Introduction
What do equity research analysts, fund managers, broker-dealers, individual investors, companies considering acquiring other companies, and investment bankers (IBs) all share in common? They perform, at one point or another, due diligence (DD).
To someone hearing the phrase for the first time, a question mark might pop up. So, one can dub DD as a deep and thorough company analysis, to avoid beginners' confusion.
In this article, two key components of DD will be discussed: a) Hard Due Diligence, and b) Soft Due Diligence, and their importance in the whole DD process.
So, let's begin now.
Hard and Soft Due Diligence
As mentioned due diligence in general can be divided into "Hard Due Diligence" and "Soft Due Diligence." Both buy-side and sell-side investors/advisors share this distinction when approaching analysis.
In this article, we will of course focus on sell-side investment banking DD in the context of middle-market companies.
Before delving into both, one can describe both hard and soft DD, roughly as quantitative and qualitative DD, respectively.
Hard Due Diligence
Hard DD effectively can be divided into three components: a) Financial Analysis, b) Legal Review, and c) Operational Review.
Let's explore each in turn.
a) Financial Analysis
Of course includes multiple analyses of different documents, ranging from financial statements, audit reports, tax returns, and any other relevant documentation.
Investment bankers will go through the, say, financial statements, utilizing financial ratios, exploring valuation multiples and similar tools to see "what kind of story the client company tells."
Then, IBs use this quantifiable information to first verify it, analyze it thoroughly, and present a compelling argument to the buyer as to why the selling company is an attractive synergy/ and opportunity.
b) Legal Review
Normally done by corporate lawyers and includes scrutinizing all legal documents related to the company, such as contracts, leases, litigation records, and compliance with relevant regulations. The goal here is to make sure there are no legal encumbrances, if you will, or issues that could jeopardize the sale.
c) Operational Review
Operational review, effectively, focuses on, well, operations. These operations can be divided into several subparts, so let's see what they are.
Supply Chain Management
An indispensable part of a company's day-to-day, month-to-month, and year-to-year (Y-O-Y) operations. The aforementioned encompasses three parts: 1) Evaluation of Suppliers and Partners, 2) Logistics and Distribution Analysis, and 3) Risk Management View.
In regards to the 3) Risk Management View, identifying any potential risks regarding the supply chain, such as single-source suppliers and/or geopolitical factors, is crucial.
Production Processes
1) Process efficiency and effectiveness, 2) Quality control, and 3) Capacity analysis, are the name of the game here. One can not ignore those while performing production process analysis.
IT Systems
1) Infrastructure review, 2) Systems integration, and 3) Data management and security.
Operational Scalability
Operational scalability involves 1) Growth readiness - or can the company scale up without incurring crippling costs, and 2) Flexibility and adaptability - or how the company updates its operations in responding to market changes and the SWOT matrix, effectively.
Cost Efficiency
Structuring, prioritizing, and seeking out where costs can be reduced, all encompass the cost-efficiency aspect of the company.
Regulatory Compliance
Needless to say, all aspects or operational aspects must comply with local, national, and international regulations, including environmental, health, safety, and industry-specific rules/ regulations.
So, this is hard DD. However, this approach doesn't tell the whole story. Another part of the coin is soft DD, and let's see what it has to offer.
Soft Due Diligence
Dubbed soft DD, one could say that from a certain aspect, it is a more challenging form of analysis since it involves intangible elements that are not always quantifiable, or a least they're difficult to spot.
This approach usually has three analysis components: a) Management and Culture Analyses, b) Market Position and Brand Reputation, and 3) Strategic Fit.
a) Management and Culture Analyses
What do Jack Welch, Simon Sinek, and Ray Dalio all have in common? As diverse as their respective backgrounds are, they preach about distinct corporate or company cultures and how they affect the whole business, from the top down to the bottom up. From management and board of directors to other employees and contributors.
Hence, analyzing the company's culture and management practices is indispensable in deciding how well this company performs.
b) Market Position and Brand Reputation
How does the company stand in the competition for market share? Does it have a potential strong brand? What are its unique comparative advantages, and who is its loyal customer base? These are all questions investment bankers have to answer when collaborating with their clients during the soft DD phase.
c) Strategic Fit
How much does it make sense to buy a company when synergies are perhaps imperfect? If the company presents a great value-add, how can it be incorporated into great industry trends? Finally, growth capital is the key to unlocking a company's potential? Likewise, very important questions in the investment banker's portfolio of research trends.
Concluding Thoughts
Being two sides of the same coin, Hard and Soft Due Diligence is an unavoidable, challenging, and very engaging part of the performing sell-side advisors of the investment banking world.
The more companies are analyzed, and the greater the track record of DD in given industries, the better the IB becomes at creating lasting value for its clients.
Essentially, building long-term sustainable value is what matters most to firms, and by extension to economies, communities, and other stakeholders.
Due diligence is just a part, but an important part, of that challenging endeavor.