The M&A Mini-Series: Leveraging Due Diligence for a 360° View

Every merger or acquisition embodies both universal interoperable requirements and unique opportunities and pitfalls.

Due diligence is the interoperable requirement where all M&A journeys begin and where many die an early death.

Any unique aspect makes due diligence even more rigorous.

As I reported in my last newsletter, because we at Blythe Global Advisors have recently helped several clients successfully close M&A transactions, I wanted to share four brief scenarios that illustrate a simple premise: Every merger or acquisition embodies both universal interoperable requirements and unique opportunities and pitfalls. That’s because every transaction is unique in terms of the enterprises involved and what each brings (or doesn’t bring) to the table – thus presenting different opportunities and pitfalls that can determine the fortunes of the companies involved for years to come. I’m calling these brief scenarios an “M&A Mini-Series.” In this first installment, I’ll share how the universal requirement of due diligence – always challenging in itself – presented additional hurdles for my clients (the buyers about 90 percent of the time), their targets, and the respective auditors and consultants. Due diligence is critical in determining if the underlying assumptions of a merger or acquisition have been correctly assessed. It’s where all M&A journeys begin and where many die an early death. In the due diligence phase, buyers need to collect, scrutinize and verify mountains of documentation from their targets in order to identify potential opportunities, problems, errors, inconsistencies, threats, etc. The team assembled to perform this information-gathering must possess – at a minimum – deep M&A experience; individual subject matter expertise to cover all aspects of the organization; and strong project management, integration, organizational and communications skills. In other words, the due diligence team needs to hit the ground running – knowing what to look for, where to look for it and how to communicate quickly and effectively with all parties. The unique aspect relating to due diligence that several of our recent engagements shared was that the targets’ financial results had never been subjected to an audit because they were either the subsidiaries or business units of larger companies or very closely held private companies. As the financial arm of many due diligence teams, the first thing we at Blythe Global Advisors want to know is, are the target’s financial results compliant with GAAP? We’ve found that when the target is a subsidiary or business unit of a larger company or a closely held private company, revenue recognition practices are often not in accordance with GAAP with the consequence that historical results can be way off – on both sides of the ledger. On the negative side, we often find non-recurring revenues or income in the historical results that make the target look better than they actually are. These usually involve complex issues such as equity-based compensation not properly accounted for, improper analysis of assets for impairment, incorrect recordkeeping for contracts or failure to account fully for potential liabilities – to name just a few. Conversely, we also often find non-recurring expenses – one-time or unusual events – incorrectly dragging down results. An example here is a costly but settled litigation. In the first instance, we’ve seen potential buyers walk away quickly at the first hint of lesser actual results. In the second instance, by looking for both missed negatives and missed positives in the historical documentation, we’ve helped potential buyers get a 360-degree understanding of the transaction and insight into potential hot buttons that could crop up during the SEC review process. I think there are two important lessons to learn from these engagements. First, it’s essential that a buyer assemble a due diligence team where each subject matter expert can look at their respective issues from both the buyer’s and target’s perspectives. At Blythe Global, we feel that buyers and sellers alike are entitled to a multidimensional, forward-looking analysis so both sides can more accurately assess current and future value. Second, if you’re lucky enough to be an attractive subsidiary or business unit or a sought-after private company, it would be very much to your advantage if you take the following five steps ahead of any overture:

1. Ensure your results are in accordance with GAAP on a stand-alone basis.
   I get it. An audit is expensive, and it’s asking a lot to suggest spending money when you’re not obligated to do so and there aren’t any buyers in immediate sight. On the other hand, if your books are really out of whack when buyers do knock, you could find yourself spending lots of money tapping into your parent company’s audit firm or hiring new auditors who have to start from scratch. In this case, I recommend spending the money. Just be sure to note it as a one-time, non-recurring expense.
2. Identify the non-recurring elements of your historical results that you need to explain to a potential buyer.
3. Identify adjustments to EBITDA that should be excluded according to normal cash flow calculations.
4. Identify and explain potential liabilities that may not be reflected in your financial results.
5. Correlate the adjusted historical results with future projections so they make sense to a potential buyer.

Following these suggestions can help ensure that the due diligence effort is a first step to a successful close of deal and not a deal-killer. If you would like to discuss anything in this or any of my newsletters, please contact me. We have a proven track record of helping companies make investment decisions with confidence. I’d be delighted to talk with you.

To discuss this important topic further or if you’re looking for general accounting advice and counsel, contact marc@blytheglobal.com