Due Diligence & Advisers - M&A (#7)

0:00 hey everyone welcome to the last video in the m a transaction series in this video we're going to be talking about due diligence uh and why it's so important so there's a very this is a fairly uh short video uh to cap off the series compared to some of the other videos um so primarily you know in the in the previous videos we've talked about kind of why it's so important to do due diligence why geologists is worth

0:27 its weight in gold and that's a big statement because due diligence can be quite expensive you know you can easily spend 200k per advisor on a transaction even for a relatively small acquisition because the same level of work still needs to be done and granted it does scale up from there um so you know you can spend 200k on financial due diligence another 150k on tax due diligence maybe another 150 200k on commercial due diligence and then on

0:51 top of that you've got to pay your legal fees as well both for your legal due diligence as well as your kind of your sale agreement spna drafting so there's a lot of money you can spend between 500 and mil on some transactions and they don't even have to be that big of a transaction um so you know it's a lot of money so why is it so important to just to quickly recap some of the earlier videos

1:14 as to why it's so important well we know based on the purchase price calculation about how each of these kind of elements impacts the purchase price so ebitda there's a multiple of that impacts your headline purchase price so essentially every dollar of ebitda that your advisors can essentially save you if from the buyer's perspective or conversely on the seller side if you've got sell side advisors investment banks etc who can add an extra dollar of ebitda

1:42 you know to the final you know agreed terms is going to give you a multiple of that so the multiple is 10 times ebitda you're gonna get an extra ten dollars of that right so you know even if your advisors can save you an extra hundred thousand dollars in ebitda just by being on board times it by ten you're talking about a million dollar difference to the purchase price so that very quickly adds up on top of that you've got your

2:05 completion adjustment so we know from the previous videos that a dollar of net debt and cash [Music] sorry i'll just go full screen we know that a dollar of net debt and cash adjust to the purchase price one to one essentially any dollar any extra dollar of net debt that you can add on here adds an extra dollar to the purchase price or vice versa depending on how you go so again if you have even better

2:31 advisors who can for example if you're a buyer and you've got really high quality financial duty if they can dig around the counts and find an extra say a million dollars in net debt items and argue that well this should be included or maybe it's something that's contingent that's off the balance sheet that should be included as well maybe your lawyers found that or maybe on the seller side for example you could argue that certain you know

2:57 items of cash that may appear like trapped cash is actually should be part of the cash and therefore increase the purchase price adjustment right so it's you know if they can find a million dollars of savings and net debt or cash on either side of the equation right they've got another million dollars to the purchase price right and then you can see how this can very quickly pay back the advisor fees and then quickly add value beyond that as

3:23 well and that's even before you know general approach speediness um you know clauses on you know capex and commitments and liabilities etc so the the the value really starts to add up they could also kind of help you uh potentially if you've got a able to negotiate a better comps analysis by using you know advisors who are able to argue a certain point which you might not be able to do by yourself for example they might say

3:50 oh you know when you do your comps analysis this company should be included it's too high and if you take that out these are the comparable ones it's actually a lower or a higher multiple and therefore save you some money on that through the purchase price as well they could argue with different kind of methodology for using someone might be using you know they might be arguing your company should be using evo for sales instead of

4:09 ever ebd ebitda which results in a better overall purchase price so just quickly going through so that's why it was really important to just have really good advisors because at the end of the day it might not seem like it might seem a cost but the end of the day if you have good advisors they're really a value add to the process so let's just quickly skip ahead now sorry i just wanted to revisit some of

4:33 the older slides and recap on some of the lessons that we've learnt from the earlier videos they can also help you navigate the sale and purchase agreement to avoid any issues down the track as well so in terms of the actual process timeline you know when do the kind of advisors come in where do they potentially help so even before you've kind of put together a deal even before you've kind of signed heads of agreement before

5:03 you've done dd before you signed the deal you know advisors are going to be adding value from very early stages and a good example of that is cdd and you might be just looking at an industry that you potentially want to invest in you know cdd is essentially your commercial due diligence and that's done by people like you know your your your management consulting companies like your bain you know your bcg and even there's some mid-tier options

5:26 so a good one that i recommend is strategy and from pwc because if you've ever gotten quotes from you know bcg and bain they ask for a ridiculous amount of money strategy and does you know maybe not as high quality work but it's not that different and the price is significantly cheaper so in the u.s or european markets i might also recommend using some of the more you know boutique players rather than those big four consultants because

