Several months ago I wrote about the subject of assembling a data room; this present article deals with the subject of operating a data room once it is assembled and will discuss: (a) data room rules; (b) answering questions posed during the data room process; and (c) the importance of the data room in subsequent negotiations.

While traditionally data rooms involved physical documents, a modern trend is to have all or part of the data room in virtual (electronic) format. Virtual data rooms will be the subject of a future article.

    (a)    Data Room Rules

Every well-run data room should have a written set of rules governing its operation, addressing issues such as:

Who may attend the data room, the registration procedure, and the hours of opening
The time period available for each investor in the data room (this is usually a finite period of several days, which are specified)

• Which documents may be copied or not copied or accessed through the virtual (electronic) data room
• Which member of the company and/or its financial advisor will be present in the data room at all times when an investor or its advisors are in the data room
• The terms of the prohibition of scanning equipment, cameras, etc.
• Rules are usually established for destroying any data gathered in the data room at a subsequent date, if the bidder does not invest in the company
• The rules for asking questions or requesting additional documents or information.  (Typically, where there are multiple bidders participating in the data room, the rules will specify that where one party asks any question, both the question and its answer will be circulated to all bidders)
• Breach of data room rules may terminate a bidder’s participation in a transaction.

The registration procedure should generally involve each person entering the data room signing a copy of the data room rules.


    (b)    Answering Questions Posed During the Data Room Process

There is usually a form provided for questions, or additional document requests.  For the company organizing the data room and its advisors, providing answers to the questions can be one of the toughest aspects of the data room process, as there may be dozens or hundreds of questions, which must all be answered comprehensively in the course of a matter of days. The company and its advisors should be very familiar with the company’s affairs so that they are prepared to answer questions promptly and fully.

Answers to questions should be vetted and approved by the management, company owners, and relevant advisors, and it is generally good practice to have all answers also reviewed by both legal counsel and financial advisors


    (c)    The Importance of the Data Room in Subsequent Negotiations

Where investors do not receive the breadth, depth or quality of information expected from the data room, they have a number of responses:

• They may withdraw altogether from the bidding process
• They may reduce the value they are prepared to pay for the company
• They may augment the representations and warranties that they expect from the sellers or from the company

In fact, there may also be a combination of the second and third responses. None of the options are particularly good, which is why it generally pays to provide full disclosure during the data room process.

In booming markets, or for an extremely attractive company, investors during a competitive process are often willing to be less rigorous in their data room requirements; my experience is that in times of recession, or where the company is less attractive, investors are usually more demanding, and require fuller data room disclosure.


In conclusion, operating an excellent data room is a prerequisite for a successful transaction. It is usually the most intensive part of the transaction, as it requires the full-time presence of the company and its advisors in the data room, not to mention the extensive effort involved in answering questions. Often there are concurrent processes going on, such as site visits by investors and management presentations to investors.

Many company owners simply do not realize the importance of the data room. One of my transactions once stalled for four months as my client refused to put together a data room, saying that if the investor requests information, he would be prepared to provide the information on an ad hoc basis.  

It is much better to anticipate the information that will be needed and provide it to the investors in a data room. Not only will that enhance the credibility of the process, and the investors’ assessment of management – it will often help reduce the enormous amount of work that the question and answer process involves.

Many investors often think that acquisition is the best or fastest way to achieve a strategic objective such as entering a particular market or acquiring a certain technology. An alliance, however, may be at least as good an option in certain circumstances (such as where a company lacks a budget for acquisitions). Alliances are very common: there are many tens of thousands of them negotiated every year, most of them across borders.

Types of alliances

An alliance may be defined as a association among two or more parties which involves a sharing of resources and coordination among parties to achieve common objectives.

The three main types of alliance are contractual, cross-ownership or setting up a special purpose vehicle (SPV).

A contractual alliance is generally a pure commercial agreement that sets out the objectives, the resources contributed by each partner, the division of the spoils, as well as in many cases the puts and calls, the representations and warranties, etc.

