A major element of CDD is customer and other interviews. Rarely can a CDD team tell the whole truth when explaining the reasons for its enquiries to people outside the business, therefore a key matter to establish with management is the extent to which customer and other interviews can be conducted on a disclosed basis. The closer to the truth the better. The best compromise is for the target to agree that the CDD team can say it is conducting a strategic review or customer care programme on its behalf. This platform requires the full cooperation of the target’s management and it must fit in with the company’s customer relationship programme. One target once refused to go along with a customer care platform with the curious boast that it never carries out customer surveys and its customers would know that. As might be expected with such an enlightened target company involved, that particular deal did not go ahead.

If customers are to be interviewed on behalf of the target company, staff need to be made aware of the research programme otherwise there can be embarrassment and confusion.

Management may offer to hand over existing customer surveys. Few companies conduct customer care surveys which approach the level of professionalism and detail which a well run CDD programme involves, so prior surveys are almost invariably of little practical use.

A customer care platform is not going to work with competitors. Competitor interviews need particularly skilled interviewers ‘doing some work on the market’ or ‘doing some work on behalf of a potential investor’.

The vendor, or the financial adviser running the transaction, can influence the process and attempt to limit the number of discussions which are held. It is perfectly reasonable for a vendor to wish to protect confidentiality and to understand the nature of the discussions. It is in the acquirer’s own interest to avoid unhelpful rumours in the market which could destabilise relationships between the company and its customers. What is not reasonable is for the vendor to seek to prevent the acquirer from talking on a confidential or undisclosed basis to the people who know the real strengths and weaknesses of the company. The seller who seeks to prevent reasonable access to important sources of information such as customers runs the risk of appearing to hide unpleasant facts, which is usually counter-productive because a skilled CDD team can, if necessary, make the enquiries without the target knowing. Similarly, the target sending someone to listen in to telephone interviews is to be resisted. It is highly disruptive because it limits the free exchange between interviewer and interviewee.

The CDD team is to some extent reliant on management to advise which interviewees will yield the best information and provide contact details. Some management teams are tempted to hand-pick customers while keeping the CDD team away from problem cases. A good CDD programme will not rely totally on management contacts.

Management may be wary of some of the other contacts which the CDD team will want to speak to. There may be sensitivity over suppliers if contracts are currently being negotiated. Former employees can be a particularly sensitive area; they are mentally ostracised as part of a natural management defence mechanism. The trick is to see through this and go with your instincts. Ideally the entire interview programme, including competitor interviews should be agreed with management. However the CDD team should not accept being spoon-fed. It should make its own decisions about who it contacts whilst ensuring that it does not conduct any interviews which disrupt the business.

‘Secondary’ in this context means published, or publicly available.

The detailed research phase starts with a desk research exercise, reviewing all relevant published, or secondary sources. A substantial volume of information is easily available from public sources and through commercial databases. Consultancies conducting CDD may also already have relevant data on the target markets.

Secondary sources are invaluable as a precursor to investigations in the market, using primary sources. They provide basic data and they can give the commercial due diligence team valuable background information about the industry. Industry participants are generally happy to talk to people if they understand the issues. They will soon get bored and lose patience if they need to explain the basics of their industry in order for the conversation to continue.

The desk research continues throughout the project. As the issues develop, the desk research becomes increasingly focused. With so much information available through public sources, desk researchers run the risk of picking up useful information, but not the best information. Using less than the best information obviously reduces the quality of the subsequent analysis. Instead of just going online, you should develop a desk research strategy.

Some basics for designing desk research strategies are:

Information comes from three main sources:

Secondary sources have their limitations. They are general rather than specific. They cover large, mass markets but refer to niches only in passing and are rarely completely up-to-date, which is why CDD relies heavily on primary sources.

The core of a commercial due diligence programme is detailed discussions with customers, distributors, regulators, competitors, industry observers, and other relevant contacts in the market. Even in very well documented industries, such as telecoms and financial services, these interviews remain essential. The industry’s reputable published statistical reports should be exploited to the full but it is not possible to segment the market or analyse key purchase criteria without speaking to market participants.

Figure 5.3 below shows a generic list of the various primary information sources which a CDD team typically considers calling.

