitions and due diligence to analyze the differences in private deals as opposed to delistings. For that purpose a case study is conducted. There is chosen to study cases because the response rate on a questionnaire would be probably too low for a statistical research. Therefore, case study strategy and the case selection criteria are discussed in the next sections.

III.II.I Case study research

A case study is a research strategy which focuses on understanding the dynamics present

within single settings (Eisenhardt, 1989). According to Yin (1989) case studies are an empirical

inquiry that investigates a contemporary phenomenon within its real-life, especially when the

boundaries and context are not clearly evident and in which multiple sources of evidence are

used. Besides that, Yin (1989) argues that in general case studies are the preferred strategy when

‘how’ and ‘why’ questions are being posed and when the investigator has little control over events. Moreover, the distinctive need for case studies arises out of the desire to understand complex social phenomena.

The phenomenon in this thesis is due diligence, whereas the differences between due diligence in specific transactions are not yet clearly evident and, as described in the next section, multiple sources of evidence are used.

Case studies typically combine data collection methods such as archives, interviews, questionnaires, and observations. The evidence may be qualitative, quantitative, or both. The rationale to use multiple data collection methods is that it provides stronger substantiation of constructs and hypotheses because of triangulation (Eisenhardt, 1989).

Advantages of a case study are: it enables a more in-depth examination of a particular situation than other designs, the information it yields can be enlightening and may provide new leads or raise questions that otherwise never have been asked and, the people involved usually comprise a fairly well-circumscribed and captive group, making it possible for the researcher to describe events in detail (Brewerton and Millward, 2001).

This case study makes it possible to examine in detail the acquisition and due diligence process of different transactions and to evaluate the legal influences into these processes from the point of view of involved persons. As described in the next section several data collection methods are combined to provide for triangulation.

However, case study research also has its limitations, one of the most heard concerns is that they provide little basis for scientific generalization. Yin (1989) argues that the short answer to this concern is that case studies, like experiments, are generalizable to theoretical propositions and not to populations or universes. However, this limitation should be kept in mind.

III.II.II Case selection criteria

In selecting the cases, several factors that are known out of the literature, like size, sector and

form of enterprise are taken into account in examining the differences between private and public

transactions. The main point of this thesis is to analyze the influence of legal aspects into the process of acquisition and due diligence. Therefore, less attention is given to the other factors.

Cases have to satisfy the following requirements to be selected in the sample:

• Transaction is in the Netherlands (at least the target is Dutch);

• Transaction is characterized as an acquisition due diligence;

• At least two of the cases are delistings and two of the cases are private transactions;

• Amount of delistings should match amount of private transactions (thus, at least 2 on 2);

• The buyer is a private equity party or consortium of private equity parties.

In total six cases are selected, three delistings and three private transactions. The next section provides more information about the cases and how the data is derived from the cases.

III.III Data

Firstly, the sources of data are discussed. Since this case study relies for a great part on the use of interviews, these are examined thereafter.

III.III.I Data sources

In total three data sources are used in this thesis. Firstly, secondary data is used for the literature study; this includes books and articles from the library and electronic databases. The study of this literature is used to analyze the concept and elements of the acquisition and due diligence process. Furthermore, an examination about the type of transactions regarding delistings and private acquisitions are provided by the literature, just as the discussion about warranties, representations and indemnities and legal and regulatory requirements.

Secondly, several media, like magazines with a Business and Economics scope and on the Internet are used to provide for more background information, especially regarding the cases.

Thirdly, as stated by Yin (1989) a contemporary phenomenon in its real-life context is

analysed. This is done through an analysis of several objects. Most of the data is subtracted from

these particular objects under study. In the two situations, (private acquires private, and private

acquires public) three events are analysed, summing up to six cases.

The required data for this case study is partly provided by Ernst & Young and consists of the due diligence reports and offer documents of the deals and interviews held with the persons involved in the particular transactions. Interviews are discussed in the next section.

The literature study, the use of interviews and the study of documents (due diligence reports, offer documents and merger approvals) assures data triangulation.

III.III.II Interviews

Interviews are a valuable source of qualitative information. Interviewing is an extremely flexible research tool (Breakwell, 1995). It can be used at any stage of the research process:

during initial phases to identify areas for more detailed exploration and/or to generate hypotheses;

as part of the piloting or validation of other instruments; as the main mechanism for data collection; and as a ‘sanity check’ by referring back to original members of a sample to ensure that interpretations made from the data are representative and accurate (Brewerton and Millward, 2001). Other advantages of interviews besides flexibility in the process include; collection of rich data ensures cooperation, and interviewer availability.

