IMPORTANCE OF DUE DILIGENCE AND FINANCIAL DUE DILIGENCE 12 th Nov 2011 - CA. SUJAL SHAH
Contents Meaning of Due Diligence Review (DDR) Scope of DDR Situations calling for DDR Types of DDR Financial DDR Practical Situations Findings and their Impact Limitations Risks Involved and Steps to Mitigate Reporting
Meaning of DDR Dictionary Meaning of Due is Sufficient & Diligence is Persistent effort or work. It is an investigation into the affairs of an entity prior to its acquisition, flotation, restructuring or other similar transaction Due Diligence Review is a process whereby an individual or an organization seeks sufficient information about a business entity to reach an informed judgment as to its value for a specific purpose.
Due Diligence What is it? The process by which information is gathered about: A target Company Its Business; and The Environment in which the target company operates Objective: To ensure that prospective investors make an informed investment decision
Due Diligence What is it? (Cont) It is a business oriented analysis not an accounting analysis A fact gathering exercise with focused analysis of information Understanding the industry of the target Reasonable level of enquiry into the affairs having material impact on the prospects of the business Evaluation of business model and key business practices
Scope of DDR Scope is determined by the client. The degree of diligence required in any given review cannot be precisely defined. Purpose for review defines what is due or sufficient diligence. Extent of the review required is a judgment call. Engagement letter with the client is important.
Who conducts a DDR? Chartered Accountants Investment Bankers Attorneys Lead & Co-Investors Corporate Development Staff
Situations Calling for DDR Firm considering a potential acquisition Investment banker considering underwriting a public security Banker considering the grant of a loan Venture Capitalist considering an Investment Seller of a business commissioning a DDR Lead Investment Banker in case of IPO as per SEBI Norms
Types of DDR Business Due Diligence Financial Due Diligence Legal Due Diligence Tax Due Diligence System Due Diligence Environmental Due Diligence Human Resource Due Diligence 9
Introduction to Financial DDR Financial due diligence has the highest significance the final decision, for an investor, would be in the form of financial terms and information. It is therefore imperative that the results of all kinds of due diligence should be translated in monetary terms. Identification of hidden risks& deal breakers Ensuring that all liabilities, current and contingent, are considered Establishing price adjustments/ negotiation extent of dependency on customers and vendors Off balance sheet financing Identification of specific indemnities & warranties required from target 10
Types of Financial DDR Buy Side Due Diligence commissioned by the acquirer Focused on areas of interest for potential acquirer Reporting generally issue based Dataroom < > exclusive Sell Side (Vendor DD) Independent due diligence commissioned by the vendor Key tool for maximising saleability of the business in a reduced timetable To identify potential issues and take corrective measures upfront 11
Types of Financial DDR Limited Focus on certain key areas based on the level of comfort desired by the Client Full Scale Focus on all major aspects of financial statements Extent of detail is more as compared to limited due diligence It is important to know what s driving value for your clients 12
Methodology of Financial DDR Quick Appraisal Terms of Reference Information Checklist Field Work Identifying Issues Replies from Management Preparation of Draft Report Discussion of Draft Report Issue of Final Report
Areas in Financial DDR Business Environment This would typically assess the effect the external factors have upon business. This when compared with the internal strengths and weakness, provides a good understanding of the state of business. External factors generally include markets, competition, regulation and technology. Company Operations This would involve understanding the business model of the target and the value chain of its business. Other than the main value creating functions viz. procurement and its logistics, production, marketing and sales and distribution logistics, attention is also given to the functions that support these activities. 14
Areas in Financial DDR Quality of Earnings Evaluation of the build up of operating profits Identifying key sensitive parameters which would adversely impact the profitability of the business Therateof growthinsales, EBITDAandearnings Sustainability of earnings/ cash flows Normalised EBITDA Cash Flows Analysing cash flows generated from operations and how the same are employed Understanding the level, stability, timing and certainty of future cash flows Analysis of working capital 15
Areas in Financial DDR Balance Sheet Assets and Liabilities Analysis of fixed assets -Capitalisation, depreciation and replacement policies; Capex plan, capital commitments Investments made, carrying value, valuation policies and potential diminution in the value of the investments Receivables (ageing analysis, recoverability, bad debts and provisioning policy) Inventory (ageing, valuation, write off/provisioning policies) Cash balance and bank reconciliations Analysis of other current assets like loans and advances, deposits, cash/ bank balances. 16
Areas in Financial DDR Balance Sheet Assets and Liabilities Sundry creditors (ageing analysis, subsequent payment of creditors dues) Review of loan agreements to see compliance with the terms of the lenders guidelines and also if any conversion clause exists. Review of all other current liabilities & provisions to see that all known liabilities are fully recorded and all provisions are made. Shareholders agreement in case of companies Off balance sheet liabilities-bank guarantees, commitments, legal claims and contingencies 17
