Elaborating on diligence execution in detail would be a book in itself- after all, as previously stated, my standard questionnaire is 30 pages long! We will instead provide a high-level overview, looking across the various categories, and taking account of key elements that warrant focus.
Diligence Topic 1: General Items
General items usually include at least the following:
Watch carefully for significant omissions and surprises in this early area of diligence. In my experience these indicate a large “red flag” with regards to the rest of of the process, provided there were earlier forums in which it would have been reasonable for the target’s leadership to be more forthcoming. Apart from hostile transactions and or distressed targets, diligence should not be an exercise in obfuscation on the sell side and in teeth-pulling on the buy side! How a buyer should respond depends on the deal rationale. The more likely it is that you will need to rely on the target’s existing leadership for full synergy realization, the more concerning any early-stage deceptions or omissions. At a minimum, such behavior should be considered when calculating the deal pricing and synergies, as deception is seldom a one-time behavior.
Diligence Topic 2: Finance and Tax
You should get Tax involved in the diligence process early and ensure that they are provided with copies of the target’s legal entity structure, including details on any international operations. This will allow them to design an approach that minimizes compliance exposures and tax costs. Carryforward items are also critical to evaluate early on, as these can have a very significant effect on deal value if the client has had large operating losses in prior years. I once worked on a deal with a purchase price of several billion dollars that was nearly entirely funded via tax savings from proper deal structuring and capital planning. Conversely, I am aware of another deal where several hundred million in avoidable tax costs were incurred because Tax was not allowed to participate in diligence.
With regards to the rest of financial diligence, auditors often lead the charge; however, it is important to have skilled personnel from your internal Finance organization involved as well. The auditor’s role will be to carefully analyze the provided information for completeness, accuracy, and any potential red flags. Internal Finance staff should review the auditor’s inputs carefully and raise any concerns with Leadership including the Steering Committee, the Integration Lead, and Corporate Development. Here again, there should be minimal surprises.
In addition to the above, your internal Finance resources should also be evaluating the consistency or inconsistency of policies, processes, and tools as compared to your internal structure. In this way, Finance can begin to evaluate the time and effort required to achieve your desired TOM and can inform the Data Steward of any potential data migration/integration requirements that need to occur in time for the first consolidated close. I also recommend assigning one internal resource to carefully review the financial data and reconcile it to all deal models and projections. You would be surprised how much I see omitted and misrepresented in deal models, when the information from diligence clearly refutes these assumptions!
Diligence Topic 3: Legal Compliance
If you are using an experienced outside counsel to assist in the diligence process, this portion usually goes smoothly. If you are using inside counsel, be prepared to augment their staffing and their experience with outside experts, particularly when considering cross-border transactions. Make sure all attorneys involved are aware of any red flags uncovered in your research.
Diligence Topic 4: Legal Contracts
It is my experience that contracts frequently get under-researched during diligence. Migration/novation of contracts: customer, subcontractor, contract manufacturer, and/or outsourcer, can easily be the “long pole” in many integrations, and usually comes at the expense of significant investment in both time and legal fees. Pay attention to any restrictions on assignment, novation, or termination as these may bind you to a model that differs from that of your desired TOM.
Also, pay close attention to any contractual arrangements that might inhibit your ability to alter pricing or costs of inputs! Inquire as to whether any verbal representations have been made to customers and/or vendors regarding terms or pricing. If the client in our “Double Trouble” example (see March 2018 blog) had included this in their diligence research, they would have known that there was no legal way to raise pricing after the acquisition. Also, if your value proposition includes substantial benefits from cross-selling, pay attention to contract overlap with your existing customer base. It could be that you have captured most of the TAM (total addressable market) already and thus the acquisition is of little additional value.
Diligence Topic 5: Facilities
Facilities diligence should bring to light risks in areas such as environmental and/or safety hazards; furthermore, it should also assess whether the facilities present any obstacles for your chosen TOM. Are you planning for shared occupancy for a period of time? Then note whether the space can be easily demised, with proper access controls and security.
