Effective financial due diligence requires an in depth analysis of the assumptions and information supporting a transaction, a commercially-focussed assessment of whether they align with the strategic objectives of the transaction and early identification of potential risks.

It is a critical process that allows parties to identify and resolve any issues before they become roadblocks to a successful transaction. Identifying potential red flags early in the process provides an opportunity to get ahead of the problem and find a solution (or, in more extreme cases, walk away from the transaction before investing too much time and effort).

Coupled with legal, commercial and other workstreams, financial due diligence will also deepen a potential acquirer’s understanding of the target business, potential synergies and integration priorities.

In our experience, successful transactions come about where:

• diligence is commercially focused, rather than a ‘tick the box’ exercise (which requires that all involved in the diligence process are commercially minded and understand the business);
• those undertaking the diligence understand the transaction strategy and which ‘red flags’ need urgent escalation;
• internal teams and external advisors work closely together and share information in real time so nothing gets missed (two separate inconsequential findings may in combination point to something bigger);
• the scope of diligence is dynamic – as findings are communicated they support a reassessment of transaction strategy and assumptions, which in turn may change the diligence focus; and
• a significant portion of the due diligence is undertaken by individuals (internal or external) who can bring genuine independence as opposed to being emotionally invested in the process.

Regardless of transaction size, judgement is required in determining the appropriate level of detail and information to be assessed in diligence. Specific challenges include:

• poor quality and/or incomplete information, particularly common in small businesses which have not historically prepared financial information;
• carve out businesses where there is lack of visibility as to appropriate standalone costs;
• competitive situations, where information may be commercially sensitive; and
• limited support for forecast initiatives.

Use of data analytics in due diligence to analyse available complex and unstructured information is becoming common and should be considered as part of the diligence planning exercise: we increasingly see data analytics provide insights into the target business which have not previously been available to management. Furthermore, data is itself an intangible asset of the business, and potentially one with recognisable value upon a business combination.

Boards need to ensure there is transparency through the due diligence process and should have the opportunity to probe due diligence findings with service providers, in particular in respect to the most recent financial data which may provide early warning signs as to changing market conditions or emerging issues.

This article is part four of the ‘Transaction lifecycle’ series.

Part one: Don’t let a poorly planned transaction destroy value, or your business 

Part two: Assessing the strategy – why transact?

Part three: Assessing synergies – when is a combined businesses more valuable than the sum of the parts?

Part five: Assessing and refining the deal