This content, focusing on the role of due diligence in a transaction, features the insights of the following panelists:

Over the last 10-15 years, M&A activity has surged, and M&A can be a relatively quick way to implement strategy, grow, create value, and improve a company’s position.

But many deals fail to generate the anticipated value, often because of a lack of upfront focus on value creation and the lack of a framework for achieving this value.

Leadership must take a strategic lens for a transaction and ensure alignment with the company’s long-term objectives. Due diligence should be tailored to understand and assess the risks and opportunities of the value drivers that are critical to achieving these objectives.

What Is Due Diligence?

Due diligence involves understanding, identifying, and validating assumptions about value, and identifying risks and opportunities. This helps buyers support and adjust their views on valuation and can facilitate quicker “go or no-go” decisions.

Historically, due diligence focused mainly on financial areas. But as M&A has grown in popularity and importance, due diligence has become much more multifunctional. Financial due diligence is just one piece. Other crucial types include IT due diligence, legal due diligence, environmental due diligence, commercial due diligence, and operational due diligence.

To ensure nothing is missed, it’s important to structure your due diligence comprehensively. Any identified risks usually have a cost or financial impact, affecting the quality of earnings from a financial due diligence perspective. Thus, alignment among due diligence teams is critical to ensure findings are consolidated and assessed to understand their impact on deal.

Understanding Financial Due Diligence

Financial due diligence involves analyzing the financial profile and statements of a company to understand normalized cash flows and identify associated risks and opportunities. This generally takes the form of a quality of Earnings (QofE), which requires a detailed examination of historical data, typically over three to four years plus the year-to-date period.

Analyzing year-over-year activity on a monthly or quarterly basis, scrutinizing revenue, cost of goods sold, and SG&A is critical to understand where the target has been and to develop a sense of what is “normal.” This will include identifying adjustments to the financial statements, such as one-time items and run-rate considerations, for the purposes of presenting a normalized level of cash flows.

Ultimately, buyers need to compare the results from the QofE with the narrative being sold by the sellers and assess alignment and inconsistencies. This alignment can help assess the seller’s forecasts, allowing buyers to challenge optimistic projections that may not align with normalized historical performance.

When the acquirer is a public company, the earnings effects of a transaction are a central consideration. Over the past five to ten years, there has been a shift from treating purchase price allocation as purely a post-transaction process to integrating allocation expectations into the due diligence process. This involves making preliminary estimates of what the financials will look like post-acquisition, including depreciable and amortizable values and lives and expected goodwill, to provide management with a clearer picture of future earning during negotiations.

Companies should avoid knee-jerk answers and recognize the importance of well-considered estimates in the early stages. These estimates help gauge whether the deal is accretive or dilutive and prevent post-acquisition surprises, such as discovering all assets are depreciable/amortizable property with no goodwill, which could be disastrous.

Both buyers and sellers are becoming more strategic about allocations and their tax implications, prompting the need for early expertise. Understanding fair market values for tax purposes early on can reveal potential issues and ensure the financial projections are accurate.

Understanding Sell-Side Due Diligence

Buyers expect sellers to be prepared, organized, and able to present cohesive financial statements, so sell-side due diligence is more confirmatory versus a drawn-out investigative process.

Sell-side due diligence involves the seller adopting a buyer’s perspective to assess their business internally. This includes performing quality-of-earnings analysis and comprehensive due diligence to identify problem areas, highlight strengths, and craft a compelling and defensible narrative. The goal is to package all this information efficiently to guide buyers through the due diligence process, answer their questions, and ultimately close the deal.

Sell-side due diligence also allows sellers to control the process. This control is particularly valuable with a competitive asset, as it can optimize the speed to market and expedite the closing process. For carve-outs, sell-side due diligence is essential due to their complexity, such as the availability and quality of source data, treatment of entanglements with the parent, and the need for assumptions.

Overall, sell-side due diligence is a best practice that offers significant benefits, including an upfront understanding of the risks and opportunities prior to going to market, a preparation of a defensible view of the business, and control of the due diligence process to drive a smoother and faster transaction process.

Due Diligence Involvement After the Quality of Earnings Report

After completing the quality of earnings report, the due diligence team can remain involved throughout the deal’s lifecycle. This includes supporting buyers with lender or insurance requirements, purchase agreement review to ensure due diligence findings are appropriately reflected, and post-close adjustment support (e.g., net working capital).

Additionally, due diligence teams should regularly coordinate and share findings with integration teams, allowing for integration plans to be tailored appropriately to track and realize synergies and facilitate a successful integration of the business.