Merger time gets longer as firms step up scrutiny

Merger time gets longer as firms step up scrutiny

Mumbai: Due diligence, or inspection of all business aspects, conducted ahead of any merger and acquisition deals in India is taking longer and getting complex in the wake of serious irregularities related to governance issues unearthed in various sectors.

Till recently, most deals required only financial or tax diligence but today, a typical diligence includes promoter diligence, legal diligence, industry diligence, vendor diligence and even forensic diligence that touches upon softer issues such as the reputation of the promoter, political linkages, market outlook towards the group and background check of management personnel.

Firms are insisting on an intensive due diligence to avoid deals falling apart at the last minute or discovering corporate governance issues after the investment, say diligence experts.

“We’re seeing an increasing pipeline of deals relative to a year ago. Given that two-thirds of mergers and acquisitions in the past 2-3 years have destroyed value, Indian acquirers are exercising a much higher level of scrutiny up front on the value creation potential of a deal. This level of diligence allows acquirers to work with management teams, which has an added benefit of reducing the risk of deals falling apart for the wrong reasons," said Vivek Pandit, director, McKinsey and Co.

“There is no slowdown in our business," said Vikram Utamsingh, executive director and national head of markets at KPMG India Pvt. Ltd. “Firms no longer tell us that you need to finish the diligence in 10 days."

As a result of this, deals are taking longer to conclude. “While valuations disconnect is one of the issues, investors and promoters are now spending more time to see whether there could be unforeseen challenges that the business can face in future," said a domestic investment banker on condition of anonymity.

Pandit of McKinsey said, “not only do we spend around a month on diligence post-term sheet, but our involvement has expanded to pre-diligence on industry-level growth opportunities, and to target 100-day planning and strategy post-acquisition."

This is true for private equity (PE) firms as well that are now going in for intensive diligence to ensure a good return on exit.

“Today PE firms are seeking far more value from the diligence report than ever before" said Monish Shah, director-financial services at Deloitte Touche Tohmatsu India Pvt. Ltd.

The volume of India-centric M&As for the September quarter was $4.7 billion, the lowest in six years since the second quarter of 2005 ($4.1 billion), according to data released by Dealogic, which tracks such transactions.

“Diligence today not only helps in highlighting key risks or validating the investment thesis but also focuses on identifying optimization opportunities.... This helps funds gain a competitive edge," Mayank Rastogi, partner, transaction advisory and private equity, at Ernst and Young Pvt Ltd.

Recently, Dr. Reddy’s Laboratories Ltd called off its proposed acquisition of the pharmaceutical prescription portfolio of JB Chemicals & Pharmaceuticals Ltd in Russia and other CIS countries.

Pranav Mody, promoter-director of JB Chemicals said after the deal was signed both the parties found that some of the things were not working out as planned and these problems were not looked into beforehand.

According to the investment banker cited above, the diligence should have flagged off the operational difficulties that the firms will face going forward. He was not part of the deal process.

Firms are ready to spend more money on extensive diligence and don’t mind walking away from the deal if the findings are not positive. “We spent 80-90 lakh on a due diligence and walked away from the deal, but it was worth it," said a fund manager at a domestic PE firm that invests in mid-sized companies. He did not want his or the company’s identity to be disclosed.

The firm had asked E&Y to do a due diligence of a pharmaceutical firm it wanted to invest in. “After doing a vendor diligence, we realized that the company had the highest return of damaged or unsold stock. Also it purchased raw material at a premium to the market and the promoter would cash out the excess money," the fund manager said.

The firm also did an employee diligence and realized that the attrition rate was very high at the mid-level because of a poor incentive scheme.

With the increase in the scope and depth of diligence, KPMG, E&Y, Deloitte and McKinsey have increased their employee strength.

KPMG, which does about 300 diligence a year, has close to 210 people in the team. “There has been a 30% growth year-on-year in the team size," said Utamsingh of KPMG.

“You need highly trained and experienced people to do diligence," said Rastogi.

PE deals contribute to a significant part of E&Y’s due diligence work. It has a team of 175 for this.

The fees earned by firms from due diligence is rising even as investment banking revenue is sliding. “With the scope of diligence increasing, the fees have gone up significantly," Shah of Deloitte said. He declined to quantify the increase.

Deals India, published jointly by Mint, Dow Jones Newswires and The Wall Street Journal, is a one-stop destination for investment professionals following deal flow, deals news, private equity and venture-capital activity in India.