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Vendor Due Diligence as a tool for a M&A transaction

Sergey Goncharevich
Founder, major shareholder and leader of the Capital Times Investment Advisory
During post-quarantine crisis, investors will unwillingly part with their money that is why companies that are prepared for raising cheap financing or for M&A , will be preferred.
Global transaction volume exceeds $3 trillion annually. According to Mergermarket during Q1 2020, global M&A activity slid down to the level of the first half of 2013. In terms of a number of transactions, the current period is comparable to Q1 2008. Let us recall that in February 2008 Bear Stearns shares were at $93 and by mid-March the insolvent company agreed to the takeover by JPMorgan at the price of $2 per share. After nearly a decade of growth, global M&A activity in Q1 2020 has decreased by 39.1% and returned to levels not seen since the first half of 2013. Total cost and quantity of transactions are comparable to similar figures of Q1 2008 ($592.3 billion and 3,744 transactions). In March 2008, Bear Stearns, a New York investment bank, went bust. That was a prelude to the international banking crisis, which ended in a bankruptcy of Lehman Brothers six months later. Then 2009 annus horribilies followed and marked the bottom of the last cycle of mergers and acquisitions. It became the only year since 2004 during which the value of transactions was less than $2 trillion ($1.71 trillion) and the total number was less than 10 000 transactions (9 963).

Nevertheless, a significant part of M&A transactions failed. Based on our experience and experience of our colleagues from all over the world, we can distinguish main reasons for such failures. Poorly performed procedure of Due Diligence stands at the top of the list.

Investors, who neglect an independent assessment of a target company or do not pay attention to expertise in a rush, suffer colossal losses.

Let me give you a famous example. In 2016, SoftBank started investing in co-working WeWork. The company was private; the high-quality due diligence was not performed. Thus, investors relied on perspectives that founding fathers stated in information and investment memorandums. SoftBank planned to invest $10 bln over three years; they had already invested $7.5 bln when it became clear that the business model of WeWork did not include any profit. It was an expansion for the sake of expansion. None of the founding fathers made long-term plans to boost profit margins.

In Ukraine, agricultural holding “Mriya” went into technical default after a surge and rapid, even aggressive, growth. Creditors of Mriya relied on company’s transparency and truthfulness of provided figures, such as high EBIDTA, revenue growth, the rapid increase of the land bank and infrastructure. They willingly invested neglecting due diligence and thorough audit.

One more version of Mriya’s default is corruption by banks that granted loans for cuts. In any case, it is obvious that the main reason of investors’ headache was the poor quality of Due Diligence. Eventually, that situation led to reconsideration of issues on financial stability assessment while attracting loans from banks.

At a recent conference of Capital Times Investment Advisory and Globalscope Partners, 91% of M&A experts named high-quality Due Diligence one of main criteria for a successful transaction. Today, however, an internal audit of a company, so-called Vendor Due Diligence (VDD), is moving up to first place. Apparently, in the future post-quarantine crisis, buyers will be very cautious and focus an investment activity around high-quality assets.
Vendor Due Diligence: for whom?

VDD is a preliminary business examination in company’s and its owners’ best interests. VDD procedure is used by companies, which are going to participate in an investment processes, raise funds from international financial institutions, and for subsequent transactions.

The main goal of VDD is to eliminate two main pains of a target company: a low interest of investors and price discounting. The literate and expert internal audit gives a well-grounded and unbiased assessment of an asset and a set of recommendations in the client’s best interest. It allows analyze and correct mistakes, and after doing internal homework, enter the investment market and be as prepared as possible.

VDD will help to avoid bad situations and poor-quality KPIs calculation of a company. We had an example in our practice when a buyer and a seller agreed upon terms of a transaction relying only on the management data. Under negotiation of essential terms of the transaction when we double-checked the data, we saw that EDITDA was 25 percent higher. It pleased the seller, but upset the buyer, because he was not ready for the increase in the transaction amount. It looked something like this: let EBIDTA, before due diligence, be $1,000 and EBITDA multiple on the transaction be 6.
Before due diligence: 1,000*6 = 6,000 – value before signing and due diligence.
After due diligence: 1,250 * 6 = 7,500 – estimated value after due diligence.
VDD procedure

Quality of valuation for a target company is defined with a set of provided expert examinations. It can be financial, legal, technical, environmental, operational and other types of audit. Sometimes a number of issues for consideration is up to 200. A dedicated team is created for each due diligence. The team undertakes a detailed analysis and prepares detailed structured report. For example, one huge project had a team of 47 lawyers from a seller side who were only checking a legal part of DD.

Let us highlight main expert examinations without which Vendor Due Diligence procedure is be considered incomplete.
1. Financial analysis allows drawing conclusions on the financial situation of a company, how much resources it has for supporting its activity and development. Diligence also includes a brief analysis of tangible and intangible assets.
2. Analysis of business operational indicators, i.e. a revenue audit by activity type, the confirmed and planned income situation, verification of contracting partners, accounts payable and receivable.
3. Debt and liability audit in the course of which a list of debts (short-term and long-term) and their incurrence and repayment conditions are studied.
4. Analysis of the use of previously attracted investments, analysis of shareholder structure, review of documents that confirm investment (SPA, SHA), KPIs, return policy (scheduled and pre-scheduled).
5. Assessment of signed operating agreements, which can influence decisions of potential investor.
6. Legal VDD in the course of which existing assets, intellectual property rights of a company, the existence of a trademark are studied. Ownership and quality of its presentation are verified.
7. Examination and critical valuation of the company financial model including an analysis of model assumptions and logic.
VDD can be expanded and deepened depending on objectives and timeframe, company’s size, value of transaction, risk that potential investor or a creditor takes, etc.
Stress test for a target company

It is important to understand that all problems identified in the process of the VDD, lead to serious discounts. Thus, if a company is willing to raise investments quickly or to maximize value, it needs to work out revealed problems and eliminate risks.

Our practice shows that target companies’ chock point, which leads to significant price reduction, is volatile financial model of a business. In order to address the issue we developed a stress test system.

A stress test identifies critical points of a business, substantial risks at a given moment and in possible development scenarios. We elaborate these scenarios based on the current model and prepare recommendations on introduction of primary anti-crisis measures and a change plan for next six months.
What’s new?

In this race to attract investments, the company that is ready for transactions at any time will win. It is not unusual to prepare to sell a business at the stage of its establishment.

Based on our practice, the most effective way to communicate with investors is a pre-arranged set of documents, which is provided via the Virtual Data Room. This is an IT-solution used to upload all necessary documentation beforehand in electronic form, segmenting, analyzing weaknesses, eliminating errors and become ready for fund raising or an investment transaction.

It is better to let professionals do their job: organize, manage, and support a Virtual Data Room. In doing so you will have not only a powerful tool and be ready for a deal, but also a team of experienced analysts, who having analyzed a behavior of an investor or his associates in a Virtual Data Room, will be able to anticipate pressure points, which the investor will use for reducing the price, and prepare a defensive strategy in advance.

The transaction price is not equal to the company’s valuation. This figure is influenced by many factors, along with financial ones (EBIDTA, debt, working capital, etc.), such as quality and timing of negotiation process and more. Therefore, preparation and planning of such complicated project takes time.
Sergey Goncharevich,
Managing Partner of Capital Times
Source of article: Interfax