Due Diligence in Private Equity : Buy Side and Sell Side Best Practices [ Module 7 ]

in this module we're going to be talking about one of the central aspects of any private equity transaction which is due diligence there's almost no investment transaction that will take place without due diligence and therefore this is a central pillar of the private equity investment process as an advisor it's possible that the professionals accounting and other professionals and we find themselves playing a variety of different roles when it comes to due diligence one role may simply be that they and may end up working for an investor on the buy side due diligence in other words working for the product investor to produce reports and analysis for the purposes of the investor's due diligence that's one roll the second roll is that the advisor may be working for the company performing so-called cell-site due diligence which is a type of due diligence which we do in anticipation of a potential transaction or it could be that the they are part of a firm which is proposed to provide an opinion on a set of financial statements without performing an actual due diligence in the case of an advisor working for the company this is where self side due diligence is going to be one of the central concepts which we're going to be covering and part of an effective sell side due diligence for any advisor working for a company is firstly the ability to persuade the company and its owner that a sell side due diligence is a worthwhile investment and then secondly performing and effective sell side due diligence which can then synchronize with the buy side due diligence of any investor and that's the second key success factor the objectives of the module are to describe sell side due diligence as a pre investment process to present sell side due diligence as a roadmap to facilitate by side you diligence by an investor how to manage due diligence cost management and apportionment of cost among the interested parties a description of consultants working in due diligence and broking of private equity transactions and lastly best practices in due diligence reporting one question that's commonly asked is at one point at what point in the transaction the private entity transaction does due diligence actually start well we have to look at to keep important points the first point is whether we are talking about by side due diligence or cell-site due diligence and now have a different kind of starting point and the other thing we need to talk about is the fact that before the formal due diligence which can be defined as that where we are starting to pay third parties such as accountants and lawyers to produce work we also have a prejudicial face and there can be some overlap or gray area between between the two so let's look at this by side due diligence will start once the investor has commissioned external advisors to begin the due diligence so the starting point is simply at the moment at which these advisors are appointed and are starting to to get paid however there will also be a gray area where the the investment officer of the private equity fund may perform other types of due diligence primarily business due diligence ahead of this in order to establish whether it's worth here for the next level and this could be defined as pre due diligence and it's basically basically mostly can be centered around business but they may do and have a look at the accounting and legal situation if only to map out what they need from their advisors on the sell side it's not so structured the sell side you divisions can be performed at the leisure of the company because there is no time pressure condition by deal milestones as in the case of by sight due diligence so the Celtics are agents could be performing bits and pieces over appeared the main condition being that it should be ready ahead of the time that negotiations begin with a private equity investor the good way understand water financial due diligence ease is to consider the analogy of buying a used car as the purchaser you may be able to obtain certain documents that provide you with some comfort that the car you are considering to purchase is in good condition and these relatives are the price you are paying for example the car may have a warrant of fitness or some other document certifying its road worthiness or you may have records provided by the vendor that outlined repairs at service work performed although we may find some comfort in these documents you are likely to go into what's before your own due diligence looking at the car over taking it for a test drive and kicking the tires however if you are not a mechanic you may not be able to really make a good assessment so you may want to hire an expert who is a mechanic to make a more informed and thorough assessment of the car someone who can focus on your concerns and look more closely at matters that may be important for whether or not he eventually purchased the car the similar analogy can be applied for a house purchase where often performing an expert home inspection forms part of the outstanding conditions in a conditional sales and purchase agreement in the case of a financial accounting due diligence the mechanic is most often a qualified accountant working in an accounting practice although a financial due diligence may be a source of comfort in a priority transaction it is not an audit and does not provide any opinion as such so let's look at a few important differences between an insurance engagements let's say an audit and a financial accounting due diligence performs an audit is often subject to state regulation some shareholders rely on the company auditors to add credibility to the statutory financial statements and so it is important they are independent and competent or never had performing a financial due diligence could be done by anyone including finance staff currently working in the target company however in practices work is performed by professional accountants that have developed experience in these transactions on what assurance engagements typically involve historical financial information although it is possible to perform an examination of prospective financial information this is not common however in a due diligence the role of prospective financial information is significant and looking by the mathematical accuracy of computations as well as the assumptions underlying the numbers can be important although audited financial statements provide information that can help investors shareholders to hold sell or buy their shares such information is generally not provided in contemplation of a potential transaction which is the case for circumstances under which that your diligence is performed financial statements do not alone provide information investors need when assessing an investment opportunity the objectives of each are indeed different what governs the work performed for an assurance engagement is determined by the relevant standards such as the international standards of auditing for audit engagements or the international standards of reveal engagements for limited assurance engagements laws also play a key role for performing audits and reviews for an accounting due diligence engagements there are no standards issue and the work is governed by what is agreed between the client and the team performing the work in terms of outputs for an order of review there is a requirement to issue an opinion modified or unmodified according to the standards whereas for due diligence the work is usually communicated through a report however the due diligence engagement could conceivably be communicated as a presentation the lower the Kelty do diligence errors of focus may vary considerably much more than with statutory exercises some of the typical areas might include the following looking at the Equality of the earnings so due diligence will assess whether the earnings are maintainable or whether there are significant one-off items such as for example sale of a building or whether some of these earnings are distorted by goodwill or accounting manipulation of some kind in other areas to identify some broad trends in the financial operations and part of that may be by making use of ratio analysis the trend might be whether the sales that are growing or when the margins are deteriorating over time for instance another