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.
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