Acquisition Due Diligence: Starting Off On the Right Foot

The objective of due diligence is straightforward and simple. The acquirer is interested in minimizing its
exposure to the many problems and pitfalls that can arise when making an acquisition. The due diligence
process itself is decidedly less simple. The acquirer must begin with clear and explicit expectations of the
benefits it hopes to gain by making the acquisition. Only by clearly understanding these expected
benefits at the outset can the appropriate due diligence procedures be identified and efficiently carried
out.

Benefits typically sought by acquirers include the following :

Stronger market share in a key geographic region;

Introduction of a new product into an established distribution line;

The analysis typically begins at a relatively superficial level by identifying obvious problems that would
jeopardize the achievement of the acquirer’s goals.

Such problems might include

 Imminent bankruptcy
 Significant off-balance-sheet liabilities
 Material legal problems
 Employee retention issues
 Regulatory troubles etc.

If no deal-breaking problems surface, it is time to begin a more intensive review. If problems do arise,
however, the target can be eliminated from consideration before the process becomes costly.

The due diligence process commonly consists of the following

four steps:
1. Setting initial due diligence parameters.

Management will need to make a preliminary evaluation of the areas of key importance to the success
of the acquisition. For instance, human resources and employee retention will be critical issues in the
acquisition of many types of service firms (accounting firms, medical practices, etc.) The issue may (or
may not) be less critical when the strategic objective is to acquire the product and technological assets
of a manufacturing company.

2. Selecting the due diligence team.

Just as the process of buying real estate requires the combined efforts of a building inspector, surveyor,
title agent, the process of acquiring a company also entail some degree of team effort. The team will be
selected based on the parameter set forth in Step 1, and will typically involve members such as:

Management and employees of the Acquirer;

 Legal Counsel;
 Valuation Advisor;
 CPA; and
 Technical Consultant

3. Preparing and executing the preliminary investigation.

Management will work with the team members to identify issues that require prompt attention. These
will typically be the issues that will affect management’s decision to proceed with the acquisition, and at
what price. The plan should be broad and relatively shallow, with enough coverage of the company’s
operating, legal and financial characteristics to enable the team members to identify areas that
requires more detailed procedures. The goal of this preliminary investigation is to identify deal-
breaking issues before money and other resources (i.e., management’s time and attention) are
committed to a detailed due-diligence study. Examples of problems that may be serious enough for the
acquirer to consider abandoning the acquisition include:

 Dishonesty or concealing of facts by the seller and/or target management;

 Poor internal controls (accounting or otherwise);
 Material misstatements in the financial statements;
 Serious questions regarding management succession or employee retention issues;
 Significant contingent liabilities (legal, environmental, etc.);
 Uncertainty regarding customer retention; and
 An apparent inability of the target to fulfill the strategic objectives sought by the acquirer.

4. Preparing and executing the detailed due diligence plan.

After completing Step 3, management should reconvene with the other team members and solicit
recommendations regarding detailed due diligence procedures. At this point, there should be a
reasonable level of comfort that the acquisition is feasible and has a reasonable chance of achieving
corporate goals. After reflecting on and discussing these recommendations, management should work
with the team members to create a detailed plan of action.

The plan should be designed to ensure that, by the time the investigation is completed, everyone
thoroughly understands the important issues and unnecessary or duplicated effort is kept to a
minimum. It should be written in outline form such that each task is distinct, clearly identifiable and
assignable to one team member. This allows for personal accountability and ensures that nothing goes
undone.

It is also a good idea to clearly identify the questions that will be answered upon completion of each
task. The answer to each question should affect:

 Whether to make the acquisition;

 How much to pay for the company;
 How to structure the acquisition; or
 How to deal with any post-acquisition operational, accounting or legal issues

The Detailed Due Diligence Investigation

An abbreviated checklist of issues, which will likely need to be addressed during the detailed
investigation (step 4), includes:

Corporate Background

 Articles of incorporation;
 States in which company is licensed to do business;
 Changes in corporate name or purpose;
 Classes of stock or other securities;
 Concentration of ownership; and
 Issues discussed in corporate directors’ meetings.

