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Understanding Due Diligence In M&A Transactions.

In any merger & acquisition transaction, the prospective buyer is potentially exposing themselves to significant risks. If the target fails to perform as expected or yields unanticipated liabilities, the acquisition can do enormous financial and reputational damage. As a result, prior to completing any acquisition a prudent acquirer will undertake a detailed and systematic review of all aspects of the target company’s business and industry. This process is commonly referred to as due diligence (DD).

The goal of DD is to ensure the acquirer is as fully informed as possible about the possible risks of an acquisition prior to completing the transaction.

It is important to recognise that while it is the acquirer who undertakes DD to satisfy their own requirements and expectations, a seller has a clear vested interest in ensuring that they are fully prepared for and cooperative with the process.

That is because where DD presents unexpected issues or itself becomes a challenging process to adequately complete, depending on the magnitude of the risks and challenges involved, a buyer may seek to:

  • Walk away from the transaction completely;
  • Restructure the transaction from a purchase of shares to an asset purchase;
  • Renegotiate down the acquisition price;
  • Impose an earn-out or expand the scope of any pre-existing earn-out provisions;
  • Broaden the scope and timeframe of warranties and indemnities; &/or
  • Impose or expand pre-completion clauses.

In this blog post we provide an overview how a standard DD process unfolds in an M&A transaction. Our goal is to provide a prospective seller with an insight into what they are likely to experience as they progress with a transaction.

An Overview of M&A Due Diligence

Due diligence is typically undertaken by a prospective buyer once a term sheet has been signed and the seller has committed to engaging with the buyer on an exclusive basis. Given the time and potential expense of DD, a buyer will only commence the process once these elements are in place.

Much of the in-depth due diligence work is performed by external experts brought in by the acquirer. These experts typically include accountants, investment bankers and lawyers as well as other specialists such as engineers based on the nature of the business being reviewed.

Depending on the size of the acquirer, some of these tasks might be performed in-house. For example, a large corporate acquirer or private equity firm may have dedicated internal resources who can perform a portion of the required due diligence tasks.

A successful DD process will be carefully planned by the buyer with clear information needs and timeframes. In addition, these requirements and expectations must be conveyed to the seller along with establishing clear communication channels between the parties, including all advisors.

The buyer’s specific information requirements will be distilled into detailed questionnaires (due diligence questionnaire or DDQ) that itemises all of the documents and information that the prospective buyer needs from the target in order to conduct its detailed analysis.

Prior to the commencement of due diligence, it is also important to set clear protocols to protect the confidentiality interests of the seller. For example, the seller may not want its employees to know that a transaction is on foot. These sensitivities need to be respected and managed.

Due diligence is generally not a quick affair. It can take weeks and possibly even months to complete with timeframes influenced by factors including the size and complexity of the target and transaction, the level of comfort the buyer needs and whether the seller is prepared and cooperative.

Elements of Due Diligence in M&A Transactions

A comprehensive due diligence program will review and analyse several key aspects of the business. Typically, these areas are:

  • Commercial due diligence;
  • Legal due diligence;
  • Financial due diligence;
  • Management due diligence;
  • Other.

Commercial due diligence

Commercial due diligence (CDD) seeks to understand the seller’s commercial prospects based on a detailed analysis of the company’s business and the broader industry(s) in which it operates. This review provides the purchaser with an insight into the credibility of the company’s forecasts.

While the specifics of CDD will always be tailored to the unique circumstances of the seller’s business, common aspects of CDD include:

  • Analysing the industry both in terms of its historical and forecast growth rates and profitability levels;
  • Understanding broad industry cycles and trends and what the current and possible future opportunities and threats may be;
  • Analysing the seller’s competitors and understanding the strengths and weaknesses of the seller’s strategy against both existing and possible future competitors;
  • Engaging with key customers and understanding their levels of satisfaction with the seller’s products & services;
  • Reviewing the regulatory environment and the likelihood and possible impact of regulatory change; and
  • Understanding other areas such as the seller’s product mix, pricing power, supply chain and so on.

Legal Due Diligence

The scope and emphasis of legal due diligence (LDD) will very much depend on the specifics of the seller’s business and the areas of legal risk that have been identified by the buyer and their legal advisors.

For example, if a seller operated in, say, the aged care sector, a key area of LDD would be around the company’s current and historical compliance with the onerous regulatory obligations of that specific industry.

Nevertheless, there are common areas of LDD that apply to most companies. These include a review of the following:

  • Corporate documents such as certificates of incorporation, shareholders’ agreements etc.;
  • Key contracts with customers, suppliers, partners etc.;
  • Employment agreements etc.;
  • Intellectual property such as patents, trademarks etc.;
  • Financial arrangements such as loans, guarantees etc.;
  • Property ownership and lease agreements;
  • Regulatory compliance, licences etc.;
  • Insurance certificates and claims history; and

Financial Due Diligence

The role of financial due diligence (FDD) is to provide an acquirer with a level of comfort around the integrity of the financial information provided by the seller, particularly in relation to the seller’s financial performance and position.

Those charged with undertaking FDD will engage with the seller to better understand the historical and forecast financial performance of the business and the accounting and financial systems that the business has in place.

At the beginning of the due diligence process, the FDD team will formally seek a range of information and material from the seller including annual reports, audit files (if available), management accounts, tax returns, business plans and forecasts, board papers and so on.

Key areas of the FDD report will include:

  • An analysis of the company’s historical performance;
  •  A review of the company’s current financial position;
  • An analysis of the company’s forecasts and the reasonableness of underlying assumptions;
  • An analysis of future working capital and capital expenditure requirements;
  • A review of the adequacy of employee provisions and entitlements;
  • A review of the company’s taxation arrangements; and
  • An analysis of the adequacy of accounting controls, systems and oversight.

Management Due Diligence

As part of the due diligence process, an acquirer will conduct a review of the company’s management team to determine its strengths and weaknesses, assess whether there are any gaps in skills and experience and also consider the extent of key-person risk.

Another more intangible consideration will be trying to assess the prevailing corporate culture within the seller’s business and whether it will be relatively easy to integrate management and staff into the new business and what the challenges of doing so might be.

Other Areas of Due Diligence

Beyond the standard areas of due diligence outlined above, certain transactions may require additional specialist due diligence reports.

For example, a company that operates in mining or chemicals might require an environmental due diligence report or a company that operates in highly technical fields such as IT or biotechnology may require dedicated expert reports into their underlying technology.

Due diligence is a key milestone in the progress of any M&A transaction. While it is the buyer who conducts due diligence, it is in the interests of both parties to work cooperatively to make the due diligence process as transparent and frictionless as possible.

For a seller, being ready for due diligence is a significant undertaking that requires careful and thorough planning and preparation. If you would like to discuss how CFSG can assist you in readying your business for sale, please don’t hesitate to contact us.

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