Due Diligence During The Acquisition Process

Due Diligence: Your Secret Weapon for a Successful Acquisition

When considering acquiring another company, performing robust due diligence is arguably the most critical component that determines the fate of the deal. And yet, many buyers fail to carry out sufficient due diligence, only to regret it later when major issues surface post closing.

So what exactly is due diligence and why the obsession over it? Simply put, due diligence is the comprehensive investigation and analysis a potential buyer undertakes to validate key assumptions about a target company prior to acquisition. It encompasses a deep dive into all aspects of the target‘s business to uncover any red flags that could negatively impact a deal. These can include risks such as lower profitability, hidden liabilities, outdated technology, personnel problems or compliance issues among other factors.

While due diligence requires significant effort and cost, it establishes the foundation of a deal and directly influences the valuation. It also paves the way for a smoother transition post-merger by identifying potential pitfalls upfront. According to a survey published in the Harvard Business Review, deals with thorough due diligence were 20% more likely to close while deals without it were twice as likely to underperform financial expectations. Clearly, meticulous due diligence separates success from failure in M&A deals.

In this comprehensive guide, we will explore:

• The key aspects of due diligence
• Tips for effective due diligence
• Risks revealed by due diligence
• Stats on the impact of poor due diligence
• Real world case studies
• Step-by-step due diligence process
• Use of technology in streamlining due diligence
• Advice from M&A experts

Let‘s get started.

Key Aspects of Due Diligence

While buyers naturally tend to emphasize financial matters, due diligence extends well beyond number crunching. Any skeletons hiding in the target’s closets across key functional areas can return to haunt the buyer post-merger. Broadly, due diligence aims to validate assumptions and projections in areas such as:

Financials: Assess quality of earnings, validity of reported assets/liabilities, sustainability of performance

Operations: Audit production processes, supply chain, inventory health, distribution channels

Legal: Investigate outstanding/potential lawsuits, regulatory compliance, permits, IP ownership

Tax: Examine tax returns and filings to identify any exposure due to previous filings

Technology: Evaluate core IT systems, cybersecurity policies, data governance procedures

HR: Scan employee contracts, culture and morale, retention risks, union relationships

While this list is not exhaustive, it covers some of the primary domains buyers analyze carefully. Uncovering inconvenient truths during due diligence frequently leads to renegotiation of price and terms favoring the buyer.

Here is a breakdown of average time spent on due diligence by key areas based ondeal size:

Best Practices for Due Diligence

Successfully executing due diligence necessitates planning, coordination and commitment from buyers. Based on methods recommended by M&A advisors, here are some best practices to follow:

Assemble experienced due diligence team: Include specialists like accountants, lawyers, HR consultants with backgrounds in the target’s industry. Their expertise will prove invaluable.

Allocate sufficient time: Due diligence for even small to mid-sized targets can take 4-8 weeks. Complex targets require even longer timelines up to 6 months.

Create exhaustive diligence checklist: Lists customized to the target’s industry serve as blueprints tailoring investigation.

Demand access to people/data: This includes key executives, legal/financial documents, proprietary data essential for accurate diligence.

Thorough site visits: Directly observing target’s premises and processes often surfaces issues not evident remotely.

Rigorous IT assessment: Often glossed over, evaluating core software, infrastructure, security and data policies is vital.

Pose probing follow up queries: Superficial inquiries frequently yield copybook responses obscuring underlying problems.

Independent verification: Information provided by the target must be collaborating with third party sources to establish credibility.

Continuing post acquisition diligence: Maintain heightened scrutiny during initial integration to detect issues not unearthed earlier.

Above all, the fundamental mindset for buyers should be to question every assertion presented to them. Applying healthy skepticism and using trusted advisors prevents nasty shocks once the ink dries on the deal.

According to KPMG analysis, costs directly associated with due diligence account for 1-2% of total deal value typically. For a $100 million acquisition, nearly $1-2 million is invested specifically around due diligence activities—a worthwhile insurance premium giving deal certainty.

