FIGURE 6.2 The commercial due diligence process

Note: * Where possible and typically when working alone

Terms of reference

Like all due diligence, CDD should not be conducted in a vacuum. As mentioned in Chapter 4, the CDD team must be aware of the full circumstances of the deal, why it is being done, how the target fits with the buyer’s strategy and what the buyer intends to do with it once the deal is done. Only then can the CDD team do its job properly and add value. CDD is essentially a mini-strategy review of the business you are buying.

As with any strategy review it is counter-productive to attempt to ‘boil the ocean’. Inevitably, there is a small number of issues critical to the target’s future. Given the time pressure and the inevitable desire to keep costs under control (although CDD is the least expensive of the main due diligence streams) it is essential to prioritise efforts on areas of uncertainty, risk and uplift.

Issue analysis

There are two basic approaches to problem solving as shown in Figure 6.3.

In simple terms, issue analysis involves setting out a logic tree for the factors that underpin the core question so that the work follows a structured, analytic approach. That core question might be as simple as ‘Should we buy the company?’, but it is better for it to be more specific, as in some of the examples above.

An example issue analysis is shown Figure 6.4. This is for a US niche manufacturing business, supplying cable and wire solutions. The buyer had worked out that the challenges facing the business were increasing the existing rate of growth and avoiding the commoditisation that afflicts similar markets. All of the questions are designed to provide insight into the key question.

FIGURE 6.3 The two basic approaches to problem solving

FIGURE 6.4 Example issue analysis for a niche manufacturing business

A full workplan can then flow out of the issue analysis. A task list is set up, each task being designed to answer one or more questions. The tasks are allocated to team members for execution.

Data requests

Business analysis requires data. Depending on the business and how the process is being run, the amount of data available on the business will vary from about enough to voluminous. A well-prepared company, often advised by an investment bank, will have gathered operating and financial data on the business. This is typically assembled in an electronic data room. In some cases the seller may even have hired consultants to go further than this and commissioned what is called vendor due diligence.

Inevitably the buyer and its advisers will require further operating data for its CDD assessment. Do not fall into the trap of requesting absolutely everything that you can think of that might be useful. It will not all be available, the request will annoy management and you will not use it all. The trick is to refer back to the key questions and to the issue analysis which you have prepared. You can then specifically request the data that help to crack open your understanding of the business.

The target’s business or strategic plan is a key document for the acquirer to obtain and assess. It is the job of the CDD team to validate these projections and the assumptions which lie behind them. Often the forecasts may have been re-worked and re-presented by the seller’s corporate finance house, in an information memorandum (IM). An IM is a sales document which inevitably presents the business in the best possible light. Watch out for unsubstantiated claims, financials that cover a limited time period, 3D graphics and graphs exaggerated by not beginning at zero. It is also worth working out if the plans were drawn up by management, or if they were foisted on them by advisers.

Management should be able to provide performance measures on the business. Key performance indicators (KPIs) are hard measures, although not typically based on financial information. As with any other analytical input, you need to check which measures really are relevant.

Examples of KPIs include:

• Hotel occupancy rates
• Production ‘up time’
• Product reject rate
• Consultant/service employee utilisation ratios
• Sales conversion ratios
• Average revenue per customer
• Customer retention rates
• Advertising page yield.

Whilst an internal analysis of the KPIs across a division or from one year to another is useful, the real value comes from competitor benchmarking. This requires careful planning and advanced interviewing skills to ensure that the information obtained from competitors can be used for valid comparisons. At this point it is possible to assess if certain performance levels or trends are the exception or industry-wide.

Desk research

With huge amounts of data now available to people sitting at their computers, the emphasis has moved from getting enough information to sorting it for relevance. Desk researchers often pick up interesting and useful information. But they also often fall into various traps. These can be finding interesting information that is not relevant to the questions in hand, or finding information that is flawed. The first is a red herring, the second is misleading. To avoid poor analysis – garbage in, garbage out – you need to develop a desk research strategy.

