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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 father’s 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
company’s 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 they’re
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 today’s depressed markets.

Organizing for Due Diligence


It’s a two-way street: Buyers must understand what they are buying; and targets must understand who’s
pursuing them and whether they should accept an offer.
To be successfully conducted, due diligence must have senior management involvement and control, often
assisted by outside experts such as management consulting firms, accountants, investment banks, and
maybe even specialist investigation firms.

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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.

The Due Diligence Process


Although due diligence may be only one part of an acquisition or investment exercise, in many ways it is by
far the most significant aspect of the M&A process. Done properly, acquirers should be better able to control
the risks inherent in any deal, while simultaneously contributing to the ultimate effective management of the
target and the realization of the goals of the acquisition.
As an instrument through which to reveal and remedy potential sources of risk, due diligence—by confirming
the expectations of the buyer and the understanding of the seller—enables firms to formulate remedies and
solutions to enable a deal to proceed. In many ways, due diligence lends comfort to an acquirer’s senior
management, the board, and ultimately the stockholders, who should all insist on a rigorous due diligence
process, which provides them with relative (though not absolute) assurance that the deal is sensible, and
that they have uncovered any problems pertaining to it that may derail matters in the future.
Ideally, due diligence should start during the deal conception phase, and initially it can use publicly available
information. It should then continue throughout the merger process as further proprietary information
becomes available. Full use of the due diligence information collected would mean that it is not just used to
make a go/no-go decision about whether the acquisition should proceed and to determine the terms of the
deal, but that the findings from due diligence should also be incorporated in the planning for the postmerger
integration.
Clearly it is easier to obtain high-quality data if the deal is friendly; in unfriendly deals due diligence may
never progress further than publicly available data. This lack of access to internal information has scuppered
many a deal—for example, the takeover attempt by Sir Philip Green of Marks & Spencer in 2004.

The Scope of Due Diligence1


Before undertaking due diligence—given the typical time, cost, and data constraints—it is important to focus
on areas that are likely to have the most impact on value. Thus, due diligence should be tailored to:
• the type of transaction
• the motivation for doing the deal
• plans for the target once acquired
• the impact on the existing operations of the acquirer
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 acquirer’s existing operations?
• Will certain functional operations of the target be eliminated?
• Will the IT systems of the target be retained?

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• How will the rating agencies respond to the transaction?

Types of Due Diligence Information


Each industry has its own special due diligence requirements. For example, an insurance company will
need a review of major policies, actuarial assumptions, and sales practices, whereas the purchase of a bank
would require a review of its marking policies and risk management systems.
As noted above, one starts with external sources. Although these rarely provide a sufficient overview
of an organization at the level required to obtain a proper understanding, secondary sources do equip
management with valuable information, allowing them to strategize and develop honed and more focused
questions for their further internal due diligence on the prospective acquisition.
In spite of the centrality of financial, legal, cultural, and other areas of due diligence, examples abound of
transactions that were completed without effective due diligence being done through lack of time or because
management was overconfident in its ability to understand the target, resulting in devastating losses of
stockholder value.

Financial Due Diligence


Financial due diligence enables companies to obtain a view of an organization’s historical profits, which
can then be used as a canvas on which to paint a picture of the company’s financial future. Developed
around an array of building blocks—including auditing and verifying financial results on which an offer is
based, identifying deal breakers, reviewing forecasts and budgets, pinpointing areas where warranties or
indemnities may be needed, and providing confidence in the underlying performance (and therefore future
profits) of a company—financial due diligence allows the bidder to make the proper offer for the target, or
perhaps uncover reasons for not proceeding with the deal.

Legal Due Diligence


As companies expand into hitherto commercially less experienced parts of the world in search of new
markets and products (such as China, Vietnam, or certain countries in the Middle East and Africa), the
requirement to conduct effective and sufficient legal due diligence work can prove more trying, and in certain
cases near impossible. Nevertheless, the need to check title over assets that are being sold, and to ensure
that the entity being acquired is legitimate and free of any contractual or legal obstacles which might derail
the M&A process, will undoubtedly remain pivotal to the due diligence process no matter where the target
resides. Governmental regulatory concerns (such as monopolies, employment law, taxes, etc.) will also be
investigated as part of the legal due diligence.

