High-profile corporate frauds such as FTX Trading Ltd., stricter insurance requirements, rising investor caution and higher interest rates have all pushed the scrutiny applied to proposed mergers and acquisitions to levels industry experts have never seen before.Dado Ruvic/Reuters
Due diligence has become much more than just double-checking contracts and balance sheets.
High-profile corporate frauds such as Theranos Inc. and FTX Trading Ltd., stricter insurance requirements, rising investor caution and higher interest rates have all pushed the scrutiny applied to proposed mergers and acquisitions to levels industry experts have never seen before. An entire industry of third-party specialized investigators, analysts and consultants has risen in response to the unprecedented demand.
Driving records are being pulled, former colleagues and employees are interviewed and algorithms scrape social media for anything anyone has ever said about a company or its leaders that prospective buyers might consider a liability.
As a result, deals that might have sailed through the diligence process as recently as 2021 are being scuttled in the face of such fine-tooth comb inquiries. Deals that are getting done are taking months to make it through a diligence process that previously took weeks.
More than perhaps any single factor driving spiking levels of M&A scrutiny – aside from similarly spiking interest rates – is what Mario Nigro calls the hangover from the deal-making frenzy of 2021 and 2022.
“After buying companies with numbers that weren’t as real as they looked, people are now starting to get much more intense on their diligence,” Mr. Nigro, a partner in the M&A practice of Stikeman Elliott LLP, said in an interview. “People have started to realize that a lot of the companies that were bought in 2021 or early 2022, weren’t what they thought they were, they didn’t do enough diligence. They went too fast.”
During the frenzy, just prior to the historically rapid rise of interest rates, due diligence processes were limited to 60 days, or even just 30, because sellers could easily line up multiple potential buyers.
“Even if you were off a bit on diligence and price, structuring a deal and pricing it was so much easier when interest rates were low,” said John Cho, global institutional investors group lead and head of Canadian deal advisory at KPMG. “It is easier to spend somebody else’s money. You knew that if you bought a company then, polished it up a bit, that there would be another buyer waiting for you perhaps a year or two down the road. But now, the world has changed.”
Among the most significant changes is the expansion of background checks. Previously limited to one or two senior leaders of a target company, prospective buyers now routinely probe the professional histories of entire management teams.
During one diligence process in 2022, for example, Mike Karran was running a routine court record check on a C-suite executive of a target company – “not the main guy,” he recalled, meaning not the chief executive officer or chief financial officer – when he made a deal-killing discovery.
“We found two separate lawsuits from former employees at two former jobs accusing this individual of sexual misconduct,” said Mr. Karran, a corporate investigator who works as managing director of the Mintz Group, splitting his time between the New York and Toronto offices of the global business intelligence company. “Two is a pattern, sexual misconduct at two different jobs, and in both instances there was a settlement outside of court. I cannot imagine that deal ended up going through.”
In another case, an executive at a target company failed to disclose that he had changed his name, but Mr. Karran and his team discovered his former identity on an old driving record and decided to run searches on both names.
“Lo and behold, we found a bunch of criminal lawsuits under the undisclosed name,” Mr. Karran said. “Our client ultimately did not move forward with the transaction as a result of that.”
Even secrets left undiscovered for decades are being unearthed through modern diligence. One of Mr. Karran’s routine tasks is credential verification, which is usually a mundane box-checking exercise, except for one time when he came across one credential that simply refused to be verified: the degree an executive with dozens of years of professional experience claimed to have.
“All of his biographical material on the internet and in filings listed this degree, which he made up, and made up entirely,” Mr. Karran said. “It is not as though he went to the school and just did a few classes but didn’t graduate. To my knowledge, he never stepped foot inside that school nor did he attend a single class.”
Shocking as those discoveries were, they were also found fairly quickly through straightforward searches of public databases. Adding them to a more basic diligence process typically extends that process by days, not weeks.
Personal, face-to-face asset reviews – which have grown common in transactions that involve natural resource extraction – add yet another time-consuming element to that enriched process.
Jeffrey Merk, co-leader of the capital markets practice of Aird & Berlis LLP, said the firm recently worked on a non-Canadian mining transaction in which a specialized consultant was hired to engage directly with local communities in and around a mine’s operations.
Marc Pontone, a partner in the M&A practice of Davies Ward Phillips & Vineberg LLP who often works on mining deals, said miners “would never even think of buying an asset just from a purely legal or detached due diligence.”
“Buyers want to be on the ground, talking to communities,” he said. “Getting that comfort is critical to getting a deal done. It just wouldn’t happen otherwise in this day and age.”
