ICSI Seminar

ICSI Seminar ICSI Seminar –The why , what and how of Financial Due how of Financial Due Diligence

Ashish Bansal

26 March 2011

Module 1 Setting the sceneSetting the scene

Session Objective

• At the end of this session you should :• At the end of this session, you should :

• be able to appreciate the relevance of Financial Due Diligence to a transaction; and

• at a macro level, be able to appreciate what Financial Due Diligence encompasses

2© 2011 KPMG India Private Limited, an Indian private limited company and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.

Due diligence….

The KPMG definition :The KPMG definition :

“ A Due diligence is an interactive process requiring inquiry, analysis and g p q g q y, yinterpretation of financial and operational data to assist a buyer in assessing certain risks and opportunities involved in a potential transaction ”


Due diligence….

The KPMG definition :

“ A Due diligence is an interactive process requiring inquiry, analysis and interpretation of financial and operational data to assist a buyer in assessing certain risks and opportunities involved in a potential transaction ”


Due diligence

• Due diligence : Caveat Emptor – “Buyer beware”Due diligence : Caveat Emptor Buyer beware

• Due diligence is all about learning from the past but looking at the future –

those who ignore the past are doomed to repeat it, those who fail to look towards g p p ,the future may fare similarly

• Due diligence may sound impressive but ultimately translates into basic commonsense success factors such as “thinking things through and doing yourcommonsense success factors such as thinking things through and doing your homework”


Module 2 Setting the sceneSetting the scene

What are the areas of comfort that a Purchaser requires?

• Some of the key factors which will be of importance to the Purchaser are:

Historical quality of earnings….

… and how it rolls into the assumptions for the business plan

Cash generation potential (profitability, cash flow and working capital analysis)

L l f N t d bt (EV D bt E it V l ) Level of Net debt (EV – Debt = Equity Value)

Working capital and impact of cyclicality, if any

Corporate governance

Quality of systems and processes

Are there any skeletons in the cupboard? Recorded and unrecorded liabilities, tax or otherwise (completeness and existence)


How do successful acquirers view due diligence

• Far beyond than a tick and bash process to verify data

• Analyse numbers, however challenge the deal logic and strategic rationale, Does the transaction make sense ? Is the deal worth pursuing ?

• As an exercise in determining the risks and opportunities underlying theAs an exercise in determining the risks and opportunities underlying the proposed transaction

• Look at the business case in its entirety, probing for strengths and weaknesses d h f li bl ti d fl i d l l iand search for unreliable assumptions and flaws in deal logic

• Take a focused objective and unbiased (?) approach to the process, closely consider the results, and are prepared to walk away from the deal (even in a p p y (late stage of negotiations)

• As a counterweight to the excitement that builds up as managers pursue a targettarget


Module 3 Components ofComponents of financial due diligencediligence

Components of due diligence

Financial and accounting due

• Sustainable / normalised earnings

• Sales trends – by segment product geographiesdiligence

Sales trends – by segment, product, geographies

• Customer / product profitability

• Overheads – fixed vs. variable

• Balance sheet – fixed assets, borrowings, working capital

• Unrecorded liabilities

• Commitments, contingencies

• Accounting policies

• Management BOD control environment Corp Governance etcManagement, BOD, control environment, Corp Governance etc

• Relationship between profit and operating cash flows

• Reliance on debt funds and usage of debt

• Debt repayment and potential debt trap

• Working capital lock up


Components of due diligence

HR • Organisation chart, span of control

• Attrition levelsAttrition levels

• Hiring plan

• Scales

• Retention strategies

• Employee insurance

• Pensions, retirement benefits

• HR policies fit

• Succession planningSuccession planning

• Qualitative assessment of key people


The concept of normalised earnings

Sample this – here is a profit and loss account that a seller provides you ………………..

Due diligence reveals the following ………………..

Profit and loss account

INR Million FY06 %

p y

(a) the CFO ‘s salary is directly paid by promoter group entities and is not recorded in Target’s books

Sales 153 100%

Cost of goods sold 97 65%

Gross margin 57 38%

recorded in Target s books

(b) Performance incentives of Rs 5 million for employees for six month period

Sales and distribution 11 8%

Advertisement and promotion 10 7%

Brand result 36 24%

ended Mar 06, not provided for.

