Amjad Waqar has hands-on experience of conducting and leading several due diligence procedures and acquisitions, as well as of handling post-acquisition processes, especially in the cement sector. In this article he explains the importance of due diligence and why it is required, discusses key areas of due diligence and highlights the key points in due diligence reports.
There are several steps and procedures involved in any business acquisition. However, proper due diligence (DD) is one of the most important things to carry out properly, as there is a very large number of factors to take into account. In terms of an acquisition, a DD exercise is conducted to evaluate the respective company / business unit / plant / other asset in order to understand and assess its true market value. This finds the price at which the acquisition is viable once all tangible and intangible factors have been considered. It also confirms all facts and information about the company / plant.
A cement plant can be acquired either by the acquisition of the company that runs it or by the acquisition of assets (land, plant, machinery, etc) owned by the company. In either case, it is essential to conduct thorough DD. This should:
- Provide an estimated valuation / price;
- Highlight the preferred acquisition method;
- Highlight potential liabilities that may arise post acquisition (legal, contractual or otherwise);
- Identify legal and other matters that may affect acquisition and post-acquisition processes;
- Provide pathways to make the plant more efficient and effective. The DD process also highlights areas where improvements to efficiency, production and profitability are required.
A DD exercise provides the confidence that the amount invested is ‘safe,’ without the risk of any surprises further down the line. All risks and rewards should be identified so that the buyer can ascertain whether it will make returns that it finds acceptable.
Key areas of due diligence
A team of experts (technical, financial, legal, commercial and taxation) is engaged to conduct DD, the scope of which varies on case-by-case basis. Here, I discuss some of the key areas that need to be addressed / reviewed during the process.
Plant and machinery: Areas to review include: The type of plant, its make, sourcing, year of manufacture, years in use, years idle (if any) and details of any major overhauls; Plant capacity certification and details of any major subsequent changes to the plant; Available useful life, under the same terms and conditions; Details of owned, leased and out-sourced plant, machinery and other equipment; Details of synchronisation between plant (from raw material extraction to grinding unit) in term of capacity and output; Production bottlenecks and upgrading options; Planned future capital investment in the plant and associated machinery; Plant yield – drop test; The number of breakdowns, unplanned shutdowns and reasons for the same; History of casualties (if any); Preventive maintenance plans; Asset listing and cross checking of assets with fixed asset listing, and; Details of any assets being used by a third party.
Quarry areas: Areas to review include: The type and condition of mining equipment and its ability to operate at the current and higher rates; Reserves of limestone and other raw materials, for example clay, gypsum, etc.; Expected period over which raw material will last under the current production volumes and desired / future volumes; Quality and status of mineral concessions; Validity of licenses and renewal process and conditions; Review of transportation arrangement from quarry to yard / crusher / plant.
Land: Areas to review include: Review of legal land titles, its ownership, terms of use and understanding of restrictions (if any); Detail of any obligations for use of land (if any); Review of lease period (if any) and its renewal process; Understanding the procedures to extend mining areas / purchase additional land for possible expansion; Summary of any obligations for land and use of land; Details of any public rights of way / access issued / granted / in use.
Environmental and social: Areas to look at include: Reviewing all environmental permits and licenses available / granted; Understanding the plant’s obligations of the licenses / permits and towards society in general (as per past practice); Review of correspondences, notices and files related to regulatory authorities; Environmental audit details (if any) for each property owned / leased by the company; Review of company policy and procedures with respect to environmental and social responsibilities.
Legal matters and other contractual obligations: Areas to review include: The company’s ownership documents and share-holding structure; Legal suits in which the company is engaged; The legal requirements for operating the cement plant as per approvals, concessions, licenses and permits granted to company; All material contracts with all stakeholders; All guarantees and warranties issued by the company or that are in favour of the company; All confidentiality agreements that the company has entered into; All contracts for options, forwards and others; Distribution agreements, sales representative agreements, marketing agreements, and supply agreements; All loan, financing and security agreements, mortgages, indentures, collateral pledges, and other similar agreements; Understanding whether any right is surrendered by the company under any contract.