Many secondary sources have their limitations. They cover large, mass markets fairly well, but refer to niches only in passing. They are rarely completely up-to-date. It is tempting to take their growth forecasts as gospel, which is dangerous. Looking back they are often wrong and they do not often capture the subtleties of different market segments. Therefore, in addition to desk research, do not forget that getting onto the phone or out of the office can be very valuable.

Management discussions

It is best to meet the management of the target company at the start of the CDD programme. The aim of this meeting is to:

• Reassure them that the CDD team knows what it is doing, appreciates the sensitivities involved, and will not disrupt the business’s current commercial relationships. Think how apprehensive you would feel about a bunch of consultants interviewing your best customers even without the added risk that they might let slip that you are selling out.
• Obtain a thorough briefing on the business and the market.
• Sell the benefits of the work; management should benefit from this mini-strategy review of their business. There can also be a PR spin-off with customers.
• Agree which key managers the CDD team can talk to. They will obviously be insiders to the deal.
• Outline the data request and explain why the data are needed.
• Agree the best way for the CDD team to approach customers and other industry contacts; obtain those customer details.
• Open channels of communication so that important topics can be discussed or validated as the work proceeds.

This is a very sensitive time for management. There is a lot at stake including their livelihoods; for owner-managers this is probably their retirement plan. On top of this is the inherent stress and disruption of the due diligence process itself; invariably management underestimates just how invasive the whole due diligence process can be. As these management meetings can be delicate, it is best to take experienced people. The last thing the buyer wants is a call from the vendor explaining that some bright young consultants have rubbed the management team up the wrong way. If the CDD team, or any other adviser for that matter, fails to build a positive relationship at this point it will struggle to do its work effectively.

Customer assessment

Customers pay the bills. Working out if this is going to continue is a critical part of any CDD programme. As an antidote to the inevitable spiel from the seller about happy customers, the buyer has a range of tools available to assess continuing customer loyalty and spend. These include:

• In-depth, qualitative customer interviews
• Less-detailed, quantitative interviews
• Focus groups
• Internet surveys
• Analysis of customer data.

It’s horses for courses; Table 6.2 gives an idea of when each method works best.

TABLE 6.2 Assessing continuing customer loyalty and spend

These methods can be combined. For example, internet surveys are best prepared and backed up with a brief programme of in-depth qualitative interviews.

The CDD team should determine the sample set of customers to interview, although it is to some extent reliant on management to advise which interviewees will yield the best information. Management should also provide the contact details. Beware managers who are tempted to hand pick customers while keeping the CDD team away from problem cases.

Internet surveys are increasingly powerful, if well executed. They have the advantage of covering the entire customer database. However they do not cover prospective customers whilst former or unhappy customers are unlikely to respond.

Checklist 6.2 sets out a basic list of the topics which it can be useful to analyse, depending on the specifics of the business and the acquisition.

Much of this analysis will allow the acquirer to see customer trends and draw conclusions about how the revenue mix is changing and how customer behaviour is evolving. It is worth focusing on one essential part of the customer picture, which is customer segmentation, and then seeing how this can link through the overall analysis.

Customer segmentation and key purchase criteria

Customers evaluate suppliers before purchasing, but it is not always clear to suppliers what their customers’ key purchasing criteria are; they just see that a sale has been made. Customer requirements may also vary from one market segment to another and even from customer to customer. This underlines the importance of segmenting the market accurately, as well as understanding precise customer needs.

Critical success factors

Critical success factors (CSFs) define what a company must get right to achieve its goals and fulfil its strategy. The CSFs for a sports car company would include R&D, engineering excellence and branding. These deliver the performance and reputation required by the customer. Similarly the CSFs for the family car company would include wide distribution, quality management and marketing in order to deliver price, reliability and resale value.

Table 6.4 shows the links between key purchase criteria and critical success factors, and how they then can be measured by key performance indicators (KPIs).

Maintaining confidentiality while gaining customer insight

Obviously the CDD team cannot announce the real reason for its customer interviews to people outside the business: therefore it needs to agree the basis on which interviews are conducted with management. Typically the best approach is for the target to agree that the CDD team can say it is conducting a strategic review or customer care programme on behalf of the company and the management team. This platform requires the full cooperation of the target’s management and it must fit in with the company’s customer relationship programme. One target once refused to go along with a customer care platform with the curious boast that it never carries out customer surveys and its customers would know that. As might be expected with such an enlightened target company involved, that particular deal did not go ahead.

