Why the Due Diligence Process May be Getting Short Shrift
American Express Capital Eyes
Paul Schaye, managing director at boutique advisor Chestnut Hill Partners, represented a buyer in a deal for a maker of vinyl coating for fabric. Everything went smoothly until the due diligence process uncovered the companys plant sat on a toxic waste site.
The first question we asked was are there any environmental issues and they said nope, Schaye said. Then when you get into due diligence and you say whoa, what is this?
Thats how the diligence process should work. But in the flurry of activity, is due diligence suffering? A recent survey says the hot M&A market might be causing some to take short cuts with respect to due diligence. Other dealmakers say the process is still strong, but it is being done at a faster pace and in less depth than in years past.
The survey, commissioned by accounting firm J.H. Cohn, said onethird of respondents believed current due diligence processes are inadequate. About three quarters of respondents said the flood of private equity money has compromised the quality of due diligence.
Moreover, weak due diligence is the main reason many mergers fail to create value, twothirds of respondents said.
The respondents say theres no problem with the main issues in due diligenceverifying the accuracy of financial statements, sales forecasts and valuation. The problems are with less tangible issues such as assessing management or the intellectual property a target may have. Other problems surround how to value a companys inventory or equipment up front and not just rely on postclosing purchase price adjustments.
Many say the due diligence process is more robust than ever, thanks to the advent of things like electronic data rooms for reviewing confidential documents and the use of the Internet to dig up more data than was once easily available.
Back in 1999, I would have agreed that people have thrown due diligence out the window, said Jeff Rosenkranz, managing director at Piper Jaffray. Despite how hot the market is, we really havent seen a degradation of diligence.
But the diligence process may still be lacking in some areas. Rosenkranz says it is becoming more common for junior members of a private equity firm or third party consultants to carry out diligence work rather than the senior members. The lack of experience or deep insight into a business may make it harder to foresee potential problems.
Those two are probably not the best equipped to figure out the strategic drivers of a business, Rosenkranz said. There has been much less time spent between senior management at the buyer and the seller to discuss how to drive the business.
As a result, management, organizational structure and longterm strategy get short shrift in the diligence process, Rosenkranz says. Theres more box checking going on than anything, Rosenkranz said. People may be missing the forest for the trees.
Shorter Closing Periods
Peter Taft, a partner at private equity firm Morgenthaler Partners, says diligence can be done more easily thanks to electronic data rooms. Not long ago, you were huddled in a conference room pawing through documents in boxes with a lawyer standing over you making sure you did not steal anything, Taft said. But if its easier, it also means the work has to be done faster. Closing periods for deals have shrunk from an average of 75 days a couple years ago to 60 days on average today, meaning there is less time to carry out the same amount of diligence work. Taft says its not only due to the sellers market, but also to a strategic move on the sellside to keep the buyers from digging too deeply.
You might not have the time to do the diligence you once did, Taft said. Brad Gevurtz, managing director at D.A. Davidson & Co. agrees that due diligence may not be as rigorous with the competitive market among buyers. Diligence still hits the main points, but it has to be done much more quickly.
Buyers, as well, have to accept fewer deal protections such as smaller indemnity caps and no escrow in order to keep up with the speed of deals.
But buyers are not rolling over completely. He has seen deals where a buyer uses the exclusivity period after submitting a bid to do an even more extensive review of the business. In some cases, the bidder will come back with a lower bid after the second round of diligence. But he doubts that buyers, particularly private equity buyers, have skimped on assessing management.
If a financial buyer does not feel confident in management, they will always pass, Gevurtz said. A private equity firm that would not take a serious look at management, I would doubt their viability.
This article originally appeared in FactSets Flashwire Weekly.
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