Once a relatively narrow discipline that focused on the historic performance of a business being bought or sold, the depth and breadth of financial due diligence has grown significantly in the past 10 years. David Prosser reports.
The insights generated during financial due diligence (FDD) are now “critical in informing the value creation hypothesis and the plans for the business at the centre of the deal”, says James Orr, PwC corporate finance director and co-author of the new ICAEW Corporate Finance Faculty best practice guide on FDD, published last month.
The new guide reflects the evolution of FDD (see box, ICAEW guidance). In practice, it sets out three objectives for FDD work. First, there is the traditional purpose of FDD – diligence will identify red flags and risks so buyers can make informed decisions about the deal. Then the analysis of financial performance can be used to test the deal hypothesis and to identify any areas of focus or concern that will need further work. It will also feed into the view on the overall valuation of the business.
This scope would have been very familiar to a diligence practitioner working on a deal, say, 10 years ago. But there has been a steady shift of emphasis on to the second and third areas of the work. While FDD is still charged with uncovering any hidden nasties within a business’s finances, the broader imperative is to explore the subject of value.
As one practitioner puts it: “Diligence is now less about what you will get with an asset and more about what you can do with it.”
This shift has been driven by a range of factors. Not least, dealmakers have become increasingly frustrated by the poor success rates of M&A transactions – Harvard Business Review puts the proportion of ‘failed’ acquisitions as high as 70-90% – and want more work done upfront to prevent the same mistakes being repeated over and over again.
ICAEW guidance
ICAEW’s Corporate Finance Faculty published an updated version of its Best Practice Guideline 71 on 22 October, setting out best practice for financial due diligence on both buy- and sell-side transactions.
“The fundamentals of what is covered by due diligence – and especially FDD – and why you do it haven’t changed,” says James Orr, one member of the team at PwC that updated the guideline on behalf of ICAEW. “However, in recent years there has been a big evolution in how we do diligence.”
The guideline therefore updates previous advice on best practice to incorporate the latest thinking in areas such as the use of digital tools; how FDD meshes with diligence in areas such as commercial, legal, technology and sustainability; and on reporting formats.
The goal is to produce a guideline that provides practical support for corporate finance professionals working in and around DD.
It also provides management teams contemplating a deal process – whether buying or selling – with a template of what to expect during a DD process.
The guideline focuses on financial due diligence in the context of M&A transactions, and largely concentrates on deals in the UK and continental Europe – although it also touches on how practices vary somewhat in the US and elsewhere.
Modern world
At the same time, the modern processes of FDD are helping practitioners do exactly that. “Advances in data analytics and automation enable us to efficiently identify financial risks and produce more focused and ultimately more useful FDD reports”, says Daniel Jonas, corporate finance partner at Azets. “The work we are able to do today is significantly more nuanced and sophisticated.”
Part of this story is the availability of data. FDD professionals who might once have limited their enquiries to, say, headline revenue numbers, now have the ability to drill down into the transactional detail, with businesses keeping far more detailed accounts and analysis than in the past. This informs a much richer understanding of the business, both at the current point and over time. There will be more work to do to validate and standardise data, but with the groundwork completed, practitioners can home in on any area as they see fit.
Moreover, and critically, modern technology makes it much easier to interrogate the data. Few due diligence professionals will miss the long days they once spent locked in lawyers’ offices combing through dusty ring binders of information to find key data. Instead, most deals now feature virtual data rooms (VDRs) – secure, centralised digital repositories for storing, organising and sharing documents and data related to the transaction. These can be accessed remotely, for as long and as often as FDD practitioners require – subject to the deal timetable, of course.
The data can of course be more easily sliced and analysed. Authorised parties use a range of tools to work through the information, with automation and artificial intelligence playing an increasing role. Problems hidden in plain sight should be quickly identified. But it’s also possible to build a much more detailed picture of the business.
Indeed, VDRs are becoming more comprehensive by the day. A study published recently by the market research firm SS&C Intralinks shows that the average number of pages in a typical VDR has grown from around 29,000 back in 2018 to more than 50,000 today. This enables much more wide-ranging FDD – and hopefully not information overload, as the same technology should also help to filter out irrelevant data.