Areas in Financial DDR Taxation Direct and Indirect This would involve various issues related to taxation to ensure that no undisclosed liabilities accrue to the target Assessment and validation of losses / other tax attributes Current compliance status; Tax benefits and their availability in future; and Commentary on any other outstanding tax liabilities/ material issues 18
Areas in Financial DDR Other Areas Review of various agreements / arrangements with related parties and assessment of various transactions with them Evaluation of commitments to / from related parties Analysis of human resources with respect to head count and provision for retirement benefits in line with laws applicable Review of other arrangements necessary for conduct of business e.g. contractual labour, trade unions, etc 19
Practical Situations Fixed Assets Litigated assets & property Adjustments for capitalization of assets, software expenses, etc. Capitalisation of Capital Work-In-Progress (CWIP) Physical verification of Fixed Assets Depreciation policy 20
Practical Situations Investments Investments carried at cost though realizable value is much lower Investments carrying a very low rate of income / return Clear title to all Investments 21
Practical Situations Working Capital Uncollected/ uncollectible receivables Obsolete, slow & non-moving inventories or inventories valued above Net Realizable Value Adjustment for Inventories with old names/logos in the case of hotel industry Inventories in case of discontinued products Group company balances under reconciliation, etc. 22
Practical Situations Deferred Revenue Expenditure Deferred revenue expenditure included under advances or not normally deferrable Taxes Non Deduction of TDS Timely filing of returns 23
Practical Situations Other Claims Environmental problems/claims, third party claims Huge labour claims under negotiation when the labour wage agreement has already expired Non-funded gratuity/superannuation/leave salary liabilities Non-compliance with enactments such as the Income Tax Act, FEMA/FERA, Customs Act, etc. that could result in litigation & levy of penalties Product warranties, defects & other liability claims, product returns & discounts, liquidated damages for late deliveries 24
Practical Situations Off Balance Sheet Items Target co. may not show any show cause notices which have not matured into demands as contingent liabilities. These may be material & important Target co. may have given Letters of Comfort to banks & FIs. Since these are not guarantees, these may not be disclosed in its balance sheet Commitments including long term contracts Agreement to buy back shares sold at a stated price Future lease liabilities 25
Practical Situations Profit & Loss Items Identifying seasonality in sales, dependency on customers Assessing the impact of customers gained / lost on the bottom line Dependency on customers/suppliers Revenue recognition and cut off procedures Items of one off / non recurring nature Impact of stand alone costs Agreed upon escalation in costs like raw material, rent, etc. 26
Practical Situations Profit & Loss Items Provisioning policy for employee benefits, warranties, etc Provisioning for bad and doubtful debts and advances Transactions with related parties whether at arms length 27
Findings and their Impact The DDR findings are then quantified for impact on the final valuation Deal Breakers - Those issues which would impediment the consummation of the proposed transaction Negotiation points - Those issues which would be necessary to consider in the valuation of business/ negotiation of bid price Issues for Agreements - Those issues which would warrant indemnities and identify conditions precedent for happening of the transaction Commercial Override - Those risks and issues which are knowingly taken over as a calculated commercial decision 28
Limitations For Service Providers Limited scope of review fixed by the client Too much to see in too little time For Acquirers/Investors Inability to determine the scope Inability to ensure proper co-ordination between service providers 29
Risks Involved For Service Providers Failing to meet the needs of the party commissioning a due diligence Financial indemnification of the consequential loss 30
Risks Involved For Acquirer/Investor The investor may pay higher than the fair price for acquisition The investment performance may not be upto the expectation or may perform badly A bad strategic investment may result in losing a considerable market share or reputation 31
Steps to Mitigate Risks By Service Provider Clearly understand the objectives & the complexities of the assignment based on which the scope should be finalized The DDR report should disclose all the limitations of the assignment A proper engagement review should be carried out before accepting the assignment and deciding the scope 32
Steps to Mitigate Risks By Service Provider Schedule meetings with other reviewers Collect from the client reports of all other due diligences The due diligence team should consist of at least one person who is familiar with the industry, the target is involved in 33
Steps to Mitigate Risks By Acquirer/Investor Should ensure that the scope is comprehensive Proper coordination amongst all service providers should be encouraged An integrated service provider may be hired To ensure that the target provides all necessary information 34
To Conclude.. Due Diligence plays an important role in identifying, quantifying and reducing the risks of an acquisition. Although Due Diligence focuses on negative information, the aim is not to raise obstacles to transactions, but rather to facilitate transactions by identifying problems and risks by devising solutions to problems or devices to reduce or manage the risks involved in corporate acquisitions. 35