It is often cited that the majority of M&A transactions fail to achieve the returns targeted in the original investment/divestment proposal. Put another way, as a buyer or seller, you have a 50% likelihood, at best, that you will succeed in realizing the value that drove you to do the deal - and a much greater chance that you will not!
Are you willing to risk your reputation, renege on your fiduciary duty to your shareholders to exercise due skill and care, and leave things to chance? How can you make success a reality - and leave failure to others? Read on&
Due diligence - a value added exercise
High quality due diligence would be a good starting point. This is particularly important in the Asia Pacific region where a host of issues are commonly encountered that impact upon the deal appraisal process: corporate governance considerations, restatement of financial information in accordance with international accounting standards, related party and "off balance sheet" transactions, poor quality information, transactions based on informal business arrangements rather than contractually defined terms and conditions, tax, regulatory and legal issues, complex group structures, antiquated IT systems, HR and related cultural issues - the list goes on.
The importance of a thorough and well planned due diligence investigation is well understood in developed markets such as the US and Europe. In contrast, in Asia the quality of the deal evaluation and execution process varies considerably - this in spite of the perceived much increased transaction risk in undertaking M&A in this region. Whilst more sophisticated investment professionals tend to understand the meaning and objectives of proper due diligence and the value it can add to the transaction process, short cuts are common both for corporate and private equity investors alike.
By way of example, this often manifests itself in investors requesting and relying on the performance of an audit rather than due diligence - or sellers relying on audited accounts rather than striving to maximize the return on divestment through a well managed sale, incorporating a tailored vendor due diligence process.
So what's the difference - due diligence and audit?
They are both undertaken by accountants. They both involve a review of financial information. Does the name really matter?
Yes. Yes. Yes.
Imagine a close friend entrusts you with a blank, signed cheque to go and buy them a second hand Ferrari. Having found what looks like the perfect model, the owner provides you with a certificate of roadworthiness from a reputable garage - dated last week. This certificate is required by law to be updated on an annual basis for all cars more than three years old. The procedures to be performed by a garage in providing the certificate are set out therein. The purpose is to provide a degree of comfort that the car is roadworthy.
Would this "certificate" be sufficient for your purposes? Would you rely on the current owner's representations that the car has been well maintained? Or would you insist upon performing your own "due diligence" procedures: a test drive, a look under the bonnet, a close inspection of the paintwork and doors to ensure everything is in order and "as expected"?
In fact, in addition to your own due diligence, you would probably also commission a garage of your own choosing to perform certain specific procedures with a view to highlighting any deficiencies that might impact upon the decision you have made and/or the price you are prepared to pay - for example any repair or maintenance work that might need performing. Why? For a start you know you cannot rely on the certificate of roadworthiness for your own assessment purposes. The procedures performed by the garage in that respect were defined by specific legal requirements and with a different objective in mind. Secondly, you have an obligation to your friend to obtain an independent expert opinion. They have entrusted you with a substantial sum of money and you need to be able to demonstrate that you have spent it sensibly and with due care. The special report that you yourself have commissioned will serve this purpose well.
This scenario, whilst admittedly rather artificial, is similar to an investment decision taken by corporate or private equity management. They are acting on behalf of the shareholders or fund investors and have an obligation to exercise due skill and care in the performance of their duties. This includes, inter alia, undertaking an appropriate level of due diligence as part of the deal evaluation process. To rely solely on the audited accounts of the target company would be foolish, not to mention negligent. To commission a special audit, in the place of a proper due diligence exercise, would also in most cases be inappropriate - an audit seeks to provide a degree of assurance on a set of financial statements in accordance with well defined rules and procedures (see table below), not to identify issues likely to be of interest to a buyer or seller.
Area | Audit | Due Diligence |
Who |
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Objective |
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Scope |
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Deliverable |
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Cost |
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Table 1: Differences: Audit versus Due Diligence
No second chance
To fail to appreciate the differences between an audit and a due diligence exercise can be a costly mistake to make. It may result in the payment of fees for a service/product that is not what you intended. At worst, to the extent deal breaker issues or areas of upside are not identified - because you requested an audit - you will have been negligent in your duty to your shareholders. Ignorance is not an option.
Is there a place for an audit in the M&A process at all?
The due diligence process is completed, and no issues have been identified of such magnitude that would result in the deal being aborted. However concerns have been raised as to the quality of certain assets in the balance sheet, and the full inclusion of liabilities. You are also concerned about cash being extracted from the business between signing and closing and the potential adverse impact on working capital. How can you gain additional comfort at closing that you are getting what you think you are paying for?
The performance of a completion audit exercise is an increasingly common phenomenon in Asia, usually linked in with some form of purchase price adjustment mechanism. This adjustment mechanism would normally make reference to a minimum net asset or net working capital position at completion, and sometimes to a threshold earnings number as well. In this regard the basis of preparation of the completion accounts, and the definition of key reference numbers in the Sale and Purchase agreement, is crucial. This will include, amongst other things, Generally Accepted Accounting Principles ("GAAP") to be applied, together with any specific accounting policies to be adopted instead of the target company's normal policies. This would typically apply to provisioning policies such as those relating to accounts receivable, inventory, or employee related liabilities.
But the vendor has promised comprehensive warranties and indemnities...
It is not uncommon for a vendor to promise comprehensive representations, warranties and indemnities at the outset in return for a quick deal with minimal due diligence. Do not be fooled! What is promised at the outset is usually very different to what is encountered later on in the process when it comes to negotiating the detailed contractual terms. Also, warranties and indemnities are not a substitute for a thorough due diligence process - more often than not recoveries left to this mechanism alone are hard fought, time constrained and costly in terms of management time, effort and incremental legal fees.
In cases where pre-acquisition due diligence is significantly restricted however, as often happens in an auction process, it is crucial that this is factored into the strategic planning and overall deal evaluation process. Options available include a reduction in the consideration offered to reflect the increased uncertainty (and hence risk) associated with having performed only limited due diligence, a purchase price adjustment mechanism (for example by way of a completion audit process or contingent payment terms), or the performance of a detailed post acquisition due diligence exercise immediately after acquisition with a view to identifying potential claims under warranties and indemnities.
In conclusion...
Buying or selling businesses is, by its very nature, a risky business. To succeed where others are, more likely than not, to fail requires an appreciation as to the importance of a thorough deal appraisal process - this includes understanding what distinguishes good due diligence from bad, and why an audit can never be a substitute for a specifically tailored investigation of the target company.
Jim Woods is a partner at PricewaterhouseCoopers, specialising in due diligence and other transaction related services.
