overall due diligence consulting concept

OVERALL DUE DILIGENCE CONSULTING CONCEPT

Master of International Business and Finance Advanced Mergers and Acquisitions Prof. Dr. Thorsten Feix

Ruth Barrios Avilés Matriculation Number: 953253

Rafael Arturo Duarte Castro Matriculation Number: 953747

Evangelina Gómez Canto Matriculation Number: 953746

December 2017

Table of contents. Table of contents. .......................................................................................................................... 2 List of figures. ................................................................................................................................ 4 Summary. ....................................................................................................................................... 5 Overall Due Diligence Consulting Concept ........................................................................................ 6 1.

Designing a suitable Due Diligence process. ....................................................................... 6

1.1.

Stage 1: Create a Due Diligence Strategy and Timetable. .................................................. 7

1.2.

Stage 2: Build a Due Diligence Team. ................................................................................ 8

1.3.

Stage 3. Preparation and exploratory research. ................................................................... 8

1.4.

Stage 4: Execution of Due Diligence and presentation of results. ...................................... 9

1.4.1.

Execution of Due Diligence. ....................................................................................... 9

1.4.2.

Presentation of results. .............................................................................................. 10

2.

Core milestones of the Due Diligence process. .................................................................. 11

2.1.

Due Diligence initial planning. ......................................................................................... 12

2.2.

Milestone 1. Building the Due Diligence Strategy. ........................................................... 13

2.3.

Milestone 2. Due Diligence initial preparation. ................................................................ 15

2.4.

Milestone 3. Development of the Due Diligence program and preliminary review. ........ 16

2.5.

Milestone 4. Execution of the Due Diligence review. ...................................................... 18

2.6.

Milestone 5. Development of the Due Diligence report.................................................... 20

3.

Most important Due Diligence modules. ........................................................................... 20

3.1.

Financial Due Diligence. ................................................................................................... 21

3.2.

Legal Due Diligence.......................................................................................................... 23

3.3.

Operational Due Diligence. ............................................................................................... 25

3.4.

Management Due Diligence. ............................................................................................. 27

3.5.

Human resources and cultural Due Diligence. .................................................................. 27

3.6.

Strategic Due Diligence. ................................................................................................... 28

3.7.

Other Due Diligence Modules........................................................................................... 29 2

4.

Structuring as a consultant the Due Diligence process. ................................................... 29

4.1.

Due Diligence Preliminaries. ............................................................................................ 30

4.2.

Due Diligence Execution. ................................................................................................. 31

4.3.

Due Diligence Output........................................................................................................ 31

5.

Possible instruments for a Due Diligence process. ........................................................... 31

5.1. Checklist................................................................................................................................. 32 5.2. Due Diligence Program. ......................................................................................................... 33 5.3. Due Diligence Data Room Request List. ............................................................................... 35 5.4. Site Visit Guide. ..................................................................................................................... 35 5.4. Management Interview Guide. ............................................................................................... 37 5.5. SWOT Analysis. .................................................................................................................... 38 References. ................................................................................................................................... 40

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List of figures. Figure 1. Expanded Components of Due Diligence .......................................................................... 10 Figure 2. Core milestones of the Due Diligence process. ................................................................. 12 Figure 3. Process for the selection of the target company. ................................................................ 13 Figure 4. Due Diligence modules ...................................................................................................... 21 Figure 5. Value chain activities. ........................................................................................................ 26 Figure 6. Consultant structure. .......................................................................................................... 30 Figure 7. Legal Checklist example. ................................................................................................... 32 Figure 8. Legal Due Diligence Program example. ............................................................................ 34 Figure 9. Site Visit Guide example. .................................................................................................. 37 Figure 10. SWOT Analysis components. .......................................................................................... 39

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Summary. Author: Evangelina Gómez Canto.

The main purpose of this paper is to clarify the Due Diligence process as a consulting concept. For that, it is important to notice that the Due Diligence is a sub-process within the process called ‘Transaction Management’ in Mergers and Acquisitions. Thus, the importance of this sub-process relies on that it brings to the acquiring Company legal, financial, operational, organizational, cultural, structural, among other critical information about the Target Company, which is very helpful for identify risks and opportunities and finally decide if proceed or not with the acquisition. Chapter 1 includes a general description of the four main Stages that made possible to design a suitable Due Diligence process according to the specific characteristic of the Company on matter. On the other hand, in chapter 2 there are presented the core milestones or work streams along the process that must be reached in order to make a successful M&A deal; hence, it is possible to distinguish five core milestones: Due Diligence Strategy, Due Diligence initial preparation, Due Diligence Program, Due Diligence review and finally the Due Diligence report; nevertheless, it is impossible not to forget the importance that the prior planning (plan to create value) have during the whole process. On the other hand, in chapter 3 are described the major modules of the Due Diligence according to the relevance of its content for the M&A transaction: Financial DD, Legal DD, Strategic DD, Cultural and Organization DD and Operational DD. In this chapter, the five modules are broadly described, but taking into account the most important information of each one. Finally, having as a base the three chapter before, the chapter 4 is oriented to propose a Due Diligence structure that may be used by consultants, while chapter 5 represents an assessment of the most important instruments that may be used during the Due Diligence process: checklists, program, request list for the Data Room, questionnaires for management interview, SWOT analysis, among others. In summary, this paper pretends to bring the basis for making an accurate Due Diligence process that allows the acquiring Company to take the best M&A decision. 5

Overall Due Diligence Consulting Concept 1. Designing a suitable Due Diligence process. Author: Ruth Barrios Avilés.