(c) Revenues include profit on sale of surplus land

Other overheads

Salaries and wages 34 23%

Travel and transport 9 6%

Insurance and property 2 1%

surplus land

(d) Losses incurred on business which has since been sold.

Insurance and property 2 1%

Communication 1 1%

Other expenses 16 10%

EBITDA (27) 18%


EBITDA (27) -18%

The concept of normalised earnings

Normalisation adjustments to profit and loss account

INR Million FY06 % Normalisationadjustment

Adjusted

Normalised adjustments

(a) Management indicated that[A] [B] [C] [D]

Sales 153 100% (12) 141

Cost of goods sold 97 65% 97

G i 38% ( 2)

(a) Management indicated that part of the CFO salary is directly paid by promoter group entities and to this extent are not recorded in Target’s booksGross margin 57 38% (12) 44

Sales and distribution 11 8% 11

Advertisement and promotion 10 7% 10

Brand result 36 24% (12) 23

recorded in Target s books

(b) Performance incentives of Rs 6 million not provided for.

Other overheads

Salaries and wages 34 23% 4 6 43

Travel and transport 9 6% 9

I

(c) Profit on sale of assets, being a non recurring income, adjusted from normalised

Insurance and property 2 1% 2

Communication 1 1% 1

Other expenses 16 10% 16

EBITDA (27) -18% (4) (6) (1) 3 (42)

adjusted from normalisedEBITDA

(d) Losses incurred on business hich has since been soldwhich has since been sold.

Losses would not recur in future – Rs. 3 million.


Module 4 Types of fieldworkTypes of fieldwork environment

Fieldwork approaches

FULL ACCESS DATA ROOM E-DATA ROOM

• All information is provided • Controlled environment Limited • Similar to a physical data room All information is provided with free management access

Controlled environment. Limited information and management access

Similar to a physical data room, but information is set up on a website

• Copies of all information provided

• Typically, no copies provided. Time and effort required for

• Most e-data rooms have restrictions on printing and provided Time and effort required for

inputting datarestrictions on printing and copying. Time and effort required for inputting data

• Regular information requests • Information requests and • Information requests and to update Client and Target of status of diligence

question lists are critical as further information and responses are dependent on such lists

question lists are critical as further information and responses are dependent on such lists

• While overall field work duration may be regulated, generally, timings are flexible and typically no restriction on

• Generally overall duration and daily timings are regulated and team sizes are restricted

• Fixed logins are allotted. Team sizes can be flexible if logins shared. Timings may or may not be regulated, though overall yp y

team sizeg g

duration is fixed


Dataroom approach – Dos and Don'ts

Dos Don'ts

• Be aware of and respect data room rules in respect of : • Don’t expect your photocopying and

– timelines

– photocopying of documents; and

– number of people

additional information requests to be met

– work on the assumption that a substantial portion of these requests will not be metp p

• Prioritise areas and allocate responsibilities - (use Day 1 effectively to familiarize with quality of data and how it is organised - end of day 1 action plan, share thoughts on content information gaps gang chart)

will not be met

• Don’t expect substantial interactionwith Target management during the course of the data room unless specified b d icontent, information gaps, gang chart)

• Prioritise information and maintain an issue focus

• Agree formats and templates so as to effectively capture information – Duplication must be avoided

by advisors

• Don’t remove documents from files

• Don’t expect to have individual meeting rooms etcinformation Duplication must be avoided

• Provide a daily list of additional information, documents for photocopying, queries to the advisors and regularly follow up.

• Have a daily briefing to share issues, ideas with the rest of

rooms etc

gteam/ client

• Prepare well for management meetings

• Seek guidance from advisors to help you understand where


information is placed

Common problems during full access work

ISSUE REASON SOLUTION

• Omit key questions

• Our enquiries may cover areas requiring specialised industry or functional

• Involve expert or external firm.q p y

knowledge.

• Vague or unclear responses

• Enquiries may be hindered by inability or unwillingness of target personnel to respond clearly Their answers may

• Focus follow up questions.

respond clearly. Their answers may conflict with other information.

