Separating Due Diligence
Ryan Frederick | November 15th, 2021
Due diligence as a part of any mid-market investment, merger, or acquisition transaction is a critical piece to assessing whether a transaction should occur. When an investor or acquirer is conducting due diligence on a potential transaction, it is best to have the different due diligence efforts done by separate teams. Here’s why:
- No one can be well versed enough in finance, legal, operations, technology, and more to perform proper due diligence across all of these areas. Yet, many investors or acquirers will still have the same team conduct due diligence across all the different disciplines. Or worse, they won’t even perform due diligence in all of the areas. Why? It’s easier, it's less expensive, it’s faster, and because of positivity bias. It’s easier to have the same team do all of the due diligence activities, because there is less to manage and coordinate. It’s less expensive because fewer people means fewer hours, and therefore less cost. It’s faster because the due diligence team won’t go as deep into areas where they lack expertise, thereby shortening the timeline. Single due diligence teams can be driven by the positivity bias of an investor or acquirer because that person wants the transaction to happen. In these cases, due diligence isn’t being done to know more, but rather to check boxes in a deal packet.
Sure, there are time, cost, and efficiency pressures as part of investments, mergers, and acquisitions, but if valuable and informative due diligence is going to happen it needs to be done by separate teams, and it should be allowed to be performed with reasonable parameters. Skipping some elements of due diligence is a recipe for disaster down the road, and doing so because only one team is performing the due diligence with a lack of expertise in some areas is negligence.
- The work of a single due diligence team, including their findings and scoring, can be influenced by other due diligence efforts. A team doing both financial and legal due diligence may score the company lower on one if there are topics of concern in the other, even if they have nothing to do with each other. When due diligence is done by separate teams, the teams have the ability to not share any information that they have uncovered outside of deal breakers that everyone has agreed would be non-negotiable before the work commenced. Knowing what other due diligence efforts have discovered can influence the veracity of the work being done by another team. This means that the work by all teams should remain independent so as to not bias another team’s work.
- The findings and scoring from the teams should remain unknown to other teams until everyone is brought together to review it. If anyone other than the due diligence teams will be reviewing the findings and scorings, they also shouldn’t have access to it until all of the due diligence work can be reviewed. Knowing the outcome of one due diligence effort beforehand can influence how other outcomes and scores are viewed. In simple terms, a financial due diligence with a score of 9 out of 10, followed by an operational due diligence score of 9 out of 10, followed by a technical due diligence of 7 out of 10 may predispose people to devalue the impacts of the technical due diligence score just because it followed higher scores. The lower technical due diligence may still have serious implications that you don’t want to be watered down.
The same can be the case when due diligence scores are revealed in a sequence from lowest to highest. This can create negative bias. Revealing due diligence scores in a random sequence helps to mitigate positive or negative bias to a degree, but bias will still exist. The best way to remove positive or negative bias is to reveal scores from all due diligence efforts at the same time without context for what determined the scores. The context will come later, but this protects bias from creeping in that could discount significant areas of concern. The reviewing group should then agree to the order of context review and discussion based on the priorities attached to a go or no-go decision around the transaction.
Due diligence plays such a crucial part of any transaction, and due diligence can’t be performed or judged adequately by a single team across all key areas. Proper due diligence has to be performed, scored, and judged by experts in each area separately in order to get the most value out of the efforts.