In order to design a suitable Due Diligence process, it is necessary to know what a Due Diligence process is. A Due Diligence process is a detailed and careful research which is part of a step of the merger and acquisition transaction. The basic idea is to ¨assess the benefits and the liabilities of a proposed acquisition by inquiring into all relevant aspects of the past, present, and predictable future of the business to be purchased¨ (Distler, 2016). This process identifies different kinds of risks such as legal, strategic, cultural, operational and financial risk. It also complements the investment thesis, collects information and produces insight for the future agreement. Time and costs are factors to take into account as well as deciding what would be in the scope of the Due Diligence process (Gole & Hilger, 2009). Usually, this process is made by the buyer to have a clear picture of what the buyer will acquire and it´s duties in relation to the firm. The topics to consider in this process are legal and business actions from the company to evaluate. The first step of the Due Diligence process is the formation of a team and it is important to create a checklist of the information that the participants will need for the process. The process has to be designed with the goal of checking the currently recorded data or searched data as well as information that might not even exist (Harroch, 2014). In perfect situations, the dealer or seller should share the information, alternatives, and resources of the company to develop the Due Diligence process smoothly. As well as giving enough time to the possible buyers to consider the sale. In reality, it is not like that, the sellers acquire external advisors to manage the sale and represent them. Sometimes this provides documentation and usually, it produces getting the information step by step at a slow pace (Gole & Hilger, 2009). The seller has to comply with the buyer in order to share all the information of the company in the game. The buyer is in charge to define which information is needed. The Due Diligence process takes around ten days before the final buy is made and is a two to six-week process

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during the merge and acquisition steps. Once a risk is identified by the Due Diligence team, the investor must be notified. The process has to be effective, efficient, well-structured and perfectly conducted. The development starts after a settlement with the board and the target in custody (Gole & Hilger, 2009). In the following chapters the steps and factors, how to perform a suitable Due Diligence process will be presented. Taking into account that it is fundamental to get the whole picture of the company that would be acquired, and to develop the merger and acquisition accordingly.

1.1. Stage 1: Create a Due Diligence Strategy and Timetable. “A business which fails to plan, plans to fail”. Without a structured objective, an optimal Due Diligence process can fail. The purpose of the Due Diligence has to be designed. The key matters to address have also to be defined. What area creates value to the concerning company? This question has to be answered in the process. It is also important to create a hypothesis for the investment. These objectives should be determined as market share, geographical access, financial synergy and the projections of the future. They also have to elaborate the action plan. The formulation on how to execute the Due Diligence does not have to be forgotten (Herndon, 2007). The attractiveness of the deal also incurs in proving the target’s financial projections and other synergies in the external area. What changes can be expected over time, how competitive the company is. What could be the opportunities and threads for both, the customers and the company? This previous analysis is important to create the strategy of the process (Adolph, 2006). Time will be a deal breaker, a well elaborated scheduled would help for the success of the process. The buyer must try to have the methods standardized or use software to make the steps quicker. After defining the strategy and roles of the professionals involved in the Due Diligence, the process can officially start (Adolph, 2006).

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1.2. Stage 2: Build a Due Diligence Team. To design a suitable Due Diligence process, first of all, it is necessary to create a Due Diligence team. The team should be integrated by professionals or external consultants per area and a team leader in charge of guiding and organizing each sector. If the participants have experiences in merge and acquisitions the better for the team. It is important to build a timetable for better results (Gecapital, 2017). The departments that the team should work are finance and accounting, business development, legal, human resources, information technology, sales and marketing, product management, production/operations. The three most important areas are: legal department, where contracts and agreements of any type have to be analyzed; finance department, to research about the market of the company, future revenues, competitive position, collect information for the valuation; and strategic department, where the strategic projects are presented, SWOT analysis, core competencies, competitive advantage, potential extensions and different market scenarios (Gole & Hilger, 2009). If the workers from the firm do not have the expertise needed, outsourcing would be ideal. For example, to count with an expert from an investment banking for the financial area and a lawyer for the legal part. The best would be a combination of internal and external sources (Gecapital, 2017). Once the team is established the leader of the team has to organize the communication channels between the team and the tasks and responsibilities that each of them should perform in their assigned area. Sub-themes or subtopics of areas to research has to be as well distributed (Gole & Hilger, 2009).

1.3. Stage 3. Preparation and exploratory research. After the Due Diligence team is established. The next step should be preparing the documentation that they need. Each of the members will prepare a part of the whole Due Diligence. The documentation required is the following:

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

The strategy to generate value or the firm´s practical similar that drafts the presumptions on the transaction’s skill to improve the corporation value.



Firm products information, materials and publicity documentation.



Preliminary information that should have been given by the dealer or the external agent.

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A simple, explicit Checklist.



Projected expectations, revenues, and synergies (Gole & Hilger, 2009).

It is important to select the sources that each player of the team intends to use. The quality of the process will be regulated by the sources used. For example for internal sources: site visits, interviews, management presentations, any documents of the target in the data room. And for the external references: IB reports, Internet-based reports, customer surveys, specialist interviews, competitor & supplier inquiry, benchmark-studies, secondary statistics, consultants analysis (Herndon, 2007). Afterwards, the team members can start the preliminary research. The team should target hidden facts, financial misstatements, uncertainty about customer base, liabilities, and management questions among others. The members have to review each area and search for evidence that changes value (negative or positive) or supports the current hypothesis of their department (Herndon, 2007). The data is prepared and the team has to work with the to-dolist and control it at the same time.

1.4. Stage 4: Execution of Due Diligence and presentation of results. 1.4.1. Execution of Due Diligence. The execution of the process should be finished. All the investigations must be done as planned and following the program and the to-do-list. Team players muss administrate an extended analysis. The team should revise external information like the annual report, manuals, charts, employee’s communication, industrial journals and all the information the company possesses. This is called the data room. Where the seller allows the collections of the documents of the firm. Each member has to review each internal documentation given and the key performance indicators. Not only physical data has to be overproof, also online references like the website of the company (Herndon, 2007). 9

The goal is to find deal breakers signals and hidden details. Management interviews are a key element to get an useful conclusion. Interviewing executives with a standard process should double check the information received. Also to elaborate on-site visits and observation (Gole & Hilger, 2009). The components that a suitable Due Diligence process are express in the following graphic, but to have accurate results it is necessary to extend the components and analysis more. The key is not to forget details that could be enlighted in the process. A deep examination also on expanded components of the Due Diligence process such as Sarbanes Oxley compliance risk, integration risks, cultural analysis and human capital (Herndon, 2007). The following graph shows the execution of a suitable detailed Due Diligence process with some questions to verify the work to be done.