TABLE 6.4 Relationship between KPC, CSFs and KPIs in the bicycle market

If customers are to be interviewed on behalf of the target company, customer-facing staff should be made aware of the research programme otherwise there can be embarrassment and confusion.

Management may offer to hand over existing customer surveys. Few companies conduct customer care surveys which approach the level of professionalism and detail of a well-run CDD programme. Consequently prior surveys are invariably no more useful than background reading.

The vendor, or the financial adviser running the transaction, may attempt to limit the customer research. Whilst protecting confidentiality and customer relationships is fine, it is not acceptable to prevent the acquirer from talking on a confidential or neutral basis to the people who know the real strengths and weaknesses of the company. Overly restricting access is usually counter-productive. The buyer speculates about what the seller has to hide and, if necessary, a skilled CDD team can get at least some customer reaction through undisclosed market research interviews.

Other market participants

We have already covered desk research and customer insight in this chapter. We will now look at some other primary sources, as set out in Figure 6.5.

Depending on the questions that you need to answer to really understand the value of the proposed acquisition, interviews beyond the customer set can be very valuable. These can include interviews with distributors, regulators, competitors, industry observers and other relevant contacts in the market. Even in very well-documented industries, such as telecoms and financial services, these interviews remain important. The industry’s reputable published statistical reports should be exploited to the full, but it is not possible to segment the market properly or analyse key drivers without speaking to relevant market participants.

Distributors, wholesalers, re-sellers, retailers or whoever else sells the product can be almost as important as the end customers themselves. In some markets these channels or distributors are in fact the company’s direct customers. They are almost inevitably better-informed than the end users about the detailed workings of the target company and the strengths and weaknesses of its products.

Sometimes the relationship between principal and distributor is not straightforward. For example, a leading French financial services company sold half its products through one nationally organised distributor. Enquiries revealed that this distributor strongly objected to certain conditions of its seven-year contract with the principal. These conditions had been acceptable at the start of the contract period, but had been made obsolete by changes in the industry. The principal obstinately refused to amend the terms of the contract and the distributor was actively planning to move on once the contract came to an end in less than a year’s time. This would wipe out half of the principal’s sales.

FIGURE 6.5 Primary information sources

Specifiers can be as influential as customers and distributors in certain markets. If an architect has specified a product or ‘equivalent’ then there is a strong chance that the builder will use it. Doctors are specifiers of pharmaceuticals and care homes. IT consultants specify computer hardware and software. Teachers specify school books.

Regulators can have a profound impact on industries, often in ways which are quite unforeseen. When the UK government started to encourage employees to make personal arrangements for their pensions it did not expect the pensions industry to adopt the forcible selling techniques which have given its sector a bad name. Regulators can spot and break up cartels, as for example in the UK where copper tube prices were fixed for a decade. An unwitting buyer of one of those manufacturers could subsequently find itself in court with one or more builders’ merchants claiming they are out of pocket.

Below are some examples of CDD programmes where regulatory change was a key consideration:

Suppliers can be an excellent source of information, particularly when the supplier sees the acquisition target as a key account. If you want to buy a Ford dealership then it would be a good idea to find out what Ford thinks of the business and its prospects. If you are buying a cable maker – or any other capital intensive manufacturer – then it is worth interviewing the major equipment suppliers. They should know their target customers well. They may even be able to benchmark the target’s capex programme or manufacturing efficiency against its competitors. Suppliers are normally hungry for more information on their target markets and keen to identify new angles into customers, making them willing to talk to outsiders.

Competitors can be an excellent source of information; although most people think such interviews range from impossible to daunting. However, if they are approached in the right way competitors will usually be happy to talk about their rivals’ weaknesses to anyone who listens. An ideal question to slip into a conversation with a competitor might be: ‘So, given your comments, if you were running xyz (target company) what would you do?’ Expert interview networks such as Alphasights can provide access to competitors for a fee in those cases when their use is not banned by employers.