During facilities walk-throughs, also take note of any fixtures that are of interest. I once spent weeks arguing whether a satellite dish affixed to the roof of an acquired building (and necessary to continued operation of the business) was included in the scope of the facilities purchase! Other such items might include warehouse racking, videoconferencing equipment, conveyor systems, etc. Ensure any such assets get called out specifically on the asset inventory in the purchase agreement.
Diligence Topic 6: Insurance & Risk
Investigate whether adequate coverage is in place. Companies that skimp on insurance coverage may be risk-prone in other areas as well, so it is worth noting. If the company self-insures, they should have an adequate reserve for any potential losses. Also, make sure in this instance that your broker or insurance company is willing to write the policies you need for an acceptable cost. Before completing diligence in this area, review your PESTLE assessment one more time and determine whether additional coverage or mitigation investments are appropriate.
Diligence Topic 7: Employees, Benefits, & Pensions
Employee and benefits due diligence is often a massive effort, so plan to invest in this area accordingly. It is also worth doing well, and not just from the standpoint of risk mitigation. Employee diligence provides the first real opportunity to dig into the details of what the acquisition will mean to the target’s staff, and to glimpse how day-to-day culture and practices at the two companies differ. Perhaps more than any other area, employee diligence provides also informs major components of the integration plan, including what change management and communications activities may be required. Given the scope of this effort, and its potential payoffs, I recommend staffing diligence with top personnel from HR, backfilling as needed to cover any gaps. Also, be flexible about allowing the diligence staff to bring in consultants to assist, and to hire employment attorneys to advise them.
Diligence Topic 8: Competition, Control, & Corruption
Turnover is one diligence area that falls under the competition portion of this heading. You will want to carefully review company revenues, gain an understanding of what their total market share is relative to their competitors, evaluate how much of that share is due to joint ventures/alliances/partnerships, and how great the dependencies are on particular channels and/or customers. If the company operates in more than one geography, it is also key to note whether one country is disproportionately responsible for overall turnover.
For the control and corruption portions of this heading I would suggest that you review at least the following:
Careful diligence in this area is not only a requirement, but also a useful preparation for anti-trust approval discussions with regulators. Ensure that this area is staffed with attorneys that have adequate diligence experience in the markets in question and instruct them to openly share information with your anti-trust counsel, facilitating these discussions periodically.
Diligence Topic 9: Information Technology
Note that while extensive detail regarding the IT and telecommunications infrastructure may not be required if you plan to minimally integrate, it is still a good idea to get a view of the systems landscape. Information and data security compliance is growing ever more complex, and the expectations and potential liabilities for breaches are growing as well. As with the more general areas of diligence, a careful look under the hood is appropriate, since carelessness can indicate a bigger problem with a lack of business discipline.
If you do plan to fully integrate, there is a good chance that systems and data integration will be both the longest-running and most expensive portion of your integration plan. As such, it is a good practice to have your Data Steward in place and participating in due diligence, along with any other internal or external augmentation required.
Due diligence is an intense, complex, and time-consuming effort, regardless of the acquisition. If you are considering a full-integration TOM, diligence should also become the first phase of your planning activity, informing each group as to the likely scope, timing, and extent of the effort required. You will want to ensure that you have adequate participation to not only cover the scope of the diligence activities, but also to have time to share the information learned along the way, and to discuss how this might impact the realization activities. For large deals, or deals with full integration TOMs, this may well mean augmenting existing staff with external contractors to ensure adequate coverage. Of course, the larger your diligence team, the more essential it is to have your program structure in place providing a forum for collaboration and governance.
The Due Diligence Objective
In our February 2018 blog post we noted that every successful acquisition starts with the identification of the deal rationale, or the “why” of the deal. This rationale should drive all subsequent activities including the approach to due diligence. First solidifying the business objective, and subsequently analyzing the target to assess whether it will help achieve that objective, can prevent missteps such as the “Double Trouble” example from our March 2018 post. Our goal, therefore, is to evaluate the target company to determine whether acquiring this company addresses our deal rationale objectives, while simultaneously getting comfortable that the risks are not sufficient to erode the overall value proposition.
