Caveat Emptor: Due diligence in growth strategy
(As originally published in the Financial Post, May 2013)
By Chris Hutchinson, Senior Manager, Transaction Advisory Services, EY
After a period of retrenchment as firms waited out the worst of the recent economic storm, smaller and mid-sized companies are now seeking the smartest route forward in their growth strategies. For many, that means a renewed, if cautious, interest in merger and acquisition (M&A) activity. To thrive amidst still-unpredictable conditions, timely and accurate intelligence isn't just an option, it's a necessity – and that means a professionally executed due diligence process.
A process of critical analysis is essential for successful acquisitions or partnerships. It equips buyers as well as investment partners and lenders with a clear understanding of the story behind the numbers, different than conventional reporting or audits can reveal. With ongoing changes to Accounting Standards for Private Enterprise (ASPE), that understanding may be more difficult than ever to secure. Understanding the financial, accounting and business processes provides clarity that can help protect a company’s investment, its investors and – ultimately – its reputation.
Professional financial due diligence analyzes a target company's books, records and other internal reports and documents for financial and business trends. The diligence exercise probes deeply into the quality and sustainability of earnings by examining underlying risks and exploring previous financial performance to determine whether it can reasonably be expected to continue, and to understand how changing circumstances and trends may impact the future of the business.
Think this just applies to mega-deals between large firms? Not so. Often small and mid-sized targets have less sophisticated financial reporting, which can increase the risk in a transaction. A professionally prepared due diligence report can also be a significant asset (and often is a prerequisite) when an organization is trying to secure sources of funding for a transaction.
The due diligence process can have a substantial impact on the success of a transaction.
In one recent example, we were engaged by a mid-sized company to perform financial due diligence and on the cusp of a significant transaction, discovered that a large customer of the target company had stopped placing orders just days earlier. With this discovery, the client was able to renegotiate the terms of the deal prior to the closing, rather than relying on representation and warranties which could have resulted in a potentially costly litigation after the fact.
In another example, working with a financial investor, we uncovered a simple error in a target company's interim financial statements that had a direct impact on the trailing twelve-month EBITDA, which had been the basis for the valuation. The result was a half-million-dollar decrease to the purchase price.
Due diligence provides additional clarity that may not come to light in a typical negotiation.
Going beyond the numbers, due diligence professionals meet with the target company's financial and non-financial management to understand the larger context of the business, identifying potential problems or areas that may impact the investment thesis. They look at the financial implications of findings, analyze projections, and help structure a deal that optimizes both risk and tax implications. Working with a financial due diligence team that can also draw on complementary expertise in operational due diligence, income and indirect taxes, IT consulting and more also means a smooth transition to a more fulsome diligence.
While the length of time necessary for effective due diligence varies with every project, it is prudent to build it into every transaction. Our typical steps include:
- Understand the essence of the potential transaction, including the investment thesis and key value drivers for the potential investor.
- Understand the specific risk areas that require focus, and tailor procedures to be performed.
- Manage all requests for information, and work with management to establish an appropriate work-plan.
- Perform detailed procedures including financial analysis, detailed discussions with management and site visits, when applicable.
- Provide real-time updates and present draft findings and reports to ensure that the purchaser is aware of all issues, and to be confident that the final report will meet stakeholder needs.
Companies that undertake the due diligence process with insufficient vigor, or that view it as a perfunctory exercise to be checked off quickly, do so at their peril. Now more than ever, an effective and comprehensive due diligence process can help mitigate organizational, reputational and financial risks. Savvy leaders, no matter what the size of their organization or the transaction, know that experienced due diligence professionals can be their partners in executing smooth transactions for successful growth.