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The Importance of Due Diligence in M&A

By   Dana Ereth, Tim LeClair

November 10, 2016

When negotiating mergers or acquisitions, due diligence serves as an in-depth review of the target bank organization—both its operations and its people. Much of due diligence involves a review of the quality of the assets to be acquired, but it also includes a review of bank operations, earnings and staff.  

Scope
The scope of the due diligence procedures depends on the structure of the proposed transaction. If it’s an asset purchase, you are obviously focused on the assets being acquired and staff to be hired. If it’s a stock purchase or merger, there is more due diligence required regarding organizational issues, since you are stepping into the seller’s shoes in such transactions. The review needs to include a review of organizational documents, as well as tax issues, such as the S corporation election.

Your familiarity with the target bank organization will also have an impact on the scope of due diligence procedures. If due diligence is on a neighboring bank in the next town, your familiarity with the market and staff may enable you to focus due diligence procedures accordingly. However, if the target bank is in a different state or market, you may need additional time to familiarize yourself with the organization. In addition, since many acquisitions involve banks that are not subject to a certified financial statement audit prepared by an independent accountant, the strength of internal controls can vary widely in such institutions. It is through the due diligence process that you identify potential risks and develop a list of issues to be addressed in the definitive agreement. 

Due diligence might include a review or inspection of:

  • Financial information
  • Corporate information, including material contracts and agreements
  • Asset quality
  • Lending policies and procedures
  • Asset/liability management function
  • Operations
  • Deposits an analysis of deposit growth, core deposits and rates paid on deposits
  • Internal controls (the depth and effectiveness)
  • Litigation (anything in progress or pending)
  • Environmental issues
  • Employees and human resources (staff capabilities, compensation agreements)
  • Federal, state and local tax reporting
  • Regulatory compliance

Seller Considerations
Due diligence is an opportunity for the seller to gain the buyer’s confidence and highlight the capabilities of bank staff and the bank’s operations. If you are properly prepared for a sale, the due diligence process should not result in any surprises. If you are aware of any issues, it is best to bring them to the attention of your transaction team to put the best light on the issue, since it will likely be discovered during due diligence. As a seller, you want to highlight the strengths of your bank, whether it is your market, staff or operations.             

Buyer Considerations
If you are a buyer, this is when you figure out what you are buying and any potential issues and opportunities. Prior to entering into the letter of intent, you probably projected opportunities for revenue enhancement and to gain efficiencies. Now is the time to verify your assumptions. Has the target bank written down OREO to FMV? Is the ALLL adequate and have losses been recognized? Are loan files in good order? Beyond the lending function, is the target bank treating prepaid expenses properly and capitalizing fixed assets appropriately? Have they accrued for operating costs such as employee benefits and real estate taxes? Those are areas that can be impacted if the seller is trying to inflate earnings and capital.

Timeframe
Due diligence typically takes from two to three days to a week or more, depending on the size and complexity of the proposed transaction. In most cases, due diligence is conducted onsite, but sellers may request due diligence be conducted at an alternative site or after hours to maintain confidentiality.          

Involve Your Transaction Team
It is important to involve your advisors early in the due diligence process to make sure there are no conflicts of interest, and to make sure they are involved in the development of the acquisition strategy. That would include your accountant and attorney, as well as any appraisers. It is important that they be experienced with bank transactions and the types of issues found in a typical bank merger or acquisition. 

As you can see, due diligence is a very extensive and thorough review of the target bank. It is important to have an experienced due diligence team to ensure you have identified possible risks as well as potential opportunities. Your transaction team can assist you with the due diligence checklists to make sure you don’t overlook anything in the due diligence process.