How to Structure Your Due Diligence during M&A
The topic on M&A – mergers and acquisition – sounds like a daunting one, especially for those who are encountering it for the first time. When they start to delve further into it and are met with other seemingly highly technical terms, they are even more intimidated. Certainly, M&A is quite a complex process, and not something that everyone can understand easily.
In this article, we hope to shed some light on one of the aspects of M&A that many find confounding: Due Diligence.
You will learn 1) what is due diligence and 2) how to structure a due diligence.
DUE DILIGENCE IN M&A
One of the first questions asked is, “what is due diligence?”
Broadly speaking, due diligence is defined as the “assessment of the legal, financial and business risks that are often associated with a merger or an acquisition”. It is a thorough and painstaking look into a business, in order to get to know it inside out, and use the results of examination or assessment to make the final decision on whether to acquire the company or not.
Role and Importance of Due Diligence
That is the main reason why due diligence is deemed very important. It serves as a confirmation for buyers of the financials, contracts, and other pertinent information of selling companies. In other words, due diligence is especially vital for the acquiring companies, since it addresses the issue on whether acquiring the target company makes sense or they should look for another target altogether. For all intents and purposes, due diligence can be described as a ‘fact-finding’ activity that will enable acquirers to spot the targets that will give them their desired results and weed out those that have no potential at all.
This should not be an entirely new concept at all. If we liken it to a simple transaction of purchasing an appliance, or even a house, the potential buyer will often insist on inspecting the goods or the property first before making a decision. Testing would often be involved, as well as looking into the specifications of the appliance. In the case of the house, the potential buyer will be inclined to insist on having home inspections done on the property first. It’s basically the same with M&A transactions.
What aspects of the target company are looked into in due diligence? Many definitions cover it in broad strokes, speaking about the process providing insights on the regulatory exposures of a company, as well as its potential financial and legal exposures. But if we are going to look into it more deeply, due diligence can also provide a whole slew of valuable information including, but not limited to, the following:
- The structure of the company being targeted for acquisition;
- The flow of operations within the target company;
- The culture governing the organization of the target company;
- The current human resources in use by the target company;
- The relationships of the target company with its suppliers, customers and other partners;
- The competitive position of the target company; and
- The goals and future outlook of the target company, be it short-term or long-term.
Due diligence is required for the parties to seek validation on the proposed valuation of the M&A deal. There are bound to be instances where, after due diligence has been conducted, the parties would agree or compromise on revised valuation, depending on the results of their fact-finding mission.
Another reason why due diligence is important is that it will serve as an aid to management when it is time for the integration process to begin. Armed with the information and knowledge obtained through due diligence, the integration and transition can be facilitated and performed smoothly and seamlessly.
It is also one way of preparing the combined business for its future operations. During due diligence, they will be informed of potential problems, issues or risks that they may face after the business combination. Having knowledge of these problems early on will aid them in coming up with preemptive actions and solutions.
Ultimately, due diligence is conducted in order to minimize risks and maximize shareholder value in an M&A transaction.
Frequently Asked Questions on Due Diligence
Here are some of the frequently asked questions regarding due diligence.
How long does it take to complete the due diligence process?
It is to be noted that due diligence takes a lot of time, primarily because gathering and compiling all the relevant and pertinent information is time-consuming. It could go from several days to even several months, depending on the speed with which the parties concerned work in compiling the information.
Who performs due diligence?
There are some who say that due diligence must be performed by the acquiring company; after all, they are the ones mulling over the probability of acquiring or purchasing a company. Others argue that it is the responsibility of the company being acquired, since they are the ones that are going to be marketed and sold.
If we look at several definitions of due diligence, it would clearly appear that due diligence is a process that each of the parties undertake. This means that both the acquiring company and the target company are involved in the process.
When does the due diligence process end?
It ends when the transaction or the deal has been closed or abandoned. Throughout the period, you can expect the parties to be frequently and almost constantly requesting information gleaned from the review.
STRUCTURING DUE DILIGENCE
Now it is time to take a look at the main steps in due diligence. Many M&A experts and authorities list down several steps, but we can simplify them into three major stages: Preparation, Execution, and Closure.
Stage 1: PREPARATION
In every process, preparation is very important. This is where you plan all the activities that will come later on. You will be laying the groundwork for the entire fact-gathering process.
Due diligence officially starts when the two parties – the acquiring company and the target company – have reached an initial understanding regarding an M&A deal. In many cases, it is when the two parties have signed a letter of intent, or LOI, regarding a possible merger or acquisition.
Once this is done, you can get started.
1. Set boundaries
There is a need for the parties to have an agreement, in black and white, on the confidentiality of the information to be gathered and compiled during due diligence. Often, the parties draw up non-disclosure agreements, where they set the ground rules about the use and disclosure of any and all information, the scope and limitation of the review that will be conducted, and the extent of freedom of the employees or personnel of the parties when it comes to the exchange of sensitive information and other matters related to the deal.
In the same vein, having a communication plan in place is also important. This plan should detail the external and internal communication layout, and indicate what should be said and who should say it. This is one way to clearly define the accountabilities of everyone involved.
In the conduct of due diligence, confidential information and documents will be gathered. There is a need for a secure place to keep all these documents. Having a physical location is a good idea, but more and more companies are seeing the benefits of establishing online data rooms. They are more efficient and far cheaper than maintaining a physical data room – you have to spend money on utilities and maintenance, as well as the wages of people that will maintain and keep it secure – and they are also more readily accessible. The authorized people can log in any time they want, instead of waiting for specific hours when they can personally visit a physical data room to get the information they want.
