Due diligence by external consultants plays a crucial role in merger & acquisitions

Kenneth Ma

On 4 July 2019, the SFC of Hong Kong issued the “Statement on the Conduct and Duties of Directors when Considering Corporate Acquisitions or Disposals”, reiterating the importance of independent professional valuations in relation to the fiduciary duties of the directors of public companies in their planned acquisitions or disposals. The authority particularly points out the importance of due diligence, which is an area that many valuation practitioners in Hong Kong do not possess the relevant expertise nor resources to advise and work on.

In fact, buying a business is a calculated risk. What may seem eye-catching at the first glance may actually be entirely different inside. That is where due diligence comes in, regardless of such being a standalone exercise or part of a valuation. Whether the form of investment is through equity, debt, or other arrangements, due diligence plays a crucial role before an investment or divestment decision is made. Due diligence does not only look at the historical performance of a business, but also gives professional and independent views on projections and prospects.

In general, due diligence is either performed voluntarily or for compliance with statutory requirements or investment policies. For acquirers, this procedure provides a robust assessment of the expected costs, benefits, and risks and returns of a proposed transaction. It is also a cornerstone for a robust business valuation which determines a reasonable price an acquirer should pay. For vendors, due diligence entails them consolidating historical and forecast information of the targets which makes clear their negotiation standpoints with the acquirers.

Nowadays, due diligence is becoming dramatically more complex that different types of due diligence serving different purposes exist. These include but not limited to financial due diligence, commercial due diligence, operational due diligence, tax due diligence, and vendor due diligence. Despite the variability among the types of due diligence, all of them have the same intention of performing investigation, audit or research to confirm material facts related to the transaction.

In short, the scope of work of a due diligence differs from acquisition to acquisition. Nevertheless, it usually includes reviewing financial statements and historical financial performances, material contracts with customers and suppliers, related party transactions, market analyses, competitive landscape, future performance, cash flow projections, intangible assets, corporate tax and tax planning to corporate governance, management culture, human resources management. The typical deliverables include financial situation analysis, a summary of key financial findings, an overview of business drivers including possible risks and the achievability of projections. Where a specific risk is identified in acquirer’s due diligence, it is often advisable to specifically address that risk in separate clauses in the sales and purchase agreement, such as profit guarantee, sandbagging, and earn outs.

Likely involved in the due diligence processes are either, or both, internal and external consultants. Each has their own set of expertise, which can satisfy companies’ needs differently. Internal consultants typically have a deeper understanding of the acquiring firms, including their procedures, policies and ethos, than external consultants. They are more able to issue advices and proposals that may be readily adopted by the firm as they have better knowledge and are more familiar with the firm’s culture. 

However, the employment status of internal consultants often leads to conflicts of interest or independence issues. At times, even if a corporate governance and internal control framework exist, external objectivity can be decisive in potential M&A transactions, especially in connected transactions, related party transactions or pet projects that influential executives want the corporation to invest in. As external consultants are hired on a project basis, they are relatively detached and are able to provide objective advices.

On the other hand, firms may not always engage in M&A transactions that are within their industry and expertise or familiar geographical locations. In such occasions, external consultants play an even more important role in advising the acquiring firms as they have vast experience with various markets and sectors or even presence in other countries. They might also be able to bring innovative ideas and best practices that are kept up with current market trends. Moreover, their international network and expertise in local tax and legal matters would also offer additional values to the acquirers and hence reflect in the valuations of the targets.

In fact, except for large corporations that have numerous M&A opportunities, setting up an internal consultant team may not be cost-justified in many ways. In most cases, a hybrid internal-external team can leverage deep institutional knowledge, together with external objectivity and expertise. Their complementary roles work best together and should always be exploited when possible.

How we could assist you
Moore Stephens’s due diligence and valuation approach is to provide comfort by identifying all the critical factors for which an informed decision can then be made. We focus on a smart, innovative and forward-thinking approach in providing a wide-ranging variety of solutions. Our assignments are closely led by directors to ensure any key issues are identified at an early stage to avoid any last minute surprises. 

Our Moore Stephens International network has a coverage of over 100 major cities around the world. As a closely connected network and with technologies such as online data room/virtual data room, we are able to provide you a one-stop, jurisdiction-specific and language-barrier free solution, regardless of whether your transactions are domestic or cross-border(s).