Due Diligence - In search of gold and skeletons

Whether buying or selling a business, doing proper due diligence can help uncover both treasure and skeletons hidden in the closet. Helen McCombie provides some tips to directors on how to get the process right.

The private equity boom in Australia has well and truly put due diligence in the spotlight. Indeed, with the abundance of money and deals afoot, private equity players need to be certain that they know what they’re buying and that they are getting meaningful value.

In the case of Qantas, Airline Partners Australia (APA) wanted a 12 week due diligence period. The Qantas board deemed that to be too long and offered a six week period instead, which was accepted. In the first phase of due diligence, information was made available to the consortium. In the second, APA reviewed the materials presented and sought clarification. In the third phase, there were negotiations and in the fourth and final phase, an offer was made, which the Qantas board considered.

The challenge of making the right decision requires detailed analysis of both the financial and operating activities of a business. There are many examples where not doing proper due diligence has caused financial disaster, even failure.

The purchase of FAI by HIH is one of the classics. When it bought the company for $300 million in 1998, HIH didn’t conduct any due diligence. FAI boss Rodney Adler refused to allow it, and HIH had to rely on publicly available information which didn’t disclose significant under-reserving of FAI’s insurance business.

The estimated losses were $590 million and contributed to HIH going under.

National Australia Bank’s disastrous purchase of the Homeside business in the United States, which resulted in $4 billion worth of write-offs five years later, also raises questions about the adequacy of its due diligence process.

Questions also surround BHP’s purchase of Magma Copper in Arizona in 1998. It was forced to write off $3.97 billion, the entire value of its most ambitious purchase, just three years after the acquisition had been made.

In 2002, Bain and Company conducted a survey of 250 senior managers with M&A responsibilities, found that their due diligence process had failed to highlight vital issues. Some of the key failures were:

• failure to discover critical issues;
• not identifying the target had been dressed up for sale;
• insufficient strategic fit;
• not acknowledging potential integration issues;
• overestimation of synergies; and
• problems coordinating a large due diligence team.

Due diligence is normally, as in the Qantas case, conducted under a very limited timeframe, so proper planning is everything.

Corporate finance advisory firm VMC Global cautions that the success of the diligence review relies on proficient scoping. Factors to consider are the time available, the co-operation of the target company and access to information, the buyer’s familiarity with the target, the size of the target and the experience of the due diligence team. A due diligence team typically involves accountants, lawyers, consultants and other experts.

VMC Global director Manda Trautwein says it’s crucial to begin with some high level work on the industry in which the acquisition is being made, so you can evaluate how businesses in that industry typically perform and how they are typically valued.

Public companies are less likely to have significant skeletons in the closet because of their continuous disclosure requirements. But Trautwein says: “Most private companies aren’t even audited so when you do due diligence on a private company you are much more likely to find skeletons in the closet.” The idea, she says is to find them, so you can negotiate on price.

Trautwein says the best place to start is with a high level diligence review where you identify key issues, then launch into a full scale review, where you go through, step-by-step, various different areas. While a lot of due diligence is focused on the risks, you have to look at the opportunities as well, she says.

“We call that upside due diligence,” says David Nott, the head of KPMG’s transaction practice. “You are looking for the key drivers, and understanding how they are tracking, whether or not improvements can be made, because in competitive bids you need to know where you can extract more value than the next guy. Sure, you are looking at risks and issues and valuations that might help to fine tune how much you are prepared to bid, but a focus on what opportunities there might be, or an operational improvement or a strategic improvement is absolutely critical.” That’s a key focus in the due diligence KPMG is now asked to undertake.

Stephen Lomas, transactions partner with Ernst & Young, is recommending that directors consider pre-sale due diligence. This process has been market practice in Europe for the last seven years, but is not that popular in Australia.

By incorporating vendor pre-sale due diligence into the process, Lomas says boards can maximise proceeds from a sale. Potential buyers are presented with an independent report, commissioned by the vendor company, disclosing the commercial, legal and financial issues.

There are a number of benefits to this process. The vendor company minimises productivity losses which happen when management’s time is spent responding to bidder’s inquiries rather than on running the business. It also allows the seller to identify issues earlier that bidders might identify during their due diligence.

“The vendor can then deal with those issues by making some changes, or at least having them out there so they are not used against them at a later stage of negotiation,” says Lomas.

