Nine Due Diligence Blunders and Ways to Avoid Them

Published on 26 Dec, 2018

Due diligence seems understandable on the face of it but is difficult to implement. For PE and VC firms, making the right investment is critical to success, as it carries significant financial risks and rewards. Hence, it is important to be aware of due diligence blunders to avoid huge financial repercussions on the acquirer/investment firm.

Due diligence is not a superficial investigation. It comprises detailed study of every aspect of the target’s operations. It is essential to uncover potential liabilities and financial risks (current and future) and make sure that nothing remains in the unknown territory. Due diligence protects both parties but primarily the purchaser. There are several types of due diligence, such as commercial, financial, and legal, that are undertaken before investing in/acquiring a company.

Commercial and financial due diligence play a vital role in understanding the true value of a company and, most importantly, whether or not to make an investment. However, identifying risk is not the only goal of commercial due diligence; the process also helps the company as well as the acquirer to assess potential opportunities and play as per their strengths.

Nine common mistakes in due diligence that impact the success of a transaction are:

  1. Higher focus on deal making: Focus and effort are largely diverted toward executing the deal and people fail to address important integration and operational factors. Elements such as product quality, team expansion capability, operational/competition risks should not be ignored, as these are fundamental issues that can hamper a company’s growth.
  2. Focus only on financial parameters: Due diligence is considered narrow and limited if focused only on core essentials such as financial performance. It should be comprehensive to cover detailed assessment of market outlook, intensity of competition, strategic approach, cultural differences and organizational capabilities to implement expansion plans.
  3. Focus on ticking the checklist:  Most due diligence providers consider it a routine task and generally wear a blinder, which keeps them focused only on checklists. They do not look beyond the obvious or try to obtain critical insights regarding where value will be created or destroyed. Over-reliance on data collection and finishing the checklist is a big hurdle to effective due diligence.
  4. “One-size-fits-all” perspective: No two transactions/companies are alike, and the same is applicable to due diligence. It is, therefore, important to treat every transaction as unique and understand the DNA of the deal. The objective of due diligence is to identify unique value/risk opportunities that require custom handling.
  5. Limited focus on competitive landscape: Focusing on a company’s capabilities is an integral part of commercial due diligence. Along with that, it is crucial to assess the competition scenario. This will help understand whether the target company is capable of capturing a significant market share or not – a key parameter for future success.
  6. Jack of all trades, master of none: It is impossible for a generic analyst to undertake comprehensive operational due diligence of each and every sector. This, therefore, necessitates bringing onboard a sector expert, who will help understand the nitty-gritty and ground-level insights specific to that sector. Prudent combination of resources is key to successful due diligence.
  7. Dependence on unaudited or management information: Information provided by the management needs to be taken with a pinch of salt. Most due diligence efforts are ineffective due to the reliance on unaudited financials/management information. As information provides a guideline, it is the due diligence analyst’s job to triangulate it and ask counter-questions to the management to get the real picture.
  8. Key drivers and assumptions not triangulated: The actual profit and loss (P&L) statement does not tell the complete truth. A detailed assessment of drivers and assumptions is required to understand P&L line items. It is extremely important to cross-question and triangulate drivers and assumptions with industry benchmarks to arrive at a recommendation.
  9. Absence of physical checks; all work is theoretical: To understand the actual dynamics of the target business, onsite inspection or on-the-ground presence is important. The due diligence team must physically visit the production site, vendor and customer touch points. It is essential for the team to walk the floor, interact with employees, take views from customers, observe the flow of materials/products, and thereafter make a detailed assessment based on actual observation in addition to reviewing the business data on paper.

Being aware of pitfalls will help an investing firm understand the real due diligence process and activities, and accordingly select the right due diligence provider. Rushed due diligence had an adverse impact on the Time Warner and AOL merger, which resulted in the largest annual loss ever reported by a company. Similarly, over-reliance on management projection without any triangulation resulted in a lawsuit for Mattel (acquirer) by its investors—the company was eventually compelled to sell The Learning Company (target) within one year of acquisition.

At Aranca, we are fully aware of the challenges and ensure the due diligence exercise is comprehensive and the end result is of value to the client. Aranca’s key USP is that for each due diligence, we onboard an industry expert with more than 15 years of experience in the similar field as the target company who work along-with our experienced sector-focused due diligence analysts. We also consider each due diligence exercise exclusive, bearing little or no resemblance to previous efforts.