Excerpt from ‘The Young Professionals Guide to Conquering Private Equity Transactions’ available on Amazon
Financial Due Diligence (Chapter 1)
The typical areas of diligence on every deal are financial and legal diligence. Financial due diligence (“FDD”) focusses on the value areas of a transaction:
Earnings Performance
How has the business performed historically? Are there any indications that earnings may change post-deal? The focus is on presenting historical information on a consistent basis – with required adjustments to reported earnings.
The emphasis is understanding how the business makes money – the value drivers. It is then possible to assess the forecast performance and the associated assumptions. Current trading analysis during the deal then becomes a bridge between the two.
FDD should cover the basis of preparation of the financial numbers, reconciliations of numbers and a clear explanation of accounting policies particularly those relating to revenue recognition.
Cash Performance
Looking at the cash conversion of the business is an essential component of FDD, building on the understanding of the value drivers and their conversion to cash. The cash conversion is crucial to determining appropriate debt leverage and its structure. FDD would normally comment on average working capital, intra-month cash swing requirements and net debt.
Assets And Liabilities
The balance sheet represents what is being purchased. FDD reviews historic assets and liabilities to identify items that might require further investigation in terms of accounting policies and capital expenditure requirements.
Control Environment
Considering the controls in the business and an insight into the key performance indicators (“KPI’s”) and whether these remain appropriate for the business.
There are three approaches to address identified FDD issues:
- Price reduction
- Legal protection: this is typically achieved through escrow accounts (cash set aside to cover a potential outcome), indemnities (a promise to pay if an event occurs) and warranties (these are a harder mechanism to recover economic value, but they are used to encourage disclosure).
- Post-deal: post-acquisition actions perhaps as part of a 100-day plan.
Further Reading:
- Warranties and Indemnities (see Chapter 20 of ‘The Young Professionals Guide to Conquering Private Equity Transactions’)
- Warranty and Indemnity Insurance (see Chapter 21of ‘The Young Professionals Guide to Conquering Private Equity Transactions’)