“We will still kick the tyres on the numbers, but we will also frame our report in terms of what the numbers mean for the deal,” says Alex Judd, a partner in the corporate finance team at Buzzacott. “We’re trying to help clients question and challenge their rationale for a deal. What are the KPIs they should focus on with this business? How are they shifting? How are its customers behaving? Where will the business be in five years’ time?”
Inevitably, this conversation takes the FDD team into broader areas. Increasingly, says Nick Fox, managing partner of the transaction diligence practice at EY, he finds himself working with the growing number of specialists conducting other types of diligence. “There is then an exercise to be done to synthesise all the outputs from those other disciplines and deliver holistic advice for the client.”
Some due diligence strands are long established. Commercial due diligence will attempt to evaluate the business’s market position and customer relationships, for example, and will also include competitor analysis. That workstream can often be completed effectively in-house in a trade deal. Meanwhile legal due diligence will identify any potential risks and liability a buyer may be taking on by purchasing the business.
Using tech
Virtual data rooms (VDRs) have become ubiquitous in modern deal processes, streamlining due diligence workflows and facilitating collaboration without compromising security or confidentiality. VDRs come with robust access controls, generate audit trails and feature granular permissions to ensure sensitive information is protected from unauthorised access or disclosure.
However, other technologies with the potential to support due diligence are at an earlier stage of adoption. Not least, the format of financial due diligence (FDD) outputs should not be overlooked. Modern reports are far more accessible than the paper documents that were once prepared. Charting tools, graphics packages and interactive functionality make it possible to produce accessible work that the client can digest quickly.
Artificial intelligence (AI) is a major area of opportunity. AI-powered tools can parse larger datasets than any human can – and extract actionable insight much more quickly, too. AI tools can run sentiment analysis, conduct financial modelling, review contracts and assess risk, all essential parts of the due diligence process.
Predictive analytics tools, one subset of AI capabilities, are proving to be particularly powerful. Algorithms can increasingly extrapolate from historical data and trend insight to assess the likelihood of a deal delivering on its objectives – as well as to anticipate issues such as integration challenges.
“AI technologies are evolving so quickly,” says PwC’s James Orr. “They have the potential to transform the DD process within a couple of years, and DD providers will have to make sure they have access to the skills needed to get the best out of these tools.”
Blockchain is also set to play an important role in more due diligence work. The principle of blockchain – that it provides an immutable, tamper-proof record of information exchange and transactional work – is ideally suited to supporting the diligence processes. Smart contracts, typically deployed through a blockchain, can play a role in ensuring that both parties respond to issues identified in diligence in the agreed way.
Beyond the financial
Other types of diligence have only recently become more common. Technology DD, for example, is increasingly important, with buyers keen to understand the competitive advantage a business’s technology may generate, and for how long; but they will also be wanting to investigate risks such as cyber-security vulnerabilities.
Diligence relating to environmental, social and governance (ESG) themes is also conducted much more regularly in today’s market environment. Buyers need to understand the carbon footprint of the business, as well as its future path to decarbonisation. They will also want to assess other ESG hygiene factors, which could include anything from the business’s supply chain practices to its record on diversity, equality and inclusion.
“The results of all of these different diligence processes may play into the second stage of the deal,” says Judd. “As we’re supporting clients from making that initial valuation of the deal to agreeing the consideration to be paid on completion, we’re often trying to collate all of the work done across those different diligence workstreams.”
This isn’t straightforward, points out Fox, as assessing the financial implications of many aspects of broader DD work can be difficult. “We’re having to think about what this means for the valuation, for the financial modelling on the deal, and how the findings and advice will translate practically into the sale and purchase agreement to protect the client.”
What the FDD team is trying to get to here is a set of recommendations to the client concerning completion. The buyer’s initial valuation of the business may need to be adjusted – to take into account risks or vulnerabilities that have emerged during the diligence process, for example, or to reflect a potential additional upside that had not previously been considered.
“We are striving to answer the ‘what if’ questions with evidence,” adds Fox. “We’re trying to support the equity and value creation story – to help the client understand where they may need to adjust their expectations, for better or for worse, and what that might mean for what they are prepared to pay for the business.”
