Managing Technical Due Diligence in M&A

As businesses become more global and transactions faster-paced, organizations are increasingly exposed to complex, interconnected risks in mergers and acquisitions. As an essential part of risk management, properly executing due diligence has become more technically challenging for companies planning deals. This week, John Herbert explains the technical aspects of risks involved in transactions and how technical due diligence assessments help to ensure successful deals.

Defining Technical Due Diligence

Technical due diligence (TDD) is the independent examination of the science and technology within a potential asset from an engineering perspective. Whether a company is involved in a real estate deal, setting up a wind farm, negotiating a hotel management contract, or establishing a new manufacturing facility, technical due diligence has a vital role. It’s important to note that this is not a substitute for other forms of due diligence, but an essential and specialised part of the whole due diligence process.

A technical due diligence assessment attempts to identify the following:

• Potential liabilities

• Risks

• Deficiencies associated with the technical aspect of a project

• Added value opportunities

The TDD Assessment as Part of Risk Management

Anyone can walk onto a site and see whether or not a standby generator is fitted, but you’ll need an engineering expert to decide whether the generator is serviceable or whether it has suffered from deferred maintenance. Will you need to replace it next week? Does it have the potential to be converted to use alternative fuel? Can it be converted for use in a cogeneration plant? These are engineering questions that technical due diligence assessments try to address.

For example, imagine you plan to acquire an existing industrial biofuel facility. Financially this deal may appear to be an attractive proposition. However, most legal adviser are not prepared to assess the technical aspects of this type of transaction. What is the condition of the existing mixing and treatment plant, is it state of the art technology? Has any deferred maintenance been noted? Are there any code violations that require immediate repair? Even a single engineering deficiency can cause serious operational headaches. Arranging for technical due diligence early in the process can provide information essential to a successful deal.

Traditionally, due diligence involved financial, legal and related regulatory matters and usually examined a limited range of risk exposures. Under this model, however, many critical engineering related risks were overlooked. Given the increasingly litigious nature of developed economies, exposing your company's stakeholders to such risks is not an option if you want to stay in business.

Limiting technical risk exposure is also one of the most important elements in equipping your company for rapid establishment of operations. It is important to know whether your operations manager will require USD 1 million to improve energy efficiency, and comply with current codes before your acquisition, not after it. A good TDD firm will not only highlight and assess these risks before the transaction, but also can provide ready to roll out solutions for any deficiencies uncovered.

Plan Ahead to Address Carbon Risk

Investors can no longer ignore climate change, and its implications for business. Governments around the world are busy implementing carbon taxation schemes which will impact facility operations. Australia and the USA amongst others are mulling schemes to cap emissions at a building level. The risk is real, and an imperative for the future, but often overlooked.

Depending on the business sector, the total cost of energy is normally the first or second largest cost centre. Imagine acquiring a facility only to find aged steam boilers suffering from low energy efficiency. A smart assessment could look past the pile of rust, and help clients identify opportunities to upgrade, lower fuel costs, and even monetize carbon credits.

Assessment Approach

An assessment approach is divided into stages covering:

1) Document Review -- It is no surprise to find a modern facility lacking drawings or other operational documents. For major capital equipment, their history and Mean Time Between Failures (MTBF) track record needs to be evaluated. Reviewing maintenance records, spares, and repairs carried out should be verified against the manufacturer's approved maintenance manual where available.

2) Fieldwork -- Just because a turbine is spinning today does not mean it will spin for the next thirty years. A TDD inspector walks through the site to check all major items of plant and equipment, inspect monitoring systems, and identify any deferred maintenance, all of which can involve risk and cost implications for future operations. Another issue to be investigated is the availability of spare parts. Without adequate spares bespoke equipment could be just one breakdown away from complete replacement.

3) Value -- Identifying opportunities for improvement. A TDD inspector can identify potential energy efficiency improvements or carbon management opportunities.

4) Further Investigation – Based on the findings, and any deficiencies uncovered, further investigation may be warranted. An inspector might call for additional evidence such as witnessing recommissioning tests. For example, under testing many standby power generators may fail to perform their function, necessitating expensive repairs or replacement.

5) Post Transaction – Once the transaction is complete a good TDD firm can facilitate the management of outstanding technical issues. For example, remediation projects to achieve compliance with the local fire and electrical codes, and attending to deferred maintenance. An effective TDD advisor can help guide the new owner toward the most cost effective repairs in cases of non-compliance.

A technical due diligence assessment is essentially the creation of a methodical step by step shopping list of technical risks, coupled with matched solutions deliberately designed to avoid the unexpected.

John Herbert is Managing Director of Kelcroft E&M Limited, an environmental consultancy he founded in 1999. John has more than twenty-five years international engineering experience gained on three continents in commercial, healthcare, hospitality, and industrial sectors. He can be contacted at john@kelcroft.com.hk