Conducting an Effective Financial Due Diligence
In the mergers and acquisitions (M&A) environment, whether a person is undertaking an acquisition or an investment, a financial analysis on the potential target is important. Understanding the transaction and the risks involved enables the acquirer or investor to potentially mitigate the risks and make sound decisions.
The due diligence review looks at the Target’s business, the key drivers, the product mix and the industry the Target is in. It also delves into historical performance trends, liquidity, forecasts and projections. In a nutshell, the exercise is directed at basically knowing your Target and scrutinizes the past, present and future from the financial aspect of the business.
However, a financial due diligence is not always foolproof in uncovering anomalies. Conducting a financial due diligence too hastily, or with limited scope and coverage may lead to issues not being identified. Certain questionable deals have arisen in the past even after a due diligence is done, such as Hewlett Packard’s acquisition of Autonomy in the United States of America, or locally, Top Glove’s acquisition of Aspion in which both had claimed fraudulent representation. As such, choosing the right team, scope and professional firm for your due diligence exercise is important.
In this publication, we are honored to share our knowledge and the issues to focus on when conducting a financial due diligence.
If you are currently in the midst of an M&A transaction and are considering a financial due diligence specialist, please feel free to talk to us.
Who Needs Due Diligence?
When acquiring a company or investing into a company, we need to keep our eyes open and know what we are getting into. U-turns and regrets may be too late. We have to ensure that the transaction we are entering into is safe from critical financial issues and misrepresentations by the seller. A due diligence may also be needed for reasons unique to the acquirer. Often, an acquirer’s concern is that they are paying an excessive price for overstated assets or understated liabilities. If the value of the target is below that as represented by the seller, the acquirer may wish to re-negotiate the acquisition price. Some may be concerned about whether their acquisition will reap synergies, competitive advantage, increase of market share and enhanced profits. The variety of users and their reasons for conducting due diligence exercises are:-
Reduce exposure in transaction risks and costs i.e. issues that are uncovered during the due diligence process which may introduce concerns on the certainty of closure of the acquisition
Interested in the upside potential of investments, and the ability of the target to pay interest or dividends
Why is Due Diligence Necessary?
A financial due diligence is an integral part of the M&A environment. Seldom do acquirers make acquisitions without undertaking either a limited or full due diligence exercise on the target. The key objective is to identify the risks arising from the transaction and thereafter to put in place a proper mitigation strategy.
Due diligence findings will also help the user to consider the most optimal structure for making the acquisition and to take advantage of potential tax savings. Options to invest or exit will always depend on the findings and the right pricing. There are times where due diligence findings have led to a lower pricing as a result of adjustments. Acquirers or investors should not under-rate the necessity of these exercises because of past accounting improprieties in the financial statements of target companies such as those in the acquisition of Autonomy by Hewlett Packard in the United States of America.
The purpose of conducting a financial due diligence is simple - it is for “Fact Finding”. It is not an audit. Due to this mistaken impression, many acquirers are of the view that a due diligence is not needed if an audit had been conducted. Being a fact-finding mission, the due diligence deliverable comprises a comprehensive due diligence report that consists of details and the reasons behind the numbers that will help to alleviate the concerns of the user. The key differences between an audit and a due diligence exercise are:
Scoping a Due Diligence Engagement
Every due diligence assignment is different and requires a different approach with focus areas that are tailored to the requirements of the Client. The nature and scope of due diligence depends on the type of transaction, the size of the investment and the timeframe available to conduct the due diligence. A pre-consultation with the acquirer and other relevant parties will be done to understand the nature and scope required. Subsequently, after perusing the preliminary information received from the Client, a discussion will be held to highlight potential red flags following which a scope of work will be prepared for the Client. The scoping process is as follows:-
- Pre-consultation/ assessment of target company
- Full scope/high-level review of target company’s financials – this depends on costs and risks
- Identify red flags and communicate
- Scope and focus on high risk areas
