Financial Due Diligence

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11 February 2015

www.pwc.com

Financial Due Diligence

Restricted Circulation

3rd National Seminar on

Due Diligence - ASSOCHAM

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Agenda

1 Introduction to Financial Due Diligence

1

2 Why Financial Due Diligence ?

5

3 Purpose and types of diligence

7

4 Focus Areas of Financial Due Diligence

14

5 What value does Financial Due Diligence bring ?

17

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11 February 2015

Introduction to Financial Due

Diligence

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What is financial due diligence?

Section 1 – Introduction to Financial Due Diligence



Financial Due Diligence (FDD) is a reasonable level of investigation into

the financial affairs having a material impact on the prospects of the target

business (historical + forward looking)



Goes beyond the traditional audit and looks at business from a commercial

perspective



May not necessarily only look at the historical financial performance of a

business but will generally consider forecast financial performance also

.



Is also about assessing:

• reasonableness of accounting judgments and estimates used by the

target company management in the preparation of financial statements

• completeness of target’s financial statements / accounting information

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Section 1 – Introduction to Financial Due Diligence

Financial Due Diligence •

Financial due diligence is not an audit

Financial Due Diligence

_Audit

Report to shareholders/ Accounts users

Business Understanding to Investor

Prior to Transaction Annual Closing

Comfort / Transaction focussed

True and Fair

Industry Standards, Deal Drivers, GAAP,

GAAP, Companies Act / AS

Effect on Purchase Consideration, Txn Drivers

Effect on Profitability / net assets / reporting / disclosures

Controlled Access _{Full Access}

Purpose

Timing

Opinion/

Report

Governing

Rule

Effect

Access

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Section 1 – Introduction to Financial Due Diligence Management Presentation Preliminary Report Information Memorandum Data Room / VDD Exclusivity Full access due diligence Debt Syndication

Initial Offer Revised Offer Final Offer/ _{Sign SPA}

Transfer of shares/ Acquisition Integration Final Report / SPA drafting support Report Credit contracts « Phase 1 »

Preliminary business appraisal « Phase 3 » _{Post signing}

« Phase 2 »

Detailed review & signing

Operations /PMI work Initial Feedback Modelling Stage of deal Client Closing Tax DD & structuring, Pensions, IT Tax DD & structuring, Pensions, IT

Financial due diligence is carried out at various stages

of the Deal

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11 February 2015

Why Financial Due Diligence ?

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Key benefits of financial due diligence

Adjustments

to purchase

price

Identification of

negotiation

points

_{Identification of}

separation and

integration

issues

Assessment of

sustainability of

revenue and

margins

Identifying cost

savings

opportunity

Areas for reps and warranties and impact on SPA

Identification of

Potential deal

issues

Section 2 – Why Financial Due Diligence ?

Softer aspects

on the

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11 February 2015

Purpose and types of diligence

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Section 3 – Purpose and types of diligence

Types of due diligence based on purpose

Buy side

diligence

Sell side

diligence

(also

known as

vendor due

diligence)



Due diligence commissioned by the acquirer



Focused on areas of interest for potential acquirers

(financial or strategic)



Reporting – generally issue based



Auction <> exclusive

Due diligence commissioned by vendor

Focused on areas of interest for potential acquirers

Identifies potential ‘show stoppers’ allowing an

effective mitigation strategy to be devised

Key tool for maximising success of the transaction

in a reduced timetable through maintaining

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Purpose : Buy Side Vs Sell Side Due Diligence?

Are you buying what you think you are buying??

Buy Side

Due Diligence

Assist the buyer maximise his

return on the deal

Do you know the issues a potential buyer may negotiate on?

Sell Side

Due Diligence

Assist the Vendor / Seller get

the best value on the deal

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Tangible impact on the purchase price – Buy Side Due

Diligence

Time

Pre -di ligence/ M o U Pri ce Disputes/ warranties/ claims Contractual obligations/ Capital commitments Fi na l Pri ce One-off/ Non-recurring revenues/ margins Poor quality of assets/ inadequate provisions Poor quality data given to acquirers Tax litigations

Due diligence review process

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How sell side diligence / VDD supports a successful

disposal?

