News & Articles

What is due diligence and why is it important?

Written by Mark Jolley | Jul 9, 2024 12:30:00 AM

Due diligence has both a legal and a commercial context. In a legal context, it means taking care to avoid situations or actions that could cause harm to oneself, to others, or to property. In a commercial context due diligence refers to the audit process that a buyer, seller, or lender undertakes prior to a significant transaction to ensure a well-informed decision. 

The consequences of failing to exercise due diligence can be severe while the benefits of a well-considered transaction can be high. The consequences of failed due diligence include not simply the financial or physical harm caused by any negligence but also the cost of subsequent legal or regulatory action. 

The simple act of washing hands might be considered an exercise of due diligence, especially in the context of a restaurant where food poisoning can have serious repercussions. 

Every commercial transaction requires some amount of due diligence. In a personal context, it might simply involve taking a car for a test-drive or arranging a building inspection when buying a house. In a commercial context, it depends on the nature of the transaction. 

The most extensive due diligence is most commonly exercised by auditors, firms engaged in M&A, banks, and asset managers (including private equity and VC firms).  Fraud analysts are employed in all areas of business, ranging from multi-billion dollar acquisitions to vetting a new supplier. No firm wants to be tied to a supplier employing child labour. Equally, no supplier wants a distributor with a tawdry reputation.

This article seeks to examine the foundational elements of due diligence: What it is, why it exists, the different types, and who carries it out.

Table of contents

 

Why is due diligence important?

Due diligence, in each case, refers to the analysis undertaken prior to a transaction. The purpose is to gain as deep an understanding as possible of the target acquisition, investment or borrower: Its finances, its people, and how it operates. The objective is to ensure that any decision taken is well-informed. 

The extent and complexity of the due diligence process depends upon the deal. The due diligence process is exhaustive for M&A because a merger or acquisition represents the biggest corporate transaction that any business will undertake and will have long-term consequences. 

Due diligence is easier for VCs and PE firms because in most situations target companies actively seek investment and will happily furnish whatever information is needed to secure funds. The same typically applies to bank loans. Banks have considerable access to information about existing customers but must undertake considerable due diligence when lending to new customers.

Active asset managers conduct extensive research before making investment decisions. Greater research is typically undertaken prior to an IPO because, in most cases, asset managers will be unfamiliar with the company that is listing.

The due diligence process depends on the amount of information available to economic agents and the complexity of the information needed to make a reliable decision.

In most situations, the audit process will rely heavily on a company’s published financial accounts, insights from industry experts and consultants, and information garnered from meetings and site visits. Depending on the transaction, target companies will be more or less generous with information. If the goal is to attract investment or secure a loan, companies will be more eager to furnish information. Agents, however, must still assess the reliability of provided information.

With M&A, acquisition targets are typically reluctant to supply information. Here we have two companies, very likely competitors, thinking about combining. For obvious reasons, companies do not like to disclose details of their operations and financials to every company that expresses an interest in M&A.

They will not want to give away valuable trade secrets in the event that the deal falls through. In the case of a hostile takeover, a target will typically do everything in its power to hide key information from a raider.

The Harvard Business Review reports that from 70% to 90% of all M&A deals fail. In many cases, failure can be traced to inadequate due diligence, particularly with regards to understanding a target’s financials and understanding how a target might be integrated into the existing business.

What types of due diligence are there?  

There are four types of due diligence:

  1. Financial due diligence (FDD)

  2. Operational due diligence (ODD)

  3. Tax due diligence (LDD)

  4. Legal due diligence (TDD)

In general, VCs, PE firms and security investors concentrate on financial due diligence. PE firms frequently seek to change the operations of target companies and so will also engage in extensive ODD. Companies seeking to engage a supplier, distributor or JV partner will typically concentrate more on operational and legal due diligence. 

In the modern era of money laundering, banks focus on legal as well as financial due diligence.  Some will also undertake operational due diligence to ensure that companies are not operating in forbidden jurisdictions or known illegals.

Whereas most functions require one or two types of due diligence, M&A requires all four. The quantity of data and documentation required in an M&A deal is bewildering. In most cases, a company will hire consultants from a major accounting firm to assist with the task, which can be overwhelming to an inexperienced team. 

Most companies engaged in a potential M&A transaction hire consultants to coordinate the audit process in each of the four areas listed above and to provide structure around the process. Most importantly, they standardise the way that data is collected from M&A targets. 

Back to top

Financial due diligence

Financial due diligence (FDD) investigates the financial performance of a company. The purpose of FDD is to gain a comprehensive understanding of a target company and its prospects for the future.

