Financial Due Diligence With Alternative Data
August 23, 2021
Whether it’s sourced from sensors, social media, or websites, alternative data is becoming more powerful each day. It is increasingly being used by retail and institutional investors and business managers to improve the decision-making process and increase performance. When you consider a deal or an investment, you need to make sure that you are aware of all the risks involved to mitigate any potential adversities appropriately. Performing financial due diligence is different from accounting due diligence or the legal requirements. The following sections will introduce you to this concept and how alternative data can improve this process.
What is financial due diligence?
Financial due diligence is the process of examining and verifying a potential investment or deal opportunity. It purports to confirm that all the information and facts are correct and clear, providing peace of mind to the buyer.
As a result, it is obvious that transactions (or investments) that undergo this process have a higher rate of success. Due diligence aims to help individuals make informed decisions based on accurate, quality information.
Financial due diligence is similar to an audit. It consists of an investigative analysis of a given company’s financial performance. It is usually conducted by external third-parties to understand the financial situation and assess its value without bias.
Also, financial due diligence may also reveal problems or strengths not obvious in the financial statements. When you use alternative data, you can enrich this process by collecting and analyzing data from a variety of sources, so you can look at the entire picture.
In short, financial due diligence aims to provide investors with a better understanding of a company’s financial performance. Unlike audits, financial due diligence goes deeper into different key areas, such as the sustainability of its earnings, historical sales, working capital needs, and others.
What is the purpose of due diligence?
The aim of due diligence for businesses or investors is to ensure that every decision is well informed so that you can gain all the benefits of your transactions. In other words, due diligence is seen as a method of reducing risk by ensuring that the interested party is aware of all details.
When you want to invest in a stock in the long term, you should perform fundamental analysis to find out the performance and growth of your chosen company. You can enrich this process by supplementing the readily available financial statement data with alternative data.
For example, you may want to see the number of job postings listed in the past years, as this could indicate that the company grows or struggles. You may also understand consumer sentiment by accessing social media information or learning more about the company using firmographic or technographic data.
The importance of financial due diligence
The most important benefit of due diligence is that it allows you to make better-informed decisions, so your expectations have a higher rate of turning into reality. For example, purchasing a business (M&A) without performing adequate due diligence significantly increases financial risks for buyers.
Due diligence also benefits the seller in any transaction. For instance, financial due diligence using alternative data might, in fact, help you find out if your company is undervalued or overvalued. So, in the case of an M&A, the seller might perform their own financial due diligence and even discover that the business is worth more than the initial price.
What are the types of due diligence?
There are numerous types of due diligence processes. The main ones include:
- Financial due diligence: it focuses on the financial health of a business.
- M&A tax due diligence: it examines all the taxes associated with a business.
- Legal due diligence: it is mandatory for any merger or acquisition and focuses on examining all material contracts (i.e., financing agreements, licensing, guarantees, loans, etc.)
- Intellectual property due diligence: this assesses the quantity and quality of the intellectual property
- Operational due diligence: it investigates all the operations, processes, and facilities
The financial due diligence process
Each financial due diligence process is slightly different, according to your objective and scope of this analysis, available information, and methods. The most common information sources include historical, current, and forecast financial data. This process can be enhanced by using alternative data collected from a variety of sources, including web scraping and social media.
The first step is to obtain access to all of this information, such as contacting the business by sending a Due Diligence Questionnaire (DDQ) and using alternative data from your chosen provider.
The next step is data management, a crucial process in which data is exchanged between departments and ensures proper data storage and backup. Then, all of this information must be investigated and confirmed by different authorities, such as tax institutions (if the case).
Once data is curated and accurate, the financial due diligence process can be completed by:
- Analyzing all the documents received (i.e., financial statements)
- Clarifying issues (if the case)
- Optionally, a third-party consultant can verify the information (i.e., financial transaction and accounts)
- Review of all the findings and investigations
How long does the financial due diligence process take?
The financial due diligence process depends on your objectives, how much data you have access to, and how long it takes to analyze it. In formal cases, due diligence may take one to two months, which many buyers consider sufficient to evaluate a firm thoroughly. For instance, in the case of an M&A, when the seller is not ready and does not have the required information, the process can be very time-consuming.
Is financial due diligence better than an audit?
Audits and financial due diligence could seem similar if we consider the fact that they both involve a thorough analysis of a company’s financial statements. However, they have different purposes and are conducted via different methods. Financial due diligence and audits are not substitutes, and there are many differences between them.