Business performance

Process preparation

Process management

• Clear and full articulation of issues and presentation of its strengths

• Consistent story from management to bidders via the IM/VDD

• One-off events/issues effectively explained to investors

• Consistent financial data • Provision of clear, relevant

information on the investment rationale and process

• Sufficient resources and advisor levels for the VDD process

• High quality budget and forecast preparation, consistent with historical data

• Meeting process deadlines

• Answering bidders 'questions fully and confidently

Confidence in the

selling business

Confidence in the

process

Confidence in process

management

A strong VDD report will underpin a successful investment process

and protect value

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Types of due diligence based on access



Full Access to the target management, staff, accounting, financial and legal

data



Limited Access to the target management, staff, accounting, financial and

legal data



No Access: Strictly controlled environment, typically based on publicly

available data



Virtual dataroom: gaining lot of recognition, especially in cross border

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Investor’s expectations from FDD....an evolution

Traditional/ Stereo-type

• Mainly buy side due diligence • Full access and exclusivity in

processes

• Significant information available • Full access to management

• Completion accounts and purchase price adjustments

• Adequate time to discuss, deliberate and negotiate due diligence findings

Current Scenario

• Vendor due diligence prevalent, with limited top up buy side due diligence • Focused reporting on what is important • Limited access to management and

managed Q & A processes pre exclusivity • Short lead times for completion of work • Move towards locked box mechanisms

(specially in developed markets)

• Contribution to all aspects of the process including the valuation model

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Focus Areas of Financial Due

Diligence

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Section 4 – Focus Areas of Financial Due Diligence

Focus areas of FDD

Overall



Compliance with the relevant GAAP



Any qualification in Auditors’ Report



Management letters



Commenting on accounting policies



Quality of carve-out financial statements (where applicable)



MIS vs. financial statements

Trading Results



Understanding key revenue and cost drivers



Analyzing quality of revenues and underlying earnings



Analyzing key customer contracts and operating agreements



Analyzing business dependence on customers and vendors



Critiquing prospective financial information and assumptions

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Section 4 – Focus Areas of Financial Due Diligence

Focus areas of FDD (continued)

Indebtedness, Cash Flows and Working Capital



Analyzing underlying cash flows and working capital



Net assets adjustments



Debt and debt like items



Identifying significant unrecorded commitments and contingencies



Identifying capex needs of the business to meet the projected revenue and

margins

Other matters



Providing observations on key personnel and management’s track record



Assessing management information systems



Related party transactions - Highlighting separation / stand alone issues



Highlighting post-acquisition / integration issues.

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11 February 2015

What value does Financial Due

Diligence bring ?

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Section 5 – What value does Financial Due Diligence bring ?

How does financial due diligence impact valuations?

Based on:

• IM EBITDA

• IM / initial view of market positioning, growth and financing arrangements Adjusted for: - Due diligence findings re maintainable EBITDA - Due diligence findings re market positioning and growth potential Adjustments Debt/WC Pension/ Tax Other Final Equity Value Equity Value

Final equity value Price to be paid will

also be affected by tactics – i.e. “value” is not the same as “price” To reflect issues ‘outside’

EBITDA: - Debt - Working capital - Pension deficits - Tax issues - Capex/restructuring costs Adjusted Enterprise Value

Due Diligence Findings

Adjusted multiple A dju st ed E B IT D A Initial Enterprise Value Info Memo Assessment Multiple E B IT D A

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Due Diligence Approach : Quantifiable Benefits

1. Quality of Earnings (QoE)

Direct adjustments to proposed

valuation

+

Negotiating points with the seller

+ Go forward issues + Inputs to validate assumptions in business model / projections of Target

2. Net Asset Adjustments (NAA) 4. Working capital

3. Debt/ Debt like adjustments

FYXX Reported operating EBITDA xxx

Net sales xxx

Operating EBITDA as a % of net sales xx%

1 Margins from non core business w hich is non recurring in nature

2 Margins from discontinued products

3 Potential impact consequent to w ithdraw al of the extant excise duty benefit on margins of menthol business 4 Expenditure (currently capitalised) pertaining to patent

application that may not be granted in future

5 Revenue expenditure capitalised as CWIP to be w ritten off

6 Inventory valuation of WIP not as per Indian GAAP 7 Short provision for certain expenses

8 Pre-operative expenses incorrectly capitalised 9 Exchange loss on creditors/ debtors (net)

xxx

Adjusted operating EBITDA _xxx

Adjusted operating EBITDA as a % of net sales xx% INR in m illion

Proposed diligence adjustm ents to operating EBITDA

Sub total

INR in m illion 31 Mar XX Reported net w orth as at 30 Jun 08 xxx Proposed due diligence adjustm ents to net w orth

