In this episode, we take a quick run through the area of financial due diligence with Luke Malone from Prosperity Advisors. We cover some of the terminology in this space, and many of the issues that should be considered on both the buy side and sell side – including timelines, working out the right level of DD, and some interesting stories about skeletons that can be found in the cupboard.
- Basic concepts of financial due diligence
- Looking into normalised earnings
- Working out the right level of due diligence
- Consequences of rushing through due diligence
- What can be done to fast track due diligence
- Finding the appropriate multiples to use
- Financial due diligence from the vendor’s side
- Drivers that affect the due diligence timeline
- Some of the biggest skeletons uncovered
Joanna: Hi it’s Joanna Oakey here and welcome back to the Deal Room Podcast, brought to you by our commercial legal practice, Aspect Legal. Now today we have on the show, Luke Malone from Prosperity Advisers to talk to us about the fascinating area of accounting due diligence. It is fascinating.
Luke: It is. Absolutely, Joanna. Very exciting stuff.
Joanna: It is. Look, we’ve has spoken on this podcast, you as our listener may recall quite a few times about DD from a legal perspective. But I thought I’d get Luke along today to talk about the accounting and financial perspective to give us something other than just the legal DD side to focus on and think about. So Luke, welcome onboard. Thank you for coming to the Deal Room to talk today.
Luke: Thank you very much Joanna.
Joanna: Great. I want to start off maybe by giving our discussion a little bit of context so maybe you can just give us a little brief overview of who you are and who you work with in this space.
Luke: Sure, absolutely and thank you very much for the opportunity to talk to your listeners today. I guess in terms of myself I’ve been working as a chartered accountant for the last 20 years, predominantly focussing in the SME and fast growth businesses area, a lot of entrepreneurial businesses, a lot of businesses looking for growth, acquisitions, potential exit events, BB through private equity or IPO.
We work very closely with our clients. The clients that we work on are in a variety of industries, but typically range in the sort of 5 million turnover up to a 200 million turnover usually. We work collaboratively with them to help them navigate that due diligence pathway.
Basic concepts of financial due diligence
Joanna: Okay great. All right, wonderful. Let’s then talk about due diligence. I’d like to just start off with the basics, so let’s just start right from the ground up. What are you usually looking at when you’re conducting your financial accounting due diligence?
Luke: Yeah, I guess if we’re doing a financial due diligence, Joanna, that is on the I guess buyside as you’d like to call it. We’re looking to work closely and cooperatively with our clients in looking at that potential target.
We look at a number of things obviously the historical financial information is critical, so getting a good understanding of the EBITDA (earnings before interest, taxes, depreciation and amortization) and the operating metrics of the business, the revenue, the expenditure profile, trying to help determine what the normalised earnings of that business may be over a 3 year period for example.
Looking into normalised earnings
Joanna: Can I just stop you there? I think it might be useful for some of our listeners to dig a little bit into this concept of normalised earnings, so maybe can you talk briefly about that as well in terms of what you’re doing when you’re looking at normalised earnings?
Luke: Yeah. Sure. I mean it’s usually a key component of the DD, the normalised earnings, because it then drives the multiple and I guess the eventual purchase price that they maybe end up paying for the business. Making sure that those normalised earnings are well looked at and considered is very important.
The normalised earnings themselves is looking to strip out I guess transactions that wouldn’t be there once the acquirer takes over the business, so that may include things like related party transactions or transactions with existing shareholders such as their salaries and other fees or arrangements with them if they were not to continue in the business.
It may include other costs that may not be there going forward, so if we were to be able to for example remove a warehouse or a rental property, leased premises that are no longer required post acquisition. It’s those kind of things that we can remove and then give the acquirer a sense of what does the business look like post acquisition.
Joanna: How are you identifying each of these areas to strip out? Some probably are fairly obvious, but I can imagine there’s quite a lot of nuance in finding some of the you know.
