Due Diligence

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What is 'Due Diligence'

Due diligence is an investigation or audit of a potential investment or product to confirm all facts, such as reviewing all financial records, plus anything else deemed material. It refers to the care a reasonable person should take before entering into an agreement or a financial transaction with another party. Due diligence can also refer to the investigation a seller does of a buyer; items that may be considered are whether the buyer has adequate resources to complete the purchase, as well as other elements that would affect the acquired entity or the seller after the sale has been completed.

In the investment world, due diligence is performed by companies seeking to make acquisitions, by equity research analysts, by fund managers, broker-dealers, and of course by investors. For individual investors, doing due diligence on a security is voluntary, but recommended. Broker-dealers, however, are legally obligated to conduct due diligence on a security before selling it. This prevents them from being held liable for non-disclosure of pertinent information.

 

BREAKING DOWN 'Due Diligence'

Due diligence became common practice (and a common term) in the U.S. with the passage of the Securities Act of 1933. Securities dealers and brokers became responsible for fully disclosing material information related to the instruments they were selling. Failing to disclose this information to potential investors made dealers and brokers liable for criminal prosecution. However, creators of the Act understood that requiring full disclosure left the securities dealers and brokers vulnerable to unfair prosecution if they did not disclose a material fact they did not possess or could not have known at the time of sale. As a means of protecting them, the Act included a legal defense that stated that as long as the dealers and brokers exercised "due diligence" when investigating companies whose equities they were selling, and fully disclosed their results to investors, they would not be held liable for information not discovered during the investigation.

A standard part of an initial public offering is the due diligence meeting, a process of careful investigation by an underwriter to ensure that all material information pertinent to the security issue has been disclosed to prospective investors. Before issuing a final prospectus, the underwriter, issuer and other individuals involved (such as accountants, syndicate members, and attorneys),will gather to discuss whether the underwriter and issuer have exercised due diligence toward state and federal securities laws.

The Due Diligence Process

Below are detailed steps for individual investors undertaking due diligence. Most are related to equities, but aspects of these considerations can apply to debt instruments, real estate and other investments as well.

Step 1: Analyze the Capitalization (Total Value) of the Company 

The first step: determine just how big the company is. The company’s market capitalization says a lot about how volatile the stock is likely to be, how broad the ownership might be and the potential size of the company's end markets. For example, large cap and mega cap companies tend to have more stable revenue streams and a large more diverse investor base, both of which generally equate to less volatility. Mid cap and small cap companies, meanwhile, may only serve single areas of the market, and may have more fluctuations in their stock price and earnings.  When you start to examine revenue and profit figures, the market cap will give you some perspective.

Conversely, the largest, most expensive real estate in any market is generally less liquid than more average-priced properties.

You should also confirm one other vital fact on this first check: What stock exchange do the shares trade on? Are they based in the United States (such as the New York Stock Exchange, Nasdaq, or over the counter)? Or, are they American depositary receipts (ADRs) with another listing on a foreign exchange? ADRs will typically have the letters "ADR" written somewhere in the reported title of the share listing. This information along with market cap should help answer basic questions like whether you can own the shares in your current investment accounts.

Step 2: Revenue, Profit, and Margin Trends

When beginning to look at the numbers, it may be best to start with the revenue and profit margin (RPM) trends. Understanding a company's gross revenue, profit margins and return on equity and whether it is growing or shrinking is essential in any equity or corporate bond investment.

Look up the revenue and net income trends for the past two years at a general finance website. These should have links to quarterly (for the past 12 months) and annual reports (past two to three years). Look at the recent trends in both sets of figures, noting whether growth is choppy or consistent, or if there any major swings (such as more than 50% in one year) in either direction.

Profit margins should also be reviewed to see if they are generally rising, falling, or remaining the same. Some investors demand that a company's return on equity plus its profit margins be equal to 50 or greater – the higher the better. This information will come into play more during the next step. 

Step 3: Competitors and Industries

Now that you have a feel for how big the company is and how much money it earns, it's time to size up the industries it operates in and who it competes with. Every company is partially defined by its competition. Compare the margins of two or three competitors. Looking at the major competitors in each line of business (if there is more than one) may help you nail down just how big the end markets for products are. Is the company a leader in its industry? Is its industry growing overall, and could its position in the field change?

