Why do we need Financial Due Diligence when we already have statutory Audit?

Sarah94's picture
Rank: Senior Monkey | 74

For example, a potential subsidiary that's already been audited. Everything is crystal clear already and out in the public. So why do we need due diligence? Why do we need to pay the same auditor(in case of Big 4s) to carry out due diligence?Thanks

Comments (4)

Dec 10, 2016

Had a guest lecture from a Big 4 FDD couple of weeks ago. Basically it's an extra independent check in the M&A process. For instance, the balance sheet as reported in the annual accounts is not clear on the net interest bearing debt amount. It's especially crucial with locked box offers.

A lot of people with more knowledge on the subject here though, please correct me if I'm wrong :)

    • 1
Dec 21, 2016

bump

Best Response
Dec 21, 2016

I am a CPA, former B4 auditor, and now work in diligence (debt transactions) and have a couple thoughts:

  1. Statutory audits do not have the same focus as diligence procedures.

Statutory integrated audits, for publicly traded and most large private companies, focus on whether financial statements are free of material misstatement and that management has internal controls over financial reporting that are designed effectively and operate effectively within the audit period.

The focus is historical and does not provide insight into the future. As the focus is purely on the face value of the numbers, there is uncertainty to what is driving these numbers.

  1. Diligence discloses details relevant to the specific transaction.

This is where diligence goes "under the hood" of the company the diligence is being performed. We must first understand what the bank, alternative lender, investment manager, or any other entity us, perceives as risks and opportunities associated with the transaction. It also helps to understand the context of the transactions - i.e. why is the company obtaining capital, why is the deal structure one way or another, etc.

Diligence scrutinizes a company's trial balance to understand their accounts, how they are used, and how they roll up to the face financials. During the process, we challenge the company's growth strategy and pro-forma revenue and operating assumptions. This helps us determine a normalized EBITDA run rate which the lender will use to help with their assumptions and modeling.

For example, if we are doing diligence on a senior secured credit facility, we will dive deep into the accounts associated with the collateral. We will normalize these accounts, pull out non-recurring noise or items not to be included per a borrowing base. Face financials and footnotes in a statutory filing do not come close to providing this level of information.

If we are looking at earnings for a cash flow loan, we get deep into what is driving earnings. We look at profit centers' revenue and contribution margins and cost centers' cost structures and determine how quality and recurring the earnings will be.

All of this information, within the context of the transaction, is compiled into a large report we issue to our client. I like to think of it as a bespoke 10k to help with the deal making process.

    • 5
Dec 31, 2016
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