Deal Detectives

Today, due diligence means digging deeper and getting granular, as there is less leeway for underwriting assumptions to be wrong.

On Nov. 8, Binance CEO Changpeng Zhao proclaimed that a takeover of rival firm FTX was imminent and that he would be “conducting a full DD in the coming days.” Due diligence, or “DD” as Zhao calls it, is the exploration of every nook and cranny of a pending agreement to uncover any bad news or “unknown unknowns” before sealing a deal. Normally, it’s a process that takes anywhere from 30 days to 12 weeks or longer, depending on how complicated the transaction is. For FTX? It took just over 24 hours of looking at the numbers for Binance to exit.

“A deal may look lucrative from the outside; but after digging into a target’s financial models and EBITDA, it may not actually be feasible or wise to pursue,” says Cullen Sinclair, a partner in the corporate department at law firm Paul, Weiss, Rifkind, Wharton & Garrison. Buyers rely on careful and accurate due diligence to “make the tough calls when the better choice is to walk away.”

Zhao credited Binance’s corporate research on FTX as well as news reports for uncovering “mishandled customer funds and alleged US agency investigations.” Now, FTX is in the midst of a sweeping criminal probe of its founder and former CEO, Sam Bankman-Fried. The incident underscores a new intensity to the diligence process, which has become more precise, deep and robust in the face of economic headwinds. Buyers are extra-cautious, it seems.

“Investors are fearful that rising interest rates and a slowing economy will impact both growth and margins in 2023,” says Dileep Saksena, managing partner at private equity firm 40|73 Capital in New York.

Furthermore, new regulations on everything from money-laundering, transparency and privacy to the environment and diversity offer a host of new considerations. They definitely “play a role in investor decision making,” says Tristan Reni, group product manager at PitchBook, a data firm offering due diligence services across the globe, and “diligence requirements may vary by industry, company stage or specific investor.”

A target company based in China, for example, requires in-person diligence in addition to the standard perusal of documents. This was rather difficult to do in recent years, because Covid-19 lockdown measures made in-person meetings with Chinese regulators virtually impossible. That’ll likely continue, according to law firm Harris Bricken.

Special Scrutiny for Startups

Of course, startups seeking venture capital get a different type of scrutiny than companies with a more established track record, explains Saksena. “Venture and early-stage growth capital is a higher-risk asset class that does not rely on third-party historical financial analysis by accounting firms as much as leverage buyout investors,” Saksena says. “So, it is hard to make the case that venture capitalists should undergo the same type of financial due diligence methodology that a leverage buyout investor would undergo.”

Saksena, 40|73 Capital: Investors were concerned that margins may not continue in 2023 and beyond.

In 2021, JPMorgan Chase spent $175 million on Frank, a startup with an online portal connecting students to financial aid and online classes via accredited universities. The firm praised Frank and its 29-year-old founder, Charlie Javice, for offering “a unique opportunity for deeper engagement with students.” But Javice provided “most” of the answers to due diligence questions, and “chose to invent several million Frank customer accounts out of whole cloth,” JPMorgan alleges in a lawsuit filed in December. Also, the online classes were nonexistent. JPMorgan declined to comment on its fumble.

Corporates and private equity firms have grown so apprehensive that a whiff of something like unsatisfactory margins is enough to end a courtship—even before the due diligence process begins.

“I have had two recent examples where investors have not moved forward,” says Saksena. One target was a “high-margin, high-growth distributor,” the other a software reseller. Both failed partly because “investors were concerned that margins may not continue in 2023 and beyond,” although vendor concentration and other factors were also at play.

“Investors often are simply passing on investment opportunities rather than even engaging with third-party accounting firms on formal due diligence if they believe margins and growth are not sustainable,” he says.

Recent M&A data shows fewer deals are getting done. Dealogic reported a 35% nosedive in deal value to $3.7 trillion for 2022, compared to the $5.6 trillion peak in 2021. In 2022, M&A volumes in the US fell by about 41% to $1.5 trillion, while Europe and Asia-Pacific (excluding Japan) saw a 27% and 24% drop, respectively.

“In 2021 and the first half of 2022, deal activity was going gangbusters due to a more favorable economic climate,” says Paul, Weiss partner Sinclair. But higher interest rates are making deals more expensive.

This year, expect dealmakers to lean on their outside advisers “more and more, to ensure that deals are thoroughly ‘diligenced,’” Sinclair says. They’ll also double down on “existing risk-shifting tools,” such as representations and warranties (R&W) insurance, as well as special indemnities and earnouts.

40|73 Capital’s Saksena agrees, especially when it comes to R&W insurance, expensive policies that buyers purchase to cover their hides in the event that a target isn’t on the up and up. R&W is too pricey for deals under $25 million, so for mid-market buyers the diligence process must be precise.

“For larger deals, investors are using reps and warranties insurance to protect their downside,” Saksena says. The premium for R&W insurance is typically a percentage of the limit of coverage—as much as 4%. And if an M&A transaction is $100 million, the R&W insurance limit may be 10%, or $10 million.

Diligence Talent

Despite the current lull in M&A activity, corporates and private equity firms continue to hire third-party consultants, especially for specialized expertise. “For example,” Saksena offers, “your team may make an impact investment in an opportunity zone that would require the support of specialized tax lawyers and tax accounting assistance with knowledge of the opportunity zone program.” A firm focused on a particular sector, such as clean energy, will tap experts in, say, wind and solar.

Due diligence also varies depending on the type of deal being done. In the case of FTX and Binance, the deal would have required “real-time balance sheet information, customer-depository information and fund-flows information,” Saksena explains.

But no matter what type of transaction is in the works, successful due diligence depends on having a reliable team in place with the ability and tools to give clients a heads-up on issues such as customer concentration, supply chain problems, stiff competition and recession vulnerability.

And just because something looks awry once a deal closes, that doesn’t mean buyers should feel remorseful.

In fact, today’s buyers have more leverage to reallocate post-closing risk to sellers, “rather than simply going pencils down on a potentially problematic deal,” Sinclair says. “Many times, creative contractual provisions and risk-shifting mechanisms can address thorny issues that crop up in diligence and help get a transaction over the finish line.”