By Steven M. Lewis, Senior Vice President, Fitzmaurice Companies, Inc.

Payroll expenses are typically a company's largest expense. Health, Welfare & Retirement (HW&R) benefit costs (fringe components of payroll) can equate to as much as 35 percent of total payroll dollars. The Health & Welfare component of employee benefits are by far the largest component of fringe (usually exceeding the combined cost for the two other primary fringe items - taxes and retirement plans), and with the exception of retiree medical, are generally not specifically identified on a company's financial statements. Rather, they are typically buried among various miscellaneous expenses. Therefore, with a buyer's attention spread over many fronts, this substantial area of a target's expenses can be easily overlooked or ignored.

Today's Environment: Hyper-Inflation & Regulatory Scrutiny

While the bulk of our economy teeters on the brink of deflation, health care inflation continues unabated. With trend running in the mid-teens, most employers are experiencing health care renewals north of 20%. That means for a typical mid-size company spending $5 Million a year on medical coverage for their employees, they can expect to see a $1 Million increase year over year or a doubling of their current expenditure in 5 years!

With respect to retirement plans (defined benefit and defined contribution plans), the costs are not so much the issue as is the regulatory scrutiny. In this post-Enron, Worldcom, et al world, the qualification of tax-deferred benefit plans is being subjected to far greater oversight as a result of the misdeeds of others.

What is Employee Benefits Due Diligence?

Employee benefits due diligence is the in-depth analysis of a target company's HW&R benefits. The analysis focuses on auditing the seller's representation of the benefit plans and costs, uncovering previously undisclosed liabilities, disclosing potential cost savings, and providing benefits advice / structuring plan alternatives for the new entity post-close.

As employee benefits have become significantly more costly and complex in recent years, buyers have begun to recognize the value of engaging employee benefit professionals to assist in the evaluation of a target company's HW&R benefits.

On the legislative front, it is important to note that buyers will be responsible for ensuring that the newly acquired company's HW&R benefit plans comply with benefit laws and regulations (both federal and state mandated) and with accounting standards specific to these benefits. Material financial penalties could result if any offenses undetected pre-close subsequently come to light. catastrophic protection at a lower premium relative to a whole turnover policy.

Transaction Types Where Employee Benefits Due Diligence is Critical

There are two types of M&A transactions where buyers should pay particularly close attention to employee benefit-related issues: Carve-outs/Spin-offs and Industry Consolidations.

Under Carve-out transactions, actual benefit costs of the spun-out entity (often a division of a larger organization) must be looked at carefully. More often than not, a seller's representation of actual benefit costs for the division is not reflective of costs on a go forward basis since costs are typically average cost allocated across divisions.

While the average costs may represent the seller's current allocated expenses for that division, rarely does it reflect an accurate projection of stand-alone costs (the division may be a beneficiary of subsidies from other lower cost divisions; conversely, the targeted division could be supporting more costly units). Issues relative to a reduction in economies of scale are also a significant consideration. While the buyer needs to understand current costs as relates to the division being purchased, an even more important understanding to gain is the true cost projection on a go forward basis.

With regards to Industry Consolidation transactions, an employee benefit evaluation is critical. The obvious reason for such an evaluation is the inherent duplication and overlap of many coverages and associated costs that will result without a strategic plan of attack. In addition, this is one area where the platform company can gain true synergies and efficiencies as they continue to make add-on acquisitions. These efficiencies are a direct result of the new entity's greater leverage in the marketplace as a larger organization.

The following are two case studies in which employee benefits due diligence was necessary:

The Due Diligence Process

The goal of the employee benefits due diligence process is simple: protect the buyer's financial and legal interests. The following is an overview of the key stages of the due diligence process:

1. Review the following documents for all items relating to employee benefits:
   • Offering Memorandum
   • Letter of Intent
   • Purchase and Sale Agreement
2. Compile all HW&R benefit plan information from the seller and the various benefit vendors. Review and cross reference the following data:
   • Summary Plan Descriptions (SPDs)
   • Plan Documents
   • Vendor Bills
   • 5500 Filings
   • Funding Arrangements / Reserves
   • Accounting Documents (i.e. FAS 106)
   • Claim Experience Reports
   • Employee Demographics
   • Employee Contributions
   • Employee Contracts
3. Uncover benefit issues that may require resolution between buyer and seller. Such issues include but are not limited to:
   • Wide discrepancies between the projected stand-alone costs and seller's representation of same;
   • The employment and benefit status of previously terminated, retired or disabled employees; and,
   • The existence of previously undisclosed and/or unfunded liabilities.
4. Establish new / revised benefit plans, associated costs, and policy and procedures for target company post-close.
5. Introduce new benefit plans to target company employees. Generally, plans are effective on the close date of the sale; therefore, plans must be implemented with all benefit vendors simultaneously.

Employee Benefit Considerations Post-Close

As the employee benefits due diligence is being conducted pre-closing, buyers should not lose sight of benefit-related issues that will affect the target company on a go forward basis.

1. Employee Retention
   In any labor market, it is often essential that the buyer retain key management and, in many cases, key skilled employees. Benefits are a critical area of concern for employees during a transaction. Right after "Who is this acquirer of our Company?" and "Do I have a Job?" employees want to know what their benefits are going to be under new ownership.
   
   Not only must a buyer provide employees with an industry competitive and cost-effective benefits package, but they must also be able to effectively communicate the programs.
2. Communicate Early
   It is essential to communicate benefits as early as possible to the newly acquired employees. By sharing accurate and detailed information with the workforce, feelings of uneasiness and vulnerability may be alleviated.
3. Controlling Costs
   The new benefit plans should be designed to control costs for at least three to five years out. One-time, first year savings should not be the exclusive goal, rather long-term financial commitments from the benefit vendors will better protect the new entity from fluctuations in the evolving and consolidating benefits marketplace.

Conclusion

As buyers perform due diligence to determine the feasibility of transactions, ample time and resources should be spent on evaluating the health, welfare and retirement component of a transaction. Such evaluations can help buyers avoid potential benefit landmines and allow them to confidently build accurate benefit costs into their business models.




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Fitzmaurice Companies, Inc. is an advisory firm that puts mid-size companies in control of their employee benefit programs. We specialize in providing focused M&A Due Diligence and Portfolio Company services to the Private Equity community, as relates to their employee benefit plans. Steve can be reached at 212-594-0821; e-mail: slewis@fitzmaurice.com or visit their web site: www.fitzmaurice.com.