However, interviewing, as with all research methods, is also open to a number of biases and shortcomings. The most critical is the difficulty of achieving reliable and valid results.

Quantification and objectification of interview-derived data are the most powerful ways to remedy this, and highlights the importance of the researcher maintaining an objective stance throughout the research process. Other disadvantages besides the openness to biases and the poor reliability include that it is time-consuming and the low accessibility of the data.

Types of interviews

Interviews can take a variety of forms depending on the type of data required to inform the research question being asked. Brewerton and Millward (2001) discuss four forms of interviews;

structured interviews, unstructured interviews, semi-structured interviews and ethnographic

interviews. In this thesis, semi – structured (for the case research) and unstructured interviews

(for defining the unit of analysis) are discussed below, since these forms are used as data

collection method in this study (for a discussion about the other forms, see Brewerton and

Millward (2001)).

Unstructured interviews allow the researcher carte blanche to address any or all of a given number of topics which may be of interest to the research. Questions and their order are not fixed and are allowed to evolve during the interview process. Here, comparability and ease of analysis and quantification are secondary to obtaining rich, salient data from each individual using open- ended, rather than forced-choice, questions. Breakwell (1995) points out, however, that the depth of exploration in unstructured interviews may well be of the same level as that present in structured interviews, since both are dependent on the knowledge and skills of the researcher,

Semi – structured interviews are interviews that incorporate elements of both, fixed-choice responding and the opportunity to explore and probe in more depth certain areas of interest (Brewerton and Millward, 2001).

Regarding this thesis, firstly, to identify areas for more detailed exploration and to generate the investigate questions, unstructured interviews are held with persons of Ernst & Young with (i) a considerable amount of experience in due diligence, (ii) experience with delistings and private acquisitions, and (iii) a person specialised in the legal aspects of due diligence. Secondly, for the case research, where possible, interviews are held with internal people from Ernst & Young who were involved in the six transactions to report about their perceiving of the transactions. Thirdly, interviews are held with officers of the buying parties to analyze the due diligence process conducted at their targets in detail. In addition, to provide for better insights into the processes also two interviews (in each type of transaction one) are held with strategic parties (one advisor and one firm) on the selling side.

To sum up, a total of nine interviews are held, six about the cases and three with internal people of Ernst & Young. The lengths of the interviews varied from one till one-and-a-half hour.

Furthermore, a considerable amount of short meetings are held with Transaction Services

professionals of Ernst & Young. It is chosen to use unstructured interviews because it was

expected the acquisition and due diligence processes of all cases were different and in this way

questions can evolve during the interviews. However, each time the starting point was the general

checklist (appendix 2) to provide for consistency in the data obtained. The questions from the

general checklist are derived from the standard acquisition process in figure I, complemented

with findings in the interviews with internal officers and the literature.

Furthermore, after the interviews, several follow-up conversations over the phone are held with interviewees to specify if interpretations made from the data were representative and accurate.

IV Results

The empirical part of this thesis is based on the six cases that are examined. Although each case is analysed in detail, the findings of the two types of transactions are grouped to search for general contexts within the cases. Therefore, the research findings of delistings and private transaction are discussed independent from each other in relation to the investigative questions in sections 4.1 and 4.2. Thereafter, the generalized findings and cross relations between the two groups and the literature are discussed in an analysis of differences and similarities in section 4.3.

IV.I Delistings

Due diligence to a publicly quoted company is restricted by several legal and regulatory requirements. Furthermore, no warranties, representations and indemnities can be derived. Both influences the level and scope of due diligence and are discussed in sections 4.1.2 and 4.1.3. This section starts with discussing the acquisition process in section 4.1.1.

IV.I.I The acquisition process

This thesis uses the acquisition process as described in section 2.2.1 as the standard acquisition process. Therefore, figure I out of this section is reproduced here (for a detailed figure of all elements in the acquisition process of delistings, see appendix 3 and a case by case description appendix 5). The points where the process of delistings differs from the standard process in figure I are discussed.

It appears that even the first points of figure I already differ with delistings. In two cases it

was the buyer that initiated the sale. In the other case, it was the seller who reconsidered its

strategy, the board concluded that a delisting by a private equity party would be better for the

continuation of the company and therefore the board initiated the first contacts. According to the

interviewee the buyer was selected based on the reputation and experience of the private equity

party. In the other two cases the target was selected based on historical relationships and general

conversations about the industry in earlier stadiums. This reveals that none of the targets is selected based on certain formal criteria.