In addition, pre-sale due diligence can fast-track the purchase and increase the number of potential bidders. It also puts the seller in the box seat, able to manage the information flow rather than constantly reacting to bidder enquiries. It reduces risk when the process identifies an issue that could block or delay the sale and it reduces the negotiating power of the buyers who could use the last minute discovery of negative information to bargain.

Of course, each due diligence review is unique and requires a different approach. You can’t follow a rigid checklist.

VMC’s Trautwein points out that successful due diligence should allow company management and the board to walk away from a bad deal

A treasure map for directors

Due diligence isn’t easy for directors, largely because they are often not close to the process.

Ernst & Young transaction partner Stephen Lomas says from a director’s perspective, it’s all about making sure there is a proper process being undertaken by management. He believes that it is important that the key findings and issues from the due diligence have flowed up, in some form, to the board. In addition, he says directors need to know who is conducting the due diligence, whether it’s internal people or external, or a mix of both.

One of the dangers for a board during an acquisition is that its management may be too close to the deal.

“There’ll be a team of management who particularly want to do a deal and will stop at nothing to get it done,” warns Lomas. The way to deal with this, he says, is by making sure there is proper communication. Its probably advisable to also get somebody independent of the particular business unit closely involved in the process.

One option is for the CFO of the company to oversee the due diligence process. On top of that, some companies set up a sub-committee of the board to make sure that effective due diligence is undertaken.

Ernst & Young also counsels boards to question advisors and the management team directly, so they have a more hands-on role in the process.

KPMG’s head of transaction services in Australia David Nott says directors need to be conscious of how much information can be accessed. “That may be limited to a data room, so you could have an information shortfall, and that could be a great concern,” he says.

Limited access to senior management is also something to watch for. Nott notes that often in a due diligence all that is offered is a brief question and answer session, whereas in reality a deeper, longer access would be quite helpful.

The timeframe to undertake the due diligence review can also be a problem. “Often you aren’t given very much time at all to look at the information and to consider it in detail,” warns Nott.

In addition, attempting to acquire private companies can throw up other issues. Manda Trautwein, director of corporate finance advisory firm VMC Global, says sometimes in private company situations the owner of a business might be working in the general manager’s role for a less-than-market salary. Or one of the related parties might own the premises where the company operates from and the company might not pay market rent. “You would be looking to normalise the profit-and-loss statement to find out what the profit would have been if everything was on a normal commercial basis,” she says.

The ability to retain staff is another issue for directors to consider. Trautwein says it’s important to know what sorts of agreements they are employed under, how long they have been with the company, who are the key employees, and whether or not there is an incentive scheme in place which has locked the employees into the business. “When you are acquiring someone else’s business, the last thing that you want to happen is have half the employees walk out afterwards,” she says.

Lomas also warns that there is a danger of people overestimating what the synergies are going to be when they acquire another company. “You have to look at the motivations behind the acquisition and the objectives that they set out to achieve.”

At the outset, it’s important to decide why you are making the acquisition. Factors to consider include: what you are looking to achieve, whether you are looking to diversify your product range, whether you are looking to diversify geographically, or whether you are looking to just simply achieve synergies in terms of operating costs and economies of scale?

“You need to tailor your due diligence to ensure that it will tell you whether or not those objectives are realistic and whether they will be achieved so that you don’t run into the acquisition and then realise afterwards that you haven’t achieved what you set out to achieve,” says Lomas.

Questions directors should ask their advisors:

• What is the historic financial performance of the business?
• Is the financial information robust?
• Does the business generate sufficient EBITDA to justify investment?
• What are the key drivers of growth or financial performance?
• What is the current trading performance of the business?
• What are the cash flow characteristics?
• Are forecasts achievable?
• What are the working capital requirements and will they change?
• Has there been sufficient investment in the business?
• How well controlled is the business?
• What are the tax liabilities and risks?
• What are the risks that assets and liabilities are mis-stated?
• Are the IT systems adequate for the existing and future business needs?
• Is this an attractive market in which to compete?
• What sort of agreements are there with employees?
• What and where are the synergies?

Helen McCombie is a communications expert, working in a boutique media and government relations company. After a decade of reporting for Australia’s premier business current affairs program, Channel Nine’s Business Sunday, Helen now consults to a wide range of companies on media and communications strategies.