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Top 3 Ways Buy-Side Investors Can Prevent Due Diligence Failures

by John Kogan
July 14, 2021

Every investor knows the axiom: delay equals deal risk. Sellers risk losing the deal or having the price reduced based on events or revelations during diligence. The buy-side risks are more nuanced, from the reputation of the individual promoting the transaction to the risk of syndication failure. The deal can be lost to another bidder if the term sheet exclusivity expires and the seller perceives risk or begins to believe they can get a better price.

Here are three ways buyers can help ensure their diligence is adequate while reducing the risk of delay and deal failure.

1. Set Parameters With the QOE team and Be Involved

As a direct result of private M&A deal growth in both volume and size, and to help ensure all the bases (and backsides) are covered, buyers regularly hand off considerable portions of diligence to an outside firm, usually an audit firm. This typically entails a quality-of-earnings (QOE) report with adjusted EBITDA. It is the number one area where diligence tends to bog down.

Investor oversight of this part of the process is usually very low. This is partly by design, as auditor independence is important. But an unfortunate result is reduced interaction of the deal team with the seller — interaction that holds important clues regarding the organization’s potential success that are not captured anywhere in black and white.

Investors may ask their QOE consultant to focus on a particular area or two, but often do not provide more detailed guidance. QOE teams want to leave no stone unturned in trying to adjust EBITDA to the “correct” number. Frequently, items under $10,000 result in additional questions to the seller’s management team, causing unnecessary delays and making the seller feel they are being nickel-and-dimed.

The seller is under tremendous pressure to perform better than ever, while simultaneously producing the most detailed information they’ve ever had to compile. Responding to multiple requests for similar items from the investor diligence team and the QOE team can quickly become confusing and frustrating to the seller’s management, who will vary in their understanding of the deal dynamics. Thinking “didn’t I already provide that?” regularly causes them to set questions aside, delaying the process.

You can mitigate this problem by coordinating and sharing information with the auditors. By taking the time to agree upon what is and is not important and establishing reasonable materiality thresholds with your QOE team, you can save valuable time with minimal addition of risk and prevent seller frustration. Using a cloud-based deal data room with a master due diligence/data request list shared by all is very helpful.

2. Define the Goal

Is the objective to marginally improve the acquirer’s performance by taking advantage of economies of scale, for example? Or is it to transform the acquirer’s business model? The latter has a higher chance of step-function profit improvement. The former is much more likely to fail, or at best only help ensure that expectations of continuous improvement are met.

As a simple example, a bakery with a delivery service may buy another bakery that delivers in the same area, thus getting higher capacity utilization and margin for existing labor and trucks. The buyer and the target serve the same customers, product and service. A bakery that buys a bookstore to offer both books and food is transforming its business model, reaching new customers not only by adding the bookstore’s customers, but by creating a new way to utilize both products, potentially creating an entirely new market.

Either way, it is critical to define the objective and tailor diligence accordingly. (Asking what the acquirer hopes to achieve also is critical to the seller, for multiple reasons. Frequently, the seller retains an investment in the ongoing entity. In addition, understanding the buyer’s goals allows the seller to better showcase the ways the target is a fit.)

3. Control Environment – Examine the Soft Factors

Checking the boxes across the details of financial, compliance, legal and strategic elements can subsume the importance of getting the big picture of the control environment. Auditors don’t opine on this critical area. The best way to reduce risk is to understand, at a high level, how the company is run.

Do your homework and don’t just rely on company-provided employees and references. Ask to speak to off-list employees and seek out independent insights from vendors, customers, ex-employees and online feedback forums such as Reddit and Glassdoor. Consider these key factors, which often are not unearthed until it is too late:

  • Values: What does management really care about — not just the mission statement but in reality? What is the message to employees? Revenue at all costs, customer satisfaction as first priority, concern for employees? Candid, one-on-one conversations with parties with varying perspectives will be enlightening.
  • Resources: How well is labor supported? Do short-term bottom-line concerns or cash constraints color every decision, reducing the availability of the tools and human resources needed to excel? Will the investment rectify deficiencies, or do they originate in the CEO’s mindset?
  • Authority: Are the right people in the right roles? How free are they to exercise their expertise? Is a single person’s inability to delegate authority creating damaging bottlenecks?
  • Financials: Where are the holes in reporting and personnel? How are they being addressed? Are there inconsistencies in information from various sources? These point to process weaknesses. Extend your examination beyond the accounting department to operations and R&D to understand how information is gathered and used to drive results.

Balancing these soft factors with an examination of “hard” facts such as a QOE report and diligence checklist helps you see the big picture and ensure critical components of risk are not overlooked, greatly increasing the probability of deal success.

To learn more about helping the due diligence process run smoothly, contact our experts.

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Author
John Kogan
Director
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