Making the decision to buy or sell a business is challenging enough, but once a buyer is lined up for the target company, the next stage in the process may be even more daunting – completing the due diligence process.
Due diligence involves gathering all the information that the buyer needs before completing the deal, including the target’s financials and projections, as well as details of its cash flows, costs and contracts.
This process is regarded as a major factor for the overall success of the transaction. Research published in 2013 by Cass Business School and Intralinks Holdings found transactions involving a longer due diligence process provide higher long-term shareholder returns for the acquiring company.
However, due diligence can be lengthy and involved, often taking 60 days or even longer to complete. In another study by Intralinks DealNexus, almost 38 per cent of M&A professionals identified due diligence as the most tedious part of deal-making.
It can also be a time when emotions run high. David Blois, managing partner at M&A Advisory, says that from a seller’s point of view the due diligence is not just a question of providing relevant information. For someone who has spent ten or fifteen years building up a business, selling can be quite an emotional process.
DUE DILIGENCE PRESSURE
Mr Blois points out that, throughout the sale, a great deal of work is put in by both buyer and seller into fostering a strong relationship as they will need to work together post-deal. But once the due diligence process kicks in that fledgling relationship can come under significant pressure.
“Financial elements aside, the seller chooses the buyer on the basis of good chemistry, compatible culture and a strong vision for the future,” he adds. “Due diligence is often carried out to tight deadlines by people who are not always party to the relationship-building element of the deal. All of a sudden there’s effectively an impersonal and backward looking MOT test carried out on the seller’s company, which can potentially damage that relationship if not handled correctly.”
Love it or hate it, the process is an opportunity for the buyer to look under the bonnet of the target company and verify any assumptions that may have been made earlier. Potential problems that may prevent the deal from proceeding, such as a large pensions hole, a failing customer relationship or a key contract which has not been renewed, should be identified.
From the buyer’s point of view, due diligence is also an essential opportunity to validate the strategic benefit of the transaction. “A key goal for the buyer is to verify their investment hypothesis,” says James Fillingham, a partner at PwC. “You might be backing a macro-story, such as growth in Eastern Europe. You might be backing an industry trend, such as digitisation. Or you might be backing a turnaround play, where you think the target is a mismanaged business or an unloved corner of a large corporate and you think you can do a lot better.”
Love it or hate it, the process is an opportunity for the buyer to look under the bonnet of the target company and verify any assumptions that may have been made earlier
Before the financial crisis, a buoyant market had led some companies to cut corners in this process, according to Mr Fillingham. “Back then companies were cutting diligence to the bone, but we are seeing a more belt-and-braces approach now,” he says. “People are doing a lot more hygiene-factor diligence: ‘Are the numbers right? Are the margins right? What liabilities are we inheriting?’”
M&A due diligence involves a number of different elements and should be both backward and forward-looking. Backward-looking due diligence focuses on the target’s past performance, while forward-looking due diligence is a strategic exercise focusing on the future prospects of the company and the value proposition of the transaction.
DON’T DESTROY VALUE
Mr Fillingham says that, while companies don’t necessarily struggle to understand the scale of the market opportunity, integrating the opportunity into the business can be more of a challenge. Many acquisitions are ultimately value-destroying from a shareholder point of view, due to a failure to execute the deal properly and achieve the desired synergies.
As a result, companies now tend to engage a broader range of people in the due diligence process than in the past, including not only the finance team, but also operational management personnel in areas such as IT, sales and manufacturing.
Thrilling it may not be, but due diligence is a crucial step in M&A and the more information the potential buyer has about the target business, the better placed they will be to assess the strategic benefits of the deal.
The term “M&A insurance” usually refers to warranty and indemnity (W&I) insurance, which is used to cover warranty breaches which might arise following the completion of an M&A deal. Other types of M&A insurance may cover risks identified during the due diligence process, such as tax issues.
“The most common use of M&A insurance is to bridge the gap between the expectations of a buyer in relation to the level of recourse it is seeking for a breach of warranty and the ability or desire of the seller or warrantors to provide such recourse,” explains Andrew Graham, vice president, European mergers and acquisitions, at Allied World.
W&I insurance may be sought by both buyers and sellers, although the majority of policies are initiated by buyers. As well as mitigating risks, insurance is increasingly being used as a sales tool. “W&I is a powerful tool for a private equity fund in selling mode, allowing the fund to limit its risk and maximise distribution of cash to investors,” says Richard French, head of Howden’s transactional team.
Providing a transfer of risk, M&A insurance is regarded as an alternative to escrow services – money held by a third party on behalf of the transacting parties – or at least a means of reducing the size of an escrow.
Adam Fox, head of transaction liability at insurance broker Arthur J. Gallagher, points out that capping future liabilities through an insurance policy is more efficient than one or both sides of the transaction putting funds into escrow, which ties up capital and can be an expensive option.
This type of insurance has been around for a couple of decades and is used for the majority of M&A deals in Australia, but has only begun to make its presence felt in UK deals in the last few years. Familiarity with the product has been low, but is now beginning to gain momentum as more companies adopt it.
“Demand is currently very high and the insurers are having to prioritise the inquiries they are getting,” says Teresa Jones, a partner in the M&A team at JLT’s Financial Lines Group. “It is the responsibility of experienced brokers to help in this process and ensure opportunities are maximised among all the insurers, and that cover is secured on time and at the best price.”