All about Financial Due Diligence

Introduction

During the course of my job in Abu Dhabi once the CEO of the company came up with 2 proposals to me wherein the seller wanted to sell their companies for a possible alignment with our established company,in other words,a possible merger with our company and both the proposals were sent to me for vetting of the said proposals.

The first company was into the business of laying pipelines without destroying the surface of the roads and the second proposal was a company that had expertise in laying Italian marble/high-quality modified and tailor-made designer tiles according to the need of the consultants/Customers.

So I began my financial due diligence by going through the financials of both the companies for the available 3 years and on scrutiny we found that both the companies were not managed properly and there was a hidden fact about the finances of the companies which was not disclosed to us earlier but found later.

How to trace a company that you want to acquire is not managed well?

• Too much of interrelated parties
• Too many outstanding balances in inter-company transactions without settlement for anywhere between 1-3 years
• The accounts receivable amount itself is fictitious
• Accounts payable shows that dues to suppliers are not made over the due date
• Booking of unjustified expenses and pocketing the same by the owners in their personal capacity contrary to their responsibility as enshrined in the AOA
• Having inflated sales without any backup or unnecessary tampering with the sales figure
• Flaws in the procurement area
• Not complying with the normal economic laws & Commercial laws of the nation
• Unhealthy accounts receivable position with outstanding of more than 6 months.
• Recording of assets without any supporting documents
• Not following consistent policies of accounting
• No consistent policies on following a stable depreciation policy on depreciation
• The assets used for the business have been overused and they are unfit for utilization in the business, in other words, they are as good as scrap.
• No proper records to justify the Bank Reconciliation statement and perpetual adverse balances appearing in the BRS
• No confirmation of either accounts payable or accounts receivable over the year-end
• No annual balance confirmation of the bank balances in the course of the annual audit
• The presence of an audit report with too many qualifications in the other sense it’s not a clean balance sheet
• Auditors have expressed doubt about whether the concern is a going concern or not
• Very weak financial positions with lots of overdraft, nonpayment of term loans which can be both long-term loans as well as short-term loans, and non-existent cash in hand.
• The management spends too much money on themselves and shows very low interest in the business.
• The seller just wants to sell his company on the basis of window dressing and he has failed to secure a buyer despite making the best efforts.
• Material misstatement in the financial statements was overlooked by the potential buyer due to non-adherence to financial due diligence.
• And after careful analysis on an overall basis, I gave a red signal to the management and our company dropped the intention to buy the above-mentioned companies and avoided a possible failed M&A

Now let us come to the same case in the Indian scenario, the companies involved are Skava and Panaya which were acquired by IT Giant Infosys which later turned out to be a bad deal, let us just have a look at this failed case of M&A

Infosys acquired Panaya, which offered a wide range of services, including cloud and automation, in an all-cash deal for $200 million During the stint of earlier CEO Vishal Sikka in the year 2015. Panaya was acquired for USD 200 Million &Skava was acquired for $120 million in the same year in all bought-out deals of USD 320 million

Overvaluation of the two firms and not being a right fit for the company then created controversy. It wouldn’t be too much of a stretch to say these two firms were their earlier CEOs of Sikka’s undoing. Mr. Sikka quit Infosys in 2017 and the promoters jumped in to stabilize the company.

One of the measures included the sale of two firms, which did not go as planned, as the company could not find any potential buyers. Till March 2019, the company had seen its fair value reduce by close to Rs 854 crore on impairment, owing to a fall in the holding value of these two entities.

Now the question arises as to whether the CEO single-handedly acquired the aforementioned companies without the board’s permission &resolutions to that effect, no it’s not the case but it’s a case where the deal has gone horribly wrong which resulted in a huge write-off almost Rs 854 crores which is not a small amount to be ignored but it has happened in reality.

Now let us see the failed M&A In an objective manner and analyze the valid reasons.

Flawed Intention

Flawed intentions often become the main reason behind the failure of mergers and acquisitions. Companies often go for mergers and acquisitions getting influenced by the booming stock market. Sometimes, organizations also go for mergers just to imitate others. In all these cases, the outcome can be too encouraging.

Often the ego of the executive can become the cause of an unsuccessful merger. Top executives often tend to go for mergers under the influence of bankers, lawyers, and other advisers who earn hefty fees from the clients.

Mergers can also happen due to generalized fear. The incidents like technological advancement or changes in economic scenarios can make an organization go for a change. The organization may end up going for a merger.

Due to mergers, managers often need to concentrate and invest time in the deal. As a result, they often get diverted from their work and start neglecting their core business. The employees may also get emotionally confused in the new environment after the merger. Hence, the work gets hampered.

