The COVID-19 pandemic has changed the way due diligence is handled as part of the mergers and acquisitions process.
A Rapidly Evolving Picture
In the COVID-19 environment, investors need additional insights to make informed decisions about acquisitions, and they it need it quickly. An experienced and agile investigative team can help determine if a company is worth the asking price, whether its market is positioned to bounce back, and whether the management team is up to the job. Post transaction, they can help the buyer determine whether the target company lived up to its promises, had the right systems and controls in place, and whether it faces problems with fraud or corruption.
In the short-term, businesses will need to dramatically revise their approach to diligence, grappling with increased deal speed, and adjusting their investigations to capture the details necessary to gauge a business’s ability to adapt to a post-coronavirus economic climate, while managing social distancing and travel restrictions.
M&A Activity: Where It Is and What It Needs
There has been an initial drop in M&A activity since the beginning of the pandemic. Per Dealogic, M&A volume in the first quarter of 2020 declined 36 percent. Another M&A tracker, Refinitiv, charted a further 72 percent drop in merger activity in April.
Deals, however, will return—perhaps with greater-than-expected force as buyers hunt for bargains and distressed companies search for acquirers, preferably those paying in cash. As Dealogic reported in its review of first-quarter results, only four transactions in Q1 were mergers of equals, and 63 percent of deals were cash transactions.
At the moment, we are seeing three types of deals being discussed most frequently:
- Legacy deals, or strategic transactions planned prior to the crisis that are being reframed as a result of business changes brought on by the pandemic.
- Deals to help companies grapple with the rapidly changing business climate, such as reshaping or enhancing a supply chain or acquiring a new customer base.
- Distressed company deals, where financial results have been deeply affected by the economic turmoil or a business is unable to gauge future demand for its products and services.
With the present economic turbulence and unprecedented risk, buyers will want to go beyond historical performance to delve more deeply into forward-looking financial information—budgets, forecasts, strategic plans—and scrutinize the company’s ability to adapt to rapid changes in the marketplace. Buyers need to gather and analyze information from multiple sources: a wider-than-usual group of experts in the business sector, current and former employees, and regulators, among others. Without this information, an acquiror may be hard pressed to determine whether the target company can weather the present crisis and achieve future growth.
The pandemic has made traditional in-person meetings and site visits impossible in many cases. Records, whether paper or electronic, may be difficult to obtain on short notice. Diligence will require the adept use of technology to meet with key stakeholders and the interviewing and digital research skills necessary to extract relevant information to help a buyer make informed decisions.
Buyers and targets may be anxious to complete transactions quickly to stem a further erosion of business at distressed companies, to finalize a deal before a potential second wave of the coronavirus, and to minimize the impact of stock market volatility.
Intelligence gathering during the due diligence process will help determine whether the business can quickly adjust to meet the challenges of a post-coronavirus environment; uncover issues that surfaced during the economic turmoil that may derail future success, such as a broken supply chain or customer interface; and establish whether the business is positioned to take advantage of potential opportunities for industry consolidation.
To answer buyers’ questions about the viability of a potential acquisition, diligence teams should focus on the company’s management team, strategy, market position, systems and controls, and third-party relationships. Here are a few of the issues they may need to explore:
- Management. In a typical due diligence effort, a buyer explores the competence and integrity of management, but the usual questions may not address the ability of the team to handle change or a crisis. Now, diligence efforts should also probe the business’s ability to handle issues should employees become ill: Are succession plans in place if top managers are sidelined by the virus? Do key employees have backups to ensure the smooth operation of the business? Interviews with current staff should be supplemented with insights from former employees and business partners.
- Strategy. Buyers should gather intelligence around the clarity of the company’s post-pandemic business strategy, how it will evolve to meet challenges, and which competitors may be better situated to recover and why that is the case. Targets may underplay critical demographic and regulatory developments or ignore concerns around the availability of materials. All of these elements could have a material impact on the company’s valuation and require renegotiation around price.
- Market position. Is the business facing fundamental questions about market size? Is it located in an environment where the pandemic is managed well, or is the region chaotic, leading to a longer-lasting crisis? Industry experts can provide invaluable assistance in assessing market risks and forecasting future performance, providing additional perspective on the regulatory and political factors at play. Informed industry sources can help gauge the company’s position in the market as well as its reputation, ability to innovate, customer base, and more.
- Systems and controls. The pandemic is testing the strength of corporate systems and controls. Are they overly stressed or failing to detect fraud? Is regulatory compliance overlooked as a priority? A compliance assessment can identify and quantify the perils associated with potential regulatory issues, high-risk clients, and transactions, and continuing this process post-acquisition can further mitigate inherited issues. In addition, recessions rarely result in relaxed regulatory enforcement activity. If anything, increased activity on the part of regulators can further complicate the regulatory picture.
- Third-party relationships. How well a supply chain is performing may be pivotal to the success of a deal in the current environment. Consider the recent chain of events in the food industry. As meat suppliers closed because of COVID-19 outbreaks at processing plants, some fast-food chains were forced to stop or limit sales of product at locations. If a supplier goes down, will the targeted company be in a similar position? Are there adequate plans in place to cope should the company face illnesses or other setbacks? These are critical questions to ask in diligence.
- Fraud detection. The diligence process is also an opportunity to identify and root out fraud and corruption, often surfacing because of financial pressure resulting from the pandemic. During the deal process, the diligence team should speak to customers and contacts and covertly observe businesses to determine the causes of low productivity, and also identify patterns and anomalies in data that suggest fraudulent activity. Given the fast-moving deal environment, sophisticated frauds are often identified only after a transaction has been completed—highlighting the need to conduct additional diligence after the deal closes.
The Investigative Approach
For many companies, the diligence process is enhanced by relying on independent investigators who go beyond a cursory diligence process and leverage their resources and experience to rapidly gather valuable and insightful information to support decision making before, during, and after a transaction. This process has undoubtedly changed given the limitations of in-person activity, but technology can help enhance source interviews and information gathering.
In the “normal” diligence process, it is best practice to deploy a mix of intelligence-gathering techniques to enrich the due diligence information provided. Approaches could include:
- Open sources. Examining publicly available websites and databases and leveraging experience to filter and analyze this material to spot trends and patterns that may not be obvious to most observers.
- Human sources. A thoughtful interview process can yield exceptionally valuable intelligence that could affect pricing and decisions about the how the buyer will manage the enterprise. Deep industry contacts and on-the-ground resources around the globe make it possible to conduct this process quickly and thoroughly, even in complex, fast-moving deals.
- Digital sources. With deep digital skills and access to often proprietary technologies, investigators can track digital footprints and online breadcrumbs tied to companies and their assets. This can be a major benefit when looking for possible fraudulent activity.
- Field sources. In addition, observation and analysis through site visits and access to corporate records when feasible are often helpful aids in developing due diligence in a post-coronavirus environment.
In sum, the pandemic is changing many facets of business, including due diligence and deal making. Investors still require a complete and in-depth picture of a target company’s resilience in the new normal — diligence must not fall to the wayside. As the world adjusts to the new normal, it will require flexibility and innovative approaches that draw on experienced investigative teams to find the critical information to ensure a successful investment or acquisition.