The ins and outs of conducting a due diligence

Due diligence is a term used for the process whereby a potential purchaser evaluates a target company for acquisition. It amounts to an investigation of a potential investment that includes reviewing all financial records plus anything else deemed material to the sale. Offers to purchase are usually dependent on the results of due diligence analysis.

The importance of a due diligence – as many other business processes – is well illustrated by its failures. A high-profile example was the due diligence conducted for Hewlett-Packard on Autonomy, the UK software company. HP subsequently claimed that Autonomy had inflated the value of the company prior to the takeover, which led to a write-off of more than $8.8 billion related to allegedly fraudulent accounting at Autonomy.

While a breach of ethics is central to these accounting scandals, ethics has a further relevance for a due diligence. A due diligence should serve to confirm all material facts, for example in regard to a sale. It is also intended as a means to prevent unnecessary harm to either party involved in a transaction.

But, in the absence of an ethical culture, the facts can be skewed by the company being sold - as illustrated by the example above. The acquisition can also pose significant future risks to the purchaser. This can range from liabilities and penalties associated with fraudulent practices to having to change the company’s entire culture. Thus the difference between an ethical and unethical company is so noteworthy that ethics should be considered a material fact.

Conducting an assessment of the organisation’s ethics as part of a due diligence can add considerably to the depth of insight into the target company. For an ethics assessment to add this value, it is crucial that it is an accurate and reliable assessment. This rests on three factors.

Firstly, an instrument should be used that will produce correct and trustworthy results. The effectiveness of a tool such as the Ethics Monitor survey is that it taps into employees’ knowledge as a way of surfacing and uncovering unethical behaviour. Although there are cases when knowledge of wrongdoing is limited to the perpetrator, in most cases there are other people within the business who know, or at least suspect, that something is not right.

Secondly, the results must have a high level of credibility. To realize this, the results should be based on the experiences and perceptions of all employees (including management and executive directors) and key stakeholders – or at least the vast majority. The views of the select few on the board of directors are too limited to being viewed as a credible, representative result.

Thirdly, an ethics rating should be conducted by an independent third party. This adds to the reliability of the assessment and avoids any suggestion of manipulated results. An independent third party can also offer the assurance of confidentiality and anonymity to allow respondents to share their views freely without fear of comeback.

The optimal value of the inclusion of ethics in a due diligence should be to increase the level of assurance about the value of the seller’s ethical capital: In fact, the seller with a sound ethical culture should insist on an ethics assessment to clarify that value. The inclusion of ethics is also important to minimise the risk of future problems. Although it may not be possible to prevent other scandals by means of better due diligence, ensuring that the due diligence is the best it can be should be a recognised goal.

By Cynthia Schoeman

Published in The Star & Pretoria News Workplace, March 2013