On this episode of Deal-By-Deal, host Greg Hawver is joined by Cathleen Hughes, Kroll’s Director of Corporate Finance and Restructuring, for a deep dive into due diligence, including M&A transactions and post-closing.

Risks associated with M&A deals have evolved. “And these risks include those that can be discovered pre-transaction as well as risks that may not exist at the outset, but can require some continual monitoring post-close in order to mitigate the emergence of such risks.”

Greg and Cathleen discuss how the due diligence process guides the successful completion of a deal. It can be divided into various phases including initial structuring diligence and confirmatory diligence. They also emphasize the importance of addressing the post-closing aspects of due diligence, which can be overlooked as investors move on to new deals. 

Cathleen also provides insights on due diligence categories that are often overlooked but very impactful. These include background checks, corporate culture, cyber risk, and digital chatter. 

Meet Your Guest

Name: Cathleen Hughes

Title: Director, Corporate Finance and Restructuring at Kroll

Speciality: Cathleen is a director in Kroll’s Corporate Finance group, based in Chicago. She brings more than 20 years of experience to her work in M&A with a focus on financial sponsor coverage.

Connect: LinkedIn

Acquired Knowledge

Top takeaways from this episode 

• Make the most of financial and accounting due diligence in M&A deals. Conduct a quality of earnings assessment prior to the transaction with a thorough corporate structure analysis.
• There are new due diligence options to consider. Consider background checks and investigations in diligence, especially for deals involving new markets or new-to-you categories.
• Consider digital chatter an early warning indicator. Monitoring online discussions and activities across various web platforms can provide insights into emerging risks before they materialize.

Contact

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This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.

You're listening to Deal-by-Deal, a McGuireWoods independent sponsor podcast. Deal-by-Deal invites you to conversations with experienced independent sponsors and other private equity professionals. Join McGuireWoods Partners, Greg Hawver and Jeff Brooker as they explore middle market private equity M&A to provide you with timely insights and relevant takeaways.

Hi, and welcome to Deal-by-Deal, a McGuireWoods podcast for independent sponsors and other private equity professionals. I'm your host, Greg Hawver. I'm a M&A attorney in the PE group here at McGuireWoods. Today we're going to be taking a deep dive into various aspects of due diligence, both relating to M&A transactions, and then post-closing. So this could be categorized as one of our kind of M&A toolkit episodes. So we hope you find this really helpful. I'm happy to be joined today by Cathleen Hughes of Kroll, and I want to in a second kick it over to her to give an intro.

Cathleen, welcome. Can you tell us a little bit about yourself and about Kroll?

Sure. Cathleen Hughes. I am a director in the corporate finance group at Kroll. I'm in the M&A group with particular focus on financial sponsor coverage. So we work with a variety of sponsors primarily doing M&A buy and sell side work, transaction advisory services, and a whole array of other services that we'll get into as we go on.

Great. Great. Good deal. Good deal. Yeah, so we've done podcasts about equity term sheets and LOIs and other kind of strategic considerations around M&A. And I think that due diligence and as a buyer, your approach to due diligence is an equally strategic decision both before entering into the deal and after. So before we go into the menu of what are the latest and greatest due diligence options, which Cathleen will walk us through, just to set the stage, there's all sorts of different transactions from an M&A perspective, and there's different probably levels of due diligence that you might want to do with respect to those. On one end of the spectrum, you've got small asset acquisitions where maybe it's an add-on strategy. You want to take a light touch on due diligence and you want to structure the acquisition agreement so that the buyer only takes on specific liabilities and leaves everything else with the seller.

And that can give you a little leeway as far as the level of diligence you're going to do. On the other end of the spectrum, you've got large competitive processes where a seller is going to say, I'm going to sell you the equity of this business, of this large complex business, and you as a buyer are going to step into the shoes of all the pre-closing liabilities because you're the new owner. And you can either, buyer go get a rep and warranty insurance policy, or you can on the furthest end of the spectrum, you buyer can sort of self-insure and trust your diligence and turn over every stone. And maybe you don't have to go get rep and warranty insurance, but the seller's not going to stand behind any liabilities with respect to that business. And so between those two ends of the spectrum, there's all sorts of strategic decisions.

