What is Due Diligence?
Due Diligence (DD) is the examination and evaluation of the target company during a corporate acquisition, considering the financial, legal, tax, and economic current state. In addition to the ‘classic’ due diligence by the potential buyer, in recent years, sellers have increasingly conducted so-called vendor due diligence before starting the sales process to identify and eliminate deal breakers early on. In most cases, external consultants with specialized expertise create an opportunity and risk assessment of the target company based on documents provided by the seller. The potential buyer can then prepare for contract negotiations based on an objective assessment. The results of the due diligence influence the purchase price, the warranty catalog, the Post Merger Integration (PMI), and in some scenarios, even the later exit.
External IT Due Diligence for Plannable IT Project and Operating Costs in Carve-Outs
With a targeted focus on M&A, we conduct IT due diligence for our private equity clients and subsequently develop a comprehensive solution for the IT carve-out and future IT operations as a standalone company or platform acquisition.
First, the current state of the target’s overall IT situation is assessed to determine which hardware and software are needed for standalone operations. An important aspect is a transparent IT organization and a thorough discussion of the IT processes to be undertaken. In coordination with the planned corporate strategy of the new investor, a proposal is prepared detailing which IT services will continue to be provided by the seller after the legal change of ownership (closing) for the agreed transition period and recorded in the so-called Transitional Service Agreement (TSA). If the timeframe for the sales process is very short, we create a so-called Red Flag Report, which contains only the essential ‘stumbling blocks’.
IT Due Diligence: The 3 Phases of the Technical Process
The technical process from IT due diligence through IT carve-out to standalone operation or, in platform acquisitions, to carve-in consists of three phases:
- Analysis of the current state: Current Mode of Operation (CMO)
- Definition of the transition state until the end of the TSA period: Intermediate Mode of Operation (IMO)
- Implementation of the target state: Future Mode of Operation (FMO)
The buyer is also provided with a cost outlook for the IMO and FMO phases in the IT due diligence. The total costs are divided into investments/one-time costs (Capital Expenditures), such as purchasing new hardware, and operating costs (Operational Expenditures), such as monthly license fees or costs for managed services.
The results of the IT due diligence are incorporated into the IT carve-out project plan to be created when the target is purchased by the investor. This includes the required separation steps and their risk on a timeline. It also shows relevant dependencies between the project stakeholders as well as the ramp-up of the new IT landscape and the ramp-down of the (TSA) services.
Often, targets are separated from corporations that were adapted to comprehensive process specifications. We therefore offer our clients a fundamental re-design of the processes for the FMO to eliminate existing friction losses and generate cost optimizations. The adapted IT can thus form the basis for restructuring projects and a realignment of the target, significantly contributing to the rapid implementation of the strategy change.
Phase 1 of IT Due Diligence: Current Mode of Operation (CMO)
Since it is still uncertain at the time of the IT Due Diligence request by the investor whether they actually want to purchase the target, the examination is initially limited to documents that the seller provides in a virtual data room. In addition to IT-specific documents, information about IT is often found in headcount lists, asset accounting, financial and investment calculations, production and shared services descriptions, as well as supplier documents. This initial IT analysis is then discussed with the investor, and open questions are clarified in a Q session with the CIO / CTO from the target company. Here, the findings are validated and adjusted if necessary.
For a successful IT Due Diligence, three essential aspects are listed here, among others, which apply to a variety of project scenarios:
● Adjustment of cost planning to the new corporate structure: The documents provided in the data room often contain financial calculations based on group prices. When separating the target from the group, volume discounts and kickbacks for licenses and IT operations may no longer be available in the future. Years of postponed investments can significantly increase the capital requirements in the short term and must be identified early. Additionally, it must be checked whether maintenance, license, and warranty contracts with software and hardware manufacturers will transfer to the target or need to be renegotiated. Caution is advised with in-house developments that may remain with the seller and for which alternatives must be found.