Commercial Due Diligence


Given that companies are bought not for their past performance but for their ability to generate profits in the
future, acquirers must use commercial due diligence to obtain an objective view of a company’s markets,
prospects, and competitive position. As noted by Towers Perrin in a discussion of operational due diligence,
2
there is a “need to look at all the relevant sources of value to avoid unpleasant surprises.” This means a
deeper query into certain operations that heavily determine a target’s ultimate value to the acquirer—i.e.
growth opportunities and resulting future income.
Whether obtained to reduce risk associated with the transaction, help with the company valuation, or plan
for postmerger integration, commercial due diligence enables acquirers to examine a target’s markets and
performance—identifying strengths, weaknesses, opportunities, and threats. Focused on the likely strategic
position of the combined entity, commercial due diligence, by reviewing the drivers that underpin forecasts
and business plans, concentrates on the ability of the target’s businesses to achieve the projected sales and
profitability growth post acquisition.
Despite the seemingly obvious pivotal benefits that commercial due diligence can bring to acquiring
organizations, Competitive Intelligence Magazine reported in 2003 that “only 10% of respondents to an

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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.”

Innovation Due Diligence


Linked closely to commercial risk but meriting special attention is the due diligence of the research and
development (R&D) process. This is more than just an analysis of intellectual property rights. Many
nonindustrial companies may not have explicit R&D groups, but still remain dependent on the development
of intellectual property to maintain their business growth. It must be understood how this is encouraged.

Management Due Diligence


Naturally, acquirers need to perform discrete investigations in order to evaluate both the competence of the
target’s management and the quality of their past performances, and to ensure that the management of the
target and acquirer are compatible. One would think that this would be recognized by any acquirer today, but
one acquisition team recently told us that their senior management felt confident enough in their own ability
to conduct their management due diligence that they could do this “over a cup of tea,” basically, by eyeing
the management team from across the table. Nevertheless, in the rush to do deals in the peak merger year
of 2007, many of the largest deals properly included extensive management surveys, including 360 degree
appraisals, psychometrics, and even investigative reporting.

Cultural Due Diligence


Since one of the more difficult areas for integrating two companies concerns combining their corporate
cultures, due care needs to be applied to ensure cultural fit. Indeed, cultural fit is so important that 85% of
underperforming acquisitions blame different management attitudes and culture for the poor performance
of the combined entities, as reported at a conference in 2006 by Towers Perrin and Cass Business School.
Thus, by assessing soft factors such as a company’s leadership style, corporate behavior, and even dress
code, an acquirer may be able to build an accurate picture of a target’s values, attitudes, and beliefs, and so
determine if there will be a good cultural fit within their own organizational structure.

Ethical Due Diligence


There is an emerging area, best described as ethical due diligence, that overlaps in many ways with
management and cultural due diligence but is not to be confused with legal due diligence. The most obvious
requirement of ethical due diligence is to determine whether management have engaged in unethical
professional acts (as defined, usually, by the ethical standards of the acquiring company), but it also
necessarily includes assessment of the corporate social responsibility activities of the company.

Risk Management Due Diligence


It is critical to understand how the target reports and monitors its inherent business risks. The events in
financial and real estate markets in the past several years highlight the need to check carefully not just all
risk management systems, but also the culture of risk in a company.

Case Study

Failure in Due Diligence: VeriSign’s 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 Jamster’s mobile content services were intended for
adult customers only. Perhaps more disturbingly, only days before the acquisition VeriSign discovered that
a significant portion of Jamba’s profits came from the distribution of adult content in Germany—despite 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, Jamba’s 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 entities—failed 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 short-
termism 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): 6–9. 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: Today’s 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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