"Greater general concern for the environment means that investors are increasingly interested in the environmental performance of their investments, both on a personal level and in order to maintain good standards of corporate governance of the investing company." RPS Technical Director, Heather McKay speaks to Financier Worldwide Magazine. Read the full article (first appeared in the June 2007 issue of Financier Worldwide Magazine) below:

The Evolution of Due Diligence

It has become common knowledge that a significant percentage of M&A deals fail to achieve their objectives. In the hope of avoiding the pitfalls of their predecessors, companies today are taking a fresh approach to due diligence. There was a time when a cursory glance over the account books was enough to satisfy diligence criteria - but this is no longer the case. The process has intensified and become far more sophisticated. Its scope is often all-encompassing, taking in multiple aspects of business operations, from human resources and management profiling to market research and environmental issues.

Due diligence is quickly permeating the risk profile of corporate deals. The aim is simple: to reduce risk by developing a complete understanding of the target company. To highlight the progressive importance of due diligence, this aim has even filtered down from mega deals into mid-market transactions. Indeed, some of the most meticulous due diligence processes are adopted in mid-market deals, where issues that could be glossed over or absorbed in a larger deal could prove fatal to a smaller entity. Due diligence practices are also spreading internationally. Whereas US processes were historically the most rigorous, the European M&A scene has picked up the trend and improved its own investigations in recent years.

Areas that were previously overlooked or downplayed have become firm fixtures on the agenda. One example is environmental due diligence, the importance of which has escalated due to changing environmental laws and a general concern for the world's climate, according to Heather McKay, a director at RPS Group. "Stringent environmental regulations can result in potentially significant costs associated with maintaining compliance and more severe penalties when compliance is not achieved, both of which can affect the value of a business and represent a risk to the investment," she says. "Greater general concern for the environment means that investors are increasingly interested in the environmental performance of their investments, both on a personal level and in order to maintain good standards of corporate governance of the investing company." In the mid-market, the cost of compliance can be disproportionately high, particularly in the wake of recent regulatory overhauls on environmental matters. As a result, clients are increasingly demonstrating a tendency to start the environmental due diligence process earlier than was previously the case.

Another area that has witnessed dramatic developments is commercial property transactions. Investigation processes have become more focused due to increased deal activity, the threat of litigation against deal advisers and the fact that technology has made information easily accessible. "In the past, due diligence for property transactions was considered a necessary evil, mainly to satisfy lenders. It was unusual for a property vendor to prepare thoroughly in advance of marketing a property asset. But for a variety of reasons, some legislative, others to do with improvements in technology and market conditions, much more serious attention has been turned to due diligence," says James Keys, Director of Investment Agency at Nelson Bakewell.

Overall, the breadth of due diligence has widened and more specialists have been introduced into the process. Nick Hood, Senior London Partner at Begbies Traynor, points out that advisers have been added to the transaction process almost in response to the emergence of new risks. "As investors and financiers have begun to analyse risk, the human angle has become more important, bringing in management profiling and HR specialists. As markets have globalised, research specialists have replaced generalist commercial consultancies. High profile environmental disasters and the increasing influence of the green lobby have opened another field for investigation. Many more stones need turning and the bugs underneath need more precise examination," he says.

Particular disciplines of due diligence have also evolved. A decade ago, environmental due diligence was largely a box-ticking exercise, but now involves collecting information through a combination of desk-based research, environmental data, management questionnaires and site visits. "The focus and scope of environmental due diligence has changed dramatically in recent years," suggests Ms McKay.

"Historically the focus was primarily on land contamination and the associated impact on property value. EDD now not only includes compliance of the target's activities with current and foreseeable legal requirements, but can also include the safety of products and raw materials, technical assessment of processes and equipment, and emission trading." She adds that there is no 'one size fits all' guide to EDD, and that it must be carried out in a manner determined by the unique requirements of the target business and the sites involved. Commercial property due diligence provides another example of the explosion of detail and manpower within a single discipline. "More and more people are now involved in the property transactional process based on the risks associated with making the wrong property investment decision," says Mr Keys. "To demonstrate the extent of diligence undertaken, the professionals that could be involved in the process include lawyers, property and corporate valuers, building surveyors, structural surveyors, deleterious materials technicians, and environmental surveyors, among others."