• Incomplete or incorrect

• Target management may seek to increase the perceived attractiveness of

• Ask several people the same questions and utilise appropriate

information target by misrepresenting facts. professional skepticism.

• Too much data • Target management respond to information requests by providing documents which do not directly satisfy

• Focus on issues. Polite persistence may help to overcome this attitude.

y ythe request.

• Lack of co-operation

• Target personnel have normal company responsibilities in addition to giving time to and preparing

• Polite persistence. Our approach should be one of healthy skepticism We may need to report to giving time to and preparing

information for the TS team. Managers may have hidden agendas.

skepticism. We may need to report this to the client


Fieldwork – key pointers

• Be aware of and respect timelines

M i t i f i t ti ti l b i f l ti t t• Maintain focus on issues, transaction rationale, basis of valuation, target background and transaction structure

• Regular updates to manager and understand needs of individual managersg p g g

• Maintain and update issues log

• Maintain healthy skepticism

• Prioritise areas and allocate responsibilities

• Be aware of all issues and big picture

• Regular updation of pending information and pending scope of work


Module 5 How do DDHow do DD findings impact a deal ?deal ?

What should an acquirer want to achieve through due diligence

A due diligence is not an off-the-shelf product, with a standard scope of work

• Assessment that the business is what it appears to be

work

• Identification of potential deal breakersit appears to be

• Qualitative and quantitative analysis on financial performance and to get a

f li d / i

deal breakers

• Secure information useful in valuation

sense of normalised / earnings

• Are there hidden liabilities/ onerous clauses in contracts / other exposures

• Negotiating price concessionsp

• Identify operational inefficiencies and what it will take to enhance

• Defining representations ,

• Is existing IT up to date ? How much more investment is needed ?

warranties and CPs

• Structuring options ( )


(Escrow etc)

Example DD issues and how dealt with - One off item

• Our client negotiated a transaction, purchase consideration for which was valued at 5x normalised EBIT for year ended 31 March 2005valued at 5x normalised EBIT for year ended 31 March 2005

• Purchase consideration was set at INR 2710 million (5x542million)

DD revealed that :

• reported EBIT of INR 542 million included profits from sale of surplus land, amounting to INR 74 million

Solution

• Client successfully negotiated a downward reduction of 370 million


Example DD issues and how dealt with Sticky receivables

On a particular transaction, DD revealed that :

R i bl i l d d INR 50 illi di f 360 d• Receivables included INR 50 million outstanding for over 360 days

• Target continued to argue that these were recoverable, however was unable to provide any convincing substantiationp y g

Solution :

• An amount equivalent to INR 50 million was held back from the purchase q pconsideration in an escrow, with an agreement that all collections within the next 6 months from these parties would result in a matching release of funds from the escrow


Example DD issues and how dealt withOutstanding union settlement

DD revealed that :

W k i i d d h h l h d i d 2• Workers were unionised and that the wage settlement had expired 2 years back . A charter of demands was outstanding, however, the accounts had not considered this

Solution

• An estimate was made of the potential liability for previous years, based on record of negotiations with the Union in the pastrecord of negotiations with the Union in the past

• This amount was deducted from the purchase consideration

• The Share Purchase Agreement contained a clause that additional any• The Share Purchase Agreement contained a clause that additional any liability for the past would be to the seller’s account


Example DD issues and how dealt with Volume discounts

• An FMCG company had a scheme to offer its distributors a year end volume discount based on achievement of targetsdiscount based on achievement of targets

• A transaction was concluded in prior to the year end

DD revealed that :

• The accounts did not consider any volume discounts

Solution

• An estimate was made of the potential liability at year end, based on volumes achieved to date and likely volumes based on overall forecasts

• This amount was adjusted against the purchase consideration


Example DD issues and how dealt with Common services

• Our client was acquiring a wholly owned subsidiary of a large Indian textile player

DD revealed that :

• The subsidiary relied on the parent’s infrastructure considerably. Common services included :

• IT server, Finance, secretarial, legal, HR and various other support functions, space in Corporate officespace in Corporate office

