Good Fraud or Bad Fraud in the M&A world

Does it sound weird? Is there such a thing in the M&A world as good fraud? In a word, yes! Put simply, good frauds create opportunities to buy undervalued companies and cut costs. Bad frauds, in contrast, dilute the value of the deal. Distinguishing between the two is not very difficult, once the consequences are clear.

Bad frauds generally kill deals?generally, the buyer either walks away or uses the discovery of the fraud as a negotiating ploy. Good frauds, by contrast, are to be treasured and kept under wraps until the deal closes, since eliminating them often reduces costs and improves the acquirer's bottom line.

Bad Fraud: Buyer Beware

Any deal-diluting misconduct qualifies as bad fraud. The most common types are financial misstatement and undisclosed legal liability.

Cooking the books is bad fraud because it can cause a buyer to pay too much for an acquisition, unless it is found in time to negotiate a purchase price reduction or other compensation. Although sellers can dress up the books in various ways, false financial statement schemes fall into seven basic categories:

• Revenue recognition schemes where the target recognizes revenue prematurely (i.e., before the terms of sale are completed), or records fictitious revenues (i.e., falsified documentation supporting fabricated sales)

• Understating liabilities or schemes arising from costs and expenses where the target delays costs associated with sales, fails to record liabilities for future costs, or improperly classifies expenses as assets

• Overstating assets where the target inflates the value of inventory, cash, accounts/loans receivable, property, plant and equipment, or fails to establish adequate reserves for uncollectable receivables

• Related-party transaction schemes such as conflict-of-interest transactions with undisclosed related parties that are not done on arms-length terms and can involve price, quality or quantity misstatements or non-existent services

• Misappropriations of assets including failure to recognize loss of assets

• Management discussion and analysis issues that can arise when management omits contingent liabilities, excludes significant events, or fails to disclose serious fraud involving directors, officers or employees

The Laws in many jurisdictions hold the acquirer liable for all criminal and civil charges arising from any illegal actions of the target prior to acquisition. While the acquirer can either continue or stop the illegal conduct, he may lose either way. By continuing the illegal practices, the buyer may save on taxes, but take on greater liability. Ceasing the practices may keep the acquirer from going to jail, but increase operating expenses.

Good Fraud: Buyer Benefits

Good fraud is any misconduct that, if detected and deterred, reduces costs and increases earnings. Consider procurement fraud. A purchasing agent buys raw materials at inflated prices and receives a kickback from the vendor. Because the company pays too much for raw materials, earnings and the value of the enterprise are lower than they should be. A prospective buyer who spots the kickback scheme during diligence and stops it after the deal closes will get a bargain.

Study after study?both public and private?demonstrate the significant impact fraud has upon earnings. According to the US Department of Commerce, fraud losses for the average American company equal 6 percept of revenue. Companies doing business in higher risk markets suffer substantially greater losses.

Good fraud directly reduces the bottom line, so a dollar saved by reducing fraud equals a dollar increase in earnings. The earnings impact of fraud management depends upon a company's profit margin: the smaller its margin, the greater the impact. As the following example illustrates, a company with a 10% profit margin stands to gain a bigger earnings boost by eliminating fraud than a company that operates on a 30% margin.

The effect of eliminating good fraud on enterprise value can be even more significant, depending on the industry's EBITDA multiplier: the greater the multiplier, the bigger the impact. A case in point: company X operates in an industry with an EBITDA multiplier of 4 and earns $150 million against $500 million of revenues. Eliminating fraud equal to 6% of revenue?or $30M?would increase company X's enterprise value by $120 million, from $600 million (4 x $150 million) to $720 million (4 x $180 million).

While this example illustrates the positive impact of eliminating fraud, it is neither cost-efficient nor even possible to eliminate all of it in most cases. However, fraud reduction is highly practical and offers tremendous, often untapped, cost-saving opportunities.

Detecting Fraud During Diligence

Avoiding bad fraud tends to be the first priority of corporate and financial buyers, since no one wants to overpay or risk going to prison. Many buyers mistakenly assume that their diligence teams will detect bad fraud. Fraud often lies buried in operations and rarely surfaces during typical financial analysis. Unless the acquirer spelled it out, most accountants believe that fraud detection lies beyond the scope of their audit or diligence engagement.

This means that acquirers themselves must become familiar with the "red flags” of fraudulent schemes, broaden the scope of diligence to uncover the operational, reputation, cultural and financial warning signs of bad fraud, and be prepared to conduct follow-up investigations

Good frauds exist in virtually every acquisition target. So buyers who focus on avoiding "bad fraud” without searching for "good fraud” often leave money on the table. Identifying good fraud requires upfront planning and investigation. The diligence team should be concerned about both internal and external misconduct, as well as waste and abuse, since each has the same bottom line impact. A typical review looks at the procurement, supply chain, sales and marketing and financial operations of a target company.

• Procurement - The highest incidence of good fraud is found in procurement. While well-managed procurement departments generally do not have many fraud risks, poorly managed or structured ones are highly vulnerable to fraud. It is therefore critical that a prospective buyer assess the structure of the target's procurement department and its processes for qualifying and selecting vendors and awarding contracts. It is equally important to review any spending outside the traditional procurement process, such as the purchase of professional services.

• Supply Chain - Manufacturing, shipping, receiving and distribution centres also give rise to good fraud, since they often are vulnerable to property theft or corporate espionage. The diligence team should assess the adequacy of accounting, inventory and security controls.

• Sales and Marketing - Sales and marketing are vulnerable to both good and bad fraud. Diligence should look for kickbacks arising from the selection and deployment of internal and external sales forces, independent sales representatives and distributors, and also search for irregularities in advertising and promotional expenditures.

• Finance and Administration - Diligence should examine the structure and day-to-day management of the accounting, treasury, human resources and accounts receivable/payable functions, along with management of the target's international and domestic subsidiaries, joint ventures and strategic alliances. These functions can be the instruments of both bad and good frauds. Consider, for example, payroll fraud schemes where monies are paid to fictitious employees. From the acquirer's perspective, these frauds are wonderful as they deflate the target's earnings, which, in turn, decrease its EBITDA value. Ceasing the payroll scheme post-close will reduce costs, increase earnings and ultimately enhance enterprise value.

The search for good and bad fraud should not end when the deal closes. Building upon knowledge gained during diligence, the buyer should conduct a more thorough fraud and security risk analysis as soon as there is full access to the company. Target employees eager to please new management or likely to leave the company can be valuable sources of information. It is absolutely critical that these employees be interviewed before they leave the company, as it is far easier to interview a current employee than a former one.

Acquirers must also make sure that their purchase and sale agreements contain adequate remedies for bad fraud discovered within a reasonable interval after closing. Such remedies include escrow agreements, representation and warranty clauses, purchase price adjustment mechanisms and indemnifications.

No buyer can afford to be nonchalant. Management should diligently search for good fraud, and find out whether a target's potential fraud loss is more than, less than or equal to the national average of 6 percept of revenue. While these statistics are not good, they suggest that even "average” companies may contain enough "good fraud” to keep them undervalued. By searching for good fraud, a buyer may find a bargain, or at least opportunities to reduce costs, inefficiency and waste. Either way, he wins.