Due diligence

-ICAI
Contents

► Transaction Life cycle

► Due diligence
► What & Why

► Types

► Comparison with audit

► Key focus areas for financial due diligence

► QoE, QoNA, QoCF

► Financial due diligence – certain sectors

► Annexure - examples

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Transaction life-cycle – where does due
diligence fit in

Preferred Post
Pre-preparation Initial offer Final offer
bidder? completion

Business plan Post-acquisition

Financing
Robust structure actions
Management team

Search Target Due diligence Negotiations Completion Integration

► Desktop ► Value ► Warranties ► Audit

► Approach ► Risk ► Indemnities ► Settlement
► Disclosure
Heads of Sale & Post
Target
selection agreement Key issues purchase acquisition
Indicative bid? agreement review

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PART I – Due diligence

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Due diligence

Financial and
Tax Legal
Accounting

Forensics (FCPA) / Commercial /

Human Resource
Background check Business

Information
Technical Environment
Technology

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Pillars of financial due diligence

ACCOUNTING SUBSTANTIVE

ANALYTICAL

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Why due diligence?

► Validate transaction rationale

► Provide an input to pricing / valuation

► Identify negotiation points

► Inputs to sale and purchase agreement (SPA) – e.g., EBITDA, working

capital, warranties, indemnities, completion accounts, etc.

► Provide leads to post-acquisition management and integration

► Provide overall comfort on reported financial numbers

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Due Diligence is transaction focused;
Audit is stipulated by governing rules
Due Diligence Audit
Why needed Transaction support Report to shareholders , Useful for
accounts users
Timing Prior to a “transaction” Annual closing, etc

Opinion given Deal advice; comfort only (not an True and fair
audit)

Materiality Varies according to concerns of the Effects on profitability

buyer
Governing rules Professional guidance Companies Act / Accounting
Standard
Atmosphere Pressurized Controlled

Working environment Controlled access Full Access

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Types of financial due diligence

• Buy side due diligence – Strategic / Private Equity

• Vendor due diligence

• Carve-out

• Vendor assist

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Vendor due diligence

► Auction process / Multiple potential investors

► Sell side due diligence

► Presentation of facts and analysis

► Issues / key findings are subtly presented

► Opportunity for management to present proforma upsides

► Two phased – Due diligence + Investor meetings

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Carve out

► Carved out financial statements – quality, basis, periodicity, etc

► Separation costs

► Standalone costs

► Nature of interdependence to group

► Transition Service agreement

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PART II – Typical areas for Financial due
diligence

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 Typical areas covered in the due diligence

Typical scope of work

Quality of earnings Quality of cash flows Quality of financial information

Earnings summary Free cash flow Sources of numbers and reconciliation

Adjusted EBITDA Capital expenditure Significant accounting policies and procedures

EBITDA bridge Working capital trends Quality of management information

Key business drivers Working capital requirements Audit work papers

Current trading Cash flow sensitivity analysis Assessment of Vendor due diligence report

Last twelve months

Full year outturn Quality of net assets Others
Stand alone costs
Foreign exchange Consolidated balance sheet Closing due diligence
Net working capital Sale & Purchase Agreement
Fixed Assets
Other assets and liabilities
Other assets and liabilities

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Quality of Earnings (QoE)

► Key value drivers – customers, projects, products, etc

► Accounting policy – consistency / compliance

► One-offs / Non-recurring items

► Non-operational items

► Discontinued businesses

Enterprise Value = EBITDA * Multiple

► Standalone costs

► Proforma items

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Quality of Net Assets (QoNA)
Balance sheet considerations:
Assets should exist and be properly valued:
► Stock obsolescence?
► Debtor recoverability and aging?
► Fixed asset impairment?
► Trapped cash?
Liabilities should be complete and properly
valued:
► Accruals and provisions sufficient?
► Contingent liabilities?
Equity Value = Enterprise Value – Net debt
Net Debt = Debt – Liquid cash
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Net Debt considerations:
► Any future cash outflow not included in
EBITDA should be considered within net
debt, that are either
- deducted from the purchase price;
- “left behind” with the vendor; or
- protected via indemnity in the SPA
► Common debt like items include:
- Employee liabilities,
- Deferred revenue,
- Non-current provisions (to be cash
settled),
- Transaction fees / bonuses,
- Deferred/backlog capex,
- Contingent liabilities (e.g. legal
liabilities),
- Trapped cash
Quality of Cash flows analysis

► Normalised working capital

► Definition of working capital

► Seasonality of working capital

► Capex – maintenance vs. expansionary

► Catch up capex

Purchase Consideration = Valuation +/-

Variation to normalised working capital

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Preparation for due diligence

