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Home > Mergers and Acquisitions Best Practice > Due Diligence Requirements in Financial Transactions

Mergers and Acquisitions Best Practice

Due Diligence Requirements in Financial Transactions

by Scott Moeller

Executive Summary

  • There is an urgency for companies to conduct intensive due diligence in financial deals, both before announcement (when it should be easy to call off the deal) and after.

  • Traditional due diligence merely verifies the history of the target and projects the future based on that history; correctly applied due diligence digs much deeper and provides insight into the future value of the target across a wide variety of factors.

  • Although due diligence does enable prospective acquirers to find potential black holes, the aim of due diligence should be this and more, including looking for opportunities to realize future prospects for the enlarged corporation through leveraging of the acquiring and the acquired firms’ resources and capabilities, identification of synergistic benefits, and postmerger integration planning.

  • Due diligence should start from the inception of a deal.

  • Areas to probe include finance, management, employees, IT, legal, risk management systems, culture, innovation, and even ethics.

  • Critical to the success of the due diligence process is the identification of the necessary information required, where it can best be sourced, and who is best qualified to review and interpret the data.

  • Requesting too much information is just as dangerous as requesting too little. Having the wrong people looking at the data is also hazardous.

Introduction

This is not your father’s due diligence.

Due diligence is one of the two most critical elements in the success of an Mergers and Acquisitions (M&A) transaction (the other being the proper execution of the integration process) according to a survey conducted in 2006 by the Economist Intelligence Unit (EIU) and Accenture. Due diligence was considered to be of greater importance than target selection, negotiation, pricing the deal, and the development of the company’s overall M&A strategy.

But not even a decade ago, when due diligence was conducted in financial transactions, the focus was almost always limited to financial factors, pending law suits, and information technology (IT) systems. Today, those areas remain important, but they must be supplemented during the due diligence process by attention to the assessment of other factors: management and employees (and not just their contracts, but how good they actually are in their jobs), commercial operations (products, marketing, strategy, and competition—both existing and potential), and corporate culture (can the companies actually work together when they’re merged?). But even these areas are now mainstream when due diligence is conducted. Newer areas of due diligence are developing rapidly: risk management, innovation, and ethical (including corporate social responsibility) due diligence.

The 2006 EIU/Accenture survey also found that although due diligence is considered as a top challenge by 23% of CEOs in making domestic acquisitions, this rises to 41% in the much more complex cross-border transactions, which make up the majority of financial transactions, even in today’s depressed markets.

Organizing for Due Diligence

It’s a two-way street: Buyers must understand what they are buying; and targets must understand who’s pursuing them and whether they should accept an offer.

To be successfully conducted, due diligence must have senior management involvement and control, often assisted by outside experts such as management consulting firms, accountants, investment banks, and maybe even specialist investigation firms.

To quote from a PricewaterhouseCoopers report issued in late 2002: “We always have to make decisions based on imperfect information. But the more information you have and the more you transform that into what we call knowledge, the more likely you are to be successful.”

That said, there is only a certain amount that can be handled by the number of people involved, the time restrictions under which they are working, and the quality and variety of resources available to them. Moreover, there is the danger of being overloaded by too much information if those involved do not have good management and analytical methods they can deploy.

By and large, it is not the quantity of information that matters so much as its quality and how it is used. Although diligence may not be cheap (as a result of fees charged for often highly complex work by professional services firms), the alternative of litigation or the destruction of stockholder value (as a consequence of having been “penny wise and pound foolish” in the execution of the due diligence process) may prove far more costly in the long run.

The Due Diligence Process

Although due diligence may be only one part of an acquisition or investment exercise, in many ways it is by far the most significant aspect of the M&A process. Done properly, acquirers should be better able to control the risks inherent in any deal, while simultaneously contributing to the ultimate effective management of the target and the realization of the goals of the acquisition.

As an instrument through which to reveal and remedy potential sources of risk, due diligence—by confirming the expectations of the buyer and the understanding of the seller—enables firms to formulate remedies and solutions to enable a deal to proceed. In many ways, due diligence lends comfort to an acquirer’s senior management, the board, and ultimately the stockholders, who should all insist on a rigorous due diligence process, which provides them with relative (though not absolute) assurance that the deal is sensible, and that they have uncovered any problems pertaining to it that may derail matters in the future.

Ideally, due diligence should start during the deal conception phase, and initially it can use publicly available information. It should then continue throughout the merger process as further proprietary information becomes available. Full use of the due diligence information collected would mean that it is not just used to make a go/no-go decision about whether the acquisition should proceed and to determine the terms of the deal, but that the findings from due diligence should also be incorporated in the planning for the postmerger integration.

Clearly it is easier to obtain high-quality data if the deal is friendly; in unfriendly deals due diligence may never progress further than publicly available data. This lack of access to internal information has scuppered many a deal—for example, the takeover attempt by Sir Philip Green of Marks & Spencer in 2004.

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Further reading

Books:

  • Howson, Peter. Due Diligence: The Critical Stage in Mergers and Acquisitions. Aldershot, UK: Gower Publishing, 2003.
  • Moeller, Scott, and Chris Brady. Intelligent M&A: Navigating the Mergers and Acquisitions Minefield. Chichester, UK: Wiley, 2007.
  • Sudarsanam, Sudi. Creating Value from Mergers and Acquisition: The Challenges. Harlow, UK: Pearson Education, 2003.

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