Considering the vast army of advisers that might be engaged on any given deal, the most proficient acquirers will be selective, tailoring their use of specialists to their acquisition strategy and previous experience. Sharon Mattingly, a principal at Hewitt Associates, notes that the requirements for human resources and cultural due diligence, for instance, will be heavily influenced by the buyer's post-deal intentions. "In deals where the benefits are largely derived from financial restructuring, people issues may not be a significant concern. However, if aggressive integration is required in order to drive out the business benefits, such integration is dependant upon harnessing the efforts and energies of key people from both sides, and organisations may well engage a specialist people adviser to develop a specific approach to engaging critical talent," she says.

There are also considerable differences in the way due diligence will be carried out on behalf of a strategic buyer versus a financial buyer. These differences stem from the buyer's goals and the nature of their investment models. "As a general rule, private equity funds are more focused in their due diligence on issues that impact cash flow, while strategic buyers are more focused on how the target can be integrated successfully into their larger operations. While each approach will review the same documents and pay attention to similar issues, a well structured diligence effort will focus on what it is that the buyer is seeking to achieve with the acquisition and tailor the diligence review to meet those objectives," says Mark Thompson, a partner at King & Spalding LLP.

With the vast array of investigative strands that could form part of the due diligence process, management of the entire process must be carefully planned to minimise cost and resource wastage. Some professionals insist this aspect is paramount. "Not surprisingly, managing the due diligence process is one of the single most important aspects of a transaction," notes Mr Thompson. "It is crucial that not only is the relevant information gathered by the due diligence team, but that information needs to be filtered and provided to the decision makers in time for them to make informed decisions." He adds that, particularly on multi-jurisdictional transactions, it is important to have an organised diligence team operating with a pre-defined set of protocols that enable information to be gathered and disseminated efficiently. Each person involved should know their place and role, although they are ultimately answerable to the client and their legal team. It is also prudent to pass all information onto the management team to optimise the post-acquisition value creation strategy. In this way, the benefits of due diligence extend far beyond the deal negotiation stage and can have a huge influence on the long-term results of the investment.

A targeted, well-executed due diligence process is often cited as the foundation of a successful acquisition. Its contribution is more obvious in certain areas than others, such as cultural integration, which frequently contributes to deal failure, according to Ms Mattingly. "The due diligence process will reveal significant amounts of information about the culture of the target organisation, just through the way that information is presented and shared and through the way different people from the target are involved in the process," she says. "An understanding of the culture of the target is only truly useful if there is a similar understanding of the acquirer's culture, and also of the desired culture that will support the achievement of the deal strategy." She adds that while organisations recognise the impact of culture, they still tend to overlook it during the early stages of deal preparation.

But even spending a short amount of time focusing on the key fundamentals of culture can make the difference between establishing a favourable culture and allowing a negative culture to develop on its own. All the evidence points to the continued growth of due diligence, and new areas of exploration. With interest in M&A at an all-time high, and investors watching more closely than ever, executives and buyout firms are under pressure to deliver the anticipated returns promised by their acquisition strategies.

Taking stock of all the inherent risks in a transaction will be pivotal to fulfilling this duty. "The more due diligence we do, the more risks we tend to identify, so deals have to be structured to take account of this greater risk awareness," argues Mr Hood. "Transactions tend to be far more driven by disclosures, warranties and indemnities, which assume greater and greater importance. The more we know through the due diligence process, the more we need to protect the parties against it."

Due diligence is a useful tool in creating value, and recent progress is considered a positive move towards greater certainty in M&A. For this to truly manifest itself, companies must prepare to integrate the results of due diligence into their business plans. This forward thinking will guide investigations to meet the needs of individual deals - a far more robust and efficient system than the generic due diligence seen in former merger waves.

This article first appeared in Financier Worldwide's June Issue 2007.
© 2007 Financier Worldwide Limited. Permission to use this reprint has been granted by the publisher.

For more information please contact:
RPS Manchester - HSED
T: 0161 2379858