Put simply, due diligence is a fact-finding mission for businesses who are considering completing an M&A deal: by carrying out a thorough investigation on the target company, the purchasing company can determine whether moving on with the acquisition is the right move.
The term ‘due diligence’ originates from American security laws, first appearing in the 1933 Securities Act. It confirmed the validity of financial statements when shareholders accused broker-dealers of insufficient information on the company being sold. In M&A terms, it is used so that the purchasing party in a transaction can be informed as thoroughly as possible about the intricacies of the seller. The name is newer than the concept: the Roman saying ‘Let the buyer beware’, has a similar feel.
Therefore, from the buyer’s point of view, due diligence means obtaining the necessary information about the seller to feel confident in pursuing the deal. The seller will aim to convince the buyer that the potential acquisition would prove worthwhile.
The timeframe of the process depends on the quality and quantity of the staff involved, and also the size of the target company. It is possible to complete due diligence within a month, yet companies should not be keen to rush this step in the acquisition process and should not be surprised if it still has not been completed after 10 weeks.
Primarily, due diligence falls into three categories: legal, financial and commercial.
Legal due diligence looks into the legal basis of a transaction, including contracts, loans, property and employment. Its main objectives are to uncover any potential liabilities or contractual obstacles in the deal, and finalize the terms of the agreement. Clearly, legal due diligence could be seen as one of the safety measures to prevent company from unnecessary lawsuits in the future.
Financial due diligence (FDD) ensures first and foremost that the target business will continue to perform to and equal or higher level than it has in the past. It will also verify that relationships with customers a strong and likely to improve, as well as examining accounting policies and checking there are no impending higher maintenance costs.
Commercial due diligence considers the market in which a business is located, and in turn makes sure that the business plan will be able to withstand the challenges of the relevant market climate. It also helps to find a suitable valuation for the deal and to plan for integration following the acquisition. Other types include environmental, tax, IT, and human resources due diligence.
M&A activity has reached new heights in the past couple of years. It is thought that global M&A reached combined values at over $4 billion in 2015, in turn adding up to $1.9 trillion to the companies involved.
The vast data which due diligence uncovers should not be underestimated. Not only does the purchasing party obtain hard data, such as financial, legal, and regulatory exposures, but it also gains an insight into the structure of the target business, investigating its work culture, human resources, and future outlook. Through doing this any deal makers or deal breakers will be spotted and influence the buyer’s decision.
But it is not just significant for the deal itself: assuming the acquisition does go ahead, the detailed and holistic view of the target company can be of vital use as the two parties integrate over the coming months and years. A deep understanding of the financial ongoings and work ethos on both sides will facilitate a smooth transition into a single business and ensure that everyone is pulling in the same direction moving forward.
In terms of timing, a due diligence procedure takes place at the mid-point in a holistic M&A process, coming between the valuation of the target company and the negotiations process. As such it is a critical point in the process: if the purchasers are satisfied, the acquisition will make rapid progress towards a conclusion; if they are not, everything will grind to a halt.
A good due diligence exercise should be objective and expansive, taking a comprehensive view of the target company. Yet taking the time and energy to carry this out pays dividends in both the long and short term.
There are several purposes of due diligence which should be taken into account.
Firstly, as far as financiers are concerned, the operation allows the buyer to confirm an appropriate price at which to purchase the company, and it is also an opportunity to evaluate the financial risks of the transaction. This allows a buyer to avoid unnecessary expenses and eventually pay a reasonable price.
Secondly, the information obtained from a due diligence process should be used to determine details that may be relevant when it comes to drafting out the acquisition agreement. This requires a strong legal presence, since it is essential to determine compliance with relevant laws and disclose any regulatory restrictions on the proposed transaction.
Finally, a thorough due diligence operation will go further than the raw figures and allows the purchasing company to gain an understanding of the staff and culture of the target company. This helps the company to identify and prioritize the human resources issues that need to be dealt with both during and post-integration.
The financial implications of due diligence are variable on several factors:
Of course, the costs of due diligence need to be monitored, but if it means guaranteeing an in-depth understanding of the structure and future prospects of the target company, the costs are worthwhile.
It is important to strike a balance between a due diligence operation which is incomplete- leading to legal and financial issues further down the line- and excessive due diligence- ending up more expensive than the acquisition itself.
However, the process should not be viewed as simply as a necessary checklist so that an M&A deal can progress: it is about collecting the right information which allows the correct decisions to be made regarding the transaction.
The very nature of due diligence often causes disruptions to both parties and conveys mistrust to the seller. But even when the relationship between both groups is strong, there are several obstacles to consider.
Confidentiality arrangements: Due to the potentially catastrophic consequences of any breaches of information, the selling party and their legal team are likely to make excessive demands in the area of confidentiality.
Losing focus: The amount of information gained can make it difficult to separate key pieces of information from the rest of the pile. This is where having the judgement and expertise of advisers is helpful, since maintaining a complete perspective is key to ensure a quick and smooth program.
Reliability of information: Sometimes, even without lying, respondents can be misleading. Therefore it is essential to bear in mind the nature of the information- internal data is usually more reliable than external- and to keep an eye out for irregularities in the paperwork.
Human bias: It is all very well acquiring the information, but the way in which it is interpreted is highly subjective. And when other influences come into play, such as friction between the two management teams and unwanted media attention, rash and biased decisions can be made.
Cross-border transactions: Cross-border deals are becoming increasingly common, although the largest, that of telecom companies Vodaphone and Mannesman, which was worth $186 billion, took place in 1998.
This obstacle is most prominent in legal considerations. In Europe, for instance, whereas French law seeks to protect the buyer, the British legal system favors the seller. This means that a French seller is obliged to release any information regarding the valuation of the acquisition, and so thorough approach of British companies may seem over the top in a due diligence process.
Virtual data rooms (VDRs) have become a great way to ensure an efficient due diligence process, improving the cost-effectiveness, speed, and simplicity of a transaction by accessing up-to-date documents inside a secure virtual space. The popularity of VDRs is expected to continue to replace the use of physical data rooms and material documents.
You can also find some additional information here on how virtual data rooms can improve M&A due diligence process.
Sustainability is becoming increasingly important for both large and small firms, as customers are becoming more preoccupied with ethical purchases. For this reason, and also to avoid large outlays on upgrading eco-destructive equipment and buildings, environmental due diligence is likely to increase in importance.
Finally, there appears to have been a change in mentality in recent years as companies give more priority to ‘culture’ due diligence, which seeks to reconcile the different visions and values of the two parties. What is the point in spending large amounts on legal and financial due diligence if you are not going to pay any attention to how well or badly the two companies might cooperate. The reason that between 55 and 77 per cent of all mergers do not meet their original financial aspirations is in part due to the failure to prepare for the cultural integration of businesses. As such an awareness of qualitative as well as quantitative data will be needed.
M&A’s are predicted to continue at the same rate and size as in the previous years, but in order to guarantee a successful and worthwhile purchase, due diligence needs to be taken seriously and carried out expansively.