SOME ADVICES ON CONDUCTING A DUE DILIGENCE FOR TYPICAL M&A TRANSACTION
The goal of this article is not to write “a step by step” article on how the due diligence process should happen but rather share with you some thoughts and advices I am getting from my operational experience.
For many middle-market businesses and private equity firms, buying or selling a company can be the deal of a lifetime — one that carries significant emotional and financial risks as well as rewards. Comprehensive, well-executed due diligence can make the difference between success and failure.
In the domain of M&A, due diligence is an investigation that a business or physical person (potential investor) will make before an acquisition. In this article business or investors will be referred as “buyers” and Sellers’s company will be referred as “target”.
This investigation process will allow the buyer to make reasonable decisions based on the due diligence results. It allows frequently the buyer to lower transaction price based on due diligence findings.
Also, by properly anticipating the related issues that may arise, the target company will be better prepared to successfully achieve the sale.
Findings and conclusion will be shown in reports (i.e. key findings report) but there is no existing formalized standard process. Depending on the type of due diligence, scope and negotiation between parties the process could be very different from one due diligence to another.
This is why the exercise could be quite subjective and leading to material errors if the process and objectives are not carefully reviewed.
A formal process is a necessary step. It brings discipline and it helps parties get the important things right.
Also risk approach can differ among buyers. Some would prefer to invest in several steps to try to limit risk and invest within a step by step process; when meanwhile others would like to acquire fully and quickly the target to take control asap and then also limit the risk!
Without due diligence, the buyer could eventually miss significant information to be able to take an informed and reasonable decision.
I have known a company who wanted to acquire during 7 years in a row a competitor. They were conducting initially a due diligence during the first year. They didn’t agree on terms of the transaction and were successful only seven years later. They thought company business model and financial risks didn’t change and they didn’t proceed to a new due diligence. It appeared after the transaction was completed that some assets being acquired were not in line with buyer business model and were not creating any synergies. The buyer had to sell them immediately for a much lower price than the acquiring price. Funny enough (in reality this is sad!) some of these assets were purchased back by the shareholders target. No need to say that this was a painful process and this could have been easily avoided during at least an “updated” if not new due diligence process.
The due diligence process can take few months (around 3 months for some small business) to several months/years if we speak about international group. It should be adapted to the size of capital invested regarding the total size of buyer business.
When process is long enough, it becomes painful for all parties involved. We should always keep in mind a reasonable view for duration and how it can impact the daily operations of the target. Each question from buyer typically means work for the target and time away from running their business. Using your questions wisely can increase the efficiency of your due diligence and improve your relationship with the entrepreneur.
But according my experience, duration should not be minimized especially on buyer side or you will always have the risk to miss significant issues. I remember a M&A where the final buyer has had no time to check carefully all documents (this was during a bid implicating several participants) and had no specific warranties on the transaction contract. This was resulting in huge provisions taken in the new consolidated company.
Also, documents presented (in the data room) by the target should be well reviewed.
In mergers and acquisitions, the traditional data room will literally be a physically secure monitored room in the target’s office where all useful documents are stored. Nowadays we are using virtual data room on internet to store documents.
Another example of issues with documents was the buyer only having access in data room to printed documents from the target accounting system. Target didn’t allow direct access to their accounting system. It appeared that documents were “re-worked” by the target and target representatives. Global business picture presented to the buyers was wrong and financial projections were highly overestimated.
“Experience is here a key asset to possess but you will also need patience and empathy. Target management will let you know about main issues only if they feel they are in a trust environment.”
Interviews are key part to get “the secrets” of the target and try to assess what are the main and potential future issues of the business. Management and shareholders of the target business have some very valuable information that you would like to know. You can get it only through interviews.
If management is very open to share knowledge it will be reported directly as it is in the due diligence report and it will contain valuable information. But to be only an “Egyptian scribe” is not enough.
Management could not be so opened, trust could not be there, or you can simply miss information. You should put in place some “unformal interviews” which can happen anywhere (smoking places, dinners, …) and/or organize more interviews (not only with management but also with sub-managers).
In addition to identify main business or financial issues, it will help you to assess the management team in place and know already their strengths and weakness to anticipate properly the post-acquisition process. It can also make you know history of challenges faced by the shareholders and management.
You will have to cross-reference information to get something valuable. This is how you create value to potential buyers and you can potentially drastically lower the price transaction.
I remember a draft due diligence report showing no particular or material issues. But after a second round of interviews with shareholders sellers and target company management it was clear that the business was also depending on hidden cash transactions. This became the center of discussions for the future transaction. It is then very important to approach a due diligence not only from a formal point of view but also to get the truth from figures. It is well known that you can make say anything from figures and this is certainly true.
Experience is here a key asset to possess but you will also need patience and empathy. Target management will let you know about main issues (voluntary or indirectly) only if they feel they are in a trust environment. Because we all know that these main issues can impact strongly the transaction price.
A due diligence goes far beyond a standard financial audit as we are also thoroughly checking the target company assets from a strategic and commercial point of view. A financial audit states if errors are material at a given time and due diligence will also approach figures from their future perspective. It will also be good to detect the “off balance sheet items” during the review.
I think it is very important for the buyer and target to have common values and how they see rules to conduct a business. To my experience, it is a key success as this is creating this “trustful atmosphere” which is so important for the success of the transaction but also for the target employees to become full part of the new company.
It’s crucial to identify and address material risks to the transaction as early as possible in the due diligence process. Waiting until the last moment can seriously endanger — or even kill — a deal, especially the trust factor between the parties. It can also unduly influence decisions on other important issues if transaction costs that could have been avoided by raising the issues early on must now be taken into consideration.
It may also be wise if the process is long enough to integrate in the target structure a financial director sent by the buyer (temporary or not) who will have more facilities to obtain any confidential information than a consultant who will always be regarded as a non-operational and external element. This financial director could be in this case the central communication point of the process. It is important to have in any case a central person in the target liaising and communicating with the buyers. Identifying one-point person who manages interactions with the target simplifies communication lines and helps clarify team roles and responsibilities from the start.
This person should help developing a master calendar of key milestones and goals for the duration of the due diligence process, including regular check-in calls with the team. Again, this allows to anticipate any issues and raise the trust between parties.
It is important to keep a global view and understand what is important and what is not important. It is easy to get lost in details during the commercial and financial reviews. Keep in mind the strengths and weakness of the business. Don’t under estimate the importance of cash generation and working capital needs during the financial review. They are often important to detect issues than P&L and balance sheet. How is “working capital” determined for purposes of the acquisition agreement? Definitional differences can result in a large variance of the dollar number.
A product manufacturer may face new regulations that could have a significant impact on shipping and inventory down the road. Not understanding the cyclical nature of a target company’s sales and related inventory needs could also directly affect the negotiation of the purchase price and working capital adjustment.
Finally, all parties need to be transparent with each other during the process and if answer is “no” then you will need to communicate it Asap. If you think “maybe” and not “yes”, the other party will feel it and then you can destroy the trust and miss the transaction.
As you understand due diligence process can be quite complex and subjective. This is why you will need even for small business to be accompanied by specialists.
My next article will be a summary of the most significant legal and business due diligence activities that are connected with a typical M&A transaction.