AWG's massive overpayment for Morrison holds out a vital lesson for companies on the acquisition trail: make sure you leave no piece of paper unturned when investigating the value of a business.
The passenger in the chauffeur-driven car parking beside the Laing construction site has not come to admire the view. It's Ray O'Rourke, chief executive of subcontractor O'Rourke, and he wants to know exactly what he is buying. So he is personally visiting every big Laing site to go through the contracts with a fine-tooth comb.

The need for such an exacting approach to eyeing up the value of the business – the process of due diligence – has been reinforced in the wake of the Morrison–AWG (formerly Anglian Water) debacle. It has transpired that the £263m the water company paid for the construction firm was too high. Earlier this month, AWG said that losses on six construction contracts had forced it to write more than £40m from the value of the group. This announcement prompted O'Rourke to double-check the accounts.

But assessing a construction company's true value is not so simple. How do you pin down the value of a project in progress? Are there any holes in past contracts that a buyer may become liable for 10 years down the line? In fact, the process of due diligence is so complex and costly – up to £1m – that it is seen as one of the main reasons why there have not been more industry mergers.

The expense of carrying out such a thorough investigation encourages some building companies to cut corners. But, as Garvis Snook, chief executive of property and construction company Rok Group, warns: "You can land yourself in very serious trouble if you don't understand the company you have bought."

Roger Feast, chief executive of contractor YJL, which bought fellow contractor Allen Group earlier this year, says he "wouldn't be able to sleep at night if we didn't go through due diligence properly and I didn't personally have involvement". For Feast, as for O'Rourke, the key to due diligence is a hands-on approach when checking operations. For him, this takes precedence over checking the accounting, legal and commercial features of a company.

Feast says that a team of QSs from YJL visited every site belonging to Allen, and that he personally looked at about 10 of the largest contracts because, "It's on site where the money in construction is either lost or made." He says: "Looking at a project gives you a real feel for the way a company does business. To get to know every brick would take months, but a general look tells you a lot. You soon get a feel for how good a project manager is."

John Morgan, chief executive of contractor Morgan Sindall, agrees that due diligence is a personal process, and it is one he always gets "thoroughly engrossed in". He makes an effort to talk to as many people from a selling company as possible. "I am interested in the heart and stomach of a company," he says. "To gauge this, one must consider the company's culture and its relationship with any holding company."

The people issue is crucial to Morgan because his focus is firmly centred on how Morgan Sindall will assimilate a company once the acquisition goes through. "This is something you should be bearing in mind at all times," he adds.

The other top priority in the due diligence process is to weigh the value of the seller's work-in-progress. This carries the highest risk factor for the buyer, because the jobs are not complete, yet it is where the bulk of a builder's assets are tied up. But measuring this value is notoriously difficult; Morgan describes it as "something of an art rather than a science".

Snook explains the problem: "For the valuation of individual contracts you are depending on the knowledge of individual QSs. It is up to you, through due diligence, to work out the underlying value of a contract." Snook, like Morgan, emphasises what a subjective task this is, because until you reach the final account of a project, you cannot know the absolute value; all you can do is project into the future.

For these reasons, Andrew Gay, former chairman of M&E engineer Drake & Scull, says that sellers will tend to inflate the value of work in progress, and this area is one of the key potential pitfalls for buyers. "It is very difficult to calculate the amount of risk on something like a complex PFI project. The amount of risk affects the value of a contract. The seller will take a more positive view on the amount of risk involved."

He also points to the efforts of some companies to "polish" their accounts by reorganising the ways the numbers are divided. But something even more difficult for the buyer to establish is whether the seller has accurately represented all the "facts" of a contract.

"Misrepresentation is harder to uncover than an inaccurate contract valuation," says Gay. "The classic example is that the seller reveals that it owes a subcontractor £100,000 now, but it might not reveal – or may not have recorded - that it owes another £50,000 in the future."

I wouldn’t be able to sleep at night if we didn’t go through the due diligence process properly and I didn’t personally have involvement

Roger Feast, chief executive, YJL

If there is any doubt about the facts or value of a contract, Gay says, the buyer should ask the seller for a warranty confirming that all the facts it has given are true to the best of its knowledge. If a problem later transpires, the seller's holding company has to cover the unexpected cost – or the company that is sold must have sufficient cash available to the buyer for it to handle any unforeseen liabilities.

