Due Diligence: investments and business

In modern investment practice, Due Diligence (DD) is a very popular service.

The need for DD can be explained, first of all, by the fact that growing competition constantly increases the demands of investors, financial institutions and buyers for transparency of information.

Due Diligence as an investment consulting service allows market participants to get a real assessment of a particular business, determine the financial health and development trends of the enterprise, and reveal the risks associated with participation in a specific project.

As a result of the professional actions of specialists, the customer can receive complete and well-structured report that will influence the adoption of effective management decisions.

Brief history and basic principles of Due Diligence

For the first time the term Due Diligence was used in the banking sector and referred to a system of collecting and analyzing information about potential / existing customers and partners in order to protect their property from possible losses, including reputational losses.

The basic principles of Due Diligence were laid down in Switzerland, which can be explained by the traditional practice of keeping large private assets in Swiss banks.

The concept of Due Diligence first appeared in the US Securities Act of 1933, where it introduced a complex procedure for a broker to disclose information to an investor about a company whose shares were traded on the open stock market. In 1970, the Swiss Bankers Association, for the purpose of coordinating the activities of its members, first developed schemes formalizing the Due Diligence procedure, where modern standards were developed in order to avoid strict state regulation and control over the activities of banks.

Although this term can be literally interpreted as a proper or honest examination, none of the above options fully discloses its essence.

Some financial experts interpret DD as a legal audit, which not only does not allow to understand the essence of this process, but also contradicts the very concept of audit.

In general, the interpretation of this term is ambiguous both in regulations and in the scientific literature.

DD can be considered as a comprehensive diagnosis of the company, which allows the financial team to identify ways to optimize the business, prepare investment projects and apply the most appropriate solutions for the development of strategic policy of the enterprise.

Due Diligence is the collection and analysis of information to assess the various risks associated with investing.

On the other hand, it is a process of in-depth analysis of all assets of the enterprise, with verification of their origin and legal "purity", as well as assessment of liabilities and real financial health of the business.

The standard Due Diligence procedure emphasizes four aspects:

• Market analysis.
• Product/service analysis.
• Management analysis.
• Financial analysis.

In practice, the most attention is paid to the assessment of the management team and the organizational structure, which is the foundation of the success of any large investment project.

However, in view of the rapid changes in the market environment, market analysis is becoming increasingly important in DD procedures.

Another positive point is that in the process of conducting this analysis, "increased dangers" are identified, which determine the high level of risk of investments in the target company. The most common dangers include unreliability of data provided in business plans and / or financial reports, inconsistency of founding documents, licenses and patents with the requirements of current legislation, as well as signs of fictitious bankruptcy and others.

Due Diligence allows companies to avoid or reduce existing business risks, in particular:

• Risk of default by the debtor.
• Risk of acquiring an enterprise at an inflated cost.
• Risk of corporate conflicts, including takeovers, lawsuits.
• Risk of dishonest actions of competitors, including collusion and lobbying.
• Risk of not receiving or losing permits that determine the further activities.

In the modern market environment, the list of Due Diligence service customers has expanded significantly. Not only commercial banks, potential investors, but also a wide range of companies are interested in using this service.

This determines the list of applications of this service, including the purchase of a ready-made business, investing significant funds in new projects, creating joint ventures, mergers and acquisitions, demonstrating financial transparency to potential investors, checking the reliability of the counterparty, etc.

Both company representatives (owners, managers) and third parties (buyers, investors, banking institutions) are interested in conducting Due Diligence. In particular, DD provides the opportunities listed in the table below.

Table: Potential benefits of DD for investors and business owners, investors, buyers and lenders.

Benefits for investors:	Benefits for owners:
Identifying the negative aspects of the project.	Evaluation of the work of the company and its structural divisions.
Assessment of risks for the future existence of the business.	In-depth analysis of key aspects of investment deals.
Protection against possible negative financial events.	Optimization of the sales process of a specific project.
Making the right decision about the feasibility of investing.	Determining the optimal cost of the project.
Benefits for buyers:	Benefits for lenders:
Obtaining detailed information about the target company.	Comprehensive analysis of the borrower's business.
Identification of potential benefits from project implementation.	Analysis of the investment project and its potential.
Determination of the optimal contract structure.	Determination of solvency and liquidity of the borrower.
Analysis of key aspects of the investment project.

Due Diligence can be carried out in different directions, since the classification of this tool is based on a wide range of issues related to the activities of a particular enterprise.

Classification of Due Diligence procedures and their application

There are different classifications of Due Diligence procedures in the scientific literature depending on the nature of the business, the time factor, the interaction with other objects, the magnitude of risk, etc.

Experts often distinguish Due Diligence procedures by the nature of the object of study.

For example, it can be an analysis of intellectual property and other intangible assets, analysis of real estate or various entities (hedge funds, holdings, trusts and other corporate structures).

The classification of DD by the object of study is considered the most important in the Western financial literature, especially in the study of business. The implementation of Due Diligence in developed countries is extremely comprehensive, including surveys of employees and partners, analysis of financial and legal documentation, preparation of analytical reports.

Table: The most common classification of Due Diligence procedures.