Figure 5.3. Primary information sources

Customers pay the bills, making their opinions the most important. They are best grouped into three categories:

An excellent customer fit is always a good start point for an acquisition. This is not just so that the buyer can cross sell, but it also means that the buyer understands how to deal with that group of customers. It is therefore unsurprising that early forms of commercial due diligence were in fact enhanced customer referencing exercises.

If customers hold a business in high esteem and will continue to buy from it, then its future is more likely to be healthy than if the opposite applies. However, customers are customers for a reason, therefore the scope of interviews needs to be widened to overcome their in-built bias. Non-customers are part of this widening.

Distributors, wholesalers, resellers, retailers or whoever else sells the product are almost as important as the end customers themselves. In some markets these distributors are the company’s direct customers. They are almost inevitably better-informed than the end users about the detailed workings of the target company and the strengths and weaknesses of its products.

Sometimes the relationship between principal and distributor is not straightforward. For example, a leading French financial services company sold half its products through one nationally-organised distributor. Enquiries revealed that this distributor strongly objected to certain conditions of its seven-year contract with the principal. These conditions had been acceptable at the start of the contract period, but had been made obsolete by changes in the industry. The principal obstinately refused to amend the terms of the contract and the distributor was actively planning to move on once the contract came to an end in less than a year’s time. This would wipe out half of the principal’s sales.

Specifiers can be as influential as customers and distributors in certain businesses, most notably in the construction industry. If the architect has specified a product ‘or equivalent’ then there is a strong chance that the builder will use it. Doctors are specifiers of pharmaceuticals and care homes. IT consultants specify computer hardware and software. Teachers specify school books.

Regulators can have a profound impact on industries, often in ways which are quite unforeseen. When the UK government started to encourage employees to make personal arrangements for their pensions it did not expect the pensions industry to adopt the forcible selling techniques which have given their sector a bad name.

The box below sets out examples of CDD programmes where regulatory change was a key consideration:

Suppliers can be an excellent source of information, particularly when the supplier sees the acquisition target as a key account. If you want to buy a Ford dealership then it would be a good idea to find out what Ford thinks of the business and its prospects. If you are buying a cable maker – or any other capital-intensive manufacturer – then it is worth interviewing the major equipment suppliers. They should know their target customers well. They may even be able to benchmark the target’s capex programme or manufacturing efficiency against its competitors. Suppliers are normally hungry for more information on their target markets and keen to identify new angles into customers which makes them willing to talk to outsiders.

Competitors usually keep a close eye on each other, they should have the most carefully researched information about the market and its future prospects – and if they are doing their job properly, they should have studied the weaknesses of the target company. Asked in the right way, competitors will usually be happy to talk about their rivals’ weaknesses to anyone who listens. An ideal question to ask a competitor might be: ‘...so, given your comments, if you were running xyz (target company) what would you do?’

Former employees can be an excellent source of information, but they are not always easy to include in the research programme. First, they can be hard to find. Once found, their opinions sometimes have to be discounted as they can have personal reasons for liking or disliking their former employer and former colleagues, particularly if they left under difficult circumstances. But they can also be superb sources of information. For example the customers of a market-leading instrumentation company unanimously agreed that the target company had the best products in its market, thanks to a first-class R&D department. Speaking to R&D people in the main competitor it was apparent that they were recent recruits from the target. It transpired that the target company’s management had emasculated the R&D department in order to improve the results of a disappointing year. The move was effective in the short term, but in the long term the company would clearly suffer from a lack of new products in an increasingly competitive market.

New entrants to a market will usually carry out a considerable amount of independent research before taking a market entry decision, so their views and plans are normally worth listening to. These companies can be hard to identify, although most market moves are advertised in some way; for example, in technical markets the research community will often get wind of potential developments.

Industry observers such as trade journalists, trade association officials, academics, and consultants follow developments in their industries closely, and are familiar with many of the major players. Talking to them should provide a good introductory briefing to an industry and its issues. Industry observers can also refer you to other useful contacts. The downside is that industry observers have their own agendas, like trying to pick up CDD work for themselves.

Trade journalists are often talkative and are delighted to share their views with interested outsiders. Generally the more niche the industry, the more accessible and talkative they are. Trade associations have to be careful to avoid being seen to promote the interests of one member firm above others, so they are rarely willing to offer opinions about individual companies. Nonetheless they can often help to describe some of the key characteristics of the industry, which helps to inform later discussions.

