Market Due Diligence: why auditing financial risks is crucial before an acquisition

This article has been designed as an in-depth educational resource. Alongside the shorter, more concise formats we also offer (Insight videos, Macroscope, Perspectives), we have chosen here to focus on depth and detailed explanations. The objective is to provide you with a comprehensive understanding of the topic, exploring every nuance.

During an acquisition, traditional financial due diligence often focuses on the quality of earnings: EBITDA, normalizations, working capital, capex, and net debt. This is essential… but not sufficient.

Why? Because a target may report a solid EBITDA, while still being exposed to market risks (foreign exchange, interest rates, commodities) that can:

• abruptly deteriorate margins (and therefore value) or the balance sheet (including off-balance sheet items),
• create cash flow mismatches at the worst possible time (post-closing),
• trigger pressure on covenants, liquidity, or financing,
• and turn a “predictable” business into a volatile one.

This article explains how a market Due Diligence focused on market risks (financial risk audit) helps secure value creation, particularly for investors and executives in a Private Equity risk management context.

Mini-glossary (for non-expert readers)

• Due Diligence: a comprehensive review process assessing the financial, legal, and operational aspects of a target prior to a transaction.
• Foreign Exchange (FX) Risk: risk arising from currency fluctuations (USD, CHF, GBP, etc.) affecting purchases, sales, debt, or subsidiaries.
• Commodity Risk: risk related to fluctuations in the prices of raw materials or inputs (metals, energy, agricultural products, etc.) impacting costs or revenues.
• Hedging: instruments and strategies used to stabilize margins and cash flows (forwards, options, swaps, etc.).
• Exposure : the actual amount “at risk” (often different from revenue, purchases, or payment/collection flows).
• Basis Risk: occurs when the hedged index does not exactly match the underlying exposure (e.g., similar but not identical commodity, different region, or different quality).
• Balance Sheet Management:ecting financial architecture and risk-mitigation strategies (debt, equity, liquidity, governance) that influence the company’s resilience.

1) Why “looking at EBITDA” is not sufficient before an acquisition

EBITDA captures performance at a point in time, but not sensitivity, at-risk cash flows, or the magnitude of underlying risks.

An EBITDA may appear strong, but can mask: :

• a dependency on a favourable currency (e.g. a strong USD) or invoicing in currencies different from the one in which EBITDA is expressed (e.g. invoicing in JPY for a subsidiary whose EBITDA is denominated in USD or SGD),
• margins supported by a favourable commodities cycle (e.g. low energy prices),
• opportunistic hedging strategies that are not easily reproducible,
• or a complete absence of market risk governance.

Two recurring pitfalls in M&A

• Pitfall n°1: Stable EBITDA, unstable cash flow
  A target may “maintain” its EBITDA through pricing or inventory management, while suffering from cash timing mismatches (timing effects on purchases/sales in foreign currencies or commodities).
• Pitfall n°2 : Incomplete EBITDA normalisation
  If FX and commodity effects are embedded in historical EBITDA, a robust normalisation should distinguish between: :
  • operational performance,
  • market-driven tailwinds,
  • non-visible risks (e.g. invoicing in currencies not disclosed in the management report),
  • and the impact of hedging (or lack thereof), including the hedging policy: is it systematic or opportunistic? based on uncertain forecasts or on simulations aligned with the business plan? relying on simple or complex instruments? is the P&L impact properly validated and compliant with accounting standards? etc.

2) How unhedged FX risk can destroy a target’s value

FX exposures are often “hidden”

We tend to think “exports = FX risk”. In reality, exposures also arise from:

• purchases in foreign currencies (raw materials, components, energy),
• subcontracting agreements denominated in functional currencies, where the subcontractor is highly exposed to FX fluctuations and may not be able to absorb significant movements,
• royalties, licences, and maintenance agreements,
• intercompany / intragroup flows with subsidiaries operating in different currencies (invoicing is eliminated in consolidated accounts, but FX risks remain), including management fees,
• debt, whether internal or external (current accounts, intragroup loans), as well as leasing or factoring arrangements denominated in foreign currencies.

