How M&A due diligence has changed in 2023/24 and how to master it

The due diligence is at the heart of every M&A transaction. The due diligence is the thorough investigation of a potential acquisition or investment to confirm crucial facts that impact the buyer's decision and terms. The process of the due diligence ensures the accuracy of information before entering any financial and legal agreements. The due diligence involves understanding a company's commitments, including debts, leases, contracts, legal matters, customer agreements, and more.

M&A demands extensive due diligence to clarify what's being purchased and the obligations involved. Often, a special focus during the due diligence is given to financial aspects, IT, evaluating hardware, software, data protection, and other organizational aspects. However, the focus and the way of doing due diligences has changed in 2023/24.

1. High-interest rates

Elevated interest rates challenge companies looking to growth through acquisition, because companies often rely on debt to finance expansion and acquisitions. The increased borrowing costs directly affect the financial aspects of potential transactions, influencing purchasing price, risk assessments and the overall viability. And as borrowing costs rise, the discounted cash flow projections used in valuation models for M&A deals may result in lower valuations as well.

2. Alternative financing with ESG

In response to the challenges according to increased borrowing costs, that we talked about earlier, some companies have made use of sustainable financing. Sustainable financing includes strategies such as Environmental, Social, and Governance (ESG)-linked loans to make best use of available tax credits. These mechanisms entice companies dedicated to meeting sets of sustainability performance targets with advantageous terms and interest rates.

3. Sustainability due diligence

Within the realm of M&A, an increasing emphasis on environmental, social, and governance (ESG) factors is expanding to encompass the evaluation of the sustainability and ethical practices of potential M&A targets. The incorporation of sustainability due diligence is becoming a crucial component of the process, ensuring a comprehensive assessment of the environmental and ethical impact of the transactions. Especially for deals in the real estate industry, ESG due diligence enjoys increasing prominence as the sector undergoes heightened scrutiny from governmental bodies and prudential authorities regarding its environmental impact. Interestingly a Deloitte study found out that 71% of respondents would not pay a premium if a target has positive environmental, social and governance attributes, but 84% of respondents would either apply a discount or not bid at all on a target that has negative ESG attributes.

4. Transition to data-driven due diligence

The landscape of due diligence has experienced a profound transformation, shifting from the conventional document-centric approach to a more advanced, data-driven methodology. This evolution reflects a growing recognition of the power and efficiency that data recognition, analytics and technology bring to the due diligence process. Due diligence in 2023/24 is not about documents, but about data. Only teams, that can extract all relevant data from documents and connect it with each other in a reasonable manner, will be successful and efficient with their due diligence process. Leveraging data enables a more comprehensive and insightful assessment of potential risks and opportunities, enhancing decision-making and success rates in M&A deals. Leading teams use fully digitalized due diligence tools and processes, that are able to process classical documents as well as other structured data in a common workspace for the transaction. Go to www.smartmerger.com to learn more about a digital due diligence.

5. Dealing with crisis and disruption

2023 has been a volatile era characterized by disrupted supply chains, geopolitical conflict, wars, decoupling activities with China, tight labor markets, stubborn inflation, soaring interest rates, political polarization, and social discord. We expect CEOs and M&A teams to have become more resilient to deal with continued crisis and volatility in 2024. Based research from Ernst & Young, 89% of CEOs anticipate actively engaging in strategic transactions within 12 months.  

6. Thorough asset valuations

Evaluating assets is and remains a major challenge for M&A teams, specifically during times of high financing cost and high uncertainty and volatility in the market. According to a study from Deloitte, 74% of respondents see asset valuations as the greatest challenge to M&A success.

It is crucial to create transparency and awareness about the objectives of the due diligence. In other words: What do you want to find out? What information and data do you need to conduct an informed decision for a transaction? In general, you can plan a due diligence according to the scope that is important for you. The objective of your due diligence will most likely also correlate to the type of due diligence that you will conduct. Typically, all types of due diligences are one of the following types of due diligences:

1. The financial due diligence: The financial due diligence focusses on the financial performance of the company. During a financial due diligence, the team needs to find out and ensure that any numbers presented in the reports and financial statements are accurate. The financial due diligence helps to understand the acquirer if the target company has the potential to generate value, growth, synergies or other business objectives that are important for the purchasing company.
   
   
2. The tax due diligence: The tax due diligence focusses on the tax implications of the acquisition. The due diligence team needs to ensure that any tax liabilities are paid in full to date or are transparent to the purchaser. The tax due diligence also reviews at how a merger can affect the tax liabilities of the new entity created by the transaction.
   
   
3. The legal due diligence: The legal due diligence focusses on the legal framework of the transaction. During the due diligence, the team would typically review intellectual property and licenses, regulatory issues that the company has, contracts with customers, partners, suppliers, and any other legal liabilities that may be pending.
   
   
4. The operational due diligence: The operational due diligence focusses on processes and structures of the day-to-day business of the company. This type of due diligence is primarily forward looking, and opportunity focused. Therefore, the operational due diligence complements the risk-oriented types of due diligence very well. The objective of the operational due diligence is to assess the sustainability of the target’s operations into the future.
   
   
5. ESG due diligence: The ESG due diligence offers a comprehensive assessment of material ESG risks, liabilities, and opportunities for a target. It involves an analysis of human capital, product safety, social opportunities and risks, corporate governance practices and policies, business ethics and also governmental aspects and aspects of public policy. In general, the ESG the due diligence helps identify and mitigate potential risks around those factors. This kind of due diligence also starts with setting up a data room, but involves fare more activities such as discussions with key personnel, review of financials ad transactions, site visits and inspections and ESG risk assessments.
   
   
6. Supply chain due diligence: Most companies had to learn the hard way about the critical role of supply chains during the Covid-19 pandemic and still feel impacts from geopolitical disruptions and wars around the globe on their supply chains. Robustness and resilience of supply chains has become a critical business component and measure of success. A supply chain due diligence assesses the performance of the company’s supply chains and provides valuable input into the M&A process. The output from a supply chain due diligence may be a risk and maturity assessment, a benchmarking and/or a portfolio of initiatives that defines the supply chain path forward, as well as likely consequences and impacts on the purchase price.
   
   
7. GDPR in the due diligence process: Recently, the GDPR (European Union's General Data Protection) has accelerated the importance of data privacy, data protection and data compliance with respect to M&A transactions. The GDPR law affects the due diligence process to the fact that data extraction, data analysis and data storage activities must be compliant with the regulation. Any non-compliance with GDPR can result in heft fines.
   
   
8. Privacy and data security due diligence: Privacy and data security matters may come up in two different ways. The first question is: Is the due diligence process itself secure and adequately protective of privacy rights. The second and more complex question, that you have to answer during the process is: Have there been any past data (privacy) breaches, is the target company complying with laws and standards and how is the company dealing with past and future potential breaches. Privacy and data security issues can heavily affect company reputation and purchase price.

If you would like to discuss or explore best practices with your M&A team, reach out to mklawon@smartmerger.com.