First meetings and negotiations took place in all cases after the signing of so-called confidentiality statements and stand-still agreements. The stand-still agreement assures that the parties will not trade in outstanding shares of the target company until the public offer is issued.

The confidentiality statement assures that negotiations about the proposed acquisition are held confidential and that information about the negotiations is held behind closed doors. After the signing of these two documents, a valuation of the business is conducted in all cases. Advisors of targets and buyers value the business and formulate a range of reasonable prices.

According to the interviewees the next step (step 6) involve conversations and negotiations about the strategic intentions, the future expectations, the participation of senior managers and the board of management in the acquired company and about price and conditions. The reason why the price is revealed early in the process is to take speculations out of the market. Further, based on certain conditions and this specified price the seller allows the buyer to conduct due diligence.

The following step in figure I reflect the signing of a letter of intent. It appeared that a letter of intent is called a merger protocol. According to the interviewees in the merger protocol agreements about exclusivity (with adherence to minimum thresholds), the offer process (in the form of a timetable) and important issues about the company, like operational and strategic plans are specified. In addition, agreements with the boards about the cooperation into the new company are formulated in the merger protocol. In this way, interests of the management and the buyer are aligned. Because the possibility of a counter bid is held open, limited exclusivity is provided to the buyer which causes that the merger protocol is not a strictly binding document.

The case research reveals that due diligence is conducted before and ends at the moment the merger protocol is signed. This is because legal requirements of the AFM have to be satisfied on this moment (more about this in the next section).

In two of the cases limited due diligence is conducted. The reason was that the buyers

assumed that the numbers of a listed company should be reliable because of the compliance with

regulatory requirements. Further, in one of these two cases the main objective of due diligence

was to manage that the transaction should succeed. In the other case, the private equity party

trusted on the management of the target company. In the case where an extended due diligence

was conducted, the interviewee mentioned that the reason for this was to give the banks (who had to fund a part of the deal) some comfort about the target company the private equity party wishes to invest in.

The case research reveals that private equity buyers decides to do a commercial due diligence to the business to highlight important commercial aspects in the business plan. A commercial due diligence can used as a preparation of the other aspects in the due diligence. For example, in one case there was decided to do an environmental due diligence because the production facilities used a considerable amount of oil. However, in one case, the knowledge about the commercial aspects was derived from conversation with management. In the other cases, although the buyer was specialised in the particular industry, specialists in this industry and strategic consultants were involved. This specialists where selected based on experience and reputation and out of their direct network.

It appears that before signing the merger protocol, it is important to make agreements with majority shareholders to support the offer. This is accomplished by signing irrevocables with them. In two of the cases this is done. In the other case, the shares of majority shareholders were bought for a lower price as the offer price during the process. Furthermore, when the offer price is known, the supervisory board can decide on a fairness opinion. This is an independent investigation of the business to advice shareholders about the fairness of the offer. In one of the cases, the supervisory board decided this was not necessary; however it is a common document.

Thereafter, formal negotiations take place because the final SPA is very similar to the merger

protocol, which reflects the most important features of the deal. It appears that the SPA is an

extended edition of the merger protocol, only complemented with some practical issues and

specifications prescribed by the AFM. For the buyer in a delisting, this moment (point 8.2)

reflects a go or no-go decision, because the price can not be adjusted because of negative issues,

since new information is not possible. Furthermore, shareholders would never accept a lower

price as the stock price. Therefore, when the offer price is specified (and fixed) earlier in the

process, this negotiations round does not take place at all. In none of the case the offer was

negative adjusted after due diligence was conducted.

However, in one case the price specified in the merger protocol was adjusted upwards, but, as the interviewee said, this was not caused due to due diligence conducted but because a couple of shareholders bought shares after the issuance of the offer and formed a block against the acquisition. This block agreed with a higher offer price in a later stadium.

IV.I.II Legal and regulatory requirements

Press announcements mark important legal aspects in the process. The moments when press announcement regarding public offers should be made are all specified by the AFM. The requirement influences the acquisition process from start until closing. Exhibit 1 in appendix 4 gives an overview of the requirements that should be fulfilled in a public offer. According to the interviewees the moment that the first press announcement should be made is the moment where the expectation a public offer will be issued is justified. The essential point of the regulatory requirements of the AFM is the equality of information to all interested parties. This makes the acquisition as well as the due diligence process a difficult process, since all information has to be shared with shareholders. To avoid the requirements of the equality of information, the case research revealed that due diligence is conducted early in the process, before the first announcement is made. Moreover, it appears reason no detailed agreements can be made among the involved parties. In addition, the relationship between shareholders and the target company is damaged when the acquisition is not managed to a good end. One interviewee advocates to speed up the process by conducting a vendor due diligence by the seller. This vendor due diligence should have a focus to explore stock price sensitive information.