Financial Data

 Source and authenticity of financial data;

 Analysis of assets and liabilities;
 Accounting methods and practices;
 Related-party transactions;
 Contingent liabilities;
  Historical profits and losses;
 Profitability (gross profit, operating profit, pretax profit, net profit);
 Non-recurring revenues and expenses;
 Sales volume by product;
 Order backlog;
 Internal controls;
 Revenue and expense trends;
 Fixed and variable costs; and
 Financial budgets and forecasts

Products

 Major classifications and relative importance;

 Descriptions of all products;
 Analysis of seasonality/cyclicality;
 Primary competitors;
 Market share;
 Registered trademarks or trade names;
 Historical marketing strategies and initiatives;
 Product safety;
 Quality standards;
 Supply relationships; and
 Regulatory issues
 Production Methods
 Fabrication and assembly methods;
 Compatibility with acquirer’s processes;
 Production controls;
 Salvage management;
 Storage and distribution;
 Safety, productivity and efficiency; and
 Waste treatment/disposal.

Personnel

 Organization chart;
 Duties and qualifications of key management personnel;
 Employment and non-compete contracts;
 Employee morale;
 Management succession;
  Post-acquisition employee and management retention;
 Wages and benefits;
 Union considerations; and
 Corporate personnel policies and procedures

Facilities

 Owned land and buildings;

 Leased land and buildings;
 Suitability of facilities for other purposes;
 Market-level lease rates for leased properties;
 Equipment records (accounting and maintenance);
 Operating vs. capital equipment leases;
 Utilities; and
 Spare capacity.

Research and Development (R&D)

 Existing patent portfolio;

 Patents pending;
 Research in progress;
 Commercial viability of R&D efforts; and
 Documentation policies and practices

Legal

 States of incorporation;
 Rights of shareholders;
 "Blue Sky" laws;
 Corporate charters and bylaws;
 Executory contracts;
 Title to owned assets;
 Lease rights and obligations of leased assets;
 Strength of patent protection;
 Contingent liabilities; and
 Antitrust issues.

The conclusion of the due diligence process is not the time for "buyer’s remorse," where unwarranted
attention is paid to the insignificant weaknesses that invariably exist in any business. Rather, it is the
time to constructively deal with issues that can realistically be overcome. Depending on the nature of
these issues, the acquirer can often take steps to minimize future exposure to problems and their
consequences.

 Structuring contingent payments into purchase terms;

  Requiring escrow accounts funded by the seller to immunize a contingent liability;
 Developing contingency plans; and
 Abandoning the transaction (obviously, the last resort)

Due diligence should not (and, indeed, cannot) simply be delegated to outside professionals, although
these professionals will certainly contribute to management’s ability to carry it out. By working together,
management and its advisors can timely and efficiently identify and execute those due diligence
procedures that will most improve the likelihood that the acquisition will achieve the goals desired by
the acquirer

Horizontal Integration/Conglomeration
Pll wants to gain a foothold in a lucrative new expanding market but lacks any experience or expertise in
the area. Through generation of synergies that add long term value to the merged organization, success
rates would be mixed and realized over a long term period. One way of overcoming this may be to
acquire a company that already has a track record of success in the new market. Companies sometimes
use mergers or acquisitions as a way to enter a desirable new market or sector, particularly if they
expect that market or sector to expand in the future. Proprietary and intellectual property protection
can be an important consideration in sectors that are characterized by rapid change and innovation and
PLL through this acquisition would be driving the proprietary and intellectual property protection
through proper confidentiality agreements. Next step would be to have a vertical
integration with the sizeable customers groups who could ensure a steady income for the acquisition.
Also a fair thought to be provided in reducing the competitors through the added value in the
acquisition. This international merger will create an international scale and can effectively link the
customer demands and the associated capital to some of the short terms exclusive construction.
There is some evidence to suggest that merger success or failure should be measured in longer term
variables.

In Mergers and Acquisitions, readers are challenged to think in an integrated manner; like a strategist,
financier and project manager, but all at the same time.

