The deal’s been agreed so why the need for financial due diligence?
Rob Dawes · October 11th 2023 · read
Takeovers often grab the headlines in the business press, particularly where a sports team is involved. One recent eye-catching announcement has been the agreement for 777 Partners to acquire a 94% shareholding in Everton FC.
Let’s hope they’ve done their financial due diligence (“FDD”) – it was reported in the Independent that Mike Ashley bought Newcastle United for £134m without the time to do the usual due diligence, later discovering that the club’s debts were £30m more than he was expecting.
As much as everyone will have an opinion on player values, this is not an area where an FDD provider will have direct input. However, there are a number of considerations impacting the value of the business where FDD can help. Here’s just a few:
- What is the status of the new stadium and what are the capital expenditure commitments related to this?
- What payments are still owed to third parties for transfer and agent fees?
- What income has been forecast for the next two to three years and to what extent is this reliant on the club maintaining its premier league status?
- What is the status of existing sponsorship deals?
- How much bank (or shareholder) debt is there?
- What happens to the cash received in advance for all the season ticket sales?
- How do all these things affect the valuation of the club?
- Financial Fair Play implications and accounting treatments compliant with these?
FDD will help the buyer get answers to these questions, either giving it confidence in its offer for the club or providing the basis for re-negotiation.
For any business acquisition, FDD will be used to help an acquirer answer three key questions it will have before completing a deal:
What are the maintainable earnings of the target?
What is the net cash/debt position?
What is the net working capital requirement, and to what extent do earnings convert into free cash flow?
How has the business performed historically? Are there any indications that earnings may change post-deal? (Relegation?!) The focus for FDD is on presenting historical information on a consistent basis and assessing any potential adjustments to reported earnings (e.g. for the impact of Covid).
The emphasis of FDD is getting to understand how the business makes money – its value drivers. It is then possible to assess the forecasts and the associated assumptions.
FDD should cover the basis of preparation of the financial numbers including relevant reconciliations and give a clear explanation of accounting policies, particularly those relating to revenue recognition.
The net cash/(debt) position is typically treated as an adjustment to the headline deal price, but this is not limited to how much cash and debt is held through bank accounts. There are other items either on or off-balance sheet that can be considered as part of debt:
- What happens with any outstanding shareholder/director loans?
- Is the cost of future capital expenditure plans included as debt?
- Has the business delayed necessary maintenance/investment that needs to be caught up, and should this be treated as debt?
- Are there overdue balances owing to suppliers which could be considered part of the debt?
- Are there assets in the business with outstanding finance leases or instalments to be settled?
Elements of the above are highly judgemental and subject to detailed negotiation. FDD enables a buyer to understand the relevant position and negotiate a fair outcome from a position of knowledge.
Net working capital and free cash flow
Looking at the cash flows of the business is an essential component of FDD, building on the understanding of the value drivers and what impacts their conversion to cash. FDD would normally present a view on average working capital and intra-month cash trends to identify the ‘true’ working capital requirement of the target.
Everton may have made a slow start to the current premier league season, but optimistic fans will remember that Newcastle United were in 19th place when taken over by the Saudi Arabia Public Investment Fund in October 2021. This season marked their return to the Champions League.