5:50 they're just ridiculously expensive but what they do is essentially they're the consultants they look at the market you might say i want to go into you know the veterinary industry so what they'll do is they'll look at what's the historical growth rates of the industry what are the forecast growth rates of the industry you know they'll speak to experts they'll form a view as to kind of what are the risks what are the tailwinds of the industry they'll help

6:11 segment it down into the different drivers you know into volume into price into you know and then do another level down say okay well number of households and the number of pets per household um and then you know so essentially they'll look at the drivers of the industry and and and help you determine whether this is an investment that you even really want to get into at least from the buy side from the sell side they might also help

6:35 do the same thing but put put together what's called vendor due diligence which is essentially a pack prepared by the sell side which kind of helps mitigate the need on the buy side to do the same analysis and they can also help kind of frame the messaging a little bit to be a bit more positive so that's that's when cdd comes in they'll kind of understand they'll help you understand the industry the opportunities the risks you know any possible synergies any

7:01 possible kind of cost savings they'll as i mentioned before they'll speak to a number of kind of experts in the industry whether that's employees business owners you know ceos of industry leaders they'll also help you to kind of form a view of the market they'll also help do a competition analysis so you'll help you understand who are the key players what's their market share how has that changed over time you know if you're looking for acquisition opportunities

7:26 they might help you kind of segment the market into possible bolt-on acquisitions or mergers or even segmenting you know the number of independents in that market so i mean that's not a conclusive list of what they do but hopefully it just gives you a little bit of flavor as to what the management consultant will do and where the value is you know that that service is a little bit expensive but i can say you know i would much much

7:49 modest much rather spend 200k on analysis realize the risks of a particular industry and not invest rather than invest in an industry spend you know 50 million dollars on a transaction or 100 million and then figure out this huge amount of risk and then be stuck with a dodgy asset that i can't sell definitely better to pay the due diligent advisor phrase up front definitely worth worth it you might be familiar with the expression don't be

8:16 uh penny smart dollar dumb and this is a perfect example of that so you're spending 200k and people might want to save money but at the end of the day the real money that we're talking about which is your investment uh we want to be smart on that not this not the small dollars so next step in pre-diligence is when you're actually structuring the proposal and this might be drafting you know high level terms might be heads of agreement

8:40 might be talking about kind of um you know how do we define ebitda what the multiple we're paying uh you know what items are included in net debt how are we structuring the deal you know is there an earn out is there an equity component is it all cash you know what's the vendor component like determining the jv percentage you know any other kind of qualitative terms and explaining why you're the preferred buyer so typically you might not engage

9:06 advisors at this point unless you're not really in the business of doing this for example you're a strategic trade buyer who's just looking for a bolt-on acquisition you don't typically do acquisitions you might help you might engage like a tax or investment banking advisor to help you with this step next step is commercial consideration so this is when you might do a bit more of a deep dive with the commercial due diligence guys and typically it's it's

9:31 it's in two phases one is a little bit of a high level kind of analysis and that's kind of identifying the high level risk and then once you're actually ready to go a little bit further you do the deep dive cdd which is kind of all the items that i was talking about before with the you know the the market analysis the competitor analysis the the interviews etc that's mostly going to go into that kind of

9:52 second stage down here next is you know the deal is progressing we're now kind of getting through the main diligence period and typically you know we're only going to get to this period once uh you know we've received a certain level of exclusivity in the heads of agreements and maybe we aren't the only party remaining in the due diligence period otherwise you know while we'll be committing all this capital uh this cost to advisers so we might be running looking at

10:18 assessing trading and cash flows so this is your core financial and tax due diligence so for financial you might want to appoint you know a big four accounting firm uh you know your kpmg your pwc your ey or your inst oh sorry hillmacing or your deloittes and if you tax your diligence you might just use the same company or you could use a different i'd probably use the same company just because there probably is some synergies with the financial

10:42 judicial team and the tax religions team they'll typically work together they might include it in the same deck tax due diligence is a very important one so don't skip out on this because if there are any tax liabilities you can include this as a net debt adjustment item and you really want to be aware of any tax issues because it can be quite a substantial amount in dollar terms so typically it's going to be in in you

11:07 know three phases which is number one key issues which is just basically your red flags report so your financial and and uh tax due diligence they'll say okay we you don't need to read the full report but these are the key issues we've found for example you know we fight maybe they've been underpaying their employees maybe we think uh you know the accounting policy on revenue might be understating what the true recurring underlying revenue we think should be going forward maybe

11:32 we've identified a couple of stamp duty issues right so that's just a couple of examples what you might see in a key issues or red flags report next is remaining field work so i'll typically give you an update throughout this process and then do maybe a deeper dive and that also gives you an opportunity based on that initial key issues red flags report to maybe hone into a couple of issues and do a bit more work in those particular issues

