By Ngonidzaishe Makaha
One of Africa’s reggae icons, the late Lucky Dube, expressed his music in an imaginative and emotional way that would drive anyone to pause, analyse, reflect, and perhaps institute corrective behaviours and thoughts.
In his song, It’s Not Easy, Lucky figuratively chants about a young man who is so enthusiastic about getting married that he calls his mother to convey the message. Listening to the song, I can only picture a mother who was disconcerted and measured in her response.
The mother aptly responds with a pertinent question: “Son, did you take time to know her?
As to what happens thereafter, this song is a must-listen. Only Lucky’s voice contains the emotion that builds to the climax of this distinguished masterpiece of storytelling.
“…You looked so beautiful, so beautiful and so innocent
I did not know that behind that beauty
Lies the true colors that will destroy me in the near future
This choice I made didn’t work out to be what I thought it would…“
In financial transactions – mergers, leveraged buyouts, venture capital – the young man Lucky sings about is a perfect analogy to investment professionals on the concept of due diligence. In finance and economics, due diligence is enhanced investigation, assessment, and review of a potential investment transaction to confirm all relevant facts and extract an informed decision.
Due diligence comes in variations, according to specific deals, but central to it is risk assessment, financial analysis, legal analysis, operational diligence, commercial diligence and economic diligence.
Why due diligence
Facebook’s founder, Mark Zuckerberg, controls one of the most influential conglomerates in the world, Meta Platforms Incorporation.
Meta has revolutionised social media and digital communication. Within its empire, there is a stark contrast in outcomes borne out of investment decisions that have shaped it over the years. Zuckerberg bought Instagram in 2012 for just US$1 billion. Two years later, he got enticed by the WhatsApp craze and subsequently bought the company for a staggering US$19 billion.
Fast forward to today, Instagram has contributed far more to the business than WhatsApp, which has barely made a significant profit and could be spun off the Meta family according to a report from Bloomberg.
The ultimate price of any investment deal or transaction is to derive value within a stipulated period. Due diligence is fundamental to this goal from the outset. The dichotomy in the fortunes of the two social media giants, Instagram and WhatsApp, clearly expresses the shortcomings of poor due diliegence.
In many transactions, investment practitioners have their cognitive abilities often clouded by sentiment and rhetoric. At the time of acquisition, WhatsApp was the trendy buzzword in the street while Instagram only had thirteen employees, with most protagonists labelling the acquisition as the greatest mistake of the decade.
Zuckerberg probably viewed WhatsApp as a business unit that would add to global reach and, before someone else did, he had to pounce on it. In essence, he largely answered to the sentimental call which was devoid of proper value analysis. Unfortunately, the consequences are playing out today. As for Instagram, many reports point to an acquisition driven by the need to quash and incorporate competition.
According to leaked emails, Zuckerberg was clearly unsettled with the contest that Instagram was bringing. It is quite apparent that there was a careful study of Instagram and its business model by Zuckerberg and his investment advisors.
There was little sentimental value placed on the Instagram transaction. Today, due process is winning over sentiment and rhetoric. Instagram is returning much more on investment than WhatsApp.
What are the elements of due diligence?
Due diligence processes come in many shapes, but for most transactions, the primary elements are centred around financial due diligence, legal due diligence, operational due diligence and market due diligence. Due diligence is never cast in stone, and it extends to some elements including human capital, taxes, technology, strategy, environment and management.
In transactions, financial due diligence is crucial because it is at the centre of the ultimate investment goal – return on capital. Using tools such as audited financial statements, debtor and creditor analysis, cost analysis, return on equity, earnings and projections through careful financial modelling, financial due diligence can extract hidden facts which could be detrimental to the acquirer’s objective or in contrast, provide the much-needed comfort about the prospects of the transaction.
In 2011, Hewlett Packard, the American tech company, bought a British based start-up company called Autonomy for US$11 billion, a price which the start-up company was not worth. Hewlett Packard fell victim to Autonomy’s exaggerated financial forecasts and mischievous accounting practices.
At the time of acquisition, Autonomy was the largest British software company on the FTSE 100 by market capitalisation. Lack of proper due care by the acquirer culminated in the late realisation of improper accounting practises where revenue was inflated, a position which could have resulted in an artificial acquisition price.
Apart from Russia’s invasion of Ukraine, amongst the topical issues for the year is Elon Musk’s bid to take over Twitter, a widely popular social media platform. After a lot of frenzy from Twitter shareholders who were probably going to cash in, and the users who are generally cast between the extreme right and left, Elon Musk recently came out to announce that the deal was not proceeding as planned.
The reason Musk backed away is contestation over the actual number of fake accounts on the social media platform. The fact that the acquirer is worried about the accurate number of fake accounts is a clear indication that he is not relegating the due diligence process. He isn’t willing to suffer the operational and financial consequences attached to lack of due care.
The millennials would know about a social medial platform that was called Myspace. Myspace was a hot social media site and during its formative years. It outpaced every other competitor including the now popular Facebook.
A media conglomerate, News Corp, bought the company in 2005 for US$580 million dollars but did not institute proper strategic and competitor due diligence. This resulted in the company shedding active users from a peak of 300 million in 2007 to just under 40 million by 2013. News Corp ended up disposing of the company for only US$35 million, just a fraction of what it initially invested. Another case of sentimental value over proper due care.
It is imperative for any practitioners of leveraged buyouts, mergers, growth equity or venture capital transactions to understand that every acquisition action has consequences. These consequences could be financial, legal, operational or market-based and there is need to institute proper due care in that regard.
Sentiment and rhetoric can be crashing impediments to any acquisition strategy and due diligence is never a once-off affair, but a continuous process that keeps transactional value in check.
About Lucky Dube’s song, a few months or perhaps years later, the young man filled with agony calls his mother crying over his decisions and choices which had not worked out and driven him to divorce. In corporate transactions there is a perfect analogy between due diligence and the pertinent question the young man’s mother had asked just as he was about to get married. The consequences of inaction on these virtues are inherently the same – hurt, loss of value and divorce!
Ngonidzaishe is a financial professional with keen interest in Alternative Investments and Corporate Finance