Former employees know the business intimately, but they are not always easy to include in the research programme. With social media such as LinkedIn, as well as expert networks, they are now fairly easy to find. Once identified, their opinions sometimes have to be discounted as they can have personal agendas, particularly if they left under difficult circumstances. But they can also be superb sources of information. For example, the customers of a market-leading instrumentation company unanimously agreed that the target company had the best products in its market, thanks to a first-class R&D department. Speaking to R&D people in the main competitor it was apparent that they were recent recruits from the target. It transpired that the target company’s management had emasculated the R&D department in order to improve the results of a disappointing year. The move was effective in the short term, but in the long term the company would clearly suffer from a lack of new products in an increasingly competitive market.

New entrants to a market will usually carry out a considerable amount of independent research before taking a market entry decision, so their views and plans are normally worth listening to. These companies can be hard to identify, although most market moves are advertised in some way; for example, in technical markets the research community will often get wind of potential developments.

Industry observers such as trade journalists and trade association officials, as well as academics and consultants, follow developments in their industries closely. Talking to them should provide a good introductory briefing to an industry and its challenges. They can also refer you to other useful contacts; the downside is that they can have their own agendas and constraints. Trade associations avoid being seen to promote the interests of one member firm above others, so they can help to describe some of the key characteristics of the industry as opposed to offering opinions about individual companies. Trade journalists are often talkative and are delighted to share their views with interested outsiders. Generally the more niche the industry, the more accessible and talkative they are.

Why should people talk?

There is a tremendous amount of information available to those who pick up the phone. Rather than being reticent, people generally talk much more than they should. But to get the best out of telephone interviews it helps to have the right approach. The secrets of success are set out in Checklist 6.3.

Market analysis

The key questions that shape the CDD will inevitably include market analysis. To various extents, all businesses are victims of their markets or, in the words of Warren Buffett, ‘when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.’

There is a lot more to market analysis than buying the latest industry report. There are three essentials to get right:

• Define the market accurately.
• Do relevant analysis with valid data.
• Work out what makes that market tick.

Clear result

The reporting topics and style differ according to the transaction, who is doing the work and, most importantly, the audience. Commercial due diligence exercises are allowed three to four weeks – and often less. Because time is short, it is essential to focus on the critical issues which means concentrating on the areas at greatest risk.

The vendor will not be privy to the report in the first instance. However as part of the negotiations the buyer may choose to release part or even all the report to the vendor as a tactic to prove that the business has less value than originally thought.

FIGURE 6.6 Example of a revenue bridge: how commercial due diligence feeds into forecast analysis

Table 6.5 shows a CDD report format which has stood the test of time and has proved highly satisfactory for a wide variety of acquirers and investors.

Earnings

FDD should assess the level of maintainable earnings of the target business because it usually provides a guide to the future performance of the business. This requires a thorough understanding of the entire business and its market: it is much more than the identification and stripping-out of non-recurring profit and loss items.

Assets

FDD should review the business’s assets. Again, this work will have an eye on the future – it will look at accounting issues, but it should be mostly concerned with the nature of the assets, and their suitability for the business. Cash flow is going to suffer if assets are reaching the end of their life and will need replacing soon after the business is acquired. FDD can also identify any assets the business owns, but does not necessarily need.

The investigation can also compare the market value of assets with their net book value. For example, low net book values may give a misleading view of the level of capital required by the business over the long term, and so may flatter the true maintainable earnings of the business. FDD should consider asset ownership; a sale and leaseback transaction may be an efficient way to release cash, indirectly helping to finance the acquisition itself.

Liabilities

The investigation of liabilities should look for any liabilities which have not been disclosed, or whose value has been underestimated. This part of the investigation tends to be more backward-looking: but, of course, the key underlying objective is to spot any unexpected future costs. Under-funded pension liabilities would be an obvious example.

Cash flows

To what extent are profits not reflected as net cash inflows? There may be good reasons for a business not to generate cash – the business may have invested heavily, or a business may be growing rapidly with the increased working capital requirement draining cash. These are important issues for any new owner of a business who may have to find extra cash to finance it properly.