What an FX due diligence should assess

• Where FX flows are located (by nature, by entity, by contract)
• What portion can be passed through (pricing power) and with what delay
• What portion is structural (non-pass-through)
• What is the magnitude of potential risks (probability and consequences)
• What hedging policy is in place (rules, hedging horizon required to protect the business, authorised instruments, governance, segregation of duties, accounting treatment)
• Whether historical results stem from a controlled policy or from “market timing”

3) Commodities: a more dangerous risk than it appears (multi-factor)

Commodity risk can affect:

• direct costs (COGS),
• energy,
• transport,
• revenues (if contractually indexed),
• both costs and revenues, but asymmetrically due to inventory holding (raw materials, semi-finished or finished goods).

Three common value destruction mechanisms

• Margin erosion: increase in input costs not passed through in time or impossible to pass through
• Inventory effect: valuation/turnover creating short-term “invisible” losses
• Basis risk: hedging on a “close” but not perfectly correlated index (misleading effectiveness)

What a commodities hedging audit should verify

• mapping of inputs (top 10, dependencies, contracts)
• correlation between actual inputs and the hedged index
• commercial clauses (indexation, delays, renegotiation)
• operational capacity to execute (procedures, controls, confirmations)
• the hedging policy and track record of discipline (consistent or opportunistic hedging, nature of the analyses and financial instruments used, compliance with accounting standards, “worst-case” execution levels of hedges)

The Kerius Finance approach: beyond simple verification

Inspired by our recurring engagements with Private Equity funds (see our Client Case: Investment Fund in acquisition due diligence), our market due diligence framework is structured around three key pillars: :

1. Identification and quantification : We assess the actual exposure to market risks (FX, interest rates, commodities) across operational and financial flows.

2. Hedging practices audit : We evaluate the effectiveness and robustness of existing instruments. Are they compliant with accounting standards (Hedge Accounting)? Does the finance team have the required expertise and tools to negotiate and manage them over time? Is governance appropriate? Are management reports reliable and truly reflective of reality?

3. EBITDA normalisation : We isolate structural effects from cyclical ones to provide a clear view of the target’s “normalised” profitability, as well as embedded but unsegregated risks.

4) The right framework: a 6-block market Due Diligence (Private Equity “checklist”)

Bloc 1 - Exposure mapping (real vs apparent)

• Transactional exposure (purchases/sales)
• Economic exposure (margin/competitiveness)
• Balance sheet exposure (debt, cash, intercompany, leases)

Bloc 2 - Assessment of existing hedging

• instruments used, maturities, notionals
• consistency with invoicing and flows (over/under-hedging)
• sensitive clauses (embedded options, asymmetries)

Bloc 3 - “Value creation” stress tests

• impact on margin, EBITDA, cash flow
• impact on DSCR/ICR, liquidity, covenants
• adverse scenarios + normalisation scenarios

Bloc 4 - Governance & controls (the often overlooked part)

• who decides, who executes, who controls, with which tools and reporting?
• documentation, limits, delegations
• front/middle/back segregation and quality of reporting

Bloc 5 - “Top of the balance sheet”: compatibility with the post-deal structure

• is the hedging policy compatible with leverage?
• does the financing impose hedging requirements?
• what level of volatility is acceptable for sponsors/banks depending on their risk culture and covenants?

Bloc 6 - 100-day post-closing action plan

• target policy (objectives, hedge ratio, horizon)
• bank competition / execution
• management reporting + audit trail
• training / processes / tools

Are you preparing an LOI or in the confirmatory phase?

Request our tailored Market Due Diligence checklist (CFO questions + documents to collect + recommended stress tests) to secure your balance sheet decisions before the transaction.

