I thought I’d write this post about due diligence (also known as ”DD”) which is the least exciting part of every investment or M&A (Mergers and Acquisitions) transaction. We’ve advised hundreds of investors, buyers and founders of businesses and many hope or ask to skip over due diligence either through light due diligence or completing due diligence post deal.
Invariably these deals that skip detailed, formal and thorough due diligence suffer almost without exception whether the acquisition is small or large e.g. listed public companies.
Why do Investors, Often Experienced Try and Avoid Due Diligence?
Experienced M&A professionals and investors have seen enough deals to know that due diligence is a mandatory step in any transaction, however I’ve seen many CEOs, CFOs and directors (even of ASX listed companies) ignore acquisition due diligence on the basis that:
- It will slow down the acquisition – due diligence easily adds 3 to 8 weeks to any transaction of substance and
- It will kill the deal – of course that’s the point, when you find a key issue sometimes you need to walk away from the whole transaction
- Due diligence is a difficult process and raises issues that buyers and vendors need to work through and resolve
- Wanting to appear to be the ‘white knight’ or friendly buyer in a competitive process – vendors are sophisticated and this just leads to acquiring risky ventures with little upside
- The business or sector is well understood, either it’s a Management Buy Out or a competitor – whilst this may be true to a certain degree, the business has it’s own risks and liabilities
What are the Benefits of a Detailed Due Diligence and Commercial Analysis of the Target Investment?
There’s a multitude of benefits, including ensuring that the vendors disclose everything that may impact the value of the business – not doing so allows for a potential future claim against warranties in the sale agreement. Other benefits include:
- Ability to review the detailed financials of the business (not just high-level P&L) to determine if there has been personal owner or non-commercial transactions embedded in the financials.
- Reconciling the P&L to the bank statements is a great exercise and often these don’t match.
- Understanding the quality of the assets and IP of the business – whether they actually exist or are owned by a third-party.
- Legal review of contracts with hidden change of ownership clauses.
- Review of customers and clients which may have been boosted prior to the sale and may actually leave or have contracts about to expire.
- Understanding what revenues may stay with the vendor and what costs may be burdened on the for sale business – this is a common tactic that is not always evident in initial negotiations
- Assessing the staff and determining if some may leave soon after acquisition and require a pay-out or are under-performers left on the books that the vendor is unwilling to deal with before the transaction
How to Manage a Due Diligence Process?
Normally you would involve an M&A Advisor for the commercial due diligence and high level accounting and legal review. Can an accounting firm or lawyer do all the due diligence? Typically no – there’s significant commercial acumen required and from what we’ve seen over the years, accounting and legal professionals have select expertise rather than broad deal and transaction skills.
Due diligence is usually run as a formal process with a timetable and initial due diligence list (see our high level due diligence guide) that evolves rapidly as information is received. It is also common to maintain a Question & Answer (Q&A) list where the buyer asks questions and the vendor identifies the right person at their end to help answer the question. Both the due diligence list and Q&A register often form part of the sales agreement as a schedule.
How Long Does Due Diligence Take?
Allow at least 3 weeks at the very least, due diligence takes time and isn’t about just receiving materials – you will need to read and review each document and identify the hidden and potential issues. Normally it is about working out what key business challenge is being hidden or glossed over. Vendors themselves will struggle to get you all the materials quickly as they should review them before providing – often this whole process takes a month before you even get into detailed Q&A around select specifics.
What about Management Buy-Outs?
In a management buy-out (MBO or LBO, Leveraged Buy-Out) the management team is undertaking the acquisition from the parent company. There’s a perception that due diligence should be quick and light. A few significant issues typically emerge:
- Management does not know everything about the business or the legal entities
- The deal structure may transfer significant risk to the buyer
- Third-party investors are overly reliant on the management team – it is suggested to undertake detailed review to break this reliance
What if Key Issues are Discovered?
Quite simply this is the whole purpose of due diligence and key issues discovery will often trigger a price discussion or a change in the deal terms or simply the buyer should walk away – bad deals lose value quickly and lead to significant disputes.
M&A Due Diligence Checklist
You can see our simplified due diligence checklist here.