Information about competitors can be found in company profiles on most major research sites, usually along with a list of certain metrics filled in for both the company you're researching and its competitors. If you're still uncertain of how the company's business model works, you should look to fill in any gaps here before moving further along. Sometimes just reading about some of the competitors may help to understand what your target company does.

Step 4: Valuation Multiples

Now it's time to get to the nitty-gritty of price-to-earnings (P/E) ratio, price/earnings to growth (PEGs) ratio and price-to-sales (P/S) ratio and the like, for both the company and its competitors. Note any large discrepancies between competitors for further review. It's not uncommon to become more interested in a competitor during this step, but still look to follow through with the original pick.

P/E ratios can form the initial basis for looking at valuations. While earnings can and will have some volatility (even at the most stable companies), valuations based on trailing earnings or on current estimates are a yardstick that allows instant comparison to broad market multiples or direct competitors. Basic "growth stock" versus "value stock" distinctions can be made here, along with a general sense of how much expectation is built into the company. It's generally a good idea to examine a few years' worth of net earnings figures to make sure most recent number (and the one used to calculate the P/E) is normalized, and not being thrown off by a significant one-time charge or adjustment.

Investors in real estate sometimes examine the cost to replace a building as compared to the value of the entire property.

Not to be used in isolation, the P/E should be looked at in conjunction with the price-to-book (P/B) ratio, the enterprise multiple, and the price-to-sales (or revenue) ratio. These multiples highlight the valuation of the company as it relates to its debt, annual revenues, and balance sheet. Because ranges in these values differ from industry to industry, reviewing the same figures for some competitors or peers is a critical step. 

Finally, the PEG ratio brings into account the expectations for future earnings growth, and how it compares to the current earnings multiple. In some areas this ratio may be less than one, while in others it may be as much as 10 or higher. Stocks with PEG ratios close to one are considered fairly valued under normal market conditions.

Step 5: Management and Share Ownership

Is the company still run by its founders? Or has management and the board shuffled in a lot of new faces? The age of the company is a big factor here, as younger companies tend to have more of the founding members still around. Look at consolidated bios of top managers to see what kind of broad experiences they have; this information may be found on the company's website or on SEC filings.

Also look to see if founders and managers hold a high proportion of shares, and what amount of the float is held by institutions. Institutional ownership percentages indicate how much analyst coverage the company is getting, as well as factors influencing trade volumes. Consider high personal ownership by top managers as a plus, and low ownership a potential red flag. Shareholders tend to be best served when the people running the company have a vested interest  in the performance of the stock.

Step 6: Balance Sheet Exam

Many articles could easily be devoted to just the balance sheet, but for our initial due diligence purposes, a cursory exam will do. Look up a consolidated balance sheet to see the overall level of assets and liabilities, paying special attention to cash levels (the ability to pay short-term liabilities) and the amount of long-term debt held by the company. A lot of debt is not necessarily a bad thing, especially depending on the company's business model. But what are agency ratings for its corporate bonds? And does the company generate enough cash to service its debt and pay any dividends? Some companies (and industries as a whole) are very capital intensive, while others require little more than the basics of employees, equipment, and a novel idea to get up and running. Look at the debt-to-equity ratio to see how much positive equity the company has going for it; you can then compare this with the competitors to put the metric into better perspective. In general, the more cash a company generates, the better an investment it's likely to be.

If the "top line" balance sheet figures of total assets, total liabilities and stockholders' equity change substantially from one year to the next, try to determine why. Reading the footnotes that accompany the financial statements and the management's discussion in the quarterly/annual report can shed some light on the situation. The company could be preparing for a new product launch, accumulating retained earnings or simply whittling away at precious capital resources. What you see should start to have some deeper perspective after having reviewed the recent profit trends. 

Step 7: Stock Price History

At this point, you'll want to nail down just how long all classes of shares have been trading, and both short-term and long-term price movement. Has the stock price been choppy and volatile, or smooth and steady? What was the price three and six months and one, two, three, five and 10 years ago? Is it rising or falling? Does this history match its profit trends? All this outlines what kind of profit experience the average owner of the stock has seen, which can influence future stock movement. Stocks that are continuously volatile tend to have short-term shareholders, which can add extra risk factors to certain investors.