● Streamlining processes and IT architecture for the FMO: The separation of a business unit from a group offers the opportunity to make processes leaner and more effective. The new stand-alone company can redefine workflows and thus eliminate legacy issues. The same applies to IT – unused software and hardware are eliminated, and the architecture is adapted to the current company situation and strategy. This often results in significant cost reductions in operational activities.
● Implementation of the investor’s goal in IT: To seamlessly integrate IT into the investment case alongside the Financial, Legal, and Tax workstreams, it is important to know the transaction structure, buyer strategy, and investment horizon precisely. Is it a share or asset deal? How will the number of employees change? Is the target a short-term or long-term investment?
At signing, the buyer and seller sign the purchase agreement (Sales and Purchase Agreement) for the target. With the transfer of assets (Closing), the next phase begins for IT – unless pre-closing activities are planned, such as preliminary migrations.
Approach during the Due Diligence process
Phase 2 of IT Due Diligence: Intermediate Mode of Operation (IMO)
Based on the findings of the IT Due Diligence, we develop a proposal for the scope of TSA services, in which the target continues to have access to the seller’s IT systems. This transition phase is usually set at three to twelve months; in exceptional cases for multinational targets with complex Enterprise Resource Planning (ERP) systems, up to 36 months can be agreed upon. The IT Carve-Out should not cause any interruption to ongoing business operations.
Based on the planned management of the target, IT legacy systems are sorted out and new systems are flexibly set up according to the investor’s vision. If the existing IT systems consist of outdated software and hardware that is no longer supported by the manufacturer or unsuitable for the investor’s new corporate strategy, a new comprehensive solution is prepared. The separation of IT systems can be carried out using a big bang, iterative, or hybrid approach, depending on requirements and methodology. If the target is not intended to operate as a standalone company but is part of a platform acquisition, we examine compatibility with existing portfolio companies and extend the cost outlook and IT business plan to include the merger of IT systems, also known as Post Merger Integration (PMI). Since the buyer incurs monthly costs for both the ramp-up of future IT systems and TSA services, they have a great interest in keeping the duration of this financial double burden as short as possible.
Phase 3 of IT Due Diligence: Future Mode of Operation (FMO)
With the expiration of the TSA phase, the IT separation project also ends, and the newly implemented IT system operates flawlessly and cost-optimized. The scope of IT services can be flexibly adjusted if needed. To achieve this goal, our IT Due Diligence report presents the FMO as precisely as possible and evaluates the associated opportunities and risks of the Carve-Out.
This information is included in the IT Due Diligence report:
- Overview of the general transaction structure with a focus on IT
- Summary of the current situation as a starting point for later carve-out planning, e.g., divided into infrastructure, non-ERP, and ERP. If the target is to be subsequently integrated into another company, the carve-in must also be considered.
- Planning of the required effort for IT separation and standalone operation
- Assessment of project complexity, especially dependencies of IT systems
- Recommendation for the duration and scope of the TSA
- Cost outlook for investment, operating, TSA, and project costs for CMO and FMO
Furthermore, it is crucial to incorporate the investor’s motivation and planned approach for increasing the target’s value into the IT due diligence. Should the target be fundamentally restructured, integrated into an existing portfolio company, or grow as quickly as possible under its own power?
digatus as an Experienced Provider for IT Due Diligences
In summary, it can be stated that an IT due diligence provides valuable insights for the purchase decision, price negotiation, and post-merger integration. In the shortest time possible, the buyer thus has a reliable statement about the current IT health status of the target and knows what efforts and costs are associated with the IT carve-out. The IT due diligence adapts to the transaction structure of the deal and offers a technical as well as economic examination of the IT. The recommendations for IMO and FMO are based on the investor strategy with the goal of process optimization and cost savings.
Christoph Pscherer
He has been working in the IT environment for almost 30 years, gaining experience in various roles and areas. Through his years of experience as a Service Manager, he knows the challenges and needs on the customer side. He has been applying this deep understanding and knowledge at digatus for more than eight years. As Head of BU IT M&A and Transformation, he and his team support all IT topics along the value chain of M&A projects. This includes due diligence, carve-out, and integration projects.