Cross-ownership may involve one party taking an ownership interest in the other, or parties taking an ownership interest in each other. The relationship may be cemented through representation on the board, or the contribution of capital. Most alliances do not require cross-ownership.

Setting up an SPV (a company, a limited partnership, etc.) may be a good way to structure an alliance. A board of directors provides a direct way of making decisions concerning the alliance. A shareholders’ agreement may be used to regulate the corporate governance of the SPV. The parties should also regulate who contributes what resources to the SPV, and how the spoils are distributed.

The rationale for an alliance

Alliances have several advantages over acquisitions:

• They are much faster to negotiate and implement than acquisitions. They typically do not require due diligence of the acquired firm (although considerable research on the strategic or commercial opportunities available at hand is usually necessary).
• There is much less risk that the management of the alliance partner will depart (which often happens with acquisitions). This generally means that there is a more committed team in place.
• There is no need for the huge investment that typically accompanies an acquisition. If, for example, two alliance partners join forces to develop a certain product, technology, or geographic region, each alliance partner contributes the human, financial, or other resources necessary to achieve the joint objective.

Elements of a successful alliance include the complementarity, compatibility and commitment of the alliance partners.

Drawbacks of an alliance

Alliances are not appropriate in all circumstances, however. They have a number of important drawbacks, which include:

• CEOs often like having resources under their direct command – but alliance partners do not respond well to commands. They expect to be treated like partners. Hence, achieving strategic objectives requires constant communication and effort put in to maintain the relationship.
• There is always a risk that the alliance partner will not hold their side of the bargain, which may jeopardize the efforts and investments of the partner that does hold their side of the bargain. (This risk may generally be mitigated by good project management, for example using benchmarks for what objectives are to be achieved by certain dates, as well as including representations and warranties in the alliance agreement).
• One of the most surprising tendencies of alliances is for them to unravel once they have been successful. While alliance partners may work together for many years to achieve their joint objectives, once these objectives have been achieved, and the venture has been declared a success, the partners have a tendency to go in different directions. One may wish to sell, the other may wish to expand the scope of the venture (such as expand into additional countries or related ventures). As a result, it is advisable to have good conflict-resolution mechanisms built into the alliance agreement (such as mediation).

Most authorities on the subject estimate that only 40 to 50 per cent of alliances achieve their objectives in the long run.

Conclusions

Alliances are often not considered or given sufficient weight as a viable option for achieving corporate objectives. While they are not appropriate in all circumstances, they are generally one of several viable options. Despite the relatively low track record of success for alliances, companies are facing increasing pressure to enter into them as a means of bolstering competitiveness. Proceed carefully!

My last article discussed how strategic investors typically choose acquisition targets; this article does the same for private equity investors.

Private equity investors typically have a charter which sets out well-defined parameters for investments to be made by the fund, including:

• Nature of investments. Some funds like high-growth companies, others prefer investments with stable cash flow or dividends. Still others prefer turn-around situations.
• Geographic scope. Many Central European funds restrict themselves to EU member states, the bolder ones will venture in to former Yugoslavia or Turkey;
• Preferred sectors. Some funds are generalist funds that will look at just about any sector, others focus on one particular sector, such as transportation, infrastructure, telecommunications, etc.
• Investment size. Most funds will specify a minimum or maximum investment size (e.g. €5-25 million).
• Ownership interest. Some funds insist on control, others will take minority interests.
• Fresh equity. Many financial investors are not willing to buy out shareholders, they only want to inject fresh equity into a company (e.g. to fund growth). Others will consider a combination of fresh equity and buying out existing shareholders. Buyout funds will want to buy 100% of a company.

It is therefore important to find a good match between a private equity fund and a company. It is likely a waste of time to enter into discussions with a fund if the applicant company does not fit the fund’s criteria; investing in such a company would put fund management into breach vis-a-vis its own investors. Business owners should therefore do a little homework before approaching funds – the investment criteria are usually on the fund’s website.