Luke: Yeah, there certainly is. I guess it takes I guess an experienced team and good people on the ground to work collaboratively and proactively with the target. So there’s a lot of time spent on site with a management and getting I guess under the bonnet in terms of their PNL and how their business operates. Getting a real understanding of what those transactions may be, working with their finance team and their accountants to get a sense of what they are and obviously coming up with what we think that normalised earnings should look like.
Joanna: Okay, great. And sorry, I think I interrupted you when you were running through the other things that you look at when I wanted to talk a bit more about normalised earnings. Are there other key areas that you’re also looking at?
Luke: Yeah, absolutely Joanna. So I guess then sort of as I said the historical financials are a key aspect to give I guess the acquirer a sense of what that business might be able to generate for them in the future, what are future forecasts look like as well and what about the balance sheet I guess in terms of what’s on the balance sheet. Are we comfortable with the accounting treatments that have been adopted? Are they in accordance with accounting standards? Are things like their liabilities and what not complete? Are there any risk areas or understated liabilities for example that need to be considered in light of the context?
Obviously, that then dovetails into the legal process in terms of understanding you know what sort of warranties and things that we need to have in the share sale agreement, are there any particular risk, and then that also feeds into the tax due diligence component of it as well.
Joanna: Well that’s a really long list there, Luke.
Luke: It is.
Working out the right level of due diligence
Joanna: We know why sometimes it can take awhile for these a proper due diligence process to be conducted. But as we all know transactions differ in size and in risks. Sometimes those two elements, size and risk, correlate sometimes they don’t.
But there’s always this question. Let’s put our commercial hats on, how do we work out what is the right level of due diligence to be looking at. Certainly from a legal perspective that’s something that we have to be acutely aware of because to some degree there’s no end to the amount of legal DD you could do. I’m sure it’s the same from a financial perspective. But we always have to sit here and say well what’s reasonable and required in the circumstances. So how do you go about that process of working out the right fit for each transaction?
Luke: Yeah, that’s absolutely right Joanna. I mean you’ve got to be commercial and pragmatic about these things. I guess the way that we work and operate in that regard is we work closely with our client who is looking to acquire that particular business and get an understanding of their risk profile and what they’d like to see. But at the same time give them our insights and experience as to what what we would recommend in terms of the level of due diligence.
I guess a current example, we’re working with a large Chinese listed business that’s looking to acquire some businesses here in Australia. They need a lot of guidance and help because they’re not so sure of the Australian regulatory environment and they may have a different risk profile to someone that’s operating here today for example. The amount of years of due diligence they want done again may be different to someone else that understands what they are going into a little bit better so.
Joanna: Yeah. I think it’s a fabulous point you make there because I think understanding your client is a really important element but quite often you know we have clients that have come from a range of different countries when buying into Australia and certainly if they’ve not had experience in the Australian environment obviously it becomes an environment where you’re providing more of an educational function.
Joanna: Compared to maybe organisations that are based here. But it’s about picking that level right I think, because I think that’s where you know and certainly complaints I hear around in the industry often revolve around the failure of advisors to pick that level right. I mean lawyers and accountants and other people in the process, so I think that’s a really important consideration for advisors to be making.
Luke: Yeah, absolutely right. I think you know you’ve got to work very closely with the clients to help them understand the risks that they’re going into and then get the level of work that’s appropriate for them to match their risk profile as well as obviously the services they need and the fees and their budget etc.
It has got to be a collaborative approach working closely with them. There’s basics that must be covered on all financial due diligence that you would say are non-negotiable. But there’s other parts that you know you can work around if required.
Joanna: And budget is an important thing. It’s good that you’ve pointed to that, and I also find timeframes. I mean I’m sure you’ve been in the situation where you have clients that are wanting DD process to happen as quickly as possible.
Joanna: And I guess there’s other issues for advisors here in managing client expectations as well. But finding that fine balance between an appropriate level of investigation into an organisation as well as fitting in into the commercial imperative of the deal.
