If you are considering an investment, one of the first things to do is to conduct due diligence. There is a misconception that due diligence is a process that involves reviewing, verifying and stress testing financial information. This is a mistake – due diligence can and should go further.
Due diligence can be approached in a number of ways and by looking at numerous different areas, but there are some key aspects an investor should consider when agreeing the scope of their due diligence.
The investor needs to evaluate what they are actually buying. Key considerations are as follows:
The investor should look at the market the business currently operates in and the customers it currently has. Given that key customers can provide a great insight into the potential capabilities of a business, customer references should be validated. Where practical, and if confidentiality provisions allow, it is beneficial to ascertain their views of the business and how they, as customers, are managed.
In addition, a competitor analysis should be performed, company market share, profitability and revenues by product and geographical region. If applicable, the views of industry specialists should be sought and reviewed to assist in identifying the unique selling points and competitive advantage of the products or services of the business.
The costs of the business will have to be assessed during the due diligence process to fully understand the key variables and drivers in the business profitability. It will be necessary to identify non-recurring revenues and costs in order to assess the companies underlying probability, post-transaction. Sensitivity analysis should be undertaken to understand the implications of, for example, significant reductions in sales volumes or achievable prices. Technical due diligence may be necessary to consider the full process required to deliver the product or service, including (if applicable) a full analysis of any patents or intellectual property rights.
The capabilities of the people and the technology in the business should be assessed and considered. Where permitted, key staff should be met and interviewed to evaluate their ability, their loyalty and their views of the business.
Asset base and liabilities
Consideration will need to be given to the constituent elements of the balance sheet summary that assets are not over-valued and that there are no hidden or contingent liabilities. In particular, a thorough review of the company tax affairs is crucial to ensure that they are in order. It may also be necessary to, for example, obtain up to date property valuations.
The cash position of the business will need to be reviewed thoroughly and cash flows sensitised to ensure there is adequate cash in the business to fund the ongoing operations and any potential contingent requirements.
In conclusion, due diligence is ultimately about considering key assumptions and being professionally sceptical when challenging these. An oversight or a key assumption not considered appropriately may lead to a poor investment decision with significant financial loss.
At Grant Thornton we have undertaken a large number of due diligence exercises supporting different transactions in the last 12 months. In each occasion the team identified issues that needed to be addressed either as part of the deal negotiations or the price consideration. For some, the issues resulted in the potential acquirer quite rightly reassessing their decision. Due diligence should as a minimum add value to the understanding of the business and not simply be a re-run of the information memorandum. Due diligence should pay for itself. A nasty surprise post transaction can turn what looked like a very good deal in to a very poor one.