It is, however, our observation that many people who lead mergers and acquisitions in practice come
from a single functional background. This may be part of the explanation for many of the failures in
mergers and acquisitions, and for the recent rise of specialist merger and acquisition project
management consultancies, particularly in the US.

Business acquisitions need to have an extremely detailed study, adopts a more quantitative approach
than the strategic rationale and implementation areas. Strategists and project managers (implementers)
have to be able to think in terms of a wider range of variables and drivers than financial specialists.

A process model of mergers and acquisitions process is a description or analogy of the action and
operations involved in achieving a mergers and acquisitions system

The idea of a process model is to represent the stages and phases involved in a task. A user should be
able to look at the process model and be able to use it as a kind of map or guide to assist him or her in
developing the outcome of the model. Process models are useful because they are general
representations of what has to be done in order to achieve a specified outcome.

In an acquisition the negotiation process does not necessarily take place. In an acquisition company A
buys company B. Company B becomes wholly owned by company A. Company B might be totally
absorbed and cease to exist as a separate entity, or company A might retain company B in its pre-
acquired form.

This limited absorption is often practiced where it is the intention of company A to sell off company B at
a profit at some later date. In acquisitions the dominant company is usually referred to as the acquirer
and the lesser company is known as the acquired. The lesser company is often referred to as the target
up to the point where it becomes acquired.
One tactic for avoiding a hostile takeover is for the target to seek another company with which it
would rather merge or be acquired by.

Rationales consist of the higher level reasoning that represents decision conditions under which a
decision to merge could be made. Drivers are midlevel specific (often operational) influences that
contribute towards the justification or otherwise for a merger.

The strategic rationale may also be fundamentally defensive. If there are several large mergers in a
particular sector, a non-merged company may be pressured into merging with another non-merged
company in order to maintain its competitive position.

Discussions for the pre-merger negotiation

The pre-merger negotiation phase usually starts right after the commitment to proceed. In this phase
the senior managers of the two organizations enter into negotiations in order to reach agreement on
the structure and format of the new combined organization.

The negotiation phase often involves external professional consultants such as specialist contract
lawyers. In many cases (especially in the US) specialist merger project management consultants are
used as negotiation drivers and facilitators.

Once the negotiations are complete, the deal itself takes the form of a detailed merger contract. The
contract sets out the rights and obligations of each party (organization) under the terms of the deal.
Merger contracts can be extremely complex and are usually developed and finalized by specialist
external consultants working with in-house specialists

Each phase of negotiation may have to be concluded and agreed before the negotiation process can
move through that gateway and on to the next phase. It is common practice to establish precise
performance achievements before each gateway can be passed. It is also common for merger
implementation managers (see Modules 9 and 10) to establish detailed reviews and associated
reporting procedures for each phase. These procedures can be very useful in ensuring that the entire
merger remains focused and on track. The external consultants are usually primarily involved in
setting up the contracts and the remaining aspects of the deal.

There is usually some point at which implementation is designated as being complete, at least from an
independent project point of view. This point is usually followed by a longer term phase in which the
new organization acclimatizes to the new organizational structure. This phase is usually referred to as
commissioning. In some cases the commissioning phase can continue for several years.

Where possible the integration team should be involved at the earliest possible time. In general
terms, the greater the involvement the implementation people have in planning the merger, the
greater the impact they can have on the development of the plans and the more easily they can
actually implement the plans after the deal is signed.

The integration team consists largely of operational people. Their early involvement is likely to
provide a clearer view of the work required to implement the merger. This clarity contributes
significantly to understanding the timescales and magnitude of cost involved, and will in turn lead to
more accurate estimates of the true value of the net benefits to be derived. It also militates against
over-optimism on the part of the strategic planners and financial advisors.

The other major long term problem indicated by the literature is ineffective implementation.
Numerous mergers continue the implementation process for much longer than was originally
intended. In addition it is common to find that the original implementation plans are changed during
the integration process as it becomes apparent that the implementation plans were not sufficiently
well thought through, or that the problems associated with full integration were not fully appreciated
during the planning stages.