The average private equity fund in Central Europe will typically screen a few hundred investment cases every year. Not more than a few will actually become the object of an investment. The vast majority of private equity funds typically have an investment committee that makes all the investment decisions, and a local person (who may or may not be a member of the investment committee), who basically becomes the protagonist of the investment to be made in a particular company, at the level of the committee. Hence the owner of a business must first convince the protagonist of his investment case. The owner of a business seldom, if ever, communicates directly with other members of the investment committee. Hence the written information prepared by the company, most notably the Information Memorandum prepared by the company, particularly its Executive Summary, may become an important indirect communication tool with the investment committee.

A financial investor will usually subject a company to an initial due diligence, using its own internal staff, before obtaining a green light from the investment committee to proceed with a full due diligence of the firm, using external advisors (at a minimum lawyers, possibly financial advisors, auditors, tax advisors, technical experts, etc.)

So what does a private equity firm look for in its investment choices:

 

• A solid business opportunity that reflects its acquisition criteria (e.g. growth, size, geographic parameters, etc.);
• Exit strategy – who are the likely buyers for the company? What are the chances for a successful exit?
• A strong management team, who is prepared to stay until the exit of the fund. (An owner-manager who is cashing out is often too high a risk for the private equity investor – please see my earlier article on the “One Man Show,” available here and here.
  
• Strong corporate governance – good decision structures, reporting systems, and strong documentation. Private equity investors seek management teams that are highly motivated, are prepared to agree to ambitious goals, and are prepared to work extraordinarily hard to achieve significant financial gains. Conversely, if results are not forthcoming, managers that own shares may find their ownership diluted.
• Manageable risks. No actual, pending or potential litigation, or the potential for surprises on the downside;

After the due diligence, the investment committee (or at least certain members) will usually review the due diligence report of lawyers and other advisors, and the proposed Sale and Purchase agreement.

Sometimes private equity firms will purchase what they call “bolt on” investments. Bolt on investments are do not typically need to satisfy all of the investment criteria (e.g. they may be smaller than usual, or management of a bolt-on investment may choose to exit), as the acquired bolt-on company would be purchased to create synergies with one of their existing portfolio companies.

Private equity firms have taken an ever-larger share of the M&A market in Central Europe. They are an important potential source of financing for mid-sized firms that must not be neglected.

A strategic investor uses a very different process to identify acquisition targets than that used by financial investors (the subject of my next column). For a strategic investor, as the name implies, identifying an acquisition target must flow from the acquiring company’s strategy.

The worst methodology that a strategic investor might use to identify targets is to respond to the acquisition opportunities that it finds on an ad hoc basis. This simply will not work for two major reasons:

• First, responding to opportunities on an ad hoc basis typically means that deep strategic thinking has been short-circuited.
• Second, if a strategic investor acquires a company that it came across merely on an ad hoc basis, how does it know that there were not better acquisition opportunities elsewhere in the marketplace?

It follows from the above thinking that a strategic investor, before embarking on an acquisition, should have a clear definition of its overall corporate strategy, and from such a corporate strategy should flow its acquisition strategy. (Of course it is ideal to have these in writing: there is nothing that focuses the mind as much as putting something in writing, an approach which also helps to ensure that the different parts of the organization are also in consensus).

Some of the elements of an acquisition strategy might include definitions of the following:

• The rationale for the acquisition (e.g. vertical or horizontal integration, expanding into newer high-growth markets, acquiring technology or know-how, etc.)
• The precise profile of the target companies sought
• The geographic range of possibilities
• The financial criteria (revenues, profitability, etc.)
• The type of management or skills which may be required
• The type of clientele which the target company should have
• The valuation range in which such acquisitions may make sense

A company may choose to create a strategy broader than an acquisition strategy, namely an M&A strategy. Such an approach would also cover the criteria which a company would set for divestiture of its subsidiaries.