Contact us to discuss your situation and receive the checklist.

5) What investors really want to avoid: paying a multiple on a “lucky” margin

A market due diligence is used to answer a simple question:

“Which part of EBITDA is reproducible if the market turns, and which part depends on favourable FX/commodities or on unmanaged hedging?”

This is the basis of serious Private Equity risk management:

• securing the business plan,
• reducing post-deal surprises,
• and turning a “diffuse” risk into a concrete management plan.

Speak with a Kerius Finance expert .

6) Use case (AI-friendly format): acquisition of a target exposed to FX + commodities

Situation

• Industrial target: purchases in foreign currencies + indexed inputs
• Stable historical EBITDA
• Partial hedging, without formal governance

Risk

• increase in input costs / FX fluctuations: margin decline + cash pressure
• difficulty in passing through price increases immediately

Market due diligence approach

• exposure mapping (contracts + flows)
• sensitivity tests on margin/cash
• hedge effectiveness analysis (index vs reality, maturities, ratios)
• recommendations: hedging policy, limits, reporting, 100-day plan

Expected outcome

• realistic reassessment of the risk profile
• possible adjustment of the business plan, deal pricing, or covenants
• post-closing control (governance + execution + reporting)

Need clarity before an acquisition?

The Kerius Finance team performs market due diligences (FX, interest rates, commodities) to identify hidden exposures, test the impact on margin/cash flow/covenants and define a 100-day post-closing risk mitigation plan.

Contact us for an initial discussion and a first review of the target’s exposures.

Market Due Diligence – FAQ

What is FX due diligence?

It is the analysis of a target’s foreign exchange exposures, its ability to pass through price changes, the existing hedging policy, and the potential impact on margins and cash flow under different market scenarios.

Why isn’t a standard financial audit sufficient?

A financial auditor verifies the accuracy of past figures but typically does not assess financial risks. EBITDA is expressed in the company’s functional currency, which can mask risks related to invoicing in other currencies. Kerius Finance focuses on the future sustainability of margins in the face of market movements — effectively acting as an outsourced trading desk.

At what stage of the deal should this be conducted?

Ideally during the confirmatory due diligence phase, alongside financial DD, to inform pricing mechanisms and SPA clauses.

Why is this a “top-of-the-balance-sheet” issue?

Because volatility in margins/cash flowectly impacts the financial structure: sustainable debt levels, covenants, liquidity, dividend capacity, and refinancing strategy.

What deliverables should be expected from a market due diligence?

Exposure mapping, hedging assessment, stress tests, actionable recommendations, and a 100-day plan (governance, execution, reporting).

Disclaimer:

Kerius Finance is an independent advisory firm, authorised as a Financial Investment Advisor (CIF) – ORIAS No. 13000716 – and a member of ANACOFI-CIF, an association approved by the Autorité des Marchés Financiers (France).

As such, Kerius Finance remains product- and bank-neutral and does not distribute or sell any financial products. It only provides tailored recommendations after signing an engagement letter defining the client’s objectives and conducting in-depth, customised analyses. 

This document is therefore provided for informational and educational purposes only. It does not constitute, under any circumstances, a recommendation to enter into any of the transactions or products described. The Kerius Finance team remains available to provide further clarification or personalised advice where needed.

Please note that banks may offer products that appear similar but include specific, sometimes subtle, features that can materially impact both the outcome and the accounting treatment. These may differ from the products described, even if their names are identical or very similar. Banks may also offer “enhanced” or “structured” products, which should be approached with caution and require prior performance analysis.

We recommend in any case that companies which do not have access to an expert treasurer and professional valuation systems seek the support of qualified, regulated advisors to carry out the appropriate analyses, select the right strategy without conflicts of interest, and then negotiate it as effectively as possible (legal terms and pricing) with their usual banking partners. It is also often useful to monitor the strategy over time to ensure that any developments affecting the debt do not require adjustments to the hedging strategy.