And, Jonas adds: “Clients are rightly more demanding of DD providers, with increasing demand for opinionated and bespoke outputs. Clients and bidders look to a DD report to substantiate, or indeed challenge, their investment or acquisition thesis; with advances in technology, our ability to be more conclusive has undoubtedly improved.”
All in the prep?
One development that has had a profound effect on due diligence is the growth of sell-side services such as vendor assistance and vendor due diligence (VDD), says EY’s Nick Fox. “A few years ago, VDD was less accepted as a product, but it is commonplace today and it does a lot of the heavy lifting that the buy-side used to have to deal with from first principles,” he explains.
With the target’s data in better shape and a basic view of the business available, buy-side DD teams can focus on much richer and more insightful analysis. With VDD typically prepared ahead of the sale process, buy-side teams have the space they need to undertake such work without compromising deal timelines.
Still, buyers will want some assurance – VDD is, after all, undertaken on behalf of a vendor looking to sell the business, with the seller picking up the bill.
“We’ll meet the VDD team to get a good understanding of how they’ve approached and prepared the report,” says Fox. “We’ll look at any limitations, issues or omissions they’ve made compared to how we would expect to approach that work. We’ll try to get to the bottom of the extent to which the vendor has finessed the messaging or analysis in the report, and challenge the VDD team on the conclusions.”
There is typically a degree of trust and goodwill, not least because with so many firms doing both buy- and sell-side work, the reputational damage an adviser would incur by painting the vendor in too positive a light would be significant. But buy-side advisers still look to top up VDD reports and to build on the foundations provided, rather than simply adopting the analysis without question.
“It’s useful not to be starting from scratch and means deal timelines can be accelerated,” says Fox. “But we’ll have our own questions and priorities for lines of inquiry based on our client’s needs.”
Finding a way
Inevitably, there will be times when this FDD leads the acquirer to have second thoughts about a deal – or even to pull out altogether. But the nuclear option isn’t always necessary. The FDD team may be able to help the buyer become comfortable with going ahead – by rethinking valuation, say, but also by providing suggestions for how protections can be built into the SPA and agreements such as earn-outs.
Warranties and indemnities in the former, for example, may be enough to protect the buyer from risks identified during FDD. The detail of an earn-out agreement with the seller will incorporate metrics built around the assessment of the business’s likely financial performance.
Naturally, buyers will require specialist legal advice on the terms of such agreements. But the financial analysis and detail underpinning these terms will typically come from the FDD team.
The bottom line, says Orr, is that FDD professionals continue to play a role in the deal process that is front and centre. “The fundamentals of FDD are as important as ever,” he says. “But we have become far more influential in helping the buyer to decide how to proceed – our work is now being used to underpin and support the value-creation process.”
More patience?
With modern tech making it easier to process and analyse large amounts of information quickly, it might be reasonable to assume that conducting due diligence should be quicker today than in the past. However, the latest research suggests this hasn’t been the case.
A study just published by Bayes Business School, based on analysis of 900 global transactions completed between 2013 and 2023, found the average DD period during these deal processes lasted for 203 days. That was 64% longer than the 124-day average DD period the Bayes team found when it last conducted similar research, in 2013 (for 2003 to 2013).
Often, of course, the process timescale will be dictated by things external to the due diligence – perhaps increased caution on the part of an acquirer in certain markets. The study’s authors acknowledge that the COVID-19 pandemic may have skewed the figures somewhat, with deal processes taking much longer during the crisis given the disruption it caused. But the pandemic’s effect does not account fully for the elongation of DD over the past 10 years. Rather, the report concludes that the increasing complexity of DD itself is to blame – particularly the fact that FDD is now commonly combined with multiple other diligence processes.
The research also suggests there is an ideal length for due diligence. Transactions where diligence periods were much shorter were more likely to fail before reaching completion, the study found. But it also concluded that longer-than-average DD periods were also associated with inferior completion rates.
“These medium-length processes appear to be hitting a sweet spot that ensures the deal proceeds smoothly, with buyers securing the data and insight they need, while avoiding unnecessary complexity and delay,” concludes Professor Scott Moeller, director of the Bayes Mergers & Acquisitions Research Centre.