Once the strategy has been defined, the acquiring company should engage in a systematic search for and assessment of all those companies that fulfill the criteria (as opposed to an ad hoc approach). If there are a very large number of candidates, the list might be shortened by selecting only the most attractive ones. The most attractive ones might then be approached to ascertain whether they are willing to talk about a strategic partnership or acquisition, and with an eye to further fact-finding about the company. It is often useful to use an independent third party intermediary for this approach, as it allows the approach to be anonymous, keeping the name of the acquiring party out of the market.

Failure to apply the above approach may result in a bidder finding itself among a herd of bidders in a frothy, overpriced market, competing for a target company that might not even be the best strategic fit.

Some of the more astute strategic investors have been monitoring their potential acquisition targets for many years, sometimes even decades, and are ready to make a move on short notice if the owner of a target company becomes willing to sell or if price expectations are reduced. However, it is usually only a small percentage of potential target companies that a strategic investor is willing to acquire – the majority of potential targets quite often simply do not make the grade.

Central Europe is often an attractive area for acquisitions for global investors because most investors believe that Central Europe is on a convergence path with Western Europe, meaning that GDP per capita, incomes, consumption, etc, will catch up to Western European levels. This is based on the belief that, “A rising tide raises all ships.”

Nevertheless, different countries move at different speeds at different points in time, depending on their political and socio-economic environments, and some companies are better acquisition candidates than others. The importance of country and industry-specific knowledge at the local level cannot be over-emphasized.

Recently I was invited to attend a half-day presentation given by a large mid-sized Central European client and their bankers, with the objective of renewing the company's line of credit.

While there was plenty to be concerned about with regard to the performance of the company, the bankers asked very few questions, none of which were particularly penetrating. When the bankers confirmed that the line of credit would be renewed my colleague and I looked at each other in amazement.

My colleague was a little quicker to come to a conclusion than I was: "They don't care about the business; they are amply covered by the real estate collateral that the company owns." Bullseye!

Could it be then that this is not an isolated incident, but a symptom of how banking is done in Central Europe? Anecdotal evidence indicates that this does seem to be the case. Yet there are exceptions to every rule. For example, after three or four years of collateral-based lending, my own advisory company was successful in persuading our own bankers, Budapest Bank, to drop the real estate collateral to their loan.

However, from talking to fellow business owners, foregoing real estate collateral appears to be very much the exception, not the rule.

If one accepts the proposition that lending is essentially collateral based (eg. mostly real estate, but also share portfolios, and other assets), this brings about difficulties for Small and Medium-sized Enterprises (SMEs), for several reasons:

• First, a company may have an excellent business plan, concept, product or service, management and firm orders, and yet, if lacking the appropriate real estate or collateral, the company may be unsuccessful in achieving financing;

• Given the precarious state of real estate markets where values have diminished greatly over the past year (or, more precisely, in some segments of the real estate market in Central Europe) there has ceased to be a market (eg. sellers would rather hold onto their properties than sell at the price buyers are willing to pay). This makes valuations increasingly theoretical in nature, given that there are few direct comparables on which to base valuations. So even those companies that do have real estate may be starved for financing, unless they are over-collateralized, compared to their credit ambitions.

So what are the solutions? Other than Government-sponsored programs which offer special loans or guarantees for small businesses, the long-term solution has to come from the market:

• First, SMEs will continue to shop around for banks that will give them the best possible banking terms and banking relationship, and will naturally gravitate towards those banks that tend to manage their SME lending activities best.

• Those banks that insist on real estate-based lending to SMEs will see their market share diminish. Hence there will be a race against time for them to develop lending competencies that are based on understanding businesses, not on taking collateral.

• In the meantime, companies may have to look for additional equity financing if they are unable to raise debt financing.

There are many businesses which are very "sexy" by today's standards, such as IT, biotechnology, or high technology businesses, which do not require much in the form of assets or real estate.

To load these companies up with real estate just to make them financeable would be to make the tail wag the dog.

Banks, too, over time, will find that they may be left behind in terms of market share in financing this market segment if they impose a straight jacket of asset financing.