Consequences of rushing through due diligence
Luke: Absolutely, I think that’s critical in the process. Time is always a bit constrained. Everyone wants their transaction or their deal done quickly and efficiently and I guess we all work hard to make that happen.
But I think the point you raise is a good one. It’s sometimes taking that little bit extra time allows for appropriate consideration of risks and make sure that the wrong decision isn’t made. There’s plenty of acquisitions that have been rushed and sometimes the outcomes are not great or that the appropriate level of due diligence wasn’t requested or performed.
Joanna: So tell us maybe do you have some examples of that, Luke. I love examples. I’d love to hear.
Luke: Yes, there’s a couple of good examples in recent times. One was a large dairy business, fairly significant transaction, the business was sort of valued around the 200 million dollar level and fairly significant operations in manufacturing in Australia.
I was very keen to proceed and they decided that they thought that they could handle limited due diligence internally and they thought they knew the risks. But unfortunately, post that acquisition, they suffered some significant, poor financial performance and results in that business post acquisition. It was not reflective of what they saw in the information they’d been provided, and I guess they hadn’t dug far enough into it to sort of understand it.
Joanna: And so that’s the sort of thing you feel that a proper DD process could have picked up.
Luke: Absolutely. I guess we then got involved and help them out with trying to unravel some of the problems. We then identified what some of those problems were that would have been very apparent had we been involved from the beginning and performed a complete due diligence process, which for that business wouldn’t have been a huge amount of money. I guess it was just imperative to get it done quickly at the time. But if they had stopped, paused and spent a little bit of money, I think they would have saved themselves a lot of the hassle that they subsequently had.
Joanna: Yeah, and I think a lot of the issues can occur from number one, I think in reality, emotion. Sometimes there’s been a long search, sometimes it just seems like the right deal. All sensible consideration goes out the window.
I guess the DD process, number one it doesn’t necessarily have to take a massive period of time. Obviously, it depends on the circumstances of the business. But what are some examples I guess of how we can speed up that DD process? Are there any things that you can think of that can provide a situation where we can get through it quicker?
What can be done to fast track due diligence
Luke: Yeah. I think a lot of it comes down to are working collaboratively with the target and helping them identify ways that we can get the information quickly depending on the size of the target and the sophistication and maturity of their finance function, it varies. Sometimes you’ll have very good processes and ability to get financial information quickly.
Other times it’s more difficult and I guess that’s where our team likes to get involved and sort of walk the target through the process, spend time on site with them and sort of drive through that process to help them. Because quite often, they’re resource constrained and they have to continue to run their business, so it’s about us sort of working collaboratively and sort of fast tracking that information process and often getting in there, getting access to the systems and just drawing that information out that we need ourselves.
Joanna: Yeah yeah yeah absolutely. And I think the interesting thing about DD and perhaps it relates to the example you were talking about before with your dairy business. I see a lot the DD process then potentially being used for redriving discussion about purchase price.
But I guess that’s the reality. When you are in there looking at the business, it’s not necessarily about “yes, we do the deal”, “no, we don’t do the deal.” It can also be about “well, is the pricing right, now that we’re looking at the bones of the business?”
Luke: Absolutely. Usually, a key component of the financial due diligence process is sort of working out of it as I said at the beginning what’s that normalised earnings, what’s the recurring EBITDA.
The existing owners of the business may have a particular view once we’ve completed our procedures. We may have a different view, and that could be because accounting treatments and other things do not follow how they should be or that there’s particular transactions that need to be normalised out as I said before, so that we can help the acquirer work out what is the true recurring earnings and true EBITDA of the business and then I can also work with them to sort of understand what an appropriate multiple in the industry is so they can then work out “okay, well what is this business really worth?”