So that's one component of it. And then just to set the stage for Cathleen a bit more as an M&A person, I kind of think about due diligence as just what's going to get me from here to closing, and there's kind of several tranches of that. I can initial structuring diligence and then confirmatory diligence, et cetera. But I'm glad Cathleen's on to talk to us about post-closing components of due diligence where I kind of sometimes move on to the next deal, but the business owners need to think about due diligence as well. And so with that kind of table setting, Cathleen, do you want to kind of walk us through the menu that you and your team at Kroll think about and talk with about sponsors?

Yeah, and let's back up too, and let me give you kind of an overview of Kroll, the firm, and it can kind of help you understand the offerings and the products that we work with clients today on. So Kroll's, formerly Duff & Phelps. We are a leading global provider of risk and financial advisory solutions. We work with a wide array of clients with the overarching goal to help them build, protect and maximize value. So practically speaking, we're an investment bank that sits inside of a larger financial advisory firm. Kroll has evolved to where it is today, having begun in the 1930s as Duff & Phelps, which was an investment research firm later expanding into corporate finance. While some non-core segments over the years such as investment management and credit ratings were spun off, the firms made many acquisitions over time, really expanding the scope of the financials advisory services that are offered today.

This includes the acquisition of Kroll, which was in 2018, adding Kroll's expertise in complex investigations, security and cyber solutions. And so the four main segments of the firm are corporate finance, which has our M&A practice buy and sell side advisory, fairness and solvency opinions, are TASs, which we'll really do a deep dive into today, transaction advisory services, pre and post close diligence, ESOP and ERISA advisory, distressed M&A in special situations. And our private capital markets and debt advisory practice is also under the corporate finance umbrella. Our valuation practice provides valuation and consulting for financial reporting, tax, investment and risk management purposes. We have our governance risk and investigations and disputes practice. And last our business service practice, which manages complex legal and business solutions. This includes our prime clerk restructuring, class action administration, mass tort administration, as well as kind of issuer agency and trustee services. So,

Great.

We kind of think of where the world is today. We've been operating in this highly volatile and uncertain business landscape for some time, which really requires financial sponsors, I think, to be just as focused on preserving existing value as they have been focused on maximizing value. And with kind of the evolution of the world, risks associated with M&A deals have evolved as well. And these risks include those that can be discovered pre-transaction as well as risks that may not exist at the outset, but can require some continual monitoring post-close in order to mitigate the emergence of such risks. And with sort of the evolution of risks, I think the evolution of technology has really helped facilitate some additional risks that didn't used to come into play. And these can come into play at any stage during a deal life cycle. So I think protecting against such risks require really an even more robust and sophisticated digital solution.

And what are some of those new risks that have come up over the last couple of years kind of arising from technology and innovations?

Well, cyber's a big one. Cyber risks can sometimes crop up as an unintended consequence to a system migration, a cloud migration, various other things, not just necessarily a hacker trying to get in the system, but I think cyber is one of the biggest risks that has really cropped up that didn't used to exist, but also in the same time, there's a lot of supplier risks that have come into play that didn't use to exist before. I think with the focus on ESG, whether you're an independent sponsor or a private equity firm, the focus on ESG has really created some necessities to kind of have things buttoned up a bit more than they used to. And we can kind of get into some of those things further as we go through the different menu of sort of diligence items.

Sure.

But I can start on sort of our financial and accounting due diligence. Most of these things are pretty commonly used and well-known to most people in the M&A space, but there are some expansions and sort of deeper dives in certain aspects that you can think about. From a pre-transaction standpoint, your quality of earnings, which we always encourage to do on a sell side, know what you're getting into sort of at the outset on the quality of earnings because you know the buy side's going to do one, but then also you can get a little bit further and do the corporate structure analysis and sort of make optimization recommendations pre-transaction. It's really important as well to look at the financial reporting and systems to review those, evaluate if they're robust enough to provide the data that will be needed for the transaction and as well as make sort of recommendations of where a buyer might identify that they're falling short, where improvements might need to be made.

And it can also come into play with sort of purchase price elements in that if it's not a very robust system and significant investment is going to be needed to make those systems more robust, it can certainly come into play a little bit from a valuation perspective. Then projections outside of just sort of the preparation of projections. And this comes into play sometimes more so if the sell side is a privately owned company, maybe they've never had institutional capital before.