► Organise information – Financial statements, MIS, Audit/Internal audit reports, Minutes,

agreements, etc

► Validate information – reconciliations between MIS / Financials, avoid data revisions

► Archive information – document information provided with version changes

► Scrutinise the financial statements for true-ups / one-offs / proforma items

► Request for a regular status update – information request list – with priority items
highlighted

► Keep engaging with the due diligence team - try and assess red flags, key areas of
concern, etc

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PART III – Financial due diligence certain
sectors

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Other focus areas by industry and nature of
observations – Construction
Key areas Nature of observations
Quality of the ► Computational errors
order book ► Variations on an estimated basis
► Nature of contracts (item rate vs. LSTK, with and without escalation
contracts)

Revenue ► Estimation of costs to complete.

recognition ► Back ending or frond ending of margins.
► Losses accounted at the end of the contract

Accounting for ► Claims on the probable expectation of outcome.

claims ► Subject to negotiation and at times arbitration.
► Variability to earnings and recoverability risks
Working capital ► Customer payment cycles
cycle ► Impacted by accounting for variations and claims: long recovery
cycle.

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Other focus areas by industry and nature of
observations – Roads (1/2)
Key areas Nature of observations
Concession ► Contractual restriction on transferability of interest
agreement ► Lock-in requirements
► Structuresto facilitate transactions which create accounting risks,
cash traps at the time of unwinding of these positions
► Sharing commitments which tend to cap the achievable IRR
► Tax concessions can impact returns.
Access to funds ► Financial closure delays
► Debt
covenants: various CPs, security obligations - creation of
DSRA and MMR reserves
Execution ► Government action
► Delay in provision for state support agreements;
► Delays in right of way, land handovers, etc.
► Create contingent liabilities and result in overruns.
► Scope changes
► Claims by nature

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Other focus areas by industry and nature of
observations – Roads (2/2)
Key areas Nature of observations
Controls over ► Collection management & minimal revenue leakages
collections ► Change in mix of PCUs,
► Implementation of price changes, etc
Accounting ► Consolidation of accounts
matters ► Accounting for major repairs and MMR
► Deferred tax accounting
► Non-cash expenses such as depreciation and MMR provisioning
► Trapped cash: impact the dividends.

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Other focus areas by industry and nature of
observations – Manufacturing (1/2)
Key areas Nature of observations
Quality of ► Revenue concentration in a region or a particular product
revenue and ► Sales push at year end/ period end.
profitability
► Sale volumes show seasonality
► Trading relationships: customers, dealers and suppliers
► Revenue recognition
Cost base ► Costs under-accrual
► One-off items
► Impact of input prices on revenue and margins
► Ability to pass on cost increases to customers
► Vendor concentration – minimum offtake commitments
Working capital ► Seasonality in the business

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Other focus areas by industry and nature of
observations – Manufacturing (2/2)
Key areas Nature of observations
Quality of net ► Fixed assets impairment and/ or aged
assets ► Operating expenses and interest: incorrectly capitalised
► Receivables managed at year end
► Inventory valuation
► Current assets recoverability
► Current liabilities understated and contain stretched balances
Related party ► Arm’s length
transactions

Net debt Reported debt may need adjustment for:

► Interest bearing liabilities considered as current liabilities
► Inter-company debt
► Debt-like items (eg, capex creditors, factoring arrangements,
restructuring) and any other material “cash” exposures

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Other focus areas by industry and nature of
observations – Power (1/2)
Key areas Nature of observations
Implementation ► Contractual restriction on transferability of interest
agreement and ► Supply of free electricity (or concessional rate) to SEB
power purchase
► Local area development obligations may
agreement
► Liquidated damages
► Taiff: levelised, cost plus or performance linked
► Minimum commitment and penalties in case of inability of meeting
the minimum threshold.
Operating power ► Variation in PLF/ CUF and Plant availability
plant ► Variation in other KPI’s including auxiliary consumption,
transmission losses, GCV, station heat rate and fuel cost impacts
► Financial health of SEB
► Transmission arrangements, fuel supply agreements

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Other focus areas by industry and nature of
observations – Power (2/2)
Key areas Nature of observations
Working capital ► Seasonality, financial health of customers, availability of fuel etc.
cycle

Project under ► Delay in execution of project

construction/ ► Incremental levies by government
development
► Delays in right of way, land handovers
► Change in scope due to geological surprises
► Claims by nature
Access to funds ► Financial closure
► Debt covenants: CPs, security obligations - creation of DSRA

