“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

Mergers and acquisitions have become an integral part of business strategy, and the accompanying table with empirical data from Grant Thornton’s Deal Tracker proves that businesses are not averse to it and are often encouraged to pursue them for growth.

Due diligence has gained in importance ahead of any merger or acquisition or investment. It is time-critical and hence requires sharp insights into a business and its numbers, apart from common sense, thereby calling for expertise that cannot really be bound by a prescription or specification. While there are several reasons for considering M&A as a growth option, due diligence provides a platform to determine the presence or absence of these reasons. The issues could range from cultural to fitment or synergy. The process also validates the various parameters (quantitative and qualitative) sought out in the M&A and confirms that there are no skeletons in the cupboard.

Diligence is not only about exchange of information. It ideally provides the parties to a transaction a robust risk transfer solution. The review usually covering both the performance history and future prospects of the transacting parties must be completed quickly (within a month to a few months), thereby posing enormous challenges to the acquirer. However, this exercise is critical, as it can not only influence the price, structure or terms of the deal but also becomes invaluable for successful integration after the transaction.

Diligence is not a tick-in-the-box exercise characterised by a procedure or norm. It calls for experience, sharpness and patience. An effective due diligence is dependent on several crucial factors.

Understanding of the business: Diligence should be undertaken with a fairly good knowledge of the business being acquired or merged. This helps in understanding whether the business is making money from its core activities or allied activities or unrelated business activities. The business model determines how strong or weak the strategies are, how they are being operated and how they could meet the acquirers’ expectations of either achieving a critical mass or entering new markets or acquiring tech knowhow or complementing existing business or benefiting from synergies or scaling up the business, and so on.

This facilitates independent corroboration of facts. The acquirer is also expected to apply logic and common sense to confirm the facts. For example, what constitutes revenue does not go by the books of accounts alone. One may need a deductive assessment to arrive at the right revenue. This requires a detailed understanding of the business evaluated, and if that requires specialists, so be it.

Understanding of the transaction: The value driver for the transaction and the structure of the transaction clearly help in planning the approach to diligence. Especially when a diligence is dependent on multiple agencies (internal or external), the objective has to be clear and transparent for a better outcome and to reduce or control risk. The transaction could be an acquisition of assets or business or company for a consideration which is all-cash, part-cash or plain exchange of shares. The consideration could be cash down, deferred or partially deferred. A clear understanding of the value drivers of a deal and the validation of the deal thesis are key to a successful diligence.

Understanding of the legal environment: The industry, location, and the associated complexities bring along a plethora of related laws, enactments, tax and regulatory issues. Awareness of the issues ensures the acquirer stays on the right side of law. Lack of awareness of the legal environment could attract draconian provisions. Given the frequent revisions in the law, ignorance could prove destructive. For example, if the transaction is mandated to be a no indemnity under the law in a particular country or situation, the diligence effort should be tailored to mitigate the underlying risk.

Understanding of the financial statement: The instances of corporate failures in recent years have raised concerns over the financial reporting and control environment. The only way to put these worries to rest is by staying vigilant against potential risk indicators, and asking relevant questions to evaluate the accuracy of the financial reporting and assess the right value of the transaction. The fundamentals of the financial statements should be tested by applying professional scepticism.

Understanding of the people: It is not only the acquisition of a healthy balance sheet and profit-and-loss statement, but also capabilities such as management expertise that are vital to growth. Building relationships with key people and being sensitive to the softer aspects is critical to a successful deal, and a robust due diligence assists in understanding these aspects in great detail. An M&A involves a marriage of cultures, involving disparate processes, policies and systems. A fair understanding of the incompatibilities, and the individual’s technical and leadership capabilities would assist in addressing gaps both before and after the transaction.

Understanding to be diligent: True to Warren Buffet’s saying, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”, a detailed due diligence is critical to avoid surprises and litigations in future, as also assess the right price and value for the transaction.

One should not shy away from questioning the facts and underlying assumptions in the data presented. An effective diligence should balance instinct with reason.

By Sridhar V, Partner, Transaction Advisory Services, Grant Thornton India LLP.

The article was published in The Hindu Business Line on 06 January 2013.