Pause, innovate, reset: an opportunity to reinvent and improve your M&A process by analysing quality of employees

May 2020  |  SPECIAL REPORT: BUSINESS STRATEGY AND OPERATIONAL PERFORMANCE

Financier Worldwide Magazine

May 2020 Issue

A hard-to-grasp yet persistent reality is that well over 70 percent of M&A deals fail to meet expected outcomes. Even with this track record, the global volume of deals continues to increase at a rapid rate, and even COVID-19 is not expected to cripple M&A activity in the long term. According to ONEtoONE Corporate Finance, the “M&A world will be revived in a few months and will do so vigorously”.

The prevalent due diligence approach which focuses primarily on quality of earnings (QofE) has only gotten investors so far. It may be time to add a new aspect to the due diligence process – quality of employees (QofEE) which values and quantifies the impact and contribution of human capital (HC) on the ability of the target organisation to achieve financial goals.

The recent proposal by the US Securities and Exchange Commission (SEC) and the standard issued by the International Organization for Standardization (ISO) (30-414) to disclose HC performance is not just to satisfy activists. The SEC has determined that HC has a material impact to the business and that disclosures about the quality of HC is integral to understanding the organisation’s ability to sustain business performance. The ISO, supported by 40 years of academic research, supports the notion that increased transparency, especially in the human capital area, generates better financial business outcomes. Many academics have confirmed the relationship between a firm’s employees – a difficult-to-replicate source of competitive advantage – and how well-informed investments in HC drive corporate financial performance.

Pause

Maybe the pause in M&A activity during this time can also be seen as an opportunity to review existing due diligence processes – a time to take stock of what is working and not working, innovate the approach and prepare for resuming deal activity with a new set of tools. According to a 2018 KPMG report, “analytical tools can now transform massive volumes of raw transactional data into meaningful financial and operational insights in record time”. Most likely, the due diligence process used relies on analytics, but only for financial data.

During this pause, a consideration of how adopting a similar ‘analytics’ approach to evaluating and determining the QofEE of the organisation may be a valuable strategy. Applying a new approach, beyond verifying and validating human resource (HR) costs – typically wages and benefits – can generate insights about the economic-creating impact of the HC of the organisation.

For most HR due diligence approaches, the process, beyond verifying current costs, is limited to reviewing employment contracts for change-of-control payments, identifying any underfunded retirement liabilities and evaluating the financial impact of any non-deductible tax liabilities – the ‘check-the-box’ approach. However, this approach does not give you any information about the quality of the employees being acquired – the engine of the organisation which will achieve the financial goals of the deal. For organisations where HC is a competitive advantage, companies can spend anywhere between 50 and 80 percent of total expenses on people, and yet, most organisations do not know what or even if they are getting a return on investment in HC and the programmes that support the workforce. This approach is akin to buying a pre-owned car and checking the transmission but not the engine.

Innovate

Now is the time to innovate your approach to M&A due diligence to include a data-analytics approach to HC assessment. With this approach, buyers and investors can understand the impact HC costs have on the income statement and grasp the underlying behavioural trends of the HC and its ability to support the business model. The approach should include two levels of analysis – financial and operating.

Financial HC due diligence focuses on the impact that the total spend on HC has on financial outcomes, such as earnings before interest, taxes, depreciation and amortisation (EBITDA) and includes indicators such as HC return on investment (HCROI), HC value added (HCVA), and productivity – all measured over time and correlated to financial performance.

HCROI quantifies the return on pre-tax profit for each dollar invested in employee pay and benefits. If contractors make up a large portion of your workforce, their cost should be included in the calculation. HCVA is the profit an average employee brings to an organisation. Productivity identifies the level of revenue attributable to each employee as an indicator of organisational performance.

The value of calculating these metrics is to understand performance over time and how strongly correlated HC performance is to financial performance. This data is easily curated from financial information provided in the data room and will be an indication of the organisation’s ability to sustain the current and projected performance. Is HCROI trending up or down over time? How does this correlate to EBITDA performance? How does this measure up to comparable organisations, either in the portfolio or in the market at large? Visualising the data often helps to identify trends, correlations and issues.

Declining HCROI, HCVA or productivity are signals that additional time should be spent examining the effectiveness and efficiencies of the HR programmes by employing operating HC due diligence to pinpoint the source of the problem.

Operating HC due diligence focuses on the efficiencies of HC deployment and HR programmes. Upwards of 20 HC ratios can be calculated, benchmarked and correlated to financial performance. Examples of these indicators can include attrition, retention, diversity and mobility, and are recommended to understand the source of declining HC financial indicators. Some indicators are easily improved, others may take time and require investment. Two of the most easily measured indicators are attrition and diversity.

Attrition. Losing employees is costly for organisations and employee stability is essential for sustainable performance. This metric should be calculated monthly as an annual calculation will not reveal actual employee stability.

Diversity. Research has shown that there is a direct and statistically significant relationship between an organisation’s level of diversity and corporate financial performance. The goal is to have equal representation in all ethnic and age categories.

These indicators of QofEE will have an impact on deal value that should not be ignored. Either the deal price for the enterprise is overestimated because the current HC cannot deliver on proforma projections, or there are potentially serious problems with the HC that will require high levels of investment to address QofEE issues.

Reset

Our experience with dozens of due diligence projects using this approach has resulted in close to 90 percent of buyers re-evaluating the deal price – for the most part, either adjusting down to reflect issues discovered in the QofEE review or restructuring the terms of the deal.

Some examples using this analytics approach include a financial services company whose HCROI declined 15 percent over the trailing 12-month period. This decline was due to a combination of management instability and declining levels of employee performance. For this organisation, employee-related costs represented 50 percent of total operating expenses. It was determined that the declining HCROI was directly related to a 38 percent decline in EBITDA. This would not have been discovered if HCROI had not been calculated.

A further example involved a technology company. A private equity (PE) firm that purchased a technology company used the QofEE approach and learned that the business model underestimated the HC skills needed to deliver projected performance over a five-year period. This was discovered by measuring productivity over time. The shortfall had a projected negative impact of $14m in EBITDA on revenues of $170m. The staffing model was revisited, integrated into the financial assumptions, and the deal value was then recalculated.

Successful M&A transactions rely on clear and complete information, including a deep understanding of the target’s underlying value, pitfalls and opportunities. What makes this approach valuable is that the analytics can be concurrent with financial due diligence and requires relatively little additional expense if conducted by an experienced HC due diligence practitioner. Because required data is curated from existing documents, no additional data is required, no interviews with target company executives or employees are needed, and no surveys distributed. Conducting due diligence using this approach respects social distancing.

If employees are the engine of economic value creation and a single source large expense item for the enterprise, quantifying HC impact should be a high priority in the due diligence process – maybe even higher than understanding customers and revenues, accounts receivable, inventory, technology, supply chain or research and development.

Solange Charas is the founder of HCMoneyball. She can be contacted on +1 (646) 275 2022 by email: scharas@hcmoneyball.com.

© Financier Worldwide

BY

Solange Charas

HCMoneyball

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