Finance- Basics of Due diligence Process

Basics of Due diligence Process

Due diligence is an important aspect in every aspect of business planning. However when it comes to private equity deals, LBOs, MBOs or any other M&A deals it becomes an absolute necessity. Here I will be discussing some basic aspect of any generic but quality due diligence that should be considered during the process. There is nothing new in this. All the analysts use these or follow these in some way or the other depending upon the context and requirement.

Objective: Any due diligence should start with very clear understanding of the objective by all the stakeholders. It is not so uncommon to find that the substantial part of analysis go waste or redundant due to unclear, incoherent, and vague articulation of objective and goals. The goals and objective should be properly articulated and understood.

Project planning- Once the objective is clear and well articulated, there should be a proper work and project plan. This seems like too obvious but this is not so easy, mostly due diligence projects are tight on deadline and thus even slightest mistake in project planning can cost a lot. Project planning requires extensive experience, great amount of knowledge and trouble shooting skills. It needs following understanding of which part of due diligence project should be followed by which part- this is very tricky and important. If you could not decide on the order of the segments of analysis the project might fall into a loop and in the end the whole tam end up taking much more than required time. E.g generally analysis of financial forecasting section should start once market opportunity section has been done upto certain extent.

Best practices of due diligence analysis- this sounds very trivial but if you don’t know this you might end up keeping yourself awake for several nights! Most of the analysts who complain of over stretching on due diligence projects don’t follow the best practices – they think they are saving time by not following this! Some of these are- keep the repository of sources (used directly in the analysis) handy and as detailed as possible. Make them such that in case at time you need to see where and how did you get some important info, you can look for it in 10 seconds. And this is not about file management. Another can be keep a handy and clear repository of all the major and minor assumptions that you make along with the supporting arguments. There are many other analysis and probelem solving best practices.

Execution- Once project planning and scheduling are done, hard analysis should start. Generally the order of the analysis should flow in the following direction; however it can and should vary depending upon the context and requirement

• General macro economic analysis of the target company’s county of operations (if the company is major MNC this is generally ignored).
  Identify from which region/country the target company is deriving significant revenue. Analyze the macroeconomic environment the regions/ countries.
  The above two become very important specifically if the target company has been operating for quite some time i.e. in technical terms if it is in mature stage.
• After macroeconomic analysis, industry sector of the target company should be analyzed. The important point is, if you analyze only the direct industry sector of the target company, you may miss on some very significant issues that can affect the investment in the long run. You need to analyze at least the first branch of partner industries growth of which can affect the target company’s growth directly or indirectly. E.g if you are analyzing Equinix, a data center company, you need to analyze the IT Industry in brief as reduction in IT budget can have both positive and negative impact on Equinix. This is not as simple as sounds, as, if you are not experienced you might end up analyzing all industries! The idea is to analyze the industry that affects the target company’s industry not the revenue verticals of the target industry!
• Once the microeconomic analysis is done, you should come to business models. Most of the analysts and firms jump to analyzing the target company before analyzing business models. This might lead to wrong conclusions. The point is even if a company is doing badly for the time being but if the business model is robust and lucrative in the long run business can be turned around more easily. Thus analyzing various business models- integrated, specialized, niche, broad business mix- before analyzing the company is preferable. This requires good amount of problem solving skills as this is more indirect and inference based and requires sound business judgment.
• After analyzing Business Model, comes company analysis. Here the analysis is separated primarily into two parts.
  Financial – this is standard financial statement analysis- growth, margins, capital use.
• i. Financial statement analysis needs to be conducted from both a time series and cross sectional viewpoint. The time series provides perspective on historical performance that provides backbone for further analysis and cross sectional analysis in which each ratio is compared to a benchmark average provides relative performance. Again, this is not as simple as I have written and should be customized as per the industry, region and maturity stage of the target company.
  ii. Financial ratio analysis can be combined with multiple discriminant analysis to predict the likelihood of bankruptcy.
  iii. Cash Flow analysis- probably on of the most important parts of financial segment in case of private equity deals. Cash generation and capital use, Debt capacity and funding sources, Levered equity cash flows, capital expenditures and other capital outlays, free cash flow are some important items that need special care
  iv. Valuation- there is nothing more to explain. People who have done it properly, can understand! Whatever way you are using (FCF, DCM, Multiples, Earning) if you are doing it properly it can be as complicated as you want to make it. Treatment of simple Cash items can be a day long affair in some cases! This is too vast and need separate treatment. I will write more on this later.
  v. Financing and IRR- This is fairly sophisticated and minor misassumption can lead to significant deviation. But in the end this is what is going to matter the most.
• Strategic- here you analyze the target company from strategic perspective. Like its business strategy, growth strategy, diversification strategy, product and services, operating model, comparative analysis, gap analysis etc. This needs a separate treatment and I will be writing details on this later. This section is very sensitive as your other sections should be in sync with this section. Many problems arise during review if this section is not done in coordination with financial section.
• Exit strategy - This needs special treatment and should be done with utmost care. There is no thumb rule or one size fits all formula. This should be scenario based and iterative.