In particular, FDD provides the basis for assessing the economic value of an entity. A key element in FDD is the task of assessing the veracity of the financial statements. If the numbers are falsified, most deals end in disaster.

FDD is central to the audit process because an understanding of what drives a target company’s numbers will typically make or break a deal. All the other elements of due diligence feed into the valuation assessment provided by the FDD.

ODD focuses on understanding the operational intricacies of a company. Any incremental value found by the ODD team will feed into the FDD assessment. Similarly, any tax implications of a transaction will feed into the FDD valuation.

Tax implications can be significant for JV arrangements. Any legal issues uncovered by the LDD, such as hidden litigation liabilities or restraints of trade, will likewise feed into the FDD and ODD analysis. 

How financial due diligence works

FDD typically begins by analysing the last 5 years of financial statements (in the US, for example, this would mean the 10-K, the 10-Q, and the proxy filings). These statements are not taken at face value but are subjected to intense scrutiny to uncover issues that might affect the quality and accuracy of the accounts. 

Forensic analysis will seek out irregularities and inconsistencies in the accounts that may reveal hidden financial risks. In particular, the forensic phase of the FDD is looking for evidence of account manipulation, which might suggest the target is overstating its earnings. In this event, the reported earnings will not be sustainable.

The exact process employed in this forensic process will vary depending on the workflow employed by the accountants in the FDD team, and the number and experience of the forensic accountants on the team. To be sure, however, they will scour the income statement, the balance sheet and the cash flow statement for irregularities and patterns that might indicate manipulation. 

Those who are familiar with forensic accounting will know that there are hundreds of anomalous patterns to investigate. They will look for:

  • The relationship between revenue and cash flow, between revenue and inventories and revenue and receivables.

  • Signs of financial strain, especially focusing on unusual margin signals and the quality of cash flow.

  • Income from non-operating sources and from affiliates.

  • Evidence of premature revenue recognition from accruals, expense capitalization and other sources of unusual growth of long term assets. 

  • Management pay. 

  • Dilutive issuance and earnings restatements. 

  • Exceptional items and relationships with subsidiaries and affiliates. 

  • The distribution of clients, determining  whether particular clients are dominating the numbers.

  • Unusual discretionary expenses, changes of auditor, and change in accounting practices.  

This kind of forensic analysis requires extremely experienced accountants, is slow and expensive, and can often be inconclusive in the sense that the due diligence team is unsure what to do with the findings. 

In short, accountants or asset managers undertaking FDD will scour the accounts for evidence of anomalies that might point to wrongdoing. At this stage in an M&A deal, the due diligence process will require extensive discussion with the management and accounting departments of the target company. These discussions will typically focus on such things as relationships with affiliates, an extended explanation of notes to the accounts, end-of-quarter transactions, and insider stock sales.

Once satisfied that the accounts are clean, or satisfied the appropriate adjustments have been made, the FDD team will set about valuing the investment. The valuation approach is similar, whether one is looking to acquire an entire company or is an asset manager looking to invest in an IPO or a listed security. 

The valuation will incorporate a range of metrics to assess future earnings growth, coupled with the risk associated with earnings, leverage and cash flow. FDD teams undertaking M&A or a PE acquisition will incorporate the findings from the ODD, TDD and LDD into this valuation.

When estimating the growth outlook, some investors identify a fifth category of due diligence, known as commercial due diligence (CDD), which undertakes market research and considers a target’s positioning to estimate the outlook for sales and margins.

Back to top

Operational due diligence

Operational due diligence focuses on the operational mechanisms and workflows that generate a target company’s financial numbers. It  examines how a company turns inputs into outputs. 

The ODD team takes that understanding and asks how a target’s resources might be better used to create more value, especially if integrated with the company’s existing assets or business model. For PE firms, this often means determining which resources to keep and which to spin-off. Activist asset managers conduct ODD with a view to pressuring managers to make improvements. 

Whether engaged in M&A, private equity or activist investing, the ODD practitioner makes recommendations about how a target’s operations might be changed and estimates the value created by such a change. In this sense, ODD is the most forward looking aspect of due diligence. 

The role of ODD is to set a strategy for an acquisition or investment. In M&A, the strategy is set for the combined entity. Business integration can be extremely difficult, making this one of the more challenging aspects of due diligence.

How operational due diligence works

The framework for conducting ODD normally begins with an examination of the business model of the target or investment. It will consider how the business generates cash flow looking at factors including the working capital cycle, margins, asset turnover and leverage. The idea is to see how the model varies from other firms in the same industry. 

