Due diligence is an area of M&A that tends to fill people with trepidation in spite of few having ever experienced it. So what exactly is due diligence and when does it happen?
Due diligence is an information-gathering and assessment exercise through which buyers effectively check that what they have been told about a business (that they are intending to buy and have made an offer for), combined with what they reasonably expect to find in a well-run company, is matched by the reality of the target business. In other words, it is a way for a buyer to mitigate the risk of buying another business.
The main investigations of due diligence, or “DD” as they are often known, follow the signing of Heads of Agreement in the second half of a deal timetable and take between three and eight weeks (depending on the complexity of the business being assessed).
Due diligence usually cover four broad areas.
Financial due diligence leads the whole due diligence exercise and is usually carried out by a team combining the buyer and their accountants.
This team first checks that the historic financials they have seen on the business are accurate and a fair and complete representation of its past performance and risks. Then, for all budgets and forecast financials provided, they look closely at the base inputs and underlying assumptions, assessing whether, amongst other things, the expected growth rates are achievable and sustainable.
Where forecasts are deemed to be unrealistic, or where new significant financial information (P&L, balance sheet and cash flow) comes to light, buyers may begin to reassess the basis of their offer or more dramatically reconsider their appetite altogether. For these reasons, careful preparation of all financial information distributed to buyers in a sale process is vital.
In legal due diligence, buyers look at all the various contractual arrangements that underpin a target business and its value – contracts with clients, consultants, suppliers and any other commercial partners –which as a future owner they will inherit.
Here buyers are looking for any unexpected legal gaps or uncertainties that mean there is more risk to the business than they had believed when they made their offer to buy it. Incomplete employment contracts, tax issues, or undisclosed litigation disputes are some examples of legal DD issues that will cause concern on the part of buyers.
The findings and conclusions drawn from buyers in its legal due diligence, and indeed in the other DD areas, influence the warranties and indemnities they seek from vendors in the Sale and Purchase agreement (“SPA”).
Buyer’s operational due diligence looks at the day-to-day workings of a business – its methodologies, processes and structures – and how well these run. Often buyers do this as a quality check of the target business but also as groundwork for future integration plans by understanding the extent to which operations are compatible with their own.
In the case of Private Equity buyers, who are usually sector generalists and therefore not experts in the Recruitment sector, operational due diligence will tend to be even more rigorous, extending into areas such as IT systems, insurance cover and even environmental risk, and be undertaken by specialist DD service providers in each operational area.
Buyers will always seek to assess the Management team who will manage the business following completion, either informally by meeting them in person and taking market soundings about individuals, or more formally through psychometric testing and client referencing of individuals (also beloved by Private Equity).
In a sale process where the vendor is planning to leave the business following completion, succession risk is understandably highest and will attract more attention by a buyer during due diligence.
Due diligence is a necessary part of any exit and will cover predictable areas of any recruitment business. And the risk that due diligence presents to a successful deal completion should never be underestimated.
There are two ways that the risk of due diligence can be reduced for vendors. The first is by the vendors being open and proactive in familiarising their M&A and legal advisors with their business and its risks. Doing so ensures that the advisors can best plan how the relevant information can be disclosed to buyers in way that avoids eroding value and does not defer issues until later on when buyers are in a stronger negotiating position.
The second way of managing due diligence risk is for owners’ advisors to stay alert and watchful for any concerns that begin to emerge in the minds of buyers during their due diligence, and to respond to these decisively and constructively before they gain momentum. Doing so will often smooth the path to completion.
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