third area might be to analyze working capital to see if there are the company's working capital situation is satisfactory or whether there may be some issues like for instance the build up in inventory or some slow moving inventory for example full-fare would be to look at the key assumptions of the measurement forecasts the management will prepare a full cast plan and some of the assumptions may be something that could be challenged it could be that there's over optimistic that's a growth in sales or the marketers seem to grow too quickly or there's some assumptions about efficiency which may not be backed up according to historical performances fifth could be to analyze litigation regulatory issues whether there's been any outstanding litigation on the company or whether any regulatory judgments which may impact the company going firms and this is regulatory issues can be very important particularly regulated industries such as banking and telecoms another way would be to assess the accounting resources and systems as the company have a strong management information system like a computerized system that can easily generate monthly reports is the system sufficiently bookkeeping system sufficiently computerized and these will be also something to do with the process quality which will also be assessed and then there may be a number of other areas which may be agreed ad hoc between the seller and the buyer according to the sector and the different types of companies that may exist in the market how to report on due diligence findings well there's no specific template or regulatory requirements have a report should be done in practice different accounting firms will use their own different styles and so it is possible for the investor or the sell-side advisor to give guidance to the those performing some structure due diligence on how they would like the report formatted but normally there would be an executive summary a main body and some appendices like any any good report people want to have a quick overview in the executive summary and then some of the more detailed information going to an appendix and obviously a friendly user-friendly layout like any document would be would be very will be very important source our due diligence pre investment the Flores to introduce the topic of sell so do diligence many private equity and indeed other deals tend to be derailed when a surprise emerges from the sales side during the investment process because this makes the buyer I think what else may be there by doing an internal homework ahead of time the sailors can enhance value and improve negotiations because the buyers will have a higher level of confidence that any surprises are not present if a salsa our seller does not do a suicide due diligence and an issue is identified by the buyer and the seller indeed was not aware of it which happens this could put the seller in a very defensive position as regards to the terms of the deal and put them at a strong disadvantage a surprise emerging when a buyer may performs due diligence tends to wipe out the credibility of the seller because the buyer then questions how much else is there Dumas also due diligence allows the buyers to actively identify matters impacting value because they've been flagged on what this does it minimizes the uncertainty of the process and increases the value of the investment for a more technical point of view the objective of due diligence include forecasting the future performance of an organization by looking at the potential risks and threats that are present at the time investment and to identify any problems which may create unanticipated liabilities in the future as we could see the chart on this slide summarizes many of the errors as we can see the due diligence is widely encompassing of several areas it goes from the main risks so risk analysis and an examination of the balance sheet looking out was a competitor's in industries looking at the cap the company's capital structure looking at the management of the company and many other areas some of the reasons for conducting and due diligence or some of the things one is trying to look for or assess the level of will include the hidden risks which may be attached to the transaction looking for the skeletons or the secrets which most business tend to have either explicitly inadvertently or deliberately and finally to assess the level of company the company's corporate governance what is a source our due diligence the Senate takes a critical look at its own financial position and assesses the risks and opportunities the company faces prior to seeking an investor so it's an exercise done by the seller from himself looking forward to a potential negotiation with an investor the other focus of the self-surgery diligence will be burying the objectives the biocide to veterans in other words anticipating in different areas where the buyer may perform due diligence technically this means analyzing earnings looking at the credibility of forecasts looking at capital working capital requirements looking at tax risks customers suppliers and other key relationships and contracts the company may have the social side do diligence would be performed early in the investment process ahead of the BIOS I do diligence whereas the BIOS our due diligence would be one of the latest steps an investor process typically performed after the term sheet has been signed the sir sir do diligence report that would be produced by the advisors may be provided to the potential investors in order to assist in an understanding and to provide them with a roadmap to make their by side due diligence more precise more efficient and more cost-effective obviously they would have to sign a nondisclosure agreement to protect some of the confidentiality of the information concet contained in a sale side due diligence report the Mossad your diligence is performed by the investor and the different advisors working for the investor this bias our due diligence in the case of multiple investors potentially looking at the company would not be shared with the other investors so it would be proprietary to the investor had commissioned it this barse our due diligence may be partially share a full share with the seller on certain conditions but it will depend on the cost arrangements between the parties for the bias our due diligence the level of due diligence and any sensitivities that may come out from it as far as the depth it tends to be a more in-depth exercise than a Southside due diligence and therefore concert with the consequently higher cost as well there are broadly speaking five main types of due diligence business due diligence which refers to a review of the business legal due diligence which refers to checking out the legal aspects and the level of legality of the company accounting due diligence which focuses on the financial statements of the company and assesses whether these are of a little sufficient to be credible technical due diligence which may be performed in the case of assets of the company which require technical review and environmental social and governance due diligence which referred to whether the company is environmentally sound and is respecting good social and governance norms looking at some of the features of the due diligence the business due diligence is performed journey by the private equity fund manager themselves they may sometimes use third-party contractors for specific things such as doing market research or investigating the background of senior managers for instance it's a journal wide-ranging review analyzing the business plan looking at the company in the market potentially talking to suppliers customers and even competitors legal due diligence is a structured exercise performed by a firm typically it will it will be including whether the company owns its assets if there's any outstanding litigation whether all the company's permits are in order and all the key agreements of the company are properly league at leading executed an accounting due diligence is performed by foreign accountants and it will consist of reviewing the historic accounts either at a limited level or at a firm level depending on circumstances and it may also extend into helping to review the financial section of a business plan such as the forecasts technical due diligence is performed by a specialist firm often