Specifics of the Due Diligence Process in M&A

What is M&A due diligence?

Put simply, the due diligence process in M&A is a fact-finding mission for businesses who are considering completing an M&A deal: by carrying out a thorough investigation of the target company, the acquiring 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 business transactions 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 selling company’s financial performance to feel confident in pursuing the deal. The seller will aim to convince the buyer that the potential acquisition would prove worthwhile.

The duration of the due diligence period depends on the quality and quantity of the staff involved and also the size of the target company. It is possible to complete the due diligence process M&A within a month. Yet, both the buyer and seller should not be keen to rush this due diligence stage and should not be surprised if it still has not been completed after 10 weeks.

M&A due diligence on a private company

It’s worth noting that conducting due diligence on a privately held company is way different and far more complex than on a publicly listed company.

Unlike publicly traded companies, private companies are classically traded on the stock market.

Investment bankers can’t acquire shares of a target private company unless they are its founders, employed there, or have invested via private equity firms or venture capital. 

It’s also challenging for most business owners to conduct proper due diligence on a private company since such organizations are not obliged to publicly disclose as much of the financial information as public companies do.

What are the different types of due diligence?

Primarily, due diligence falls into three categories: legal, financial, and commercial.

• Legal due diligence looks into the legal aspects of a transaction, including contracts, loans, property, and employment. Buyers conduct due diligence to uncover any potential liabilities or contractual obstacles in the deal and finalize the terms of the agreement. Clearly, the legal due diligence process could be seen as one of the safety measures to prevent the potential buyer from unnecessary lawsuits in the future.
• Financial due diligence (FDD) ensures, first and foremost, that the target commercial business will continue to perform to an equal or higher level than it has in the past. It will also verify that relationships with customers are strong and likely to improve. During the M&A financial due diligence, a potential buyer prior reviews the financial statements of the target company checks financial records, evaluates the current cash flow, examines accounting policies, and makes sure there are no impending higher maintenance costs.  
• Commercial due diligence considers the market in which a business operates and, in turn, makes sure that the company’s business model and business plan will be able to withstand the challenges of the relevant market climate. It also helps to find a suitable valuation for the business deal and to plan for integration following the acquisition. Other types include environmental, tax, IT, and human resources due diligence.

Why is due diligence important?

M&A activity has reached new heights in the past couple of years. The value of global M&A deals reached almost $4 billion in 2015, in turn adding up to $1.9 trillion to the companies involved.

The vast data which due diligence focuses on should not be underestimated. The purchasing party not only obtains hard data, such as its financial records, information on legal issues, and regulatory exposure details. It also gains insight into the structure of the target business, investigating its work culture, human resources, and outlook on future growth. Through doing this, any deal makers or deal breakers will be spotted and influence the buyer’s decision.

But proper due diligence 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 business owner and acquiring company 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 process takes place at the mid-point in a holistic M&A transaction, coming between the valuation of the target company and the negotiation stage. 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. 

Functions of a due diligence process

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 that should be taken into account.

• Firstly, as far as financiers are concerned, the operation allows the buyer to assess the target company’s revenue and confirm an appropriate price at which to purchase the company. 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 the purchase 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 process will go further than the raw figures and allows the purchasing company to gain a full understanding of the target company’s staff and culture. Reviewing corporate records helps the company to identify and prioritize the human resources issues that need to be dealt with both during and post-integration.

How much does a due diligence program cost?

The financial implications of the M&A due diligence process are variable on several factors:

• The number of discussions that need to be held: the level of contact between the two parties involved will obviously be dependent on the complexity of the target company — the number of products, markets, and areas of perceived risk.
• The professionalism of personnel undertaking the process: extracting information from the target company can sometimes be difficult, and it requires staff with relevant qualifications in order to ask the right questions and establish the necessary facts.
• The time frame: since most of the costs of a due diligence exercise go towards the staff, the time frame allotted to the process will determine both the quantity and expertise of the personnel.

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.

Due diligence activities in M&A transactions

The due diligence process in M&A deals always depends on many factors, such as the target company’s size and expectations of the transaction in general.

However, below are the most common activities every due diligence typically includes.

1. Evaluating the goals of the deal. The first due diligence phase is defying the purpose of the upcoming transaction. The prospective acquirer should outline the results he wants to achieve after completing the mergers and acquisitions deal. This will help to clearly see the target company’s potential to meet those requirements.
2. Analyzing business financial information. The main goal of this due diligence activity is to make sure financials and other supporting documents given in the Confidential Information Memorandum (CIM) are genuine and that the financial performance of the target company is satisfactory. Financial due diligence checklist usually includes such financial information on the company’s operations as financial statements, future forecasts and projections, income statements, balance sheets, profit and loss records, annual reports, information on current debts, and stock history. 
3. Reviewing business-related documents. This is usually the most long-term stage of the due diligence period. During this due diligence phase, the buying side requests the selling side to provide various business-related documents: information on the company’s intellectual property, material contracts, tax forms and reports, employment contracts of employees, environmental research, etc.
4. Assessing the business plan and model analysis. The next phase of the due diligence activity is to assess the business plan of the selling company. This is important to understand how viable its business model is and what are the growth plan prospects of potential integration.
5. Evaluating risks. Before forming a due diligence report, an acquiring side evaluates potential risks of the upcoming transaction to avoid possible losses in the future.
6. Preparing a final offer. After all, the documents are reviewed and a proper investigation of the selling company is conducted, specialists of the acquiring side prepare the due diligence report. It helps to make informed decisions and define the fair deal price.

Structuring a successful due diligence program

It is important to strike a balance between two kinds of due diligence operations: 

• Incomplete — leading to legal and financial issues further down the line
• Excessive due diligence — ending up more expensive than the acquisition itself

However, the process should not be viewed as simply as a necessary due diligence 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 data gained can make it difficult to separate key pieces of information from the rest of the pile. This is where having the judgment 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 Vodafone 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 such a thorough approach of British companies may seem over the top in a due diligence process.

What does due diligence look like in the future?

Based on the latest world M&A activity statistics, below are a few trends in the M&A due diligence that are more likely to be ongoing in the nearest years. 

Virtual data rooms are in demand 

Virtual data room (VDR) has become a great way to ensure an efficient due diligence process, improving the cost-effectiveness, speed, and simplicity of a transaction by accessing all the 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 the M&A due diligence process.

Sustainability is in focus

Sustainability is becoming increasingly important for both large and small firms, as target 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.

Corporate culture is important

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% 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.