Deal evaluation 10 failure modes

Shared by: gsa16110

Tags

failure modes, failure mode, rcm analysis, failure rate, environmental consequences, physical assets, process fmea, fault tree, design fmea, failed state, risk management, functional failures, failure mode and effects analysis, decision making, maintenance tasks

Stats

views:: 5
posted:: 5/12/2010
language:: English
pages:: 5

Public Domain

Document Sample

FINANCIER
WORLDWIDE corporatefinanceintelligence
North American Middle-Market Review 2005

PRIVATE EQUITY & VENTURE CAPITAL

Deal evaluation:
10 failure modes

Financier Worldwide Magazine
Reprints & Syndications Department
R E P R I N T
The Exchange, 19 Newhall Street,
Birmingham, B3 3PJ
T: +44 (0)845 345 0456
F: +44 (0)121 710 5574
United Kingdom
www.financierworldwide.com
PROFESSIONALopinions

Deal evaluation: 10 failure modes
BY TODD ANDERSON AND DAVID FISHMAN

T his year marks the ﬁfth anniversary of
the NASDAQ bubble bursting, mak-
ing it an appropriate time to review com-
nies began offering online services, and it
became nearly impossible for an internet
only company to compete. The traditional
5. Failure to understand key uncertainties
Investors often donʼt include a full set of
variables that could impact ﬁnancial results.
mon deal failure modes. What follows are grocer already had a distribution system in Even in cases where a relatively complete
10 common evaluation mistakes observed place which could be leveraged with little set of factors is modeled, analysts rarely
during the run up of the NASDAQ. These incremental costs and could buy the technol- handle risk and uncertainty well. Generally,
errors fall into three groups: failure to an- ogy cheaply from failed internet grocers. inputs are tested using sensitivity. Typically,
ticipate market changes; ﬁnancial evalu- analysts examine a +/-10 percent change in
ation failures; and failure to execute after 3. Assuming market valuation remains each input to evaluate how it impacts the
the investment is made. These mistakes are constant bottom line. However, this method fails to
no less common today than they were ﬁve The safest assumption is that market valu- take into account the variation unique to
years ago. ation will not be constant over three to ﬁve each uncertainty. For example, an analyst
years, a typical length of time to hold an as- may know a ﬁxed cost for a critical com-
Failure to anticipate market changes set before exit. For example, the valuation ponent, but overall revenue will have wider
multiples assigned to internet companies variation. For this reason, we recommend
1. Failure to anticipate technological are vastly different today than they were assessing each variable as a range with the
change ﬁve years ago. The same conclusion holds low case being a tenth percentile, the high
Frequently, investors put money in tech- true in a different industry, the utility sec- case being a ninetieth percentile, and the
nologies that represent a paradigm change. tor. In the late 90s, utilities were looking base case being a ﬁftieth percentile. By us-
There is often a failure to ask when newer for non-regulated, growth businesses as the ing common deﬁnitions, it then becomes
and better solutions will eclipse this tech- market assigned a higher multiple to these possible to rank each variableʼs impact on
nology. The length of time that a solution earnings. In the last 12 months, many utili- key metrics with their intrinsic uncertainty
dominates the market should be a key as- ties have taken huge write-offs in nontra- taken into account. The next analytic step
sessment, and a wide range of potential sce- ditional areas. Today, the market does not is deﬁning how these variables interact
narios should be tested. Also, as technolo- differentiate, and earnings are earnings to a and determine the range of results given
gies evolve and mature, margins are likely utility investor regardless of their source. all of the uncertainties. A Monte Carlo or
to be challenged, but projections often fail some other probabilistic analysis is recom-
to reﬂect this reality. Investors assume ei- Financial evaluation failures mended. Failure to capture uncertainty and
ther constant or slowly decreasing margins, their correlations generally results in sig-
whereas a competing solution would likely 4. Applying a uniform discount to ﬁnancial niﬁcant underestimating the overall risk for
have a more deleterious impact. projections an investment and is a cause of many deal
Deal makers focus on projections provided failures.
2. Failure to account for competitive by management. While they know that the
response by incumbents projections are only estimates and inher- 6. Income statement focus
A company entering the marketplace with ently optimistic, many investors deal with Examining only the income statement fails
a new solution must anticipate its competi- this bias by discounting earnings. In real- to focus on the intrinsic value that is being
torsʼ responses. A common mistake is to not ity, earnings will not simply scale upwards created. In the late 90s, most clients focused
deﬁne broadly enough who the competitors and downwards. Changing just one or two on some multiple of the income statement.
will be. Online grocers in the late 1990s felt critical inputs can entirely eliminate or com- The most common metric used was some
their primary competitors were going to pound future earnings. Thus, it is important multiple of EPS or EBITDA. However, in
be other internet grocery delivery services. to change the underlying inputs to deter- the most extreme cases, valuation by multi-
However, it turned out that the greatest com- mine the overall variability in earnings and ples of revenue was conducted without any
petitive threat was from preexisting bricks cash ﬂow and not just apply a bottom line regard to cash ﬂows, the balance sheet, or
and mortar grocers. Large grocery compa- “haircut”. even earnings. Any of these methodologies 8

