Massimo Acquaviva: What is Due Diligence?

Massimo Acquaviva: What is Due Diligence?

Massimo Acquaviva, 2R Capital Investment Management Limited co-founder, is an experienced business leader who takes a keen interest in talent acquisition and investment training. This article will look at due diligence and how it helps to analyse and mitigate risk in investment and business decisions.

Due diligence may be conducted via an audit, investigation or review confirming the details and facts of a matter under investigation. In the world of finance, due diligence is a process that involves examining financial records before entering into a transaction with another party.

Individual investors conduct due diligence on stock they are contemplating investing in, using readily available public information. The same strategy may be used with many other forms of investment, examining a company’s figures, comparing those figures over time and benchmarking them against the business’s main rivals.

The term ‘due diligence’ is applied in a variety of different contexts, for example reading product reviews or conducting background checks on a potential employee. In the US, due diligence became routine practice following the passage of the Securities Act in 1933. Under the legislation, securities brokers and dealers became responsible for giving full disclosure of all material information about the instruments they were selling. Following passage of the act, brokers and dealers who failed to disclose these facts were liable for criminal prosecution.

The writers of the Securities Act realised, however, that requiring full disclosure left brokers and dealers vulnerable to unfair prosecution for failing to disclose information they were not aware of at the time of the sale. Lawmakers therefore included the legal defence that as long as brokers and dealers exercised due diligence when investigating companies whose stocks they were selling, giving full disclosure of the results, they could not be held liable for information not discovered during the investigation.

Today, due diligence is performed by broker-dealers, fund managers, equity research analysts, individual investors and companies considering acquiring another company. From the individual investor’s perspective, due diligence is voluntary. Nevertheless, broker-dealers are legally obliged to conduct due diligence on securities before selling them.

There are different types of due diligence depending on context. Some of the main types include:

Legal due diligence, a process that ensures that a company has all of its legal, compliance and regulatory aspects in order, including everything from ensuring that the company was properly incorporated to pending litigation on intellectual property rights.

Tax due diligence, assessing a company’s tax burden, whether it may owe back taxes and its potential to reduce its tax liabilities going forward.

Financial due diligence, involving audits of a company’s books and financial statements to ensure there are no irregularities and that the company is on a sound financial footing.

Commercial due diligence, considering a company’s competitive positioning and market share, including its future growth opportunities and prospects. This aspect will also take into account the company’s supply chain from suppliers to customers, encompassing its overall operations, including IT, human resources and management.

Due diligence may be categorised as hard or soft based on the approach adopted. Hard due diligence involves analysing data and figures found on financial statements such as the income statement and balance sheet. This can entail analysis and use of financial ratios to assess a company’s financial position and make predictions for the future. Hard due diligence is driven by mathematics and legalities, and can help to flag up accounting inconsistencies and other red flags.

Soft due diligence, on the other hand, is a more qualitative approach that explores aspects such as quality of management, a company’s key employees and the loyalty of its customer base. In terms of assessing how successful a business is, there are some aspects that are not reflected in numbers, such as leadership, corporate culture and employee relationships. In fact, according to Investopedia, experts suggest that more than 70% of mergers and acquisitions fail due to parties neglecting to pay attention to the human element of the business.

Due diligence is a term broadly used across multiple disciplines, particularly in corporate and legal realms. In a business context, it refers to the investigations carried out by an interested party, such as a private equity or venture capital firm, to vet companies earmarked for potential investment and merger and acquisition targets. Although far less common, due diligence may also describe investigations performed by a buyer into a seller, a process sometimes referred to as ‘sell-side due diligence’.

Mergers and acquisitions have a notoriously high failure rate, with up to 90% ending in a bitter corporate split. The longer and deeper the due diligence process, the better the chances of success for both sides. From a corporate perspective, due diligence presents an opportunity for the acquirer to identify and assess liabilities, risks and potential problems with the company before completing the transaction, potentially helping the acquirer to avoid losses and bad press later on.