Figure 1. Expanded Components of Due Diligence (Herndon, 2007)

1.4.2. Presentation of results. An explanation of the risk finding should be detailed in a report. The team members must elaborate and review a report with the summary of the process that they made and their final conclusions and recommendations. It is even better if the team players can proportionate facts 10

for the integration process, tasks and plans. A presentation should be scheduled to analyze the results (Herndon, 2007). To conclude all the necessary elements to develop a suitable Due Diligence process will be listed as follow: 

Prioritize the issues to be addressed in the Due Diligence and focus on value driver.



Assign clear roles and objectives to the Due Diligence team. Avoid repeating the task in the team.



Create a time scheduled for the team members and a standardized report system which increase efficiency and facilitates management.

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Keep the team updated with any new findings, objectives, changes and share data.



Install a clear and simple communication channel between the groups of professionals developing the Due Diligence.

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If permitted, create copies of the data received.

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To maintain a log of the issues targeted organized by relevance. This log will be useful in the conclusion summary stage of the process.

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Review and proof link and volume of synergies.

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The Due Diligence should review the price of the premium paid, that should be taken into account in the conclusions (Gole & Hilger, 2009).

2. Core milestones of the Due Diligence process. Author: Evangelina Gómez Canto.

Mergers and Acquisitions (M&A) are intrinsically risky investments decisions, and they may become even more risk when the acquiring Company bases the final decision in weak assumptions due to the lack of wide knowledge about the target Company (Gole & Hilger, 2009). How it was explained in Chapter 1, Due Diligence is the sub-process within M&A Transaction Management that brings to the acquiring Company the critical information needed about the other Company, which includes legal, financial, operational, organizational, cultural, structural, and other specific aspects ( GE Capital Corporation, 2012) that allow it to minimize risk and bring confidence about the acquisition, its respective price and the value that may create for the Company (The Boston Consulting Group, 2017). In chapter 1 the 11

process to design a suitable Due Diligence was described through major stages, nevertheless, in this chapter, these stages will be analyzed in more detail, as core milestones of the Due Diligence process. The next Figure summarizes the main milestones that integrate the Due Diligence process.

Milestone 1 DD Strategy

Milestone 2 DD initial preparation

Milestone 3 DD program

Milestone 4 DD review

Milestone 5 DD report

Figure 2. Core milestones of the Due Diligence process.

2.1. Due Diligence initial planning. This is not precisely a milestone but it has a large importance for ensuring the success of the rest of the Due Diligence process. For creating value through M&A, the Company needs a clear Strategic purpose for the acquisition, which means that the Company should know the exact reason or the value that expects increase through the transaction. Only in this way, the purpose may be transferred to the Due Diligence team for implementing a successful investigation. For example, if a company wants to increase technological performance through the acquisition, the objective of the Due Diligence team will verify the key expectations about technology (Gole & Hilger, 2009). It seems that defining the reason of the M&A is pretty simple but the reality is that first it was needed an exhaustive analysis, which includes the following elements: o Strategic assessment. The evaluation of all aspects around the Company, as the macro and microeconomic environment, the market trends, changes in demography, technological advances, etc., in contrast to the current weakness and strengths of the Company for determining where is needed to invest (which market). o Market targeting. This step includes the evaluation of the identified market, followed by an analysis of the competitors. The last analysis brings to the Company a clue for deciding to invest in own sources, partnerships or M&A; in the last two cases, it also identifies the possible target companies.

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o Investment Objectives. The final step is to determine the specific purpose of the investment. For this is also needed to select the final candidate or candidates for the acquisition or partnership (Gole & Hilger, 2009). As this paper is focused on the case that an acquisition was chosen, the next Figure shows the process for selecting the best candidate, also called Company target.

Figure 3. Process for the selection of the target company (Gole & Hilger, 2009).

2.2. Milestone 1. Building the Due Diligence Strategy. The Due Diligence process officially begins with an initial understanding between the acquiring company and the target company regarding the future transaction (Cleverism, 2016). Then, it is necessary to build the Due Diligence Strategy in order to keep the same focus in all stages of the process, for that, the Top Management should establish the key areas and the primary objectives of the process as well as the exact denotation of value for the acquisition, the last, through the definition of the investment thesis and synergy (Feix, et al., 2017). The investment thesis is the clear statement which describes how the company will create value through the acquisition deal, in other words, it remembers to the Management the exact reason for doing the transaction (Harding & Rovit, 2004); on the other hand, in M&A the synergies are oriented to generate added value due to the fact that combination of 13

two parties produces an effect greater than the produced by each party individually, which represents a financial benefit for the acquiring Company (Eliasson, 2011) (Gole & Hilger, 2009). Furthermore, there are two essential tools that may be useful for the definition of the Due Diligence Strategy: the Letter of Intent (LOI) and the Non-Disclosure Agreements (NDA) (Feix, et al., 2017), both will be explained next: Letter of Intent (LOI). The letter of intent is a written document which contains key elements for the M&A transaction, including sale price offer, timeline proposal, structure (stock, cash, vendor takeback, earn-out, etc.), and primary terms of the deal, (Tequity Inc., 2017). The LOI should be signed by the involved parties, despite on being a non-binding agreement - not prescribed by law – because it represents a moral obligation between the parties. Likewise, it is important to mention that the use of this tool is not mandatory, nevertheless, it is highly recommended because it is very helpful during the transaction and it avoids the time wasting due to the key elements of the deal were outlined since the very beginning (Vertess Advisors LLC, 2017) (Tequity Inc., 2017). Non-Disclosure Agreements (NDA). The Non-Disclosure Agreement is a legal tool that brings the logistic and legal guidance for the transfer of information. This kind of agreement complies with the main purpose of protecting the information by restricting the use of confidential material which otherwise may be used in benefit of the counterparty or other external parties (Lewis, et al., 2009). Thus, the NDA should include the specification of the value of the information, the extent to which this is known inside and outside the company, the measures used by the company for protecting this confidential material, among other relevant factors (DLA Piper LLP., 2012). The importance of this tool relies on that during the Due Diligence process is necessary to ensure the accurate flow of information between the parties, in order to assess and deciding if the acquisition is feasible for the Company (Lewis, et al., 2009).

