Due Diligence for Global Deal Making

Do Your Diligence - And Do It Right

If you’re considering a cross-border acquisition, begin by understanding that your chances of a happy outcome aren’t so good. That doesn’t mean you shouldn’t proceed - certainly many M&A deals work famously - but go into the process with your eyes wide open. A 1999 KMPG study of the top 700 cross-border deals between 1996 and 1998 revealed that most - more than 53% - diminished the buyer’s shareholder value. In 1995, Business Week examined 150 merger and acquisition transactions valued at more than half a billion dollars. Only 17% resulted in substantial shareholder returns to the investors.

“Like the foundation of a building, due diligence is the key structural support, but not much of it is visible when the building is completed.”

These dreary statistics aside, it is an interesting trend that M&A is no longer the sole domain of domestic corporate giants. Mergerstat reports that between 1992 and 2000, M&A transactions between U.S. buyers and non-U.S. targets rose from 403 to 1,400 - a 247% jump. The total dollar value rose from $14.05 billion to $136.75 billion - an 872% hike. M&A activity involving non-U.S. buyers and U.S. targets also soared, from 167 to 1,248 - a 647% rise - with the deals’ value growing from $9.3 billion to $299.2 billion - a 2,217% increase. With more international M&A activity than ever, and the value of deals soaring, it clearly has become critical for buyers to gain a high degree of confidence in the value of deals before moving forward. That’s the role of due diligence. There are several types:

• Legal due diligence - Certain fundamental legal issues are related to due diligence. Determine if the target’s debt and equity securities have been validly issued. Does the target have good legal standing where it does business? Is it in compliance with its domestic tax laws? What’s the state of its pension obligations (ERISA lawyers inevitably get involved here). Considerations include tariffs, duties, government-worker laws and regulations, tax treaties and more. These matters will be covered in the target company’s representation of its warranties and covenants and in the purchase agreement, but having the option of suing your new partner after the deal is done is cold comfort. Due diligence can help you avoid reaching that sorry point.
• Financial due diligence - Review the balance sheet, the value of fixed assets, and liabilities and operating results from both a current and historical perspective. Consider trends in profits and revenue, and the returns to investors. Examine the cost of sales, general and administrative expenses, any extraordinary and nonrecurring expenses, the financing and capital structure of the firm and, of course, cash flow. Assess the reliability of financial statements to avoid the problem of inflated earnings that result from aggressive accounting practices.
• Operational due diligence - Determine how well the target company is being run in terms of issues that may have an impact on the value of the transaction. These issues may include toxic chemical tort exposure, risk management concerns, pensions, profit-sharing, key personnel and creation of the products and services. Is there one genius whose loss would reduce the company’s value? Has the company skimped on recent R & D investment to inflate earnings? Does it own the rights to the intellectual property it depends upon? What is the company’s relationship to its markets? Who are its buyers? What factors affect demand? What are the prospects for increasing its market share? For due diligence, take a close look at human resource matters, including the organizational chart, successors to key managers, internal career paths, retention, a pattern of unfilled positions in key slots and payroll.

“These days, even small and middle-market firms regularly engage in cross-border mergers and acquisitions.”

During the due diligence process, integration is key. Legal, financial and operational due diligence tends to occur in silos when, really, the boundaries are porous. For example, a toxic waste disposal site problem affects a target firm’s legal, financial and operational standing.

Strategic Due Diligence

About one in five deals will fall through after the announcement. Of those that close, somewhere between half and three-quarters will fail to generate shareholder capital, based on studies by the Harvard Business School and others. Transactions across borders can be even more complicated. The secret to a successful cross-border M&A is ensuring that the two companies can achieve strategic alignment. Assess this by conducting strategic due diligence - which is also called commercial assessment or commercial review.

“A good deal is vastly better than a good lawsuit, and given a choice between a good lawsuit and an aborted deal, most savvy buyers would choose the latter.”

Begin strategic due diligence by examining the current strategic plans of both companies. Transactions should only occur when they improve the strategic position of the investing companies. Consider opportunities for cost reductions due to the merger; a market overview; distribution-channel analysis; customer retention; an overview of the competitive position and an analysis of what new core competencies might be added by the merger. Sometimes the acquisition will create value by enabling investors to recoup their investment due to advantages of scale, such as bulk purchasing power. Other times, value will be created because the target’s products and services are very similar to those of the acquirer, or "right next door" in the marketplace. This is an "adjacency-driven transaction." The key is accurately measuring the new combined company’s degree of increased appeal to consumers. Cross-selling opportunities are required for this type of deal to make sense.

