Due Diligence: Art or Science?.

Article | Jan Fachot | 11th April 2022

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Definition

The origins of due diligence can be traced back to the 1930’s, when the term “reasonable investigation” was introduced in the US Securities Act of 1933. This legislation recommended a law against dealers accused of disclosing inadequate information regarding a purchase of property or securities to investors.

Nearly 90 years on from the concept being formulated through US law, there is still no dictionary definition of the term. In its simplest form, it is a process of enquiry and investigation made by a prospective purchaser to confirm that they are buying what they think they are buying. The term “Caveat Emptor”  is central to the acquisition process. It is a Latin term which means “let the buyer beware”.

Dealmakers typically take this definition a step further. They see due diligence as an exercise to reduce transactional risk; i.e., to:

  • identify issues that feed into the price negotiations, and hence reduce the risk of paying too much; and
  • de-risk the deal by identifying points against which legal protection should be sought.

However, does this exercise really go far enough? What are you planning to do with the business following acquisition? Considering your response to this latter question is equally, if not more important to ensure deal success. Due diligence should therefore not be limited to identifying and isolating pre-deal risks. It should be seen as an opportunity to provide an insight into post-deal integration. Pre-deal synergy evaluation becomes a powerful tool in ensuring a successful outcome. A carefully considered due diligence exercise would also consider whether the target would fit both culturally and operationally with your existing business.

Art or Science?

How should you approach due diligence? Discussions concerning the best approach to due diligence continue to rumble on. There is no “one size fits all” approach to this exercise. Each prospective acquisition will have its pros and cons that require careful evaluation. A thoughtful due diligence process needs to therefore be both an art and a science.

Science: is a systematically organised body of knowledge on a particular subject.

Art:  is the expression or application of human creative skill and imagination

The science of due diligence seeks to understand the financial model of the target and sensitivity to critical parameters. On the other hand, the art of due diligence focusses on who the entrepreneurs are and deals with the non-traditional, the unknown conditions and circumstances that the buyer should be made aware of to enable an effective and efficient decision-making process. As due diligence is part science and part art, the scientific aspect can be likened to knowledge, whilst the art of this approach is based on wisdom and experience.

Don’t speculate to accumulate. Validate to succeed.

We’ve all heard the expression “speculate to accumulate”. Normally this refers to accepting a degree of risk today, in order to make meaningful gains tomorrow. In the due diligence sphere this could be compared to the costs associated of undertaking essential due diligence. All buyers reluctantly  acknowledge that good due diligence costs money! If the transaction does not proceed any due diligence costs will have been wasted. But will they? If the due diligence identifies issues which are considered deal-breakers, then a moderate cost will save you more money in the long term. Assessing the information available through due diligence will enable acquirers to make an informed choice before signing the share purchase agreement (“SPA”).

Equally, in the desire to save costs, due diligence often does not begin until the deal is practically guaranteed to happen. If this is true, then what is the purpose and value of due diligence? To simply confirm that the transaction should take place! Professionals in the M&A market are trained to identify, assess, and mitigate risk. However, due diligence is more than a risk identifier and quantifier. It is a strategic tool that will deliver value as part of a long-term business proposition. What happens after the deal is signed is far more important than a successful acquisition.

Over reliance on warranties

Due diligence and the warranties provided in the SPA play an inter-related role when undertaking mergers and acquisitions. An extreme stance would be to forego due diligence in favour of relying exclusively on representations and warranties to provide comfort as to a business acquisition. However, the law affords limited recourse to the buyer in the event that the assumptions underlying the purchaser’s commercial case are false. Therefore, a prudent buyer, would seek to fully understand the risks of what they are buying before signing on the dotted line.

Act in haste, repent at leisure…

There will be plenty of time to reflect and consider all the “if only” questions following your purchase. The ramifications of poor corporate decisions will be felt long after the ink has dried on the contract; the costs of failing to undertake due diligence can soon escalate and impact the sustainability of your existing business. Due diligence should therefore be something that is embraced (and not tolerated) as a necessary part of your acquisition strategy. Good due diligence will not only limit pre-deal risks, but it should be used as the blueprint for your post acquisition integration.

If you are prospecting target companies for acquisition and would like to discuss your due diligence requirements, please contact us at pem@pem.co.uk.

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Jan Fachot | Partner | Business Tax | PEM

About the author

Jan Fachot

Jan joined PEM in 2012 and is a Partner in our Business Tax team, providing tax advisory and compliance services to companies. Read more about this author …