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Due Diligence Requirements in Financial Transactions
Due Diligence Requirements in Financial Transactions
by Scott Moeller
Executive Summary
There is an urgency for companies to conduct intensive due diligence in financial deals, both before announcement (when it should be easy to call off the deal) and after. Traditional due diligence merely verifies the history of the target and projects the future based on that history; correctly applied due diligence digs much deeper and provides insight into the future value of the target across a wide variety of factors. Although due diligence does enable prospective acquirers to find potential black holes, the aim of due diligence should be this and more, including looking for opportunities to realize future prospects for the enlarged corporation through leveraging of the acquiring and the acquired firms resources and capabilities, identification of synergistic benefits, and postmerger integration planning. Due diligence should start from the inception of a deal. Areas to probe include finance, management, employees, IT, legal, risk management systems, culture, innovation, and even ethics. Critical to the success of the due diligence process is the identification of the necessary information required, where it can best be sourced, and who is best qualified to review and interpret the data. Requesting too much information is just as dangerous as requesting too little. Having the wrong people looking at the data is also hazardous.
Introduction
This is not your fathers due diligence. Due diligence is one of the two most critical elements in the success of an Mergers and Acquisitions (M&A) transaction (the other being the proper execution of the integration process) according to a survey conducted in 2006 by the Economist Intelligence Unit (EIU) and Accenture. Due diligence was considered to be of greater importance than target selection, negotiation, pricing the deal, and the development of the companys overall M&A strategy. But not even a decade ago, when due diligence was conducted in financial transactions, the focus was almost always limited to financial factors, pending law suits, and information technology (IT) systems. Today, those areas remain important, but they must be supplemented during the due diligence process by attention to the assessment of other factors: management and employees (and not just their contracts, but how good they actually are in their jobs), commercial operations (products, marketing, strategy, and competition both existing and potential), and corporate culture (can the companies actually work together when theyre merged?). But even these areas are now mainstream when due diligence is conducted. Newer areas of due diligence are developing rapidly: risk management, innovation, and ethical (including corporate social responsibility) due diligence. The 2006 EIU/Accenture survey also found that although due diligence is considered as a top challenge by 23% of CEOs in making domestic acquisitions, this rises to 41% in the much more complex cross-border transactions, which make up the majority of financial transactions, even in todays depressed markets.
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To quote from a PricewaterhouseCoopers report issued in late 2002: We always have to make decisions based on imperfect information. But the more information you have and the more you transform that into what we call knowledge, the more likely you are to be successful. That said, there is only a certain amount that can be handled by the number of people involved, the time restrictions under which they are working, and the quality and variety of resources available to them. Moreover, there is the danger of being overloaded by too much information if those involved do not have good management and analytical methods they can deploy. By and large, it is not the quantity of information that matters so much as its quality and how it is used. Although diligence may not be cheap (as a result of fees charged for often highly complex work by professional services firms), the alternative of litigation or the destruction of stockholder value (as a consequence of having been penny wise and pound foolish in the execution of the due diligence process) may prove far more costly in the long run.
Some basic questions to ask include: Is the acquirer a strategic or a financial buyer? How fully integrated will the target be once acquired, and in what time frame? Is the whole company being acquired? Does the target represent new product lines, marketing channels, or geographic territories, or is there overlap with the acquirers existing operations? Will certain functional operations of the target be eliminated? Will the IT systems of the target be retained?
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Accenture survey of M&A practitioners said that their due diligence process included four or more sources from outside the company.
Case Study
Failure in Due Diligence: VeriSigns Purchase of Jamba
In June 2004, VeriSign acquired privately held Berlin-based Jamba for US$273 million. VeriSign was an internet infrastructure services company which provided the services that enabled over 3,000 enterprises and 500,000 websites to operate. Through its domain name registry it managed over 50 million digital identities in more than 350 languages. Revenues exceeded US$1 billion dollars in the previous year. VeriSign had extensive experience with acquisitions, having made 17 acquisitions prior to Jamba, including four that were valued at more than this particular purchase.
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Jamba had millions of subscribers and was the leading provider of mobile content delivery services in Europe. It was best known for the Crazy Frog character used in the most successful ring tone of all time. But, beneath the surface, trouble was brewing that could easily have been uncovered by even the most rudimentary due diligence: complaints to regulators had noted that Jamster, the UK and US rebranding of Jamba, was targeting children, despite the fact that Jamsters mobile content services were intended for adult customers only. Perhaps more disturbingly, only days before the acquisition VeriSign discovered that a significant portion of Jambas profits came from the distribution of adult content in Germanydespite a VeriSign policy of not supporting adult or pornographic companies. There were backlashes in Germany over other issues and Jamba was forced to make a declaration of discontinuance regarding many of its contracts. Other legal actions were pending in Germany and the United States. Unsurprisingly, Jambas revenues peaked early the following year.
Case Study
No Cultural Fit for Sony in the Movie Industry
In 1988, Sony (a Japanese electronics manufacturer) acquired Columbia Pictures (an American moviemaker) for US$3.4 billion. With cultures that could scarcely have been more different, the acquisition which involved little consideration of cultural fit between the two entitiesfailed to live up to commercial expectations, with Sony famously writing down US$2.7 billion on the deal by 1994.
Conclusion
According to the EIU/Accenture survey, only 18% of executives were highly confident that their company had carried out satisfactory due diligence. This is probably due to the lack of attention given to this critical aspect of a deal, or to the view that it is merely a box-ticking exercise conducted by outside advisers. In short, the probing of a wide variety of due diligence areas should provide a counterbalance to the shorttermism of traditionally limited financial and legal due diligence, helping acquirers to understand how markets and competitive environments will affect their purchase, and confirming that the opportunity is a sensible one to undertake from a commercial and strategic perspective, especially in cross-border deals.
Making It Happen
Key factors in conducting informative and timely due diligence are: Identifying the critical areas to probe: financial, legal, business, cultural, management, ethical, risk management, etc. Identifying the most important information to collect in those areas, as there is never enough time to look at everything in as much detail as one might want. Identifying the right sources for the desired information. Identifying the right people to review the data: this should include those who know most about that area and also those who will be managing the business post acquisition.
Due diligence should not be a mere confirmation of the facts. Bridging the strategic review and completion phases of any merger or acquisition exercise, the due diligence process allows prospective acquirers to understand as much as possible about the target company, and to make sure that what it believes is being purchased is actually what is being purchased. The due diligence process digs deeper before the point of no return in consummating a deal.
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More Info
Books:
Howson, Peter. Due Diligence: The Critical Stage in Mergers and Acquisitions. Aldershot, UK: Gower Publishing, 2003. Moeller, Scott, and Chris Brady. Intelligent M&A: Navigating the Mergers and Acquisitions Minefield. Chichester, UK: Wiley, 2007. Sudarsanam, Sudi. Creating Value from Mergers and Acquisition: The Challenges. Harlow, UK: Pearson Education, 2003.
Notes
1 Adapted from Fell, Bruce D. Operational due diligence for value. Emphasis no. 3 (2006): 69. Online at: tinyurl.com/d7w36t 2 Ibid.
See Also
Best Practice Acquisition Integration: How to Do It Successfully Coping with Equity Market Reactions to M&A Transactions CSR: More than PR, Pursuing Competitive Advantage in the Long Run Mergers and Acquisitions: Todays Catalyst Is Working Capital Viewpoints Viewpoint: James E. Schrager Checklists M&A Regulations: A Global Overview Overview of Tax Deeds Planning the Acquisition Process The Rationale for an Acquisition Structuring M&A Deals and Tax Planning
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