Some companies have never even had to require or have never been required to provide projections, whether it's because they don't have debt and don't have a bank that requires them. But even if they have been required by a lender to prepare them, there's not a lot of analysis and stress tests sometimes behind them. And so through the M&A process, there's going to be a lot more scrutiny on really sort of what market assessments were behind the projections, what are the assumptions and drivers, the historical trends in the year to date performance, deep dive into the quality of the backlog, CapEx requirements that may or may not be factored in as well as assessing sort of the value of tax attributes or buyer tax basis step up.

And Cathleen, over the past 18 months, have you seen a kind of difference in practice, and this is kind of if you're thinking about it from the sell side, but difference in practice around how those projections are prepared, and how aggressive or conservative those are?

Absolutely. In the last 18 months, there has been significant scrutiny on projections and the assumptions behind them. And so for certain sellers that have just had sort of high level projections prepared, there may not have been that much thought that have gone into them, but you better be sure that the buyers are going to take a really deep dive at what's behind those projections and if they think they're feasible or not.

Got it. Got it.

And then also there's a working capital analysis and trends that should be looked at as well as sort of a net debt analysis, and then there's the transaction structuring and accounting that I think it really helps to use an advisor to help with that part of it. So that's sort of the finance and accounting piece on a pre-transaction basis. Throughout deal negotiation, where you want to think of that is through the documentation phase and the tax due diligence phase, as well as sort of purchase price adjustment mechanisms, looking at your reps and warranties, but also transition planning and interim service agreements. And those are things to think about as you go through sort of the deal negotiation phase.

And then on the financial and accounting side, post-transaction, you're looking at closing working capital, purchase price allocation, opening balance sheet. One area that isn't always thought of immediately after the fact but is important is sort of your board of directors and management advisory plan. There's also the IT kind of due diligence component, which can factor in implementations of recommendations that were made on a pre-transaction basis. And any sort of bolt-on diligence analysis should be factored in post-transaction as well as you go through the deal lifecycle.

Flipping back quickly to Q of E and working capital analysis and things of that nature. One thing that I'm seeing a lot recently is deals are getting stuck in the Q of E phase. A buyer comes in and agrees to a purchase price, and then the lawyers kind of usually put our pencils down for a little bit until the business diligence checks out to save on the legal bill. But I'm seeing a lot more haggling, frankly, around purchase price around the Q of E not checking out. What do you think that's a function of? Is it just buyers being more conservative and worried about their downside in this market? Can firms like Kroll, how does a sophisticated firm like yours kind of help in that haggling, for lack of a better word?

Yeah, I think it's a couple of factors that are coming into play on that. I think one of it is a function of the post Covid world. Right. So you had your Covid period and then sort of you had in certain industries the surges of business as we sort of came out of the pandemic. So getting to a normalized revenue is definitely a little bit trickier in today's world. So I think there's a lot of a deeper dive in sort of substantiating what a run rate number is, and that kind of also comes back into play with projection stress testing, what is the normalized, what is normal now is a little bit harder to determine.

So I think that's one reason why there's additional scrutiny and time allocated to the quality of earnings part, but also I think the continued uncertainty means that buyers can't get it wrong, right? They've got to get it right. They've got to get to what the number is, especially in this higher interest rate environment. If they're going to over equitize a deal more so than they normally would, you really need to understand and get to the right cashflow number.

Yeah. Yeah, and I think one other thing that I see is that if you're a buyer, time is your friend, and an easy way to buy some time is to get stuck in the Q of E and keep double checking and triple checking the numbers.

Right And I think a little bit more recently, the timing of the Q of Es that's come into play is for most firms, it was a really slow, the debt markets kind of closed up fourth quarter of last year, and then not much was happening with deals in the first quarter. Everyone was sort of waiting to close their books and seeing what the first few months would be like. So I think the M&A activity has seemed to pick up in this second part of the year. And so with that, I think that some providers are getting a little bit jammed up, and so turnaround times are increasing a little bit from that perspective as well.

Kind of good to hear. I mean, not good to hear people are getting a little jammed up, but good to hear that people are busy in the PE ecosystem.

