Quaker Group Strategic Due DiligenceHydrocarbon Supply Chain & Related Businesses

Creating value by investing equity in closely held businesses will always pose some degree of investment risk. Strategic Due Diligence (figure 1) mitigates acquisition deal risk and increases net deal return over the life of an investment. Quaker has deep industry and functional expertise in the hydrocarbon and related industries. Our unique industry background, methodologies and skills, along with a wide array of industry resources, provide us with unique expertise and insights that significantly increase the quality of capitalized cash flow analysis. Quaker’s deep understanding of hydrocarbon processing and related markets, technology drivers and the competitive landscape lead to advantaged deal negotiation and close strategies for our clients.

Most of the time, the seller will know more about the business being sold than the buyer. This can result in the buyer overpaying, bearing more risk than the seller and ultimately result in the destruction of large amounts of share-holder value. We can assist our clients in evening the playing field and in some cases have known more about the target assets and operations than the target executive management. The easy part of valuing a target acquisition is building the discounted cash flow (DCF) model to project the income statement, balance sheet, and cash flows (figure 2). The difficult part is developing and quantifying the assumptions that drive the key lines of the valuation.

There is no such thing as a risk-free transaction and there is no set of perfect information. There will always be unanticipated external factors or further discovery that can cause a deal to go off-track or not achieve expectations. Quaker’s strategic due diligence service offering improves the efficiency of the deal process and maximizes the risk/reward aspects of deals under the backdrop of a buyer or seller’s current portfolio, specific deal characteristics, investment horizon, value proposition and exit strategy.

Quaker Strategic Due DiligenceNominally due diligence is the process by which buyers contemplate and evaluate a potential acquisition. The broad term is used to describe activities in a variety of functions including legal, accounting, environmental, human resources, and technical. Of these different due diligence activities,

Strategic Due Diligence(Rigorous Deal Analysis)

Market Assessment Target Market Defined (Figure 3)

Customer Analysis (Figure 4)

Competitive Assessment (Figure 4)

Quantitative Value Analysis (Figure 5)

Valuation Analysis- Capitalized Cash Flow (Figure 6)

- Sensitivity Analysis (Figure 7)

- End-Game Strategy

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Figure 1

the three that generally receive the greatest attention (and funding) are accounting, legal and Environmental, Health and Safety (EHS) assessments (most certainly in hydrocarbon and related businesses).

These three activities are non-discretionary elements of closing a deal. Typically, acquirers will engage professional service firms with specialized expertise to perform an objective appraisal of these due diligence areas. The outcome of these legal, accounting, and EHS reviews can result in renegotiating the transaction price and deal terms and in some cases, abandoning a transaction.

It is important to recognize that the information obtained from these assessments provides little insight as to whether a potential acquisition will be successful. Verification of historical performance and checking the veracity of a seller are important non-discretionary aspects of an acquisition. However, the one-time costs associated with addressing identified problems from the past are often minor compared to the overall economics and risk adjusted value of a transaction. The primary driver of the quality of an acquisition is the purchase price less the capitalized value of risk adjusted cash flow. Typically, the estimated deal is driven by items such as revenue growth, gross margin improvement, operating synergies, and cost of debt. These factors are generally greater than the cost of settling an outstanding legal claim or resolving an environmental problem.

Strategic diligence on the other hand, reveals the most important insights regarding a company’s future value based on an integrated rigorous assessment that provides clarity as to the real value (price) of a company. Broadly defined, it represents the set of activities involved in evaluating a target company’s markets, technology advantage, competitive position, and strategic EHS issues. The approach provides a unique perspective that appropriately balances industry and financial valuation inputs. Quaker clients use these insights to their advantage in the bid and negotiation process.

Market AssessmentThe objective of the market assessment is to provide in detail the market, customer, and competitive landscape such that an informed, risk-adjusted, assessment of the target company value can be determined (figure 3). The customer and competitive assessments are typically done in the strategic due diligence phase as they are complementary and, in some cases, overlapping. For example, customers are often the best sources of information on competitors, and hence, the interviews performed in the customer analysis will provide important insights into the key competitor analysis questions. The objectives of market assessment are to establish the current market size and to forecast the expected growth in the segments specific to the target company. This could include more than one market segment along the hydrocarbon supply chain or could include markets in different industries. The first part of this activity is to construct the appropriate strategic segmentation of the market given the target’s business model. A strategic segment is that portion of a market that requires a defined set of competencies, technology, business model, assets and geographic presence in order to compete. Strategic market segmentation can take several forms (figure 4) as the following examples illustrate:

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Figure 3

• Customer - Many hydrocarbon related businesses are aligned based on the end-user’s supply chain segment since the supplier requirements differ by segment.

• Geography - This is the most common strategic segmentation for service oriented and less capital intensive businesses (fracking chemicals) as a local presence is often required.

• Cost Competitiveness - Price is a common means of segmenting target customer markets as many factors including product quality, service levels, and sales channels may differ based on price point.

• Technology - Technology capabilities are very important in segmenting hydrocarbon related businesses as the threat of substitution must be fully appreciated to quantify current and future technology risk.

Quantitative AnalysisThe required granularity of the quantitative analysis is a function of the following:

• How well known is the target and its markets

• How large the transaction is in absolute terms (relative to the market) and relative to typical equity deal sizes (figure 5)

The further the target company is from the typical acquisition target in terms of product/service offerings, customers, competitors, or geography, the greater the required level of

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Figure 5

Figure 4

strategic due diligence. Similarly, the larger the relative deal size, the greater the level of required strategic due diligence.