CDD should not rely solely on information provided by the company, or internal information held by the acquirer. Nonetheless, internal information is required to understand the business and allow external comparisons. The commercial due diligence team will normally request the business plan, performance measures and market-related information.

The target’s business or strategic plan is a key document for the acquirer to obtain and validate. It is the job of the CDD team to validate its projections and the assumptions which lie behind it. Often the forecasts may have been re-worked and re-presented by the seller’s corporate finance house, in an information memorandum (IM). An IM is a sales document, which inevitably presents the business in the best possible light. Watch out for unsubstantiated claims, 3D graphics and graphs which do not begin at zero.

Management should be able to provide performance measures on the business. Key Performance Indicators (KPIs) are hard measures, although not typically based on financial information.

Examples of KPIs include:

Whilst an internal analysis of the KPIs, across a division or from one year to another, is useful, the real value comes from competitor benchmarking. This requires careful planning and advanced interview skills to ensure that the information obtained from competitors can be used for valid comparisons.

CDD has a number of similarities to a standard strategy review or the type of strategic marketing review which would be carried out prior to launching a new product, it therefore uses a number of the techniques and tools used in such reviews.

Critical success factors (CSFs) define what a company must get right to achieve its goals and fulfil its strategy. The CSFs for a sports car company would include R&D, engineering excellence and branding. These deliver the performance and reputation required by the customer. Similarly the CSFs for the family car company would include wide distribution, quality management and marketing in order to deliver price, reliability and resale value.

Table 5.4 shows the links between key purchase criteria and critical success factors, and how they then can be measured by Key Performance Indicators (KPIs).

A critical element of CDD is to provide a clear opinion on the target company’s forecasts and their achievability. The simple way to analyse forecasts is to establish growth in the relevant market segments and then to review the variance between the target’s forecast growth rate and that of the market (see Figure 5.5). Plenty of companies claim to serve markets which are growing at 3–4 per cent p.a., yet their sales forecast is for 6–8 per cent p.a. This means that the company is gaining market share. Before buying it, you must work out if it really is capable of gaining share and who in particular is losing share. This is where a critical success factor (CSF) analysis can bridge any gaps. If the business can be proven to have an above-average performance against CSFs for the industry, then it can be expected to outperform the market. Conversely if it is below average on its CSF performance then any claim to outperform the market is difficult to believe.

Figure 5.5. An example of sector by sector review of forecasts

Business models and cultures in similar businesses vary, particularly between different countries. We can all describe the differences between British Airways, Virgin Atlantic and Ryanair. The informal, even colloquial, expressions we use are the tools that people will need if they are to attempt to integrate two or more cultures.

Do not forget that a company’s business model will reflect its culture, and vice versa. Culturally you cannot just swap the employees of BA, Virgin and Ryanair. Each airline would get even more complaints!

The important points are to:

Commercial due diligence can be carried out internally or by an external organisation. Some frequent acquirers have built teams and developed a great of deal of in-house CDD expertise. If you have the resource, conducting CDD in-house saves money, builds expertise and, most importantly, avoids any loss of information between the CDD and the acquisition integration phase. However, most acquirers do not have sufficient resources with the right skills and experience to cope with the intense workload of an acquisition. Moreover, an in-house team cannot disguise its identity and will find it difficult to talk to market participants, especially competitors. The other problem with in-house CDD teams is ‘going native’ and saying ‘yes’ to a bad deal. The situation can become impossibly uncomfortable for staff members if a senior director is on the warpath and wants to push his pet project through.

A range of external firms offer CDD services. The major audit firms have set out their stalls with some form of CDD offering, although the quality of their results can be impeded by their fear of litigation. The mainstream management consultancies are perhaps too well qualified for the work and are often expensive. Other marketing consultancies can suffer from the inverse problem. Acquirers are therefore typically best off using a specialist CDD consultancy.

Ferranti

In 1988 Ferranti bought International Signal Controls (ISC) without conducting CCD, and bankrupted itself. Ferranti was a long-established British electronics company with particular expertise in the defence sector. ISC was an American defence electronics company which claimed to have won a series of lucrative contracts with the defence procurement bodies of a range of foreign governments.