Net cash or debt

Businesses are typically valued free of cash or debt; if either is in the company, this may impact on the transaction price. Assessing the level of cash or debt is not always easy. If the business is very seasonal – such as tourism or retail – or if some financial debt instruments are accounted for off balance sheet then the calculations are harder.

Management

An FDD team will have a lot of contact, discussion and interviews with the target’s management. Consequently a commercially minded FDD team should be well placed to comment on the strengths, weaknesses and even organisation of the management team. Experienced acquirers ask for these opinions as they are keen to anticipate how the target’s management team will fit into the new environment of the combined businesses.

Shopping lists

It is common practice to provide the vendors and their advisers with a detailed information request list (or ‘shopping list’). FDD advisers have standard lists. The experienced ones know that it is best to tailor them to the circumstances of each particular transaction. Too many due diligence investigations get off to a bad start because the various advisers inundate the unsuspecting vendors with huge ill-considered requests for information, with considerable duplication across the different lists. Understandably, the vendors take this badly. Then, either because they are genuinely annoyed or for tactical reasons, they may exploit this poor preparation to put the purchaser on the back foot, trying to weaken his negotiating position.

Appendix A provides an example of a shortened FDD information request list.

Interviews with the target’s management

Interviews form a critical part of most financial investigations. They will often be based around documents, but the investigating accountant will also steer the conversation away from hard issues, always seeking to improve his or her understanding of the target business, its strengths and weaknesses, what it can achieve and where it might prove vulnerable. Covering similar ground with several different members of the target’s management team can be enlightening; for example, comparing the views of the managing director, finance director and production director.

As the sale of a business is often a traumatic period filled with uncertainty for its managers, the investigating accountant must be sensitive to the different circumstances of each transaction and each manager’s agenda. A newly-recruited manager may have little ‘baggage’ and be more ready to criticise the business while a long-standing manager has valuable, detailed knowledge but may be less objective and feel that any criticism of the business amounts to a personal criticism.

An owner manager, who has spent his life building his or her business, will naturally tend to present the business in a favourable light. The prospects of a professional manager who is not a vendor and who is being ‘sold with the business’ are quite different; he or she may quite quickly ‘change sides’ and identify with the purchaser, the prospective employer. He or she may even be motivated to show the business in a poor light, so that good performance following the acquisition is attributed to the manager’s subsequent good management.

The target’s historical advisers

It is common practice for the investigating accountants to review the working papers of the target’s auditors and to interview the auditors. This is for two reasons:

• To gain an initial understanding of the target company and its business
• To get a feel for the quality of the audit, and so gain comfort that any clean audit opinions are supported by appropriate audit work.

But the target must formally give the auditors permission to open its files and the auditors will usually seek a ‘hold harmless’ letter signed by the investigating accountants and their client to ensure they cannot be sued. Negotiating this and related letters can be painfully slow and even then the auditors may not open up their files quickly. Sometimes no agreement is reached at all, forcing the purchaser and its advisers to manage somehow, perhaps by extending the scope of their investigations. In a similar vein, it is also useful for the investigating accountants to exchange views with the tax and legal advisers of the target, so long as access problems can be overcome.

History and commercial activities

The prime purpose of FDD is to assess the level of the target’s maintainable earnings. The underlying objective in reviewing any historical information is to give an insight into the potential of the business to generate profits.

Examples of issues which might arise in the investigation of a target’s history and commercial activities include:

