The price might be right. But, value still leaks out of most M&A deals. Why does a majority of M&A deals fail to meet their objectives? It all boils down to doing due diligence, thoroughly and diligently. Due diligence is a vital ingredient of M&A deals and is generally used for validating underlying deal assumptions. Says Partha Ghosh, partner in the Mumbai-based PricewaterhouseCoopers: "A good due diligence is needed to confirm that there are no black holes ahead".

A comprehensive due diligence helps to uncover the underlying reality of historical data, turn the spotlight on negotiating issues, identify potential deal-breakers and generate a clear opinion on the target company's status and prospects.

Validating projections
Quite often, sellers and buyers share no financial information. That is why it is essential to validate whatever financial statements the seller places on the negotiating table. Projections might be placed alongside. It is here that the buyer should make an offer subject to due diligence and evaluation of the projections furnished.

During the negotiation stage, the seller makes representations about the company, its products and its employees. All these representations need to be confirmed during a due diligence. That is the pricing aspect of due diligence.

The price might have been fixed and both the parties might have agreed to put the deal through. However, a due diligence might be needed for the Board. In such cases, due diligence is just a formality.

Due diligence for comfort
In an acquisition deal, the price or the purchase consideration depends on due diligence. What the buyer and the seller do here is to sign a memorandum of understanding (MoU) with broader terms. This MoU is not a legal document. The price is determined only after a due diligence is carried out.

Of late, foreign acquirers, particularly those from Europe, have become obsessed with the environmental issues surrounding the target company. So, one needs to carry out an environmental due diligence. Most buyers however want to acquire a company without any hanging litigation pertaining to matters such as income tax, sales tax and excise demands. The buyers want the sellers to settle all pending matters before a deal is put through. A due diligence in such cases has become a must. Says Ghosh: "Due diligence offers comfort in an acquisition deal."

Matching cultures
A majority of deals fail post-acquisition. Reason: cultures, ethics and practices of the acquirer and the acquired do not match. So, what is very important in an acquisition is this: check out what is unique about the target company and whether the cultures of both the acquirer and the acquired match. That is why much significance is placed on human resources due diligence these days.

Thanks to potential post-acquisition blues, it has become essential for the acquirer to study the steps he would have to take in integrating the acquired company with his. Though not a part of due diligence, this study is its logical follow-up.

Value-additions
In any due diligence, it is necessary to see whether consolidated reports and consolidated management information systems are compatible. Not just that. Information technology packages of the acquired need to be examined and studied. Says Ghosh: "These are all value-additions which are critical to the success of an acquisition deal." Acquirers need to go a step further. They should look at employee packages too.

Uncovering hidden liabilities is another value-addition vital to any due diligence. But, quite often hidden liabilities are limitations of a due diligence. Deal-makers should ensure that the top management of the target company makes representations on unrecorded liabilities, gets in touch with the target company’s auditors and tries to unravel the hidden liabilities as much as possible. Says Ghosh: "No due diligence is fool-proof."

However, an attempt should be made to derive maximum advantage out of a due diligence exercise. Quite often, the sellers offer projections based on historical accounts and on certain assumptions. It is necessary to validate them.

Another value-addition is using due diligence to make tax-efficient acquisitions happen. A due diligence should provide a potential acquirer answers to these posers: whether to go through the Mauritius route or not, should the whole company be bought or just the plant and machinery and whether to buy the technology or just the brands.

Quite often, there might be pending issues in a target company. Such issues could either be legal or regulatory or related to labour. These issues can be crystallised only after a due diligence.

One thing that needs an emphasis here is that due diligence is different from an audit. Audit is a mandatory requirement of the Indian Companies Act and its parameters are determined by the Institute of Chartered Accountants. But, due diligence is mandated by the buyer and what course it should take is determined by the acquirer. Says Ghosh: "Due diligence is specific to a deal and is mandated by the acquirer." For instance, an acquirer might want to look just at the payrolls and thus commission only a payroll due diligence.

Forms of due diligence
When you have decided on due diligence pre-acquisition, you must be prepared to do it in four different forms. These are:

Market due diligence
Market due diligence provides a clear and coherent view of business of the target company. That calls for a detailed and focused understanding of the target company's business and its competitive position in the market in which it operates.

Operational due diligence
This involves evaluating all operational assumptions that are key inputs to the success of an M&A deal. Example: prior to an acquisition of technology, it is essential to do a due diligence on the profits the technology is likely to generate. Only such a due diligence can help to determine the acquisition price.

Financial due diligence
This covers review of financial statements of the target company. It involves many areas of enquiry, wider than those relevant to a statutory audit. However, the degree of verification is lesser compared to a statutory audit. The objective of this due diligence is to make sure that the acquirer is buying what he thinks he is buying.

The areas of enquiry in a financial due diligence are: whether assets and liabilities are properly stated in the balance sheet, whether there are any hidden liabilities, how to evaluate contingent liabilities, whether debtors are good, whether the provision for doubtful debts is adequate and whether the inventory has been valued conservatively.

Legal due diligence
This covers the legal aspects of an M&A deal. Example: whether the target company has necessary licences to carry on its business and whether such licences are easily transferable. Licences might be transferable but subject to certain conditions and it is the function of legal due diligence to go into such covenants.

Due diligence in stages
Due diligence is needed at various stages of an M&A deal. Whether it is evaluating a deal or executing a deal or harvesting a deal, due diligence is vital.

Evaluating a deal
A no-access due diligence is generally carried out at the deal evaluation stage itself. This primarily consists of desk-top reviews. It involves combining financial analysis with market intelligence that can be gathered without access to the target company. Such an evaluation is indispensable at the early stage of any M&A deal.

Executing a deal
At the execution stage of any M&A deal, a detailed due diligence is carried out. The deliverables include a detailed report which focuses on negotiating points and areas to be protected in the acquisition agreement.

Harvesting a deal
Nowadays, a sell-side due diligence is also carried out. Such a review covers a rounded view of the business, encompassing its performance and prospects and all issues that may be relevant to an acquirer. The objective of such a review is to uncover the deal issues and ensure that these issues are controlled and dealt with by the seller, rather than being used as negotiating points by the acquirer.

Put differently, harvesting a deal means doing due diligence on the assumption that buyers are waiting out there. It is doing due diligence at the seller's end. It involves assuming the existence of a buyer, foreseeing his problems and expectations and doing a SWOT analysis before a sell-off. Such a due diligence by the seller might be acceptable to the buyer at times.

No-access due diligence
Thanks to the mania for consolidation, no-access due diligence is gaining ground. This involves a comprehensive desk-top review at the buyer's end. This is just the reverse of harvesting a deal. No-access due diligence assumes there are sellers around and does not entail going to the seller's office. At the buyer's office, a seller's public documents such as annual reports, documents pertaining to the Registrar of Companies, stock exchange documents such as listing agreements are examined. This due diligence helps to decide whether to give an offer and if so to which potential seller.

To be sure, due diligence adds value to M&A deals and helps to steer clear of potential hurdles. It might not be fool-proof but it certainly is an indicator of potential black holes and roadblocks ahead.