Managing transaction risk through comprehensive due diligence

In his book Big Deal, Bruce Wasserstein identified multiple forces driving organizations to pursue a growth through acquisition strategy. Wasserstein’s list included regulatory and political change, technological change, financial change [at the macro and micro levels], leadership, and economies of scale[1]. However, despite the continued pursuit of corporate growth through acquisitions, many academic studies have documented how merger and acquisitions often appear to destroy shareholder value. But why? Is it that acquiring other companies is an inherently flawed strategy or is it simply a poor execution of a good idea? Additionally, if so many transactions fail to meet expectations and the root cause is not the concept of mergers and acquisitions in itself, but merely the execution, why is poor execution so prevalent in the business community? In their paper, “Why Do Mergers and Acquisitions Quite Often Fail?” T. Mallikarjunappa and Panduranga Nayak identify more than 20 common reasons for poor results from pursuing an acquisition strategy[2]. These causes can be summarized into four broad categories: Strategy flaws, poor internal transaction process and execution, inappropriate price and structure, and an incomplete due diligence on the target company. Baker Tilly’s experience has led us to believe that, assuming the strategy was not flawed from the outset, the transactions with the most thorough due diligence have ultimately had the most success. The utilization of information gathered from due diligence can not only verify the target company’s economic earnings but also validate the investment thesis as a whole and lead to a more robust post-transaction plan that, when vigorously executed, can significantly increase shareholder value.

Confirmatory due diligence

More often than not, financial and accounting due diligence is executed to verify the quality of earnings. In addition to the audit-like procedures that an accountant may perform as part of the confirmatory due diligence process, analytical procedures are often applied, which are designed to raise questions challenging the quality of the earnings of the target company.

The quality of earnings is measured by how closely the chosen earnings metrics reflect the sustainable cash flows that are generated from continuing operations that become available to relevant stakeholders. Earnings before interest, tax, depreciation, and amortization (EBITDA) is frequently utilized as a primary measure of economic earnings. EBITDA, while easy to calculate, has some inherent flaws. Unless the company has no working capital, no fixed assets, and does not need to pay income taxes, it may not reflect the cash flows that will be available to service debt or distributed to equity holders.