A thorough, smart and stealthy due diligence process is among the top ingredients for successful mergers and acquisitions. We spoke to finance executives and deal makers about the homework a growth-hungry company needs to do. “The due diligence report is often just used to tick the box and the findings are not adequately translated into the pricing and sale and purchase agreement,” says Karin Hodson, Partner and Transaction Services Leader at Deloitte. Failure to undertake adequate due diligence can result in significant erosion in value and potential losses of customers, staff and everything in between, she adds.
By Toni Muir
- Read what Standard Bank's Dr Andrew Balnaves had to say about due diligence.
- Read what Sibanye Gold CFO Charl Keyter had to say about due diligence.
Karin Hodson has worked in transaction services for 16 years and has been involved in close to 320 transactions during this time. Over the last two years alone, she has been involved in some 40 transactions. One of the more recent deals in which she was involved was the acquisition of Neotel by Liquid Telecommunications. That deal closed in eight months and was relatively quick compared to the prolonged Vodacom offer, which was eventually abandoned as regulatory approval was not obtained.
She said of the deal:
"This deal was particularly interesting due to the complexities involved in understanding the debt and working capital requirements in the company and how this was translated into the sale and purchase agreement. It was also particularly impressive how Liquid managed to act so swiftly to obtain all the required regulatory approvals to ensure the deal was closed in the shortest time frame possible."
Due diligence is used to gain insight into operations, financial and legal matters. And it is fun, says Karin. "The ability to add tangible benefits through adjustments to the valuation model, input into the sale and purchase agreement, such as warranties, indemnities, conditions precedent, and purchase price and closing mechanisms, as well as transaction structuring and post deal considerations make the work enjoyable. Clients rely on this information to make an informed decision."
Vendor due diligence
"Companies must understand what they buy and what the transaction structure is," Karin says. "Are they buying the shares or are they buying the business out of the company?" Companies embarking on a deal usually consider their own capabilities and what they can they do in-house before reaching out to specialists or advisors. Funders and investment committees often require independent due diligence reports. "There is also the vendor due diligence, which is commissioned by the seller and is made available to prospective buyers." This allows prospective buyers access to the same due diligence report in a controlled manner and minimises disruption to the target entity.
The extent of the due diligence undertaken and the work streams that are covered are largely dependent on the industry and the buyer, says Karin, explaining there are vast differences between strategic and private equity buyers. "Specialised industries drive the need for additional due diligence experts, such as mining, insurance and banking." It is important that the due diligence findings are factored into the valuation, she notes, as well as the sale and purchase agreement. "The due diligence report is often used to just tick the box and the findings are not adequately translated into the pricing and sale and purchase agreement."
Half-hearted
"Success doesn't necessarily mean the transaction is going to happen," says Karin. In her opinion, a successful due diligence process includes setting expectations upfront, having regular communication throughout the process, and sharing information between work streams. Sometimes access to information and management is limited. "Often, when a company is up for sale the market and employees are unaware, so you have limited access," Karin explains. "Likewise, access to competitive information is often restricted."
Companies that overlook the due diligence process, or which do a half-hearted job, stand to lose value, Karin says:
"Financial risks relating to the valuation model may not be adequately identified, resulting in potentially overpaying for the acquisition. There could be customer and supplier losses, for example, if contracts include change of control clauses. You could also end up with HR issues if there are different corporate cultures and staff need to be integrated, or if you lose key people post transaction."
Outside of this, she cautions, there may be other considerations, such as tax contingencies that weren't in a company's financial records, legal and employee claims or regulatory/environmental exposures. "You also need to consider technical aspects such as plant and equipment. Likewise, IT systems may be inadequate and capex is required for integration or replacement."
The CFO's role
The CFO's role depends on the transaction and the client, as well as who or which team is running the process, Karin says. "Certainly, I would want to see CFOs involved in this process. They need to think beyond just the financial implications and consider the strategic fit and the commercial viability." It is also important to understand the rationale for doing the deal and to identify synergies, she notes. "CFOs need to be intimately involved in appointing advisors and ensuring the points that affect value and synergies are covered. They must also familiarise themselves with the risks they will need to deal with in their post-merger implementation plans."
Sometimes, companies try to do everything in-house, often to their detriment, Karin notes. "Rather invest time and money upfront, and understand what you are buying." Outside advisors deal with M&A every day and also provide an independent assessment of the transaction, she adds. "Your advisor will give you an honest point of view because they aren't emotionally attached to the transaction."
Karin's due diligence top 5
- Understand the rationale for doing the transaction and the strategic fit.
- Identify the risks in the entity and the impact this has on the valuation, sale and purchase agreement and post-merger implementation plan.
- Understand the commercial drivers: customers, suppliers, competitive conditions, products and any risks or sensitivities.
- Familiarise yourself with the operating model (systems, people, infrastructure) to enable integration with your business, as well as regulatory or legal matters that need to be addressed in the sale and purchase agreement, such as regulatory approvals, IP protection, restraints of trade and change of control clauses in contracts.
- Understand the current and forecast cash flows of the entity and identify potential sensitivities that impact the ability to generate cash and achieve required returns and debt repayments.
