Many mergers and acquisitions (M&A) deals in the 1980s were transacted without much emphasis placed on due diligence. The result? Too many less than ideal outcomes for acquirors caused by post-M&A issues such as cultural mismatches, unexpected legal complications, overly optimistic pre-sale performance forecasts and unrealistic valuations. Consequently, today’s acquirors are much more demanding when it comes to obtaining information about potential target companies, and nearly all deals now include various types of due diligence conducted early in the M&A lifecycle.
Given the priority of due diligence in M&A, not to mention other corporate situations including joint ventures and financing, it’s important to understand types, benefits and challenges as well as the differences between due diligence and financial statements audits. Before we dig into all that, let’s start with a look at how due diligence fits into the M&A life cycle.
Due Diligence in the M&A Lifecycle
An M&A lifecycle has three stages, with due diligence beginning in stage two:
- Strategizing and Scooping
- Establish corporate growth goals
- Identify ways to achieve growth plans
- Evaluate identified growth options (i.e. organic growth vs. growth through M&A)
- Review internal capability to undertake M&A options
- Establish investment principles and acquisition criteria
- Screen for potential targets that meet acquisition criteria
- Develop a target-buyer synergy analysis for all selected potential targets
- Develop a target-buyer merger valuation model for additional quantification of best value
- Due Diligence and Finalization
- Conduct financial, accounting, tax and legal due diligence
- Negotiate and finalize transaction terms
- Announce transaction completion
- Post-Merger Integration (PMI)
- Establish PMI process
- Refine PMI plan
- Obtain all relevant data on business areas and activities
- Choose an experienced PMI leader who will coordinate the process
- Implement PMI plan and finalize PMI report
Types of Due Diligence
In the context of M&A, due diligence is a pre-acquisition investigation of a potential target by an acquiror. Below are the common types of due diligence and tasks associated with each type:
- Financial Due Diligence
- Review business strategy
- Review proposed transaction terms
- Review proposed financing terms
- Perform an independent valuation
- Conduct a feasibility analysis
- Conduct a quality of earnings audit
- Accounting Due Diligence
- Ensure compliance with relevant accounting rules and policies
- Perform trend and financial ratio analysis
- Conduct an external financial statements audit
- Review the effectiveness of internal controls
- Tax Due Diligence
- Analyze current tax position
- Analyze historical tax exposure
- Perform a tax impact assessment
- Evaluate tax savings opportunities
- Structure tax neutral deal options
- Legal Due Diligence
- Assess balance sheet and off-balance sheet liabilities and potential risks
- Evaluate the mechanics of a proposed transaction and its execution
Benefits of Conducting Due Diligence
For all types of due diligence, conducting a thorough examination can be time-consuming and costly. Benefits greatly outweigh costs, however:
- Benefits for acquirors
- Obtain information to assist with go/no go decisions
- Reduce post-M&A unpleasant “surprises”
- Better prepare for PMI strategy implementation
- Benefits for targets
- Smooth the transaction finalization process
- Reduce the likelihood of post-close disagreements
- Identify and rectify post-sale tax issues
- Benefits for stakeholders
- Set realistic expectations of the merged company
- Assure investors and lenders that their equity and loans are recognized
- Keep employees, vendors and customers engaged in the M&A process, thus providing a sense of security
Common Due Diligence Challenges and Issues
Across all types of due diligence, certain challenges and issues tend to arise:
1. Application of relevant accounting standards
This is a very common cross-border M&A due diligence issue in which the target’s financial statements do not comply with the relevant accounting standards required by the accounting authority where the acquiror is domiciled. M&A accountants will need to undertake the tedious and complex process of retroactively restating the target’s financial statements to ensure compliance. However, with more accounting authorities adopting International Financial Reporting Standards (IFRS), this issue will be less widespread in the future.
2. Sarbanes–Oxley (SOX) compliance
Small to medium size foreign private companies often do not have the bandwidth for or see the benefits of implementing strong internal controls. Publicly traded U.S. acquirors must ensure that they have the resources to bring these targets to post-merger SOX compliance in a timely manner. Added uncertainties surrounding targets without strong internal controls increase the transaction risk for acquirors.
3. Contingent liabilities
Another common issue involves contingent liabilities and other off-balance sheet obligations that were not disclosed by the target. For example, there may be unused and unpaid PTO liabilities, outstanding insurance and taxes or business activities that might violate laws and regulations where the acquiror is domiciled.
