Growth via acquisition can result in unwanted property commitments
"Diligence is the mother of good luck.” - Benjamin Franklin
This article focuses on the all-too-common problem of inadequate due diligence of property commitments during M&A activities. The impact of inadequate due diligence is always negative and can vary from an unwanted but manageable surprise to a material impairment to the intended outcomes of the M&A transaction. We provide an insight into the LPC approach to due diligence on property commitments when considering an M&A transaction and how this approach helps mitigate risk.
The impact of Inadequate due diligence of property commitments in M&A transactions
“Rule No. 1 is never lose money. Rule No. 2 is never forget Rule No. 1.” - Warren Buffett
The annual reports of acquisitive listed companies often reference unexpected and negative surprises relating to acquired property commitments.
Helius Ltd is just one Australian-listed company where inherited property commitments have resulted in unexpected occupancy costs and unwanted misalignment of these commitments with business strategy and business requirements. The impact of this misalignment increased business risk and contributed significantly to Healius’ financial stress. Effective due diligence of the property commitments would have mitigated the misalignment and the inadequate acquired infrastructure, which drained reserves.
Woolworths' expansion into the home improvement sector via Masters was another Australian example of overlooking the risks related to property commitments. Restrictive covenants and zoning issues were handbrakes on the business rollout, contributing to substantial losses and the eventual closure of Masters' stores.
In New Zealand, Fletcher Building demonstrated that inadequate property due diligence is not a uniquely Australian problem when it acquired Formica. Along with the business acquisition came the acquisition of property commitments with environmental liabilities that increased cost and impaired the intended post-acquisition business plan rollout.
While the above examples involve large companies that are well known, inadequate due diligence of property commitments is a widespread problem in both major and minor acquisitions. In recent years, we have seen the emergence of multi-site organisations providing health-related services that have grown by acquiring the businesses of independent practitioners in conjunction with taking over the lease on the premises. In many bolt-on acquisitions, the owner of the acquired business and the premises becomes the lessor. Pursuant to working out a time-framed profit warranty, the lessor’s primary concern is passive, risk-free rental income, which is opposite to the objectives of the acquirer, who seeks to contain occupancy costs and derisk the property commitment. The outcome is often an unsustainable accommodation arrangement typified by annual escalation above CPI, premises that require tenant-funded capital works to align with updated business requirements, bank and personal guarantees, lease terms not aligned to the business plan, and limited lease flexibility if the business plan does not work out as intended.
The summary message is that inadequate due diligence pertaining to acquired property commitments will inevitably lead to negative post-acquisition surprises in the form of financial losses, operational disruptions, constraints to the business plan rollout, disputes with legal action, and reputation damage. Knowing what to look out for and ensuring thorough due diligence are necessary to mitigate risk.
Mitigating post-acquisition risk relating to property commitments
“Patience and diligence, like faith, remove mountains.” - William Penn
The basis for informed property commitments is captured in the tagline 'business before space.' In relation to M&A activity, it is essential to consider what property commitments are aligned with the post-acquisition strategy. This is the starting point for assessing the alignment of the current locations, premises, and commercial terms with the business strategy as reflected in the post-acquisition business plan. The following simple questions set the scene for effective due diligence focused on the right issues: Do the locations fit today and into the future? Do the premises require capital works to enable the business plan? Do the commercial terms for each lease support the business plan for the business and for each location?
As is always the case with due diligence and risk management, the devil is in the details. Due diligence relating to locations should include analysis using location economics data and verifying current and future zoning and land use. In relation to the premises, informed judgement includes assessing the property condition, discovery regarding environmental liabilities and regulatory parameters, and what is required to use the premises for the intended current and future purposes. Assessing the commercial terms for fit requires in-depth interrogation of each lease to identify constraints or unsustainable occupancy cost obligations having regard to the post-acquisition business plan. If the due diligence is conducted early in the M&A negotiation process, then the findings create buyer leverage in the negotiations, whilst also identifying how well the property commitments are aligned to the business plan.
Achieving intended outcomes and mitigating the risk of negative surprises post-acquisition requires well-directed due diligence. As is always the case, it is essential to start with the end in mind and work back through the details of the locations, premises, and commercial terms that will be inherited. The aim is to verify alignment, highlight gaps, and inform the pre-acquisition negotiations.
Who is LPC, and how do we help futureproof their accommodation arrangements?
LPC is a conflict-free advisor to commercial tenants across Australia and New Zealand. We facilitate strategic review of accommodation strategy, represent occupiers to secure best-fit accommodation arrangements, provide a lease management service to multi-site occupiers, and oversee client fit-out and relocation. Contact us to help with your accommodation strategy review.
