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  • Writer's pictureAmedeo Montonati

Importance of Due Diligence in M&A’s Operations

Importance of Due Diligence in M&A
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The term Mergers and Acquisitions most simply known as M&A gets widely used and most of the times without giving the related importance to which steps, procedures and operations it includes.

Talking about Mergers and Acquisitions we generically describe the consolidation of companies or assets through various types of financial transactions, including mergers, acquisitions, consolidations, tender offers, purchase of assets and management acquisitions.

One of the key and most important steps during a Merger and Acquisition is the Due Diligence. Let’s define the term before deep diving into the scopes and importance of such process.

Due diligence is a process of verification and investigation of a potential deal or investment opportunity to confirm all relevant facts and financial information and to verify anything else that was brought up during the M&A deal or investment process.

Due diligence helps investors and companies understand the nature of a deal, the risks involved, and whether the deal fits with their portfolio. Essentially, undergoing due diligence is like doing “homework” on a potential deal and is essential to informed investment decisions.

The M&A lifecycle usually involves different stages of involvement in the deal, broadly defined as: Pre-Deal, Pre-Announcement and Post-Announcement.

During the Pre-Deal stage the focus is centred into establishing a corporate strategy for the M&A strategy and subsequently in defining a target screening.

The Pre-Announcement stage involve the valuation and due diligence prior the deal. This involve actions as accounting, tax and financial due diligence, target valuation and structuring, internal control diligence and negotiations.

At the end, in the Post-Announcement stage the operation aim to shift the focal point to the integration or separation planning and finally the integration or separation execution. During this process after the finalization of the deal the key clear-cuts are establishing the business models, conduct and deploy clean room analysis and execute the communication strategy.

Usually in most of the small and mid-size deals, the Due Diligence is conducted only at the Pre-Announcement stage for financial purposes but to minimize the risks and making sure to achieve the best outcome from the M&A’ operation, due diligences can be conducted also at preliminary, negotiation and after deal-closure stages.

Furthermore to the goals expressed as "to get the best deal" and minimizing the risks, due diligence is also important to the M&A process from a buyer's perspective to better understand how the business, its owners and its management operate. The due diligence process helps understand synergies, potential scalability of the business with enhanced operations and more access to customers from the buyer's company. Potential buyers will also look at ways to reduce the overall expenses of the business to increase profitability.

As per above in fact we can try to separate the due diligence operations in an M&A deal in 3 major key topic areas: Strategy, Law and Finance (Strategic Due Diligence, Legal and Financial). Keep in mind this is a break down to analyse the major focuses, due diligences (DD) can also target environment, human resources, IT etc.

In this article we will mainly focus on the financial due diligence scope of works after first, briefly touching-base the other two types of DD (strategic and legal due diligence).

Strategic and Legal Due Diligence

In contrast with financial and legal due diligence, which aim to determining a deal’s correct price and structure, strategic due diligence focus on determining if a deal’s value is adequate, realistic, and attainable. It does so by first understanding the overarching deal thesis and objectives and then assessing the deal against those objectives. The target organization’s market and competitive landscape are then systematically analysed to understand the size of the opportunity and how to effectively compete. These are key areas for the target screening, target screening is the systemic first level review of potential acquisition candidates to identify a refined list of companies for further due diligence and consideration.

Moving further, legal due diligence is the process of collecting, understanding and assessing all the legal risks associated during an M&A’ operation. During the DD operation, the acquirer reviews all the documents pertaining to a target company and interviews people associated with it. The idea behind this investigation is to understand if there will be any future legal problems due to this acquisition or not.

Some examples of the usual application during the legal DD includes examination and review of but not only the following elements:

  • Memorandum and Articles of Association.

  • Minutes of Board Meetings for the last three years.

  • Copy of share certificates issued.

  • Copy of all guarantees to which the company is a party.

  • All material contracts, including any joint venture or partnership agreements.

  • Licensing or franchise agreements.