“In business, as in life, the personalities of the people involved are critical for success.”

Other deals, called "scope-driven transactions," add new capabilities to an existing company. Companies such as Cisco, Microsoft and Intel have acquired companies whose technology would be too expensive to replicate or develop internally. The trick here is to identify the capabilities you seek, and then accurately access their marketplace value and the target firm’s ability to meet your needs. Other deals are "transformation-driven." Changes in the market or in technology may require a company to alter its business radically; often the best way is via an acquisition or merger. Due diligence is essential to gauge the risks of trying to redefine your company or industry. The two firms must have a sound fit, so factor in cultural barriers.

Operational Due Diligence

Companies mistakenly focus too much on evaluating a target’s assets instead of its workflow, operational procedures and quality control. These critical components should be part of due diligence. If you lack personnel who are able to evaluate the target’s operations, take warning, since most successful deals involve two companies in related spheres of business. Operational due diligence is often given short shrift. If properly done, its findings should make their way into the deal’s financial projections, negotiations and pricing. On the other hand, operational due diligence should not become a pro forma exercise of "kicking the tires." Operational due diligence should cover:

• Manufacturing goods or providing services.
• Analysis of products, services, sales, distribution, customer base, market positioning and brand.
• Analysis of the general support systems in the value creation processes, including people, training and corporate culture.
• Analysis of supply and resource procurement, including supply-chain management.

Financial and Accounting Due Diligence

Financial and accounting due diligence are the heart of a prospective cross-border deal. This may be the investor’s only opportunity to evaluate the target’s true economic viability and future prospects. Inadequate research or unrealistic expectations can cause any deal to fail.

“Cross-border tax due diligence for any investor involves a balance between tax compliance review and future tax planning.”

No due diligence can completely uncover a sophisticated pattern of manipulation of financial data by the target company. For that reason, companies must also assess the integrity and qualifications of the target firm’s personnel and management. Conduct background investigations, including criminal background checks, on all senior and middle managers. In a surprising number of cases, managers have criminal backgrounds or may have even violated securities laws. Consider the closeness of the independent CPA to the corporation. A long, positive relationship suggests that the accounting results are more defensible. Investors should analyze any possible impact of the target’s fees on the CPA’s independence and objectivity.

Legal Due Diligence

Legal due diligence primarily consists of looking for something that ought not to be there. Like most detective work, it involves searching for results that may often be uneventful, yet it is pivotal to closing a deal. The contracts ultimately will reflect effective due diligence. The most obvious error is assuming that domestic and foreign laws are similar, particularly since they may seem superficially alike.

“Sound transactional due diligence is a prerequisite to successful transactions in good times and rising expectations and in bad times when success may be more vital.”

Poor communication is one of the greatest pitfalls in legal due diligence. Attorneys must overcome cultural and language barriers to ensure that the proper documents are reviewed. Because of language differences, contracts in a cross-border deal should contain a clause specifying which language is to be used in interpretation. For example, the American billion is a British "milliard," while an English billion is what Americans call a trillion. Obviously, which language commands the contract’s meaning is important in this circumstance, and many others. Attorneys must perform thorough due diligence, regardless of pressure to work quickly. A good deal is vastly superior to a good lawsuit, especially in cross-border transactions, where you may find yourself dealing with a foreign jurisdiction.

Human Due Diligence

The field of human due diligence is one of the most interesting aspects of due diligence practice. Due diligence teams should include human resource specialists who have a strategic perspective, individuals familiar with the national culture where the deal is occurring and target company representatives who can explain organizational peculiarities. Consider these issues:

• Time - Is it viewed as a precious commodity, or as merely a continuum where personal matters are just as important as business.
• Task versus relationship orientation - Some companies focus on tasks, while others build their success on relationships. Know what type you are merging with.
• Free will versus fate - In Eastern cultures, people tend to believe fate determines existence. In the West, the emphasis is more on individual actions and control.
• The employees’ relationship to authority figures - Many Indian employees, for example, are known for doing what they’re told even if they know the instructions are ill advised.
• Rewards - Western culture perceives rewards as linked to merit. In other cultures rewards are based on family connections.
• Feedback mechanisms - People in some cultures feels that direct criticism causes shame or loss of face.

“Transactional due diligence is the investor’s determination of the true, correct, and complete value of the target company.”

Today’s due diligence professionals are under more pressure than ever. On the plus side, the best ever technology is available to them. The Internet has expanded the idea of an "international public record," which due diligence professionals can search. However, technology doesn’t answer every problem. It still takes a due diligence professional with a mind like a detective, sufficiently patient to search until every question has been answered.