Smart due diligence for a smart investment

Rationale for mergers & acquisitions

With the improving economy and the trend towards trade and investment liberalization, foreign investors are now being attracted to invest in the Philippines in order to expand their market or to enhance their earnings. The shorter way for foreign investors to secure foothold in the Philippine market is through merger with, or acquisition of an existing domestic company. The acquisition may be through purchase of the entire, or a substantial portion of the equity, or of the assets of a company. Recognizing this development, local investors are in turn entering into merger with, or acquiring other companies in order to strengthen their competitive positions by 1) broadening their marketing network, 2) achieving synergy and operating efficiency in operation, and 3) increasing their financial resources.

Need for evaluating acquisition

The bottom line is that acquisitions are extremely risky. The immediate concern then of a prudent investor will be to decide whether or not it is worthwhile to invest in a particular company (the Target). If he decides to invest, he will then have to negotiate the appropriate price and terms of purchase with the Target. The investor may initially have been provided by the Target with very limited confidential information on the company. The prospective seller may even ask the investor to submit his bid price based on the limited information. Under such a situation, however, there will usually be an agreement between the seller and the investor that the bid price is a preliminary offer, subject to the results of a full due diligence to be conducted by the buyer.  The objective of the due diligence is essentially to guide the investor in coming up with a comprehensive risk analysis prior to making the acquisition decision. Specifically, it is aimed at identifying the following types of issues: potential deal breakers, or issues of such significance as to affect the investor’s decision on whether or not to acquire the Target company, issues affecting the value or purchase price of the Target company, and issues affecting the other terms of purchase so that the investor can negotiate for favorable or advantageous terms.

Components of due diligence

In many cases, the investor is a strategic investor, thus he will be much interested in the long-term growth prospect of a potential acquisition, and the compatibility or synergy, of such acquisition, or of his prospective business partners, to his present business.

The due diligence usually consists of three major components, namely: legal, commercial, and financial and tax. The investor will likely ask a domestic law firm to conduct the legal due diligence, which involves looking into the legal implications of current litigation, claims, and court judgment, orders or settlement issues for or against the Target, if any, terms of major contracts and agreements ( like loan or lease agreements) and regulatory compliance by the Target for their possible adverse legal consequences on the Target, ownership of major assets, and other relevant legal matters.  The commercial due diligence may be conducted by the investor himself if he is in the same business, or by a business/financial advisory firm. This involves carrying out commercial analysis of operations, assessing key issues involving the market, such as the industry’s key drivers and growth prospects, the Target’s competitive position, and its strategy and policies relating to major areas of operations.

Smart due diligence

One of the most common mistakes which investors commit is not leveraging the information and knowledge they have at the time they make a decision, resulting in the lament “We should have known this might happen.” And while hindsight is 20-20, foresight makes all the difference. To improve their foresight, acquirers need to engage, in most cases, a business/financial advisory firm to perform the review. Essentially, this involves evaluating the current financial condition and prospective performance of the Target company. The Information Memorandum which contains brief information about the Target and its operation, and audited financial statements with accompanying notes, which the Target usually provides to the potential investor, may be informative, but it still will not be sufficiently comprehensive as to disclose certain significant issues that are critical to a potential investor in making his decision. In addition, this document normally contains a statement that the issuer does not provide warranty on the accuracy and completeness of the information therein. The interested investor is enjoined to conduct his own independent investigation into the Target.

The investor may, for certain reason/s, prefer a limited financial due diligence and focus on certain critical areas only, or he may already be familiar with some aspects of the Target’s operation, and exclude these in his investigation.But where the investor has no limitation, a full due diligence would, among others, be looking into the following areas:

prospective level of profitability and its sustainability,

quality of earnings,

quality of assets,

significant tax exposure,

other unrecorded liabilities,

contingent liabilities,

synergies with the investor’s operation, and

weaknesses in operation or areas for improvements, which need to be addressed during integration.

The extent to which the above areas can be assessed by the investor will depend much on the information which the Target will be willing to provide.

From the above scope, it is clear that the due diligence team which will perform the actual review should preferably be multi-disciplinary. Depending on the nature of business of the Target, the team should include specialists in finance, economics or marketing, in the Target’s industry or operation, and in general management.

Conclusion

A smart due diligence is one that provides the prospective investor with a comprehensive risk analysis framework,  and in the process, allow him to make an informed decision on 1)

whether or not to go through with his planned investment, 2) a fair price to offer, 3) specific terms to negotiate which will provide adequate safeguards to his investment, and 4) appropriate measures to adopt to enhance post-deal performance of the Target by identifying specific synergies and weak areas of operation that need improvement.

(Agustin P. Perez is a Director in the Business and Financial Advisory Services group of Manabat Sanagustin & Co., CPAs, a member firm of KPMG International, a Swiss Cooperative. This article is of general information only and is not intended to be, nor is it a substitute for, informed professional advice. While due care was exercised to ensure the quality of the information contained in this article, readers should carefully evaluate its accuracy, completeness and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances. For comments or inquiries, please email [email protected] or [email protected])

(KPMG International provides no client services and is a Swiss cooperative with which the independent firms of the KPMG network are affiliated.)