  • Copies of all loan agreements, bank financing agreements, and lines of credit to which company is a party.

Financial Due Diligence

As per image and table above, to achieve detailed insights to approach the deal, one of the most important types of due diligence is the financial due diligence that seeks to check whether the financials showcased in the Confidentiality Information Memorandum (CIM) are accurate or not. Financial DD aims to provide a thorough understanding of all the company’s financials, including, but not restricted to, audited financial statements for the last three years, recent unaudited financial statements with comparable statements of the last year, the company’s projections and the basis of such projections, capital expenditure plan, schedule of inventory, debtors and creditors, etc.

The financial due diligence process also involves analysis of major customer accounts, fixed and variable cost analysis, analysis of profit margins, and examination of internal control procedures. Financial DD additionally examines the company’s order book and sales pipeline in order to create better (more accurate) projections.

During the DD is important to maintain Working Capital and Cash Flow Considerations. The analysis of working capital, especially in capital intensive industries, can significantly impact the financial due diligence.

Further to cash flow and working capital there are Quality of Earnings Considerations to assess. Some of other items that can be faced during a financial DD and that can impact the quality of earnings but may not be included in adjusted EBITDA can be some and not only the following:

  • Financial Reporting Process such as application/consistency of revenue recognition and cost capitalization, internal controls, actual vs. budget or prior year analyses and Interim vs. year-end accounting methods and reporting policies.

  • Revenue/Growth Assumptions such as organic vs. acquired growth, changes in revenue models and the impact of transactions in foreign currencies.

  • Compensation Expense Analysis such as cash vs. non-cash, headcount analysis and bonuses and other ‘lumpy’ payments.

  • Cost Assumptions such as cost structure and fixed costs vs. variable costs.

In some cases, acquirers have a separate section of financial analysis focused on the target company’s debt situation, evaluating both short-term and long-term debt, applicable interest rates, the company’s ability to service its outstanding debt and to secure more financing if needed, along with an overall examination and evaluation of the company’s capital structure.

Tax Implication in Financial Due Diligence

Ultimately, taxes implication it is a key standpoint in the financial due diligence. In fact taxes implications taking a big percentage of the whole financial DD they usually get broken down in: Due Diligence, Structuring and Planning.

During the Tax Due Diligence the scope of work is to identify and understand the nature of historic tax exposures that buyer could become primarily or secondarily liable for as a result of the proposed transaction and to consider a possible tax indemnity provided by the seller. Further gain information that will be useful for: structuring the transaction, obtaining financing and negotiating the contract terms.

After the assessment of the DD, Tax Structuring aim to develop a tax structure for the proposed transaction and evaluate the tax impact to buyer and seller, to developing a model prospective effective tax rate and cash taxes for the Target, including the tax basis step-up and ultimately to communicate with tax counsel to ensure that the tax structure for the proposed transaction is properly reflected in the transaction documents.

In the end, Tax Planning ensure to assess if there are taxes attributed (e.g., NOLs) to the Target that will carry over in order to consider potential limitations on the use of such tax attributes. To further control if Target and buyer use different tax methods of accounting to consider the implications of Target (or buyer) adopting new tax methods of accounting post-transaction and last but not least to consider opportunities to streamline the legal entity structure of the Target.

Conclusion and Opinion

To conclude and “wrap-up” the information disclosed above, we want to simply bring to your attention the importance of a detailed and well-assessed Due Diligence. Of course costs of external firms that can assist during such procedures can be impactful but for most of the cases those procedures can help to avoid significant or even disastrous consequences – minimizing the risks it sounds as common sense. As you can observe from the very brief information of this article, the key areas to assess are multiple and it require specific expertise and a cut-cost approach might just bring high risks. The costs of undergoing a due diligence process depend on the scope and duration of the effort, which depends heavily on the complexity of the target company. Costs associated with due diligence are an easily justifiable expense compared to the risks associated with failing to conduct due diligence.

For more information you can contact AOGB Professional Services Group.


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