engineers and this will involve inspecting and potentially valuing technical assets and systems of a firm or Factory which may have assets which are difficult to assess without bringing in an expert environmental and social juda Regents is often done by specialist firms checking of the assets and the presence comply with relevant environmental regulations so business due diligence it's performed by the investor directly so the members of staff although in some different markets it may be subcontracted to some extent or with larger deals it may be subcontracted so it includes and now analyzing the business plan background checks of management's interviews with key stakeholders and a general research in the market and potentially other other other types of research well here are some examples of business due diligence and some of the outcomes that can come from a satisfactory business due diligence in the first example it turned out that the some of the customers had been pre-selected by the seller and coached to tell a specific story to the investor who then noticed it and then insisted on speaking to other customers and discovered a different picture in another case the company had all its permits and contracts in place and the seller was reluctant to now the fund manager to talk to the city authorities who issued those permits when they found a way to talk to them they discovered that there was going to be a change in regulations which would then impair the business and thirdly it can also be the case that the sale was not actually aware in the case of the tobacco investment the fund was doing their bias our due diligence I went to talk to some of the big advertisers who were placing ads for cigarettes on those magazines and discovered they were planning to discontinue these and in fact the entrepreneur was unaware of that because he hadn't been in regular contact with them so it can also be an accidental discovery bloomer due diligence that's performed by a law firm it's very rare for the fund managers to try and do it in-house it has happened in some smaller cases where there may have a lawyer as part of the team but it tends not to be very effective that way it consists of a legal review of the company and some of the main items they will check is whether the company has legal title to their assets so do they own their assets is there any outstanding litigation and what is the potential amount of of that are the operating and other permits in order up to dates and legal reviewing key contracts and arrangements such as contacts with suppliers customers managers employees and others and checking checking the regulatory environment and its potential impact on the business in the case of regulated business to review the likely changes in the regulatory environment and their potential impact for a couple of examples of legal due diligence in the first example of the top the due diligence was being performed on behalf of a debt provider who was planning to the way the company with some long-term debt after the private equity fund had made their investment and one of the happy discoveries made by doing that legal due diligence that had not been discovered before was that the telco the national telecoms company did not own the tubes in which its cables were laid giving therefore access to the tubes to the cable TV company in another example we had a situation where the telecoms company was lobbying the city to change the regulations concerning access to eating tubes in order to block the cable TV company from putting their cables in it and they did that by engineering a bylaw according to which people were not allowed to put technical equipment into these cheese because it damaged the tubes so they said and the cable TV company was using a kind of mechanical robot to pull the cable suit and after the spiral came out they found a very genius solution in both ends up involving a dog and therefore were able to circumvent this by not accounting due diligence it's generally performed by an accounting firm and it consists of a financial review of the company so it's a fairly straightforward and clear exercise and this means it could either be a familiar to a limited review there may be some special analysis of areas of uncertainty depending on the sector it could involve preparing financial statements so reclassifying financial statements which are not prepared according to international standards and reclassifying in a way that's more intelligible to the buyer and potentially also reviewing the financial section of the company's business plan where we serve a couple of examples and accounting to diligence in the top example the accounting firm proposed the firm on it but the fund manager declined and decided to do a firm only of the payables and receivables which were the main areas of concern and great thanks to that they save 75% of the original quotation sometimes things can go very wrong this this happen in a major Mediterranean country because the the due diligence was not very well managed and they decided to leave to very late stage the visit to a brewery in the south of the country they then discovered there was actually no plant and and this exposed the major shortfall in the balance sheet of the company and clearly the deal then collapsed technical due diligence almost always performed by a specialist consultant hired for the purpose generally consists of a non-smart on-site inspection of technical assets and systems the condition of these systems the valuation of the assets potential improvements in case of weakness an example the example shown on the slide is that management wanted to buy a new bottling line for their brewery but the expert commissioned by the investor concluded that all was required was spend a small amount of money to refit the existing line and it could be in a continuing therefore that enable the investor have a very substantial cost saving environmental due diligence similar to technical due diligence was performed by specialist consultants and the broad objective is to check whether the company's assets and processes will comply with environmental regulations be these local national or supranational such as EU level regulations and again these these costs can be managed there was an example of an investment in the chain of 30 gas stations where the investors decided to ask the environmental specialists to only do it for an inspection of two of the 22 of the 30 and see what results that would give one well it turned out that everything satisfactory they're able to save 80% of the original fee estimate it's very difficult to estimate the cost of a due diligence exercise because so much of it depends on the specific transaction and the specific company each one is going to have its own issues broadly speaking the bigger the company probably the higher the costs the more the company has land building and other assets probably the higher the cost if we give a generic example of a middle sized company the likely total due diligence costs might be something of the order of 50 to $100,000 another rough rule of thumb that's used is to estimate the total costs at between one to three percent of the of the deal size this includes also the contractual constant drafting drafting legal documents the management of the cost of due diligence is also complicated sometimes the consultants hired are usually paid on an hourly or daily basis and their tendency is to try and maximize fees by proposing more work than maybe strictly necessary therefore that the investor needs to understand the relative importance of the different parts of due diligence and since whereas are the most difficult ones which need more in-depth analysis and often the two-step modular approach is best by commissioning a consultant to do a phase one due diligence examine the results of the phase one and then proceed to phase to do due diligence if the results suggest further work may be necessary but ultimately managing the due diligence process is part of the experience that any investor should potentially develop another one of the issues that will be discussed is the question who pays for the due diligence cost where there should be the investor or the company who's potentially receiving the investment question 1 which type of due diligence reviews the company in its market please select one a legal due diligence be