It took some time for the fact that several of these contracts did not in fact exist to be discovered, and it was two years before the resultant gaping hole in Ferranti’s balance sheet finally sank the company. Parts of the company survive within former competitors like Marconi and Thales. How could this disaster happen, and why did it take so long for the consequences to follow?

Ferranti sales and profit/loss

One reason why Ferranti bought ISC was to defend itself against a likely hostile bid from another British group, STC. Ferranti knew that STC had looked at ISC itself but had decided against going ahead. Ferranti believed that acquiring ISC would create a sort of poison pill, and thus divert STC’s attentions. It was correct, but the pill was more poisonous than expected.

ISC persuaded Ferranti that certain contracts were too sensitive to be investigated, and that following the acquisition they would need to be ‘ring-fenced’ and run separately from the main business. Ferranti, in a hurry to close the deal before STC’s bid materialised, agreed.

Amazingly, none of the claimed customers was approached to confirm the existence of the contracts. Admittedly, the nature of the business made such contacts more difficult than is usually the case – and one of the most important contacts had the misfortune to make an unplanned exit from a helicopter in mid-flight. But these obstacles do not diminish the need for proper commercial due diligence. The financial due diligence was also sloppy as Ferranti relied on the audit, but it was the failure to carry out commercial due diligence that sank the ship.

FDD should assess the level of maintainable earnings of the target business because it usually provides a guide to the future performance of the business. This requires a thorough understanding of the entire business and its market: it is much more than the identification and stripping-out of non-recurring profit and loss items.

FDD should review the business’s assets. Again, this work will have an eye on the future – it will look at accounting issues, but it should be mostly concerned with the nature of the assets, and their suitability for the business. Cash flow is going to suffer if assets are reaching the end of their life and will need replacing soon after the business is yours. FDD can also identify any assets the business owns, but does not necessarily need.

The investigation can also compare the market value of assets with their net book value. For example, low net book values may give a misleading view of the level of capital required by the business over the long term, and so may flatter the true maintainable earnings of the business. FDD should consider asset ownership; a sale and leaseback transaction may be an efficient way to release cash, indirectly helping to finance the acquisition itself.

The investigation of liabilities should look for any liabilities which have not been disclosed, or whose value has been underestimated. This part of the investigation tends to be more backward-looking: but, of course, the key underlying objective is to spot any unexpected future costs. Under-funded pension liabilities would be an obvious example.

To what extent are profits not reflected as net cash inflows? There may be good reasons for a business not to generate cash – the business may have invested heavily, or a business may be growing rapidly with the increased working capital requirement draining cash. These are important issues for any new owner of a business who may have to find extra cash to finance it properly.

Businesses are typically valued free of cash or debt; if either is in the company, this may impact on the transaction price. Assessing the level of cash or debt is not always easy. If the business is very seasonal – such as tourism or retail – or if some financial debt instruments are accounted for off balance sheet the calculations are harder to make.

An FDD team will have a lot of contact, discussion and interviews with the target’s management. Consequently a commercially minded FDD team should be well placed to comment on the strengths, weaknesses and even organisation of the management team. Experienced acquirers ask for these opinions as they are keen to anticipate how the target’s management team will fit into the new environment of the combined businesses.

It is common practice to provide the vendors and their advisers with a detailed information request list (or ‘shopping list’). FDD advisers have standard lists. The experienced ones know that it is best to tailor them to the circumstances of each particular transaction. Too many due diligence investigations get off to a bad start because the various advisers inundate the unsuspecting vendors with huge ill-considered requests for information, with considerable duplication across the different lists. Understandably, the vendors take this badly. Then either because they are genuinely annoyed or for tactical reasons, they may exploit this poor preparation to put the purchaser on the back foot, trying to weaken his negotiating position.

Appendix A provides an example of a shortened FDD information request list.

Interviews form a critical part of most financial investigations. They will often be based around documents, but the investigating accountant will also steer the conversation away from hard issues, always seeking to improve his understanding of the target business, its strengths and weaknesses, what it can achieve and where it might prove vulnerable. Covering similar ground with several different members of the target’s management team can be enlightening; for example, comparing the views of the managing director, finance director and production director.