Finding the appropriate multiples to use
Joanna: That’s a fascinating topic in and of itself, the appropriate multiple to be using and there’s a lot of discussion around about the difficulty of picking appropriate multiples and of course you know multiples are useful to a degree. But at the end of the day, a price is just what the market will bear at the point, so multiples can change wildly over time and depending on the business.
What sort of issues do you see with business owners coming in with an idea of a multiple that they think is applicable and then how are you driving, how are you finding the multiples to use as comparisons I guess.
Luke: Look I guess it varies so some business owners will come to us with sensible multiples and understand where they sit in their particular industry. Others have got more lofty aspirations and believe that they may have a higher value and that could be driven for a particular reason. We also have I guess acquiries that are willing to pay higher multiples for particular strategic reasons, so it’s not all, as you say, it’s not always just the multiple. It can be different for different reasons, if there’s a strategic fit for a particular target.
How we go about looking at that, we’ve got access to our valuation specialists. We’ve also got access to market transactions and databases that we look at in terms of particular industries and research that we can share with our clients in terms of like oh well, this is what this particular in this industry at the moment these are sort of the businesses that have been sold, these are the multiples that are being generated and obviously there’s a lot of publicly available information. But we also have access to stuff that’s not necessarily publicly available.
Joanna: Do you have many instances where you go through the DD process and then you use that to help reevaluate price?
Luke: Yeah. Quite often, quite often. We did a transaction I think was last year with a private equity firm, helping the existing owners of that particular restaurant, large restaurant business to work out what the multiple should be to exit. We came up with a number of examples of recent transactions and other information to help them sort of support that process.
Other clients will ask for a full blown valuation to be performed to sort of work out what the true valuation from a valuer’s perspective of the business might be as well, so it varies.
Financial due diligence from the vendor’s side
Joanna: Yeah. All right well then if we swap around briefly, we’ve been talking a lot about DD from the side of acting for the acquirer. But if we look at the you know sort of stepping in the seller shoes here. They’re staring down the barrel of a buyer wanting to go through a DD process, what can they do to put themselves in the best shape? Obviously the aim of the game is for the DD process to not reveal too many holes in the business, right? So how do they put themselves in the place of number one going through the DD process and having an outcome where the buyer still continues with the transaction, doesn’t try to drive down the price, and number two making it easy from the timeline perspective.
Luke: Yeah. I think on the vendor due diligence side, I mean we act for a lot of businesses that are looking to sell and quite often that can be through a variety of paths – trade sale, private equity or even an IPO or listing. The key advice is start early. Think about it two to three to four years away, if possible. That’s not always possible. But particularly if you’re going to go down an IPO path, you need to prepare, start to prepare the business a fair way out to make sure the financials are presented in the best possible light.
Quite often, in our role I mean I’m also an audit partner as well and we’re working closely with businesses about preparing to go down that exit path, so we’re often looking into work with them and advice on how to present their financials in the best possible light, and create maximum shareholder value on exit and a lot of that is around how do we drive EBITDA north. How do we make sure that accounting treatments and everything else are complied with.
Then obviously from a vendor due diligence side, we’re looking to put together something for a potential investor or buyer of the business that presents that business in the best possible light. It’s about making sure that there is no hidden skeletons in the closet so to speak, and how do we help management and the board sort of iron those out so that when DD is done, we’ve done a lot of heavy lifting already for the acquirer. So in so far as yes I’ll certainly send in their own people to do DD, but a lot of it you would hope that 90%-95% of the questions are answered.
Joanna: What sort of timeline should, and I guess is relevant to both sides of the transaction, but what sort of timeline from your perspective are realistic for the parties to set aside for DD? Assuming that they’re in the position where they want to move as quickly as possible, but not urgently as sometimes happens.
Drivers that affect the due diligence timeline
Luke: Yeah. Look I guess a transaction window it varies I guess typically based on size, but not always. That’s not always the main driver but I’ve had DD processes that we were helping a client sell their business and it can take a few months or a month or two. Others can take a longer period of time.