Financial and related matters: Matters to investigate include: A review of past five years’ performance and an analysis of operational effectiveness and efficiency; The type(s) of fuel in use, availability, license and costing; Electricity sourcing - self-generation or from the grid?; A review of the company’s financial modelling, forecasts and available budgets; A review of liabilities and related terms and conditions; Understanding details of related party transactions, receivables and monies payable; For each category of fixed assets, intangible assets, provide segment-wise detailed description of assets and their cost, written-down value and rate of depreciation; Review policies of the company, namely capitalisation, impairment, revenue recognition and others; Review of the latest fixed assets valuation reports - If this is not available, a DD process is the perfect time to conduct one; Estimation of the value and age of stores and spares as well as identification of slow, obsolete and zero value stock; Segment-wise ageing and subsequent position of debtors and creditors; Detailed review of investments made by the company, the terms and conditions and return thereof; List of all bank accounts, detail of authorised signatories, bank reconciliations and terms of deposits if any; Details of sales by market/product/distribution channel for the past five financial years; Arrangements and terms agreed with key customers; Policies relating to discount rebates and returns; Breakdown of cost (production, operating, marketing and others) with its classification in fixed and variable components for each segment; Taxes: review of all notices, correspondence and payments for taxes; Penalties: Review details of each penalty paid by the company during the past five years; Insurance: Review all insurance policies, their appropriateness, claims, settlements and pending matters; Review of any hedging contracts in which the company may be engaged; Review of selling prices, margins, variances, dividends, etc.; Review growth and key indicators for growth and steps to be taken for achieving future growth targets.
Human Resources: Aspects to investigate include: The company’s personnel handbook and a schedule of all employee benefits, holiday and sick leave policies; Review all employment, consulting, or non-competition agreements between the company and any of its employees and contractors; Details and terms and conditions of the top management; Details of retirement plans and obligations; Details of any disputes with employees, Unions or other parties; Stock options and any other rights granted to employees; Evaluation of appropriateness of number of employees at each level.
IT Infrastructure: Areas to investigate include: Details of hardware, software and networking arrangements in use and integration between different departments (from quarrying to dispatch) and reporting systems; Review of licenses and terms of use; IT contingency plan and the resources dedicated to it; Third-party contracts for development and maintenance of IT infrastructure; Evaluate appropriateness for future use and integration of any group-wide system already used by the purchaser.
Key factors in a DD report
A DD report should answer fundamental questions under each of the above headings. Based on this, a strengths, weaknesses, opportunities and threats (SWOT) analysis of the company / plant / asset should be prepared to understand the economic benefits that could be derived from an acquisition.
Substantial answers
The DD report should provide the following substantial answers: That the seller possess the legal titles of all properties and has the ability to sell; A clear understanding of the ownership of all intellectual properties and the rights and obligations for each; That the condition of plant and machinery to be acquired and capital expenditure needed to keep production at current levels (and the potential for expansion and growth) is understood; The sufficiency of raw material for the targeted life of the acquisition and availability of alternative sourcing and pricing is known; All financial obligations associated with acquisition are identified and there are no hidden obligations that will be acquired with the acquisition; Legal and contractual requirements / obligations for operating plant in the relevant jurisdiction are understood; Legal suits, claims, possible liabilities and the likelihood that these may arise as the result of legal judgements are well understood;
All environment and safety requirements; Identification of cash flows required for improvement (if any), modernisation etc, are understood; Financial performance and evaluation of financial feasibility of the plant, break-even and potential areas for improvement are understood; The rights and obligations under each contract are understood; Financing arrangements and requirement of any renewals after the acquisition are sufficient; The market, key customers, credit ratings and potential for growth are well understood, as well as the demand for other associated products that may be sold in same market; Procurement contracts raw material, fuel and others are understood; Potentials for cost saving opportunity that may exist in supply chain are identified; Key employees that are critical for the continuation of operations in the short and long term are understood, as well as plans for their succession.
Beside consultants, a team needs to be assembled, either in-house or out-sourced, that not only reviews the progress of the whole process of acquisition but also advises the DD consultants, finalises their scope of work, follows up and leads the DD process and complies with the legal and regulatory requirements of the acquisition.
There are several formalities (statutory, administrative and others) that need to be completed during the whole acquisition process, including but not limited to intimation to key stakeholders, that also need to be complied with.