11:53 rather than just doing a generic across the board dd and then they might report again give you an update throughout that process and maybe do another refining do a deep dive on a couple of areas and then the final phase is essentially just closing off the report and that's providing a full financial diligence and tax due diligence report which is a typically a pdf report prepared in powerpoint which might be you know 50 to 100 pages long

12:20 and you know each stage you've got agreed outputs there's key issues hit early and negotiation value issue issues are prioritized because ultimately that's what the buyer and seller care about now in terms of that first point the agreed outputs in each it's each stage i didn't touch on this earlier but it's applicable for all kind of appointment of of uh advisors regardless of cd cd tax commercial uh legal whatever it is all of these before you engage them what

12:50 you typically do is you agree a mutual scope and the advisor will typically rely on you to provide that initially based on kind of what you think the key focus area is and if you're not really sure about what that looks like you can just say to them look can you just give me a fairly generic one and i'll edit that and that's typically what they'll do they'll give you a standard list based on what they think it is you'll

13:10 then go through it and review it and say okay based on my knowledge of the company i kind of want to look at this or this is what i'm particularly worried about so let's do a bit more area on say you know wages and salaries for example because it's a lot of competitive pressure in that particular area of the business so you might it's kind of a refinement process you then give it back and that helps kind of

13:29 determine what the advisors will look at in particular okay so the next step is completion structuring and spna support so this is helping you okay so how do you actually structure the deal how do you actually draft the sale and purchase agreement that includes kind of what terms you're going to include and these are all the key issues we came across before including kind of you know definitions deal structure warranties and indemnities material adverse clause you know wording of you know upfront

13:59 your completion mechanisms missing your net debt like including what items are included what items aren't so you might have advice from your tax dd in terms of any particular issues you particularly want to focus on in terms of you know including a net debt or potentially mentioning in the warranties in demons you know you might have specific accounting warranty warrant and warranty sorry accounting warranties indemnities based on some of the findings from the accounting and financial due diligence

14:29 and you might even have if you have an investment banking or other kind of you know sell side advisor they might advise you on the completion mechanisms and wording around that as well so the next step of the main due diligence period is essentially and this is after you've you've signed the uh the spna is essentially preparing for post deal action and this is when you're starting to focus more on that kind of big picture strategic side so

14:55 less less to do with the numbers and in the detail in more big picture so what are we going to do in our first hundred days you know if there are any kind of synergies identified and factored into the purchase price how are we going to achieve them you know how we're going to integrate the teams how are we going to make sure that there's no kind of turnover and resignations and the culture stays the same

15:14 you know how do we make sure that you know the growth we're forecast in our dcf analysis is going to be hit and what kind of actions and implementation plans do we need to implement to reach that are there any cost cuttings required that we've kind of flagged earlier on so you know who's going to lead the company do we need to fire anyone because there's two ceos or two cfos or two ceos right so it's thinking about that stuff

15:38 putting together an integration plan now there are advisors who do this um you know i know kind of the big four accounting does this i know that you know the management consultings do this i don't think there's any one firm who's particularly good at it i don't think professional advisors in general are that credit integration plans i think ultimately the company buying it should be the one doing this because you know at the end of the day there needs to be

16:00 a strategic reason why you are buying this company and ultimately you can't have an advisor tell you what that is you need to have a reason for it you need to have a plan for it and ultimately you need to take responsibility for the acquisition i think it's very common for companies to just say i want to do an acquisition and then hand off all responsibility to the advisors but at the end of the day like

16:19 the advisor is going to step off the deal at some point typically around completion and at the end of the day you will be held responsible for the growth and you know i think a lot of acquisitions don't perform uh post acquisition because of that reason so this integration step is probably one of the most important points out of all of these just having a really good integration plan and i guess this is also coming back to

16:40 that very first video that we talked about in terms of m a strategy which i'll quickly flick to you know why are we doing why are we doing the deal in the first place you know and it's ultimately ultimately needs to be one of these reasons right so is it improving the target company's performance because we think we can do better and we know there's inefficiencies there is it because there's consolidation to remove excess capacity from the industry

17:09 you know do we need to close plants as a result of that you know do we need to fire people and restructure the business the third strategy was accelerate market access for the target or buyer's products so if we're using our you know kind of target companies or sorry i should say the other way around if the target company plans to use the acquirer companies infrastructure you know what's the integration plan for making that happening for onboarding it

