Due Diligence - Imperatives

For years, due diligence has been viewed as the tedious part of a merger or acquisition. A series of US accounting scandals and the recent pick-up in deal activity has forced investors to take this fact-checking process ever more seriously.

The importance of due diligence was clearly demonstrated in 2004 when the chairman of Smith & Wesson resigned following the disclosure that he spent 15 years in jail in the 1950s and 1960s for the part he played in a series of armed robberies. He apparently had not revealed his past when appointed to his executive post because "nobody asked". When the facts emerged, he departed.


An example from Control Risks Group's due-diligence division demonstrates the pitfalls that a thorough due diligence review can avoid. A major international investor was considering a substantial acquisition in the Czech Republic: the acquisition target had a strong profile and its management appeared to be western-oriented with a strong business plan and good development prospects. However, it was not a publicly-listed company and the information available was limited. In addition, the company's senior management had been associated with a major trading group that had recently been driven into bankruptcy through collusion by its shareholders and management. Control Risks Group conducted detailed due diligence into the target and discovered that the initial capital for the company had been embezzled by the general-director and founder from his previous employer.

Control Risks also uncovered evidence of 'tunnelling' between suppliers and customers controlled by the general-director. The advisory group consequently advised its client on how to structure the transaction to minimise their risks by replacing key personnel and introducing controls into the company as a prerequisite to the investment.

The private-equity firm CVC Capital Partners, was able to negotiate a lower price when it bought Kwik-Fit, the car-servicing business, from Ford in 2002 after accounting irregularities were found during the due-diligence process.

The basic purpose of due diligence is to confirm that everything at a company is as it appears to be in public. It is the predators' chance to examine their prey, warts and all. Without such a process, buyers cannot know whether a potential acquisition target is a poisoned chalice.

Typically, during a merger or acquisition process, the bidding company sends teams of advisers into the target company's specially-created 'data room'. A review will usually examine the financial, legal and operational condition of a business.

The length of time it takes depends on the complexity of the target company or the timetable of announcements. Depending on the size and complexity of the deal, costs can run into hundreds of thousands of pounds, but huge sums are spent every year on carrying out due-diligence exercises ahead of mergers or acquisitions.

According to Capcon, the UK's only quoted risk-management and corporate-investigations group, lawyers who study and verify contractual words, and accountants who audit the numbers, generate most of the costs of due diligence while little is spent on looking behind the contracts, profit-and-loss accounts and balance sheets, or on the key individuals and trading relationships.

Issues that are often overlooked include information on whether tenants of properties being acquired can walk away from their leases tomorrow, or under what circumstances a lender can suddenly call in its loans.


Without the answers to some of the key questions like the ones raised above, the company could turn out to be worth a whole lot less than a buyer pays for it.

When it comes to a hostile bid, due diligence becomes even more important as the bidder will only have access to basic public documents. The UK Takeover Panel's code gives a hostile bidder an equal opportunity to receive information that has been handed to a friendly purchaser. Alternatively, a bidder can launch an offer without due diligence but typically offers a lower price because it is 'buying blind' and needs to leave a margin to cover the risk of discovering the unknown.

Private buyers also do intensive due diligence before backing a management buy-out and any purchase of a private company comes without the comfort of reporting obligations that public companies observe.



Management due-diligence process

Focus on the capabilities of potential senior executives and non-executive directors has also intensified. According to Armstrong Craven, a European executive-research and business-information company, growing concerns about changes in corporate governance standards, the need for more transparency, and the recent pick-up in deal activity has led to management due diligence being taken more seriously.

Armstrong says the approach used to be ad-hoc, simply involving investment directors or advisers making a few calls to support their instinct that a management team was backable. Now, however, the management due-diligence process has evolved to become an integral part of the transaction process.

Among other exercises, the process now includes competency-based interviews to assess whether team members have the critical competencies necessary to deliver the aims of the business, psychometric personality profiles and professional referencing.

Cultural due diligence

Over the past few years, cultural due diligence has taken on a new importance. A cultural review can help determine what the target company's ethics are regarding its employees and shareholders and its ties with communities, as well as assessing the emotional and soft issues that a purchase will throw up. These issues can range from how employees are remunerated to whether they are allowed to dress down on Fridays.

Due diligence - Link to integration

Most value destruction in the mergers and acquisitions world is found in failed integration rather than poor deal execution. The process may provide valuable opportunities to get to know company personnel, their state of mind and level of motivation.

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