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IT Due Diligence for successful IT Carve-Outs with Private Equity Investors

Due to the deep anchoring of IT in all corporate divisions and business processes, a company acquisition without its precise consideration and adaptation is unthinkable nowadays. Accordingly, IT due diligence is becoming increasingly important alongside financial, legal and tax due diligence.

What is Due Diligence?

Due Diligence (DD) is the examination and evaluation of the target company in the context of a company acquisition, taking into account its financial, legal, tax and economic status quo. In addition to the “classic” due diligence of the potential buyer, in recent years sellers have also increasingly carried out vendor due diligences before the start of the sales process in order to identify and eliminate deal breakers at an early stage. In most cases, external consultants with specialist expertise use the documents provided by the seller to prepare an opportunity and risk assessment of the target company. The potential buyer can then prepare for contract negotiations on the basis of 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 subsequent 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 diligences for our private equity clients and subsequently develop an overall solution for the IT carve-out as well as future IT operations as a standalone company or platform acquisition.

First, we assess the current state of the target’s overall IT situation in order to evaluate which hardware and software is required for standalone operation. It is important to have a transparent IT organization and a detailed discussion of the IT processes to be implemented. In coordination with the planned corporate strategy of the new investor, a proposal is prepared as to which IT services will continue to be provided by the seller for the agreed transitional phase after the legal change of ownership (closing) and recorded in the so-called Transitional Service Agreement (TSA). If the time frame for the sales process is very short, we prepare a so-called Red Flag Report, which contains only the main “stumbling blocks”.

IT Due Diligence: The 3 phases of the technical process

The technical process from IT due diligence to IT carve-out to standalone operation or, in the case of platform acquisitions, to carve-in consists of three phases:
  1. Analysis of the current state: Current Mode of Operation (CMO)
  2. Definition of the transition state until the end of the TSA runtime: Intermediate Mode of Operation (IMO)
  3. Implementation of the target state: Future Mode of Operation (FMO)
A cost outlook of the IMO and FMO phases is also provided to the buyer in the IT due diligence. The total costs are divided into investments/one-off costs (capital expenses), such as the purchase of new hardware, and operating costs (operational expenses), such as monthly license costs or costs for managed services. The results of the IT due diligence flow into the IT carve-out project plan to be created when the investor purchases the target. This includes the required separation steps and their risk on a time axis. In addition, it shows relevant dependencies between the stakeholders of the project as well as the ramp-up of the new IT landscape and the ramp-down of the (TSA) services. Targets that have been adapted to comprehensive process specifications are often removed from corporations. We therefore offer our customers a fundamental redesign of the processes for the FMO in order to eliminate existing frictional losses and generate cost optimizations. The adapted IT can thus form the basis for restructuring projects and a realignment of the target and make a significant contribution to the rapid implementation of the change in strategy.

Phase 1 of IT Due Diligence: Current Mode of Operation (CMO)

Since at the time of the IT due diligence request by the investor it is still open whether he actually wants to buy the target, the review is initially limited to documents provided by the seller 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, and supplier documents. This initial analysis of the IT is then discussed with the investor and the open questions are clarified in a Q&A 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 are applied in 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. If the target is separated from the group, it may no longer be possible to take advantage of volume discounts and kickbacks for licenses and IT operations in the future. Investments that have been postponed for years can greatly increase capital requirements in the short term and must be identified at an early stage. In addition, it must be checked whether maintenance, license and warranty agreements with manufacturers of software and hardware will be transferred to the target or need to be renegotiated. Care must be taken with in-house developments, which may remain with the vendor and for which alternatives must be found.

Streamlining processes and IT architecture for FMO: Separating a part of a company 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 burdens. The same applies to IT – unused software and hardware is eliminated and the architecture is adapted to the current corporate situation and strategy. Significant cost reductions in operations are often achieved in this way.

Implementation of the investor’s goal in IT: To ensure that IT is seamlessly integrated into the investment case alongside the financial, legal and tax workstreams, it is important to have a precise understanding of the transaction structure, the buyer strategy and the investment horizon. 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 the signing, the buyer and seller sign the sales and purchase agreement for the target. With the asset transfer (closing), the next phase begins for IT – provided that no pre-closing activities are planned, such as upstream migrations.

Procedure in the course of 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 during which the target will continue to have access to the seller’s IT systems. This transition period is usually set at three to twelve months: in the case of multinational targets with complex enterprise resource planning (ERP) systems, up to 36 months can be agreed in exceptional cases. As far as possible, the IT carve-out should not trigger any interruption to business operations.

Based on the target’s planned management, legacy IT systems are sorted out and the new systems are flexibly set up according to the investor’s ideas. If the existing IT systems are outdated software and hardware that is no longer supported by the manufacturer or is unsuitable for the investor’s new corporate strategy, a new overall solution is prepared. Depending on the requirements and the process model, the separation of the IT systems can be carried out using a big bang, iterative or hybrid approach. If the target is not to operate as a standalone company, but is part of a platform acquisition, we check the compatibility with the existing portfolio companies and extend the cost outlook and IT business plan to include the merging of the IT systems, also known as post-merger integration (PMI). Since the buyer incurs monthly costs for both the ramp-up of the future IT systems and the TSA service, it has a strong interest in keeping the term of the financial double burden as short as possible.

Phase 3 of IT Due Diligence: Future Mode of Operation (FMO)

With the completion of the TSA phase, the IT separation project also ends and the newly implemented IT system works error-free and cost-optimized. The scope of the IT services can be flexibly adjusted as required. In order 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.

The IT Due Diligence Report contains this information:

  • 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 then to be integrated into another company, the carve-in must also be considered.
  • Planning of the effort required for the separation of IT and standalone operation
  • Evaluation of the complexity of the project, in particular dependencies of the IT systems
  • Recommendation for the duration and scope of the TSA
  • Cost Outlook of CAPEX, OPEX, TSA and Project Costs for CMO and FMO

It is also crucial to include the motivation of the investor and the planned approach to increasing the value of the target in the IT due diligence. Should the target be fundamentally restructured, integrated into an existing portfolio company or grow as quickly as possible on its own?

digatus as an experienced provider for IT due diligence

In summary, it can be said that an IT due diligence provides valuable insights for the purchase decision, price negotiations and post-merger integration. In a very short time, the buyer has a reliable statement about the current IT health status of the target and knows what effort and costs the IT carve-out is connected. The IT due diligence adapts to the transaction structure of the deal and offers a technical and economic examination of the IT. The recommendations for IMO and FMO are based on the investor strategy with the aim of process optimization and cost savings.

Christoph Pscherer

Christoph Pscherer
He has been working in the IT environment for almost 20 years, gaining experience in a wide variety of 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 over two years. As a project manager, his main focus is on IT M&A, where he mainly manages carve-out projects.


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