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Finally, it is important to mention that the Due Diligence Strategy may vary from one Company to another because it depends on the specific purpose that the Company pursues, and other relevant factors discussed before, for that, it is necessary to spend a considerable time for determining it correctly.

2.3. Milestone 2. Due Diligence initial preparation. After the definition of the Due Diligence Strategy, the next milestone is the initial preparation for the process, which includes the design of the Due Diligence plan and the selection of the Due Diligence team (Feix, et al., 2017). For designing the Due Diligence plan is necessary to settle the main assumptions, opportunities, and risks of the acquisition, in order to identify the priorities of the Due Diligence process that later will be transferred to the Due Diligence team; hence, the main function of this plan is to serve as a guide for ensuring that all the process will be oriented to generate value (Gole & Hilger, 2009). Once the plan for generating value is established, the Company should make an accurate selection of the internal sources and the external support needed (advisors) for implement the process, i.e. selecting the Due Diligence team (Feix, et al., 2017). The importance of working with external support relies on the fact that they bring knowledge, experience, speed, objectivity, and confidentiality to the process, nevertheless, their function should be giving advice not making decisions, for that, it is important that the Company founds the way of keeping the control during the whole process (Howson, 2003). However, many companies are not sure about how to select the accurate Firma for external support, for that, is necessary first to establish the specific services needed according to the Due Diligence plan, and secondly, evaluating the possible candidates according to their skills and experience, but also taking into account interpersonal factors, only this way is possible to select the best advisor (Howson, 2003). It is also important to mention that the team should be a diverse group, this means that it should be integrated by members – both internal and external – with expertise in each of the main areas defined in the Due Diligence plan (financial, legal, operational, strategic, management, audit, etc.) (Dykes, 2012). Doing a Kick-Off meeting is the best way to ensure that all team members are at the same level of knowledge (Feix, et al., 2017). On the other 15

hand, the expertise of the team is independent to its size, actually is best to integrate a small group, because it will avoid the inefficiency and the dispersity of information, also because it is easier to reach agreements in small groups than in larger groups (Howson, 2003). Once the Due Diligence team is integrated, is essential to set up the responsibilities and duties of every team member based on the main elements of the Due Diligence plan, and to establish the communication plan which ensures the constant flow of information through regular updating meetings (Howson, 2003). In addition, during this stage is recommendable to prepare a Non-Disclosure- Agreement (NDA) for the team members for protecting the information (Feix, et al., 2017).

2.4. Milestone 3. Development of the Due Diligence program and preliminary review. After integrating the Due Diligence team starts one of the most intense stages of the process, which includes the development of the Due Diligence program and the preliminary review phase. In this intense stage, the acquiring company is anxious for doing the first investigations (Due Diligence review) and validating the assumptions established before, while the seller company is engaged to show its business under its own conditions for sharing information (Gole & Hilger, 2009). “The Due Diligence Program is the ‘playbook’ used in conducting the review” (Gole & Hilger, 2009), it includes the delimitation of the procedures needed for obtaining information of the target company and validating the key assumptions established in the plan for creating value. For that, once that the team members have clear the key elements of the Due Diligence process and their roll on it, it is necessary that they develop individually the part of the program according to their specific area, the result should be a document which clearly defines the objectives of the review, and at the same time it should bring the guidance for conducting the investigation with focus on the key issues of the respective area. The document also should allow reviewers to reach conclusions and detecting fails in the assumptions of the Due Diligence plan. In summary, the objectives, the procedures and the conclusions/recommendations are the main information that the Due Diligence program should include (Gole & Hilger, 2009). 16

After all the individual parts of the program are done, it is necessary to realize a meeting under the direction of the leaders of the project in order to fulfill the following goals: o Complete the program. The person responsible for each area should present the final version of its respective section of the program to the team leaders, then, they should assess the content and make corrections if is the case. o Enhance team cooperation. The cooperation between team members is essential during the whole process, and it is the key to its effectiveness, for that, it is necessary to encourage the continuous interchange of information within the group. The leaders of the team should be informed about all new findings, and views and they are also responsible for deciding with whom, how and when this information should be shared. o Identify and resolve overlaps of information. In many occasions, the same documents are reviewed by different team members but with different perspective according to their respective area, in those cases, it is mandatory to realize a cross-check of findings and conclusions. o Transfer logistical information. Information about timetables and location for the review, as well as the respective duties of each team member, should be communicated through a memorandum, in order to avoid misunderstandings within the team. o Tackle potential deal-breakers. Identify issues which if are not solve could cause the failure of the deal, for example, financial mistakes, hidden information, all kind of doubts about the finance, management or operation of the company, etc. (Gole & Hilger, 2009) (Feix, et al., 2017).

Finally, to this stage/milestone also correspond the respective preparation of the tools that will be used in the next stage: Due Diligence questionnaire and request list for the document review, the onsite visits plan, and the management presentation and interview guides, each of them will be explained in the next milestone.

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2.5. Milestone 4. Execution of the Due Diligence review. The Due Diligence review includes two main elements: an exhaustive review of the target Company’s documents corresponding to the areas established in the plan (financial, legal, business, etc.); and the bilateral communication between the Management team of the seller (target) Company and the Due Diligence team, the instruments for ensuring this adequate communication are: management presentations and interviews. In addition, the onsite visits are other instruments that may be included during the review, but its use will depend on the relevance for the specific business to review (Gole & Hilger, 2009). All the elements mentioned before will be explained in this section: Management Presentations Usually, the management presentations introduce the process known as ‘Due Diligence review’, hence, its main purpose is to ensure an accurate understanding (of the acquiring team) about the business and market of the target company. The second purpose of the presentation is to assess the management team as a whole but also to every team member individually. During management presentation the offering document emitted by the seller is very useful, because it contains the main information about the business (products and services, market, financial performance, organizational structure, etc.), thus, in case that this document exists is advisable to base the presentation on it (Gole & Hilger, 2009). Management team Interviews. The management interviews are instruments used during the review process for developing and tackling areas of concern. Usually, there are formal and informal interviews; the formers are commonly meetings by functional area which includes several participants and an established timetable; while the lasts are more casual and flexible interactions. Whatever the type of interviews, what is really important is that the Due Diligence team ask for the face to face interactions as much as necessary, for asking the questions needed for approaching accurately the areas of concern (Gole & Hilger, 2009).

