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Posted: May 01, 2012

The best way to do due diligence

Avoid these three mistakes

Jeffrey Johnston & TJ Kern

Three Mistakes to Avoid When Conducting Acquisition Due Diligence
By Jeffrey E. Johnston and TJ Kern

In most middle market merger and acquisition (M&A) transactions, the buyer and seller agree to economic and general deal terms in a letter of intent (LOI). The LOI is a non-binding document that outlines the terms of the transaction the parties have agreed to, and it is almost always subject to a due diligence review of the target company to be acquired by the buyer. 

Due diligence serves to confirm all material facts with respect to the transaction. During due diligence, the seller typically works exclusively with the buyer to complete an audit or review of the target company within a specified period of time.  The length of time granted to complete due diligence varies based upon the size and complexity of the target company, and if third party capital sources such as a bank or subordinated debt provider are needed to fund the deal. 

In most cases, due diligence can be completed within 45 days; however, depending upon circumstances, it may extend as long as 90 days.  Sellers desire a short time period and may negotiate for specific milestones to be completed throughout the diligence period, thus putting added pressure on the buyer to efficiently complete due diligence.

For experienced strategic and private equity acquirers, the due diligence process is very repeatable with internal and third party experts working seamlessly together.  In the middle market, a financial advisor can provide significant benefits to less experienced buyers. Translating negative due diligence findings into appropriate economic or risk offsets can preserve long-term value creation for the buyer. 

While hiring a third party financial advisor helps to professionalize the process, it does not eliminate the risk of making mistakes even for the most experienced acquirers.  Most due diligence mistakes are not rooted in complex technical vagaries or the discovery of unidentified issues post close.  Rather, these mistakes are systemic in M&A transactions where buyers are required to perform due diligence under time and competitive pressures.  Below are three common mistakes which can be avoided:

1.) Poor Communication with Seller: Establish an open communication channel and build rapport early on with the seller.  Clear and timely explanations of negative findings should create a constructive environment to resolve a due diligence issue.  Preview the initial findings and allow time for a thoughtful, fact-based response from the seller.  This will typically produce a less emotional response.  There is a tendency by buyers to limit or delay communications of negative diligence findings with the seller.  Perhaps it’s simply human nature or a desire to avoid conflict, but waiting to disclose negative findings until the end of the diligence process almost always creates undesired results.  The seller may perceive an attempt by the buyer to ‘game’ the system to gain some last minute leverage.  Surprises late in diligence rarely result in a win for either party.     

2.) Lack of Internal Coordination: Ultimately, coordination is all about living up to assigned responsibilities.  Establish an internal ‘project manager’ with responsibility for all aspects of the transaction supported by functional team leaders. Each of the functional team leaders, which may include accounting/ finance, tax, commercial, legal and environmental, to name a few, may also have responsibility coordinating with third party advisors such as a financial advisor, legal or accounting firm.  The mix of employees and outside advisors can be challenging to manage, which places a premium on communication and focus to maintain momentum.  Creating a distinct master calendar with all diligence events and holding weekly all-hand’s calls are effective ways to keep the team organized and aware of deadlines.  An experienced financial advisor can help prioritize and set realistic timing goals.  Poor internal coordination leads to frustration for both buyer and seller, lengthens the process and increases the likelihood of missing critical diligence items.

3.) “Be Quick, Don’t Hurry:” Basketball fans may recognize this as a classic quote from UCLA coaching legend John Wooden.  On the basketball floor this meant playing your best and filling your role while limiting turnovers and mistakes. The concept is appropriate in the context of due diligence - particularly with sellers pushing for shorter and shorter diligence periods.  Experienced acquirers establish a timetable and process early on to guide the team throughout the diligence process.  Changes are made as facts necessitate, however always with the full knowledge of the entire due diligence team and with appropriate disclosures to the seller.  Conducting due diligence without a detailed plan of action is a sure way to leave your team hurrying to meet deadlines.  Losing focus and attention to detail late in a due diligence process can come back to haunt a buyer after close.  So whether it’s driving for a game winning layup on the basketball court or wrapping up a key diligence item on an acquisition, remember to be quick, but avoid the mistake of hurrying.

Mistakes made during the due diligence process often lead to headaches or even incremental costs post close.  Overpaying for a business is always of paramount concern for buyers, however there are many other less obvious implications tied to due diligence mistakes that can be costly as well. 

Issues such as misjudging the nature of the target’s customer relationships, a misaligned capital structure (balance sheet not optimized for underlying assets) or disproportionate risk sharing (inadequate indemnification protection) may ultimately reduce the financial attractiveness of the deal or even potentially damage the reputation of the buyer. Conducted properly, acquisition due diligence should provide buyers with a validation of purchase price and identify potential deal risks. 

Taking the time to communicate issues and expectations; coordinate tasks and responsibilities; and focus attention to the details will pay off in the long run.  

Jeffrey E. Johnston is a managing director in the mergers & acquisitions group of KeyBanc Capital Markets, Inc.  He may be reached at 216-689-4115, or jjohnston@keybanccm.com.

TJ Kern, SVP, is commercial banking manager for KeyBank NA in Colorado.  He may be reached at (720) 904-4505 or todd_j_kern@keybank.com.

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