Know Thy Partner: The Importance of Due Diligence Before Deals or New Hires

November 2006

IN THIS ISSUE

— Look Before You Leap
— Making your decisions better: success stories in due diligence
— In the next issue

GREETINGS!

Welcome to the first edition of our monthly newsletter. Each month, we’ll highlight trends in fraud that are of importance to your firm and your clients. This month we’ll take a closer look at what’s involved in performing more thorough and careful due diligence before signing off on a transaction or making a new hire.

LOOK BEFORE YOU LEAP

Trust. It’s an essential part of both your client’s lives and your client’s business. Yet all too often, your clients don’t know enough about the party sitting across the table – and a lack of knowledge can cost them dearly.

Suppose your client is an engineering firm looking to grow by acquiring an engineering software company and incorporating the software into its consulting business. Having failed to interview the software company’s existing customer base extensively, the engineering firm missed out on knowing how dissatisfied customers were with the bug-riddled software and the poor customer service. By the time the deal closed, most of the software company’s customers had migrated to a competing product, making the software company’s customer base far less valuable than it had been when negotiations began.

These scenarios occur all the time. While a thorough analysis of financial data – both past performance and forward-looking projections, models and assumptions – is critical, the human element – trust – is key, and is often overlooked.

Several of our past cases have hinged on seemingly modest deceits, the notion that someone would simply try to hide an unfortunate part of their past from a potential acquirer, partner or employer. In one case, a candidate for a high-level position at a financial services firm failed to disclose a manslaughter charge that happened 20 years earlier on the other side of the country. In another case, a potential vendor to a client failed to disclose that he was fired from two separate financial services executive posts because he bypassed the firm’s routine due diligence procedures when making loans to persons of questionable character – who then used their financial positions to secure an automobile and other perks for the executive’s family at deeply discounted rates.

At other times, due diligence can seem more routine, but can be just as critical to your firm or your clients. Suppose the chief financial officer of a company in which your client has invested heavily resigns abruptly. What were the true reasons for his departure? Who will replace him? Most importantly, how will this affect the overall direction of the company and its ability to meet stated goals? The answers to such questions can be vital to the success of your client’s investments, and the odds are great that the answers will not lie in the company’s 8-K (if, in fact, it’s a public company.)

The best way to find these answers is two-fold: first, a thorough examination of public records involving the persons or company on the other end of the deal, including news articles, litigation, and an analysis of publicly available financial information (for companies, payment histories; for individual, bankruptcies, liens and property records.)

After available information has been assessed, the next step is to cultivate a list of former supervisors, colleagues, or friends involved with the individual or the company in question. Do they have any explanations for the events that came up in the public record? Do they support or refute the claims made in news articles? Do they know anything beyond what is in the public record that sheds light on the subject company or individual’s reputation and ability to make good on promises?

These are tough questions to ask, and difficult questions about which to get an honest answer. Using a Certified Fraud Examiner trained in both public records analysis and interviewing techniques will help you avoid the many potential pitfalls that will otherwise await you on the road to that next big deal.

MAKING YOUR DECISIONS BETTER: SUCCESS STORIES IN DUE DILIGENCE

A client looking to invest in a market research company wanted to know how the new CEO, on the job less than a year, was being received by more tenured subordinates. After lukewarm to negative feedback we gained from interviews, the client decided not to invest, and the new CEO abruptly resigned a short time later.
Another client sought to acquire a small business that had a positive reputation among its clients and community. The target company also had a habit of entering into agreements to be acquired and backing out when the primary owner would get nervous or feel that he wasn’t ready to let go of “his company.” Our client was armed with this vital information before beginning negotiations.

IN THE NEXT ISSUE

With the holiday season fast approaching, next month we’ll look at employee fraud and crime: why it happens, how to stop it in its tracks and the steps necessary to fully investigate offenders once a crime occurs.