#	Type	Description
1	Financial DD	Financial DD concentrates on checking the company's financial activities and accounting records. This information serves as the basis for assessing the real value of an enterprise or an investment project.
2	Legal DD	Legal DD analyzes the most significant legal aspects of financial and economic activity, issues related to compliance with antimonopoly legislation, licensing requirements for certain types of activities, and fulfillment of contractual obligations.
3	Tax DD	Tax DD is aimed at checking all tax aspects of planned transactions, analysis of tax returns and key documents characterizing planned tax payments.
4	Commercial DD	Commercial DD refers to the procedures of a comprehensive analysis of market and technical factors of the enterprise.
5	Environmental DD	Environmental DD provides for checking compliance with the procedure for using the subsoil, land, water, air and other resources that are part of the natural environment.
6	Technical DD	Technical DD may consist of a review of engineering documentation. Great attention is paid to the working drafts of the most important technical elements of the project, as well as to the cost documentation.
7	Marketing DD	Marketing DD includes the study of a system of measures aimed at harmonizing production with the current market situation and ensuring sustainable sales. In this context, it is also important to study product, pricing and communication policies, promotion systems, personnel management, etc.
8	Economic DD	Economic DD investigates such aspects of activity as economic processes at the enterprise and the state of assets, the situation in the financial sphere, monetary settlements, etc.
9	Management DD	Management DD includes assessment of management quality, organizational structure and opportunities for its improvement, systems for staff motivation and professional development.
10	Political DD	Political DD refers to a professional analysis of political risks associated with both the company's activities and political risks threatening the implementation of an investment project.

Financial teams should remember that the use of each of the elements of the Due Diligence procedure should be systematic, which as a result will make it possible to draw correct conclusions about the feasibility of certain investments.

Using modern highly effective methods and software tools, specialists will provide a complete and objective report on any asset, project or enterprise before making an investment decision.

Due diligence procedure in investment consulting

At the moment, there are no general theoretical approaches to the methodology of conducting Due Diligence, which would be considered standard for every business.

Some investment consulting firms conduct this analysis, relying on their own understanding of which areas of activity of the enterprise should be researched, which issues should be covered, and which documents should be studied for this.

Other firms, providing due diligence services, rely on the experience of leading European and American experts, applying the most common approaches and adapting them to a specific project, taking into account their own knowledge and competence.

Based on the international experience of conducting DD, the practice of conducting a preliminary legal, engineering and marketing analysis is quite common. It can be based on information obtained by studying documentation, conducting interviews with competent specialists who are related to the investment project and possess knowledge in related fields of activity (officials, experts or employees). Such a rather informal approach can be considered imprecise, but it allows the financial team to quickly assess the presence of certain risks or opportunities.

When conducting Due Diligence, it is useful to follow the two-step rules, which will help save money and time.

The first step is an express check, during which the most important facts and documents critical for making a decision are checked. If the results of this express check are satisfactory, it makes sense to proceed to the second step, that is, a more detailed analysis.

When planning DD, a potential buyer or investor determines how much money he is willing to spend on the services of external experts, which employees he can entrust with responsible work and to what extent he can rely on their opinion. A large company can conduct high-quality DD independently, gathering a team of qualified internal experts for this purpose. But in this case, it should be taken into account that the main task of this procedure is to form an objective and independent opinion about the investment project and report to the management about significant shortcomings.

It is not surprising, but it is the subjectivity of the conclusions that is the main problem when conducting Due Diligence by an internal team.

Figure: A typical algorithm for conducting Due Diligence of large investment projects.

Stage 1: Preparation
Receiving an offer to conduct the DD procedure	Acquaintance with the customer and general assessment of the project	Establishing the purpose and tasks of the DD: the customer of this investment consulting service must clearly formulate and define the most important issues that must be investigated.	Recruitment of a competent team in accordance with the needs of the customer and specific tasks of the DD

Stage 2: Information support

Formation of the necessary package of documentation to ensure effective performance of the task. Experts need to determine the list of necessary documents, since the sources of information can be accounting documents, financial, tax and statistical reporting, legal documents (contracts, licenses), acts of inspections and certificates of state control bodies, etc.

Stage 3: Conducting Due Diligence

Stage 4: Drawing up a report for customers

Stage 5: Presentation of results

The preparatory stage of the Due Diligence should cover such aspects as concluding a contract, forming a team with relevant experience and establishing clear objectives for the analysis. It is obvious that any mistake at the preparatory stage can turn into serious problems in the future. Choosing the right team is a significant contribution to the overall success of the project.

At the second stage, it is necessary to create a package of documentation to ensure the performance of all tasks.



The information to be used by experts must meet the following requirements:

• Information must be received in a timely manner.
• Information should help the customer make a quick decision.
• Information must be reliable and not contain hidden factors.
• Information should be detailed.

Attention should be focused on the third stage of the procedure, namely the choice of the DD direction.

The analysis can be carried out in one of the directions (financial, tax, legal, technical, marketing or environmental), but the fact that the effectiveness of this procedure depends on its comprehensive implementation should be taken into account.

When conducting Due Diligence, the following facts should be taken into account:

• DD results are valid only as of the date the analysis is performed.

• The results cannot be used other than in accordance with the goals and objectives set forth in the contract between the customer and the investment consulting firm.

• The contractor is not responsible for the decisions made by the customer based on the information about the research results.

Preparation and compilation of the report and presentation of the inspection results are the final stages at which the customer sees the result of the DD and can assess the current state and potential of a specific project or company.

The report on the results of Due Diligence is drawn up in various forms (depending on the traditions of the consulting firm, specific tasks of the analysis and agreements with the client) and reflects information about the legal basis for conducting the audit, the questions raised by the customer, the list of documents examined, the methodology of researching the questions raised and conclusions about the research results.

The presentation of the results of the DD procedure allows customers (investor, buyer, bank, company manager) to make a decision or focus on the main problems and risks of business.