2. Form your due diligence team
Due diligence cannot be conducted by a single person. It is best performed by a team that is put together for the specific task of performing due diligence. When putting together your diligence team, make sure that:
- the team is composed of financial, business and legal professionals that are skilled and experienced in matters related to M&A;
- the team members speak the same language, meaning that they should be able to communicate and interact with each other easily, even if they are experts in varying but complementary fields;
- the team should include the integration manager, or the person that will be tasked to manage the business immediately after merger or acquisition;
Take note that there is no strict number on how many members should be in the team. Some companies prefer to keep the team small, since having a large team often ends up with them being uncoordinated.
3. Outsource due diligence to professionals
There is no rule against bringing in outside help. In fact, many recommend hiring outside experts, since they have the advantage of being objective and independent of the whole M&A process. This is also highly advised if there is no one in your current lineup of personnel who have the skills, qualifications, expertise, or experience in M&A, or in performing due diligence. Often, companies look towards banks, consultants, accounting firms and law firms for help.
4. Prepare your due diligence team
You have to get your due diligence up to speed, apprising them of the M&A transaction in question, such as its features, structure and economics. This will allow them to plan their activities and structure the entire due diligence process depending on what they thought must be prioritized first. If the M&A is under strict time and resources constraints, it would be a good idea to let them know about it up front, so they can adjust accordingly.
In this step, some companies prepare due diligence checklists, which are created depending on the risks that are associated with the target company.
5. Prepare all the necessary requests for data and information
Finding the information is relatively easy enough; getting them for your use often poses the bigger challenge. You do not want your due diligence team to be wasting time and resources because they cannot get the information that they need. Therefore, you have to make sure that all data requests are prepared.
At this point, the team should already know the potential sources of information, so they can prepare the data requests accordingly. For sure, they will not be limited to the company’s management and various departments, but also suppliers, distributors, and other regulatory firms or agencies that the target company is exposed to.
Stage 2: EXECUTION
When all the preliminaries are in place, it is time to perform the due diligence tasks. This is where due diligence takes on the form of an audit, where the due diligence team collects the facts and thoroughly goes through every one of them in order to fully understand the ins and outs of the company.
The Execution stage will have the due diligence team collecting the information, analyzing and evaluating them, and eventually sharing the results of their analysis or evaluation, as appropriate.
Take note that all three must be conducted. The team cannot conduct a thorough and credible analysis if it does not have all the information required. Similarly, analysis and evaluation would be deemed useless if the results are not shared to anyone, especially the parties that require them for the decision-making process.
Collection or gathering of documents is facilitated by the data requests prepared during Stage 1. These documents are then organized and distributed to the members of the due diligence team for review. The documents are kept in a data room, readily accessible by members of the team.
During this stage, some of the areas or information looked into include the following:
- The target company’s organizational structure
- Who are the key employees, particularly the members of the management team?
- How is the performance of the management team?
- Which members of the organization are considered to create and contribute value the most?
- Which members of the organization should be retained, and which should be “laid off” after the integration?
- Presentation of the financial statements of the target company
- Do they accurately reflect the financial condition – financial position, liquidity, solvency and profitability – of the company?
- Will the integration have potential impact on the company’s financial condition and, if so, what is the effect?
- Are the financial statements indicative of an increase in the company’s profitability?
- The target company’s market and competitive outlook
- Is the outlook for the company’s competitive positioning positive?
- Does the company have the ability to keep its customer base and even increase or expand its reach?
- Risk exposure of the target company
- Are there any significant regulatory or governance risks that the target company is currently facing, or will face in the future?
- Will the target company be likely facing risks of having liabilities after the integration?
- What is the likelihood that there will be unexpected risks, and will the company be able to handle these risks?
- The target company’s long-term sustainability
- What are the environmental factors that can affect the company’s operations (i.e. production process, supply and distribution chain, sourcing of raw materials)?
- What is the status of raw materials and direct labor availability, and what are their impacts on future operations?
- The culture that governs the target company
- What corporate culture is currently at work in the target company? What national culture, in case of international M&A? Are the cultures of the companies compatible?
- Are there potential culture clashes – both corporate and national – that can take place during integration? If so, what are they?
- Will any culture clash be easily overcome once integration happens?
- In the case of international M&A, what cross-border transactions or challenges are likely to arise? Examples are legal and tax issues, differences in accounting bases, employment and labor laws, and environmental and topographical challenges.
Take note that the review by the due diligence team may take a while, depending on several factors, such as the availability of the documents, the complexity of the underlying transactions, and the cooperation of all parties involved, to name a few.
Stage 3: CLOSURE
Finally, the review is over and the due diligence team were able to come up with their findings. Now it is time to disclose the results of the review to the management, who will then make the final decision.
There are several possibilities or findings by the due diligence team.
- A “clean bill of health”. This means that they found nothing that would materially make the management NOT go through with the M&A. It’s a go, and the team can immediately proceed to integration planning.
- There were several irregularities or risks. This could also mean that the review turned up several misrepresentations made by the management of the target company. In this case, the management can take any of the several actions:
- Continue with the integration as planned;
- Lower their bid for the target company, using the findings as a basis for revaluation;
- Request modifications of the findings and require warranties from the target company; or
- Tweak the contract or purchase agreement to address potential damages that may incur in the future as a result of the misrepresentations.
The results of the due diligence review are detailed in a “due diligence memo”, which is created in order to organize, manage, and keep track of all the documents that have been reviewed by the members of the team. This is also where the findings or issues identified are indicated. Many M&A transactions repeatedly refer to the contents of the due diligence memo when making important decisions.
It is safe to say that a due diligence process for M&A is successful if it reveals an all-encompassing, complete and accurate view of the company, by providing information that either confirms or contradicts the proposed valuation of the target company. If the results of due diligence is unable to give management a clear path towards making a decisive choice on whether to acquire a business or look for a better deal, then it is unsuccessful.