Some Scenarios for Failure

 An inability to agree terms

 Overestimation of the true value of the target
 The target being too large relative to the acquirer
 A failure to realize all identified potential synergies
 External change
 Shortcomings in the implementation and integration processes
 A failure to achieve technological fit
 Conflicting cultures
 A weak central core in the target

Accenture based
Why, then, do private equity firms go from one due diligence to another with an apparent grace that
most corporations only dream of achieving? In this article, we identify four distinct actions private
equity firms take that can help corporations streamline the due diligence process, make due diligence
more effective, and ultimately enable better M&A decision making
Based on the above pictorial it is very clear that the most important success factors include

1. Planning and executing the integration factors

2. Conducting due diligence
3. Understanding cultural issues

However, traditional due diligence tends to be backward-looking, concentrated on validating historic

performance and identifying potential liabilities and risks. While it is certainly important to
understand that an acquirer is actually buying the assets it thinks it is buying, focusing on the
current rather than the future only addresses a minority of the acquisition target’s enterprise
value.

This can require a disproportionate emphasis on at least two due diligence work streams: strategic
and operational.

Strategic due diligence involves validating the acquisition target’s fit with the acquirer’s strategic
rationale for the acquisition, and understanding the target’s market position and outlook to inform
the price offered.

A strategic fit assessment typically covers an in-depth analysis of whether the acquisition target
enhances the acquirer’s competitive position and explores areas where synergies could be realized.
These synergies should be quantifiable, where possible, so the acquirer can evaluate the additional
value the combination could create. A market assessment and future outlook is equally
important to this effort

Look forward as well as backward

Look forward as well as backward because it can enable the acquirer to assess whether the acquisition
target has a realistic management plan. A thorough review of assumptions underpinning the
management plan—and, more importantly, comparison with market dynamics, competitive position
and operational capabilities—often can highlight discrepancies in the target’s management plan. To
address this, acquirers can apply sensitivities—in other words, change assumptions—to make the
management plan more realistic and value the business appropriately. Strategic due diligence also can
highlight potential restructuring opportunities to create further value and identify bolt-on acquisitions
that can accelerate growth.
Operational due diligence involves understanding the operational characteristics of the target (for
instance, organization structure, IT systems, and culture) and hence the integration approach and
timeline that will be required, as well as validating the target’s operational and capital expenditure
outlook to inform the price offered.

An operational due diligence assesses whether the acquisition target’s capabilities, operations and
infrastructure support the delivery of the target’s management plan.

Any private equity deal maker can testify that one of the key drivers of the bid for an asset is future
growth and stability of cash flows, as they determine both the asset’s value and the appropriate
degree of leverage. This is validated by Accenture’s shareholder value analysis research,1 which
shows that a significant part, in many industries the majority, of the average public company’s
enterprise value is based on expectations of increased future cash flow growth over and above the
current level (Figure 2).

Operational due diligence involves understanding the operational characteristics of the target (for
instance, organization structure, IT systems, and culture) and hence the integration approach and
timeline that will be required, as well as validating the target’s operational and capital expenditure
outlook to inform the price offered.

An operational due diligence assesses whether the acquisition target’s capabilities, operations and
infrastructure support the delivery of the target’s management plan.We believe acquirers should
consider resisting the temptation to perform such an exercise for each functional area, and instead
focus on developing a tailored approach for selected areas that may be critical to measuring the
success of integration.

For example, an IT due diligence could uncover the material risks an acquirer must address when
migrating the target’s infrastructure and applications onto the acquirer’s IT platforms. In addition, it
behoves an acquirer to understand the future outlook for IT costs, how they can be managed and
whether opportunities exist to generate operational cost savings. Similarly, HR issues can be an
important factor to consider, particularly in the case of cross-border acquisitions.

It would be prudent to understand as to what are the costs involved with the various functions so as
to be able to place the cost feasibility for each operational aspect in the due diligence process.

