Is conducting financial due diligence enough?
Over the last five years, trends suggest that commercial due diligence has increased in popularity. This is due to a number of factors, the obvious ones being that buyers are more sophisticated now and that there has been a shift by private equity away from opportunistic purchases. These factors, coupled with competition from sovereign wealth funds and nervous senior debt providers, are delivering a greater need to understand the commercial and market context of the transaction – even before embarking on the financial due diligence.
Commercial due diligence is considered to be important because the numbers can be checked, double-checked, and even triple-checked, but if you haven’t set the numbers in the correct market context you are likely to be at best missing a trick and at worst wasting your time.
We believe it is crucial that commercial due diligence kicks off first to obtain robust feedback before the financial team wade into the numbers. That way there is some reassurance that they are doing their work in the proper context.
What is checked during commercial due diligence?
A range of activities are performed in commercial due diligence, such as assessing market access and qualification of assumptions (sales forecasts, product/service pricing, margins, cost base, etc). Work performed here will often look at market segmentation and product positioning, timing, the pipeline and the competitive landscape.
Signposting the issues to be explored during financial due diligence is key here. An approach often talked about is the integrated or holistic approach in which the commercial and financial due diligence are performed by the same firm. Others favour the approach that sees the commercial due diligence work completed by one firm while the financial due diligence work is conducted by another.
Either way, these are two services that when combined provide a feature-rich study into the likely prospects of a target in prevailing market conditions. Many deals will only be progressed when all aspects of the business have been explored.
What is the value of operational due diligence?
Tough market conditions are causing many potential buyers to focus on checking all aspects of a target. A few years ago, it would have been much less common to have a detailed review of the operational aspects of a target. Private equity houses have been instrumental in pushing for this form of due diligence. Known as operational due diligence, it involves checks relating to the quality of people, processes, relationships in the supply chain and the quality of the management team.
Work performed here often has real value to all parties and may be used to develop a plan for performance improvement by management. This type of review is also helpful to bridge a gap or deficiency, and so may become a good indicator of synergies for the deal.
How has the downturn affected due diligence?
Target businesses are unlikely to undergo a financial due diligence exercise alone. Demanding market conditions and a tough economy are forcing more potential buyers to complete commercial and operational due diligence, and this in its own right will place great demands on a target while it is courting potential suitors and trying to deliver business as usual.
Buyers should think twice before making the decision to run exclusively with financial due diligence. The commercial context is key and the operational aspects of the business will help to identify opportunities.
Sellers should make the most of the process as it’s akin to having consultants in and looking at the market and operational capabilities. Make it clear that you would like copies, and use the material wisely.