1

Provision for redemption of premium on FCCB 2

Forex gain / loss on forex assets 3

Inventory valuation of WIP not as per Indian GAAP 4

Short provision for expenses 6

Provision for slow moving inventory 7

Revenue R&D expnses incorrectly capitalised 8

Incorrect capitalisation of interest cost 10

Provision for debts doubtful of recovery 11

Diminution in the value of investments in subsidiaries 12

Tax exposure - dividend received from group co 13

Tax exposure - Failure to fulfil export obligation Total adjustm ents

Adjusted net worth as at 31 Mar XX xxx

INR in m illion 31 Mar XX Reported net debt xxx Less: unrestricted cash

Debt-like adjustm ents: Bills discounted

Buyer's credit Capital commitments Capital creditors

Creditors against letters of credit ('LC') Creditors beyond 180 days

Provision for employee benefits / unfunded Provision for redemption premium on FCCBs Commitments and contingencies

Adjusted net debt xxx Seasonal pattern of w orking capital

Total debt like adjustm ents xxx

INR in m illion 31 MarXX

Inventory Debtors

Loans and advances

Current assets xxx

Sundry creditors and provisions

Reported w orking capital xxx Adjustm ents

Insurance claim receivable included in debtors - Provision for proposed dividend - Net of capital creditors/ (capital advances) - Provision for redemption premium on FCCBs - MTM loss on forw ard cover -

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Examples of real life deals and impact of financial due

diligence

FDD on a print media company in

Eastern India

(Deal breaker)

Sell side due diligence on a foods and

beverage company

(QofE issues)

Inbound investment into lighting

business of an auto components

manufacturer

(Deal structure change)

Proposed investment into an

upstream oil and gas asset

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Final comments....things to remember for a successful

diligence



Tailor-made scope of work of financial due diligence based on the Deal

contours..remember..each deal is unique !



Synchronise the work of various work streams – financial, tax, legal..close

co-ordination yields best results !



Timely availability of quality information.



Representation and warranties...significant inputs from FDD and Tax DD teams.



Clear definition of key terms – involve financial due diligence specialists right from

the term sheet stage:

o

EBITDA

(GAAP / Audited vs. Unaudited / Reported vs. Adjusted)

o

Deal multiples

(Revenue, EBITDA, etc).

o

Debt & debt like items

(specifically define debt like items)

o

Working capital peg

o

Earn out mechanisms

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Typical FDD adjustments – only for reference

Quality of earnings and margins

 ‘Normalised’, ‘pro-forma’, ‘adjusted’ EBITDA

 Impact of differences between

accounting policies / GAAP followed by investor and investee

 Revenue recognition and cut off procedures

 Discontinued operations / one offs  Provisioning for doubtful receivables  Normalised level of overheads

 Inventory valuation

 Employee retirement benefits  Promoter and key managerial

remuneration

 Expenses not incurred exclusively for business

 Identification of one off/ non recurring items effect

Quality of assets

 Adjusted net assets position

 Fixed assets related adjustments including accelerated depreciation, physical

verification, capitalisation of soft costs, ageing of assets helping in identification of growth and maintenance capex

 Quality of receivables  Quality of inventories

 Deposits with tax authorities

 Write-off of non recoverable assets

 Under provisioning of expenses, employee benefits

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Typical FDD adjustments – only for reference

Debt and debt like items

 Net secured debt from banks, financial institutions and other external financers highlighting of key covenants and financial terms of debt agreements with such parties  Comment on effective interest rates

 Debt like items such as:

o underfunding of employee retirement benefits

o old outstanding vendor payments o capital creditors

o tax related obligations

 Commitments and contingencies o Guarantees given by the investee and

promoters

o Capital commitments

o Contingent liabilities & off balance sheet item

o Outstanding tax proceedings

Working capital

 Identification of normative/ average

historical levels of working capital employed in the business

 Identification of impact of seasonality and impact of financing considerations

 Fixed working capital – deposits with tax authorities, lease deposits and other long term deposits essential to operate the business

