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October 26, 2016 Article 4 min read
The areas of real estate, employee benefits, and internal controls are often overlooked during the due diligence process, even though they can be fraught with risk. Learn what questions you must ask to minimize risk.

Corporate buildingsThe due diligence process for target acquisitions should extend beyond what’s evident — financial performance, tax liabilities — and cover those elements of business operations and holdings that present tangible implications for the post-integration entity. This section considers three critical, though often overlooked, areas fraught with risk:

  • Real estate
  • Employee benefits
  • Internal controls

Real estate

With so much attention directed to your target’s finances and performance trends, you must not overlook the land and buildings involved in any prospective deal, as property can have a substantial impact on the performance of the post-integration entity.

As part of the initial due diligence stage, assess the target company’s real estate portfolio. Will you be inheriting a lease agreement or purchasing real estate as part of the transaction?

If you stand to inherit the lease, there are a number items to factor into your valuation. Determine your rights and duties versus the landlord’s rights and duties, including any obligations regarding maintaining mechanical systems, parking lots, or restoring the facility back to its “original” state. Include scheduled rent escalations into your ROI projections, and don’t forget details regarding termination provisions or renewal options, including the timing of notice provisions. The type of lease (triple net, absolute net, modified gross, gross, etc.) may also carry unique financial considerations. Finally, perform a mark-to-market assessment of the real estate, categorizing them as above, below, or at market.

If you’re inheriting the real estate portfolio as part of the acquisition, consider a facility condition assessment to uncover deferred maintenance or deficiencies of the facility. Additionally, as you consider the growth potential of the post-integration company, consider a sale-leaseback arrangement of real estate. Such a vehicle can generate immediate funds to pay down debt or expand operations, while affording you the opportunity to reposition the asset.

Whether you inherit a lease or the actual facility, investigate existing incentive agreements on a state and local level. These agreements can exert a tremendous liability on the post-integration entity, necessitating an exhaustive due diligence review. If they exist, review any clawback provisions of the agreement. Does the incentive agreement coincide with your long-term vision? Will the facility location need to be consolidated or relocated? If so, determine whether you can rework the incentive agreement prior to closing as you may lose leverage to modify it afterward.

Employee benefits

According to the U.S. Bureau of Labor Statistics, employee benefits average in excess of 30 percent of the total costs for employee compensation for the private sector, with costs in some industries averaging much higher. Therefore, it’s easy to see the importance of conducting a thorough review of employee benefits costs for your target company.

The impact of employee benefits on future earnings can be considerable, especially for major legacy expense items such as pension obligations and OPEB (other [than pension] post-employment benefits) liabilities such as healthcare benefits, life insurance, and disability. These liabilities can extend beyond the target company following a deal. In fact, a recent court ruling found multiple private equity funds managed by a major private equity firm to be jointly and severally liable for unfunded pension liabilities owed by a bankrupt portfolio company.

When looking at a financial statement, review its long-term liabilities carefully, as the actuarial assumptions and methods prescribed to establish OPEB financial statement liabilities do not provide an accurate reflection of the actual long-term impact on cash flow.

Finally, evaluate other employee benefits-related items, including those tied to IRS and/or DOL compliance, employee reactions to anticipated benefits changes, potential need for preemptive negotiations with union representatives, and potential union pension withdrawal liability. All of these can impact the performance of the post-integration company, which must be addressed prior to finalizing the purchase.

Internal controls

With significant focus on quality of earnings, the due diligence process for target acquisitions often fails to identify deficiencies within the target company’s internal controls environment — key factors that pose post-integration risks.

Family-owned target companies are especially prone to these internal controls shortcomings, with a lack of resources to deliver accurate financial information.

In order for you to address this risk, in addition to performing the necessary due diligence on the target’s financial records — its quality of earnings and balance sheet health in an effort to assess EBITDA and calculate a valuation — special attention must be directed at your target’s internal controls. It’s one of the most effective ways to ensure that the financial information is reliable.

For instance, if your target lacks controls to correctly determine whether a recorded sale is a valid sale (or worse, inflates the transaction to boost earnings), the earnings assessment will produce inaccuracies. Additionally, a lack of proper controls can also result in complacency at the expense of sales efficiency (timeliness) and accuracy (proper recording). Both of these scenarios pose significant risks to achieving your post-integration performance goals. As you evaluate your target’s internal controls, we encourage assessing the capabilities of your target’s existing finance team.

As you consider the proper forward-looking strategy for your target, having a solid financial reporting function is key to maintaining and supporting organizational growth and change. Is the current finance team qualified and capable of handling your reporting demands and requirements? Assessment of the finance team may also include revamping your target’s financial reporting framework. Consideration of the target’s reporting systems, methodology, and efficiency will be a key determinate in a successful acquisition.