M&A diligence: Buyers and sellers want deeper insights

Thorough scrutiny can improve transaction deal capture

Enterprise-wide diligence has always been an important part of the mergers and acquisitions process, but it has become increasingly critical in the past three to five years.

Buyers are becoming more sophisticated in their analysis and scrutiny of their acquisition targets, and sellers have to be prepared for that rising level of inquiry. Buyers and sellers have come to understand that just performing financial diligence does not provide nearly the level of insight needed in a deal.

The effects of the COVID-19 pandemic brought into focus the need for close scrutiny of supply chains as well as workforce issues that include key talent retention and HR compliance. And as technology has become a differentiator for all kinds of businesses, buyers and sellers need insight on IT systems and capabilities — and cybersecurity risks and controls.

Lack of attention to culture often contributes to a deal’s failure to attain the expected value. And on the heels of the great resignation, which led to increased reliance on digitalization, buyers are considering more pricing issues related to deals.

Understanding systems and technology

An organization’s technology and systems play such a key role throughout operations that they need to be understood to get a full picture of an acquisition target’s capabilities.

“A technology application is really just a defined business process that you purchase or license,” Sittema said. “The real asset is the company’s data. And so that’s what buyers and sellers need to understand. What data is there? How is it being stored? How is it being transmitted and how is it being protected?”

Data protection may be one of the most important risks of the whole transaction. A seller with lax cybersecurity controls poses a greater risk of introducing breaches to the merged organization’s systems when the technology is integrated after the close. The potential for harm is immense, so cybersecurity risks need to be fully understood during diligence, and solid cost estimates for the remediation of known gaps need to be developed.

Diligence on people factors

One critical factor for achieving full value in a deal is the organization’s ability to keep key talent. A 2019 study by a MIT Sloan Management School doctoral candidate showed that within the first year of a company’s acquisition, 33% of acquired workers left, compared with 12% of regular hires with similar skills and work experiences.

“Those are the people that you need to run the business to capture the value of the transaction,” Nalwa said.

That’s why it’s important to identify critical talent long before the transaction closes. Mergers and acquisitions are often  unsettling for most employees at an organization — sometimes unnecessarily so. In many cases, the best employees are unaware that one key aspect of the deal is the contribution that they will bring to the reconfigured organization.

When effective enterprise diligence is conducted, those people are identified early. Leadership can then communicate transparently with them and provide the incentives necessary to convince them to stay.

Meanwhile, diligence can uncover HR compliance issues that can have a critical impact on a deal. Workforce classification issues in particular can have a substantial effect on deals, as the thorny question of whether certain workers should be considered employees or independent contractors can cause significant compliance risks for the buyer in a deal.

What to look for in operations

Diligence in operations in a transaction generally focuses on the pillars that affect the value of a deal — service, cost, cash, and risk:

Service: The ability to deliver top-line revenue is contingent upon the delivery of a product, service or information. Anything that interferes with that service delivery will prevent the generation of the revenue that is part of the deal thesis.

Deficiencies or inefficiencies in the supply chain, production processes or delivery mechanisms pose a threat to revenue. In some cases, acquisitions are designed specifically to solve those deficiencies or inefficiencies. But it’s important during the transaction process to gain an understanding of these issues.

Cost: The margins achieved after a deal are affected negatively when costs exceed the expectations laid out in the deal thesis. Higher-than-expected people costs, system costs and operations costs can all lead to disappointment with the results of a transaction.

“Your ability to deliver EBITDA as expected is considerably reliant on the efficiency and effectiveness of your operations,” YoKell said.

Cash: The working capital and cash-to-cash cycle that result from the order-to-cash, procure-to-pay, and inventory management operational processes have direct financial implications that are included in financial due diligence. Taking a deeper dive into those key operational processes ahead of close can help de-risk cash flow barriers and obstacles that may need to be mitigated sooner rather than later.

Risk: Buyers need to enter deal negotiations with a robust understanding of the risks that may be encountered as a result of the transaction. Sellers also need to take stock of how shedding an asset might affect their risk profile.