Feature Article

The Important Role of Due Diligence in M&A Deals

By Jennifer Martin, CPA, CFE, of MarshBerry

The term “due diligence” is synonymous with words like: assessment, investigation, scrutiny, and audit. It also conjures up descriptors such as: slow, laborious, or painstaking. Because of this, the importance of the due diligence process in merger and acquisition (M&A) deals may be easily dismissed or perhaps rushed – defeating its true value and purpose: to thoroughly examine the crucial elements of a transaction to the benefit of all parties. And a “thorough examination” of a potential M&A deal could mean the difference between tremendous success or disastrous failure of a partnership.

Reasons Some Firms May Forego Due Diligence

Because of the assumption that the due diligence step will slow down the process of a deal, some firms may gloss over or rush this step because of the timing and/or cost. There are also some assumptions that experienced owners know their business or the industry so well, there is no need for outside consultation or expertise to perform due diligence. But having an experienced third-party due diligence review is more about having someone who understands the steps in the process, understands the insurance industry, and can provide unbiased assessments that both parties can trust, ultimately to help everyone make informed decisions.

Due Diligence is Valuable to Both the Buyer and the Seller

As tiring and taxing as the process may seem, having both buyer and seller really dig into the details of the transaction can benefit both parties. Unlike the early courting phase of partnerships, which can feel like speed dating, the due diligence phase allows each party to slow down and really assess how the moving parts of both businesses will work together.

For many buyers, they have done this before and recognize due diligence as a critical step in the M&A process. For them, it’s about understanding all of the potential risks, opportunities, and business components of their potential investment or acquisition. The more informed a buyer is, the better the relationship will be through integration post transaction.

For most sellers, this may be the first time (or only time) they are involved in an M&A deal and might find the due diligence process inconvenient and unnecessary. But sellers should understand that due diligence provides them an opportunity to address any concerns, questions, or potential risks identified during the review. In fact, a seller should consider conducting their own pre-due diligence assessment in order to be prepared for questions from the buyer.

Getting Started

Once a letter of intent is signed with a target to exclusively negotiate on an acquisition, confirmatory due diligence begins. This phase is often driven by the buyer and/or the buyer’s advisors. Some buyers perform due diligence in-house, but most buyers involve an outside advisor to represent their interest, and it is often a requirement of the buyer’s capital provider. However, it is just as important for the seller to confirm their understanding of the buyer during this phase. Afterall, the end goal is a successful partnership with no buyer or seller remorse. Like dating – there will be many twists and turns, but most can be anticipated and/or avoided with proper planning. And properly planned due diligence can help prevent deal fatigue by both parties.

Risk Assessment and Potential Pitfalls

Performing a risk assessment at the onset of due diligence can save time down the road, help identify what matters most, minimize the unexpected, and allow for a more efficient process. Most due diligence assessments start by looking at the “why” behind doing this transaction in the first place. What are the goals and objectives of this partnership? How will everyone define and measure success for this deal? Once these are clearly identified – next, it’s important to think about and document the potential pitfalls that could undermine the “why” of doing the deal.

Here are some top pitfalls to watch for:

● Culture clashes. Integrating people from different corporate cultures can be one of the biggest challenges and potential pitfalls to a successful deal. Healthy work cultures, team chemistry, and individual personalities of senior-level leaders aren’t identified on financial spreadsheets. These are qualities that need to be examined and evaluated closely and are proven to impact M&A deal success rates.1

● HR issues. Every organization handles staffing differently – ranging from the classification of workers (i.e., full time, part time, independent contractor) to salary structures for sales personnel to restrictive covenants. It’s important to understand how a partnership may impact those existing employment structures.

● Lack of strategic alignment. M&A can be a powerful tool in helping both parties achieve their strategic goals. However, it is important to ensure that both parties are aligned on their vision and objectives. Without a clear strategic fit, the deal may not deliver the benefits as anticipated by both parties.

● Pro-forma disagreements. Pro forma EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization) is often a primary driver of valuation in most deals. Therefore, sellers are motivated to be aggressive in their pro forma assumptions, and buyers are motivated to take a more conservative approach. It is important for both parties to understand the methodology utilized in building the pro forma and agree on how any synergies or shared costs will be treated. Not only is this important for the initial valuation, but also for earnout purposes if contingent payments are part of the deal structure.

Resolving Issues

As items are identified during the due diligence process, whether positive or negative, keep a scorecard and compare with the initial risk assessment. Keep track of how issues are handled as they arise. Afterall, in any partnership it is not a matter of “if” issues will arise but rather “when” they will arise. Take note on how collaborative or not your potential partner is being in determining an agreeable solution. It is better to gain this level of understanding during the engagement phase rather than after a completed transaction.

Every deal carries a certain amount of uncertainty and risk. However, properly planned and executed due diligence can help minimize the risk for potential issues post transaction and can help keep emotions in-check. Documenting, quantifying, and analyzing the risks during diligence can help make buyers and sellers more comfortable on the day they are signing or making that wire transfer.

If you would like to learn more about how to navigate the complexities of partnership deal negotiations, email or call Jen Martin, Vice President, MarshBerry, at Jen.Martin@ MarshBerry.com or 440-287-6790.

Investment banking services offered through MarshBerry Capital, LLC, Member FINRA and SIPC, and an affiliate of Marsh, Berry & Company, LLC, 28601 Chagrin Blvd, Suite 400, Woodmere, OH 44122 (440) 354-3230

1 https://www.mckinsey.com/capabilities/m-and-a/ourinsights/the-flip-side-of-large-m-and-a-deals