The problem is that with the largest projects, if something goes wrong the holding company might not have sufficient funds to cover the buyer's costs. In this case, Gay says, "the buyer may be able to drastically lower the price of the company it wants to buy".

The warranties and guarantees given to a seller's clients throughout the years must also be considered. Andrew Pearson, director at project manager and QS Graves, oversees the due diligence process of construction companies.

"If you don't consider this, you could find yourself liable for projects completed years ago." Graves says that it can also be a telltale sign if the seller owes its creditors a lot of money, or is owed a lot of money itself – will it be able to collect it? "It's worth getting to know the seller's supply chain – as well as its main clients. They can tell you whether the company is a late payer."

George Marsh, assistant chief executive of Galliford Try, created last year with the merger of builder Galliford and the Try Group, agrees that payment and receipt are crucial. "The ultimate arbiter is always whether you are being paid for the job. It all goes back to the issue of work in progress."

Snook draws attention to the importance of looking at the insurance record of a company – for example, if it is insured against asbestos claims. The company's pension fund is crucial, too. "Pension funds have not performed so well on the stock exchange of late, so you have to be careful that the company is covered there," he says.

Due diligence is an enormous undertaking and potentially expensive. Consultancy Ernst & Young says its due diligence services cost between £25,000 and more than £1m to hire. Richard Smee, head of the consultant's real estate, hospitality and construction division, says that although its fees sound high, they are a fraction of the risks identified by the firm. Also, to do due diligence properly is a task requiring many people. "Around 50 or 60 people from our team worked on the Skanska and Kvaerner transaction last year, alongside Skanska's own people," says Smee. The team was large because it had only 30 days or so to go through Kvaerner's books. Smee says this is a standard period to carry out the assessment; due diligence begins immediately after the buyer and seller agree heads of term – the principles of the transaction.

Often, both the handshake agreement to merge or acquire and due diligence will be carried out privately. Smee says the reason for this is that if a buyer publicly goes through due diligence and then drops the acquisition plan, it loses face in the eyes of the City. "The City says to the buyer, 'You should have been aware of the problems in the seller', while the seller will not be happy that the buyer has seen all that sensitive information about it to no effect."

He adds: "The press is bad for both sides, so this is why companies carry out a 'desk-top study' before they make a move."

Morgan says he personally would not flinch from pulling out of a deal if due diligence indicated this to be the best policy. But he has not needed to do so yet.

In the wake of the doubts raised over AWG's due diligence process over Morrison, O'Rourke is clearly right to double-check Laing's books. But, at the end of the day, chief executives with years of experience say it is all about taking a magnifying glass to construction sites and measuring your gut reaction against what is happening there.

O’Rourke’s microscope

Laing has already lost millions on high-profile projects – including Cardiff’s Millennium Stadium and Number One Poultry – so it is understandable that O’Rourke is taking a microscope to its current projects. In an astute move, O’Rourke is brokering a deal whereby it gives John Laing, the parent company of Laing Construction, a £27m deposit, with the remainder of the sale price coming from a share of the construction division’s profits over the next three years. Sale negotiations so far seem to indicate that the risk of two projects is likely to stay with Laing rather than transfer to O’Rourke – namely, The National Physical Laboratory at Teddington, Middlesex, which is half-finished but could possibly make big losses, and the A130 road in London, anticipated to make a loss. It is also understood that Laing has offered £60m to O’Rourke to cover any outstanding creditors.

Spotlight on due diligence

Since a solid utilities company bought into what the City has traditionally perceived as the risky construction business, a spotlight has been cast on the issue of due diligence. It has transpired that AWG has suffered massive losses since it bought Morrison for around £270m last August. It used its own team to assess Morrison’s worth. Last month, in its first full-year accounts since the takeover, the utility had to admit that it had overestimated Morrison’s assets by £22m and had suffered £33.8m in losses from six of its construction contracts. AWG said that the losses only came to light after the deal had gone through. AWG’s lawyer, Herbert Smith, is now looking for ways to recoup some of the money.