accounting jus diligence see technical due diligence D business due diligence will now turn to the specific question of southside due diligence and the benefits for the company and for potential investors in the company let's start by summarizing the specific benefits to the company performing a suicide due diligence a level plane filled in the bidding process potential investors can submit bids with more confidence and that leads to reduce ability by the investors to renegotiate on price and turns later which is something to the benefit of the company minimize surprises being upfront with the issues discovered in a sell side your diligence will enhance the credibility of the seller and will lead to a better negotiation which is built on more trust and more willingness by the investor to to trust the sellers representations proactive corrective measures if one identifies a problem during a sale so do diligence you can report to the buyers that steps are currently underway to correct issues identified and that will have the effect of minimizing their impact in negotiations and therefore leading to a better deal for the seller accelerating closing sell Saji diligence will have to streamline and reduce the cost of a buyer's due diligence which will have the effect of attracting more buyers and increasing the options available to the seller some other more secondary advantages to the players involved oversell sanju diligence is in the case of a standalone business social Sergi diligence can put all the company information into a single comprehensive document which provides a roadmap helps to build the data room and identifies area of concern and this can be particularly helpful in the case of a division that's been being put for sale that doesn't have its own autonomous set of accounts divestiture the investments have an added layer of complexity due to the central functions which are not within the division as also due diligence can highlight across structures contribution margins cost allocations and the balance sheet car by accountants so it makes it more easy to understand what needs to be done when you carve out a division in a divestiture Advisors well the main objective of advisors is to maintain control of the sale process in order to maximize value for the seller and reduce the risks if the issues have already been vetted analyzed and identified by a seller do diligence the due process is more effective and so-called land mines are not present within the company for investors they will have a better understanding of the company's financial information much earlier in the process which is a very useful for them and for the seller this will result in a more competitive bid with more confidence and less caveats because the buyers will be sure that there will be no surprises later and the investor can then focuses attention on the most attractive deals and having a good sell side your diligence makes a deal more attractive for an investor who presented this side of a case study of a sale without due diligence which concerns panini a major trading cards company based in northern Italy panini was put under administration which is a procedure similar to chapter 11 as it's known in the u.s. under which it's administered by a court and the magnate of the administrator was thrown as a quick sale of the company and then passed on the proceeds to the creditors and because of the legal requirements of the procedure it was impossible to allow any sell-side guarantees and that included no sell side due diligence because that was not allowed by the procedure and therefore the buddhist the buddhist due diligence which was performed by them and not shared with the sellers gave an actual information vantage because it turned out that they ended up knowing much more about the company than the administrator of the company who was there mostly folks in crisis management but evenings was therefore then sold to a private equity group led by Bain who paid 15 million euros for the company and then was able to resell after only two years four hundred and ten million here is another example of Exim Bank here in Serbia and this is where a very far south side you diligence was performed Exim banker was an SME bank in Serbia he had been acquired by a private equity consortium led by sauce and the strategy was to sell the bank after a number of years to a major Western group the preparation of sale included sell some due diligence reports the preparation of electronic data room a board member act is the project manager of the sale and giving actual training and presentation skills to the management this allowed for a very competitive sale at sale process and a lot of interest by bidders and eventually it was sold to Bank Austria for two and a half times Book value and the investors enjoyed a profit of ninety percent let's look at to sell our due diligence from that another point of view as a signal to the market commissioning the sell side due diligence sends a signal to the market that the company's serious about the process of acquiring investor and wants to be transparent many companies or entrepreneurs will enter into negotiations out of curiosity without any serious intention the fact that people see that an investment has been made in the sell side your diligence is acts as evidence of seriousness a sell side you do due diligence can also reduce significantly the time and the costs of the investor's due diligence and their further invest so we weren't willing to enter and engage into negotiations with this company and thirdly the sell side your diligence will allow any advisor to go to the market with more enthusiasm and confidence that the deal will go through the advisors job is partly as a promoter so their job is to go and sell the potential investment to potential buyers if they know their backs are covered if you will because the company there won't be any surprises they will go out with that much more enthusiasm and dynamism into the market ultimately it's about credibility if we think about the level of credibility at different points in our investment transaction so no credibility tends to be at its highest when the investor first gets information in the company introductions have been made the sentence been presented then we move referrals in the transaction if discrepancies and surprises come out so things are not as presented the credibility of the seller reduces or may evaporate to zero in the case of evaporating to zero it's likely the buyer will walk away so at a certain point if credibility is reduced too far the investor may walk away because they don't have confidence in the process while subversion is that the business description the sales the cost and profit figures must hold up throughout the investors examination the biggest mistake that is made in the preparation phase by the Southside is to create a rosy picture to entice investors in the hope that the rest of it will somehow work itself out or perhaps the investor won't discover everything this is an illusion it's naive and all it will do is waste everybody's time the golden rule in investment and in society diligence is no surprises let's now look now look at sell sérgio diligence from the point of view of its serving as a roadmap to facilitate the buy-side due diligence sell side versus buy side due diligence southside due diligence is normally commissioned on expectation that a biocide due diligence will be coming in the near future in other words so so due diligence commission because we anticipating an investment transaction and an integral part of any investment transaction will be a buy side due diligence the investor will not rely on the sell side due diligence because it's been before mother seller the investor will rely on his by sight due diligence only therefore the objective of the sell side do diligence are necessarily different from the objectives of the buy side due diligence the objectives of the sell side unions are specifically one to increase the interest in investors in engaging because knowing was a cell sentence being performed them less likely to waste their time secondly to make sure there is no surprise that seller was unaware of it's very embarrassing for sale and to discover a problem in their company they didn't know about themselves it makes them look very weak in the eyes of the investor and thirdly to act as a roadmap