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Document review. During the last stage (milestone), the Due Diligence team requested to the seller company all the documents needed for the review process (request list); however, only after all the asked materials have been collected and prepared is possible to move on the next stage: the revision (Dykes, 2011). The document review is a key element of the Due Diligence process because it allows the acquiring Company to corroborate all the information provided before by the seller company through the offering document, management presentations, management interviews and others; later on, this procedure also allows to incorporate representations and warranties in the sale/purchase agreement. Nevertheless, it is necessary not forgetting that the true importance of this process relies on the validation of the assumptions established in the plan to create value (Gole & Hilger, 2009). On the other hand, the called ‘Data Room’ is indispensable for the document review, which is a physical or virtual space where financial, legal and business documents are shared for being examined by the potential acquirers. Traditionally, these rooms where only physical however due to the technological advances nowadays is possible to use virtual data rooms or even online data rooms (Dykes, 2011) (Gole & Hilger, 2009). Onsite visit. The onsite visit also knowns as ‘tour of the facilities’ is a common practice during the Due Diligence review process and it represents the best opportunity to certify processes and crosscheck compiled information regarding the business’ operations (Swiss Analytics, 2009). This process also allows to verify the way in which the business is run and to identify improvement areas for implementing after the acquisition. Nevertheless, the relevance of using this instruments vary from one business to another, because this kind of visits contribute more information when the business has manufacturing or more complex operations for example (Gole & Hilger, 2009). In summary, the review process represents an intense stage which allows making a deeper analysis of the target Company for verifying information, identifying opportunities and risks, detecting deal breakers and finally validating the synergy thesis. 19

2.6. Milestone 5. Development of the Due Diligence report. Once that all material has been analyzed, a process that may last weeks or even months, it possible to reach either of two different outcomes: going ahead with the acquisition or not going (Dykes, 2011). In the first case, the results of the review may renegotiate some major terms of the deal, for example, the purchase price, the structure of the deal or any other. In the second case, the decision usually may influence by different inconsistencies between the information presented by the Target Company and the findings of the Due Diligence team during the validation of the key assumptions established in the plan to create value, or because the acquisitions represent too much risk for the Acquiring Company. Nevertheless, whatever the final outcome, is necessary to prepare a report justifying the decision, for later arranging a management presentation with the main purpose of communicating the findings, explaining the decision and renegotiate contract terms if is the case (Feix, et al., 2017) (Gole & Hilger, 2009). To summarize, during this chapter it was presented the core milestones/stages of the Due Diligence process, regarding this, it is important to remind that the starting point of the process is to stablish the Due Diligence plan to create value, only once the plan is completely clear is possible to move on the follow stages: 1) To build the Due Diligence Strategy, 2) To start with the preparation of the process, 3) To Develop the complete Due Diligence program and to make a preliminary review, 4) To implement the Due Diligence review of the legal, financial and business documents of the target company; and finally 5) reach conclusions and prepare the respective report explaining if the acquisition will proceed or not. Thus, the success of the Due Diligence process will depend on the ability of the Due Diligence team to perform accurately each of the milestones mentioned before.

3. Most important Due Diligence modules. Author: Rafael Arturo Duarte Castro.

In the Due Diligence process, the acquirer must examine every part of the target company, hence the acquiring party must execute Due Diligence process in different fields. This most important fields that integrate the modules of DD are the financial, the strategic, the operational, the legal and organizational Due Diligence. 20

Financial

Human resource and cultural

Legal

Due Diligence modules Strategic

Operational

Managment

Figure 4. Due Diligence modules. Source: Self-made.

3.1. Financial Due Diligence. This is one of the most important components in the analysis of the target company. This process requires the analysis and test the Audited Financial Statement. But it must be highlighted that this process is not an audit, because Financial DD, unlike auditing, it doesn’t focus only on the past but also in the future, it will not go very deep in the numbers and instead it will focus more on finding the reason behind this numbers and what do they have to say about the company (Feix, et al., 2017), (Howson, 2003). The process includes methods such as interviews and discussion with the management team and key employees and to speak to the auditors. This is necessary to a better understanding of the company and the underlying probability (Howson, 2003). Objective. The main purpose of Financial Due Diligence is to provide a complete understanding of the actual financial situation of the target company to detect risk and opportunities prior to closing the deal, as well as assuming future financial situation to subsequently give the

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acquiring party better valuation of the target company (Feix, et al., 2017), (LehmanBrown International Accountants, 2014). The 4 key points that Financial Due Diligence aim to provide are: o Verification of the numbers: It is important to make sure that all data provided on which the offer is based, are reliable. Also, the buyer could make a bad assumption in the performance of the target company. o Identify deal breakers: Accounting or legal aspects that need warranties or indemnities like undervalued of assets and liabilities, adequacy of provisions and potential black holes like under-funding pensions etc. o Tools for negotiations: These are the elements that the acquirers could use on the negotiation table. Examples of these tools are: Highlighting risk, highlighting liabilities, challenging forecast, difficult accounting treatments, down-rating past performance, etc. o Maintainable Profit: Understanding the business it is very important to forecast the profit that the target company is capable to make. These processes aim to reveal if the future performance of the business will be similar to the past and other elements such as clients and if suppliers will continue with the company (Howson, 2003). Elements of Financial Due Diligence report. To be able to achieve the purpose of the Financial DD is necessary to cover all elements of the report by following the next steps: 1. Verify the quality of the information system and accounting: The first step is to ensure that the accounting reports and management systems are reliable. This part of the report cover elements such as accounting policies and practices, management information, control procedures, computer systems etc. 2. Analysis of the financial performance: The next step is to analyze the past and actual financial performance of the target company. This is a key element of Financial DD and includes 3 main elements: The Profit and Loss Analysis- Break down the figures to understand where the profits come from, also the performance indicators such as EBITDA, EBIT, ROIC, etc. Is 22