Is it, for example, asset heavy or asset light? Does the target enjoy above average margins, a shorter inventory cycle or faster asset turnover than peers. If so, why?  If not, why not? A key question is always how does working capital compare with peers and can it be improved?

Once the ODD obtains a good understanding of how the target or prospect generates cash flow, attention will then focus on the separate elements that contribute to the process: Human capital, intellectual capital, long-term assets and inventory management/logistics. 

The ODD audit will then conclude with a risk assessment of the operations. In the case of M&A, this will include some kind of SWOT comparison with their own company’s operations to see where synergies might be found. 

At the end of the ODD process, the team should have a clear idea about the cash generation process and the sustainability of the company. 

In general, the ODD of human capital will employ people from the human resources team to assist with the evaluation of the investment target’s people. This especially applies to sales and engineering personnel. Similarly, the ODD team will take experts from IT, product research and development, sales and marketing and even legal to assess the asset base of the company as they relate to their areas of expertise. PE firms engaged in ODD of human capital with a view to seeing where staff can be trimmed or engaged more efficiently.

After this evaluation, the ODD team will formulate a list of operating risks faced by the target company. In other words, how would the loss of key people affect operations? Is the product pipeline too thin to sustain the current operating capacity. What will it take to get the target company’s operations up to best-in-class? In the case of M&A, is there any conflict between the ethos or business model of the target and the acquiring company.

Naturally the ODD process means spending time on-site in the target company. On-site visits involve asking a battery of questions related to the culture at the on-site operations to assess the presence of structure, delegation of authority and key person risk. The uniformity of answers in this assessment is critical. Diverse answers will suggest lack of structure.

The ODD process also involves making on-site visits to relevant players both  upstream and downstream in the supply chain (e.g. suppliers, distributors, service providers, etc.) to gain an external perception of the company. 

At the end of the ODD process, the team should have a clear idea about the cash generation process and the sustainability of the company. 

Back to top

Tax due diligence

Tax due diligence (TDD) involves a thorough examination of all of the tax implications of a proposed M&A, JV or PE transaction. It involves gaining an understanding of the target company’s existing tax structure, and the tax consequences of a proposed transaction. 

Tax implications will influence how a deal is structured. Apart from the straightforward due diligence aspect, a key objective of TDD is to reveal tax opportunities. TDD allows the FDD team to incorporate tax impacts into their assessment and into the different integration scenarios proposed by the ODD team. This allows senior management or the investment team responsible for a deal to make more informed decisions.

While often overlooked as an aspect of M&A, JV or PE deals, taxes can sometimes be a motive for undertaking a transaction, especially if an acquirer has significant capital gains or if the target has tax concessions that are due to lapse. Most recently, one could argue that tax considerations drove Elon Musk’s acquisition of Twitter. 

Tax is a complex subject and mistakes in TDD can impact the profitability of a deal or lead to onerous penalties. It is one of the more technical aspects of due diligence, particularly when businesses are conducted across multiple tax jurisdictions or employ different tax accounting methods. 

How tax due diligence works

The first step of the TDD process is basically a tax audit. It involves an examination of all aspects of a company’s tax affairs to ensure the target’s taxes are correct and up-to-date, especially in respect of deferred revenue, and that all of the target’s estimated taxes have been remitted.

The second step aims to understand the tax structure of the company being analysed. This will allow the TDD team to better understand the tax implications of a proposed transaction. In essence, this means understanding a target company’s method of accounting. 

In most cases, the TDD team will simulate the target’s earnings and taxes using the buyer's accounting method to ensure there are no unexpected tax hangovers. This would apply equally to foreign taxes. At this point, the TDD team will typically assist the FDD team to reconcile income related to tax payments with that reported in the income statement.

The third step of the TDD is to assess ways to to minimise the tax consequences and/or maximise the tax benefits of a potential investment. PE firms frequently own businesses across multiple tax jurisdictions and tax considerations will often be a major consideration when seeking opportunities. 

For example, there may be potential for offsetting some of the target’s historical tax credits or other features against the costs of an acquisition. The TDD team will report the tax implications of different M&A strategies to management or the investment team.

Depending on the nature of the M&A transaction, there will need to be considerable cooperation between the buyer and the target in undertaking TDD. In particular, the TDD team will need to work with the target’s auditor and to review the target company’s tax audits if there have been any. If a tax audit is ongoing, the TDD team will need to advise on the likely impact this will have on the transaction and propose measures to limit liability. 

