Due Diligence Investigations
Introduction
Investing in a business through a merger or acquisition is an extremely important decision. It is crucial to gain a thorough understanding of the details of the target business so as to make a well-informed decision.
The process of gaining a thorough understanding is commonly called a “due diligence” investigation. A due diligence investigation typically considers the financial, tax, legal and operational perspectives of the target. Experts are typically engaged from within the acquiring organisation or from outside.
The due diligence reviews are a key stage in the M&A process, and usually take place as soon as the price and key terms of a transaction have been conditionally agreed between the buyer and vendor, but before detailed contracts are negotiated. Due diligence typically takes between 2 weeks and 6 weeks to undertake.
Benefits of Due Diligence Investigations
Buying a house is reasonably straightforward in that “what you see” is typically “what you get”. The location, design and condition of the house are clear to prospective buyers and there are usually a multitude of comparable houses from which to gauge the likely market value.
The nature of a business, on the other hand, is uncertain and what you see is not necessarily what you will get. Like a yacht at sea subjected to wind and waves and various risks, much of which is outside the control of the crew, a business is subject to forces like the market, the actions of competitors, laws and regulations, outside the control of management. The business is also subject to the actions of management, such as the type of product offering, the composition of the labour force, the equipment used in production, etc which can also influence the performance of the business.
Assessing the likely influence of these forces in order to predict the future performance, and therefore value, of a business requires some “science” and much subjective judgement. A good due diligence investigation is conducted by experts in a disciplined way in order to ensure that the findings are as accurate and reliable as possible and that they address any exposures of the buyer.
The benefits of undertaking thorough due diligence investigations include the following:
- Independent perspective: Both buyers and sellers can be unconsciously biased. Buyers may exaggerate the potential synergies and their ability to improve the performance of the target. A due diligence review carried out by independent experts or internal experts who are trusted to provide an unbiased, independent and factual assessment can help correct any biases in decision-making concerning an acquisition.
- Increased Confidence: The acquirer will gain confidence in the integrity of the target business and its management team as a result of a clean result from thorough due diligence reviews. The acquirer will likely also gain a peace of mind knowing it is unlikely that there will be “surprises” following the acquisition.
- Expedite the Transaction Process: The clarity and greater confidence resulting from positive due diligence reviews can significantly reduce the transaction risks and shorten the path to completing a transaction. The due diligence reviews also identify issues and information that guide the choice of transaction structure, warranties and indemnities and other contract terms for the acquirer.
- Negotiating leverage: Due diligence findings can often be used in discussions with the seller to strengthen a buyer’s negotiating position and improve the deal.
- The blue-print for an integration plan: the due diligence reports usually also highlight the means of resolving integration issues and milestones for incorporating into the integration plan to create value from the acquisition.
Financial Due Diligence
A financial due diligence is a detailed examination of a target firm’s financial performance and financial position and the contributing factors that determine its performance.
There are two fundamental components of a financial due diligence:
Integrity Check: this checks the accuracy of the target firm’s historical, current and forecast financial statements and accounting processes to confirm that they present a true picture of the performance and position of the business. An integrity check is like a financial audit; If the target firm is audited it may reduce the extent of the integrity check.- Earnings Sustainability Review: this investigates the reliability and sustainability of the earnings (often called the quality of earnings) to determine the confidence the acquirer can place in the future financial performance of the business. This review commonly focuses on the business plan, the market,competitors, the target firm’s competitive advantage in the market and potential risks or opportunities.
The findings of this work may lead the acquirer to re-value the target, or potentially withdraw from the acquisition all together. If the acquirer decides to continue, then the financial due diligence will often be used as the rationale for driving negotiation of the final price, contract terms and acquisition structure.
The breadth and intensity of the financial due diligence can vary significantly, depending on the preferences and requirements of the acquirer and the size and nature of the target firm.
What is the difference between an audit report and financial due diligence?
An audit report is concerned with historical financial statements only and essentially gives no opinion on the future prospects of a business. An audit report only provides a judgement as to whether the financial statements reflect a ‘true and fair’ view of the company’s finances and operations, and whether it adheres to correct accounting standards.
Audit processes may be employed in carrying out the integrity check component of a financial due diligence, but that is where the similarities end. A financial due diligence review also scrutinises the underlying factors that determined the historical performance to gauge whether those factors, and others, can be relied upon to drive the future performance of a business. 
This analysis can help determine the degree to which the past performance can be relied upon as a guide to the future performance. The outcomes of this work are most often then used by the acquirer to refine the forecasts in the financial model created to determine their internal valuation of the business, and guide their bid price and final price negotiations.
Tax Due Diligence
A tax due diligence provides an understanding of the target firm’s tax profile by analysing its tax returns, financial statements and any other supporting information. The primary purpose of a tax due diligence is to confirm that the company being acquired has complied with its tax obligations and that the buyer will not be exposed to unknown tax liabilities. A tax due diligence can also help a buyer or seller consider any tax risks or tax saving opportunities before the transaction’s execution, enabling any tax matters to be addressed before the acquisition.
A tax due diligence also aids structuring of the acquisition to ensure that the tax outcome (usually on both sides of the transaction) is optimised.
Legal Due Diligence
A legal due diligence is like a tax due diligence in that it is largely a compliance driven review aimed at confirming the compliance of the company being acquired. A legal due diligence is essential for most, if not all, acquisitions to guard against taking on unknown legal risks (e.g. litigation, product liability claims, workers compensation claims, etc.).
Operational Due Diligence
An operational due diligence is a review of the internal operations of a business. When the acquirer is in the same industry as the target business, they typically feel qualified to undertake their own operational due diligence. However, it can also pay for an independent adviser with operational and strategy expertise to participate in the operational due diligence to bring an “outsiders” perspective.
What can Cambian Corporate Advisory do for you?
Cambian can arrange for its trusted experts to undertake each of the above types of due diligence reviews.
Call Grant Kirby on +61 408 855 566 to discuss how we can be of assistance.