For example, when pursuing a foreign acquisition, a large state-owned oil corporation identified the
retention of critical talent as key to measuring the success of the integration. To develop an HR
retention and cultural integration plan, the acquirer collected relevant HR information from both
public and acquisition target sources during due diligence. By analyzing the skills and experience of
each individual alongside his or her existing position (and future potential) in the target organization,
the acquirer was able to identify key individuals it should retain. The acquirer then developed a
retention plan that included both monetary and non-monetary incentives prior to deal
announcement, and subsequently communicated with key employees soon after deal announcement.
This approach helped enable the acquirer to minimize unwanted attrition during the integration phase
and, thus, retain a key driver of the deal’s value.

In contrast with the financial and legal varieties, high-quality strategic and operational due diligence
do not generally require an army of specialist advisors. Rather, the due diligence work streams can be
staffed by the acquirer’s own people, selectively augmented with advisors who bring targeted
insights, such as independent perspectives on the market outlook or an in-depth assessment of the
timeline and cost to get to a common IT platform.

Focus on the key value drivers

Corporate acquirers, on the other hand, face the temptation of curiosity. Due diligence is often seen
as a once-in-a-lifetime opportunity to take a close look under the bonnet of a major competitor, or
perform a case study on a successful peer in another market. Instead of focusing on the target’s most
important facilities, the operational due diligence work stream performs risks turning into a “grand
tour” of peripheral operations to see what the acquirer can learn from the way the target company
performs its business (all without a clear link to the deal rationale or the valuation).

Similarly, the strategic due diligence work stream might put disproportional effort into assessing the
market outlook of a minor part of the target’s activities— not because it has material impact on value,
but because it is a segment the acquirer itself is considering entering. As a result of this lack of focus
and discipline, due diligence can become an expensive, draining exercise, and the key issues are often
lost in the reams of data produced.

To resist this temptation, corporate acquirers can take a page from the private equity due diligence
playbook. Rather than asking the due diligence work streams to develop their own lengthy check lists
that they then go through from top to bottom, the deal leaders can provide each work stream with a
set of key issues that are directly linked to deal rationale and valuation. Once there is clarity on those
key issues, leaders can decide whether the due diligence work stream has completed its mission, or
whether there is another set of issues to investigate.

Rigorously revisit the synergy case

Due diligence activities might be structured so that they expressly validate the expected synergies.
Second, consider using the data made available in the due diligence to further break down the initial
assumptions on expected synergies as a way to create more granular estimates for both the value of
the synergies and the timing.

This can be a very efficient approach to increase the robustness of synergy estimates as it is intended
to relentlessly flesh out unrealistic assumptions.
 Third, take a step back from the hour-by-hour due diligence frenzy to revisit the synergy case and
deal rationale in light of the new insights gained, and incorporate those insights into the valuation.

Consider the integration roadmap

Private equity firms build a detailed financial model incorporating the financial impact and timing of
initiatives to accelerate revenue growth and improve operational performance to get an accurate
forecast of future cash flows and exit valuations. Corporate acquirers could take the same rigorous
approach, even if the ownership horizon in this case is perpetuity, and that they would take into
account opportunities for synergies in addition to stand-alone growth and operational performance
initiatives.

A key to getting an accurate picture of what stand-alone improvements and synergies to expect, as
well as their timing, is having a clear view of how the acquirer will integrate the target company. This
can require creating a high-level integration road map designed to identify key milestones for each
functional area across the targeted integration timeline. With the information made available during
due diligence, an acquirer might be better able to get a sufficiently detailed picture of the target
company to understand the issues that will likely have a fundamental impact on how much value the
integration can generate and at what rate integration can take place. Three such issues are how the
combined company and the integration program should be organized; how quickly cost synergies can
be realized; and what it takes in terms of integrated sales forces, offerings and systems support to
generate revenue synergies. The resulting outputs could be modelled at least on a quarterly basis and
used as an input to valuation. This work is important enough that many successful acquirers turn it
into a due diligence work stream in its own right.

Another potential benefit of developing an integration road map during due diligence is that it can
allow the acquiring company to accelerate its integration planning. This can have benefits both in
terms of the time value of money from earlier synergy realization from the core integration activities,
as well as being able to swiftly execute the keep the- lights-on integration activities required on the
day the transaction closes and when ownership changes.