M&A due diligence changing in wake of new risks

Brexit, Trump; the updated Payment Services Directive (PSD2) and cyber security: financial services firms face more risks than at any time in recent memory. To address this, the conventional way of conducting due diligence is changing to keep up. For those in the financial services sector and, indeed companies in other industries, due diligence is even more critical than before.

Traditional due diligence, solely looking at the target company’s balance sheet, is no longer adequate to deal with the multitude of risks ready to cause problems. New style due diligence, according to EY partner Arjan Groen, is more forward-looking and about testing value creation hypotheses. This means that questions must be asked if the operation is fit for purpose in the current climate, considering sector-specific changes as well as more general risks that effect a wide number of sectors.

The main issues to take into account when conducting due diligence are: operational issues, and commercial considerations, like what the marketplace is like, what the track record of the company is, and how to value the business. Once these three issues are assessed, then estimating the value of a target becomes a lot easier.

Bray Muyambo, director of M&A transaction services at PwC, said that the level of focus placed on each issue depends on what kind of business the buyer has, the reasons for buying the target business in the first place and what the key issues in the sector are. As an example, for healthcare businesses, a reliance on skilled labour means an increase in minimum wage would only affect them minimally. For a manufacturing plant, an increase in the minimum wage is likely to have a big effect on the balance sheet. Having a sector focus enables a more granular approach to assess risks unique to that specific business.

KEY TAKEAWAYS:

•          Traditional due diligence is no longer suitable to address the many risks, instead new style due diligence is more forward looking and about testing value creation hypotheses;

•          Across all sectors, the main issues to take into account when conducting due diligence are: operational issues; commercial considerations, like what the marketplace is like and what the track record of the company is, and how to value the business;

•          For the financial services industry, PSD2 is said to be one of the biggest risks. This is expected to change business models due to far more intense competition from brand new players.

One of the biggest risks to the financial services industry is technology. With PSD2 encouraging greater use of technology into the industry, this will inevitably change business models and the way businesses and their customers interact with one another. The directive opens up the possibility of tech conglomerates like Facebook or Google directly competing with traditional banks. In the next decade, the landscape of financial services could be very different and this has to be at the forefront of buyers’ minds.

“Technology is a big factor,” said Muyambo. “It has brought a lot of information into the hands of the individual and because of it smaller players are entering the fray, many of whom were not part of traditional financial services.”

Financial services have never been as competitive and this is only going to intensify. An increasing number of fintech start-ups are eager to take the market share of established high-street banks. PSD2 forces these banks to share the personal data of their customers with so-called account information service providers and payment initiation service providers, vastly increasing the competition in the sector. This makes reducing costs all the more challenging.

For the infrastructure sector, for example, focus shifts more onto yield and the price for that yield, power purchase agreements and whether there is any political risk, particularly in relation to subsidies. Infrastructure funds learnt tough lessons during the financial crisis that a misunderstanding of assets and applying an inappropriate capital structure could prove to be disastrous. Proper due diligence is absolutely crucial to ensuring that these risks are mitigated.   

A UK director of global due diligence said that one of the greatest risks is the period of time between the start of an assessment and the moment a bid is made. To minimise the challenges, companies should take on advisors and cross-communicate with each other. Adding due diligence professionals to stress teams also helps.

“It is also about trying to find some potential upsides, how to mitigate risks and how to fully exploit opportunities in the sector,” they said. “It’s not the floorboards themselves, so to speak, that cause the most difficulty, it is the gaps between the floorboards. You have to ensure that communication is good between the different groups.”

The role of due diligence has become more important in recent years, and as Brexit approaches, this is only going to become even more crucial. To truly take into account the changes and their impact on markets, companies need to ensure that their due diligence steps change too.  

See also

Maximising returns in a competitive M&A market

The pros and cons of merger break fee reintroduction

How to bid for business