for the buyer side do diligence therefore reducing the cost the investor will see the main areas they need to investigate much more quickly if there is a roadmap provided by the seller on due diligence let's make a brief comparison of buy-side and sell-side due diligence as typically found in a typical transaction in terms of the cost the sell-side cost because it's a more simple exercise in the buy side I prepped a kind of preparation if you will for by side because of the sale so due diligence will typically be maybe 20 to 25 percent of the cost of a biocide you with it due diligence because of the accounting side of it s also due diligence would generally be unlimited reviewed with in detail follow only if something was discovered some red flag emerged on the buyer side it would most if it could be a firmer audit or a partial order and it may be performed in two stages needless legal due diligence will be limited to a limited review and then an analysis of known issues which are already present in the company in the case of the buyer side it will be a standard review fiducial reasons the lawyers will work through a checklist and it's their duty to make sure they've identified all the issues so the legal the buyer side will be a more structured exercise on the technical side the south side there may be a Judas down usually to justify valuations of technical equipment in the case of the buyer side the technical due diligence may be done by an external expert or the own star for the buyers and it's it's often frequently the case there may be differences in opinion on the buy-side and sell-side your diligence particularly as concerns the valuation of technical assets on return of ESG due diligence on the sell side is typically not profound particularly except for a very simple environmental review often because of the lack of know-how on the sell side on the buyer side it's more mature and some investors will do it just environmental some investors will do a fruit ESG it will depend on the type of investor and so the ESG side is a bit more loose in this case question 2 what are the objectives of sell side due diligence please select the relevant once a to act as a roadmap for by side due diligence hence also reducing its cost B to tick the box C to make sure there is no surprise the seller is unaware of D to spend money not to turn to the question of due diligence cost management and apportionment so one of the big issues here is who pays the cost and the question of who pays due diligence costs can become a very important issue during any transaction and can actually be a source of a great deal of irritation and and conflict due diligence costs due diligence costs are frequently a sensitive question and can become the object of the great deal of negotiation during any transaction the argument on the side of the seller for the investors to pay is well you want to do diligence you should pay for it now we're referring obviously to the by sight due diligence the self sanju digits cost are automatically paid by the seller the argument on the investor side for the company to pay is one well if you want my money you'll have to pay otherwise I'm not gonna invest secondly the results of the due diligence that we perform on the buy side will create value because we'll share this with these results with you and you'll be better informed at your own company than you were previously and the third argument for the company to pay is well if this due diligence exercise is shared with you it will save money on future audits and other type of corporate governance where as some of the work has already been done in Fast and it's typical in the market for those and to be some kind of compromise where the due diligence by side units causes splits with many many different combinations being possible another very important question when we are talking about buy side due diligence costs is whether the due diligence costs especially in the case of a broken deal in other words a deal that doesn't proceed are paid by a private equity investor from his fund budget or from the budget of the management fees of his fund management company and it's quite useful for an entrepreneur or a seller to find this out because if the due diligence costs are paid by the fund the investor will be less sensitive about the costs of his by side you diligence if the cost of the due diligence are paid from the management fees of the private investor the investor will be much more difficult as regards having to pay his share of fees let's examine now consultants and advisers who work in true due diligence and broking of transactions in the private equity space we'll look at the types of consultants the way their fee structures work the main risks that occur when in consultants and advisers work with entrepreneurs on private equity transactions there are several types of investors that we can find in in emerging markets and this is pretty much the same in every emerging market ranging from central Eastern Europe to Latin America you have investment banks which tend to operate in the larger size of the market and is very unlikely in the Mid Cap space that these will be present in any recognizable firm then we have accounting firms accounting firms primarily will be looking at transaction support but some accounting firms may have a unit dedicated to breaking transactions a kind of M&A type advisory unit thirdly we have management consultants of different types who will operate in the middle market either as deal brokers but also sometimes as transaction advisers they wouldn't they might advise more on the business side of the transaction and then finally small boutiques and individuals who will operate in a small or middle sized segment of the market often on a successor eBay sis and they will have they tend to have much more limited resources and centers at mostly as brokers the nature of the advisory relationship with with the consultant is very specific because of the one-time nature of the transaction so it's a one-time transaction or at least an investment transaction company will occur only a few year every few years it's not ongoing operational type involvement the transaction can be very critical or even existentially essential to the investment into the company's existence in other words this investment is really going to change the company and a very high risk so what is required there has to be a very high degree of trust on both sides of the seller and the adviser working for the seller and what tends to happen because of this high degree of trust and the level of confidentiality and importance is that the selecting the adviser selection tends to work very much on the word-of-mouth and on the track record because it's not a decision to be taken particularly lightly where are some of the pitfalls that may occur so from the point of view of an adviser interested in securing a mandate to work with a seller for an investment transaction we have certain risks that may come forwards the first one is unrealistic expectations the owner of the business may have ideas which are not realistic about the valuation of the company about how the company will be managed post investment or about the deal structure the second risk is so-called cold feet the seller is committed to the deal the deal proceeds everything works smoothly the sell side you diligence the buy said the negotiation the deal reaches a very advanced stage but just before the final closing the owner decides at the eleventh hour that he has changed his mind and is not ready to go through with it with a consequent damage to everybody in terms of losses in terms of costs reputation and time and the third another risk is bad faith the owner has no real serious intention to go through with the transaction but is looking to get an education about financing or is looking to get a cup a check for the valuing the company perhaps with a further purpose in mind some of the other things and advise on the sell side may discover is the last resort syndrome the owners tried everything else bank finance seeing other investors and comes the adviser once is exhausted a lot of possibilities therefore giving the adviser a difficulty because of the reputation of the deal in the market free materials the owner is not looking to do a transaction but wants to make use of the adviser to generate materials and