necessary to understand the past to be capable to analyze the possible trends of the elements that could have implications in the results. Balance sheet- It similar to the P&L section, it breaks down numbers in each section of the balance sheet to find key elements. In the Assets side examine primarily if the composition of the fixed assets and if they are correctly valued, depreciation policies, required capital expenditures etc. and also individual currents assets like the inventory and accounts receivable. In the passive side, analyze the financial structure and elements of the debt and receivables like the age, trends, consistent policies, and vulnerability to large liabilities such as Pension funds. Cash Flow analysis- Cash flow decomposition is very appreciated in the valuation of the companies, is used in the analysis of the relation between profit and cash that may reveal the most important cash drivers. Also, possible projections of the cash development 3. Normalization of the earnings: The third step is to take out the effect of Non-recurring and Non-periodic of the results to improve the forecast of the results development. Examples of these are legal climes, restructuration costs, change of accounting policies, supplier bonus, the release of provisions etc. 4. Budget performance: The next step is to analyze the budget forecast and performance of the target company. It is very important to understand the process of the creation of the budget and how effective is in the reality. 5. Net debt: This step important to analyze the debt for a prosaically value of the company. Not only the cash position and other liabilities, but also future and undiscovered debts. 6. Management summary: Collection of the most important points from de Financial DD from the Top-Management perspective. (Feix, et al., 2017) (Howson, 2003) (LehmanBrown International Accountants, 2014). 3.2. Legal Due Diligence. The module seeks to make a comprehensive assessment of the possible legal risks of the target company such as legal disputes, labor contracts, intellectual property and other assets.

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From the acquisition side, is very important to clarify and consider legal issues before buying; in other words, to know what the company is buying (PwC, 2017), (Feix, et al., 2017). Objective. The purpose of Legal DD is to minimize the risk of unknown liabilities bye covering 3 areas: uncover potential liabilities, find legal or contractual obstacles and form the basis of the final agreement (Howson, 2003).

Uncover potential liabilities. When a company acquire another company, not only acquire the assets but also the actual, future and contingent liabilities. That is why the acquired company needs to be sure that there is not hidden important liabilities that could change the price of the acquisition or bring problems in the future. These hidden liabilities could sometimes are not recorded in the accounting records a need to be found somewhere else. The most important areas that layers need to works in the target company are pensions, contractual issues in the financial area, environmental obligations, intellectual property, contracts, litigation and the legal structure of the target company (Howson, 2003), (Allen, 2017). Legal and contractual obstacles. The company needs to be sure that there is no legal concern regarding the shares that were previously sold. To be able to do so, it requires to do: 1- Exanimate all documents regarding the issue, transfer, approval, and registration of the shares. 2- Inspecting shareholders´ certificates, and 3- Verify that there are no changes in the share to be sold. Other legal obstacles that need to be verified are regulation issues such licenses, permissions, registration, etc. and consents and releases such as pre-emptions rights and debenture release from a parent company (Howson, 2003), (Allen, 2017). Take part of the basis of the final agreement. All the information of the legal Due Diligence will be included in the disclosure letter and in somehow in the agreement. This means that this information needs to be in the final 24

agreement and basically says who pays what liability. But before complete the transaction, an agreement need to be made for purpose of: making sure the parties complete the transaction, ensure that the target company don’t do significant changes to the company before the transaction is complete, and arrange scenarios in case something emerge that should be disclosed (Howson, 2003). 3.3. Operational Due Diligence. When a company acquires another company it aims to acquire the value creator of the company. Unfortunately, without the complete understanding of the operating of the business, can cause that some operational issues are ignored and lead to unexpected cost and problems of integration, difficulty in the implementations of the operational strategy and problematic post-deal process. The operation process of the target company may not work or need adjustments once integrated to the Acquirer. That’s why in Operation DD is important analyzed the complete value chain of the target company to reveal the operation reality behind the financial numbers and understand the key value creators. The buyer full knowledge of the target company is a key factor for a successful acquisition (Feix, et al., 2017), (Laven Partners, 2014), (PwC, 2017). Objective. The purposes of Operational Due Diligence is to give a clear understanding of the operation of the target company by providing: 

Key operation drivers.



Identify technical treats and operational risk.



Analysis of the sustainability of current production methods and identify costly and inefficient business processes.



Areas of opportunities for improvement such as growth in income and cost reduction.



Information to develop a plan to create maximum value.



Synergies review between the buyer and acquired company.

(Corporate Finance in Europe, 2017), (PwC, 2016).

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Process. The process can be divided into 3 phases: Phase 1- Learn about the organization: This phase is to get familiar with the company and how is organized. Is important to identify the main activities to understand to be able to understand the revenues and expenses. Phase 2 - Analyze the value chain: The next phase analyze the core activities, business environment, and operational and business process. The value chain is different for every company. The next Figure shows an example of activities:

Figure 5. Value chain activities, (Feix, et al., 2017).

Phase 3- Identify key factors: Compare this activity with other companies of the industries or with the benchmark to identify opportunities, savings and investment requirements. Phase 4- Results: The results of the Operational DD depends on the acquirer objective and assignment. The results are the outputs from the prior phases and form an important part of the integral Due Diligence. (Mass, 2016), (Feix, et al., 2017).

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The activities of the Operation Due Diligence are very important to certify that the target company is compatible with the business plan and could add value and synergy to the buyer. Is also important to ensure a successful post-acquisition integration. 3.4. Management Due Diligence. Management Due Diligence focuses on measuring the management quality and assesses organizational structure. Although no many companies carry out this module, Management DD is very important due that acquisition of a good management could add value to the company or in case of a bad management, fail to carry out the strategic plans. (Howson, 2003), (Feix, et al., 2017). Objective. Management DD purpose is to, identify the key integrations issues, prepare the integrated future structure and examine the management, as a team and as individuals, if they will be needed for the new structure (Howson, 2003). Process. The process embraces collecting information from documents, references and observation but mainly by individual interviews. The interviews evaluate coalification and competences of the managers and examine other contract issues (Howson, 2003), (Feix, et al., 2017). 3.5. Human resources and cultural Due Diligence. H&C DD is useful to understand the composition of the target company in terms of the employee structure and culture so the buyer can take a decision. Human resource and cultural Due Diligence deal with the employee before, during and after the acquisition and it is a relevant factor in the success of the strategy implementation. One of the main problems is that many talented people leave the company few years after the acquisition due to the lack of integration. H&C DD helps to assess this kind of problems (Howson, 2003), (Haring & Rouse, 2007).

