Due diligence is a process of holistically collecting and reviewing all the information on the relevant aspects of a party before getting into any kind of business engagement with them. Simply put, due diligence is taking the requisite caution by knowing your suppliers/ service providers/ acquirees/ investment targets/ transferees inside out
Example: There is a software company which has gathered a huge customer base. Now it wishes to outsource the work of customer dealing to a call centre (as their expertise is in building software and not in customer care). But how will it select which one to hire out of hundreds of call centre service providers? Of Course, the price will be a consideration but it is not the sole or priority criteria in such deals. That’s where due diligence comes in.
This software company will hire services of an organisation like SignalX who will run due diligence on the prospective service providers and check:
- Do they have the financial strength to stay buoyant throughout the contract’s tenure?
- Do they have all the required licences/ approvals from the govt for the work?
- Do they have any conflicts of interest?
- Do they pay their taxes and fulfil their compliances on time?
- Have they ever been investigated or sanctioned by any regulatory authority?
- Have they ever been sued for fraud/ money laundering/ cheating/ privacy breach, etc?
- Is the company or any of its Promoters or Directors politically exposed?
- How’s their track record with their existing and past clients?
And many other questions which will help this software company to make the most well-informed decision on whom to engage in serving its customers. Selecting the most appropriate service provider by can greatly boost the software company’s business by bolstering its credibility & customer satisfaction and ignoring the same can have equally severe ramifications.
What are the different types of Due Diligence?
The best way to classify due diligence is to categorise it on the basis of the subject of due diligence. The most common types of due diligence processes are:
- Administrative Due Diligence
- Financial Due Diligence
- Legal Due Diligence
- Operational Due Diligence
- Information Technology Due Diligence
- Human Resource Due Diligence
- Intellectual Property Due Diligence
- Customer Due Diligence
- Environment Sustainability Governance Due Diligence
Terminology varies, some consultancies mention Tax Checks separately while some merge it under Financial, some call Operational Checks as Business, etc. Commercial & financial due diligence is done by businesses on third-party suppliers and also by an acquirer entity on an acquiree entity. Legal due diligence is done on promoters as well as on investment targets. In M&As, a combination of the aforementioned (depending upon transactions’ demand) is performed and all the insights are compiled in a due diligence report.
In short, there is no rule of thumb.
Many enterprises, especially post-COVID, perform periodic due diligence on their suppliers to mitigate the risk of disruption in their value chain during times of upheavals like the Russia-Ukraine war or COVID lockdown or the US-China trade war. Even investment firms check startups’ supply chain resilience before investing to see whether they are geared up to survive business threats.
What are the Critical Points of Due Diligence?
Financial, Legal & Regulatory checks are the most common examples of due diligence, so we will take that as an example. For Financial due diligence, we extensively vet a company’s financial statements and convert the data into insights. Some core points of focus are:
- Company’s corporate structure: Which institutions (govt or private) and individuals (connected or unconnected parties) hold how much equity/preference or unclassified shares? How much percent of equity is public and how much private? What’s the percentage of Directors’ shareholding? Is there any foreign investment?
- Crucial Financial Highlights: Total Income, Total Expenses, Net Profit, Cash at Year End, Net Profit Margin, Accounts Receivable & Payable, Quick Ratio, Current Ratio, Reserves & Surplus, Debt Utilisation, Revenue from Operations, etc.
- Analysis: Insights-driven analysis of Balance Sheet, Income Statement, Cash Flow and Index of Charges, Liquidity Analysis, Total Debt & Net Debt Dynamics, and Leverage Ratios.
- Peer Comparison to facilitate negotiations based on the same aforementioned parameters like Revenue Multiple, EBITDA Multiple, Earnings Multiple, Book Value Multiple, etc with YoY Trends analysis.
- Valuations and Projections: Projected Revenue Growth, Weighted Average Cost of Capital, Terminal Growth rate, Terminal Value, PV Terminal Value, Operating Data Projections, Balance Sheet Projection and Build Up Free Cash Flow.
- Forensic Checks: Profit and Loss Misstatement Checks, Balance Sheet Misstatement Checks, Pilferage Checks & Audit Quality Checks.
Similarly, in Legal due diligence, thorough vetting is done on the following aspects:
- What are the no. of active and disposed cases (by the company and against the company)?
- What is the nature (civil or criminal) and type (debt recovery, money laundering, contract breach, taxation, intellectual property, etc) of the cases?
- How much has been claimed in damages/compensation in civil proceedings or what would be the sentence in the criminal proceedings?
- Before which judicial/quasi-judicial forum are the cases pending (district courts, high courts, supreme court, tribunals)?
- Who are the opposite parties (government, suppliers, directors, competitors, etc)?
- What are the legal cases against the connected parties of the target?
- Has the no. of active cases increased or reduced over the years (litigation tracking)?
- What contracts has the business entered to with its customers, suppliers and employees? Are there IP assignments that have happened in the past? What IP or commercial obligations do these contracts create on the company that may material to its enterprise value? And much more.
How does Due Diligence Aid Business?
- It helps in filtering higher the quality of potential investment targets, trade partners, suppliers and counterparties..
- Aids pre-deal negotiations and facilitates the discovery of the correct valuation/price of the investment target/supplier.
- Reduce the odds of expensive and unnecessary future litigations with business partners.
- Saves the company millions in the cost of terminating the services of the wrong supplier and relooking for the correct one.
- Helping in selecting long-term business partners/suppliers and establishing synergy thereby bringing stability to the supply chain.
- Protect your company from the reputational loss amongst the industry peers and masses.
Case Study of Barclays and Deutsche Bank
This is the story of two banking giants, Barclays (the world’s 5th largest bank by total assets) and Deutsche Bank (the world’s 11th largest bank by total assets). This due diligence fiasco costed them £72 million and £163 million, respectively.
In the case of Barclays, in the haste of landing some super-high net-worth clientele, they slipped up their due diligence. The clients were politically exposed and should have been under a higher degree of scrutiny by the bank. Trading of securities of offshore companies amounting to GB £1.88 billion (owned by the same clients) was done.
In 2015, Financial Conduct Authority (FCA) levied a fine of £72 million on Barclays for ignoring the due diligence made for preventing economic offences. In a very similar situation, in 2017, FCA slapped a fine of £163 million on Deutsche who failed to undertake proper due diligence to identify money laundering from Russia to the UK worth＄6 billion.
Now imagine, had Barclays discovered the political exposure of these clients before getting into business with them, they could have run more meticulous checks on them and could have saved themselves from fines and loss of name as a renowned banking institution. Had Deutsche performed adequate customer due diligence, it wouldn’t have become, even unknowingly, a vehicle for the dastardly crime of money laundering.
Conclusion
Due diligence is an absolute must for all businesses. It protects the company from the threats of tedious litigations, financial frauds, reputational loss, risky investments and unreliable suppliers. Some of the world’s largest and most influential institutions have committed the mistake of underplaying the task and have suffered the consequences and have become an expensive example for the business community. It is the backbone of many organisational processes like outsourcing, expansions, and strategic investments and thus should be done given due consideration.