For acquisitions that are very close to other recent deals in term of the core business, participating in a familiar geography, and involve a relatively small financial commitment, the work required in the target market assessment may be minimal.

Valuation and Negotiation The objective of the Valuation and Negotiation advisory support services is to utilize the strategic insights from the strategic market assessment to determine the true value creation potential of an acquisition and to make informed decisions in the negotiation process. There are three distinct activities in this phase.

Valuation AnalysisThe results from Quaker’s strategic market assessment provide the competitive intelligence to reduce the guesswork (risk) normally associated with this element. A similar process applies to the cost side of the income statement. If customers characterize their supplier choice as principally driven by the suppliers’ ability to introduce new technologies, an investor will likely need to maintain or increase the present R&D budget in the forecasts. The key is to utilize the unique Quaker insights from the market assessment to drive the quantitative assumptions in the financial valuation model. If unable to make a defensible and credible estimate of a forecasted key income statement or balance sheet item, more analysis is required.

In valuing the target, two separate analyses should be performed. The first is to forecast the stand-alone value of the target and the second is to add revenue, cost, and balance sheet synergies associated with the new ownership of the target to the stand-alone value. This could be other equity investors in the form of venture capital firms, management buy-out equity and/or other ownership rights such as subordinated debt. This value represents the maximum acquisition price (figure 6).

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Figure 6

Sensitivity Analysis Once both the base-case stand-alone value and synergistic value of the target have been established, the next step is to perform a scenario analysis of the key assumptions driving the valuation (figure 7).

There will always be some uncertainty regarding a few key assumptions. This uncertainty is best understood by conducting sensitivity analysis, or varying the key assumptions around the range of uncertainty and measuring the impact on the target’s value. Sensitivity analysis is an important tool for three reasons: (1) it highlights the most critical factors driving the valuation of the target and distills the valuation assumptions into 5 or 6 six critical considerations; (2) sensitivity analysis helps to quantify the size of the economic risk (often these decisions are made on gut instinct or intuitive feel, however the analytical rigor of sensitivity analysis will lead to considerably better investment returns); and (3) if the deal is completed, this analysis can serve as a focus for post-acquisition mergers or exit value to potential acquirers.

Negotiation Strategy The last step in the strategic due diligence process is to determine the price to bid for a company within the value creation range. As discussed supra the stand-alone value of the target is the seller’s minimum price and represents the bottom end of the range. There are several factors that play into the bid strategy for a specific deal including: • Confidence in the Base-Case Assumptions - As a general rule, the less sensitive a target’s value is to

the range of uncertainty surrounding the key assumptions, the higher the bid. This would not be true, however, if the uncertainty distribution curve were skewed toward the favorable range.

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Figure 7

• Competing Bidders - The more common the synergies to be realized among likely competing bidders, the more likely it is that other bids will come in on the high end of the bid range. Here a higher bid may be necessary.

• Alternative Valuation Techniques - Other bidders may use alternative valuation techniques to set their bid, such as multiples analysis. Depending on the valuation of the target calculated by these techniques, the higher or lower will be the bid required to stay within the value creation range.

• Strategic Implications of Not Doing the Deal - This represents the opportunity cost associated with the transaction. The value of the acquisition needs to be compared to the value associated with the next best use of the allocated capital. The less favorable the risk-return trade-offs associated with the competing options, the higher the appropriate bid range.

• Mitigating Risk – Deals can be constructed that mitigate current risk by incorporating future performance into the payout to the seller just to mention one. In this type of contingent transaction a higher ultimate purchase price may be justified due to: 1. The seller has greater incentive to ensure optimal implementation; and 2. The overpayment risk for the buyer is reduced (at the expense of somewhat limiting future

upside)

Benefits of a Quantitative Approach Applying a systematic approach to strategic due diligence adds significant value to the deal process. These advantages include:

• Without market, technology and com-petitive analysis, revenue forecasting is unreliable at best and guesswork at worst. Simply basing future projections on historical growth curves will produce unreliable forecasts and target valuations.

• The careful forecasting of the key revenue, cost and balance sheet line items results in Quaker establishing specific commitments on the part of the acquiring company’s management team. This allows management to know what it is “signing up for” before the deal is closed, and provides the opportunity to change assumptions and the final bid price if concerns are raised.

• An analytical approach to establishing a target’s stand-alone and synergistic values helps remove the emotional element associated with trying to win a bidding war. A robust valuation model supported by the appropriate strategic information provided by Quaker will prevent buyers from over-paying in the excitement of final negotiations and under-bidding for valuable strategic attributes.

• The results from the strategic due diligence process provide the acquiring company with the strategic information it will need to manage the target company. For example, understanding how customers’ needs are evolving or identifying the most important competitive/technology threats will be critical to guiding the company’s strategic direction going forward. Strategic due diligence accelerates this learning process and expedites the achievement of the longer term goals and maximizes exit realizations.

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Quaker’s approach to valuation is based on a rigorous cash flow analysis. This provides a clear, analytical framework for understanding the true value of an asset considering both cash flow potential and systematic risk elements. Our extensive industry market and technology insights along with unique valuation techniques provide added perspective in the valuation analysis. In summary, a thorough and systematic strategic due diligence process in combination with legal, accounting, environmental and other due diligence efforts will greatly improve deal value.