Conduct Due Diligence Research
Most integration professionals will have a standard due diligence “checklist” of items that the buyer would like the seller to provide for evaluation. Mine is just under 30 pages in length, single-spaced! On a large deal I will usually get to submit less than half of the questions on my list, and for smaller deals I might be able to submit only 15-20%. So, one critical early step is to pare the list of inquires down to something that is manageable but still provides sufficient information to evaluate the target.
Spending a few hours on research is one way to effectively whittle down the checklist. You would be surprised how much information is available via:
Buyers can be reluctant to invest the time in this research; however, I find it often yields a treasure trove of information that can be used to answer some diligence questions preemptively, and certainly helps to focus the diligence checklist! If you don’t have time to do the research yourself, bring in a temp or an intern. The work isn’t difficult and it is well worth doing before you commence with decisions about designing due diligence scope. I once found information on an industry blog about a well-known defect in a target’s primary product, which had not previously been apparent from any of the provided documents, and which had a material impact on some of the valuation assumptions we were using. Bottom line- take the time to dig- it’s worth it.
Use PESTLE to Further Refine the Diligence Plan
After compiling research, a useful starting point for scoping due diligence is to revisit some basic strategic frameworks. If you’ve been following the method we discuss in this blog you will already have used Porter’s 5 Forces and SWOT in your initial target identification. For diligence purposes the PESTLE (sometimes spelled PESTEL) framework is useful. PESTLE is an acronym:
Political risks usually take the form of potential changes in regulations or policies. Health care and social media are good examples of industries facing political risks.
Economic risks are pertinent to businesses with commodities exposure, heavy reliance on discretionary consumer spending, foreign currencies, or other key economic factors. For example, these are significant considerations when I do deals in the international oil, gas, mining, or food/beverage industries.
Social/cultural risks relate to the potential for loss of goodwill, litigation, or eventual political exposure due to negative public perception of the company or industry. I’ve seen this in media and entertainment with regards to violent content, and social media is definitely facing scrutiny here as well, as are processed food companies.
Technological risks arise due to the disruption of existing businesses by emerging technologies. Who would have imagined 10 years ago that we might have self-driving vehicles? As robotics and automation improve, most industries will need to consider technological disruption to some degree.
Legal risk refers to current or potential litigation risks. These aren’t always a bad idea. I’ve seen bargain purchases of companies that were facing litigation exposure, but risks should be thoroughly investigated in diligence so that valuation can be properly adjusted.
Environmental risks are critical in resources businesses like oil, gas, timber, and mining; however, depending on the political environment any company can incur substantial changes to their cost structure due to environmental regulations.
Determine Participants for Due Diligence
There are conflicting schools of thought when it comes to participants for due diligence. Strategy and Legal experts seem to prefer as few participants as possible, while Finance and Operations want to see broader representation.
Here again the deal rationale and its corresponding TOM can offer guidance. If the TOM calls for minimal integration, you should need fewer diligence participants. Where the TOM calls for medium to full integration, you should consider putting a larger team in place. Regardless, the best results are produced when the diligence team is broad enough to validate TOM assumptions, and to analyze the deal in terms of the deal rationale. This is the one reason I advocate for the use of code names, and for a thorough onboarding process for diligence resources.
Keep in mind that work done to eliminate a deal from consideration is not “wasted effort”, it’s production! Rationalizing investment choices is a legitimate activity, regardless of the go or no-go decision resulting from the analysis. Should the decision be to move ahead with the deal, a properly organized and executed diligence process generates a significant portion of the integration plan and budget, thus saving time later in the process.
Appropriate participants will vary by deal, but some general guidelines are as follows:
Note that the recommended participation, even for minimum integration, still extends across quite a few areas. We’ve spoken before about the importance of including Tax to ensure that the deal is structured in the most efficient way possible. Legal and HR are required to ensure compliance. Finance will be key to analyzing deal value, providing modeling inputs, and establishing synergy measures. The Integration Lead will be responsible for overseeing realization of the chosen TOM and the corresponding synergies.
Take the time to research publicly available information on your target. Apply the results of your research using some standard strategic frameworks, incorporating all this information into the on-boarding materials for your diligence participants. Let the TOM inform the composition of your diligence team, but don’t hesitate to include more resources- the broader participation should pay off in terms of better results.