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Objective. The human resource and culture Due Diligence purpose to structure the workforce and make possible a smooth integration assessing both cultures for a post-integration culture. The principal goals are: 

Identify and prioritize issues in the human resource that need to be assessed during and after the integration



Identify potential cost and risk of the employee's liabilities.



Identify cultural difference.



Creating new policies for the new organization



Selection and retention of the employees



Create a compensation program



Post-integration strategy.

(Howson, 2003), (SHRM, 2016), (Feix, et al., 2017). It is very important to consider the human factor for a successful implementation of the strategy. In many countries like France, is not easy to dismiss the employees so this type of issues could be counterproductive if the strategy is to shut down the business unit. Here is the importance of HR&C DD because makes sure that there is no problem between the buyer´s plans and human resource before and after the transaction. 3.6. Strategic Due Diligence. This is one of the most important modules of Due Diligence. Strategic Due Diligence doesn’t focus too much on the past but instead in the future of the target company. It aims to give a forecast analyzing the company future prospects, strategic direction, and possibilities. It focuses on the dynamics of the market, commercial forecast, company competitive position, and company core-competences, (Howson, 2003). Objective. The purpose of Strategic Due Diligence is to give a forecast of the future performance of the target company so the buyer can make a decision from the complete understanding of the strategy, combined and individual, (Howson, 2003), (Feix, et al., 2017). 28

Strategic Due Diligence development. To achieve the objective of the Strategic DD, the next stages are suggested: 1. Company analysis: In this first stage, the DD will focus in analyzing different parts of the company such as market attractiveness, decomposition of the portfolio, strategy direction, value chain, the position of the company in the industry etc. 2. Differentiation and weakness: The next stage is to find the value originators and risks of the target company by determining the core competencies and weakness with SWOT analysis and analyzing the business model. 3. Strategic program and forecast: The third stage is to consider all the information and make projection by looking to the strategic programs of the business units. 4. Synergies: The next stage is to analyze the real synergies between the 2 companies and value the company as a stand-alone company and look for possibilities of improvement. 5. Complete with Financial Due Diligence: To be able to give a better forecast, Strategic DD and Financial DD should work together. For example, analyzing the growth of sales compared with the market size, or the cost saving is aligned with the strategy, etc. By doing this, the forecast of the future performance would be more precise and will affect the course of the transaction. (Feix, et al., 2017), (Bain & Company, 2017). 3.7. Other Due Diligence Modules. In the Due Diligence process, if some business sector is very relevant for the company, other modules could be required. This is the cases for Environmental DD, Intellectual Property DD, Antitrust DD, etc. Usually, these modules form part of others modules.

4. Structuring as a consultant the Due Diligence process. Author: Rafael Arturo Duarte Castro.

Some companies have more experience with M&A than others. But in both cases, a consultant in Due Diligence it always recommendable due to the importance of this stage in 29

the M&A process. There are 2 types of consultants, specific consultants who work in a specific module such as Legal DD or Financial DD, and general consultants who give advice about the whole process. The next part is a proposal of Due Diligence structure as a general consultant. The Due Diligence process has a level of complexity, so is important to have a clear structure for the purpose of working orderly and exploit the time for a better performance. The structure proposed is divided into 3 stages and each stage has different activities. The division is made in this way to give to the people involved a clear understanding where they are in the process and what they should be doing.

Preliminaries

Execution

• DD Program • Assamble the team • Warm-up meatings • Data requirment

• Data analysis • Interviews • Onsite visit

Output • Assamble information • Saumary and presentarion

Figure 6. Consultant structure. Source: Self- made

4.1. Due Diligence Preliminaries. 1- Once the company has developed the strategic Due Diligence, the first activity is the Due Diligence program. Here, the company defines the extension and time of the process. Determine what the most important aspects to cover are and which Due Diligence modules are going to use. Each company is different, this means some companies need modules like environmental Due Diligence and others would cover this part as Legal DD. 2- The second activity is to assemble the team. The company has to choose the size of the team and the people that are going to work in each module. The people chosen need to be according to their knowledge and expertise and, if necessary, work with external advisors.

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Once the team is made, it is important that they understand the goal of the acquisition, timetables and the DD program to maintain the focus all the time on the objective. 3- Warm-up meetings. The next activity involves the management of the target company and key employees. Here is where general presentations by the managers are made. Each of the team modules would start having the first information of their respective area. 4-

The next activity is required data and establishes a communication plan. Each module

team will make a checklist of the information they need. Also, it needs to be decided who can provide the information, by what communication channel, who to approach, etc. 4.2. Due Diligence Execution. 5- The next step is to analyze all the data provided by the target company. Break down the numbers, review legal documents and operation procedures are some example of this activities. 6- After the reviewing, the data and information, managers and key employees are interviewed to get more accurate information. 7- Another activity at this stage is the onsite visit. This activity helps to find improvement and risky areas. 4.3. Due Diligence Output. 8- In the last stage, all the information of the modules should be compiled to a better understanding of the company. 9- The last activity after months of work is the presentation of the results. From the outcome of the Due Diligence, a decision should be made.

5. Possible instruments for a Due Diligence process. Author: Ruth Barrios Avilés.

There are different instruments that would be useful in the Due Diligence process. The tools are distributed during the whole process of a Due Diligence. There are also instruments 31

needed for the different areas and stages of the Due Diligence. In this chapter, the main instrument for the Due Diligence Process including some of the instruments needed for each type of Due Diligence will be described.