Step 8: Stock Options and Dilution Possibilities

Next, investors will need to dig into the 10-Q and 10-K reports. Quarterly SEC filings are required to show all outstanding stock options as well as the conversion expectations given a range of future stock prices. Use this to help understand how the share count could change under different price scenarios. Are there any insider lock-up expirations on the horizon? Is it conceivable that the company may complete a secondary offering?  While employee stock options are potentially a powerful motivator, watch out for shady practices like re-issuing of underwater options or any formal investigations that have been made into illegal practices like options backdating. With real estate, look to see if there is any inventory that could be brought to market nearby?

Step 9: Expectations

This is a sort of a catch-all, and requires some extra digging. Investors should find out what the consensus of Wall Street analysts for earnings growth, revenue and profit estimates are for the next two to three years. For real estate, what is the opinion of professionals regarding future price trends and interest rates? Investors should also research discussions of long-term trends affecting the industry and company-specific details about partnerships, joint ventures, intellectual property, and new products/services. News about a product or service on the horizon may be what initially turned you on to the stock, and now is the time to examine it more fully with the help of everything you've accumulated thus far.

Step 10: Examine Long and Short-term Risks

Setting this vital piece aside for the end makes sure that we're always emphasizing the risks inherent with investing. Make sure to understand both industry-wide risks and company-specific ones. Are there outstanding legal or regulatory matters, or just a spotty history with management? Is the company eco-friendly? And, what kind of long-term risks could result from it embracing/not embracing green initiatives? Investors should keep a healthy game of devil's advocate going at all times, picturing worst-case scenarios and their potential outcomes on the stock. 

What is the worst case scenario? If a new product fails or a competitor brings a new and better product forward, how would this affect the company? How does an investing plan manage downside risk? For real estate, how would a jump in interest rates affect the ability to carry a mortgage on a property?

Once you've completed these steps, you should be able to wrap your mind around what the company has done so far, and how it might fit into a broad portfolio or investment strategy. Inevitably you'll have specifics that you will want to research further, but following these guidelines should save you from missing something that could be vital to your decision.

Due Diligence Basics for Startup Investments

When considering investing in a startup, follow the above-mentioned steps (where applicable). But here are some startup-specific moves, reflecting the high level of risk this sort of enterprise carries.

  • Include an exit strategy: More than 50% of startups fail within the first two years. Plan your divestment strategy to recover your funds should the business fail.
  • Consider entering into a partnership: Partners split the capital and risk among themselves. Thus, there is a lower risk, and you lose fewer resources should the business fail in the first few years.
  • Figure out the harvest strategy for your investment: Promising businesses may fail due to a change in technology, government policy or the market. Be on the lookout for new trends, technologies and brands, and harvest when you find that the business may not thrive with the introduction of new factors in the market.
  • Choose a startup with promising products: Since most investments are harvested after five years, it is advisable to invest in products that have an increasing return on investment (ROI) for that period. Furthermore, look at the growth plan of the business, and evaluate whether it is viable.

One fairly recent development in the mergers and acquisitions (M&A) world is the delineation between "hard" and "soft" forms of due diligence. In traditional M&A activity, an acquiring firm deploys risk analysts who perform due diligence by studying costs, benefits, structures, assets and liabilities, etc. This is colloquially known as hard due diligence. Increasingly, however, M&A deals are also subject to the study of a company's culture, management and other human elements, otherwise known as soft due diligence. Hard due diligence, which is driven by mathematics and legalities, is susceptible to rosy interpretations by eager salespeople. Soft due diligence acts as a counterbalance when the numbers are being manipulated – or overemphasized.

It is easy to quantify organizational data, so in planning acquisitions, corporations traditionally focused on the hard numbers. But the fact remains there are many drivers of business success that numbers cannot fully capture, such as employee relationships, corporate culture and leadership. When M&A deals fail, as more than 50% of them do, it is often because the human element is ignored. For example, one set of a productive workforce may do very well under existing leadership, but might suddenly struggle with an unfamiliar management style.  Without soft due diligence, the acquiring company does not know if the target's firms employees will resent the fact they are bearing the brunt of a corporate cultural shift.

Contemporary business analysis calls this element "human capital." The corporate world starting taking notice of its significance in the mid-2000s. In 2007, the Harvard Business Review dedicated part of its April Issue to what it called "human capital due diligence," warning that companies ignore it at their peril.

