M&A spotlight on: IT costs

Both buyers and sellers frequently struggle to accurately predict post-deal IT costs. Getting those numbers right can improve valuation results, strategic performance, and profit estimates. Conversely, not understanding the true IT costs can result in post-deal disputes. Therefore, IT costing should be considered a key due diligence and integration issue.

Inaccurate IT costs are a real possibility

By their very nature, M&A deals tend to be time sensitive, and communication between teams may not be adequate. As the deal progresses, IT costs tend to be focused on short-term needs that may not be aligned with the merged entity’s longer-term strategic plans. IT managers are not always aware of all the business needs beyond the closing date and may have to speculate on the post-close operating model and IT requirements. That approach may not only underestimate IT costs, but also undervalue how IT can contribute to the merged entity’s success. In general, technology and its successful integration can create large, long-term profit and growth opportunities.

Inaccurate cost projections may also occur because IT is given a cost budget on the basis of cost allocation rules and preset standards for expenses. This leads to costs that may not be aligned to market or actual usage. IT costs should include one-time costs, ongoing costs, and those related to the TSA; and may become a significant negotiation issue between buyers and sellers.

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It is also easy to get IT costs wrong because acquirers do not always understand the target’s approach to IT. A “deal oriented” assessment of a target’s IT systems, infrastructure and processes, staffing and competency, and risks and controls is generally overlooked during due diligence. IT officers are simply asked for the cost of reconciling systems without getting a chance to study compatibility, replacement of systems, resources, and additional capital (CAPEX) and operational expense (OPEX) that could be required during integration.

Instead, corporate development, business, and IT teams should work closely to confirm their deal assumptions. Management, in collaboration with an independent adviser, should build IT estimates based on competitive real market (not indicative) data and create bottom up benchmarking to support and drive more meaningful analysis of IT costs and IT synergies.

Understanding the true IT costs

A complete analysis of the IT ecosystem is required for the merged entity. Companies should not just assume that existing IT systems are good enough. Relying on a legacy system is one of the primary reasons a technology synergy can lose value. While continuing to use legacy systems may be inefficient, the alternative may also be a challenge; a replacement system may be both expensive, disruptive to the business, and potentially risky.

What should companies do? IT should be considered an important integration issue and addressed early on. Technology can be one of the most dynamic aspects of a business and its capital requirements need to be understood. During a deal, back-office integrations and hiring of technology consultants tends to take priority, and companies may fail to allocate enough of their budget for new and important IT capital requirements. Estimating future system replacement costs can be a substantial undertaking with a material financial impact. However, this analysis should be performed pre-close to give the acquirer guidance on the magnitude of potential future one-time expenditures. A short-term outlook that rewards “quick wins” may lead to higher future IT costs as well as a significant negative impact on future profitability.

Companies that don’t adequately focus on IT can also minimize capacity issues. A rushed systems integration frequently leads to the parent taking over all, or most, of the assets of the target. Reconciliation of some common systems such as HR and Finance are completed, but, the merged entity runs on different systems for many other functions, leading to duplication and added expense. However, a merged entity that is focused solely on cost cutting may reduce employees, systems, and software with too much enthusiasm. Simply minimizing IT is not a recommended leading practice. Business applications, IT infrastructure, technical resources, and IT management are critical assets. An analysis of all options is advised. Requirements for Day One may be substantially different from longer-term needs. Both types of IT planning need to be understood and budgeted.

Leading practices to manage IT costs

IT integration should include a detailed cost planning and IT roadmap of the new organization. Spending plans should be tested against the deal thesis and the merged company’s operating model. IT is a crucial component of almost all business functions. It is important to have open communication about the target operating model (TOM) and timing, so that employees can resume smooth business operations post-deal. Standards need to be redefined and consolidation areas need to be mutually agreed upon. With organizations increasingly moving towards a cloud option, complications in systems and concerns about data security during migration are at an all-time high. A discussion involving all stakeholders—from vendors to customers—helps to formulate a detailed plan of action and minimize risk.

Collaboration between key stakeholders—including the CFO, the deal team, and the functional leads—will help the merged entity to understand all IT costs and their possible effects. This step can help limit unnecessary cost burdens. For example, if new assets are purchased, these should be treated as CAPEX. CAPEX can be treated as depreciation on an ongoing basis to avoid spikes in spending. Similarly, to avoid overestimation and maintain standards for future acquisitions, it will help if synergy costs and transition costs are recorded independently.

A new mind-set may be required

Unfortunately, in many deals, IT integration is considered an operational activity, instead of a strategic one. That perspective may inhibit a company’s ability to fully realize post-deal synergies. Those who adopt a more strategic approach will gain several advantages.

Forward-thinking companies should seek to understand how new business models and technological disruption are creating both risks and opportunities. Investing in high-tech operational services can help companies adapt to a quickly evolving business landscape. Budgeting for new IT solutions and investments during integration helps the newly merged company without disrupting business momentum. New technology implementation not only improves the top line by replacing legacy systems, but also helps minimize IT integration costs by avoiding duplication and wasted resources.

Buyers should focus on an overarching integration plan and the associated costs to achieve two distinct TOMs.The first affects Day One, and is most concerned with minimizing disruption; the second looks beyond Day One. In that case, the focus of the TOM is to fully support the forecast model and grow the company post transaction.

Conclusion:

Fully understanding IT costs during a deal is crucial. The continued and urgent deployment of IT by companies of all sizes has expanded the implications of IT costs and analysis during M&A. Adopting a set of leading practices can help companies more accurately predict IT costs and better use their IT investments to further their strategic goals and improve long-term growth and profitability.