A Deep Dive on the Buyer Due Diligence Standard of Care and Custom and Practice in a M&A Transaction and on the Focus of Buyer Due Diligence in a M&A Transaction

I’ve been thinking…What are the buyer due diligence standard of care and custom and practice in a M&A transaction and what is the focus of buyer due diligence in a M&A transaction?

DUE DILIGENCE STANDARD OF CARE AND CUSTOM AND PRACTICE

Standard of Care: The applicable standard of care in buyer due diligence is the performance of a reasonable investigation of potentially material information to ensure there is a reasonable basis to believe in the accuracy and completeness of material information relied on by the buyer.  The reasonableness standard is that applied by the prudent person in the management of his/her affairs.  The materiality standard is that information is required to be reasonably investigated if there is a substantial likelihood that a reasonable investor would consider the information important in making an investment decision, or if the fact would meaningfully alter the total mix of information available.

Custom and Practice: The custom and practice performing a reasonable  due diligence investigation is as follows: (i) to make inquiries reflecting a reasonable level of skepticism (that is, acting as the devil’s advocate); (ii) to follow up and reasonably understand and resolve material red flags (that is, information encountered in the course of a due diligence investigation that is inconsistent with the buyer’s understanding of the target’s businesses, executives, operations, accounting and finances or that is potentially indicative of wrongdoing and, therefore, requires the buyer to investigate further in order to arrive at a reasonably informed understanding or resolution) and to investigate and reasonably resolve issues encountered during due diligence that may not rise to the level of red flags but which warrant reasonable investigation under the circumstances; if the results of the follow up investigation are not satisfactory to the buyer, the alternatives faced are either withdrawing from the transaction or accepting the risks of not conducting due diligence with reasonable care; and (iii) to independently verify material information supplied by executives and advisors of the target (or other parties with potential conflicts of interest) on which the buyer intends to rely.

DUE DILIGENCE FOCUS

In a particular M&A transaction, the investigation performed by the buyer’s due diligence team and directed and overseen by the Board is framed by, among other factors, the nature of the target, its businesses and its executives as well as its operations, accounting and finances.  Analysis of these and other factors serves to identify the important diligence areas.  As discussed below, while the diligence for each of the accounting, financial, business and legal aspects of the target has a principal focus, there is often significant overlap and reinforcement in the respective due diligence areas investigated.  The scope of this blog does not include legal due diligence.

Accounting Due Diligence: A principal focus of buyer accounting due diligence is on understanding, among other things, the accounting and reporting areas of the target, including the review of accounting documentation, and holding discussions with the independent auditors as well as key executives for accounting and reporting.  The following are illustrative, but by no means exhaustive, of the areas and types of information investigated by buyers in conducting accounting due diligence: review of accounting work papers, including but not limited to trial balances, account reconciliations, and source documents such as bank statements, customer and vendor contracts, invoices, and inventory movement documents; confirmation that financial statements comply with generally accepted accounting principles; review of critical accounting policies related to material or high risk accounts; analysis of accounts that require material management estimates and the basis thereof, including the adequacy of the receivables reserve and the reasonableness of the bad debt expense; inquiry into areas of accounting and/or reporting issues raised by auditors; confirmation of appropriate legal, regulatory and tax compliance; satisfaction with the integrity of the system of internal controls; review of the content of auditors’ annual management letters and management’s responses; analysis of high-level financial indicators such as profit margins, working capital ratios, debt-to-equity ratios, bad debt reserve ratios, days sales outstanding and days cost in accounts payable, across comparable companies and industries; and analysis of the propriety of the target’s books and records (e.g., board materials, internal financial statements and analyses thereof, integrity of closing procedures, quality of earnings, source and nature of revenue and expense growth, accounts receivable and inventory agings and reserves, propriety of related party transactions, production schedules, quality control, operating and strategic plans, financial and operating budgets, forecasts).  The materials reviewed by buyers are designed to provide multiple layers of independent confirmation to verify information provided by the target and to serve as a reasonable basis for the buyer to believe in the accuracy and completeness of information relied on.

A buyer may not blindly rely on audited financial statements.  If red flags or other information learned during diligence provide reasonable grounds for the buyer to question the accuracy and completeness of the target’s audited financial statements, buyers are required to conduct further investigations of such red flags or diligence issues so that the buyer has a reasonable basis to believe in the accuracy and completeness of information relied on.  Moreover, it is not reasonable for buyers to rely on unaudited financial statements without further investigation; the buyer has an affirmative responsibility to investigate the reasonableness of information relied on in any unaudited financial statements.  In addition, it is not reasonable for a buyer to rely on material information supplied by the executives, advisors or affiliates of the target or other potentially conflicted parties without independently verifying the accuracy and completeness of such information.

Accounting due diligence is typically performed by accounting/auditing firms pursuant to a statement of work and typically includes the preparation of a written accounting due diligence report.

Financial Due Diligence: A principal focus of buyer financial due diligence is on understanding, among other things, the target’s historical and projected financial position and performance, including analyzing the impact of recent and/or pending acquisitions.  This includes the construction – and stress-testing under different assumptions – of a dynamic financial model of the target’s historical and projected financial position and performance, including rigorous financial analysis of, among other things, key subsidiaries and affiliates, key components of the target’s balance sheets (e.g., cash and cash equivalents, accounts receivable and the associated reserves, related party receivables/loans, inventories, working capital, taxes, debt, inter-company payables/debt, deposits, prepaids, equity, liquidity), income statements (e.g., sales, cost of goods sold, gross margin, net interest margin, taxes, net income) and cash flow statements (e.g., EBITDA, free cash flow).  The materials reviewed by buyers are designed to provide multiple layers of independent confirmation to verify information provided by the target and to serve as a reasonable basis for the buyer to believe in the accuracy and completeness of information relied on.

Financial due diligence is typically performed by an investment banking firm pursuant to a financial advisory engagement letter.  Financial due diligence is also often performed the buyer’s executive team.  Iterations of the financial models prepared by the investment banking firm are invariably shared with the buyer and form one of the bases for negotiating the acquisition price and terms and conditions of the acquisition.

Business Due Diligence: A principal focus of buyer business due diligence is understanding, among other things, the business model of the target, including its strategy, products and services as well as its customers and suppliers; plant visits and discussions with management, customers and suppliers; regulatory oversight/restrictions; competition, market opportunity and growth prospects; staffing; production; and technology.  The materials reviewed by buyers are designed to provide multiple layers of independent confirmation to verify information provided by the target and to serve as a reasonable basis for the buyer to believe in the accuracy and completeness of information relied on.

Business due diligence is typically performed by an investment banking firm pursuant to a financial advisory engagement letter.  Business due diligence is also often performed the buyer’s executive team.