But I guess in terms of the DD and financial DD process, quite often and vendor DD process quite often for us, that could be anywhere as short as a week or two weeks up to a number of months. So again it really does depend on the size of the business and what they’re looking to do. Obviously, an IPO is very different to a trade sale, to private equity.
Joanna: I guess jumping back to the examples here, as I said before I just love the stories. What sort of things have you found? Like are there any notable things you recall finding during a DD process that were very surprising, anything that really stood out in your years of this work.
Luke: Yeah. I mean you always uncover some skeletons in the closet I guess.
Joanna: We wanna hear the biggest!
Some of the biggest skeletons uncovered
Luke: I mean I think it’s probably things like where, not particularly sexy or exciting but you might be looking at provisions for example that are really understated in a particular area. Like I can think of an example where a client had a large rehabilitation provision that hadn’t been recognised. They needed to make some assets at the end of an agreement, and that was in the millions of dollars. They kept it off the balance sheet and that significantly impacted the purchase price and what was going to happen.
Other examples have come out in the tax due diligence process where there’s problems with the ATO in terms of tax obligations and whatnot of a material nature that ultimately led to legal action, so those sort of things that come out.
Joanna: What a pick up before you’re sitting in the driver’s seat of that business!
Luke: Absolutely, Absolutely. Which is what ties in to your process with the legal due diligence, making sure that you’ve got the appropriate safeguards in place.
Joanna: Excellent. Okay. All right, wonderful Luke! I think that we’ve covered quite a bit of territory today. I love some of those stories.
Luke: Thank you Joanna.
Joanna: Thank you so much for coming on the show. Now look if our listeners want to get in contact with you. How do we do that?
Luke: Yeah. Look, I guess they can contact me at obviously at Prosperity Advisers, to look up the website.
Joanna: And we’ll put a link through in our show notes, just in case you’re running along right now listening to this. You can pop into the show notes and see how you can contact Luke.
Luke: Yeah, that would be great. And look I’m happy to help anyone talk through your due diligence process and how we can work, collaborate with any of your listeners, Joanna particularly on the M&A side where there might be people out there that have got potential businesses that are looking to merge with others or to sell or vice versa, find a target. I’m happy to talk to any of your listeners.
Joanna: Great. Wonderful. Luke, thank you so much for your time. It’s been really interesting talking about this area. I know due diligence on the face of it from an accounting perspective may not sound exciting, but you’ve certainly made it very interesting for us with all your stories. Good work. Thanks Luke.
Luke: Great. Thank you very much.
Joanna: That concludes today’s overview of the basic concepts in financial due diligence in the context of business sales and acquisitions transactions, with our guest Luke Malone of Prosperity Advisers.
Due diligence is obviously a very important component of an acquisition, but hopefully today we have given you a bit to think about in terms of the considerations about working out the appropriate level of DD, both on the basis of the commercial realities of a deal balanced with the risk profile of the buyer and transaction.
As always, it continues to be the case that using advisors in a sale process who understand what they are doing is fundamental to helping to strike that right balance – both in keeping tight on timeframes, and providing the right level needed, without going overboard.
If you’re interested to learn more about this topic, you can reach out to Luke and his team at Prosperity Advisers by checking out our shownotes at www.thedealroompodcast.com. There you we’ll link through to their website and there you will also find a full transcript of this podcast episode if you would like to read it in more detail.
And of course if you are a business, or you work with businesses, who would like to have a chat about determining the right level of legal DD for a potential acquisition, or in gearing up for a sale, our team of legal eagles would be only too happy to have a free chat about an appropriate and commercial approach from a legal perspective.
Well I hope you enjoyed what you heard today. If you did, please subscribe to the Deal Room podcast on iTunes or your favorite podcast player to get notifications straight to your phones whenever a new episode is out.
Thanks again for listening in! This has been Joanna Oakey and the Deal Room Podcast, a podcast proudly brought to you by Aspect Legal.
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