• Additionally, parent bought yarn from subsidiary at cost

Solution

• Cost to set up infrastructure estimated and considered in the valuation model

• Cross charges arrangement agreed for corporate office rent, and time spent by legal and HR team

• Also agreed that transactions for sale of yarn to parent would be at arm’s length


length

Example DD issues and how dealt with Deemed dividend

DD revealed that :

T d b h d hi if B h ll f h• Target company, owned by the promoter and his wife. Both on rolls of the Company as CEO and CIO

• Instead of declaring dividends, they paid themselves extraordinarily high g , y p y gbonuses

• This was to avoid corporate dividend tax

• Risk that tax authorities would deem the bonus as dividend

Solution

• Indemnities obtained


Live example : Going the extra mile

• A leading international advertising firm looking at acquiring a mid sized Indian firm

• DD findings revealed loss of major customers, dependence on CEO for all relationships, negative feedback from competition

Cli t k d KPMG F i t t t b k d h k• Client asked KPMG Forensic to carry out a promoter background check

Findings revealed :

• 3 of 7 clients interviewed had delivery issues• 3 of 7 clients interviewed had delivery issues

• The largest customer had blacklisted target, suspecting the account manager of having been involved in a major fraud with one of its employees

• Subsequently, part of the business from this client accepted in the name of another firm incorporated for this purpose. Client not aware

• Other ethics related issues cropped up

What did the acquirer do : aborted the deal


Live example : ignoring due diligence findings….

• A PE house looked at buying majority stake in a super market retail chainA PE house looked at buying majority stake in a super market retail chain, with 75 stores in a South Indian state.

• The PE had already earlier acquired another up market chain, 10 outlets, in th tanother metro

• Planned to merge the two, use best practices

DD revealed :DD revealed :

• Entire purchasing function with promoter’s wife and son

• All cash collections from all stores sent to promoter’s house daily who• All cash collections from all stores sent to promoter s house daily, who deposited them in the bank

• Inventory records weak, no reconciliation

• Inventories at stores : 40 days of sales, despite a central warehouse that replenished stocks at stores on a daily basis


Live example : ignoring due diligence findings

What happened ?What happened ?

• PE invested, deal consummated

• No further work done on cash management and inventory modulesg y

• Post transaction, fraud discovered :

– Kickbacks from supplierspp

– Inventory inflated

– Promoter dressing up sales by inflating cash deposited in bank (cash generated from other businesses deposited and shown as retail)


Module 6 Softer issues andSofter issues and tips

Beware of ….

• Target’s hesitancy or refusal to provide information

• Unnecessary restraints ( such as restricted access to people)Unnecessary restraints ( such as restricted access to people)

• Layers of review and scrutiny before data is provided for due diligence

• Complicated ownership structures, multiple legal entitiesp p , p g

• Information provided towards the end (especially latest results or other information you have been requesting from day one and have been repeatedly told is on its way!)repeatedly told is on its way!)

• CEO involvement in process

• No MIS CEO uses thumb rules to run business• No MIS, CEO uses thumb rules to run business

• How much is the Target pampering you ?!!!

• Client sits on advisors’ head wanting him to change report /Client sits on advisors head, wanting him to change report / recommendations


Tips based on experience….

• Instead of sending a standard DD checklist to your client, brainstorm the deal logic, rationale and tailor the scope of work to the deal

• Every transaction has different due diligence priorities

• Independent challenge : assign responsibility to someone independent of the BD h i iti t d th d l / i d i i th d lBD person who initiated the deal / is driving the deal

• Involve executives who will have operational responsibility post transaction

• Use DD to fine tune business model and challenge each assumption• Use DD to fine tune business model and challenge each assumption

• Seller should not be controlling diligence process

• Avoid “analysis paralysis” acts as a hindrance in deal closure• Avoid analysis paralysis - acts as a hindrance in deal closure.

• Too much due diligence can offend the target.

• Use DD experience to deepen knowledge of and links with the Target’sUse DD experience to deepen knowledge of, and links with, the Target s management. Use it to make them feel comfortable and fostering a spirit of trust


© 2011 KPMG India Private Limited, an Indian private limited company and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.

The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International Cooperative (“KPMG I t ti l”)International”).

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