Mergers & Acquisitions: adding value through financial due diligence

Martin Athey, Transaction Services Partner at Translink Corporate Finance, talks us through the benefits of using external advisors for financial due diligence

 

What’s due diligence and why do I need it?

In the world of Mergers and Acquisitions (M&A), due diligence is carrying out a review of a business on behalf of a potential acquirer, investor or funder in advance of a deal completing. The due diligence process will provide them with a greater understanding and insight into the ‘target’ business, as it is likely that only limited information will have been shared in earlier discussions.

There are many types of due diligence including Financial, Legal, Commercial, HR, Technology and Insurance, the extent of which is governed by the nature and type of deal. Some due diligence areas are covered by external advisors with others carried out internally by the acquiror or funder themselves. Financial due diligence is a critical work stream, as it feeds into many important areas such as valuation and pricing, future prospects, and risks that need to be protected against.

What does Financial Due Diligence involve

Typical areas covered include historical and underlying trading performance, balance sheet position, cash flow, forecasts and growth prospects, and tax. Where relevant, other specific areas include analysis that feeds into deal pricing. The breadth and depth of the scope should be tailored to the specific situation, with a deep dive in key areas sometimes combined with a lighter touch for less significant matters. This can help to keep the work focused on the main deal drivers and risk areas, whilst avoiding ‘deal fatigue’.

Quality financial due diligence is the cornerstone offering of a Transaction Services team, which should also be equipped to navigate other hurdles as they arise along the deal process, such as complex accounting matters, tax structuring, and advice on the financial aspects of the deal’s legal documents.

Sounds good, but could I do that myself? How will using an external provider add value?

Effective financial due diligence (FDD) involves a rigorous interrogation and, at the most basic level, will give a deeper understanding of the financial position of the business under review. However, well executed FDD should offer so much more; as specialists we have the experience and benefit of working on deals day in, day out. We build a scope of work that is bespoke to the specific company and deal, use our findings to provide objective and transaction specific insight, working with our clients to help shape their views on the key risk areas. This ensures our advice truly adds value.

The FDD work should also feed into the complex completion price adjustments, such as normalised working capital and cash/debt adjusters that are a feature of many deals. Often these adjustments have a pound for pound impact on the final price paid for the business and benefit hugely from specialist input, given the substantial value that can be at stake. Good FDD will often pay for itself by driving the negotiations in this area, or by identifying other potential risks – things like recent downturns in underlying trading, margin erosion, issues around working capital management, and uncrystallised tax liabilities. Issues which may need to be addressed by protections within the legal documents, or even changes to the overall deal pricing structure.

Of course, it’s essential that an acquirer or funder remains closely involved in any deal process, but it’s also important that the demands of carrying out a thorough due diligence exercise doesn’t distract them from running their own business. Externally instructed FDD provides the additional capacity and expertise necessary to ensure the deal process maintains momentum, avoiding timetable frustrations that could derail the opportunity. The FDD work will also help the acquirer or funder shape its view of post-completion priorities, and the strengths and weaknesses of the key people within the business.

When selecting an FDD provider take time to understand their personality, approach, breadth of service offering, and experience of working on similar deals. This will give you the comfort and peace of mind that you are being properly supported, as transactional work is highly complex.

What’s next in the world of financial due diligence?

In 2024 all eyes were on the summer’s General Election result and the subsequent Autumn Budget. Generally speaking we’re optimistic about the outlook for M&A. Our feeling is that the capital gains tax changes announced in October, and the current economic backdrop, won’t significantly impact mid-market deal activity. Therefore the demand for quality due diligence should remain high. However, some specific sectors may have more challenges than others, for example people intensive businesses which may be exposed to national minimum/living wage and national insurance increases. Careful due diligence around underlying profitability will be essential.

Artificial Intelligence is a hot topic across the business environment as a whole. There’s no doubt that there are many opportunities for FDD to benefit from the ever-evolving powers of AI, such as taking some of the leg work out of data analytics and information compilation. We’re also exploring how AI can be used to further advance our due diligence offering, for example by providing us with analysis beyond the company’s regular management information. However, whilst AI is another (very useful) tool for due diligence providers, we should be mindful to not become blindly dependent on it or obsess over the quantity of data that can be sourced, so as to lose the human touch and sight of what we’re trying to achieve through the due diligence process. We believe one of AI’s main advantages will be to give us more relevant information in a quicker timeframe, and these efficiencies will allow advisors to spend more time on the value add; interpreting what the data is saying, and providing valuable business insight, opinions, and deal specific advice to our clients. The machines aren’t taking over… yet!

Martin is an experienced corporate financier within the middle market with over 25 years’ experience working in accountancy practices. He has specialised in the transactional field since 2006, working on well over 200 deals to date. Translink’s Transaction Services team provides financial and tax due diligence, and other associated services such as SPA advice and completion pricing mechanisms, typically on deals in the £5m to £100m range for corporate acquirors, private equity and debt funds.

If you would like to discuss this further, please get in touch.

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