Leaving aside the possibility that they will uncover any attempt to defraud the buyer, there seems to be a common misunderstanding about the proper role of the M&A due diligence team. They are going to carry out an assessment of the target business, but for what purpose? There is often an expectation that the due diligence team will recommend whether the investor should go ahead with the merger or acquisition of the target business … “this is a great deal, it should start immediately.” Many of our clients are surprised when we tell them that it is not our job to decide whether it is a good investment or not. “But you will tell us the good, the bad and the ugly … Right?” Not quite.
The role of the due diligence team is to ensure that the investor has the information they need to close a deal with their eyes wide open on the business, allowing the investor to make an informed investment decision. The job of the due diligence team is to evaluate the business to discover the real facts about its past, present and future operations. Determining if these facts are good, bad or unpleasant or if the business will be a good investment are decisions that only the investor should make. The objective of the evaluation is to gather the information that will support the eventual decision of the investors. The investor must determine how to weight the information based solely on his plans and strategy. The due diligence team will be most effective if it knows the objectives of the investors, but this is not always the case, nor is it necessary for them to complete their work. Knowing the investors’ goals helps the team prioritize their time.
Note that legal due diligence is primarily concerned with the current state of the business (usually at the time of closing), financial due diligence typically deals with the past performance of the business, and operations due diligence should focus on the ability of the business to sustain its future operations. This means that it is in due diligence operations where the team MUST stick strictly to the facts, but where there is also the greatest tendency to deviate towards interpreting the facts and filtering the information they provide. This is because legal and financial due diligence records hard facts where the operations due diligence team will analyze subjective data that will help identify potential risks and opportunities (based on investor objectives). An operations assessment, for example, could determine that the flow of leads is down and identify the cause of the drop. This should not be construed as a reason to recommend not investing. The risk must be reported for future sales.
Suppose the operations due diligence team discovers that a company has a poorly defined sales process as a result of a weak sales and marketing organization. Is there a risk that the company will not meet its announced projections or is it an opportunity for an investor whose strategy is to merge the target business with another business that already has a strong sales infrastructure? The appraisal team must present the facts and the investor must decide how to weigh them. This could be a great investment or a very poor one, but it is not the job of the due diligence team to decide which one.
Suppose that operations due diligence reveals that a company’s management team lacks solid experience in the market in which it intends to sell. Would this be a good investment or a bad one, not worth risking the investment? Suppose the president of the company is found to have a track record of success in another company with an innovative product that he has patented. After realizing that the product could also be applied in a new market, had you formed the new business to reintroduce the product in that market? Would this now be a risk or an opportunity? When you evaluate a trading risk or opportunity, you are considering the possibility of some event occurring. If there is any chance of failure or any chance of success, it is up to the investor, not the due diligence team, to decide if this is an acceptable bet. The due diligence team should never be willing to gamble with someone else’s money, no matter how good the odds seem. Your job is to report the facts.
Investors asking the due diligence team “Do you think this deal is worth doing?” they are not being realistic either. It’s like going to the track and asking the guy in the betting line next to you “do you think this horse is going to win?” Maybe the boy next to you knows something about the horse and maybe he doesn’t. Maybe the due diligence team understands your long-term plans and investment strategy and maybe they don’t. It is not your job to make this recommendation (and it is not your money). Your best question is “What can you tell me about this business?”
Nor should the rules change for large corporate acquisitions. Instead of an individual investor, there may be a procurement committee responsible for making the final decision. While the procurement committee members can participate in the evaluation, there must be a separation between the procurement committee and the evaluation team, even if it is only in the status of their activities. There should be absolute separation if the acquisition team is compensated in the acquisition due to possible conflict of interest. All participants must have a clear understanding of the role of the due diligence team.