When Due Diligence Ignores M&A Risks, Transaction ROI Falls Short—Captive Insurance May Help

Generally speaking, pessimists don't buy companies. Whether it's private equity rolling up a roster of similar businesses, a CEO eager to turn a competitor into an ally, or a regional player seeking wider market dominance, transactions are pursued because the buyer is confident they'll gain significant economic advantages.

Once buyers decide to move forward with a deal, optimism's confirmation bias and a focus on the big picture can lead them to look past the many factors with the potential to erode the value of the combined entity. Even robust due diligence efforts may not deliver an adequate understanding of inherent risks that can create headaches and unexpected costs for years to come.

Acquirers quantify the value of a target company's assets, reputation, workforce, and other elements that factor into the deal. More than a few go into those transactions without an accurate sense of how the potential risks the acquisition brings to the deal and the combined organization might diminish that value.

Lacking a clear sense of operational risks may complicate the integration of the target company into the acquirer's operations. It can reduce and delay the projected returns of the transaction; surprise leadership with unexpected costs, insurance claims, and compliance issues; and even trigger the departure of the target's key employees.

As we've performed risk diligence for private equity concerns and other acquirers, our team has identified many situations capable of affecting the assimilation of the target and reducing the transaction's anticipated return on investment (ROI).

Workforce-related risks rank among today's most common issues for middle-market targets, with employee compensation and benefits commonly generating adverse findings. Given regulatory scrutiny of employee health and welfare, it's critical to examine whether these areas already satisfy regulations—and if not, what it will take to attain compliance. An excellent example is wage and hour issues, where employee hourly rates may fall well below the job class, which federal regulators are likely to view as discriminatory. A company's entire workforce may need to be classified, with compensation adjusted appropriately. That process isn't exactly good for morale, either—and one of the biggest determinants of the workforce's willingness to cooperate and be integrated with the acquirer and their existing employment practices and employee benefits programs.

Atop the mind of every private equity firm or serial acquirer these days is employee health, encompassing everything from healthcare coverage to safety programs. Companies know what they want and need to offer, but with costs out of control, how can they take care of employees, so they'll be more productive and support long-term growth goals? Mergers and acquisitions (M&A) combine not just assets but cultures, too. It's important to understand what an acquirer's prospective employees have come to expect as part of their compensation and benefits packages. Anything less will be seen as a negative and could lead to turnover, so the company needs to know how falling short might impact ROI.

Workers compensation is another common pain point in structuring an acquisition. Both parties may have nearly identical characteristics, but if the target's experience modification rate is 1.25 and the platform company's is 0.75, that situation needs to be addressed and factored into the financials.

Additionally, we find middle-market companies are commonly underinsured in executive risk lines, often lacking key coverages for directors and officers, employment practices, and cyber security. Among the companies that do carry such coverages, it's often inconsistent with the acquirers' coverage or structured inefficiently.

Most of these risks involve companies failing to follow best practices, especially where risk management is concerned. For example, the target company may lack a comprehensive program to prevent and mitigate cyber risks. The acquirer will either have to finance that added risk or simply assume it. Another involves what might happen with potential future claims resulting from occurrences that preceded the acquisition.

Given the broad and varied nature of potential risks, our team uses a systematic process to thoroughly examine what hasn't been properly insured or otherwise addressed by the target company. Looking at the target through a risk lens allows us to provide insight to the deal team about the integration considerations and potential financial impact. Specialists in both property and casualty risks and employee health-related risks follow an established playbook to create a dashboard reporting the risk findings, supported by graphs summarizing how the issues translate to dollar changes.

In addition to delivering an assessment of financial and qualitative red flags the deal team should know before acquiring the business, the analysis offers recommendations for crafting solutions and policies to transfer risk, whether that involves traditional coverage or the growing use of captive insurance.

Acquirers rely heavily on teams of legal, accounting, and financial professionals to help them evaluate and properly value the targets they are considering. Adding a formal risk management process to their approach increases the likelihood that the expected synergies and actual performance of the transaction will meet or exceed their goals.

The above information does not constitute advice. Always contact your insurance broker or trusted adviser for insurance-related questions.