• Previous changes in the shareholders. This may be benign, but could, for example, indicate that the founders fell out and perhaps the remaining shareholders are difficult to live with.
• Changes in the management. The recent loss of a key manager may cause immediate difficulties to the business, but may also say something about the business or its market. Why was the target unable to retain a key manager? Perhaps there was a disagreement on strategy, or the manager believed that the company would soon be in decline. Ex-managers may make useful interviewees for the commercial due diligence team.
• Insufficient investment because the company was being groomed for sale. Reducing levels of investment will flatter profits by reducing the depreciation charge and enhancing cash flows at the expense of the future profitability of the business, but this is not sustainable over a long period. The new owners might be forced to spend to catch up.
• Dependence on a few suppliers. This may make the business vulnerable.
• Dependence on a few customers. Such dependence exposes the business to risk. It is important to understand why it is dependent on a few customers, and whether it can decrease this dependence.
• Cyclicality and seasonality. If different to the acquirer’s experience this may lead to some unwelcome surprises if poorly understood. Buying at the top of the cycle may involve paying too much.
• Competitive threats. This could be due, for example, to entry by a new competitor or from emerging technology.
• Disputes with a major supplier. These may be revealed through interviews or through observing that payments to that supplier are behind or that the target has changed to another supplier.
• Problems of quality control. Quality problems may be revealed by a high level of credit notes, reflecting numerous returns; or by a review of credit control – slow-paying customers may not be happy.

Organisational structure and employees

Legal due diligence focuses on the contractual relationships with management and employees. FDD should assess whether the people can drive the business forward after the acquisition. Investigating accountants will be interested in:

• A high degree of dependence on a few managers. This may require the buyer to take steps to tie such employees into the business or it may trigger a search for a suitable successor. Significant weaknesses in the management team can arise in both owner-managed and corporate businesses.
• Culture. A culture very different from that of the acquirer often leads to a subsequent clash of cultures, which may be harmful and difficult to manage. Marks and Spencer never really got to grips with Brooks Brothers.
• Duplication. Duplication with the acquirer’s management team should be an opportunity, but the acquirer must plan for how any such duplication will be quickly dealt with following completion of the transaction. The Travellers–Citicorp merger was a disaster due to a high level of overlap and ‘job-sharing’.

FDD can also reveal a range of issues in relation to the employees:

• Use of overtime. The target may make extensive use of overtime work, which may not be sustainable in the long term. British Airways had to cancel flights when its check-in staff would not work overtime, even at attractive rates of pay.
• A shortage of suitable skilled workers. This could restrict the potential for growth.
• A strongly unionised workforce. The workforce may be strongly unionised, making the reaction of the unions to a change in ownership a key factor to manage. Ford struggled with the unions at Jaguar. What you must also be careful to avoid is introducing unionisation into your own plants as a result of the acquisition.
• A high level of staff turnover. There may be a high level of staff turnover reflecting other weaknesses in the business.
• Rates of pay and other employment conditions. Rates of pay or other conditions of employment in the target may be significantly different from those of the acquirer. It may be difficult to resist pressure to bring all staff up to a similar remuneration package, so increasing the cost base of the combined business. British Airways suffered from this problem, for example, when it acquired Dan Air.
• The ease with which headcount reductions can be made. Redundancies may be hard to make, due to the shape of the organisation, associated costs or procedures. It cost United Technologies tens of millions of dollars to close its Paris office.

Information systems

FDD of a company with weak information systems is likely to prove difficult, may overshoot deadlines and is more expensive than the investigation of a company with strong systems. Strong information systems also give confidence in the business as a whole; it is properly managed in accordance with carefully-drawn-up plans.

Accounting policies

The review of accounting policies is an important part of FDD, even where the overall scope is limited. The reported profits of a business can depend very significantly on its accounting policies and the interpretation of them. The investigating accountant should examine carefully any changes to accounting policies. Although less easy to do, it should also look at their application.

The problem is amplified across borders: different countries adopt different accounting practices, leading to significant differences in reported results. The definition of financial debt is critical as it can have a simple and direct effect on the price payable for a target where the price is negotiated free of cash and of financial debt.

Some examples of issues that can arise on the review of accounting policies and information systems include:

• Income recognition. The approach to the recognition of income on long-term contracts can vary even when companies apparently have similar accounting policies.
• Depreciation rates. Depreciation rates for similar assets may vary significantly from company to company.
• Provisions. Provisions against investments, including goodwill, can vary enormously as they can against contingent liabilities, slow-moving or obsolete stocks and slow-paying trade debtors. All are subjective and may be used to flatter profits.
• Stock valuation. Stock valuation is always the subject of debate, particularly in manufacturing businesses, as final stock valuations have an impact on declared profits.