FW North American Middle Market Review 2005 | www.financierworldwide.com
PROFESSIONALopinions

yse a “home run” deal can cause this home
run to be only a “single” either by overpay-
ing or suboptimal management.

Failure to execute after an investment is
made

9. Disconnect between the deal and
management teams
Deal and management teams are generally
incented very differently, which creates in-
“These mistakes are no less common today herent tension between the two. Deal teams
want to complete deals, whereas manage-
ment teams want, understandably, some-
than they were ﬁve years ago.” thing that can be managed. Also, the deal
team will, at least, initially know far more
about an investment than the management
team. The earlier the management team is
involved, the smoother the hand-off once
the investment occurs.

10. Failure to have a clear exit plan
Sometimes, investors begin with clear exit
goals and fail to manage to that goal. How-
ever, more often, deals are exited early to
failed to take into account the cash crunches unusual to track 20 or more metrics and not ensure a steady stream of earnings and cash
that even a successful investment would just EPS in the exit year. In addition, hav- ﬂow. Frequently, the deals exited are the
have. These companies had to actively ing a quality valuation discussion upfront, relatively successful deals with little or no
choose between growth and cash burn, and, reveals what the investor will have to pay thought devoted to the long-term value be-
by the late 90s, with the cash running out, particular attention to as the deal matures. ing sacriﬁced or the optimal exit timing. As
growth slowed and income statement mul- a result, investing companies can quickly
tiples declined. 8. “Home Run” deals donʼt need to be create a portfolio of very lackluster invest-
analysed ments with very little potential upside.
7. Over-reliance on just one valuation The best deals require analysis. In fact, they
approach require more analysis because it is highly In the late 90s, many investors become
Triangulation provides a much better es- likely that they are actually going to get caught up in the excitement of the NASDAQ
timate of overall value, at investment and done. A careful analysis upfront will sug- bubble. While some of the most egregious
exit, than any one valuation approach. In gest how these deals can be most effectively errors have been corrected, more work is
addition, cash and debt levels must be an- managed. Also, very attractive deals may required to ensure success or avoid invest-
nually tracked in any model to ensure that come via a competitive bidding process. It ments that are unlikely to be successful.
a company is meeting their ﬁnancial cov- is critical to careful analyse how much a
enants in all the years and not just in the percentage of equity is worth to your com-
Todd Anderson is a Senior Engagement Manager and can be contacted on +1
exit year. It is relatively easy to automate pany rather than getting caught up in the (617) 478 7621 or tanderson@sdg.com. David Fishman is a Managing Director of
tracking these critical variables, and it is not competition. Thus, failure to properly anal- Strategic Decisions Group and can be contacted by email: dfishman@sdg.com

www.financierworldwide.com | North American Middle Market Review 2005 FW
Strategic Decisions Group is a strategy consulting ﬁrm renowned for
applying leading-edge decision theory to uncover opportunities for
creating shareholder value.

We guide our clients to ﬁnd innovative, creative strategies to thrive
today, while also helping them build internal competencies to meet
competitive challenges in the future. As a result, we are the preferred
strategic partner to many in the Fortune Global 500.

Boston Our Financial Services practice has signiﬁcant experience with clients in the banking, insurance,

mutual funds, asset management, and related ﬁnancial industries. Our consultants have

assisted major ﬁnancial institutions around the world with business strategy, asset portfolio
Houston
management, securitizations and transactions, product line proﬁtability, and risk analysis. Our

experiences range from addressing strategic and operational issues in the insurance industry,
London to successful leasing and credit card strategies, to innovative good bank/bad bank transactions,

to helping troubled banks in the United States during the S&L crisis of the late 1980s, to risk

New York analysis for major banks in developing countries.

Our consultants have helped many ﬁnancial services clients develop and implement strategies,
Palo Alto
create business innovations, allocate resources, and improve operations. To ﬁnd out more about

the services we offer or to discuss your requirements please contact us.

Mumbai
Contact:
David Fishman
Managing Director
Tokyo Private Equity and Financial Services practice
Telephone: +1 (650) 475 4486
Email: dﬁshman@sdg.com