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The fine art of due diligence

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In August, private equity firm ABRY Partners acquired consumer book and magazine publisher F+W Publications for $500 million from Providence Equity Partners. Three months later, ABRY filed a highly unusual lawsuit against Providence, alleging fraud and misrepresentation in the figures presented to ABRY during the due diligence phase of the acquisition process.

The lawsuit has embarrassed ABRY and Providence, both of which declined to comment for this story. While the lawsuit paints Providence as unethical, it has caused some industry observers to question the thoroughness of ABRY's due diligence.

Due diligence—the term for the research a prospective buyer performs on an acquisition target to ensure that the price is fair—has rarely been in the spotlight as it is now.

"It's just publishing 101," said Andrew Goodenough, president-CEO of Highline Media, which recently acquired Research and Futures magazines. "It's pretty simple really. That said, we have a 10-page checklist of due diligence items."

The due diligence process involves more than mere black-and-white numbers. Industry insiders say that due diligence is part science, part art—and all hard work. The process requires both rational thinking and emotional control.

Experienced buyers say they're never completely certain about the quality of their due diligence until they've been operating the new company for several months.

In b-to-b media, due diligence for a prospective buyer generally includes three areas, according to Robert Crosland, managing director at media investment bank AdMedia Partners: the market, the competition and the inner workings of the business on the block.

Assessing the financial standing of the company to be acquired is, of course, essential. Poring over invoices, bank statements and other financial documents is necessary to determine EBITDA (earnings before interest, taxes, depreciation and amortization), the figure used to value media properties.

EBITDA data, however, are backward looking and don't necessarily give a clear indication of a business' future performance. To gain a better view of the future, Crosland recommends looking at the market a company serves and its competition. "It's caveat emptor," he said. "Let the buyer beware; it's like buying a used car."

"If the market is in systemic decline, it's going to have a major impact on valuation," Goodenough said. "If the market's growing and the product is not, that tells you a totally different thing."

Most companies have a template or a checklist, which varies from organization to organization, said Barbara Flight, a senior VP at Brown Brothers Harriman & Co.

A private equity fund, for instance, might be more interested in a target's growth potential. A lender is likely to be more focused on the business' ability to pay back a loan in its due diligence. And a strategic buyer may spend some of its due diligence time on assessing integration issues, such as how the information technology infrastructure of an acquisition target matches up with the prospective acquirer's.

In many cases, the documents used for due diligence purposes are no longer hard copies. Instead, they are posted in electronic data rooms, which enable members of the prospective acquisition team to access them from anywhere in the world. "You can look at the documents at 2 o'clock in the morning or 2 o'clock in the afternoon," said Robert Krakoff, whose Blantyre Partners is still trolling for acquisitions.

Dick Ryan, president-CEO of ZweigWhite, said he believes that electronic data rooms favor the seller over the buyer. "I don't want the seller to know what I'm looking at," he said.

Ryan's comment implies that, as every experienced acquirer knows, due diligence is about more than numbers. Mathematics is critical, but so is a touch of art. Most companies go beyond financial statements; they talk with a magazine's advertisers or a trade show's exhibitors. They interview competitors. They talk to former and current employees.

Krakoff said he tries to have conversations with managers as far down the totem pole as he can go. "If you talk to enough people, they'll tell you what's really going on at the company," he said.

Mike Wood, the former CEO of Hanley Wood, said prospective acquirers should be dogged in the due diligence phase. He advised not being embarrassed by asking too much. "Usually, they groan under the weight of our requests," he said. "It's hard, but we have to have it.

Additionally, experienced acquirers say buyers should not overlook the kind of people who will be coming along with the acquired company. This is one area where art may overreach science.

Peter Goldstone, president of Hanley Wood Magazines, said he wants to make sure that the management team at the company to be acquired fits in with his company's culture. "We've had the best success buying companies where they have a similar sense of culture in terms of being growth-oriented and being aggressive," he said.

When due diligence works, it can be a boon for the buyer. Wood points to Hanley Wood's acquisition of the World of Concrete trade show as an example of due diligence uncovering many items that indicated the business could flourish as part of his company.

Because the World of Concrete was a family-owned business, Hanley Wood saw many items that were not essential to the trade show—such as an industry library—that ate up significant expenses. The result was that the first year's profit was twice what Hanley Wood originally anticipated, Wood said.

There are, however, tales of due diligence gone wrong. Sitting on the board of a company, Krakoff witnessed the purchase of a computer magazine that went sour. Under initial due diligence, the deal seemed fine, but the acquirer curtailed its due diligence as it waited for the deal to close. In the meantime, ad pages slowed, a precursor to the drop-off in ad pages in the tech market.

The lesson? "Never stop until the check is signed," Krakoff said.

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