Sales, cost of sales, gross margins

Much of the value of a business lies in its capacity to generate gross margins. FDD will identify and strip out any non-recurring events and profits to establish the main underlying trends in the performance of the business.

The review of overheads is typically easier; it will involve explaining variations from year to year and, in particular, will seek to identify any exceptional items as well as any ongoing changes to the overhead base. This leads to a view on what the likely level of the overhead might be in the future.

The FDD team can draw on many sources of information to review trading results. Typically it will begin with statutory and management accounting information. It will also be particularly interested in unofficial information, which is used by the target’s management to monitor and control the business – something not always included in the management accounts. This can contribute significantly to understanding the business: of course it also implies that the management and control systems can be improved.

Cash flow

The FDD team then needs to understand the relationship between accounting profits and cash generation. A persistent failure to generate cash while continuing to show accounting profits might suggest that the profits and the underlying accounting treatment are questionable – the profits may not be real.

The review should also analyse the quality of treasury management. Is the business financed efficiently? Does management fully understand cash flows, predicting and managing the cash position?

Net assets

We have already made the point that an FDD investigation of assets and liabilities is not an audit of assets and liabilities. An audit checks their existence and values them, generally based on historical cost. The assets and liabilities of a business are of interest to FDD only insofar as they contribute to the future earnings potential of the business.

Nonetheless, the review of assets can call on the accounting records as the starting point for enquiries. FDD should assess whether the business has the right assets of the right quality, and is able to handle current and forecast volumes of business. Is there an urgent need to make substantial investments in new equipment? Or are there assets, which are perfectly valid from an accounting and audit point of view, but which are not relevant to the core business and so can be sold?

The review of liabilities can also begin with the accounting records, but the primary concern may well be with those that do not figure in the accounting records. An experienced investigator should have a good idea of how to look for them in interviews, and especially in interviews with employees far from finance (production or sales, for example).

Examples of issues which might arise on a review of a company’s assets and liabilities are as follows:

• Creative financing. A company might own the freehold of its main premises, allowing the acquirer to consider a sale and leaseback agreement which would release cash.
• Outdated production equipment and systems. Outdated equipment may be starting to place the company at a competitive disadvantage. Ford found Jaguar’s factory to be very underinvested and had to stomach high post-acquisition costs.
• Surplus assets. There may be fixed-asset investments in non-core activities that could easily be disposed of without harming the mainstream business.
• Inadequate provisioning. For example, the terms of business may provide generous warranties, but the balance sheet may suggest insufficient provision for likely warranty costs.
• Potential litigation. Board minutes and minutes of more informal management meetings may reveal potential litigation for which no provision has been made in the accounts.

Taxation

The FDD team is often asked to undertake a high level review of a target’s tax affairs and highlight areas which appear likely to cause concern such as a dispute with the tax authorities. Any full tax investigation needs to be carried out by appropriate tax specialists. Make sure that the efforts of your various advisers are joined up, otherwise you risk increasing costs while not necessarily obtaining a better result.

The due diligence process should seek to identify tax planning opportunities both within the target and associated with the acquisition itself.

The following are examples of taxation issues that might be raised by FDD investigations:

• Transfer pricing. Transfer pricing where there is intra-group trading across different tax jurisdictions is a nightmare and needs a very thorough understanding to avoid nasty shocks later.
• Loan finance. Loan finance provided to or by the target where it is made across different tax jurisdictions.
• Management fees. Any management fees, in particular where the fees are made across tax jurisdictions.
• Tax credits. Any tax credits arising on investments in research and development in case they are brought into question.
• Tax losses. Tax losses which are presented as a future benefit to the acquirer can be a tricky negotiating point on a transaction. The vendor will of course try to sell these, but the acquirer, quite rightly, may not pay, arguing that there is no likely value to the vendor and their value to the acquirer is uncertain.
• Tax management possibilities. Creative tax structures might be possible, for example there could be scope for implementing a structure in which interest on loan finance is tax deductible twice or even three times across international jurisdictions.

Financial issues relating to pension schemes

Understanding the target’s pension arrangements and obtaining clear and up-to-date information on the future costs expected to be met by the company are essential parts of FDD. The pension fund can be worth more than the target company. Equally, pension costs may be incurred many years into the future – and long after the employees for whom the pensions are provided have ceased to be employed.

