How to Conduct Effective Due Diligence

Conducting due diligence on a potential acquisition target has two main goals:

• Confirm that the proposed acquisition is indeed the right company to buy and that the price you are offering is appropriate.
• Ensure that there are no issues that would cause you to abandon the proposed transaction, such as disputes over ownership of key assets or undeclared liabilities arising from ongoing legal disputes.

Even though the first goal is critically important, most companies spend the bulk of their time pursuing the second one. In addition, many companies seem eager to engage in due diligence as early as possible, which can be a mistake. Ideally you should start due diligence only after you are sure there is a strong possibility of concluding a transaction, which implies that you have agreed upon the key deal terms and that both parties are within the ballpark as far as price is concerned. Conducting a thorough due diligence exercise is a costly and time-consuming affair for both the buyer and seller, so it should be engaged in only after both parties are sure a deal can be done.

The level of due diligence to be carried out is critically important and will be dictated by factors such as the following:

• Transaction structure, with a simple asset purchase requiring much less due diligence than a stock sale in which you are acquiring a going concern complete with all its assets and liabilities
• Your familiarity with the industry, business model, and the company involved
• The level of representations and warranties you are going to receive from the seller and the reputation and financial standing of the seller
• The presence or absence of a competitive bidding situation

Normal practice is for the purchaser to provide the seller with a due diligence data request list. This list is normally quite exhaustive and its content is beyond the scope of this article; however, sample due diligence data requests can be found here or here. No matter what level of due diligence is planned, it’s imperative to ensure that the seller has the data room ready and the content is verified before you start the due diligence process. There is nothing worse than assembling a due diligence team only to discover that the requested information has not been provided or the level of detail is insufficient. Another point to consider is that the seller will place restrictions on the length of time available for due diligence, so you should try to avoid wasting precious time waiting for the data room to be furnished with the requested information.

The due diligence will normally be conducted by a combination of internal and external resources, and it is quite common to outsource aspects such as accounting, pensions, environmental, and legal. If you are engaging in a cross-border transaction where language is an issue, then it may be necessary to outsource a larger section of the work than normal. However, it is best to let the external resources concentrate on compliance issues so that you can devote internal resources to the key task of verifying the quality of the business and the assumptions that underpin the valuation model. The composition and nature of work to be carried out will vary greatly, but there are several key points to bear in mind:

• The composition of the due diligence team should include senior representatives of all key functions. Not only will this provide the team with credibility from the seller’s perspective, but it will also ensure that your internal organization will accept their sign-off on the transaction. The team should also include the manager who will be responsible for integrating the acquisition as the due diligence process may reveal items that require a change to the proposed integration plan.
• In addition to having access to the data room, it’s also necessary to obtain physical access to key assets such as manufacturing facilities and also have the ability to speak to key managers and members of staff. This can be a very sensitive topic from the seller’s perspective, but you need to be highly suspicious of situations where no access is provided.
• Ensure that all members of the due diligence team have been briefed on the logic behind the proposed acquisition and are familiar with the key assumptions underpinning the valuation model. It’s vitally important that the exercise be forward-looking and that key assumptions such as sales growth, synergy savings, and integration plans be verified and pressure tested during the due diligence process. Too many people focus on historic data when in reality they are buying the company for its future potential and not its past performance.
• Despite the rush to complete the process within the allotted time, you will need to be attentive to “soft” issues that only become apparent via observation or questioning. Examples of this may include the company culture and how it compares with your own. What are current human resources practices, and what is the potential impact if you need to standardize to your existing policies? If there are staff members who play key roles, how comfortable are you that they can be retained post acquisition?
• Each of the external service providers will likely have a standard due diligence list they wish to complete, and these lists can be very extensive. It’s important to look at the standard list and remove any items that you feel are unnecessary. Not only will this reduce cost and time but it will also minimize friction with the seller’s team, as they are likely to become upset when asked to produce data that they view as being irrelevant.
• The due diligence team should appreciate that they are engaged in a fact-finding mission rather than a “Spanish Inquisition.” Their interactions with the seller’s staff must be respectful, and they should attempt to minimize any business disruptions associated with fulfilling their requests.
• Ensure that a Confidentiality Agreement has been executed before any members of the due diligence team commence work so as to protect all parties involved.

Typically due diligence processes last for several weeks (sometime longer) and numerous work streams will be underway simultaneously. It’s imperative to hold regular meetings of the team to share updates on progress and findings. The due diligence process often requires recalibration, and it may be necessary to devote more resources to investigate areas that appear problematic while other areas with no issues are closed out early. In particular, obtain regular updates from external advisors so that there are no surprises when their final reports are issued.

The due diligence exercise will invariably uncover items for further investigation, and the team is responsible for keeping management up to date on developments and for making recommendations on how findings should be handled as part of the overall deal process. Broadly speaking, findings will be either insignificant or significant:

• Insignificant items by definition have little or no bearing on the quality of the business or valuation model. Examples of these might include using an incorrect depreciation rate for a certain asset class or failing to obtain certain regulatory certificates.
• Significant items are important and require that specific actions must be taken in response to the new information. Broadly speaking, three alternatives are available:
  • Adjustment to Price: This may be appropriate for items where you are comfortable that you can accurately quantify the financial impact. Examples of this would be items such as an underfunded pension liability or incorrect calculation of a sales tax liability.
  • Representations and Warranties: This action may be appropriate for items that are uncertain as to outcome or difficult to quantify. Examples of this might include pending litigation or a trademark dispute. In such cases you may require the seller to indemnify you for any financial loss arising in the future. Note that your willingness to accept representations and warranties will depend upon the reputation and financial standing of the selling organization. If you are uncomfortable doing this, then placing a portion of the purchase price in an escrow account may be more appropriate.
  • On rare occasions your due diligence will uncover problems so serious that you determine there is no point in pursuing the transaction. Examples might include discovery of unsupportable sales practices involving government agencies, serious flaws in the manufacturing process, and so on. In such cases, your only viable option is to cancel the due diligence process and walk away.

 

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