17:36 for education do we need to hire additional staff to make that happen do we need to make an investment in you know marketing or distribution costs and do we have a budget for that so those kind of questions next is get skills or technologies faster at a lower cost than can be built so we're for a tech company we're just acquiring this company for you know either a particular software they've built or the staff that built

17:58 you know how do we integrate that with our main site you know how do we you know test that how do we get that working as soon as possible for the new staff how do we make sure that they're actually retaining the business and not just staying there for a year or two years time to get their payout like how do we make sure that they stay there long term number five exploited businesses industry-specific scalability right so how do we quickly scale the

18:19 business what are the steps we need to take to achieve that and then finally pick winners early and help them develop their business all right so what's how kind of you know how do we accelerate that growth you know how do we you know drive that culture what what can we do to help that company and what's our reporting process to make sure you know over time that we are checking back and actually seeing if this company is is growing as we thought

18:42 it would over the long term so you know like this these are all the kind of the reasons why we need to acquire but in terms of that integration plan there's no correct or one way of doing things right ultimately the end of the day it's really dependent on the company you're acquiring what you want to do what your strategy is so it's a it's a difficult one it's kind of like working capital in that there's

19:05 no set definition for it necessarily but it's also the main area that most people don't really understand that well so if any of these i can ask you to try and do really well it'll be this one here so next step in terms of kind of advisor involvement is around completion accounts so you might get your um so the reason is so because the the buyer now owns this company and they have to compare these completion accounts

19:33 um you know both parties are kind of worried about how accurate the information is so a common approach is to actually get the the same party who did the financial due diligence due to completion accounts because they're already familiar with the business and they're also an independent third party so hopefully they're providing an unbiased perspective which makes the whole process a little bit more transparent so they can actually prepare the balance sheet and do the calculations as per the spna

19:58 definitions and then finally is post completion so this might be a year or two years or three years down the track or every year thereafter is essentially a follow-up review and this is the step that i think a lot of companies also really miss they do the acquisition they kind of leave it but they don't go back and revisit their initial assumptions and revisit their initial risks and just do a checkup and see how you know how

20:22 everything held up uh in retrospect and also checking out integration kind of seeing where we're at with that as well so you know there's probably not as many advisor teams with this is probably more of an internal process and i think that's why maybe it's missed a lot but there are definitely professional advisors who can help with this probably the teams that i would involve is maybe the original advisors just because they are familiar with the deal with the

20:46 logic with the due diligence etc it's worth spending the money on at least or doing it internally okay so now let's talk about the importance of due diligence which is i think i've emphasized this this message quite a few times already um you know in terms of you know it's it's it's don't be pennywise dollar dumb we want to be smart with our dollars the big dollar investments not the small dollar investments and and advisor fees are the

21:13 small dollar investments relative to the acquisition cost so the context is transactions in australia are conducted on a buyer beware basis where the onus is on the buyer to understand the assets and liabilities to be acquired and the future cash funding requirements of the business consequently undertaking due diligence is an integral and standard procedure in this transaction environment in australia so the following examples set out key risks and examples of not undertaking due diligence prior to acquiring a

21:38 target so the first area is uh integra integrity of underlying financial information so the key diligence requirement is understanding and evaluating management's accounting policies and the impact these have on the financial information so the risk of not undertaking due diligence on this area is that under accounting standards a number of areas of accounting subjectivity exist and the measurement recognition disclosure of financial information is often subject to management discretion for example revenue recognition provisions etc is a

22:10 failure to adequately understand the basis of preparation of financial information may result in overstated financial results or understated future funding obligations being included in your valuation model so an example of this is as a result of engaging big4 to undertake due diligence in relation to a pension provision obligation a confidential big four company identified an additional 10 million dollars of pension obligations that were not recognized in the financial information provided by the target this would not have been

22:39 identified had diligence not been undertaken and resulted in an equal 10 million reduction to the final purchase price next area of uh i guess due diligence is forecast trading performance so typically when you're doing due diligence the seller will provide the actual historics and they'll also provide a forecast as well so understanding um understanding forecast trading performance including analysis of management's assumptions with reference to historical performance market

23:10 conditions uh contractual arrangements and key risks and opportunities [Music] so the risk of not undertaking due diligence on the forecast is that finite forecast financial information it forms part of your valuation model which then determines your kind of the range that you'll pay for this business and it may result in you materially overpaying for the asset so an example a confidential uh company based their valuation model on management's forecast without undertaking appropriate due diligence post acquisition it became