know-how of investment potentially for another negotiation which will not involve the adviser free introductions if the owners looking to vizor to establish connections with others or PR the owner simply fakes making a little bit of noise in the market about being up for investment will raise the profile of his company even though there is no intention to proceed and these are all things that happen very frequently one of the best ways for an advisor to reduce the risk of potential sell-side client is to establish what the objective motivations are to seek an investor and these can be divided into negative motivations the seller the shareholders distressed financially distressed the company is distressed there may be a conflict among shareholders to do with money or other issues or family type conflict it could be a neutral motivation a succession issue the owners of a certain age and there's no children to take over it could be to do with personal circumstances such as a health problem it could be regulatory legal that there's a legal requirement to transact or it could be a positive motivation so the the company has found a potential acquisition of a competitor and would like to proceed with this acquisition and requires funding to do so or general ambition to grow the company organically and/or by acquisition where the there is a vision for the future which involves giving up some ownership so the fundamental part of it advisors due diligence prior to accepting any assignment is to establish clearly the motive for the owner to seek an investor what is the real motive rather than the presented motive because there can be a difference this will also impact the nature of the arrangements contractual arrangements between the advisor and the the the seller and will also impact the dynamics of the deal going forward so let's look at some of the fee components that would make up the transaction particularly from the point of view of the fees charged by the advisor on the sell side to the to the entrepreneur or to them to them to the company firstly costs so reimbursement of out-of-pocket costs such as travel costs communications accommodation printing costs these may escalate particularly if there's international travel involved retainer it's customary from advisor to seat a payment in a fixed fee to cover the work performed in preparation of the transaction such as a teaser and investment random financial model contacts with potential investors a success fee this is a fee that would be paid in the case of a deal closing based on the conditions of the transaction so paid in cash as a kind of Commission and then third party cuts there may be apart from the financial advisor there may be fees incurred to pay supporting consultants like accountants and lawyers who may be either stock contracted by the advisor or contracted directly by the by the company some of the main issues with advisory fees that we find from experiences one or two items firstly an unwillingness on the part of the seller to pay any costs or retainer fees so Commission only well this is a problem from selling for advisors which may lead to no dream being reached but if there is a choice made to proceed the way this can be mitigated is to rely on the owner or the historical advisors but the accountants of the company for preparations most of the materials and reducing one's involvement - just reviewing these reducing the essential costs of travel not doing any any international travel the risks of that is that the sell-side you diligence will not be done properly the quality of the materials may be prior and this will lower the chance of a successful deal another issues non-exclusivity that the advisors have pointed on a non-exclusive basis the way this can be mitigated is to accrete agree a limited number of advisors and agree a list of the investors to contact so that the same investor is not contacted by two or three different intermediaries the main risks is that the deal will complete with another advisor with the consequent loss of earnings or it could be that the deal collapses as the buyers pull out because of the confusion generated by different advisors competing with each other in most markets is better to have quality clients and that part of having a quality client means exclusivity and some form of retainer from view of the south side advisor there are some ways the fees can be structured to better align the interests of the advisor and the seller and to make the seller more amenable to paying such fees firstly the retainer it's possible to make the retainer paid against deliverable milestones such as production of a teaser of a memo of a due diligence report of a financial model or of a list of investors the retainer could be paid on a monthly basis for a limited period and the retainer could be offset against any success fee the success fee the fee can be based upon achieving a minimum price they can also be a ratchet mechanism with a fee increasing proportionately with valuation other features can depend on deal aspects such as minimizing funds in escrow minimizing guarantees on the seller side costs one structure could be an agreement on an all-inclusive cost budget or an agreement on a cost policy travel hotel classes or prior agreement on incurring of costs such as for a foreign trip there are some techniques to enforce or to guarantee payment by an advisor to minimize the risk of not getting paid one is advanced monthly payment and retainer the second is direct payment of expenses so plane tickets or hotels are prepaid by the company periodic payment upon delivery for deliverable such as a report or a teaser and for a success fee part of the deal structure could be instructions to the payment agent or the bank or to the escrow agent so that this accessory is paid directly from the buyer directly to the seller as advisor rather than to the seller and then the advisor I'm going to get his fee then from the seller who may then be tempted not to pay it question three which are considered risks for an advisor working on a deal please select all relevant ones a unrealistic expectations be bad-faith see confit d last resort the first example of the case study is Elcom in Italy this was an industrial controls manufacturer based in northern Italy in the very specialized Arab engineering the farmer who was in his late 50s was looking for liquidity personal equality a change in lifestyle and moving on to a less demanding role and of actually exiting the business to change his lifestyle his main motivation was maximizing the price the adviser their MMR which was a local Milan based boutique entered into successfully arrangements with an upside ratchet so they received a 2% successfully on the proceeds up to a certain level and then five percents on any amount above that there was no retainer or cost refunds so every mob prepared a fairly basic package and targeted a limited number of companies who are always operating the sector and who already knew the industry and therefore it wasn't so important in this case to do a very detailed sell-side you diligence when foreign trips were necessary what happened in practice was that the MMR would say to the founder well we're not going to come along because we can't we're not being read refunded and then father would end up paying for them because he didn't speak any English finally the company was sold brings us a consideration of 12 million dollars and MMR earned their fee this is another example this is concerned a school project in the Ivory Coast in Africa a group of parents are all working for a major bank and they approached an advisor to advise him on fundraising for creating an international school the pupils will be guaranteed because of the strong interest of staff of multinationals and the banks for sending their children to such a school WC have insisted on a fixed monthly retainer payable advance plus prepaid costs and success fees to be agreed at a later stage a few months into the project divisions within the sponsor would be merged on a multiple range of issues including the fees and led to with a wson with drove the project so WCM was open to get paid for its basic work and cover its costs and the reason WSM insisted on the advice fee was that they felt the time was a risky divided client and the client did not have cure be clear ideas about what they wanted and so they had