 Adjustments to reported working capital would primarily include

o Quality of receivables

o Obsolete inventory and inventory valuation o non operating advances and liabilities

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Quality of earnings (QoE) analyses

ILLUSTRATIVE

This analyses is

often required to

be updated at

closing date

Quality of earnings analysis

FY1 FY2 LTM3

Reported net revenue 976.9 1,084.2 652.8

1

Less: sales recognised in incorrect period (8.4) (6.2) (7.7)

Adjusted net revenue 968.5 1,078.0 645.1

Reported EBITDA (A) 226.6 223.8 144.7

Reported EBITDA % (as % to reported net revenue) 23.2% 20.6% 22.2%

Proposed quantifiable adjustments to EBITDA:

1 EBITDA impact of sales recognised in incorrect period (4.2) (3.1) (3.9) 2 a. Provision for sales return accounted in correct year - (16.3) 16.3 2 b. Provision for sales return not accrued/ short accrued - - (9.8) 3 Provision for potential doubtful trade receivables (15.7) (11.3) (12.4) 4 Under accrual of provision for employee retirement benefits - - (5.4) 5 Margin on inter company purchases in inventory (7.2) (7.8) (5.3) 6 Warranty provision (not accounted for) (9.7) (10.8) (6.5) 7 Potential provision for slow/ non moving inventories (7.0) (6.5) (3.5) 8 Bank charges included in finance cost (0.8) (0.6) (0.5) 9 Potential hard close adjustments - - (4.0)

Proposed non quantifiable adjustments to EBITDA:

10 Potential increase in go forward costs nq nq nq

Total adjustments (to the extent quantifiable) (B) (44.6) (56.3) (34.9) Adjusted EBITDA (C = A+B) 182.0 167.5 109.8

Adjusted EBITDA % (as % to adjusted net revenue) 18.8% 15.5% 17.0%

nq: not quantifiable

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Net debt & debt-like items analyses (1 of 2)

ILLUSTRATIVE

Debt, debt-like items, commitments and contingencies

MINR xx-xx-02 xx-xx-03

Secured loans 195.8 255.9

Unsecured loans 56.6 56.6

Reported debt 252.4 312.5

Less: Cash and cash equivalents (34.9) (35.5) Add: Restricted cash 7.4 6.8

Reported net debt - [I] 224.9 283.8

Proposed PwC adjustments:

Debt-like items: (to the extent quantifiable)

1

Overdue creditors 12.3 13.9 2

Creditors for capital goods 7.4 7.2 3

Unfunded employee retirement benefits 10.1 7.3 4

Share application money - 5.7 5

Accrued interest 15.7 17.5 6

Current maturities of long term loans 38.6 33.8 7

Proposed dividend (inclusive of taxes) 35.2 35.2 8

Direct tax liabilities (net of advance tax) 5.8 (16.9) 9

Potential direct and indirect tax exposures nq nq 10 Potential under accrual of income tax - 22.4 11 Deferred tax liability (net) 8.0 8.0 12 Under accrual of provision for employee

retirement benefits - 5.4 13 Warranty provision (not accounted for) 10.8 6.5

Debt-like items (to the extent quantifiable) - [II] 143.9 146.0

Debt & debt-like items (quantifiable) - [I + II] 368.8 429.8

This analyses is

often required to

be updated at

closing date

(28)

Net debt & debt-like items analyses (2 of 2)

ILLUSTRATIVE

Debt, debt-like items, commitments and contingencies

MINR xx-xx-02 xx-xx-03

Secured loans 195.8 255.9

Unsecured loans 56.6 56.6

Reported debt 252.4 312.5

Less: Cash and cash equivalents (34.9) (35.5) Add: Restricted cash 7.4 6.8

Reported net debt - [I] 224.9 283.8 Proposed PwC adjustments:

Debt-like items (to the extent quantifiable) - [II] 143.9 146.0

Debt & debt-like items (quantifiable) - [I + II] 368.8 429.8

Commitments and contingencies (to the extent not covered above):