As the sale of a business is often a traumatic period filled with uncertainty for its managers, the investigating accountant must be sensitive to the different circumstances of each transaction and each manager’s agenda. A newly-recruited manager may have little ‘baggage’ and be more ready to criticise the business while a long-standing manager has valuable, detailed knowledge but may be less objective and feel that any criticism of the business amounts to a criticism of him personally.

An owner manager, who has spent his life building his business, will naturally tend to present his business in a favourable light. The prospects of a professional manager who is not a vendor and who is being ‘sold with the business’ are quite different; he may quite quickly ‘change sides’ and identify with the purchaser, his prospective employer. He or she may even be motivated to show the business in a poor light, so that good performance following the acquisition is attributed to his subsequent good management.

It is common practice for the investigating accountants to review the working papers of the auditors to the target, and to interview the auditors. This is for two reasons:

But the target must formally give the auditors permission to open their files and the auditors will usually seek a ‘hold harmless’ letter signed by the investigating accountants and their client to ensure they cannot be sued. Negotiating this and related letters can be painfully slow and even then the auditors may not open up their files quickly. Sometimes no agreement is reached at all, forcing the purchaser and its advisers to manage somehow, perhaps by extending the scope of their investigations. In a similar vein, it is also useful for the investigating accountants to exchange views with the tax and legal advisers of the target, so long as access problems can be overcome.

The prime purpose of FDD is to assess the level of maintainable earnings of the target. The underlying objective in reviewing any historical information is to give an insight into the potential of the business to generate profits.

Examples of issues which might arise in the investigation of a target’s history and commercial activities include:

Legal due diligence focuses on the contractual relationships with management and employees. FDD should assess whether the people can drive the business forward after the acquisition. Investigating accountants will be interested in:

FDD can also reveal a range of issues in relation to the employees:

FDD of a company with weak information systems is likely to prove difficult, may overshoot deadlines and is more expensive than the investigation of a company with strong systems. Strong information systems also give confidence in the business as a whole; it is properly managed in accordance with carefully-drawn-up plans.

The review of accounting policies is an important part of FDD, even where the overall scope is limited. The reported profits of a business can depend very significantly on its accounting policies and the interpretation of them. The investigating accountant should examine carefully any changes to accounting policies. Although less easy to do, it should also look at their application.

The problem is amplified across borders: different countries adopt different accounting practices, leading to significant differences in reported results. The definition of financial debt is critical as it can have a simple and direct effect on the price payable for a target where the price is negotiated free of cash and of financial debt.

Some examples of issues that can arise on the review of accounting policies and information systems include:

Much of the value of a business lies in its capacity to generate gross margins. FDD will identify and strip out any non-recurring events and profits to establish the main underlying trends in the performance of the business.

The review of overheads is typically easier; it will involve explaining variations from year to year and, in particular, will seek to identify any exceptional items as well as any ongoing changes to the overhead base. This leads to a view on what the likely level of the overhead might be in the future.

The FDD team can draw on many sources of information to review trading results. Typically it will begin with statutory and management accounting information. It will also be particularly interested in unofficial information, which is used by the target’s management to monitor and control the business – something not always included in the management accounts. This can contribute significantly to understanding the business: of course it also implies that the management and control systems can be improved.

The FDD team then needs to understand the relationship between accounting profits and cash generation. A persistent failure to generate cash while continuing to show accounting profits might suggest that the profits and the underlying accounting treatment are questionable – the profits may not be real.

The review should also analyse the quality of treasury management. Is the business financed efficiently? Does management fully understand cash flows, predicting and managing the cash position?

We have already made the point that an FDD investigation of assets and liabilities is not an audit of assets and liabilities. An audit checks their existence and values them, generally based on historical cost. The assets and liabilities of a business are of interest to FDD only insofar as they contribute to the future earnings potential of the business.

Nonetheless, the review of assets can call on the accounting records as the starting point for enquiries. FDD should assess whether the business has the right assets of the right quality, and is able to handle current and forecast volumes of business. Is there an urgent need to make substantial investments in new equipment? Or are there assets, perfectly valid from an accounting and audit point of view, but which are not relevant to the core business and which can be sold?