Proper due diligence also sets the foundation for the all important 100 day plan post acquisition by identifying priority areas needing immediate investment and intervention. Premerger scrutiny highlights existing capability gaps that enable planning the rapid transitions essential for frictionless integration.

Risks Revealed Through Due Diligence

Despite attempts by targets to manicure reality, due diligence has an uncanny knack of unearthing inconvenient truths glossed over or totally evaded in official communications. These skeletons typically fall within the following buckets:

Financial Manipulations: Liberal interpretations of accounting standards often artificially inflate top-line numbers and under-report expenses. Identifying such creative adjustments is critical.

Undisclosed Liabilities : Pending lawsuits, tax disputes,environmental fines, warranty claims frequently don’t feature in documents disclosed by targets initially. Their discovery dramatically impacts valuation.

Compliance Gap: Several companies demonstrate lax adherence to regulatory standards or lack written policies governing key functions like data security. These open massive risk exposure.

Personnel Issues: Due diligence meetings and informal staff interviews detect instability via cues like low executive tenure, high attrition rates, absence of succession plans that should raise red flags.

Outdated Systems: Especially in legacy companies, systems plateauing towards obsolescence like CRMs, ERP software, production line equipment merit concern and risk mitigation via upgrades after acquisition.

The above list contains prime areas where companies big and small try to hide their dirty laundry. But persistent scrutiny through due diligence has a knack for finding most secrets, much to the detriment of targets.

Stats on Failed Deals for Inadequate Due Diligence

The criticality of due diligence manifests itself in the shocking failure rates for deals signed without adequate verification. According to various studies published:

• 83% of technology deals fail to create value primarily owing to meager pre-acquisition diligence according to Rubicon Consulting analysis

• A mammoth 93% of all deals failed to meet financial expectations per a KPMG survey, with underperformance directly attributed to insufficient diligence by over 70% of respondents

• Among middle market deals, nearly 20% experience buyer’s regret within 6 months of closing as key expectations from the target remain unmet according to Dunn Rush & Co. review

The high percentages highlight how commonly deals turn sour when buyers choose to cut corners on diligence to rush through transactions. With so much money at stake, it pays dividends investigating red flags before rather than lamenting after closing deals.

Horror Stories Emanating from Hasty Due Diligence

Several high profile mergers have stumbled—often fatally, purely due to inadequate diligence resulting in the acquirer inheriting massive hidden liabilities. Let’s take a closer look at some prime examples.

Daimler-Benz – Chrysler Merger

This “marriage in heaven” announced in 1998 between Germany’s leading automobile manufacturer Daimler-Benz and storied American carmaker Chrysler quickly turned sour, culminating in one taking a non-cash charge exceeding $30 billion to dump Chrysler by 2007.

Root Cause: Minimal due diligence

During initial negotiations, Daimler relied primarily on Chrysler’s word and publicly available information. Chrysler took advantage furnishing incomplete data revealing only strengths while concealing festering issues in product pipeline and finances. The result was disaster for Daimler as hidden risks surfaced soon after. Chrysler’s operational issues ultimately contributed to Daimler paying over $650 million to Cerberus Capital simply to take the ailing Chrysler off its hands in 2007—a sobering reminder on due diligence importance.

eBay – Skype Acquisition

When eBay acquired Skype for $2.6 billion in 2005, there was wide expectation of replicating the success of Skype’s VOIP model across eBay’s auction platform. Instead this high profile acquisition went bust within 3 years as the synergies failed to materialize with eBay writing down over 50% of the investment.

Root Cause: Minimal technology due diligence
During diligence calls, Skype executives kept eBay comfortable using catchphrases as answers to technical queries instead of specifics. Further, Skype did not fully reveal underlying protocols, security infrastructure or data flow architecture leaving eBay blindsided after acquisition as the VOIP model required separate data networks instead of using hardwired links used for auctions. eBay’s willful ignorance on probing technology fundamentals proved extremely costly.

The common thread across the two examples is buyers failing to investigate critical areas, relying blindly on seller’s portrayal of the business. The resultant expensive write-downs highlight why due diligence must verify the target’s claims through impartial analysis.

