• Provisioning policy : assessing the general approach towards cut-off and provisioning policies adopted by the management; (for example in the financial sector when the target management tries to postpone provisioning for non-performing assets or in the manufacturing sector when provisions for warranties tend to get accounted for only on cash basis or in the mining sector when future costs for rehabilitation under environmental regulations are currently ignored and provided for only when incurred);
• Contingent liabilities and off balance sheet items : (where aggressive tax opinions enable a target not to provide against matters in litigation); assessing guarantees/off balance sheet obligations in respect of related parties;
• Change of control matters : potential payments arising out of change of control/additional costs; severance/retention pay upon the occurrence of transaction;
• Pension and related obligations : assessing the provisioning and funding of liabilities; this is particularly important in cross-border transactions — there is a need to take the help from specialised local resources to assess the liabilities;
• Earn-outs/contingent consideration from prior business combinations : for e.g., an acquisition in the past that may have contingent payments to be taken into consideration or where receivables are securitised with a bank with recourse i.e., the target has an obligation to buy back delinquent receivables.
Separation, structuring and integration issues :
Typically, these issues are relevant for a strategic investor
engaged in a similar line of activity. The FDD exercise would focus on
identifying areas that may result in changes in the cost structure post
transaction, requirement of additional infrastructure to be created by the
client or potential utilisation of the existing infrastructure of the client or
additional cost of integration.
The areas that may be covered from a financial viewpoint
would typically cover :
• Identification of broad synergies : due diligence process should identify different kinds of synergies, and then an estimate of their potential value, likelihood, time and cost to achieve the synergies.
• Accounting policy conformity : extent of differences between the accounting policies of the buyer and the seller and its impact post the transaction. This assumes significant importance particularly in the case of a transaction where the buyer and the seller are from different countries — foreign buyer following a local GAAP — IFRS, USGAAP, etc. and the Indian seller following Indian GAAP. The differences in accounting may have a significant impact on the reported profitability/value of assets post the transaction. This may also create significant challenges in upgrading the existing systems and procedures of the target to be able to support the reporting requirements of the buyer.
• Transition services agreement : the target may have dependencies on the parent entity (the seller) and would thus require an agreement for continuity in the availability of goods or services in future (utilisation of common utilities, distribution network, etc.).
• Stand-alone considerations (impact of economies of scale, support functions) : it is essential to understand the dependencies on the parent entity and enter into the transition services agreement as mentioned above. However, it is also important to understand the impact on costs on a go-forward basis considering potential stand-alone operations.
Other matters :
During an FDD exercise, apart from the aforesaid broad areas that are directly linked to accounting matters, there are other aspects relating to the business that may have an impact on the financial position of the business and are thus important to consider during an FDD exercise. These are discussed below.
Related-party transactions :
Related-party transactions could have a significant impact on the reported historical earnings/margins of the business. Further, these transactions may also create significant dependencies and have a material impact on the continuity of the operations on the business. In such situations, it is important to identify the nature of transactions, the level of existing charges recovered from the target business, the availability of such services/facilities in future and the charges thereof. The arrangements that would need to be agreed during the transition period should be identified and provided for in the transaction documents. Further, any impact on the valuation model would also need to be considered for any revisions in the current costs.
Generally, ‘related parties’ are defined by law and the transactions are required to be reported in the financial statements. However, it is important to identify the related parties that are not covered by the definition as per law, but that are de facto related parties in common business parlance. This identification is generally achieved based on discussions with the management of the target and analysis of the key transactions in respect of purchase and sales relating to the terms and conditions.
Key aspects while reviewing related party transactions would involve an assessment of :
• Financial appropriateness of transactions within family-run businesses (arm’s-length pricing);
• Level of dependency of the target operating within a ‘group’ (assets used by the target entity but that are actually owned by a related party; e.g., office premises, the IT infrastructure or even the title to the corporate/product brand);
• Extent of sharing of resources and the allocation of common costs;
• Details of financing arrangements with related parties;
• Arrangements that are based on oral under-standings and/or are on a ‘no-cost’ basis.
Human resources :
Analysis of human resources is a multifaceted task and is generally covered by the legal due diligence, HR due diligence with defined inputs from the FDD exercise. The key focus areas of the FDD exercise in relation to human resource matters are to establish the total cost to the company (CTC) of all human resources, to assess the extent of accumulated unprovided/unfunded for liabilities in relation to employee benefits and to also understand the level of current charge of such costs and any underprovisioning thereof.
Identification of the total employee strength and total CTC of the target company may become an issue where there is a high level of contracted employees (like in the media advertising sector) or when there is high level of casual labour that is ‘permanently temporary’ !
In certain instances such as relocation of facilities post acquisition, the analysis may need to be extended to understand the implication of severance of employees not willing to transfer to the proposed new location and also additional facilities/ benefits that may need to be incurred to ensure transfer of necessary employees to the new location besides addressing the issues relating to availability of skilled resources in the new location.
It is important to analyse the movements in the level of staff in the recent period with specific emphasis on understanding if there have been attrition in respect of key staff. Particularly, in a distress situation, the current staff may not be adequate and may not represent the true requirement for the business and would need to be replenished. The costs relating to such optimum level of requirements of the staff would need to be assessed and considered in the valuation model.
In case of a strategic acquisition, matters relating to integrating the two businesses assume importance. The compensation levels and structure may be significantly different across the buyer and the seller and may have material implications for the buyer post acquisition. Thus a careful analysis is required in relation to the current staff cost of the target and potential changes post the transaction.
Conclusion :
In today’s environment, as a key input during the decision-making process and also as a part of general corporate governance, financial due diligence is considered as a must. It is not just checking of facts and summarising them, but it is about evaluation, interpretation and communication that require a proficient understanding of the business and of the transaction besides exercising strong financial and accounting skills.
Companies making acquisitions typically look for answers to four basic questions :
• What is being acquired ? (customers, competition, costs, capabilities)
• What is the target’s stand-alone value ?
• Where are the synergies and skeletons ?
• What is the walk-away price ?
It is vital that the FDD team remembers the above and exercises a degree of prudence and professional skepticism when carrying out the assignment — deal making is glamorous, due diligence is not. The FDD team may focus on negative information and on identifying the risks and problems surrounding the transaction, but as a professional service provider, the FDD team must devise solutions to problems or mechanisms to reduce or manage the risks involved in the transaction. For every man-made problem there is a man-made solution — the skill is to find it !