Cultural difference

One of the major reasons behind the failure of mergers and acquisitions is the cultural difference between the organizations. It often becomes very tough to integrate the cultures of two different companies, which often have become competitors The mismatch of culture leads to a deterring working environment, which in turn ensures the downturn of the organization. Recently many smaller PSU banks were merged with the bigger PSU banks, the earlier staff of the bigger PSU look down upon the acquired Smaller PSU staff with less respect.

What is Financial Due Diligence?

Financial Due diligence is a process of verification, investigation, or audit of a potential deal or investment opportunity to confirm all relevant facts and financial information and to verify anything else that was brought up during an M&A deal or investment process. Due diligence is completed before a deal closes to provide the buyer with an assurance of what they’re getting.

Importance of Financial Due Diligence

Transactions that undergo a Financial due diligence process offer higher chances of success. FDD contributes to making informed decisions by enhancing the quality of information available to decision-makers.

From a buyer’s perspective

Financial Due diligence allows the buyer to feel more comfortable that their expectations regarding the transaction are correct. In mergers and acquisitions (M&A), purchasing a business without doing due diligence substantially increases the risk to the purchaser.

From a seller’s perspective

Financial Due diligence is conducted to provide the purchaser with trust. However, due diligence may also benefit the seller, as going through the rigorous financial examination may, in fact, reveal that the fair market value of the seller’s company is more than what was initially thought to be the case. Therefore, it is not uncommon for sellers to prepare due diligence reports themselves prior to potential transactions.

Reasons For Financial Due Diligence

There are several reasons why due diligence is conducted:

• To confirm and verify information that was brought up during the deal or investment process
• To identify potential defects in the deal or investment opportunity and thus avoid a bad business transaction
• To obtain information that would be useful in valuing the deal
• To make sure that the deal or investment opportunity complies with the investment or deal criteria
• Costs of Financial Due Diligence
• The costs of undergoing a due diligence process depend on the scope and duration of the effort, which depends heavily on the complexity of the target company. Costs associated with due diligence are an easily justifiable expense compared to the risks associated with failing to conduct due diligence.
• Parties involved in the deal determine who bears the expense of due diligence. Both buyer and seller typically pay for their own team of investment bankers, accountants, attorneys, and other consulting personnel.

Financial Due Diligence Activities in an M&A Transaction

There is an exhaustive list of possible due diligence questions to be addressed. Additional questions may be required for industry-specific M&A deals, while fewer questions may be required for smaller transactions. Below are typical due diligence questions addressed in an M&A transaction:

• Target Company Overview
• Financials
• Technology/Patents
• Strategic Fit
• Target Base
• Management/Workforce
• Legal Issues
• Information Technology
• Corporate Matters
• Environmental Issues
• Production Capabilities
• Marketing Strategies

Why does Financial Due Diligence Matter?

Financial Due diligence helps investors and companies understand the nature of a deal, the risks involved, and whether the deal fits with their portfolio. Essentially, undergoing due diligence is like doing “homework” on a potential deal and is essential to informed investment decisions.

When M&A can go Horribly wrong

A little-known software company from Bengaluru in the mid-2000s made some quick acquisitions and headlines in the Business News Papers then with some back-to-back acquisitions raising eyebrows in the IT industry, if the FDD (Financial Due Delicence) is not made properly, it can result in cash landing of the company which happened with Subex which has not risen further despite IT Companies making a steep recovery in the share market with respect to their valuations and the share prices. I would stress that FDD has to be done thoroughly and all items have to be vetted properly before taking a call on a possible M&A

Some of the failed M&A in the international circuit and our own Indian Context have been highlighted to have a quick recap of the serious intensity of flawed FDD.

International Scenario

• America Online and Time Warner (2001): US$65 billion
• Daimler-Benz and Chrysler (1998): US$36 billion
• Google and Motorola (2012): US$12.5 billion
• Microsoft and Nokia (2013): US$7 billion
• KMart and Sears (2005): US$11 billion
• eBay and Skype (2005): US$2.6 billion
• Bank of America and Countrywide (2008): US$2 billion
• Mattel and the Learning Company (1998): US$3.8 billion

Indian Scenario

• HDFC and Max Life
• IDFC-Shriram Finance
• RCOM-Aircel merger
• Flipkart-Snapdeal Merger
• Cross-Border-Apollo-Cooper Merger
• Snapdeal and Flipkart
  • Tata Steel-Corus
• Suzlon Energy Ltd -Servian
• SRS (Shree Renuka Sugars) buyout of Brazilian Companies
• Bharti Airtel -Zain
• Sun Pharma-Taro