12 Capital commitments nq nq

13 Term loan breakage charges 3.2 2.8 14 Potential ERP implementation charges nq nq 15 Potential transaction related expenses nq nq

This analyses is

often required to

be updated at

closing date

(29)

Adjusted working capital analyses

ILLUSTRATIVE

Potential adjustments to reported net working capital

MINR xx-xx-01 xx-xx-02 xx-xx-03 1 Inventories 219.0 151.3 178.7 2 Trade receivables 339.6 260.1 296.0 3 Trade payables (131.9) (115.9) (108.2) 4

Other current liabilities and provisions (160.6) (126.8) (160.2) 5

Other current assets 273.1 220.8 258.6

Reported Net Working Capital ('NWC') - [I] 539.2 389.5 464.9 Reported revenue (net) 652.8 976.9 1,084.2

A. Debt-like adjustments *

1

Over due creditors 14.5 12.3 13.9 2

Creditors for capital goods 8.9 7.4 7.2 3

Unfunded employee retirement benefits 12.9 10.1 7.3 4

Share application money - - 5.7 5

Accrued interest 13.8 15.7 17.5 6

Current maturities of long term loans 45.7 38.6 33.8 7

Proposed dividend (inclusive of taxes) 35.2 35.2 35.2 8

Direct tax liabilities (net of advances) 3.0 5.8 (16.9) 9

Potential direct and indirect tax exposures nq nq nq

B. Other potential adjustments

10 Provision for slow moving/ obsolete inventories (7.0) (6.5) (3.5) 11 Margin on inter company purchases in inventory (14.3) (22.1) (27.4) 12 Potential provision for doubtful receivables (15.7) (11.3) (12.4) 13 Sales - reversal - impact on trade receivables (12.9) (19.1) (26.8)

Quantifiable adjustments to NWC - [II] 84.1 66.1 33.6 Adjusted Working Capital ('AWC') [I+II] 623.3 455.6 498.6

NWC as % to revenue 41.3% 39.9% 42.9%

AWC as % to revenue 47.7% 46.6% 46.0%

nq: not quantifiable * adjustments to the extent quantifiable

This analyses is

often required to

be updated at

closing date

(30)

Impact of proposed adjustments on purchase

consideration

ILLUSTRATIVE

Adjusted Purchase Price Consideration at xx-xx-03

MINR xx-xx-03

Enterprise value (a) 1,417.4 Net debt & debt like items (b) (429.8)

Trailing twelve month (TTM) sales 1,181.2 Minimum net working capital @ 44.0% of TTM sales 519.7 Maximum net working capital @ 48.0% of TTM sales 567.0 Adjusted net working capital 498.6

Net Working Capital (shortfall) / excess (c) (21.1) Net value (a+b+c) 966.5

% age being acquired 100%

Net Adjusted Consideration 966.5

This analyses is

often required to

be updated at

closing date

(31)

11 February 2015

In a Nutshell...

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Section 6 – In a Nutshell...

In a nutshell....financial due diligence

Goal

Analyse and validate financial, commercial, operational and strategic

assumptions underpinning a deal

Historical / forecast results to form a view of future and deal drivers

Focus

Output

Debt Like

&

Working

Capital

Quality

of

Earnings

Identifies

risks

and

possible

mitigators

Assessment

of

business

model

assumptions

Generates

negotiation

points

(33)

Section 6 – In a Nutshell...

Final comments....things to remember for a successful

diligence



Tailor-made scope of work of financial due diligence based on the Deal

contours..remember..each deal is unique !



Synchronise the work of various work streams – financial, tax, legal..close

co-ordination yields best results !



Timely availability of quality information.



Representation and warranties...significant inputs from FDD and Tax DD teams.



Clear definition of key terms – involve FDD consultants right from the initial term

sheet stage:

o

EBITDA

(GAAP / Audited vs. Unaudited / Reported vs. Adjusted)

o

Deal multiples

(Revenue, EBITDA, etc).

o

Debt & debt like items

(specifically define debt like items)

o

Working capital peg

o

Earn out mechanisms

(34)

Let’s connect !

Anuj Madan

Associate Director

Transaction Services

[email protected]

Mobile +91 98114 16757

PricewaterhouseCoopers Private Limited 17th _{Floor, Building 10C, DLF Cyber City}