• PAGE ONE
• INDEX
• HOME

The what and why of due diligence

Anand Krishna

ALTHOUGH there are reports of corporate deals almost every day, perhaps few people outside the relatively small world of corporate finance, realise the complexities, risks and pressures involved in putting through a transaction such as a merg er or an acquisition.

Each successfully completed transaction typically involves several professionals such as investment bankers or specialist corporate finance departments of large accounting firms, lawyers, consultants, accountants and often, even economists and engineers. And all this collective knowledge notwithstanding, the anticipated benefits, such as economies of scale and scope, increased market-share or cost savings are not realised in many (estimated at up to 75 per cent) deals.

There are several reasons exist for this, ranging from poor strategic rationale to inadequate planning to faulty execution. Yet, in spite of the low odds against success, there seems to be no let-up in the deals being put through around the world. This i s simply because in an increasingly competitive world, time is becoming a critical parameter in determining corporate success. In a world characterised by convergence of technologies, reducing product/service life-cycles and emergence of new business par adigms (e-business, for example), companies that are first off the block have substantial advantages. And often, the only way latecomers can make up for lost time is by acquiring the pioneers.

So what is due diligence and how does it impact on the success of a deal? Due diligence is an investigative exercise designed to provide the potential buyer with comfort about the business proposed to be acquired, and to minimise the risk that the buyer runs. This risk could be in many forms.

For instance, the target's business or assets may not be worth as much as claimed by the seller. Or, perhaps, the growth prospects are not as rosy as predicted. Or, there may be hidden liabilities that materialise after the transaction is completed, leav ing the new owner to face the music. It is the objective of a due diligence review to identify such ``black holes'' and ensure that their impact is appropriately reflected in the purchase consideration.

Typically, a good due diligence review should include in its scope a review of the target's market, the organisation's structure, people, information systems and manufacturing facilities. In short, every aspect of the target's business should be examined carefully and critically. The findings should be meshed with the review of the financial (including the tax position and accounting policies). Often, a legal due diligence is necessary to ensure that there are no onerous contracts or other agreements th at could affect the acquirer's return on investment.

There is no hard and fast rule about what a due diligence review must include in its scope. In practice, the actual scope of work depends on how risk averse the acquirer is, as also on the identity and pedigree of the target. The manner in which the tran saction is conducted (auction, negotiated sale, hostile bid) also plays a crucial role in determining the scope of the due diligence review.

In some situations, only a ``no-access'' or ``limited access'' due diligence review may be possible. While in others a ``complete access'' exercise may be possible. A common approach is for the potential buyers to commission an initial ``limited access'' review and seek complete access once the exclusivity has been agreed with the seller. This allows the potential bidders to make an initial offer that is ``subject to due diligence''.

A due diligence differs from audit in that, it does not provide an opinion on the accounts being ``true and fair''-- the audited accounts are typically the starting point. But, more important, a due diligence review is not focused only on hist orical results.

Indeed, a major benefit of this review is to carry out a ``sense check'' on the projections and comment on the robustness of the underlying assumptions. In the more mature M and A markets, such as the UK and the US, a due diligence is used to establish t he ``base'' levels of future earnings, after eliminating any effects of window-dressing, extraordinary items or changes in accounting policies (the last being especially important in a cross-border transaction). The objective of this exercise is to impro ve the estimate of future maintainable earnings, which represent an important element of valuation. The due diligence review is a key input to the valuation as well as to the negotiation process.

Traditionally, these reviews have been commissioned by acquirers. However, in the last few years, those commissioned by the seller (or vendor) are gaining in popularity, especially in the UK and the US. A vendor due diligence review offers several benefi ts:

The seller can use it as a ``diagnostic'' to identify weaknesses that could potentially drive down the price, and implement remedial actions. It is also useful, from the seller's perspective, in identifying potential deal-breakers beforehand and prepare suitably for the negotiations.

It enables the seller to control the timetable of the transaction more effectively.

Each potential buyer usually conducts his own due diligence. A typical disposal ``auction'' could involve several suitors, thus resulting in several teams visiting the target's plant/office and discussing more or less the same issues with the manag ement. This tends to disrupt top management's time and also increases the risk of leakage of information about the transaction, or indeed, commercially sensitive information. A vendor due diligence eliminates this multiple disruption and also redu ces the risk of premature information leaks that can scupper the deal, as well as adversely affect the target's subsequent performance, if the deal does not go through.

While the primary function of a due diligence is to ensure there are no skeletons in the closet, waiting to fall out after the deal has been closed, the principal beneficiary of a vendor due diligence is the vendor (seller). And in any deal, the buyer an d the seller naturally have opposite interests, assuming rational behaviour by both sides.

This apparently irreconcilable gap is bridged by the due diligence report being signed off to the eventual buyer, so that his interests are protected. Thus, in a situation where such a review is carried out, the buyer is not worse off than in a normal bu yer's due diligence; however, the seller is better positioned.

In a world where the buyer must be on guard, a due diligence exercise is in the nature of insurance against the potentially huge downside of a transaction that goes awry. As in almost every other aspect of life, in corporate deals too, forewarned is fore armed.

(The author is senior manager, PriceWaterhouseCoopers.)