Acquiror due diligence

Iain Campbell and Ben Brierley are directors of FC Corporate Finance, a mergers and acquisitions boutique specialising in the IT channel industry.

This is the latest in a series of articles we have written based on our experience of making acquisitions in the SME and mid-market space. These ones look at the due acquiror’s due diligence process.

What is due diligence and what is its purpose?

In the context of mergers and acquisitions, the expression “due diligence” is used to refer to a process that a buyer undertakes to investigate the acquisition target prior to completing (or legally committing to complete) the deal. For us, the purpose is to confirm:

1. That the facts and assumptions that the buyer took into account in deciding it wanted to acquire the business were sound;
2. That the facts and assumptions that the buyer took into account in deciding how to value the target and structure the deal were sound; and
3. That there are no unknown facts or circumstances that would affect the buyer’s willingness to acquire the business either at all, or at the agreed valuation and/or with the agreed deal structure.

A good due diligence exercise will thoroughly but cost-effectively address these questions, and, where the answer to i or ii is “no”, or the answer to iii is “yes”, identify what action (or, possibly, alternative courses of action) is/are required by the buyer in response.

Some buyers, particularly our friends in the private equity community, tend to regard due diligence as a second stage of target evaluation and price negotiation. The logic seems to be that their evaluation and offer was only tentative so that due diligence is the process to determine how much they really want to pay (or think they can get it for). Just because issues arise in due diligence, it doesn’t necessarily mean that the seller will or should accept a lower price – that depends on a whole set of factors we shall come onto. When acting for the seller, we have actually been asked by at least one pre-eminent PE house “what was the point of allowing us to do due diligence if you won’t agree to reduce the price”.  For us that exhibits a potentially dangerous misunderstanding of what due diligence is, what it’s for, and how it should be approached.

We categorise due diligence into two types:

1. What we call “internal” due diligence. This is the DD that the acquiror chooses itself to undertake to satisfy itself on the three areas set out above and will perform even though it may be funding the acquisition entirely from its own resources. Some acquirors will have sufficient in-house resource to undertake all of the internal due diligence in the required scope with their own personnel; others will engage external advisers/consultants or use a mixture of both; and
2. What we call “external” due diligence. Typically, this is done the behest of a PE acquiror (or a corporate acquiror that has an existing PE investor) or at the behest of lending bank (or lead bank in a syndicate). In this case, the DD work is all, or substantially all, undertaken by external advisers, usually by national or international names and is an independent reporting/attestation process.

There are three recognised principal categories of due diligence, but these have sub-categories some of which are sometimes separated and addressed as individual categories.

Financial due diligence as the name suggest is primarily concerned with financial information about the target. It includes historic accounts and management accounts, budgets and forecasts, cash flow and liquidity and KPI information that drives financial performance and risk (such as customer, supplier and product concentration), and usually taxation (though this can be separate).

Some areas that are not strictly financial but potentially have a material financial effect on financial performance, control or measurement might be addressed (eg asset valuation, litigation risk, adequacy of management and staffing, pensions, insurances cover and information technology) but from the perspective of a financial expert. Resolution of any points arising in these areas might then be referred to specialist technical advisers in those areas and/or be subject to separate due diligence.

Legal due diligence assesses the legal risk profile of the target company such as contracts exposure, potential liability to employees and the public generally, the possibility of title to assets being defective, vulnerability of any intellectual property and the possibility of claims for breach of others’ intellectual property and liability to criminal sanctions. Again, there are some sub-sets that will be covered to an extent but might need to be referred to specialist technical advisers or be the subject of separate due diligence, such as environmental compliance/issues and pensions.

Commercial due diligence as the name implies examines the target from a commercial perspective, specifically looking at the target’s current business position and its medium-to-long-term prospects. The process looks at both the target’s markets and at its position within those markets, considering issues such as market performance and prospects, competition, the target’s USP’s, barriers to entry, prospective market growth and potential challenges such as changing technology and regulation.

Who should carry out the due diligence?

As we discussed in our previous article, due diligence can be what we call internal, ie DD that the buyer chooses to do to satisfy itself about the target, or what we call external, ie due diligence that is being undertaken at the behest of a private equity investor or lending bank.

Just because the motivation to undertake due diligence is internal, it does not necessarily follow that it will be undertaken by the buyer’s own employees. It might be of course – some or all of it – if that’s how the buyer wants to go about it and if it has sufficient in-house resource in terms of personnel numbers and range of skills and experience. However, only the largest, most acquisitive companies tend to have the resources to undertake everything. This is especially so in relation to legal due diligence – if an SME acquiror has in-house legal resource at all it is likely to be one or maybe two generalists and there won’t be the breadth of knowledge to undertake an extensive legal DD review across all technical areas. In relation to finance and commercial stuff then there is likely to be in-house resource that has a good working knowledge of the industry (assuming that the target is in the same industry) but that resource might be dedicated to ongoing management and control and unable to be diverted to work intensively on occasional major M&A projects.

