To measure is to manage

“Our people are our greatest asset” is such an oft-repeated business mantra that it has become something of a cliché. How often have leaders made such rhetorical declarations? Strange, then, that – up until recently, at least – acquirers’ efforts to assess the people they might soon be employing, should a purchase or merger go through, were not a distinct work stream. Human resources due diligence (HR DD) is now becoming more common during M&A activity but, unlike financial or commercial due diligence, it is far from ubiquitous. 

Louise Hunter, who leads the HR due diligence practice at Deloitte, points out that the scope of HR due diligence has changed. “This sort of DD used to be focused very narrowly on pension liabilities,” she says. “But people are beginning to understand that there are a much wider range of people-related factors with the potential to drive deal value. It’s definitely an evolution.” 

A new guideline published by the ICAEW’s Corporate Finance Faculty and Deloitte aims to support that evolution. Launched in December, the faculty’s HR due diligence guideline should help all those involved in deals to better assess the people-related factors that form part of almost every corporate transaction. 

David Petrie, head of corporate finance at ICAEW, says that while the pensions liability issue is widely recognised as a major consideration in deals, it is not the only one: “It is obviously essential to understand the material items on (as well as those not on) the balance sheet at completion, but equally – or possibly more – important is the cultural impact of reshaping an organisation and its likely impact on morale and employee retention.” 

Beyond the deal

In that context, HR DD is not just the process of understanding the costs and liabilities of the transaction from a people perspective. It also explores the complexities of running the business in this light, considering the financial, legal and cultural issues related to the people in a deal, and assessing how the transaction might affect employee morale and retention. 

Such exercises can not only help organisations avoid making expensive missteps from a people perspective, but also increase their chances of pulling off a deal that creates value. A Bain & Co analysis of 40 M&A transactions found that 90% of those it categorised as “successful” had carried out HR DD – while two-thirds of “unsuccessful” deals had not. 

“People issues really can make or break transactions,” says Hunter. “It’s not just the numbers that matter – it is the context of those numbers that will really drive the outcome of the deal.” 

For this reason, HR DD is not an off-the-shelf exercise. “There is no one DD scope,” says Andrew Howard, a partner at Deloitte who specialises in employment law. “Our task is to develop a scope for diligence that reflects the nature of the businesses involved and the rationale for the deal.” 

Inevitably, that scope will vary by industry and sector, but also by factors such as the size of a business, the jurisdictions involved, and the shape of the transaction. There may also be an overlap with other DD work being commissioned, so it’s important to understand who is responsible for working on what and ensure roles are clearly delineated. 

Most HR DD exercises will begin with the basics – an analysis of the business’s workforce profile, from how many employees there are to staff structures and the cost of employment, including pay, pensions and other forms of remuneration. But more thorough HR DD looks below the surface to focus on staff engagement and morale, leadership capabilities and provisions that will incentivise key members of staff to stay with the business. 

Labour relations are also important. What relationship does a target have with trade unions, for example, and what is the potential for disputes? The target’s HR function itself may also be scrutinised, to understand the policies and processes it oversees. 

Significant other

The issues identified by HR DD can have a material impact on the deal itself. For this reason, it’s important that HR DD is carried out alongside other diligence exercises, including financial DD, rather than undertaken at a later stage of the deal process.  

“We work closely with other DD workstreams, including legal, finance, tax and ESG,” says Amy Bishop, a director at KPMG who leads the firm’s HR due diligence team. “Our analysis is integrated into the wider findings to provide a holistic view of the deal’s financial viability, risks and opportunities across the human side.” 

In cases where the firms undertaking HR and financial DD are not the same, there needs to be a close working relationship with those driving each process, because HR DD work will often identify financial issues that need to be factored into deal value and price. Expected changes to employee benefits and incentive plans, severance costs, and HR function synergies, for example, could reduce or increase EBITDA. Debt calculations may also need to reflect liabilities such as share plan crystallisations and retention bonuses – or even the pending outcome of any legal disputes with employees. 

