Due Diligence is an audit or investigation of a potential product or investments, designed to confirm all the facts, such as reviewing financial records, and anything else that is deemed material. It refers to the care that a person should take prior to entering into a financial transaction or an agreement with another party. It can also refer to the investigation that a seller does of a buyer, to see if the buyer has adequate resources in order to complete the purchase, and other elements which would affect the seller or the acquired entity after the sale is finalized. In the investment world, due diligence is done by companies that are seeking to make acquisitions, equity research analysts, broker-dealers, investors, and fund managers.
How it started
The process became a common practice in the United States as a result of the Securities Act of 1933. Securities dealers as well as broker became responsible for disclosing material information which relates to the instruments that they were selling. If they failed to disclose the information to investors, dealers and brokers were liable became liable for criminal prosecution. The Act also includes a part which states that as long as brokers and dealers exercised due diligence when they were investigating companies whose equities they were trying to sell, and they full disclosed the results to investors, they would end up not being held liable for the information that was not discovered during the investigation.
Why is it important?
When done properly, due diligence can create a clear opinion abut the future transaction, and it can save the firm money by revealing the potential risks. The objective is to provide investors is assurance that they will realize the value of investments. If the firm is looking to acquire a business, trusting the company’s numbers and being the only thing to take into consideration can be a very risky thing. When it comes strictly to the financial aspect of things, while the firm will have the historical financial statement, things need to be taken a step further.
The firm needs to understand every line of the income statement, and double check the numbers for the actual in the past. Additionally, there needs to be a clear understanding of everything about the company. From customer concentration to the industry that it is a part of. Additionally, people should be questioned. The firm can interview industry professionals or consultants, and even customers.
In-House or Third Party?
Due diligence can be performed in-house if the firm has the necessary team and tools for it, or the services of a third-party can be acquired, such as those of Corporate Resolutions. The team at Corporate Resolutions performs background investigations and is trained to find critical information about the company in question. In order for a transaction to be made with confidence, the private equity firm needs to have a complete picture. Sometimes, in the process of due diligence, information is discovered which can kill a deal, but there are also cases when it can lead to an enhanced perspective about the company and even restructured deal terms.
Areas and Steps
Due diligence can tend to be a very case-by-case thing, but there are 4 areas which consistently comprise and benefit from operational due diligence, and those are purchasing, general services and administration, marketing and sales, and manufacturing and supply chain. There are also certain steps that the due diligence process can include, such as the analysis of the company’s total value, review or revenue, profit, and margin trends, looking into competitors and industries, check the company’s management and its share ownership, balance sheet examination, reviewing the stock price history, gauge general expectations, and examine long-term and short-term risks.
There are also “soft” and “hard” forms of due diligence when it comes to the world of mergers and acquisitions. Traditionally, when it comes to M&A activity, risk analysts would perform due diligence by studying benefits, structures, costs, liabilities, assets, etc. This step is known colloquially as hard due diligence. In recent times, more and more M&A deals have also been the subject to the study of the company’s management, culture, as well as other human elements – this side of things is known as soft due diligence. The reason why both forms are necessary is due to the fact that hard diligence is susceptible to interpretation by sales people, which is when soft due diligence comes in, acting as a counterbalance.
Getting to know your target is very important before entering an agreement. Even if an acquisition looks extremely promising, failing to do a background check of the company’s operations can end up damaging the deal. While a deal might seem able to generate long-term value, the company in question could still fail as a result of structural inefficiencies which go unnoticed. This is why knowing all aspects of a company could end up making or breaking a transaction.