The review of liabilities can also begin with the accounting records, but the primary concern may well be with those that do not figure in the accounting records. An experienced investigator should have a good idea of how to look for them in interviews, and especially in interviews with employees far from finance (production or sales, for example).

Examples of issues which might arise on a review of a company’s assets and liabilities are as follows:

The FDD team is often asked to undertake a high level review of a target’s tax affairs and highlight areas which appear likely to cause concern such as a dispute with the tax authorities. Any full tax investigation needs to be carried out by appropriate tax specialists. Make sure that the efforts of your various advisers are joined up, otherwise you risk increasing costs while not necessarily obtaining a better result.

The due diligence process should seek to identify tax planning opportunities both within the target and associated with the acquisition itself.

The following are examples of taxation issues that might be raised by FDD investigations:

Understanding the target’s pension arrangements and obtaining clear and up-to-date information on the future costs expected to be met by the company, are essential parts of FDD. The pension fund can be worth more than the target company. Equally, pension costs may be incurred many years into the future – and long after the workforce for whom the pensions are provided has ceased to be employed.

Issues that may need to be addressed include:

Much of the information required for the due diligence investigation will be available from the following sources:

Buyers and sellers often tangle over the net worth of the pension scheme as an asset or liability of the business. Specialist actuarial advice is therefore essential. The buyer may need to commission its own independent calculations, so it is important that the question of pensions is flagged up early in the process.

The logical finishing point for FDD is a review of the target company’s financial projections. Often the review of financial projections falls into two parts:

Acquisition synergies

Forecasts are usually prepared on a stand-alone basis, without taking into account the impact of new ownership. In some cases the acquirer and the target may work together to incorporate synergies into the forecast with FDD incorporating a review of these forecast synergies and the costs of their implementation.

Figure 5.6 shows how the CDD and FDD combine to build a view of forecasts.

Figure 5.6. How CDD and FDD combine to build a view of forecasts

The legal team will inevitably want to visit the premises of the target company personally. The reason for this is that top management can prove more willing than the shareholders to disclose some matters to the acquirer. You should resist sellers’ attempts to restrict access, although the lawyer must be sensitive to confidentiality and the circumstances of the transaction.

Next the legal team will send a list of highly-detailed written questions to the seller covering the issues on the checklist in Appendix C. As mentioned in the previous section, standard information requests should be adapted to the specifics of the transaction and all information requests from advisers should be coordinated in order to avoid duplication and confusion.

If there are a number of potential acquirers, the seller may put together a data room where information about the target business is collected for all potential acquirers to review. The objective is to give potential acquirers sufficient information to enable them to submit indicative bids for the target company. The preferred bidder will usually be allowed to conduct a normal due diligence programme once selected. The depth and quality of information available in data rooms is highly varied. Do not expect too much, otherwise you will be disappointed.

At some stage the seller will ‘disclose’ against the legal questions. It is in the seller’s interest to disclose as much as possible because what the buyer finds out this way cannot be the subject of legal action later on. Disclosure letters are therefore themselves a source of due diligence information. For example, they will contain a list of current and pending litigation.

While we are on the subject, the disclosure letter invariably goes through a succession of drafts, each one disclosing more information – and possibly leading to more questions about the information disclosed, seeking further and better particulars. Make sure that the seller does not deliver the disclosure letter at the eleventh hour. At this point the word ‘letter’ may be misleading anyway, because on large or very complex transactions, it may be closer to the size of a filing cabinet! If the final disclosure letter contains new information this can derail the completion, as the buyer may need to reconsider some aspects of the deal. Early drafting of the final disclosure letter helps to keep the due diligence process within the timetable.

Acquirers need to know if the target company has the title to its properties. A shortcut can be to arrange for the target’s solicitors to deliver certificates of title. This can be quicker and cheaper than an investigation because the solicitors concerned already know the information. Another advantage is the professional indemnity insurance cover of the solicitors giving the certificate.

Specialist advisers may be needed to report on particular aspects of the business, such as environmental risk assessment. These reports have a long lead time, so they should be commissioned early. Access to the premises may also need to be agreed.

The investigation should also cover information from public sources. The acquirer is not reliant on the cooperation of the seller for this information and can verify the information which the seller provides itself. The most important public information sources are set out in Appendix D.