Due Diligence

Brendan Daley, Thomas Geelen, Brett Green

Based on: Due Diligence, The Journal of Finance (2024) DOI: 10.1111/jofi.13322

Due Diligence Affects Prices. Acquirers Are Too Diligent.

Due diligence is pervasive. Nearly every public merger and acquisition (M&A) involves a significant amount of time and effort devoted to gathering information about the target company. Naturally, the acquirer will want to understand what it is buying, what liabilities it is assuming, and what risks are involved before executing the transaction. Due diligence is arguably even more important in private equity, where the target firm has not been subject to the same scrutiny and disclosure requirements as public companies. Commercial real estate deals also involve a due diligence phase that can extend for months and even years.

Practitioners argue that due diligence is essential to ensure a successful transaction. Failure to conduct proper due diligence can have severe financial consequences for an acquirer in an M&A transaction. Elon Musk’s recent acquisition of Twitter provides a case in point. Musk forwent due diligence prior to signing a binding agreement to acquire Twitter for $44B. He subsequently tried to back out of the deal after discovering that a significant fraction of Twitter’s accounts were fake. Twitter then sued Musk, which eventually forced him to complete the acquisition at the originally agreed-upon price.

Despite its widespread use, little is known about the economic implications of due diligence. How does the acquirer’s ability to conduct due diligence prior to executing a transaction affect the deal terms, the likelihood of deal completion, and the profitability of the acquisition?

Consider a setting with identical bidders who each offer a price to buy a target firm. The target then chooses which offer to accept, at which point the winning bidder (henceforth, the acquirer) can conduct due diligence prior to completing the deal. Bidders value the target more than its current share price provided that the target does not have any undisclosed issues (e.g., a pending lawsuit or fake accounts), which may be uncovered during due diligence.

An important observation is that the right to conduct due diligence endows the acquirer with a real option: whether and when to execute the transaction at a price equal to the winning bid after collecting more information about the target. The acquirer’s due diligence problem is inherently dynamic. Both the amount and the type of information collected during the process will depend on what the acquirer has learned to date. If a potentially troubling matter is uncovered in the early stages of due diligence, then the acquirer will spend additional time and resources investigating the matter and may cancel the deal entirely. If no such issues arise, the transaction will be executed sooner.

The solution to the acquirer’s problem is to execute the transaction when it is sufficiently confident that the target does not have any undisclosed issues. This execution threshold increases with the bid (all else equal), which means that a higher winning bid will be followed by a longer and more scrutinous due diligence process. An important takeaway is that the target must evaluate offers carefully in order to balance its desires for a high price and a swift execution.

How then does due diligence affect price offers? To answer this question, we compare the setting with due diligence to a setting without it. On the one hand, due diligence enables bidders to bid more aggressively, knowing that they can back out of the deal if problems are uncovered. On the other hand, it enables bidders to implicitly extract price concessions from the seller in exchange for faster execution. The net effect on the price depends on the risk of the target (as seen in Figure 1).

Figure 1: Equilibrium prices with and without due diligence.

For high-risk targets, due diligence is necessary for buyers to be willing to make acceptable offers and for there to be any hope of a deal.
For targets with intermediate risk, the ability to conduct due diligence increases the level of price offers because a buyer knows that if it uncovers significant problems, it is not stuck paying the price it offered.
For low-risk targets, due diligence enables the acquirer to extract a price concession from the target because both parties understand that a lower price means decreased risk for the acquirer and, therefore, less scrutiny during due diligence.

From an economic efficiency standpoint, there is too much due diligence compared to the case where the deal’s total economic value is maximized. Because buyers do not fully internalize the costs of delay during the due diligence process, the level of confidence they require in order to execute the deal is too high. As a result, the due diligence process is inefficiently long, and a greater number of deals fail. We estimate that the economic loss from excessive due diligence corresponds to 4-8% of the transaction value in public M&A deals. Hence, while a market with due diligence can be more efficient than one without due diligence, it will still fall short of the gains from trade that could be achieved. Break-up fees, which require the acquirer to pay the target for failure to complete the deal, can mitigate the distortion. While seemingly easy to implement, in practice, break-up fees are observed in only 21% of publicly announced deals and are too small to restore the efficient amount of due diligence.

Technological advances in information processing (e.g., artificial intelligence) can increase the speed with which an acquirer can analyze information about a target company. Faster due diligence has two opposing effects. First, for any given price, it reduces the target’s delay costs of accepting a higher price. Bidders who compete to win the deal would thus be pushed to make higher price offers. Second, it increases the option value of conducting due diligence, which gives bidders more bargaining power. For high-risk targets, the first effect dominates, and the price increases with the speed of due diligence. For low-risk targets, the second effect dominates, and faster due diligence leads to a lower price. Interestingly, because of the first effect, faster due diligence does not necessarily reduce the time it takes to complete a deal.

Figure 2: Equilibrium prices with and without artificial intelligence (AI).

When should due diligence take place? Whether due diligence takes place before an offer is accepted or after an agreement has been reached is irrelevant in the setting described above. The critical feature is that the acquirer has the option to conduct additional due diligence after the deal is in place (if due diligence is completed before the target accepts the deal, this option will not be executed, but the right was important nevertheless). The setting above also corresponds to one with financial bidders whose primary motivation is to purchase undervalued targets. The situation changes when the acquirer is strategic and the primary motivation for the acquisition is to capture synergies. In a strategic acquisition, there are advantages to front loading the due diligence to ensure that the price accurately reflects the target’s value so as to minimize the risk of deal failure. A testable implication of this line of argument is that deals with financial acquirers should be more likely to fail after an agreement is in place than are deals with strategic acquirers.

Not all buyers are equal. How does the presence of a bidder with a higher valuation for the target affect the outcome? A high-valuation bidder will have a stronger incentive to complete the deal quickly and will therefore conduct less due diligence. As a result, the target may prefer a lower price from a high-valuation bidder over a higher price from a lower-valuation bidder. A high-valuation bidder exploits this preference and shades its bid downward. As result, the presence of a high-valuation bidder leads to a lower deal price and faster deal completion, which reduces the inefficiency associated with due diligence compared to a setting with identical bidders.

This article provides a general framework to better understand the impact of due diligence on transactions. Due diligence is critical for facilitating transactions, especially for those involving high-risk targets. The right to conduct due diligence is akin to a real option, which has subtle effects on transaction prices. Acquirers conduct too much due diligence because they do not fully internalize the cost of delay. Break-up fees can help to mitigate the inefficiency. Technological advances that facilitate faster due diligence have important implications for outcomes, but they do not necessarily reduce the time to deal completion.