Although it seems that the requirements of the AFM cause restrictions in time, in none of the cases this led to significant problems (one interviewee complained about the speed a second offer has to be issued after the forming of a block of certain shareholders). However, the condition that X% of the shares has to be tendered before the offer can be declared unconditional creates a certain uncertainty in the acquisition process.

Furthermore, the case research revealed that the scope of due diligence is influenced by the

regulatory requirements. Namely, the assumption is that financial statements and business are

managed right due to corporate governance and listing requirements. For this reason, buyers trust on the management in providing all relevant information to them.

Another legal requirement is the merger approval by the European Commission especially for companies with foreign business operations. The European Commission checks whether the intended acquisition causes a concentration risk in a particular industry. The merger has to be approved by them in a so-called merger approval. Other parties that has to approve the acquisition before closing are the Netherlands Competition Authority (In Dutch: Nederlandse Mededinging Autoriteit (NMA)) and the workers council.

According to the interviewees, it is necessary to involve legal advisors into the process from begin because the acquisition process of delistings is a very legal process; this is expressed in all documents that are signed during the process and the specifications of the AFM that has to be followed.

IV.I.III Warranties, representations and indemnities

As known from the literature, in the case of delistings it is impossible to derive warranties, representations and indemnities. There is no source to indemnify because in principle the shareholders are anonymous. It appears that the scope of due diligence to listed companies should therefore accentuate material issues. One interviewee named this ‘deal breakers’. For this reason, lower bounds to these material issues are set to examine if a particular aspect is important for a news announcement and for discounting in the valuation. This lower bound varies from 10.000 euro and higher; usually it is a function of the size of the deal. In addition, the due diligence process becomes an examination to clarify the current and potential risks of the business and emphasizes on the expectations of the business. Therefore, not all aspects of the business are explored and a standard financial, legal and tax due diligence is conducted in general. In one case an extended due diligence was conducted (taking into account the material issue bound in all aspects), the interviewee named it ‘a detailed analysis of important issues’.

Another interviewee mentioned the importance to investigate the agreements the board of

management and the supervisory board have made to each other regarding acquisitions. In one of

the cases, there was as so-called white paper, where everything about the acquisition was

formulated forwards, especially that the supervisory board should cooperate.

Furthermore, the same interviewee suggests that due diligence should be conducted to the integrity of the financial processes, in the Netherlands the so-called Administratieve Organisatie

& Interne Controle (AO/IC). This describes the administrative processes of a company and the associated intern control on these processes. This is important because no general balance sheet warrants are possible. However, only in one case due diligence was conducted to AO/IC and to the agreements the boards made to each other (according to another interviewee, it is impossible to explore this kind of agreements). Estimations should be made if these aspects can be qualified as a deal breaker or not, this depends on the size of the deal and the level of the boundary for material issues that is set.

One interviewee mentioned that a possible remedy against the problem that no substantial price adjustments can be made is to conduct due diligence early in this process (before the first announcement). If negative information is found, the board should send a press announcement about this negative information. The buyer should wait and see what happens to the stock price and decides then to proceed or not. The same interviewee also suggests letting the boards participate into the new company formed after the transaction (‘NewCo’). In this case the boards have to testimony (in a letter of representations) that no material issues are in the business and that the financial forecasts are formulated to their best knowledge. With respect to guarantees, this is actually the only possible warrant that can be derived in the process. It appears that in all cases studied officers from the seller participates in the acquired company.

Other interested findings were that due diligence focused on managing the transaction to a success and that instead of deriving warranties, indemnities and representations, in one of the cases an action-list for after the closing was drawn-up based on the due diligence, for example, to reduce the amount of the accounts receivables.

IV.II Private Transactions

Due diligence to a private company is not restricted by several legal and regulatory

requirements. Furthermore, the possibility exists to negotiate warranties, representations and

indemnities. Both influences the level and scope of due diligence and are discussed in sections

4.1.2 and 4.1.3. This section starts with discussing the acquisition process in section 4.1.1