Buy Side Financial Due Diligence In Unaudited Turkish Small And Middle Sized Enterprises

How can you identify and manage the crucial issues? 

As in any emerging market, most of the small and middle sized enterprises (SMEs) in Turkey are yet to go through an independent audit. Most of the companies in Turkey are not obliged to be audited unless they are financial institutions, quoted on the Istanbul Stock Exchange or are over the threshold required by the new Turkish Commercial Code (TCC). Most of the independent audits in Turkey are carried out to comply with these obligations or for specific reasons such as;

i. voluntary independent audits requested by holding companies, multinational companies and/or joint venture partners,
ii. independent audits based on covenants of loan or shareholders agreements,
iii. independent audits based on specific situations such as an exit or an entry of a shareholder and IPO etc.

The recent amendments made in the new TCC have regulated the matter further, with the obligatory statutory audits of all joint stock companies. The details of this process are to be elaborated on in the coming days by the Ministry of Customs and Trade.

Whether or not this new regulation and its standards will satisfy a potential buyer in the future , there will always be a need for carrying out a buy side financial and tax due diligence to examine the historic unaudited financials of a target SME .

Like in many emerging markets a buy side approach may be driven by a fear of potential misrepresentations by target companies. In some cases this suspicion is rewarded with crucial findings during the due diligence stage and the necessary issues are addressed before any closing if any. And unfortunately in some cases in which a significant misrepresentation is discovered after the closing, we tend to see a commercially destructive process between the parties of the transaction.

In Turkey, we as transactional service providers include an increasing number of independent audit and fraud detection procedures in our due diligence work programs for identifying any misrepresentation in the historic and current financials of a target. These steps could be as simple as confirmation letters with customers and suppliers or more sophisticated approaches such as benchmark price research of the raw materials acquired by a target company.

If there are any misrepresented items in the financials of a target SME in Turkey, in general they can be based on two different goals;

i. deliberate misrepresentations made to create an advantage in terms of the Turkish GAAP (tax planning),
ii. deliberate misrepresentations made specifically to create an advantage during a M&A process.

The misrepresentations made to create an advantage in terms of Turkish GAAP are generally tax related and may include out of book salary payments, irrelevant expense items to make up for the overstated profit created due to these out of book payments, shifts between inventory and cost of goods sold and other issues to minimize profits. While carrying out due diligence work in such target companies we, as service providers, generally do not have too much difficulty in identifying such practices but rather focus the bulk of our work on the accurate quantification of any such misrepresentations as they may affect the valuation of the target company.

Where there are hints of specific structured misrepresentations made to maximize the historic profitability of the target company which would affect the valuation based on false historic financials, we exercise a hybrid approach while preparing our work programs. This hybrid approach may include audit procedures such as third party confirmation work with customers and suppliers to at least provide stronger hints of adjusted working capital levels, overstated sales and understated expenses. We may also include procedures such as the detailed examination of the capitalized investments of the company to understand if any of the spending capitalized on the balance sheet should have been expensed in the profit and loss of the relevant period. In some instances we are requested to widen our scope to carry out detailed work on these specific issues to be able to quantify them.

We, as Cerebra, believe that a customized buy side due diligence in an unaudited Turkish SMEs is a significant critical success factor in the whole acquisition process and we prepare our scope of financial and tax due diligence work accordingly. We also believe that a careful distinction should be made between the findings as some of them may be benign in the acquisition process whereas some of them may be deal breakers.