5.1. Checklist. A useful tool in a Due Diligence process is the checklist. Always elaborate a comprehensive checklist for each area that will be evaluated. This instrument induces main questions to be reviewed in each area of work. The questions have to be precise and relevant to the department being analyzed (Gole & Hilger, 2009). For example, what should a checklist for the legal area contain? It should be a sheet of paper with the following clear and detailed information:

Figure 7. Legal Checklist example (Gole & Hilger, 2009).

The checklist is created with the aim that each member of the team is supported by its valuation results. The list should be made to each sector to get the most accurate conclusions of the Due Diligence. It helps the team players not to forget any key point details. This checklist was an example but it does not mean that this is the one to use in each Due Diligence process. The checklist should be designed according to the company in the game and it should be reviewed (Gole & Hilger, 2009).

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5.2. Due Diligence Program. The Due Diligence program presents a simple arrangement of a document with the objectives of the area to develop. The team member can review what he is missing and what else to add that was not included in the program. After the objectives are described the findings and recommendations come next. The team player has to explain and show the risk or factors that he or she found and how to prevent it or target it. Also, it has to be a clear well-defined redaction and standardization for the whole team (Gole & Hilger, 2009). Here is an example of the program that each team player should have for each area being reviewed. The questions can be more extensive. That depends on the company in the matter and the team leader agreement with the members.

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Figure 8. Legal Due Diligence Program example (Herndon, 2007).

Not all the programs have the same questions because it has to be elaborated according to the department of the area. For example, one program from the Due Diligence of the marketing and sales department should have questions, such as what is the projection of the sales or what is the sales strategy. In this case, they won’t ask for the agent agreements as in the legal program, the member should request the historic and projection sales of the company (Gole & Hilger, 2009). The program has to be special for each area and has to be reviewed by the team leader in order to succeed. 34

5.3. Due Diligence Data Room Request List. The data room can be virtual or traditional, in a room with documents and meetings. The most common data room is the traditional one. This is where all the data from a company is found. It is usually located in the firm or in the lawyer's department. The cost of allowing the use of the data room to participants all over the world is high (Lorca, 2017). Now the use of a virtual data room gets more common. The virtual data room presents all the documentation in an online platform. It can also give a different kind of access to the participants whether it is restricted or completely granted. The virtual data room reduces the costs in a Due Diligence process because all of the members can easily connect from all over the world and they are geographical more flexible (Lorca, 2017). The Data Room is where all the documents of the company are given to the buyer. There has to be a request list, naming all the documents needed for each sector of the Due Diligence. This request list has to be shared with all the team members involved in the Due Diligence process. The data room is usually given for a short period of time around one or two weeks. The data room is open for the possible buyers and it is made in such a way to motivate the buyers in a competitive way, but it also limits the skills of the reviewers to find any dangerous sign due to the limit time spent in the data room (Gole & Hilger, 2009).

5.4. Site Visit Guide. Site visit guide is an extensive instrument helps to organize and implement the Due Diligence site visits. It evaluates assets and liabilities. It also builds an impression of the target. This tool applies just to a few possible buyers, usually just two. The office should be of the same size, type and have the same system. Once the room is found buyers should fill the data needed from the sources to be reviewed. The dealer should plan this site visits but he just makes guidelines. There is also a host which handles the visit. Most of the time spent in the site visit room should be alone. The site visits should add data that is not given in the written proposal. This tool increases the expectations of the buyers. It is better for the participants to bring a checklist of questions to develop during the visits (The Associate Baltimore, 2013).

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The buyers intend to ask questions related to the difficulties of the company which is being sold. The traders should ask all they can about the product and the improvement potential. The Due Diligence team should select an inside team to attend the site visit. The team has to take notes and afterward brief the whole team about what happened. The agenda is usually respected and it is optimal to save time because it is in the best interest of the host and seller. The team should always take the visit site guide as a tool to collect the information presented (Stratis Health, 2017). Example of a Site Visit Guide:

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Figure 9. Site Visit Guide example (Stratis Health, 2017).

This kind of questions gives a clear and precise idea of the product including the strengths of the product and the weaknesses. Also, it suggests the similarities and differences of the product of the company that is going to be acquired in the merger and acquisition transaction compared to the own products of the different buyers.

5.4. Management Interview Guide. The importance of creating a guide for the interview is not to forget any detail and question. The buyer wants to observe with the manager what they received from the dealer and to hear the point of view of the management about the company. Management interviews are used to receive more detailed firsthand information and to get an impression of the quality and skills of the concerning firm. Who will be interviewed? First of all the buyers have to decide who will be interviewed. The business size and its complexity has to be taken into account. After choosing who will be interviewed a preparation of the questions should be established (Mercer Capital, 2017). The main purpose of the management interview guide is to double check the financial and operational information that was handed to the possible buyers. If there are doubts from the data the management interview guide answers them. Another critical issue is to clear the 37

picture of the future. What to expect in the future? These are questions that the management will answer. The point is to find a leak of the gained knowledge in the previous steps (Mercer Capital, 2017). There are two possible ways to accomplish the interview, by phone or face to face. Usually, it is a policy to make it in person. The length of the interview is around five hours which is within the cost of the Due Diligence process. An outline of the possible questions is created to support the interview (Mercer Capital, 2017).

5.5. SWOT Analysis. A SWOT analysis should be done in the Strategic Due Diligence part. This is an instrument with the objective to get a clear picture of the threads, opportunities, weakness, and strengths of the company. It will show the main factors and key issues of the business. This is important to use in the Strategic Due Diligence process to increase your knowledge of the business about to acquire (Gole & Hilger, 2009). Threats and opportunities are related to the external factors which affect the firm. The strengths and weakness are the internal characteristics of the company. The team player in charge of the strategic Due Diligence process should be the developer of the SWOT analysis. The more data the buyer has, the better. The following graph is a SWOT analysis. Each box should have answers to common questions made to gain a better analysis. Here are some examples of possible questions to consider at the time of using this tool for a Strategic Due Diligence process.

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Figure 10. SWOT Analysis components (Black Smith Co, 2015).

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