The evolution of due diligence from simple to complex and varied

In the last three decades of the last century, and even in more recent decades, due diligence primarily focused on high-level financial information, personal relationships, and a relatively modest set of documents exchanged later in the process.

That has changed. The Dealer Management System allows virtually every function in a dealership to be captured, tracked, and scrutinized. Today, due diligence has evolved into an in-depth examination of almost every aspect of a dealership’s operations, and buyers want that.

“Buyers now assume that if something can be recorded or measured, it should be reviewed in due diligence,” Bert Rasumussen, a shareholder at the Los Angeles-based Scali Rasmussen law firm, tells Getting to Go.

Increasingly sophisticated buyers and changing due diligence asks

The players in buy sell transactions, including brokers, accounting firms, and legal counsel have become much more sophisticated, Rasmussen says. They want evidence supporting ever-higher dealership valuations.

Pricing is no longer driven by a simple look at earnings or market multiples, he says, “it is increasingly tied to the quality and defensibility of the underlying transactions.”

For decades, buyers approached due diligence with a “very consistent list” of the information expected to be collected and protected, Dave Cantin, CEO of M&A advisory firm Dave Cantin Group, or DCG, tells Getting to Go.

That generally involved looking back at three to five years of financials plus current performance metrics, current real estate appraisal and the current environment.

“Boom, there’s your due diligence,” Cantin says.

Buyers now ask for a much deeper dive, including future performance potential and how the dealership or dealerships align with their current platform in terms of tucking opportunities or geographically new locations, he says, “so they do approach an acquisition much differently today, which is a different way to approach the due diligence.”

More customized due diligence

Due diligence used to be fairly uniform, Jayson Crouch, managing director at sell-side advisory firm Haig and Associates tells Getting to Go. After his firm won a deal, “I forwarded my 70 questions and requests for documents. It was standard,” Crouch says.

Now the process has become more customized, he says. For example, if the dealership is underperforming, a buyer may be buying mainly dealership real estate, Crouch says and “when stores are underperforming, the TTM (Trailing Twelve Months) is irrelevant.”

In those situations, valuations are more pro forma based. The buyer “is not buying this giant stream of income,” he says, because they think ‘I am going to create that income.’”

A buyer with a more customized approaches to due diligence -- for example, the buyer only asks for some specific information rather than an in-depth, broad report – tcan be more attractive to a seller, Crouch says,

Crouch stresses, however, that it is deal specific. “If you are buying a Toyota store that is earning $10 million a year, you are going to want to know that over the last three years it earned that, because you are going to be paying for those earnings,” he says.

Buyer vs. Seller due diligence approaches

Rasmussen notes that sellers view due diligence through a very different lens. From the seller’s perspective, the priorities are usually straightforward: Get the deal signed and closed as efficiently as possible, with the least disruption, expense, and risk to the business.

Expanded diligence can work against those goals. It may require management and employees to spend substantial time gathering documents, responding to follow-up questions, coordinating with accountants and counsel, and negotiating increasingly detailed diligence provisions, representations, warranties, and disclosure schedules.

That process can also raise confidentiality concerns. In a pending buy-sell, employees may become anxious about possible changes in ownership, management, or staffing, and even limited disclosure of a transaction in progress can create retention risks and operational distraction.

That tension can become more pronounced when dealership deals are documented using ever more elaborate asset purchase agreements modeled on broader non-dealer M&A practices.

According to Rasmussen, as some Buyer attorneys have become enamored with more expansive diligence rights and more detailed seller representations, the process can become untethered from the economic realities of the transaction.

In some cases, sellers are effectively asked to represent not merely that the business owns its assets and has performed as represented, but that, except as disclosed in numerous disclosure schedules to be prepared by the seller, the seller has functioned almost flawlessly across a wide range of legal, operational, and administrative matters.

That approach produces longer request lists, more burdensome disclosure schedules, and more cost and delay before closing. It also increases the risk that a buyer, having had a full opportunity to examine the dealership before closing, may later try to turn pre-closing imperfections into post-closing claims.

In that sense, the scope of due diligence cannot be viewed in isolation; it is closely tied to how the purchase agreement allocates risk, and to whether the process remains proportionate to the type of dealership asset being acquired.

An integral part of deal pricing

As a lawyer engaged in buy sell transactions, Rasmussen is seeing a change in the timing of due diligence. Buyers now want access to “meaningful” diligence much earlier than in the past, he says.

That can mean before a price is finalized or a definitive assert purchase agreement is negotiated. In many deals, data rooms are opened shortly after the letter of intent or Non-Disclosure Agreement is signed, Rasmussen says.

“Due diligence is no longer a post-agreement verification exercise,” he says. “It has become an integral part of risk allocation and, often, deal pricing.”

COVID and the changing value of historical earnings

Dealership transactions tanked during 2020 and 2021 due to the COVID lockdown, but their earnings skyrocketed as inventory shortages allowed them to charge desperate customers much higher prices for available vehicles. As inventory recovered, however, earnings and profits began to normalize.

That created a pre- and post-COVID dichotomy in due diligence approaches, Alex Watterson, managing director at The Presidio Group, a merchant bank involved in dealership buys sells, tells Getting to Go.

Pre-COVID the performance baseline was heavily weighted off historical earnings, he said. Then, three or five-year averages or TTM were popular performance metrics. Buyers would either do a Quality of Earnings report or some other standard due diligence “to verify that the store was making what they said it was making,” Watterson says.

“Fast forward to 2022, 2023, when earnings start to decline, (and) everyone’s throwing historical earnings out the window because, you know, they’re not worth anything,” Watterson says.

Buyers are now more interested in what they can do with the store than how it performed in the past, he says, so they are often foregoing standard Quality of Earnings reports.

“I think even the CPA firms out there are probably seeing a decline in the number of Quality of Earnings they do for clients,” Watterson says.

If one of the publics or a very large dealership group is a party in the transaction and deeper financial information is needed for underwriting the deal, “I think that’s where you still see a QE,” he says.

Otherwise, people are mainly taking a good look at the financials to make sure there is no fraud and that everything “ties out,” Watterson says.