Trends on Due Diligence Process
Due diligence is something that is here to stay; over the years the practice of due diligence has only grown and showed how effective it is. But its importance has grown more than ever; But what is it exactly? Due diligence is the process that allows buyers and investors to completely understand target Companies before arriving at a decision of merging, acquiring or investing. For the reason of confidentiality, Companies do not disclose every detail of their operations to every interested Company barring statutory compliances which only gives a bird view of the affairs of the Company. Thus, the due diligence process allows the buyer or investor to gain more insight into the Company, its financial position, it’s people, and how it functions and future sustainability.
Walking through the process
The due diligence process is a critically solid review or audit of a Company, which is usually undertaken before a financial transaction, in most cases a merger or an acquisition. Due diligence aims to ensure that any decision taken regarding the target Company is an informed one and increases the chances of adding more value in an M&A transaction.
Due Diligence Review
This review process brings forward a lot of information on the target Company, across all its operational sectors, may it be financial, legal, taxation, intellectual property, corporate secretarial, operations and human resources. The goal of the due diligence review is to put together the pieces of all the information gathered into a factual story. This mostly involves the people conducting the due diligence process convening and deciding if there exists anything that came out in the process that changes their initial opinion on an M&A deal. It also gives answers such as should a deal go further or what are the potential pain points in the deal and whether they can be avoided or not.
The History of Due Diligence
It was in the 20th century when due diligence practice took a more structured form, and it later became what we know it today. The first time that due diligence was mentioned officially was in 1933, but it will be fair to assume that after the arrival of more sophisticated management accounting methods in the second decade of the twentieth century, the first tentative steps in modern due diligence were taken.
Types of Due Diligence
With respect to mergers and acquisitions, there are typically four types of due diligence:
- Financial due diligence: It focuses on the financial performance of the Company till the present date and ensures that the numbers presented in the financial statements are accurate and realistic.
- Legal due diligence: It focuses on all legal aspects of the Company and its relationships with its stakeholders. Areas which are mostly analyzed include licenses, regulatory issues, contracts, and any legal liabilities that may be pending or foreseeable in the near future.
- Operational due diligence: It focuses on the Company’s operations – especially looks at what outputs the Company makes and how. This is generally considered to be the most forward-looking type of due diligence.
- Tax due diligence: It focuses on all of the Company’s taxation affairs and ensures that its taxes are paid in full to date, pending and undecided tax claims on the Company. Tax due diligence also looks at how a merger would affect the tax liabilities of the new entity resulting by the transaction.
Challenges of Due Diligence
Gaining an in-depth understanding of a target Company can be a highly crucial process hence it requires specialized knowledge. There is a plethora of challenges, but the following are usually among the most encountered: –
- Not knowing what questions to ask: It is extremely important to know in advance what the issues are and what diligence-based questions are needed to be asked to investigate those issues properly.
- Lack of speed in execution: Asking the proposed investor to acquire documentation or information can take time, and it often leads to delaying of the transaction’s closing.
- Lack of communication: Sellers, no matter how willing they are, see due diligence as a hassle, which can lead to impatience, poor communication, and even friction.
- Lack of expertise: There is a chance that you’ll have to bring in some hired help for some parts of the due diligence
- Cost challenges: Due diligence can turn out to be an expensive exercise, running into months and extensive specialist hours.
A number of countries in the European Union are exploring new pastures in the field of due diligence. Let’s have a look at some of them: –
- UK- Recently the UK has seen a noticeable shift in due diligence review related to its Environmental, Social and Governance (ESG) issues, especially in the large transactions. In the past years a buyer might have only a handful of questions on ESG in its due diligence enquiries, but now ESG is a more integral part of both target business planning and investor/buyer value profiling.
- Spain- Due diligence process in Spain has recently started focusing on diversity. All companies in Spain are now required to prepare a detailed gender pay report. Companies having 50 or more employees must come up with an equal treatment plan with their trade unions. Due diligence review in Spain focuses both on compliance with the equal pay obligations and on the impact the corporate transaction might have on those obligations, including whether the deal will trigger certain requirements and how it will impact equal treatment factors or measures to reduce inequality.
- France- In France the employers must inform the Social and Economic Committee about the environmental consequences of the company’s actions or proposals. Due diligence review examines compliance, which might be figured out through the target company’s written documents and minutes of meetings with the SEC.
- Germany- Germany has introduced a brand-new perspective into the due diligence review and that is its employee relations or existence of any anti-employee practices in the companies. Anti-employee representation practices in companies are now being examined more closely. Good employee relations are also likely to become a selling point for any company in the future.
Trends in due diligence
The new focus areas of due diligence will help the firms to make informed decisions regarding their business.
- ESG- So many organizations are realizing that investing in ESG is a strategic and sustainable decision for their business. For this reason, ESG investing is also known as sustainable investing, impact investing, or socially responsible investing. An in-depth analysis of these factors provides a score on how sustainable the firm is.
- Business transformation and restructuring- Transforming the business is a fundamental change in the running of a firm and business restructuring is essential when the existing functioning or strategies become less efficient. Due diligence in this field helps to know whether a turnaround strategy like transformation or restructuring a practical step is to improve the business or not.
- Divestiture- Divestiture means to dispose or sell a part of the business to improve overall efficiency. For example, IBM, Daimler, Johnson & Johnson, etc., have adopted divestment and demergers to concentrate on their core business areas. Due diligence review in this field will talk about better financial performance and operational agility.
The due diligence process is never easy, and it will not be easy in the future as well, but that doesn’t mean that it cannot be efficient and organized. With the presence of a proper framework and workflow, due diligence can be straightforward and productive because in the end the information that is discovered during due diligence is critical to a deal’s success.