By David Grumer

A division of a large financial services company was being sold.  The division was a research services provider in the mid-Atlantic region. During the course of due diligence, the CEO and the CFO of the buyer came down to "kick the tires." The buyer's executives met with key executives of the research company.  The conversation was quite frank.  The message that the buyer received was this: "Go away.  We executives here have built this thing and we're intending to buy our division from the seller.  Buying this division will not translate to a good acquisition for you."

Good information to know.  With minimal effort, the buyer learned key information about the purchase under consideration.  We would consider this a due diligence success.  This is the moment when a potential buyer should stop and consider whether its goals can still be achieved, and if so, how.

The story has an interesting end.  The buyer bought the division anyway.  Weeks later, the CEO and CFO came back to the division on a Friday afternoon to proudly announce its purchase.  On Monday morning, when our dynamic duo came in to get things started, they learned the following: 1) the acquired executives would not be returning to work; and 2) many key files were missing. 

Ultimately a number of clients were lost.

The anecdote provides several lessons about the importance of due diligence: 1) up front and personal is the best way to acquire good information; and 2) you have to interpret all the information learned and determine what it means to the big picture.  In the case of our CEO and CFO, they could have saved themselves a troublesome acquisition by having had a talk with the seller's representatives once the due diligence was completed.   The talk would have been about the impact of the key executives' attitudes on the buyer's intended goals and objectives.  If a satisfactory arrangement can't be worked out, it's time to go. 

In short, the due diligence should be used in this manner:
a)    Determine how the findings impact your goals.
b)    Communicate the findings to the other party.
c)    Seek to develop an approach that enables an obstacle to be overcome or contained and also enables satisfactory goals to be achieved.  

Today's Climate

The financial services industry is increasingly competitive. Fee schedules face downward pressure. Many in the financial services industry are experiencing declines in the volume of activity. During the financial meltdown in the fall of 2008 financial professionals of all disciplines faced frustration from customers for not anticipating the problems that arose.  Asset based fees suffered for several reasons, including the decline of assets under management.

While news stories detailed the government's shepherding of the acquisitions of Bear Stearns by JP Morgan and Merrill Lynch by Bank of America, there's been takeover activity on a smaller scale as well. Many financial services companies are facing decisions about whether they should merge.  Sometimes merger is initiated by a clearing broker who is guiding a weak correspondent broker or customer who is struggling to join up with other larger customers. In other instances firms seek out investment bankers who can find the right organization to merge with.

Many times the answer lies in the due diligence that needs to be performed.  Due diligence-the process through which a potential acquirer evaluates a target company or its assets for acquisition-can be done by the seller, as well as the buyer.  As described above, it's similar to "kicking the tires" or "looking under the hood."  Due diligence helps a buyer and seller see the benefits and disadvantages of coming together.  The job of those doing due diligence is to find the problems so that a negotiated transaction can adapt its terms to cope with the risks that are found.

Due diligence starts with a conversation.  Everything counts.  Information can be gathered from publicly available sources, such as the SEC and FINRA websites.  At some point a confidentiality agreement must be signed in order that the parties can feel comfortable exchanging sensitive information.

Although the buyer and seller can both perform their own due diligence, they will be seeking different information. 

The buyer needs to obtain or develop information that will enable it to:
    Provide important input to valuation by forecasting growth, identify key success factors and ways to increase profit margins
    Secure the best negotiating position based on the knowledge acquired
    Aid post-deal integration
    Minimize risk by obtaining a thorough understanding of the Company and its markets
    Expose potential deal breakers and hidden liabilities

The seller needs to obtain or develop information that will enable it to:
    Evaluate whether the environment is suitable for customers and employees will be acceptable.
    Evaluate the buyer's operating strength, by reviewing financial information and credit reports
    Evaluate the buyer's reputation in the community
    Identify potential conflicts of interest and other deal breakers.

Both parties also need to learn:
    Potential conflicts of interest
    Learn about the opposite parties' experience with regulation

Information To Be Gathered

The following provides a basic checklist of information that should be investigated and gathered during the due diligence process:

    Climate of the business: services provided, employee reaction to a merger, company philosophy
    The culture: the operational decision making process, executive strengths and weaknesses, attitudes towards risk-taking and horizontal cooperation amongst departmental groups
    Regulatory: history, relationships with, constraints
    Marketing: demand for services by customers, customer needs, profiles of major customers
    Financial position and results of operations: functional or departmental results, cost drivers
    Operations: vendors, controls, service providers: (i.e. clearing and prime brokers) and cost structures, the role of compliance
    Technology: compatibility between buyer and seller technology, relative benefits offered by buyer and seller technology to each party
    Legal: past and pending litigation, customer complaints, contractual commitments and other undertakings.
    People: employee benefit plans, promises made, compensation arrangements, personnel practices.

There are no guarantees that due diligence procedures identify a company that has inflated its numbers and value.  It's notable that certain well-publicized frauds escaped the detection of regulatory examinations, presumably while they were occurring.  Using procedures designed, depending on the nature of the organization being reviewed, to walk back transactions to their source, those involved with a merger or acquisition can minimize future risk and surprises.

David Grumer, CPA, is a partner at the accounting and business consulting firm Citrin Cooperman & Company (  Grumer regularly works with financial services organizations on accounting, tax and business issues.