Due diligence: A practical approach

Greg James’ guide to best practice due diligence processes reveals lessons on how purchasers can get the best return for their time and financial commitment.

New Zealand’s business confidence has been consistently rising over the past couple of years. The economic climate is ripe for growth by acquisition; in addition a number of private equity groups have recently raised new funds and will be looking for potential investments. As a result, mergers and acquisitions activity has and will continue to increase.  
Given this, it is timely to focus on best practice due diligence processes and how purchasers can get the best return for their time and financial commitment.
A potential investor performs due diligence on a targeted acquisition to understand and evaluate the business prior to acquisition. This includes the analytic review and validation of business operations and financial position performed by a buyer to substantiate valuation, assess operational performance and identify misrepresentations. It is critical to allow the purchaser to determine value drivers in the target.
It is also important that any due diligence be planned, structured and focused on the key elements; otherwise the process can drift, wasting time, money and resources, and even worse a missed opportunity or a bad acquisition.
If the investor requires finance to acquire the target the bank will normally require due diligence report(s) to be prepared by external parties to assist with their financing decision. In particular, they will normally require financial and tax due diligence reports.

Types of due diligence
There are a number of due diligence areas a potential investor can review when assessing an investment. These typically include:
• Commercial/Organisational.
• Financial/Profit Normalisation.
• Tax.
• Legal.
• Information Technology.
• Human Resources.

Depending on the target certain areas may have more or less focus than others. Key areas of focus should be around the detection of:
• Early recognition of revenues.
• Recording revenues that are not genuine.
• Increasing income with a one-time gain.
• Shifting expenses to a later period.
• Failure to record or disclose all liabilities.
• Shifting income to a later period.
• Shifting expenses to the current period.

This is particularly important to SME targets as they may not have audited accounts.

The use of external advisors
The use of trusted external advisors (accountants, lawyers, etc) is normally critical in any due diligence process. To get the most from your advisors it is important to:
• Be in regular contact so you are aware, as much as possible, of any material/key issues or so you can change the scope of work based on their findings to date.
• Work collaboratively with advisors.
• Ensure there is a forum for advisors to communicate with each other, as the findings of one advisor may impact the work of another.
• Seek their opinion on the general competence of management during the due diligence process. Advisors who have done a number of deals get a good feel for the competence of management. In addition a poorly run due diligence process by the vendor may indicate poor management capabilities. Whereas a smooth and transparent due diligence process with advisors would normally signal high management competence.
• Using advisors in foreign countries, in particular non-Western countries, comes with different issues. Always have a local advisor on your team familiar with doing deals in the respective country.

Remember external advisors are expensive. To keep your due diligence costs down you need to effectively run and manage your advisors and at the start clearly outline your expectations.

How to reduce due diligence costs

1) Agree broad purchase price upfront.
Before you commence any detailed due diligence process, to ensure you are not wasting your time it is often a good idea to agree the broad purchase price up front. This may include a review of any valuation model the target has and how the purchase price may change based on material findings during the due diligence process.
Agreeing a purchase price is also common when the purchaser is looking at acquiring a competitor and the deal is essentially unconditional subject to any material issues being discovered during due diligence. This is common sense, as the vendor will clearly not want competitors reviewing their commercial and financial information, to then not acquire the company and use this information for their own benefit.

2) Enter into exclusivity agreement with vendor.
It is common for a purchaser to try and enter into an exclusivity period in which they are the only party able to perform due diligence and they have the first right to try and negotiate a deal. If the due diligence process has multiple potential buyers it may end up in effectively a tender or auction process and your due diligence may be in vein if you are outbid by another purchaser. An exclusivity period would normally involve some sort of commitment to acquire the business subject to satisfactory due diligence.

3) Do your own homework before appointing advisors
Before appointing external advisors do your own due diligence first to determine areas your advisors should focus on. I often suggest an upfront meeting with senior management of the target and ask simple questions like:
• Are there material issues purchasers should be aware of?
• Are any agreements under negotiation or up for renegotiation in the near future that would affect the profitability of the business?
• Do you think any major customers may leave the business in the near future or as a result of the sale?
• Are there any material legal or tax issues purchasers should be aware of (i.e. recent or pending proceedings or audit)?
On the basis that any comment made by the vendor will be subject to warranties in the sale and purchase agreement, the vendor is effectively forced to fully disclose/comment on your questions truthfully. In addition to this you can state that unless they answer truthfully upfront it will be discovered on diligence any way and clearly any misrepresentation made will affect any future working relationship.

4) A phased approach.
Acquisition due diligence can be divided into two phases. Phase 1, initial due diligence, is a top-level, ‘kick-the-tyres’ evaluation that provides the visibility to reject an acquisition if it does not satisfy basic investment criteria. Phase 2, secondary due diligence, is a more intense evaluation that drills deeper into operations.
The ultimate goal of Phase 1 is to determine whether or not to proceed with Phase 2. Keep in mind that conducting due diligence requires expensive resources: a smart buyer knows when to abandon a potential investment. Phase 1 also provides focus for the subsequence evaluation during Phase 2.
Successful completion of Phase 1 due diligence will normally provide insight into the following key areas that are crucial to early acquisition evaluation:
• Entity structure.
• Historical financial performance.
• Business model.
• Going concern validation.
• Impairments.

5) Ensure the vendor is committed to a structured process.
If the vendor is organised this makes any due diligence process more efficient; the process should be agreed up front to ensure clarity and efficiency. For example:
• Who will be ultimately responsible at the vendor.
• Ensure vendor has sufficient senior resources to deal with the due diligence process.
• Confirm access to senior management.
• Agree timelines to provide requested information.

The seller
So far we have focused on due diligence from the buyer’s perspective, however a due diligence is equally important from the seller’s perspective for the following reasons:
• An inefficiently run due diligence process takes significant management time; it’s time management is not able to spend running the business’s day-to-day operations.
• Information provided will affect valuation.
• The purchaser is assessing how well management react during the due diligence process and gauge how competent they are in their respective positions.

Asset vs share deal
If the purchaser acquires a company (the shares) they acquire all the known and unknown legal and other issues within the company. Known issues are normally included in the purchaser’s valuation modelling, resulting in a reduction in any proposed acquisition price.  A purchaser will attempt to reduce any potential exposure post acquisition by ensuring the sale and purchase agreement has appropriate warranty and/or indemnity clauses – allowing the purchaser of the company, if a certain event(s) occur, to make a claim against the vendor to reduce the purchase price (for example, the company’s largest client leaves soon after acquisition, an IRD audit reveals a substantial tax exposure or a significant legal issue occurs soon after acquisition, etc).
In a number of cases if the due diligence process uncovers too many issues or uncertainties with respect to the historic operations of the company that may flow forward and expose a potential purchaser, the purchaser may insist that the company (shares) not be sold and instead the assets/business within the company be acquired, thereby leaving any potential historical exposure with the vendor.

Planning is paramount
Mergers and acquisitions are a significant deal for any company and mistakes can be costly.  They are also very emotional, with both sides likely to experience moments of low and high moral. However, the more you plan and organise, the less painful and expensive the process will be.