If external resource is needed then the options for the buyer are:

1. Keep management and control of the DD in-house and engage freelance resource to do the extra work. Freelancers familiar with M&A due diligence and integration are fairly common in finance and IT and these days there are some lawyers who work like this too; or
2. Outsource the internal DD by appointing professional advisers to do the work (or some of the work) and report based upon a specification they agree with the buyer. Typically, if the DD is internal then the scope is narrower and more focussed than external DD, not unlike how a large company would do it if it has an in-house deal execution team. Our firm is very active doing this type of DD in the SME/mid-market space looking at financial and tax matters, but we can also cover some aspects of IT, commercial and legal.

If the DD exercise is being undertaken to satisfy the requirements of an investor or lending bank, the DD will by definition be independent and undertaken in a process that is not managed or controlled by the buyer. The investing/lending institution will want either to specify who is appointed or as a minimum to approve who is appointed, and to have input into and approve the specification. For financial DD and (though to a lesser degree) legal DD, this often means that the advisers have to be “on the panel” (the existence of such panels usually, of course, being hotly denied) and will be international/national or maybe major regional at a push. After all, supposedly no-one has ever been sacked for buying IBM. Boutique corporate finance firms like ours are rarely asked to do external financial DD. For commercial DD, it’s much more spread. The international accountancy/consultancy firms are active, but there are specialist firms and smaller ones that have specialisations in particular market areas.

One issue a buyer may wish to consider in choosing DD advisers is independence. If the buyer’s lead M&A adviser is an accountancy firm, then there will typically be an option to have that firm act as lead advisor on the deal and also as due diligence advisor (for the financial DD and perhaps also some of the other DD). Typically, the lead advisory work is undertaken under a contingent or part-contingent fee arrangement.

Due diligence work in our interpretation of the professional regulations that apply to us should not be undertaken on a contingent-fee basis, though we are aware that others do appear to be doing so. Even if the DD fees are fixed, though, if the work is to be undertaken by the same firm that has a substantial vested financial interest in the outcome (through the contingent lead advisory fee), the buyer might want to think about whether that’s a good idea and the adviser might want to think about how things will look if there are problems afterwards.

Special situations – limited or no due diligence

Previous articles in this series have looked at situations where there is an acquisition in prospect and the buyer undertakes a planned and extensive due diligence investigation, either because it chooses to (as a matter of good practice and governance) or because an investor or lender requires it. There can be situations though where it is necessary or appropriate to have only limited due diligence or even, in extreme circumstances, none at all.

We once came across a very acquisitive (listed) trade buyer that was highly active making acquisitions in an industry that was rapidly consolidating. We were surprised to find that their policy was to undertake almost no due diligence on their targets. Their logic was that they were buying so many companies in the same business of similar size and profile that if they simply didn’t bother with DD they would get an industry average profile of risk and value across their acquisition portfolio. If they bought on the right pricing model and saved all the cost and time of DD, they wouldn’t be any worse off if they had to swallow the cost of the occasional bad deal and should in theory be better off. Sort of like a self-insurance arrangement. That’s a highly unusual approach that comes with a “don’t try this at home” warning, but you can at least sort of see the logic.

Other circumstances where there will typically be DD but it’s limited or very limited include:

1. Insolvency

When acquiring a business in an insolvency situation, ie from (usually) an administrator or in a pre-insolvency “fast sale” there will typically be very limited time and therefore very limited opportunity to undertake DD. In any event most of the information the buyer would want to undertake full DD won’t be available and there won’t be any time or resource to prepare it. Almost always these deals do not involve the acquisition of the corporate body. Instead, the business (or assets of the business) will be sold and the liabilities in theory left behind. In these circumstances the buyer’s limited due diligence needs to focus on:

1. The expected profits stream from the acquisition, such as what suppliers and customers may be retained, how much business will survive and what the trading terms will be; and
2. Potential liabilities that could be assumed by law notwithstanding there is no transfer of ownership of the corporate vehicle. The most common and obvious one is the assumption of employment liabilities under TUPE. This might include claims from employees dismissed by the insolvency practitioner pre-acquisition, but there could be others, such as environmental liabilities on a site that’s being taken over.

The seller will appreciate that prospective buyers will want at least some information to assess these matters and, typically, there is some, but it’s usually very limited. Given that this is the case, and given that there will be no or almost no warranties and indemnities in the sale and purchase contract, the significant additional risk needs to be reflected in the price.