Yep.

Well, great. That was a really good overview, I think of the fundamentals and a lot of the business diligence and maybe take us through, because as we were chatting, there's a lot of kind of new options from a due diligence perspective that maybe from my view, they're new and maybe not in the typical handful of things I would think about doing. So I think that'd be really helpful.

Sure. And then I can kind of circle back to, I didn't hit on the tax part yet, but there's a couple things on, I would say, well, a couple of different areas. If you look at background checks and investigations, there's some diligence things that I think people need to think about depending on the type of deal that they may not have really thought about before. And not only to think about it and see if it might be applicable, but to understand what you may not know going into a deal, and is it worth skipping over that diligence piece or not? So I think some of those things are with whether you're entering into new market or it's a new investment in a different area, you do want to do kind of background checks on whether it's your board of directors or your management. But beyond that, there's also corporate culture diligence is something that I think is really interesting. I think culture, yeah, especially in the middle market, I think corporate culture can really have a significant impact, positive or negative on the enterprise value of a firm.

And corporate culture will not necessarily come into play throughout many parts of discovery in the M&A process. Right. It's not going to come through in quality of earnings. You're not going to see it in the top customer and top supplier lists. It's not going to be reflected in your working capital analysis. But where it can come into play is doing some, it can highlight maybe some really bad actors that are at the helm of running a company and could significantly affect where the company's going to go in the future. So these corporate culture diligence items can be very eye-opening in some circumstances. They can highlight a culture that can maybe create some liability, whether it's inappropriate behavior that's just become rampant in a firm or can highlight maybe some high employee turnover and help get to the root of why that is and is there a person or a few factors kind of behind that's driving that. So I think that's something that's become a little bit more common and is really interesting and important to look at.

Yeah. Yeah. I mean, it's something that you may not pick up on with a steak dinner with the founder and the typical diligence, but going a little bit deeper. That's really interesting.

Yeah. And I don't want to gloss over either the sort of background checks. That's extremely important, especially when you're keeping management. If management's going to stay on through a transaction, that should not be something that is overlooked in a transaction.

Sure. No, totally. And from what I understand of Kroll, that's a big part of the heritage of Kroll, right? Is,

Yes.

Doing investigations and things of that nature.

Yes. Yep. Correct. Then I can kind of hit on some other areas. Obviously kind of newer is the cyber component. So within sort of the cyber diligence, it's really kind of a cyber slash IT risk advisory diligence and pre-deal. On the buy side, you're really kind of doing a systems and security review, and that really allows you to understand post-close maybe what services and monitoring need to be implemented. But it's really important to get your arms around what the current cyber program is in place, if any, and what's recommended to safeguard that going forward.

There's a lot of different things too in terms of cyber, where you can evaluate. You can evaluate just high level systems and what they currently have in place. You can do penetration testing and see how robust systems are. The fact is most cases, if hackers are going to try to get in, they will, but it's what hurdles will they have to go through first. So you really want to have an understanding of what's in place or what needs to be in place for that. And then there's also evaluating should this kind of be a managed outsource process, and what would that look like?

And this may be too deep in the weeds, but I mean, how does the cyber diligence interact with cyber insurance coverage, which I'm not very conversant in. I would assume a big piece of it is also getting some insurance coverage around that.

Yeah. And that's not an area I'm super well versed in. It's my hunch that on the cyber insurance, there wasn't as much diligence done on what the current systems in place were or are. But if it hasn't been a huge consideration in the past, I would think it has to be going forward. It seems very basic from a risk perspective.

And then moving on from there, ESG diligence, and I think this depends on what kind of sponsor it is, right? If it's an independent sponsor that is looking to eventually start a fund, it's really good to show pre fundraising, that they have these things in place. I actually read in the Wall, I think it was in the, oh, it might have been, I can't remember where I read it yesterday though, that actually that some LPs are tying carried interest to ESG metrics being hit, which I thought was interesting. It was always sort of a nice to have and really encouraged, but not necessarily a financial metric tied to it. But with the ESG part, I think sometimes it's more on a post-transaction basis, but from a diligence perspective, it's looking at reviewing policies. Is there a policy in place?