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PART IV – Examples

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Are the present level of earnings sustainable
in the future? (Example 1)
► Company involved in the business of construction showed revenue growth of
150% in 2009 and EBIT by 300%. Strong increase in receivable, inventory
and payable positions. Increase in EBIT strongly influenced by inventory
growth.
► Key questions focused by due diligence team
► Is the revenue recognition based on accounting principles? Is the revenue being
collected? If yes, at what is the rate of collection?
► Is the inventory cleared in the current trading period? How much is not liquidated?
► What is the status of payments to creditors? How many are overdue?
► Due diligence team identified that the sales were not been collected and only
a fraction of revenue had been collected.
► Receivables and payables were accordingly building up and later written off
against each other. Of the outstanding receivables, several were not realized
for more than 365 days and payables were not being paid

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Are the present level of earnings sustainable
in the future? (Example 1)
► Inventory had not been cleared to date and there was no clarity on the
existence of the inventory
► Conclusions
► There were significant concerns on the quality of reported revenue and profitability
due to unusual practices followed by the company
► There were significant concerns on the quality of receivables which would impact
on the future earnings
► There were significant concerns on the completeness of payables represented on
the balance sheet

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Are the present level of earnings sustainable
in the future? (Example 2)
► Buyout to happen in 2013, based on a multiple of EBITDA based on average
of last 2 years.
► Due diligence team focused on understanding the quality of EBITDA
► Due diligence identified several adjustments that could impact future profitability –
EBITDA influenced by one off revenue and gains from liquidation of assets,
increased provisions created in 2009 for completed projects, non-recurring
discretionary expenses, etc

► Suggested recommendation
► SPA to define EBITDA clearly

► Entities forming part of the transacted group to be “ring-fenced” in the SPA

► Accounting rules for computing EBITDA to be outlined in the SPA

► Due diligence adjustments to be negotiated as exclusions in computing the EBITDA

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What is the level of net debt as at closing? Are
there potential debt like items? (Example 3)

► A telecom tower company was on a rapid expansion by adding new towers.

The enterprise value was based on a per tower basis adjusted for net debt.
► Due diligence team identified significant liabilities on account of:
► Preference share capital which was in the nature of debt
► Significant capital creditors which were classified as working capital
► Commitments for towers that were under construction and considered as a part of
the valuation
► Debt like items were not identified as a part of the term sheet

► Suggested recommendation
► Negotiate debt like items (preference capital, capital creditors) identified during due
diligence in the definition of debt while negotiating the SPA

► Consider commitments / deferred capex as a part of net debt

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What is the level of net debt as at closing? Are
there potential debt like items? (Example 4)

► A manufacturing company managed its working capital by resorting to

discounting of LCs and bills. Significant amount of bills were discounted (on a
non- recourse basis) which were identified as contingent liabilities. The
liabilities being contingent were recorded on the balance sheet. The facility
was availed in form of channel financing and the interest costs was borne by
the vendor
► Due diligence team concluded that this facility represents a significant amount
of unrecorded debt for the business if the counter party devolves on its
obligations.
► The term sheet did not identify debt like items in the definition of net debt

► Suggested recommendation
► Negotiate debt like items identified during due diligence in the definition of debt
while negotiating the SPA

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What is the normal working capital
requirement of the business? (Example 5)
► A manufacturing company was reporting a deteriorating working capital over
the last few quarters. The business was occasionally financed by advances
from customers which accounted for 10% of contract value.
► Due diligence team identified the business being financed by an extraordinary
advance from a group company received a few quarters back. The working
capital situation was deteriorating due to decline in the advance balance.
Adjusted for this balance, the working capital showed consistent trends.
► Management had explained the cash stress was temporary

► Suggested recommendation
► To understand from the management how the management intends to financing the
working capital gap

► To consider the related party advance as a debt like item for valuation purposes

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What is the normal working capital
requirement of the business? (Example 6)
► A manufacturing company was impacted by seasonality and needed strong
inventory buildups and receivable positions for catering to the requirement of
Q3 holiday season (diwali). Majority of sales was done during this quarter and
working capital requirement was at the peak in this quarter. Post December,
working capital would dip significantly.

► Due diligence team noted that significant difference between the time of
closing and Q3. Management had paid large advances to other ventures
which were to be excluded as a part of the transaction. The working capital to
be delivered at closing would be significantly lower than the requirement
► Suggested recommendation
► To negotiate a working capital adjustment based on average working capital (to
avert the impact of seasonality) as against working capital at closing.

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Thank You

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