Then there is the rapidly expanding field known as cultural diligence. Diana Holec, an associate partner in the transaction strategy division of global professional services company Aon PLC who specializes in human resources due diligence, said buyers increasingly want to know whether their acquisition targets have a personnel culture and corporate values that align with their own.
Buyers also have a heightened sensitivity these days to potential HR and cultural issues that might exist inside a company they are looking to acquire, Ms. Holec said, as they seek to avoid brand and reputation-related risks. Making those assessments, however, can be a time-consuming, highly nuanced exercise.
“It is a little bit more of an art than a science,” Ms. Holec said.
Among the more straightforward methods her team employs involves comparing the language used in job postings from the prospective buyer and seller.
“Some organizations might say, ‘We are fast-paced and entrepreneurial in nature,’ and the buyer might say they are a ‘long-standing, traditional business,’ so we might go back and say there could be a gap there,” Ms. Holec said.
Other methods can be more abstract. One involves asking a target company’s management team questions that are ostensibly about gathering documents for standard HR diligence – whether a company sees itself as very hierarchical, for example – in which the answers serve a dual purpose by offering insight into the target company’s culture.
Aon has also developed a tool that attempts to more directly quantify employee sentiment.
“It is actually an algorithm that goes out and scrapes social-media sites like Glassdoor or Indeed and gathers information on what former and current employees are saying about an organization and the output gives you a ranking on nine different factors,” Ms. Holec said.
“It looks very scientific, but we have to remember it is social-media data so needs to be taken with a grain of salt, but it can give you a bit of a sense to say everybody talks about that company not having trusted leadership or not being competitive in terms of their pay and benefits.”
Beyond buyers seeking advanced warning of potential reputational risks, Ms. Holec said demands from representation and warranty insurance providers are another reason why cultural diligence is becoming increasingly common.
Requirements for R&W insurance, which can help reimburse a buyer for the costs of a failed transaction, have become much more rigorous in recent years, Ms. Holec said.
“A lot of the time the diligence that may have been done by accounting or legal isn’t sufficient for the sort of questions that these reps and warranties insurers are asking for,” she said. “This type of insurance has become almost standard and we are getting pulled in more and more because it is being demanded by the insurance market and the level of detail that they need to see.”
For buyers looking to acquire companies that rely on global supply chains, Davies’ Mr. Pontone said the increasing scope of anti-corruption legislation – such as Canada’s new forced-labour reporting requirements – is also leading to more thorough and lengthy diligence.
“Sometimes it is not even a direct supplier or a direct customer where the potential liability exists, it can potentially be just a tangential relationship further down its supply chain that a target company has,” he said. “The level of probing you have to do and the amount of detail that you have to understand has become a lot more significant.”
The extreme caution applied in new diligence processes is even starting to spread to the other side of deals: how sellers get paid. Previously – and especially during the 2021-era M&A frenzy – sellers often received full payment in either cash or shares once a deal closed. Today, however, diligence experts are inserting delays that force sellers to have a stake in ensuring a deal works out as the buyer expects.
Sherri Altshuler, who co-leads the capital markets practice of Aird & Berlis LLP alongside Mr. Merk, said she has seen a lot more transactions include conditions such as earn-outs and contingent rights, which can require sellers to hit certain milestones for months or even years after a deal closes.
“Buyers want strategic acquisitions that are immediately accretive to their businesses,” Ms. Altshuler said in an interview. “They really want to know how it is going to hit their financial statements right away.”
Providing that degree of reassurance usually translates to even more time spent on diligence. Davies’ Mr. Pontone said developing more specific financial projections requires asking target companies to disclose more details, which adds to the trove of data that diligence experts must then review.
“If a buyer said before they want to see every contract where you spend or receive money in excess of $2-million, maybe now it is $500,000,” he said.
Sellers are even starting to do their own self-diligence before launching a sale, according to Stikeman’s Mr. Nigro, in hopes of expediting the diligence process once a buyer is found. The trend, he said, is similar to home sellers having a home inspection done in advance of listing their home for sale – if real estate is in a buyer’s market.
“There is a growing cadre of these so-called value creation experts,” Mr. Nigro said. “Their idea is to position a company before it even goes to a sale.”
KPMG has recently experienced a surge in demand for that service.
Neil Blair, president of KPMG corporate finance, said diligence is no longer about confirming whether a company that claims to be making $5-million in annual revenue actually does make $5-million in annual revenue. The new due diligence is more about building an entire long-term strategic plan for a seller, which can then be used to augment the sales pitch to potential buyers.
“Now it is about finding the value drivers and the risks and some of the areas where there might be value erosion,” Mr. Blair said. “It isn’t just that diligence is taking longer and it is the same diligence, it is an enriched diligence process.”