If not, what post-transaction might go to the top of the list of things that you want to look at implementing? And there's great strategic advisors that can help craft a policy, but then it also takes a step further. And that policy also can kind of sketch out investment strategy and improvement plans going forward. This affects everything from the environmental side to the social and governance side. And supply chain reviews often come into play with those. Firms that have numerous suppliers that could be all across the world, don't always know exactly who and what's behind a particular supplier.

Right. Right.

And that's really important from an ESG perspective as well as just a firm value perspective. The other one I want to talk about a little bit is there's a risk that people or risks that can be discovered through certain ways that maybe aren't as obvious. So digital chatter can really provide an early warning indication of risk events that may happen in the future. So,

And what do you mean by digital chatter?

So digital chatter. So a lot of times within the surface and the deep and dark web, you can pick up a lot of chatter that can indicate of a risk that's going to emerge in about six months time. I think there's sort of a standard lead time where chatter is detected prior to a risk event happening. And this could either be fraudulent activity, human rights accusations, conflicts of interest coming out, breach reports, business disruption events. But specific to Kroll, so a big part of our business has become sort of this tech and digitally enabled solution. And one of those solutions is it's really a risk detection system, and it takes artificial intelligence combined with human intelligence and through this surface deep and dark web monitoring to kind of monitor the digital chatter.

Interesting. That is really interesting. I haven't seen that on a deal, but wow. Yeah, to the extent you can get ahead of something like that and anything AI is certainly the hot topic these days so.

Yes. And poor though, it does, it's AI combined with our human intelligence. That I think the combination of those two and sort of the historical data that we have on these things makes it a really powerful tool.

Any other items on the menu to run through?

I think those are really the, a couple of other things. So one other thing that can be thought of pre, post close, this could be on a pre, post deal basis or on a buy sell side engagement. So when you look at, this is more particular to industries, consumer, industrial or technology industries. But in terms of looking at operations, there's diligence that can be done that can help identify elements that can increase EBITDA, improved process efficiencies, help scale operations, and really increase the overall enterprise value of a firm. So this falls within our TAS group as well. It's our TAS ops group, and you can use this advisory service whether you're a seller and you're thinking about coming to market and value indications and sort of the pitch phase aren't where you thought they would be. And it can kind of be a deeper dive into why and where improvements can be made to get them to where you would like them to be.

Or it can be on a buy side in looking at if certain metrics are below industry standards, why that is, and if there are concrete things that can be identified to help bring those up. So we can look at things from an operational performance perspective, whether it's a supplier analysis and streamlining purchasing or maybe operational improvements that can be identified and cost savings quantified with those. Automation identification can be a big one. And those things are, I think they're very identifiable and quantifiable. So what investment would need to be made to automate a process and what return would result from doing that? So that's another thing to think about pre or post close from a diligence perspective.

Yeah. Yeah. It's interesting. If you're a seller, you want to do all of that analysis and make sure you get credit for it from the bidders. And if you're a buyer, you may want to keep that in your back pocket and make sure that hopefully other bidders weren't as smart as you and don't see those synergies and,

Right. Right.

Yeah. Probably goes to the broader point of, and appreciate you laying out all these different options, that information is powerful as you're trying to figure out what you're going to bid for a company, what you're going to sell a company for. And this was super informative to go through all these, the latest and greatest options of what's out there, because again, from a legal perspective, I kind of have my narrow things I look at, but this is really helpful. Any other kind of parting thoughts or ideas for our listeners who might be buyers or sellers?

Yeah, I think as you look at the menu of diligence items, you don't want to be penny wise and pound foolish, and I think going into things eyes wide open, like you said, more information is powerful and can really help not just kind of protect value, but it can help get to the right negotiation and more information and data can help you do that better.

Great. Great. Well, Cathleen, appreciate your time and the insights from you and your team at Kroll. Really appreciate it.

Thanks, Greg. Take care.

All right. Have a good one.

You too.

Thank you for joining us on this episode of Deal-by-Deal, a McGuireWoods independent sponsor podcast. To learn more about today's discussion and our commitment to the independent sponsor community, please visit our website at mcguirewoods.com. We look forward to hearing from you. This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty guarantee or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state, and should not be construed as an offer to make or consider any investment or course of action.