Beyond the Checklist

Due Diligence: 1) the care that a reasonable person exercises under the circumstances to avoid harm to other persons or their property; 2) research and analysis of a company or organization done in preparation for a business transaction (as a corporate merger or purchase of securities).

Merriam-Webster online, 2009

Much has been written about the art and science of the due diligence process. There are lists, manuals, "how-to's" and all matter of other reference materials available. Despite the technical treatises that have been compiled, investors, lenders, buyers (and sellers) at times still find themselves with most unpleasant surprises. There are surprises in the business model, the customer base, the operations and the unfortunate realities of adverse human behavior, as witnessed again recently in the alleged Madoff pyramid scheme and the apparently undetected Satyam fraud.

So rather than providing yet another technical checklist, it may be helpful to step back a bit and share some thoughts regarding the approach to a thorough due diligence process.

ADVANCED PREPARATION IS A MUST

As Plato states in The Republic, "the beginning is the most important part of the work." Plan out your due diligence process and the information that you want to elicit well in advance. Frustrations will quickly set in during that first session if you're not ready. Moreover, poor preparation will be evident to the target company representatives and may signal to them your seriousness (or lack thereof) in the potential transaction.

FORM THE RIGHT DUE DILIGENCE TEAM

There are many different disciplines that have to be covered - industry, business, operations, financial, legal, human resources, sales (and customers), etc. One cannot be an expert nor expend their resources across all of these areas. You should select team members and, when necessary, outside consultants, with the appropriate expertise, including thinking about how this company might operate under your potential future ownership.

QUESTIONING IS AN ART -- PRACTICE IT

The specific questions, how you ask them, and at what point you drill down into key areas is an art that is enhanced with experience. Within all of this, the biggest challenge to questioning is the discipline of listening. In the rhythm of a Q&A session, you can find yourself caught up in getting through your list of questions without really pausing and allowing management to talk. Pause, reflect and play back answers that are given. It's important to remember that the questions being asked speak volumes about issues, concerns, business and situational understanding. As one colleague termed it, the answers to questions could be viewed akin to a continuous Rorschach test.

LOOK FOR "DISCOMFIRMING" INFORMATION

You have an investment theme, an industry focus, an interesting target company in the right geography, a potentially willing seller and an indicative price. Now what? Presumably, one has spent significant time and resources getting to this point, and it may be natural to look for facts or anecdotes to support your thesis. Ask each member of the due diligence team to look for both supportive and non-supportive information. Within this disconfirming information - or trying to seek the antithesis - one may end of discerning new risk factors that need to be considered.

ASK ASYMMETRICAL QUESTIONS

While a response to a direct question might be a direct answer, it might not provide the full color or dimensions of an issue or opportunity. For example, a review of turnover in middle management ranks might be indicative of a failed project, or of a sales leader that sets unrealistic targets for his team because that's what the CEO demanded. Listen for how your question is being answered and be attuned to what is not being said.

COMMUNICATE AMONGST THE DUE DILIGENCE TEAM

Different people will have a different focus and set of responsibilities. At various points in the due diligence process, all parties should come together to discuss key findings to date. Notes should be distributed of key relevant points or risk areas. As the due diligence process is a series of meetings, such communication will allow the entire due diligence team to reflect upon information received (or gaps relating thereto) and assist in guiding the continuing process. One can pull the team together by a dinner at the end of the day or travel together. Both create venues and opportunities for exchange of ideas and results of the day's work. But it is important to give enough time so that cross fertilization occurs and common judgements are formulated.

STUDY THE MANAGEMENT SCORECARD

Management likely has a dashboard (formal or informal) that it uses to measure and management the business. Ask for this and, in the course of the due diligence process, keep this in mind when reviewing the business. Focus on why the management has developed these as the priorities of the business and how they use the metrics that are shown. Review whether or not these metrics are included in the key modeling drivers of the anticipated financial returns of your analysis.

MIND THE BRICK WALLS

As noted by Randy Pausch (The Last Lecture, Hyperion, 2008), everyone runs into brick walls. They exist "to stop the people who don't want it badly enough. They're there to stop the other people." Another way to think about this is to solicit from management what they think might be "defining events" in the course of the business. How has the company and the management team dealt with challenges - e.g., product development failure, a lost major customer, financial difficulty or the loss of key management? In delving into the reactions and outcomes to brick walls, one can find clues to how the company may react to future internal or external events that it will inevitably face in the future. This might also help the due diligence team to assess the company's ability in various downside scenarios.

ASSESS MANAGEMENT

This is, perhaps, the most difficult of all tasks. You might find examples of how a person or organization has overcome the brick walls, but still be uncertain as to the true character and competency of the company's leadership. Exasperation develops when we see examples of deception amongst those you thought were above reproach and whose outward actions demonstrated an ability to perform. Delving into discussions with the next layer of management below the C-level needs to be approached with some care, as responses may have a tendency to elicit the internally politically correct or more cautious answer. Soliciting direct opinions of one's view of the quality or competency of the executive team may yield less insight than desired. Often, it might be better to discuss with management how they might seek approval for a capital project, market analysis or a change within their functional area. A management team that has a holistic view of the organization may be a likely indicator that the positive feelings received in discussions with the C-level executives are, in fact, a truer reflection of their assessment.

DON'T IGNORE RED FLAGS

An outcome of the due diligence process and the team communication may be more than merely disconfirming information or proof of the investment antithesis. It may yield more significant signs of difficulty within the industry, the company, the product set or the management team. When these red flags arise, it's best to communicate these quickly amongst the due diligence team, allowing everyone to probe further and pay acute attention. It is better to walk away from a deal or a hiring decision than to ignore the red flags and deal with dire consequences later.

There is no single magic elixir that one can ingest to suddenly be wizened in the ways of due diligence. It's both an art and a science that takes preparation, skill, experience and communication, all in an unbiased manner. Through constant self-examination and refinement, your due diligence process will become a more effective tool in business decision making.