Firstly, an audit is a statutory service provided by certified accountants. On the other hand, financial due diligence is a non-assurance service (so, not provided by certified accountants); instead, financial due diligence can be carried out by a financial professional and is akin to a service offered by a consultant or financial advisor.
As discussed above, the purpose of financial due diligence is to inform an investor about the health and operations of a target company - whether they want to invest in it or acquire it. As a result, financial due diligence aims to help you make an informed decision so you become aware of all the risks involved. On the other hand, the purpose of an audit is to check whether a certain company follows the predetermined format for bookkeeping and to ensure that it follows all the relevant account standards.
Unlike an audit, financial due diligence goes much further than simply analyzing financial statements. For instance, investors may also consider the company’s background, industry, competitors, the risk involved, the overall market opportunities, and many more.
In some cases, financial due diligence reveals certain risks regarding the transaction or the company itself. This is why alternative data sourcing can be beneficial if you want to have a complete picture of your chosen company. This will allow you to understand what risks you expose yourself to and what you can do to mitigate them.
For example, financial due diligence might reveal that your chosen company’s main revenue stream is only one contract (client); in this case, it means that the company is extremely risky as it could lose the contract. You could either opt for evaluating the risks of the contract separately or invest/acquire the company only if it agrees to reduce the exposure to the client.
Additionally, you could also meet the client and see if there are any problems or warnings on their side, or they might even not be willing to accept new investors in the company, especially if it would be a majority.
In an audit, you need to use different investigative methods, such as confirming the inventory or bookkeeping standards. During financial due diligence, you need to use a broad range of analysis and review methods, including observation, interviews, and others.
As these two are not substitutes, financial due diligence cannot be compared with an audit. For instance, if you want to invest in a company, financial due diligence will help you obtain a granular insight into the company, while an audit will merely indicate if the company’s accounting practices follow the standards.
Both of them are important, but financial due diligence goes much deeper into the company’s background, aiming to understand the reasons behind the historical performance, forecasts, and might identify risks or aspects that are not apparent in the financial statements.
Finally, an audit can take longer as it might include a recalculation of financial statements, confirmation of inventories, and others; on the other hand, financial due diligence could only use analysis tools, such as trend analysis or structural analysis.
The benefits of financial due diligence
As briefly considered above, the main benefit of financial due diligence is the fact that you obtain a detailed overview of a given company. When using alternative data in this process, you lower your risks as more data, especially from different external sources, will enhance your chances of making the best decision. This is because financial due diligence enriched with alternative data will highlight weaknesses or strengths that you may not be able to observe in a company’s financial statements or its internal flows of information.
Next, financial due diligence aims to establish a thorough understanding of a company’s historical, actual, and forecast performance. This allows you to accurately compute the intrinsic value of the company, increasing your chances of investing a fair amount of money.
Also, financial due diligence helps investors to understand the company’s liabilities, assets, and operations. When combined with an audit or other forms of diligence, you obtain a solid basis for making well-informed decisions regarding a potential acquisition or investment.
There are benefits for the seller or the target company, too. For instance, a financial due diligence report helps you understand the weaknesses and strengths of your company. In turn, this may allow you to ask for a higher price and even speed up the negotiation process.
Also, suppose your company performs financial due diligence before an acquisition or before attracting investors. In that case, there is a high chance that you can identify and correct all the issues on time. Moreover, a company willing to perform financial due diligence, in this case, will inspire more confidence, so the value also increases.
How alternative data impacts performing financial due diligence
According to Hedgeweek, a Corgentum survey investigated hedge funds’ and private equity investors’ interest in due diligence and alternative data. Up to 83% of respondents stated that they would continue to increase the funds they allocate to analyze procedures regarding alternative investment managers. Additionally, about 96% of the participants who use and review alternative data expect to increase their due diligence efforts.
However, it is worthwhile to mention that research in this field is still in its infancy. Alternative data is a relatively new area of interest for many investors and businesses alike, and more and more uses are discovered. Although hedge funds have been using alternative data for some time, alternative data is expected to be broadly accepted in the industry in the next 1-4 years. The main types of alternative data used by hedge funds, for instance, are consumer spending and lifestyle information, data sourced from expert networks, web scraped data, and climate-related data.
Due diligence is a process of collecting and analyzing relevant data before making a decision, such as an investment or acquisition. Financial due diligence helps you become aware of all the risks involved in a transaction so that you can mitigate them, depending on the source of the risk. If you are interested in discussing how alternative data could help you perform financial due diligence, click the button below and leave an inquiry.
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