Due diligence starts early and involves much more than financial statements

As dealership valuations have skyrocketed, so has the importance of due diligence. Those valuations must be supported by evidence and tied to the quality and defensibility of the underlying transactions. But the evidence is not only financial.

As buyers and sellers have become more sophisticated, their due diligence demands have become more customized. For firms handling the transaction, that means adapting their processes to the new reality, including the timing and types of due diligence performed.

Due diligence timing

Sellers often engage in pre-due diligence before going to market, assembling books, analyses, and narratives that can be shared early with serious buyers and that they know will withstand scrutiny later in the formal due diligence process, says Bert Rasmussen, shareholder with Los Angeles-based law firm Scali Rasmussen.

“In many deals, data rooms are opened shortly after a letter of intent or NDA is signed rather than waiting until after the asset purchase agreement is executed,” he says.

That is how Haig Partners, a sell-side advisor, operates, Jayson Crouch, a managing director at the firm, tells Getting to Go.

As soon as the chosen buyer signs the Non-Disclosure Agreement, Haig Partners opens a data room, Crouch says. It prefers to begin collecting due diligence materials concurrently with negotiating the Asset Purchase Agreement, he says.

“There is an interpretation that until the APA is signed and all interpretations are done, the due diligence window doesn’t really begin,” he says. “It is more of a good faith to run it concurrently. It is more like the intention of ‘let’s get this done as quickly as possible.’”

Beyond financial due diligence

The types of due diligence performed are becoming much more sophisticated. Pricing is no longer driven by a simple look at earnings or market multiples, Rasmussen says, “it is increasingly tried to the quality and defensibility of the underlying transactions.”

The quality and defensibility of earnings depends on both financial and non-financial factors, and that shapes how firms run their due diligence.

For the Dave Cantin Group, it’s people first.

“Understanding the people that run a business is a huge part of due diligence.” Dave Cantin, president of automotive M&A advisory company Dave Cantin Group, tells Getting to Go.

An M&A team should know who the key employees are at an acquisition target, and if there is a bench of people underneath them who can take over if any of those key employees leave, he says.

“You must understand the dynamic of the people, because in any business, in any sector, your greatest assets are the people,” Cantin says.

Next comes performance metrics, he says. “You think due diligence, right off the bat, you think what? Finances, right? No. No. No, performance metrics come first,” Cantin says.

His team looks at a swath of performance metrics to understand a dealership’s potential. That includes units in operation, service retention, service absorption, sales effectiveness, and CSI and SSI studies, he says.

“I want to know how the customers are being treated, I want to know if they’re coming back to the store,” he says. “I want to know if the store’s underachieving, overachieving, or achieving the expectations of the manufacturer before I even look at the financials.”

Customer base due diligence

Understanding the terms of a dealership’s DMS contract is “a huge part of the deal that often gets overlooked,” Cantin says. The DMS holds a dealership’s customer base, another potential due diligence area.

Buyers may analyze a dealership’s customer base to check for concentration risk, such as a high percentage of fleet sales.

An example of a potentially problematic customer base would be a Ford dealership with municipality contracts selling “a ton of trucks” to that municipality, or if a dealership is selling lots of vehicles to rental car companies, says George Karolis, president of The Presidio Group. “That’s a red flag,” he says, “because it’s more concentrated.”

But fleet sales can also represent an opportunity, he says, because it is a common part of what some large volume domestic dealerships do. Or consider a Mercedes-Benz dealership, which may have a thriving commercial business selling Sprinter vans. There won’t be much concentration risk there because the dealership’s customer database will be huge, Karolis says.

So, the customer base won’t be “top of the list” of due diligence in those types of deals, he says. Rather, “it’s the quality of earnings and sustainability of earnings are really the big drivers in verifying earnings,” Karolis says.