Is due diligence in crisis Diligence

Monday, 01 October 2001


    Everybody knows what due diligence is meant to do. It's designed to help the purchaser decide if they're getting their money's worth and whether there's a potentially ruinous problem within the company.

    NAB chief executive Frank Cicutto inherited a massive failure of due diligence at US subsidiary HomeSide Lending Inc. At Pasminco, Greg Gailey can hardly be happy that nobody picked up Savage Resources' currency exposures before the zinc miner bought it and the currency exposures helped put the company into administration. Air New Zealand's chairman Jim Farmer implicitly blames failures in due diligence for the airline's problems with Ansett. And the legal consequences are still running of the massive reinsurance losses that AMP discovered too late in GIO Australia in 1999. All of these were mistakes costing half a billion dollars and up, and explanations may be required. It's no secret that aggrieved companies aren't slow to sue professional consultants over alleged shortcomings in due diligence . But there are plenty of smaller-scale examples too. Coles Myer was upset to find that its $42 million bid for Australian Liquor Group was way too high because, its accountants argued before the Corporations and Securities Panel, the group "appeared to have made a loss instead of the reported profit."

    Sometimes not even the major shareholder knows what's going on. Going back, Westpac was shocked at the problems it found when it bought all of its then 75 per cent-owned subsidiary, AGC. The problem certainly isn't confined to Australia, as Mercedes-Benz would agree after buying an apparently profitable Chrysler and finding massive losses instead. Although the state of due diligence may not be as bad as it looks because, as one veteran of pre-purchase audits says, "it's the bad ones that get the publicity," mistakes in due diligence can clearly range from very expensive to crippling. Everybody knows what due diligence is meant to do. It's designed to help the purchaser decide if they're getting their money's worth and whether there's a potentially ruinous problem within the company. By definition it's a multi-disciplined process that typically looks at pending or potential litigation, commercial agreements, insurance, accounts, liabilities, patents and trademarks, business names, employee entitlements and human resources in general, superannuation, major customers and suppliers, leases to be transferred, plant and equipment, stock in trade among scores of other things. But when does due diligence go wrong? According to Ivan Wingreen, an M&A and due diligence expert at Andersens, it's when the audit team treats everything within the target company as though it's all of equal importance. "A 100-page report might still miss the substantive issue," explains Wingreen. "You have to concentrate on the mission-critical things. It's quality versus quantity. And you can conclude more quickly if you focus on the big issues." The mission-critical issues will vary from industry to industry. In airlines, for example, the due diligence audit should focus on yield management issues and forward cashflow. In the resources industry, it should focus on the quality of the resource and the future of the market. ACIL Consulting's Roy Posselt has conducted due diligence for Rio Tinto's Coal and Allied Industries on more than $1 billion worth of assets over the last couple of years including the $134 million Lemington coal mine and the $US555 million Peabody Group's coal-mining interests. He agrees with Wingreen. "Always go for the critical factors," summarises Posselt. As ACIL Consulting points out in a briefing paper: "The main functions of due diligence are to highlight the key risks associated with the past and future operations, help in determining a fair value for the assets and to assist in the structuring of the transaction." This clearly presupposes industry knowledge, which is why consultancies such as Andersen these days advise directors not to accept appointments on boards of companies, however prestigious they may be, unless they have a long familiarity with that particular industry. If they don't know the sector backwards, they won't be in a position to help the management team when it wants an opinion on target companies. "For directors, industry knowledge is important in due diligence," summarises Wingreen. The Andersens' consultant suggests the most important item on the audit agenda might read: "Executive team". As he says, "It's often bad management that brings down the company, not necessarily the industry," he says.

    So bring in the human resources consultants. Many pitfalls lurk in purchases offshore. As a spokesman for Jones Lang LaSalle Hotels, purchasing agent in the accommodation industry, points out: "A due diligence checklist suitable for a hotel in Los Angeles, London or Sydney is often inadequate in Seoul, Moscow, Jakarta or Milan". You would think hotels would be relatively simple purchases compared with airlines, banks or coal mines, but not so. Among other post-acquisition shocks in unfamiliar territory, owners have discovered that the hotel's trading name wasn't its to sell (although they'd already paid for it), that some hotel occupants have permanent lifetime rights, that extra wings have been added without local government consents, and that some of up to 60 essential licences for a standard international hotel – for example to run a health club – cannot be transferred with the property. Buying an asset subject to due diligence, which is a common protection, is not necessarily the answer. When the ink is dry on even a conditional contract, say due diligence experts, the purchaser is still exposed because the vendor's legal team often sets the time frame and the terms of reference for what can be investigated. Thus they may not feel obliged to open all the books or to allow anything more than the minimum time necessary to get the job done.

    The shorter the time frame, the greater the likelihood of mistakes because it may be difficult to access important legal documents or other information quickly enough. If anything materially untoward turns up, it may still be difficult or impossible to withdraw from the deal or even bargain down the price sufficiently to compensate. Due diligence often suffers in bidding wars for a desirable asset. As Steve Jones, chief executive of Suncorp Metway, explained when the financial services group announced in July its conditional $1.24 billion acquisition of AMP's general insurance business. "Two-thirds of the time the winner is actually the loser," said Jones who is a veteran of M&As in financial services companies. That's one reason why Suncorp Metway took months over its subsequent due diligence and probably also why it hired Pat Handley, Westpac's former chief financial officer and an acquisitions expert, as a non-executive director. The audit should not be so preoccupied by the target company that it misses the wider picture. "Some due diligence should always be done outside the business," adds Posselt. "Understanding of the industry itself is very important." (Bring on the industry-savvy director.)

    As a backstop, a warranty has doubtful benefit. Although a warranty written into the purchase contract stating that the asset is what it was purported to be may provide some redress, warranties have their limitations. Consultants say they are usually expensive because vendors don't like to give them and may insist on a higher price for doing so. And if the warranty is enforced, it will almost always result in litigation anyway. That's assuming the vendor is still available. According to Wingreen, the whole argument comes down to a golden rule: "Due diligence is more than an audit. It's about the perceived value of the transaction." So it's possible that every box in a 100-page report might be ticked but still not provide answers to the big questions.


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