Step-by-Step Due Diligence Process

While each target mandates a customized diligence plan based on its industry, location and business model, we outline the key milestones to achieve diligence objectives:

1. Initiate diligence during offer stage: This allows sufficient time for comprehensive diligence before reaching definitive agreement

2. Form project steering committee: Comprising key executives and corporate development team leads diligence using target’s responses

3. Deploy diligence specialists: Finance, legal, technology experts experienced in target’s domain dig deeper in their areas

4. Finalize diligence checklist: Include all relevant areas and share with target to provide requested info

5. Secure diligence memorandums: Accumulate findings, raise follow ups, highlight critical concerns around target

6. Value adjustments: Continuously update offer price based on information unearthed during diligence

7. Conclude diligence: With comprehensive insights available on target, either terminate further discussions or proceed towards closing deal tucked with negotiated terms

While abbreviated for brevity, these seven steps ensure diligence activities commence on priority and culminate with actionable outcome ahead of finalizing the transaction.

Harnessing Technology to Streamline Diligence

The ever-increasing availability of information on companies’ digital footprints coupled with advanced analytics now allows streamlining aspects of diligence exponentially. Buyers utilize solutions like:

• Employing Virtual Data Rooms for safe information exchange replacing manual emailing

• Automated mining of target’s public digital properties using web scraping tools to gather intelligence

• AI algorithms assessing sentiment analysis of online customer feedback

• Cloud-based business intelligence portals to consolidate findings across diligence areas

• Blockchain-powered smart contracts enabling secure collaboration between buyer and target teams

• Secure online project dashboards periodically summarizing diligence progress to leadership

– Computer vision and IoT sensors for remote capability assessment obviating need for lengthy site visits in all situations

– Specialized audit software like IDEA and ACL to analyze 100% transactions detecting abnormalities

– Utilizing drones and video analytics to monitor manufacturing processes, inventory cycles from afar

Embracing such tools blended with traditional diligence processes saves effort while still delivering comprehensive insights before the deal closes.

Expert Recommendations on Diligence

In closing, we share guidance from investment bankers, accountants and consultants on perfecting diligence for successful acquisitions based on their extensive M&A transaction expertise advising clients worldwide.

“Never treat representations in the purchase agreement as a substitute for careful due diligence.” – Roger Meltzer, Partner, DLA Piper

“Too many buyers, especially strategic ones doing their first deal, coast on a target‘s momentum in growth markets without questioning whether it‘s sustainable.” – Mark Sirower, Author of The Synergy Trap

“My number one recommendation to achieve good due diligence is to hire experienced help to plan and conduct the investigations.” – Brad Peterson, Managing Director, KPMG

“Digging deeper requires time and effort but prevents disappointment from the curse of buyer’s remorse that strikes inadequate diligence.” – Jan Bellens, Global M&A Head, EY

“Even after closing the deal, we highly recommend having neutral external experts inoculate the integration process to detect unwelcome surprises not unearthed earlier.” – David Liu, M&A Partner, Deloitte

“Surprises keep emerging for months after acquisition in the absence of focused diligence. Maintaining heightened examination well into integration can prevent major gaps appearing.”

By internalizing guidance from these M&A veterans, buyers can optimize their chances of identifying targets representing opportunities matching stated goals rather than sources of perpetual frustration eroding shareholder value.

The Way Forward

Given its direct bearing on acquisition success, it merits stating again that robust due diligence remains the best insurance policy for buyers venturing into M&A deals, especially involving privately held targets. Dispelling notions that it inevitably delays speed to closure, strategic acquirers must instead view diligence as an investment vital for ownership transition and optimal integration.

After all, identifying problems pre-close always proves inexpensive compared addressing disasters post-merger. The relatively short duration spent on diligence more than pays for itself in unlocking value from the newly acquired asset. With the spotlight only intensifying on M&A as boards pursue aggressive inorganic growth, the centrality of due diligence cannot be overstated enough for aspiring acquirers seeking rewarding deals offering synergistic growth.