Knowledge is power: Why due diligence is key to successful acquisitions

Chris Harding
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Amid the excitement of securing a deal, significant unforeseen risks can catch you off guard, become extremely expensive to mitigate and can easily derail your post-acquisition strategy. Due diligence can help you strike the right balance between risk and reward.

To avoid the disappointment – or outright disaster - of a deal turning sour, a disciplined and unbiased approach will significantly improve your chances of achieving success.

Undisclosed or unidentified liabilities

Undisclosed or unidentified liabilities present a significant source of risk for buyers. They can take many forms, ranging from common accruals such as employee entitlements being missed to more complex risks including provisions, contingent liabilities, or undisclosed guarantees. Issues can also arise from inappropriate or aggressive tax positions adopted by the target business.

Once the transaction closes, it can be hard to claim compensation for losses from a vendor, especially if the sale and purchase agreement does not contain the appropriate indemnities or warranties. And, if there isn’t a dispute mechanism in the agreement, often the only option left is to initiate legal action.

A thoughtfully considered due diligence process mitigates the risk of unrecorded liabilities and informs the final negotiation of indemnities and warranties. Failing to conduct due diligence can put you at a significant disadvantage during the final negotiation phase.

Establishing underlying earnings

Information gathered during the due diligence process can help you objectively assess value. One of the aims of the due diligence process is to confirm the underlying earnings that represent the true economic potential of the business. This involves normalising reported earnings for non-recurring transactions and adjusting for non-business items such as excess (or non-market) owner’s remuneration, discretionary director expenses, and related party transactions. You might also need to consider adjusting the earnings for the impact of unusual economic conditions during the period under review, such as during the Covid-19 lockdowns.

The due diligence process is also immensely valuable in assessing the assumptions underlying forecasts or earnings projections provided by target management. Failing to consider the composition of earnings might lead to a skewed perception of value. For example, during the early days of the Covid-19 pandemic, certain businesses experienced a tremendous surge in demand for their goods or services which could not be sustained in the post-Covid environment. Paying a multiple based on inflated earnings will lead to a significant erosion of wealth for anyone who acquires the business.

Perceived synergies

Perceived synergies between businesses underpin the rationale behind many acquisitions. The most powerful synergies result from an improved position in the industry value chain, or efficiencies gained from scale. True synergies can result in sustained competitive advantages and significant economic value for a buyer. But synergies can be hard to unlock, and the benefits you perceive at first glance might not exist. 

Keeping your objectives firmly in mind during the due diligence process will help you understand the likelihood of achieving the synergies you need from the purchase and any major barriers to implementing them. You and your management team will also gain insights into how plan for any post-integration issues once the transaction is finalised. 

Quality of reported earnings

Accounting policies diverge widely between industries and even companies within the same sector. This is especially true for smaller businesses that do not have to comply with the more stringent requirements of IFRS.

This means you need to pay close attention when reviewing a target’s accounting policies; they should be fit for purpose and should not, without good reason, differ significantly from the policies adopted by other industry players.

Accounting standards are diverse and complex and often require the use of judgment. As a result, there might be a risk that a target’s financial statements do not accurately reflect the underlying financial position. The adoption of inappropriate income and expense recognition policies could also distort underlying earnings. 

Consider whether the target’s accounting policies align with your own, and the impact of post-acquisition accounting policy changes on earnings and the calculation of potential earnouts or banking covenants.

Working capital

The parties will usually establish a working capital target to be delivered upon completion that represents a normal level of working capital which the business requires to operate. This target is typically based on the average working capital over the past twelve months and acts as a level against which to measure any over or under delivery of working capital. 
Despite the target serving to protect the economic interests of both parties, it is often a highly contended area. 

Failure to carefully consider potential working capital adjustments, or to omit the appropriate provisions in the sale and purchase agreement can lead to unexpected consequences. Due diligence equips the parties with the information necessary to negotiate a fair working capital target.

Set your next transaction up for success

Acquisitions do not always lead to the creation of shareholder value.  Even with strong indemnities and warranties in place, it can be exceedingly hard to rectify your position once the transaction closes.  Due diligence can help you weigh risk against reward and provide peace of mind that you’ll achieve the outcomes you need from the transaction. When it comes to avoiding costly mistakes, prevention is better than the cure, and foresight trumps hindsight.