Performing Hard Due Diligence

In an M&A deal, hard due diligence is often the battlefield of lawyers, accountants and negotiators – an investigation by the acquiring firm to confirm it is "buying what it thinks it's buying," to quote Peter Howson, author of "Due Diligence: The Critical Stage in Mergers and Acquisitions." Typically, hard due diligence focuses on earnings before interest, taxes, depreciation and amortization (EBITDA), the aging of receivables and payables, cash flow and capital expenditures. In sectors such as technology or manufacturing, additional focus is placed on intellectual property and physical capital.

Other examples of hard due diligence activities include:

* Reviewing and auditing financial statements;

* Scrutinizing projections, normally the target's projections, about future performance;

* Consumer market analysis;

* Operating redundancies and ease of eliminating them;

* Potential or ongoing litigation;

* Review of antitrust considerations;

* Evaluating subcontractor and other third-party relationships;

* Constructing and executing a disclosure schedule.

Performing Soft Due Diligence

Conducting soft due diligence is not an exact science. Some acquiring firms treat it very formally, including it as an official stage of the pre-deal phase. Others are less targeted; they might spend more time and effort on the human resources side, and have no defined criteria for success.

Bain & Company, a leader in M&A support, emphasizes key employees during its soft due diligence phase. The concept is simple: These key employees act as cultural support structures and role models during a management transition, so the acquiring firm ought to make them comfortable. If this basic step cannot be completed, it is probably a sign the deal will struggle.

Soft due diligence should focus on how well a target workforce will mesh with the acquiring corporation's culture. If the cultures do not seem like an ideal fit, concessions might have to be made. This includes personnel decisions, particularly with top executives and other influential employees.

There is at least one area where hard and soft due diligence intertwine: compensation/incentives programs. These programs are not only based on real numbers, making them easy to incorporate into post-acquisition planning; they can also be discussed with key employees and used to gauge cultural impact. Soft due diligence is concerned with employee motivations, and compensation packages are specifically constructed to influence those motivations. It is not a panacea or a cure-all band-aid, but soft due diligence can help the acquiring firm predict whether a compensation program can be implemented to improve the success of a deal.

Soft due diligence can also concern itself with the target company's customers. Even if the target employees accept the cultural and operational shifts from takeover, the target customers and clients may well resent a change (actual or perceived) in service, products, procedures or even names. This is why many M&A analyses now include customer reviews, supplier reviews and test market data.

Due Diligence for Financial Advisors

Although they may not be legally obligated to, a financial advisor should be doing due diligence on funds or products they are interested in for clients. Researching social media for telling or negative posts is a good first step. So is looking into any regulatory actions that may have taken place at an investment management firm. Advisors should also make sure to research whether or not an investment firm has been involved in any kind of lawsuits, including those that were settled outside of court. Lawsuits that are settled often won’t appear in a company’s public documents, but they can serve as a warning about how the firm handles its business.

Bankruptcy filings and criminal records can also be found in locations where a particular manager may reside or work, and are another example of documents that should be reviewed. Clearly, they would serve as a red flag when considering whether or not to do business with this firm. Another important step to take is to verify the educational credentials that a manager may lay claim to.

Recommending a Fund

Looking at the performance history and track record of a manager’s funds is also a key part of the due diligence process. An advisor may even want to talk to various people working in other departments of the investment firm to get a sense of what has been happening there. This approach may help in learning about issues that may not be disclosed in the company’s literature.

Another key area to examine fully is the fund’s assets or holdings. It’s important to make sure that the investments in a fund are in line with similar funds or with its key benchmarks, and that the fund is not invested outside of its mandate, as this will affect performance. Relying on due diligence provided by turnkey asset management programs can be useful, but advisers should still make sure to thoroughly review these programs to find out what they cover. In fact, performing some due diligence on all vendors or third-party data providers an advisor uses is a good idea. So is carefully evaluating the brokers that hold and trade client’s assets.

Meet with the Manager

If possible, talking directly with a money manager is especially important, particularly when the manager is investing in alternative products. That’s because there are some investment vehicles, such as hedge funds, that hold certain proprietary information or follow certain strategies that they are not required to disclose in written documents. In addition,advisers should be looking for any disciplinary history an investment firm has imposed on a manager, and they should find out if the firm is willing to talk about it.