Financial DDR

A company that is raising money shows itself at its best. Its Information Memorandum (IM) holds spoken or written claims and forecasts. These are meant to support the value it is asking for. Before an AIF pays that value, someone has to check that the numbers are true.

That check is the financial DDR. DDR stands for due diligence review, the investor's close check of a company. The workbook splits it into three parts: (a) business, commercial and technical DDR, (b) financial DDR and (c) legal DDR.

The financial part checks the company's books of account, its financial statements and its business deals. The workbook calls this "the entire gamut" of checks.

It has four aims. The first is to see whether the accounts give a true and fair view. The second is to test the accuracy of the claims (representations) made in the IM and other papers. The third is to find any material financial facts not disclosed. These are facts that could change the decision to invest or the agreed value. The fourth covers other, smaller (incidental) matters.

It covers so much ground that, in the workbook's words, "a financial DDR almost amounts to a financial review of the company".

When. Due diligence review "does not commence unless the term sheet is executed by both parties". The investee company then places detailed records in a virtual data room.

Who. Business and technical DDR is normally done by the investment team itself. Financial DDR "is usually carried out on behalf of the AIF's manager by an accounting firm or an investment bank engaged by such investor". Legal DDR is normally by a law firm. Compliance aspects may be covered under financial DDR or by a practising company secretary.

Scope.

• Verification of books of account, financial statements and business transactions.
• Usually carried out for the past three financial years at least.
• In many cases, vetting of the financial forecast represented in the IM and the consequent financial milestones.
• Tax matters, both direct and indirect — tax records, filings and assessments — to find potential threats that could lead to impending or future tax demands, including legal proceedings.

Output. Confidential reports to the investment manager. A copy of the DDR report is generally not made available to the company; an extract may be sent for clarification, or the manager may send a separate observation list for responses.

Consequences. Based on the report, the investment team refines its financial model into detailed revenue and cost drivers — price, volume, raw material costs, number of branches or customers, renewal rates, fixed versus variable costs. This can lead to renegotiation: revision in valuation or disclosure statements, and stronger representations and warranties from founders, shareholders or key management. The final term sheet, executed again, becomes the basis for legal documentation.

Illustrative figures. The information memorandum of Nagpur Agro Foods shows revenue of Rs 640 crore and EBITDA of Rs 70.4 crore (11%) for the latest year, and forecasts EBITDA of Rs 132 crore in four years. The accounting firm engaged by Deccan Consumer Fund II's manager reviews the last three financial years in the data room.

The forecast is also vetted: it assumes a new plant at 85% utilisation in its first full year, while the existing newest plant is at 58%. The firm resets that milestone.

At the same EV/EBITDA multiple the fund was working with, EBITDA of Rs 63 crore instead of Rs 70.4 crore implies a valuation about 10.5% lower. The final term sheet reflects that, and adds a specific indemnity from the promoters for the Rs 4.2 crore tax demand. The company never sees the full report — only the observation list.

Chapter 7 (Investment Process and Governance of Funds) sets out the three components of due diligence review at 7.2 and describes financial DDR in the most detail of the three. Expect questions on who normally performs it (an accounting firm or investment bank engaged on the manager's behalf), how many years it covers (at least three), whether it includes taxes (direct and indirect) and forecasts, and whether the report is shared with the company (generally not).

• At least the past three financial years — not one, not five.
• It covers both direct and indirect taxes. Tax exposure is part of financial DDR, not legal DDR.
• It can include vetting the IM's forecasts and financial milestones, not only historical accounts.
• Performed by an accounting firm or investment bank engaged by the manager — not by the AIF's own auditor, and not by the investment team, which normally handles business and technical DDR.
• The report is generally not given to the company. Extracts or an observation list may be.
• It starts only after the term sheet is executed by both parties.
• "DDR" here is due diligence on an investee company, performed by the manager — not the investor's due diligence on a fund in Chapter 8.