4. Transfer pricing and related party transactions
The target’s subsidiaries may engage in intercompany dealings that might not be transacted under commercial terms. This increases the risk of transfer pricing and tax law violation.
5. Loans and liens
Loan documentation might be missing or incomplete. Therefore, the acquiror and its legal team must ensure that all target assets used as loan collateral are accounted for and disclosed. A Uniform Commercial Code lien search is a good place to start. Future disposals and sales of perfected assets without authorization from lien holders will result in lawsuits.
6. Site/Asset inspections
There may be logistical challenges when trying to inspect target assets that are located around the world. Acquirors need to balance the risk of not obtaining complete assurance over the completeness of those assets and the risk of delaying the M&A deal.
7. Tax obligations
Through understatement of turnover or overstatement of operating expenditure, the target might willfully or inadvertently underpay or not pay corporate and individual income taxes.
8. Target’s forecast and insights
Target management might have a rosy view of its company’s future potential and get very defensive when this optimism is questioned. Acquirors must remain objective because this optimism is often ingrained in the target’s forecast and business reports.
9. Measuring potential synergies
Evaluation and analysis about potential transaction synergies may contain some bias, especially when an acquiror has ambitions of forming a bigger and more diversified consolidated company. In addition, the lack of independence between the acquiror’s board and its management team might result in overlooking important M&A considerations and criteria.
10. Pressure to close
M&A is very demanding, and pressure to finalize and close a transaction quickly may result in cutting corners during the due diligence process.
Audits vs. Due Diligence
Why can’t acquirors just substitute a financial statements audit for due diligence? To answer this question, it’s important to understand the differences between the two.
The purpose of a financial statements audit is to provide the acquiror with reasonable assurance that the target’s financial statements are true and fair. However, an audit often does not identify significant issues that an investor might be interested in such as the effectiveness of the target’s management team and quality of earnings.
As mentioned in the previous section, the due diligence process covers a wide range of areas. Although a financial statements audit may provide a starting point for an acquiror’s evaluation of a target, it generally does not provide in-depth information on every area these acquirors are interested in.
A financial statements audit does provide the acquiror with an assurance that the target’s financial statements are presented in a true and fair manner, in compliance with well-defined accounting report rules. To make a well-informed investment decision, an acquiror must understand that the target’s financial statements audit is complementary to, and not a substitute for, M&A due diligence.
Due Diligence Checklist
To ensure that all types of due diligence are complete, here’s a sample checklist of what will be needed:
1. Financial information
- Last 3-5 years of financial information
- Next 3-5 years of financial projection
- Current and projected capital structure
- Description of products
- New product pipeline
- Current and future research and development
3. Sales, marketing and distribution
- Description of the competitive landscape
- Strategy and implementation
- Relationships with top customers
- Sales force productivity model
4. Management and personnel
- Organization chart
- Compensation structure
- Description of incentive stock plans
- Significant human resources challenges
5. Legal and related matters
- List of pending lawsuits
- List of material contracts
- List of material patents, copyrights, licenses and trademarks
- Historical and pending cases with the U.S. Securities and Exchange Commission or other regulatory agencies
Consider Outside Help to Get the Most Out of Due Diligence
Asking the right questions and collecting relevant data for due diligence is a very time-consuming and detailed process. Often, it makes sense to bring in an experienced outside consultant to help so that management and staff are not diverted from other priorities and nothing is missed. Backed by due diligence experts, you will be better able to realize full benefits, avoid problems and keep your team focused on what it does best – running your business.
Are you considering an M&A deal?
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About the Author
Prior to joining 8020 Consulting, Joe was an Investment Banker with experience in capital and debt markets, M&A, IPO, credit, distressed assets and financial assurance. His key responsibilities include buy-side and sell-side M&A, subsidiary spin-offs, capital raising through the debt and equity markets, structuring of hybrid securities, turnaround and restructuring and due diligence support. Over the years, Joe has advised and raised capital for REITs, property developers and major palm oil players. Joe has also lived and worked in a few of the world’s major financial cities such as Los Angeles, London, Singapore and Hong Kong. Joe graduated from the University of Southern California, and he is Chartered Accountant with the Institute of Chartered Accountants in England and Wales. Joe also holds the following FINRA licenses: Series 24, Series 63 and Series 79.