Due diligence is an exercise in truth-seeking, investigating claims to ensure that a business being offered for sale is what its sellers say it is. And like many aspects of business, due diligence has become more complicated in recent years. 

Where due diligence traditionally focused on the financial health of a business for sale, it has expanded to include environmental issues (ESG due diligence), products, technologies and markets (commercial due diligence), and HR due diligence. 

What is HR due diligence?

According to a recent guide produced by ICAEW’s Corporate Finance Faculty and authored by Deloitte, HR due diligence has two objectives:

• assessing people-related costs and liabilities within the business to help inform the pricing of the transaction; and
• analysing the potential people-related complexities in running the business and making long-term changes (post-transaction).

Point one has been a bigger focus for HR due diligence historically, namely the various liabilities associated with staff. An old defined benefit pension scheme, for example, would be a liability that would require consideration, as would share option plans. 

“The due diligence around HR-related matters used to be focused on the legal aspects of employment of people, and the financial consequences or aspects of employment,” says David Petrie, ICAEW’s Head of Corporate Finance. “Traditionally, those have been things like pensions liabilities, liabilities associated with share plans, and additional payments to employees that may be outside normal contract terms.”

It also includes potential liabilities arising from employee-related legal matters, such as cases related to health and safety incidents. 

While this is still a critical element of HR due diligence, the remit has expanded in recent years to create an overall picture of an organisation’s HR function, employees and company culture.

“The competitive advantage for all businesses comes from the quality of people in the organisation,” says Petrie. “So, carefully assessing that and understanding what really makes an organisation tick, and keeps it bound together, can tell you an awful lot about its commercial prospects.”

“Cultural misalignment is widely acknowledged as the leading cause for mergers and acquisitions failing to achieve their anticipated deal value,” adds Louise Hunter, Head of HR Due Diligence and one of the guide’s authors. “Leaders are key to embedding culture across the organisation, setting the tone from the top, and in navigating the business through the significant changes which a transaction presents."

Below are five areas of focus for modern HR due diligence, and why they matter.

HR function

Modern HR due diligence looks at the overall performance of the business’s HR function. How well managed is HR in the organisation? Those conducting the due diligence should look at the roles and responsibilities within the function, the systems and processes in place, the quality and maturity of HR policies, and how well everything is managed. Employee mobility and minimum wage compliance are other areas that might be considered. 

“Assessing HR function effectiveness is key in enabling HR to operate as a strategic partner - driving cost reduction, unlocking value creation levers, and maximising value on exit,” says Hunter.

Labour relations

How many ongoing employee disputes does the business have, and how are they typically dealt with? What are the issues? Are workers unionised? Are there any concerns about pay awards or salaries? Look for common themes within those disputes; it can signpost the level of discontent within the business. 

“There can be serious issues lurking which would cause a buyer reputational damage if they emerge after a transaction,” says Hunter. “Leadership’s approach to dealing with disputes and the culture of the business can all help to understand if there are systemic issues. For example, in Financial Services businesses it is critical to have a culture of compliance and whistleblowing in place.”

Employee retention

The employee retention rate is a good indicator of morale within the organisation. This is not just how many employees are leaving, but who is leaving – if the business is regularly haemorrhaging key employees, that could be an indicator that productivity and culture is not where it needs to be.

“You can learn a lot from staff turnover rates and the extent to which there is good morale in an organisation,” says Petrie. “The numbers associated with employing people and the liabilities and legal aspects that come from that are only just part of the picture. That's why a much broader understanding of issues such as the benefit culture, the overall culture of the organisation, the level of staff turnover, the results of employee engagement surveys, are very important, because it does give some insight into company morale.”

This also reflects on the quality of the leadership team – another aspect of the business that should be reviewed as part of the due diligence process.

Reward

This is the day-to-day salaries, pay bands and incentive plans that the business operates. Specifically, it involves looking at the benchmarking, frameworks and policies around salary, pay increases and other incentives and benefits and judging their effectiveness. For example, are incentives and benefits taken up by the staff, and are they effective in influencing behaviour and results? It is an indicator of whether reward policies will need to be reformed post-transaction.

“It will be much harder to significantly grow a business with ad-hoc bonuses or a plethora of different benefit schemes for different populations without first taking the time to review the reward strategy. So return targets might not be achieved within the timescales envisaged by a buyer,” says Hunter.

Benefits

Unlike the day-to-day perks discussed previously, this includes benefits such as pensions and other plans that might impact transaction pricing. Alongside the cost and exceptional items, this should include expected changes to understand, for example, whether any new plans might need to be established as a result of a carve-out. 

As a side note, when looking at the leadership team, the compensation and benefits package for leaders should also be reviewed, including contractual payments.