Issues that may need to be addressed include:

• Valuation. The valuation and funding of final salary pension schemes, including the basis of valuation according to actuarial schemes
• Unfunded liabilities. The existence of any unfunded pension promised to individual employees or directors
• Contingent liabilities. Contingent liabilities arising from changes in legislation not currently allowed for
• Compliance with the rules. Existing compliance with all aspects of pensions legislation and regulation
• Post-acquisition pension arrangements. Proposals for provision of past and future service pension benefits post-acquisition
• Transitional arrangements, and
• Expectations. Employment rights and the expectations of the target’s workforce.

Much of the information required for the due diligence investigation will be available from the following sources:

• Trust deeds and rules for all schemes, including amendments
• Members’ explanatory booklets and any announcements
• Annual trustees’ reports and accounts for the scheme, latest and previous years
• Company accounts (pension scheme costs and disclosures), and
• Actuarial valuation reports, latest and previous one, plus any related correspondence on the actuarial position.

Buyers and sellers often tangle over the net worth of the pension scheme as an asset or liability of the business. Specialist actuarial advice is therefore essential. The buyer may need to commission its own independent calculations, so it is important that the question of pensions is flagged up early in the process.

Financial projections

The logical finishing point for FDD is a review of the target company’s financial projections. Often the review of financial projections falls into two parts:

• An estimate or projection for the current year based on the latest management accounting information, together with any information on sales in the near future
• A review of the projected performance for two to five years following the year in progress. This will rely on a heavy input from the CDD team.

Site visits

The legal team will inevitably want to visit the premises of the target company personally. The reason for this is that top management can prove more willing than the shareholders to disclose some matters to the acquirer. You should resist sellers’ attempts to restrict access, although the lawyer must be sensitive to confidentiality and the circumstances of the transaction.

Written questionnaires

Next the legal team will send a list of highly-detailed written questions to the seller covering the issues on the checklist in Appendix B. As mentioned in the previous section, standard information requests should be adapted to the specifics of the transaction and all information requests from advisers should be co-ordinated in order to avoid duplication and confusion.

Data room visits

If there is a number of potential acquirers, the seller may put together a data room where information about the target business is collected for all potential acquirers to review. The objective is to give potential acquirers sufficient information to enable them to submit indicative bids for the target company. The preferred bidder will usually be allowed to conduct a normal due diligence programme once selected. The depth and quality of information available in data rooms is highly varied. Do not expect too much, otherwise you will be disappointed.

Disclosure letter

At some stage the seller will ‘disclose’ against the legal questions. It is in the seller’s interest to disclose as much as possible because what the buyer finds out this way cannot be the subject of legal action later on. Disclosure letters are therefore themselves a source of due diligence information. For example, they will contain a list of current and pending litigation.

While we are on the subject, the disclosure letter invariably goes through a succession of drafts, each one disclosing more information – and possibly leading to more questions about the information disclosed, and seeking further and better particulars. Make sure that the seller does not deliver the disclosure letter at the eleventh hour. At this point the word ‘letter’ may be misleading anyway, because on large or very complex transactions, it may be closer to the size of a filing cabinet! If the final disclosure letter contains new information this can derail the completion, as the buyer may need to reconsider some aspects of the deal. Early drafting of the final disclosure letter helps to keep the due diligence process within the timetable.

Certificates of title

Acquirers need to know if the target company has the title to its properties. A shortcut can be to arrange for the target’s solicitors to deliver certificates of title. This can be quicker and cheaper than an investigation because the solicitors concerned already know the information. Another advantage is the professional indemnity insurance cover of the solicitors giving the certificate.

Commissioning specialist reports

Specialist advisers may be needed to report on particular aspects of the business, such as environmental risk assessment. These reports have a long lead time, so they should be commissioned early. Access to the premises may also need to be agreed.

Collection of public information

The investigation should also cover information from public sources. The acquirer is not reliant on the cooperation of the seller for this information and can verify the information which the seller provides itself.