to make sure that their costs and their retainer were secured this was a case of the Serbian privatization agency this was an agency of government under the Economics Ministry which was created under the auspices of the World Bank and part of the money provided by the donors was also to fund retainers of sell-side advisor which were chosen by the agency through a competitive tender the the tender process was a point system which heavily favored the lowest cost bidder and many of the companies being privatized were quite unattractive companies and they also came with strings such as an insistence by government that the jobs would we prefer hiepro is preserved so many of the tenders in fact what happened was many of the terms were won by second-tier consulting firms whose only real interest was the retainer and they had no real belief that there would be as ever be a success fee or there would be a successful transaction and therefore having won the tender they then minimized a cost by putting the most junior people on the job to prepare very low quality materials in order to get their retainers paid according to masters and no real credible effort was put into selling the companies and many of the transactions ended up failing so the moral of this one is pay peanuts you get monkeys here is an example of a by side mandate this was cai be a well-known regional investment bank based in vienna was mandated by heidelberg cement to help them with acquisitions in central eastern europe CIB was required to conduct very thorough professional analysis and this was a material that had to be quality enough that would be able to be put to the board of directors of heidelberg and so CIB dedicated their very best people to the project they were paying a substantial monthly retainer plus a small success fee so these projects were interesting for CIB because they provided a very good regular monthly income contrasting some of the more successful projects and CIB was also able to develop very strong expertise in the cement sector so a strong client who always pays on time is central part of any M&A consultants portfolio one thing that one has to be careful about is what transaction is how it is defined because this will also determine whether an advisor gets paid us accessory and from the point of the owner it may be important to limit the definition of transaction so the transaction the owner is seeking to accomplish for which is returning the advisor from the advisers point of view the advisors should be careful about limiting the definition because a cut of the the deal structure could come out in a different way and they may affect the fee so a sample definition we give here means we have an all-encompassing definition of transaction so that may include not just considerations paid on the date of the closing but also further commitments to be made in the future some of the key things to look at in advisor agreements one called exclusivity typical is best practice that M&A engagements should be exclusive we've seen early the problems of non-exclusivity and also in terms of advisor to fees after the after the the term of the engagement because it's possible that the the advisor group may terminate and then shortly afterwards the transaction closes so there would be known something that was a tailor period in order to capture that the capital may as a quid pro quo for exclusivity secret ask the advisor not to represent any other entity involved in the transaction because it has been the case that advisors may represent both get paid from both sides of the transaction the term of engagement would either be definite or Peter at least a year with some annuitant causes there may also be cause us to allow the adviser the plan to terminate the agreement with obviously certain of regions surviving terminations such as earn fees expense reimbursements tell-tale period riots indemnification confidentiality and the choice of law and for the success fees one of the things that may require careful consideration is defining what we mean by consideration so the the actual volume of money which will be used to calculate success rate and that can sometimes be difficult and so particularly careful attention should be paid on details of this definition and its applicability to any transaction because this can lead potential conflict with the client the seller arguing that it should be a reduced scope and the advisor arguing that it should be more we give here a legal definition which may be used in advisory agreements so looking at what consideration could potentially include this would be obviously cash it could also include the stock or the shares of a purchaser it could include adjustments in working capital they could include assets that are retained by the business it could include rolled over equity it could include purchasing notes in the instead of cash it could include own outs in other words amounts that are paid continued on future results it could include debt so third party or bank debt assumed repaid forgiven or refinanced capital leases and other contingent liabilities so careful care must be done to consider defined consideration one of course a pause of any adviser agreement is the tail period the tail period is a specified period of time after the engagements terminated during which if a transaction is completed or agreed to and subsequently completed the advisor will be paid a success fee despite the advisor agreement having expired this eliminates from the seller the sellers incentive to terminate and advisor prior to closing and then close a transaction in order to avoid paying a success fee it protects advisor if the parties decide decide to restart the transaction within some period of time after a first termination it's usually triggered only if the transaction is done with a party with whom the advisor identified signed a confidentiality agreement or with whom advisor had substantive discussions important causes we may find in M&A advisory myths breakup fees these are fees which are payable if the transaction does not occur for any reason especially if the client simply changes his mind and withdraws and if the seller is paid a breakup fee by the potential purchaser it generally consists of a percentage sometimes around 20% of the potential success fee or the bake up fee received by the seller from the purchaser indemnification all engagement letters will contain some form of indemnification for the advisor and its employees and all agents it's generally drafted so that the advisor will be indemnified for any liability it incurs in connection with engagement rather than from liability resulting from gross negligence or Wilmers and willful misconduct on the part of the advisor themselves a few key general points to make about advisor agreements between seller and a broker the engagement letter should be structured to reflect clearly the understanding the expectations of the parties and not avoid issues that may be sensitive between them it should properly identify the client and the beneficiary of the services it should include appropriate disclaimers and other contractual provisions to limit the liabilities and the obligations of the advisor it should vet and assess potential conflicts of interest and put in place processes for their management it should give thought to provisions for the enforcement of collection of fees and expenses for example by embedding these into any deal structure one of the questions that comes out is is an M&A advisor or broker of an investment transactions really performing a useful function and there sometimes is some negative publicity about this presenting them as kind of a low-level Commission seekers but these are professional and quality M&A advisor does have an important role to play in the economy they help to provide liquidity to small and private businesses they create a marketplace between SMEs strategic investors priority funds developmental banks and professional service providers they help to act as a catalyst for foreign direct direct investment in emerging markets they help to disseminate financial know-how and culture in emerging markets it is true that in emerging markets the profession can be less organized and regulated than in developed markets it may take on a project risk that other professional advisors who are more oriented towards being paid on an hourly