Back to top

Legal due diligence

Legal due diligence (LDD) is about looking for deal breakers. LDD concentrates on all legal aspects of the due diligence target and its relationships with its stakeholders. For example, it seeks to discover legal reasons why a buyer should not acquire or invest in a target firm or indeed why a target should reject a potential buyer. 

This process involves the analysis of licenses, regulatory issues, contracts, patents, outstanding lawsuits and any other legal liabilities that may be pending. The LDD process is complex and lengthy due to the sheer number of legal documents that businesses accumulate over time. 

The document checklist that must be gathered to facilitate LDD is truly bewildering. Among other items, the list will include documents relating to: 

  • Ownership and business organisation 

  • Litigation

  • Services/products

  • Contracts and other obligations 

  • Permits and licenses

  • Intellectual property

  • Material assets

  • HR and operations

We do not propose to detail the full list of documents that must be examined by the LDD team but to give some flavor. These are some of the documents relating to contracts and other obligations: 

  • All service contracts, vendor contacts, customer contracts and obligations

  • Outstanding contracts to purchase machinery or real estate

  • Contracts for construction, architectural or engineering services for any buildings or improvements

  • Operating contracts

  • Copies of employee contracts and retirement agreements

  • Change of control regulations and copies of material contracts that are terminable upon a change of control or other corporate transaction 

  • Copies of all joint venture, partnership, and franchise agreements

  • List of contracts or provisions that may be out of the ordinary course of business

Among some of the more obvious things that LDD teams look for include outstanding or pending litigation, HR issues with departing employees, especially pertaining to safety or discrimination, contractual disputes with suppliers or clients, and current and past investigations from regulators. 

Often the risks the LDD team is trying to uncover will typically be hidden in an obscure section of an obscure document. For example, it may be that the target has obscure side deals with the founder or some related third party. Searches of recurring or abnormal transactions can sometimes reveal links to such deals.

Legal due diligence is about looking for deal breakers. 

Sometimes, in another example, targets don’t actually own all of the intellectual property (IP) associated with the company. The job of LDD is to discover IP discrepancies.  

Legal risks are often not present at the time LDD is performed but could arise in the future. Consider, for example, an acquisition or investment involving a small pharmaceutical company with drugs that have side effects or involving a software company whose software might expose clients to future hacking. The legal due diligence team will be looking to see what forms of legal protection the company has in place. 

Much of the LDD team’s efforts will focus on scouting for agreements or instruments that place restrictions or encumbrances on assets, contracts that restrict the target's right to conduct business in certain jurisdictions, contracts with obligations such as covenants.

When a target has operations across multiple countries, the importance and complexity of LDD is magnified. 

Back to top

Who conducts due diligence 

Banks engage credit analysts and fraud specialists to conduct due diligence. Asset managers, PE firms and VCs employ analysts for the task. PE firms will typically engage consultants for more complex tasks. Most accounting firms have specialist divisions that are engaged to conduct due diligence. 

In M&A transactions, diligence is conducted by a team, typically but not always, led by the CFO. The team is divided into four sub-teams reflecting the four types of due diligence. Specialists from a major accounting firm will often advise on the onerous TDD and LDD tasks. 

The COO normally leads the ODD team, which will take an assortment of specialists from operations, sales and marketing, IT, product development, operations and accounts. 

The chief legal officer heads LDD, supported by senior people from the legal department. Most companies hire independent legal advisors. LDD takes a lot of experience and independent legal counsel will often drive the process. 

The head of accounting normally leads the TDD team. Tax advisors from accounting firms normally assist when preparing structuring advice for tax.

Finally, the CFO will typically lead the FDD team which will include financial analysts and accountants from the finance department. In many cases, the FDD team will hire specialist forensic accountants from an accounting firm. 

Software for due diligence

Increasingly, software such as that developed by Transparently.AI is emerging to assist banks, auditors, fund managers and companies undertake the various aspects of due diligence. 

This software, driven by AI and other big data solutions, promises to revolutionise the accuracy of due diligence and greatly improve economic efficiency. 

The due diligence process involves requesting, organising, distributing, and preserving the confidentiality of an enormous quantity of material, much of it requested from the target company. Since the process and the material requested tends to be very similar for each M&A transaction, this data gathering exercise is well suited to automation with AI.

We will deal with this topic in our next article.

Disclaimer: Views presented in this blog are the author’s own opinion and do not constitute financial research or advice. Both the author and Transparently Pte Ltd do not have trading positions in the companies it expresses a view of. In no event should the author or Transparently Pte Ltd be liable for any direct or indirect trading losses caused by any information contained in these views. All expressions of opinion are subject to change without notice, and we do not undertake to update or supplement this report or any of the information contained herein.

Back to top