Getting Started with Due Diligence
The first step in preparing for diligence is often deciding what the deal or project will be called. I am an advocate for creating code names for the deal and each of the participants. The purpose of this is twofold. First, it provides an additional layer of security against information leakage during the critical and confidential period prior to announce (you would be surprised how much I overhear about deals in airports, hotels, and coffee shops!). Second, assigning names outside of the terms used in daily discussions helps to produce a “fresh” approach to diligence, shake resources out of their day-to-day thinking patterns, and define the acquisition as a project. Have some fun with it. Why not a Project Cheeseburger with parties such as Pickles and Mayo?
Regardless of whether you choose to use code names or maintain the actual names of the parties you will need a robust on-boarding process for diligence that features the following:
It is advisable to set up your acquisition program structure in advance of diligence. Even if the acquisition doesn’t go through, the effort undertaken to setup a subsequently-abandoned program pales in comparison to the wasted effort and potential risks of trying to run diligence with no structure in place!
There are 2 basic ways to organize an acquisition program. The first is an objective structure, where various cross-functional “tiger teams” are formed to accomplish program objectives. If your resources are accustomed to being allocated to various projects with different leads and objectives on an ongoing basis (i.e. similar to Google) you might prefer an objective program structure. The second is a functional structure, where the teams mirror the traditional internal functions of the company (finance, technology, marketing, etc.). A functional structure has the advantage of being much easier to setup and govern than an objective structure, because accountability rests with functional leadership for both ongoing operations and integration activity. For this reason, functional structures are far more common than objective structures. Regardless of which is selected be sure to consider whether performance measures, compensation, and/or incentive structures need to be adjusted to reflect changes in responsibilities.
A steering committee or committees is the preferred method of program governance. The key idea for “steerco” setup is that the steering committee members must either be C-suite executives or have access to the C-suite. Smaller companies often have the CEO, CFO, etc. serve on the program steerco. Larger companies often opt to have C-suite direct reports on an operating steerco, with the C-suite resources instead serving on an executive committee that meets less frequently to take major updates, greenlight decisions, and manage high-impact escalations. For diligence purposes it may be appropriate to have a higher level of executive sponsorship on the steerco, and then have a direct report delegate take over later in the process.
If you are using a functional structure, the steerco will be easier to design. Simply pull an executive from each function to represent his or her group. If you are using an objective structure, forming an effective steerco is a bit trickier. You need to select members that can lead each of the objective workstreams. This requires selecting executives that have significant cross-functional span of control, but also a high level of accountability for the achievement of the outcome in question. In other words, they must both care whether the objective is achieved and have the (practical and political) means to do something about it.
Remember to set your steerco up in time to get their input on the diligence process and kickoff materials. And don’t forget to require the steerco members to complete the NDA process. Really! Most of the blabbing I overhear in airports comes from very high up the ladder, and everyone benefits from a reminder to keep things buttoned up. Once the NDAs are signed, walk the steerco through the problem statement, deal rationale, and TOM assumptions to ground them in the basics of the deal and get their feedback.
Tools O’ The Trade
Your attorneys will likely provide the due diligence data room. This will quickly become a morass of documents, all organized in a structure that only lawyers and aliens from the planet Nebu can understand (in reality the data room structure is often tied in some way to the numbering system of the due diligence requests and/or questionnaires). As such, taking time to agree with your attorneys on a structure and numbering system for these documents can prevent confusion and save a great deal of time that would otherwise be wasted searching.
You will want your own repository for non-confidential documents such as kickoff decks, status reports, training materials, etc. Take the time now to set up the tool of your choice, i.e. SharePoint, Box, Dropbox, or other. This will make coordination and communication during diligence easier and carries over nicely to integration should the program move forward. Loading any existing deliverables you have accumulated to date, i.e. documentation of deal rationale and TOM assumptions, is a good idea.
Take the time to do some basic program setup, including establishing tools and governance, prior to commencing diligence. This will improve coordination and yield better diligence results. Make sure to design a robust onboarding and NDA process, and to have platforms in place whereby resources can obtain and share materials.
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