basis are unwilling to take and the value is also created by synergistically managing the delivery of different but interrelated business and financial advisory services such as business valuation strategic growth planning business performance improvement corporate finance M&A advisory personal financial planning wealth management accounting and tax legal and state planning government relations and lobbying a good M&A adviser may touch on all these issues in one transaction best practices in due diligence here we review some of the best practices in due diligence the first question an advisor should ask themselves is to understand the relative importance of the two main motives for a due diligence report one is identifying the issues the substance of the issues and secondly that the Commission of the report the client wishes to have a report with a brand name on the cover for the file for his boiled or for the other stakeholders when reviewing the corporate structure in the government's the process is to review documents and interview the management the board of directors and other advisors some of the questions that should be considered what is the company's corporate structure does this model laughter liquidity events and/or return on investment is there an exit strategy who are the shareholders does the corporate structure fit with a business model does the corporate structure allow for growth who is on the board of directors has the company have been involved in litigation does the company have all the required permits and licenses regarding the financial assumptions and revenue sources one should review on the financial documents some of the questions that should be considered are has the company completed financial projections have the financial documents being properly developed according to applicable accounting rules has the company used an independent accounting firm our revenues realistic has the company already received funding and if so how much what our pre-money valuation interns what are the follow-on funding requirements and sources have all the tax returns been properly filed what is the company's debt carry what are the ratios is the company's current valuation aligned with its current stage of development and market potential market assessment as part of due diligence one should do an independent market analysis and require customer references if applicable some of the questions that should be considered does the company's product or service address a new or existing market does the company have a well thought-out sales and marketing plan does the company have key relationships in place has it chosen the right first market does its product or service represent a market push or pull what is the potential market size what is it stage of development what is the length of its sales cycle does the company's product or service have a seasonal aspect is this a stable market and are the cost of goods sold stable competitive arena as part of due diligence one should also do an independent competitive analysis some of the questions that they should be considered on following who are the company's competitors what is the company's market differentiator what does the market share look like how will this company win its market position has the company done a detailed feature by feature analysis management team as part the due diligence is essential also to interview all the team members and the key employees references some of the questions that should be considered what is the caliber and the pedigree of the team what is the team's overall track record does have the required skills and experience is the management open to improvement to its business model has the Mandarin team been previously funded how our management and other will the employee is being compensated technology assessment we may need an expert or professional assistance in assessing the technology particularly in the case of companies using advanced type technology some of the questions that should be considered does it have market requirements and functional specifications at what stage is development does the company have any usability studies does the company have adequate intellectual property protection does it need it is the company relying on being first to market rather than on any independent position for competitive advantage and is this realistic what is product quality insurance like is it proprietary architecture or open-source code some of the questions that should be considered when considering operations does the operating plan anticipate growth is anticipated growth realistic has the company considered all aspects operations to successfully launch a product or service has the company received any citations or notices of violation does management meet regularly to ensure compliance with plans or make needed adjustments does the plan take into consideration all cash needs and anticipated cash flow does the company have an alternative plan if assumptions do not hold anymore some of the red flags that may emerge in due diligence unrealistic valuation of the company or an unrealistic revenue model which way overestimates revenues is particularly the case in the technology sector complicated investment terms heavy debt the company is a very large amount of debt missing key assumptions about the market or financial model the company that's a one product or service company of Directors or Board of Directors that is obviously not functional in experienced management and poor advisors and these are all things that can be seen very quickly at an early stage of a deal and therefore it's possible for the buyers to withdraw at an early stage as well question for what could be considered a red flag when the due diligence is performed please select all relevant answers a missing key assumptions about markets or financial models B no Board of Directors C skilled management's and employees D for advisors we here provide an example of a due diligence checklist we will discuss in a second what this is for but we need to make a statement that the World Bank hereby assumes no liability for the accuracy or completeness of such a checklist and everybody should rely on their own advisors this checklist is used by private equity fund managers in order to go through a company to see all the main elements for the due diligence and so this is what you would expect if you were sell side advisor the company that the areas that the investor would be would be focusing on therefore it's important to understand where they are coming from and any sell side due diligence should be structured in a way to us to be able to address all the different categories which are included in this checklist or at least to provide a pathway for them to be able to perform their due diligence effectively so the best starting point for any advice to the company is to look at the checklists used by Priya fund and then look at the categories which can easily be addressed and to help this will help inform the planning of the sell-side due diligence this is a typical situation any potential investor may face they for fund our due diligence and some half-dozen irregularities have emerged and now the investor has whether these irregularities are not relevant at all whether they require adjustment to the transaction or whether they're so serious that it's a deal-breaker so finally I would like to express my thanks to the World Bank for allowing me to profession of the course that I developed with them put it online my website so thanks for that certainly all the modules this module and all further modules will have a certain amount of case studies and positional materials attached to the module which are part of the learning experience these materials I will be posting on a specially created group that I have made in LinkedIn called Gavin Ryan PE course I already have to do is search our IP group and the group will come out for you to join you who are following this course you'll be eligible to join my group and get these additional materials once you've connected to me on LinkedIn and once you've subscribed to my youtube channel so when I receive requests to join this group I will check these two things and then I will admit to you to the group so thank you very much for your attention I hope you've enjoyed this module and I look forward to seeing you on the next module you