Alignment of financial and commercial due diligence as a key success factor in M&A

As a part of the M&A process, investors typically use services provided by external advisers in order to provide independent and robust input on the target’s business. Usually, the due diligence procedures included financial, tax and legal analyses which could give a lot of information on the past and current situation of the target.  But what about the future?  Commercial due diligence or as one could say, analysis of market and its perspectives as well as the position of the target on that market could be the answer.  Currently, we observe that such analysis is conducted much less in Poland and CEE than in more mature markets. It is very often required by private equity houses and foreign investors who not necessarily have sufficient knowledge of the market on which a potential target operates.   However, we also observe that it starts to attract larger interest from strategic investors in the region in order to justify the purpose of the acquisition before the investment committee or debt financing providers.

The key purpose of the financial due diligence is to provide reliable information to the investor on the financial position and financial performance of a target and to identify any significant risks that may impact the purchase price, need to be addressed in the SPA, or even draw the investor away from the transaction. The analyses are usually performed on the historical numbers included in the statutory or management accounts with more or less exhaustive interviews made with the target’s key employees (i.e. middle and top level management).  As a result of financial due diligence, the investor should understand the key drivers of the business and be able to assess the target’s financial position and financial performance, notice any events that were not representative of the ordinary course of business and adjust the valuation model accordingly. 

The key objectives of a commercial due diligence are quite different. First of all, a key purpose is to present the key drivers of the market, its attractiveness and growth perspectives as well as key risks resulting from proposed regulatory changes, potential changes in habits of consumers, introduction or development of substitute products, new market players, new technologies, etc.  Second, commercial due diligence presents the current market position of the target and its competitors as well as their road to get to this position.  Accordingly, it presents the unique business model of the target and compares it to the target’s competitors.  Combining the above with the assessment of the management’s projections vis-à-vis the expected market development, a comprehensive analysis of the target’s position, its growth perspectives and any risk or upside that could alter the management’s projections is presented to the investor. This way the investor can gain greater confidence in the financial projections and optimise the business’ valuation. 

Also, commercial due diligence could be a powerful tool in vendor-initiated due diligence and give a strong, independent foundation for the management’s projections presented in the company’s forecasts or business plans.   It is typical that if the vendor-initiated due diligence is conducted, commercial due diligence is a part of it because a well-supported forecast can significantly impact the asking price.

Financial and commercial due diligence overlap in certain areas of the analyses. This relates mainly to analysis of sources of sales revenues and their key drivers, analysis of gross margins and commercial costs (e.g. marketing expenses).  However, there are also significant differences between both analyses. This includes the already mentioned focus on different time periods (financial due diligence focused on past and present and commercial due diligence focus mainly on the future) but also the sources of information used for the analysis.  For financial due diligence these are mainly internal documents of the target and interviews with employees and management, while commercial due diligence relies both on internal (same as in financial due diligence) and external sources of information such as publicly available information provided by key market players, reliable press articles and market reports, interviews with market experts, site visits, etc.  Also (anonymous) interviews with customers and suppliers of the target are often conducted in order to get their opinion on the target and its prospects, and try to measure their satisfaction from cooperation with the target as compared it to its competitors.

Often, in the M&A process the information prepared by the target company is not clear and particular data sets do not reconcile. If a single report that consists of both financial and commercial aspects is prepared, it relies on a single data set and reconciled numbers which preparation usually consumes a significant amount of time. If the investor decides to use separate teams he might need to invest additional time to reconcile numbers between reports delivered by those teams.  This time could rather be used for better preparation for the negotiations with the vendor.  Also closely co-operating financial and commercial teams can much easier share information and as a result certain analyses are not duplicated, which reduces the time required to complete the report and therefore also reduces its cost. 

At KPMG in CEE, the dedicated commercial due diligence team often includes some members of financial due diligence teams who are able to identify certain commercial issues that impact the financial due diligence and vice-versa. Financial and commercial due diligence complement each other and in order to get full benefits for the M&A process, the investors should consider doing financial and commercial due diligence by closely cooperating teams.  For sure, the in-depth analysis of the financial and commercial aspects of the target’s business are a key success factor in M&A.

Michal Majster and Andre Schuurman