Pension entitlements continue to be a crucial consideration. At businesses running defined benefit occupational schemes – even if these are now closed to new employees – the impact of current and likely future levels of funding can be significant. A defined benefit scheme in substantial deficit may require significant contributions from an acquirer taking responsibility for its pension promises; a scheme in surplus could represent a future windfall. Sometimes, transfer of ownership will require consent from the Pensions Regulator. 

There are hidden liabilities too. One red flag would be any ‘Beckmann’ rights – reflecting the landmark Beckmann case, brought in relation to the Transfer of Undertakings (Protection of Employment) Regulations 2006 (TUPE).  

While TUPE laws largely exempt occupational pension rights from rules requiring employers to safeguard employees’ benefits when their employment is transferred from one organisation to another, the Beckmann ruling identified rights that sit outside of this exemption. The right to early retirement and enhanced benefits because of ill health, for example, may transfer across. “You may need to engage with pension actuaries to quantify potential impact,” cautions Bishop. “The costs can run into millions.”  

Outside the tickbox

In other areas of HR DD, judgements can be more subjective, but the work is no less important. “We will almost certainly look at things like template contracts, senior management and key employee contracts, policies and procedures, incentive and bonus schemes, and any claims or disputes,” adds Howard. “Other issues we will look at will then very much depend on the business and industry.” 

The goal here, particularly in deals where human capital is a critical driver of value, is to understand how contracts and remuneration schemes incentivise staff to stay. HR DD can also identify contract clauses such as post-termination restrictions that protect the business if executives decide to leave. 

Diligence around culture can be tricky to translate into hard monetary adjustments, says Hunter, but advisers can find ways to quantify certain issues. “Data such as responses to engagement surveys and studies of staff turnover, particularly when you’re comparing two businesses, can be very valuable to look at,” she says. 

“It often feeds through into the value-creation story – maybe the business plan looks like this but needs to be adjusted given how long it will take to integrate the organisations; or maybe there are positive aspects of culture that could help drive better returns more quickly when applied across the combined organisation.” 

Indeed, HR DD should not simply be about spotting problems. HR DD specialists are keen to emphasise the potential for the work to drive value. “There was a time when businesses spent considerable sums on diligence work and then just stuck the report in the top drawer,” says Howard. “We now see much more desire from clients to avoid a box-ticking approach and to really focus on what the people issues are; they want practical insights and analysis that they can use to get value out of the DD process.” 

Such reports can provide the basis for an HR workstream during the post-deal integration process. It might recommend quick resolution of a compliance issue, say, or a process to align benefits. But there might also be suggestions for tackling cultural challenges, such as how to bring two different workplaces together more rapidly and harmoniously. 

That said, Howard believes HR DD should be seen as a high-level exercise. “It falls down when you try to go too far with it, because it is not an exercise in planning exactly how to run the business,” he says. From a practical perspective, deal sensitivities and confidentiality will limit the discussions an acquirer and its advisers can have with HR business partners and others outside the deal tent. “The goal is to identify the risks and the priorities to think about, not the minutiae.” 

Genned up?

Well-planned and well-executed, HR DD can be a significant factor in deal success and value creation, identifying potential red flags and providing the foundations for smooth and efficient post-deal integration. 

It’s why this form of diligence is increasingly seen as essential in transaction processes, rather than as a ‘nice-to-have’. And, given that many of the most active sectors for M&A right now – technology, life sciences and financial services, for example – are ultimately predicated on intellectual capital, understanding the cost of that capital, and what might erode it, is more important than ever.

The cultural element, moreover, is ever more significant in an era where people demand more from their employers. In one recent Deloitte survey, more than three-quarters of Gen Z workers said it was important for them to work at organisations whose values aligned with theirs. Many also said they enjoyed working for smaller organisations, including start-ups; larger businesses acquiring such firms need to be attuned to this and respond accordingly. 

“We’ve seen a steady increase in HR DD mandates in recent years, and often with more extended scopes,” says Bishop of these trends. “Our clients now want to look across the whole people landscape in far more detail.”