Value destruction in M&A is predictable — and preventable
Studies of M&A outcomes consistently find that a significant proportion of acquisitions fail to deliver the value anticipated at the time of signing. The reasons vary integration difficulties, cultural friction, market changes but a recurring theme in Indian mid-market M&A is financial due diligence that did not adequately surface the risks that materialised post-close.
Financial due diligence is not just about verifying that the accounts are accurate. It is about understanding the quality of the earnings, the structure of the working capital, the contingent liabilities that are not yet on the balance sheet, and the financial management capability that will be required to run the acquired business once integration begins.
When these questions are answered inadequately before close, the answers arrive after close usually in the form of cash shortfalls, unexpected liabilities, or earnings that look very different from what the valuation model assumed.
The five due diligence gaps that appear most often
Gap 1: Normalised earnings are not properly identified
The most common due diligence gap is failure to properly identify and normalise the earnings of the target business. Private company accounts often include expenses that benefit the owner personally management fees paid to owner-controlled entities, salaries for family members in nominal roles, personal expenses that run through the business. These inflate the cost base and depress reported profitability.
Conversely, private businesses may have one-time revenues or cost savings that are not representative of the ongoing business. A large contract that has since been lost. A cost reduction that cannot be sustained. Due diligence needs to identify these items and present the normalised earnings that reflect the business the buyer is actually acquiring.
Buyers who pay a multiple of reported EBITDA without normalising the earnings often find that the business they acquired earns less than the business they valued.
Gap 2: Working capital is evaluated at a point in time rather than cyclically
Working capital — the difference between current assets and current liabilities — varies through a business cycle. A retail business has very different working capital at the end of a season than at the start of one. A construction business has different working capital when projects are at completion than when they are in early stages.
Evaluating working capital at the balance sheet date without understanding the cycle can lead buyers to either overpay (if they acquire at a high-workingcapital point and assume that is normal) or be caught short (if they acquire at a low-working-capital point and then need to fund the cycle).
Proper working capital due diligence analyses the trailing 12–18 months of working capital movement, identifies seasonality and patterns, and establishes a normalised working capital expectation that can be incorporated into the completion accounts mechanism.
Gap 3: Contingent liabilities are not systematically identified
Contingent liabilities — obligations that exist but are not yet certain in timing or amount — are the most dangerous financial due diligence gap. They do not appear on the balance sheet. They may not be disclosed by the seller. And they can materialise as significant cash obligations after close.
Common sources of contingent liability in Indian mid-market acquisitions include: tax assessments in progress or likely given the company’s compliance history, pending litigation (including employment disputes, contract disputes, and regulatory proceedings), warranty and guarantee obligations, and environmental obligations where applicable.
Identifying contingent liabilities requires going beyond the financial statements reviewing correspondence with tax authorities, reviewing legal proceedings, and asking targeted questions about areas where obligations might exist.
Gap 4: Related-party transactions mask the real economics
Many private businesses have significant related-party transactions sales to or purchases from entities controlled by the owner, property leased from promoterowned entities, shared services with group companies. These transactions may be on commercial terms, or they may significantly affect the economics of the business.
A target that leases its premises from a promoter entity at below-market rent will look more profitable than it actually is. A target that receives management services from a promoter entity at above-market rates will look less profitable. Due diligence needs to identify all related-party transactions and assess whether the terms are arm’s length and what the economics look like if those transactions normalise after the acquisition.
Gap 5: Integration financial requirements are not assessed
Due diligence that focuses only on the historical performance of the target does not address the financial requirements of integration. What systems investment is required? What management capability needs to be added or replaced? What is the cost of restructuring the workforce if integration requires rationalisation?
These questions are part of the due diligence process not because they affect the valuation of the business as it currently stands, but because they affect the total cost of the acquisition and the realistic return on the investment.
What good financial due diligence actually produces
The output of properly conducted financial due diligence is not just a report of what the accounts say. It is a clear picture of: what the business actually earns (normalised), what it requires to run (working capital, capital expenditure), what obligations it carries (contingent liabilities), and what it will cost to integrate and develop it (integration requirements).
With that picture, the buyer can make a genuinely informed pricing and structuring decision not one based on the accounts as presented.