1. Other “trade and assets” deals

Sometimes a deal is structured as a “trade and assets” deal for reasons other than insolvency. We most commonly see this where there has been a problem in due diligence that has identified contingent liabilities that the buyer (and, most likely, any buyer) would be unwilling to take on. There are other special situations too, such as tax or maybe pension arrangements. In these cases, it is important to appreciate that just because it’s a T&A deal, and just because you may have neutralised a specific risk or risks by structuring the deal that way, it doesn’t mean that you don’t need any due diligence. As with insolvency deals, you still need to ensure you are getting the business and profits stream you think you are getting and you still need concern yourself with liabilities that could transfer by operation of law. The overall DD will be less extensive than a share acquisition though and, unlike an insolvency situation, the buyer should have time and access to the information it needs to undertake the DD it believes is appropriate. Another issue to consider is what interruption risks there may be to the business by structuring the deal as a T&A deal. Lawyers typically fret about change of control clauses in contracts but in our experience that’s almost always misplaced commercially, and there’s no answer to it anyway. It’s much more of an issue if you have recurring income and you have to ask all the customers to pay to a new company. Some will definitely decline to do so, possibly quite a lot, or just won’t get round to it. Similarly, if the target is a regulated business that needs to have regulated contractual arrangements with its customers, some might decline to sign new agreements.

• Management buyouts and shareholder buyouts

There is a special category of deal where the buyer may already have as much (or possibly) greater familiarity with the target and the details of its finances and affairs than the seller. A management buyout would be a typical example of this. Another we see quite a lot is where there are two business partners owning a company and one buys the other out, perhaps because one wants to retire and the other doesn’t, or maybe as a means of resolving a dispute between them. Alternatively, a company might purchase its own shares to facilitate the exit of a shareholder whilst the other(s) remain.  In these situations, the buyer typically sees no need to undertake any due diligence. Alternatively, if there is an investor or lender coming into a buyout situation for the first time or increasing its exposure, the investor or lender might insist there is DD, possibly with a reduced scope.

1. “Friendly” deals

Sometimes we come across situations where the buyer doesn’t want to undertake due diligence because the situation is “friendly”. The most typical example would be where there is a family connection, for example where there is succession in a family business but the retiring or exiting family members are getting value for their shares. We have even seen non-family situations where the buyer takes some or even all DD matters on trust due to a longstanding friendship or business relationship with the seller. Whilst this this approach does seem imprudent, possibly daft, at face value, the situations where we have seen it are usually where there is a “friendly” price as well as a “friendly” approach to diligence so the justification of the approach may be that the risk is priced in.

Setting the scope

Before starting due diligence work, it is necessary to establish what the scope of the work will be, agree it between the persons responsible for setting it (which could be the board or a specific individual or team in the buyer, an investor, a lender, or a combination of these) and the persons responsible for undertaking the work which could, as we covered in a previous article, be employees of the buyer, contractors, advisers or, again, a combination. Once agreed, the scope should be documented and confirmed. Areas that might typically be included but aren’t being included should be specifically excluded for the avoidance of doubt.

We normally take the following approach to setting the scope:

1. We start with a template scope. This might be a general one or be sector-specific if we have relevant sector experience. The template will include a number of items that would normally always be in scope (for example a review of corporate taxes and VAT);
2. We consider any risks or issues that were identified in the pre-offer evaluation. If we were the adviser at that stage, we will be familiar with them. If we weren’t we ask the client;

• We undertake a risk analysis looking at the sector and the target. This includes a review of the material provided pre-offer (for example an information memorandum) and a look through the data room if there is one. We look back at issues we have encountered in previous analogous jobs and we ask the client about its own previous experience of issues in the sector generally and with any previous acquisitions;

1. We consider what regulation applies to the target’s business and any additional risk that might arise from that;
2. We typically also take a traditional balance sheet verification approach (though it’s not our job to audit). We look at the key balances and consider what sort of issues could cause them to be mis-stated or misleading;
3. We always Google the target, the directors and any group or connected companies and look at their personal and corporate histories. In doing this we are looking, for example, for previous non-compliance (eg on minimum wage or health and safety) or, if there has been involvement in previous insolvencies, the reasons for the insolvencies, in all cases as a guide to issues that might recur.

Most due diligence jobs we do involve some kind of consideration of prospective financial information. Sometimes the target or its advisers will have provided forecasts. More often than not in SME deals, if there are forecasts at all, these are poor quality and lacking in detail, and more often than not they will be materially over-optimistic. However, this is not always the case. If there is good news and we think the target is doing better than the seller’s advisers have suggested, this is important information for the buyer and we need to make sure we bring it out.

FC Corporate Finance Limited

Iain Campbell (Director) – email ic@fccorporatefinance.com

Ben Brierley (Director) – email bb@fccorporatefinance.com

FC Corporate Finance Limited is not authorised under the Financial Services and Markets Act 2000 but we are able in certain circumstances to offer a limited range of investment services to clients because we are members of the Institute of Chartered Accountants of Scotland. We can provide these investment services if they are an incidental part of the professional services we have been engaged to provide.