“When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.”-Warren Buffet
What is Due Diligence?
Due diligence is an investigation into the affairs of an entity before its acquisition, disposal, flotation, refinancing, restructuring or other similar transactions. It is a practice that investors use to determine if a target company is one of those that Buffet mentioned in M&A transactions(of course it is the best scenario and also keep in mind some defects can be tolerated). I recommend watching the video below to go deeper:
The process by which information is gathered about to ensure that prospective investors make an informed investment decision. :
- A target company,
- Its business, and
- The environment in which it operates
What are the Types of Due Diligence?
- Financial DD
- Below, we’ve covered this one in detail.
- Commercial DD
- The markets for the company’s products: domestic and export.
- Growth rates in the markets.
- Competitors’ strengths and weaknesses. Market shares.
- Pricing trends.
- Legal DD
- The company’s contracts
- Regulatory position and permits
- Legal cases started by or against the company.
- Tax DD
- Overview and analysis of any potential material tax risks identified.
- Proposed recommendations as to the risks mitigation.
- Main tax attributes and comments as to the recoverability of available tax assets
- Technical DD
- The company’s factories:
- High quality equipment?
- Efficient production?
- The company’s factories:
- Environmental DD
- Do the company’s practices for waste water, waste gases etc, handling of hazardous materials etc comply with Turkish law?
- How might Turkish law tighten in future?
- Pensions / HR DD
- Is there a large future financial burden due to the staff employed?
- Reputational DD
- Are the owners and key managers reliable people?
What is the Financial Due Diligence approach?
If the parties has started conducting financial due diligence, it means there is a strong will to proceed. However, they want to be sure everything goes smoothly as much as possible and they investigate whether any, so called ,”deal killer” exists. The reason behind this investigation is so simple: coming up with a sustainable EBITDA.
Deal killers usually assist buyer side however it may cause a termination of negotiations. This is why they are called “deal killers“.
Below is a list of examples for possible deal killers:
- Lack of legal documents (warrants, licenses)
- Out of book transactions (revenue, cost, personnel expenses)
- High dependency on a certain sales channel, some customers, suppliers, key personnel
- High level of related party transactions
- Significant lawsuits against the Company
- Significant contracts which will be expiring soon
- Change of control clause in major agreements
- Bank loan covenants
Buyer wants to understand the amount of sustainable EBITDA, because he knows he should dissipate the uncertainty of the investment to be able to avoid undesirable consequences.
A well conducted financial due diligence should highlight the financial risks. Otherwise, the buyer may take unforeseen risks which may cause significant troubles. Therefore, the areas of the possible risks should be determined and inspected wisely.
Risks are often in the following categories:
- Items affecting EBITDA (and therefore the value of the business):
- Current year EBITDA
- Past years’ EBITDA (in scope)
- Future sustainability of EBITDA
- IFRS adjustments;
- reclassifications within P&L;
- basic accounting failures;
- out-of-book items;
- one-off & non-recurring items; cost changes if business is dressed for sale
- related party items (including management remuneration).
- carve-outs of part of the business (if it will not be sold or will not continue trading).
- Items affecting net debt :
- Provisions needed
- Hidden (unrecorded) liabilities and accounting fraud
- Items which may create new debts or liabilities:
- Guarantees given
- Non-compliance with tax law
- Non-compliance with contracts or loan agreements
- Asset quality problems:
- Impaired inventories, receivables
- Unusable fixed assets
- Impaired participations
- Worthless «other assets» o Fictitious cash and bank balances