No budget for due diligence? Four checks you can run yourself

A full commercial due diligence costs more than many deals can carry. Skipping the questions saves less than it looks. In the failed buyouts we have reviewed, earnings fell for one of four reasons. Most of the time the reason was visible before the deal.

The buyer can check each one in days, with public information, the seller's own numbers and a dozen phone calls. Here are the four checks.

A commercial check asks one thing. Will the earnings you are paying for still be there?

It sits beside the legal, financial and tax work. Someone still has to read the contracts and test the accounts. But those tell you what the business earned. This check asks whether it will keep earning it.

Check 1. Is the segment really growing?

Look past the market in the sales document to the part of it this business sells into.

• Define the segment from the customer list. Who buys, what, and where.
• Look for volume, not value. Take price rises out. A business can grow its revenue for years while it sells less each year.
• Name what creates the demand. Ask whether it will still be there in five years.
• Look for the move. A shift online. A cheaper entrant. A new technology. A customer habit that is changing.
• Read what the seller says about why they are selling.

When Woolworths sold Dick Smith in 2012, it called the business non-core. Consumer electronics were moving online and prices were falling. The buyer of the later float could have read both facts in public announcements.

What bad looks like: the segment is flat or falling once price is taken out, and the plan assumes it turns.

Check 2. Is this year a peak?

The price is usually a multiple of last year's earnings. So it matters a great deal whether last year was normal.

• Get the longest history you can. Ten years if it exists. At least back to the last downturn.
• Ask what happened in the last bad year. How far did earnings fall? How long did they take to come back?
• Test the base year for one-offs: a rebound year, a weather year, a bumper season, one large contract, an accounting change.
• If the business lives off a commodity price, look at where that price sits against its own history.
• Work out earnings in a normal year, and price the business on that.

TXU, the largest buyout on record, was a bet that natural gas prices would stay high. They fell, and the company went bankrupt.

What bad looks like: the base year is the best the business has ever had, and the downside case takes ten per cent off it.

Check 3. Who else can set the price?

Some businesses do not control their own revenue. One payer, one regulator, one government, one landlord or one customer does.

• List every customer above ten per cent of revenue.
• List every contract, licence, funding agreement and lease, with its renewal date.
• Lay those dates against the years you plan to own the business.
• For each one, ask what happens if they change the terms. Leave aside whether they will.
• Read the risk section of whatever documents exist as if someone else had written it.

Envision Healthcare depended on billing patients outside their insurer's network. A law banned it.

Southern Cross Healthcare was paid mostly by local councils. They squeezed their fees, and it could not pay its rent. In every case like this that we reviewed, the risk had been written down. It had been judged unlikely, and never priced.

What bad looks like: one name on the list could take the equity to zero, and the answer is "they never would".

Check 4. Has the business done this before?

Every plan shows growth. Has this business, with these people, ever delivered anything like it?

• Split the last three years of growth into volume, price, mix, new customers and acquisitions.
• For every step in the plan above today's run-rate, ask what changed.
• Name the person who will deliver each initiative. Check they exist in the business today.
• Find the one comparable thing this team has already done. A new region. A new product. A new channel. Check the result is in the revenue.
• If there is none, price the business on its run-rate. Treat the plan as upside you have not paid for.

What bad looks like: the plan needs several times the pace the business has ever managed, and nobody has asked whether it can.

A dozen phone calls

The cheapest evidence in any deal is a customer on the phone.

Call ten customers. Include some the seller did not introduce. Ask four questions.

Why did you choose them? Who else did you consider? What would make you switch? Do you expect to buy more or less next year?

Listen to the reason they give for choosing the business. If they would say the same about its rivals, there is no advantage to pay for.

Then call two people who have left the business, and one competitor. Ask them what the business is good at, and what it is not.

Then look at the structure

The four checks are about earnings. The deal itself decides whether a fall in earnings is survivable.

• Size the debt to a normal year.
• Count every fixed charge the deal creates. Rent after a sale and leaseback is the one most often forgotten.
• Build the downside as a story. What goes wrong, and what is left?
• Write down the three things that would make you walk away. Do it before you negotiate.

When to pay for the work anyway

If the cheque is large against what you can afford to lose, pay for a full diligence. The four checks tell you whether the deal is worth that cost, and what to ask the advisers to test. A week of your own work makes theirs shorter and sharper. We cover how to brief it in a companion piece.

Our fund check asks these questions and scores the evidence behind each answer. It takes ten minutes. It stops short of saying whether to do the deal.

It gives one of four readings of the case. Keep going. Slow down and finish the homework. Slow down, there are real doubts. Or stop.

• The deal checks: buying as a fund, buying as a strategic acquirer, and selling
• How a Stages of Excellence check works
• Why do private equity deals fail?