23:41 evident that management's forecasts were highly aggressive and unachievable and consequently the company had maturely overpaid if the assets acquired and this is very common you know obviously the sellers are gonna they're gonna be more positive you know even either intentionally unintentionally they're still gonna be probably more positive uh than they than they than they should be so try and try and err on the side of conservatism next area is working capital trends so a key due diligence requirement is just

24:07 analyzing year-end and monthly working capital trends focusing on potential completion issues and future funding requirements so the risk of not undertaking due diligence is not understanding the current and future working capital requirements can result in material additional cash funding requirements post acquisition so example of this so not understanding the seasonal and intra month working capital requirements resulted in a company having insufficient cash available post acquisition to manage their working capital commitments and consequently a material further cash injection was

24:37 required post acquisition for the company to continue trading so another area of due diligence is capital expenditure so a key due diligence requirement is considering historical and forecast capex requirements including new site capex i.t and other capex so the risk of not undertaking due diligence here is not understanding the current and future capital expenditure requirements can result in material additional cash funding requirements post acquisition so an example of this is failure to undertake due diligence and understand

25:09 the full extent of the capital expenditures requirements needed to complete construction of a new packaging facility resulted in material additional capex funding being required by confidential company post acquisition which they had not included in the valuation price next area of due diligence is contingencies and commitments so understanding the target's financial commitments and contingent liabilities including the management's basis for these estimates so the risk of not undertaking due diligence here is not understanding the targets future commitments and

25:38 contingencies may result in material additional cash funding requirements post acquisition so an example of this is a company that did not undertake due diligence and consider the targets contingent liabilities pre-acquisition was required to pay a material legal liability that became payable following completion of litigation procedures post acquisition so as i've mentioned before look yes you could potentially claim this under warranty indemnity clauses in the agreement but i mean there's a number of reasons why that

26:09 might not occur number one the dollar amount might not be high enough to claim it does need to be above a certain amount in the sale agreement to actually proceed and also to be worthwhile you know the company's time number two there still might be a joint venture arrangement with the other party so you know you'd have to sue the company that you're still working with and that can really sell relationships and number three is you know you might

26:36 lose the case and it might actually go against you and you've got a legal cost on top of that and number four finally the costs actually need to be recoverable right what happens if the company that you're suing aka the seller has gone bankrupt has closed down you know has moved away and you can't contact them et cetera all right so yes it's possible but don't assume that it is and then and then finally uh tax due diligence so

27:04 why is this a key due diligence requirement because you know i mean well first of all what is the requirement so considering income tax and indirect tax to ensure tax provisions are appropriate identify unusual or contentious items and understand any ongoing disputes or open issues analyze the tax consolidation calculations and the tax carrying value of assets so i think the tax divisions is often overlooked and sometimes even skipped as part of due diligence and in part i think people because they don't

27:30 fully understand the tax ramifications i think oh tax system i'll just give it to the tax accountants they'll they'll get it they'll do the joujillah that's fine but i think it's really really really important that you have a very very strong groundwork in tax because once you do you realize wow this is a lot of money that we're talking about or a lot of potential explosion exposure i mean even just thinking about it logically if your tax rate for companies is 30

27:55 percent right that's 30 of ebitda that we're talking about for one year what happens if they haven't lost a tax return for three years that's 30 of the ebitda times three it's essentially all of your ebitda value as potential liability and that's just one you know that's that's a low risk thing but that's just one thing this the tax system is so complex there's so many different areas you know from fbt from diff 7a from shareholder loans from you

28:22 know transfer pricing you know capital gains right like there's hundreds and hundreds of potential risk areas and i think once you go through some of the tax videos which is you know later in this course i think it's really important that you do watch those videos and understand it because it's going to help you understand the importance help you understand the potential risk and i think the risk is high because the seller company often will also not fully understand all

28:47 of their tax obligations it's a complicated tax system regardless of where you are in the world and somewhere they may not have they may have missed some sort of tax issue or so i think it is really important to do that the tax analysis so the risk of not undertaking tax due diligence is not understanding the tax position of the entities to be acquired may result in additional tax obligations or commitments being payable post acquisition so an example of this is by

29:13 not undertaking tax due diligence a confidential company did not understand the full extent of historical tax liabilities in an overseas subsidiary of an entity acquired which resulted in material tax payment having to be paid by the acquirer post acquisition okay so that's the end of the the due diligence video as i mentioned fairly short and sweet but i guess the key message here is don't skimp out on professional advisors understand where they can add value in

29:43 the process and invest in them because they will you will get your money back through your investment in them and don't be penny smart dollar dumb that's really the key takeaway hopefully you found this useful and thank you for watching the mbna series