Due Diligence ('DD'), in simple terms, is a comprehensive audit of a corporate entity conducted in relation to a transaction to assess risks and confirm facts. It involves an in-depth investigation of the company's documents, including financial and legal documents, as well as its day-to-day operations. This exercise ensures that the interests of the investor are protected in the long run and facilitates the decision-making process.
1. Introduction
Mergers & Acquisitions ('M&A')1 are strategic business moves in which one or more business entities merge into an existing business entity or are acquired by another. These transactions can involve in-market or cross-border mergers. The assets and liabilities of the amalgamating company become those of the acquirer company or investor, therefore, M&A involves substantial investment and risks. Consequently, it becomes pertinent for the investing company to assess the risks and opportunities associated with the proposed transaction, to make an informed decision and protect itself from any adversities.
DD is a process through which an entity identifies, prevents, mitigates and accounts for how they address their actual and potential adverse impacts as an integral part of business decision-making and risk management systems2. It includes an analytical review of relevant documents to verify the accuracy of the information presented to investors. The goal of this exercise is to ensure that the involved parties have a clear understanding of the facts and circumstances surrounding the proposed transaction, minimising risks for investors and evaluating the overall viability of the business. Therefore, DD resolves the need for checks required in the M&A transaction.
2. Types of DD
As mentioned above, DD is conducted to evaluate the overall viability of an entity, prior to an investment decision. Such evaluation involves the investigation of various aspects of a business. We have identified 4 major types of DD, as mentioned below. However, the list is not exhaustive, and other types of DD may be identified in relation to an M&A Transaction.
2.1. Financial DD – Financial DD It is the thorough examination of financial, commercial, and operational assumptions being made. Financial DD aims to verify the accuracy of information provided by the amalgamating company to assess its financial health and future performance. It involves the review of accounting policies, analysis of balance sheet, cash flows and their stability, actual and realisable value of the assets, potential liabilities, bank account statements, quality of earnings, financial projections, etc.
2.2. Tax DD – Tax DD is the analysis and review of tax compliance, transfer pricing, identification of tax contingencies and risk areas, tax planning, tax-related risks and review of opportunities. It also involves the analysis of tax liability arising out of the proposed transaction and the lapse of accumulated losses arising out of change in the structure of the company.
2.3. Legal DD – Legal DD is the analysis of legal aspects of the proposed merger. Legal DD includes litigation search of the amalgamating company with any third party, document verification, regulatory checklists, checks with regulatory authorities, etc. It involves checking compliance with the laws applicable to the business entity, including labour laws, environmental laws, etc.
It includes the analysis of agreements between the amalgamating company and its stakeholders, such as the relationship with its shareholders via analysis of the Shareholder's Agreements and the term sheets, analysis of agreements with creditors and debtors, and any other contractual relationship with any entity or person which may affect assets and liabilities of the company.
2.4. Commercial DD – Commercial DD, also known as Business DD, is the analysis of the business prospects and the quality of investment. It may be further divided into 6 parts:
2.4.1. Operational DD – Operational DD is the assessment of operations of the Amalgamating company i.e., the main business of the company. The operational efficiency and weaknesses are assessed to determine the viability of the operations. A company derives profits mainly from its operations, if the operations of the company are not sound, it may not be a good investment.
2.4.2. Strategic DD – Strategic DD is the assessment of the rationale behind the transaction i.e. whether the transaction is commercially viable. It analyses the future projections, the business plan, competitive position, value creation opportunities, etc.
If the transaction is not commercially viable, it may not be a good idea to go ahead with it. Therefore, strategic DD is necessary before proceeding with the transaction.
2.4.3. Intellectual Property ('IP') DD – IP is an asset in the hands of a corporate entity that can be exploited or sold. The scope of IP DD is to analyse the validity and title of the amalgamating company over the IP, the valuation and exploitation opportunities and to assess whether any infringement claim lies against the company.
2.4.4. Technology DD - Technology in today's world is a very important tool, it helps the business with its positioning and can provide a competitive edge. Technology DD analyses the existing technology and the further investments that may be required.
2.4.5. Environmental DD – Environmental DD provides a thorough investigation of the current and potential environmental risks the target company may be facing. The legal aspects of environmental DD may be covered under Legal DD. Qualitative factors such as site review may be classified under the Commercial DD.
2.4.6. Human Resource DD – Human Resources are crucial for any organisation. Therefore, the acquirer may need to analyse the human resource and the factors surrounding the management of the talent i.e. the work culture of the amalgamating company, the issues and expectations of employees, the training and future growth of the employees and further hiring required, if any.
2.4.7. Information Security DD – Information Security DD analyses the risks associated with the security of data management of the target entity. Almost everything is stored online, even the trade secrets. Therefore, it becomes pertinent to analyse any associated risks and find the gaps between the technology adopted by the organisation.
2.4.8. Ethical DD – Ethical DD involves the analysis of the ethical standpoint of the target entity i.e. a non-financial risk. Ethical DD is a tool for reputation/goodwill management and analyses the reputation, governance, and ethical values of a company.
3. DD Procedure
DD is a procedure involving multiple steps such as:
3.1. Preparation – To start with the diligence process, the scope of the DD is required to be defined and the team is to be assembled. There may be a need for multiple industry experts, namely, lawyers, financial analysts, operational analysts, etc. Choosing a good team will determine the effectiveness of this exercise. Further, there may be a need to establish contractual relationships with the team engaged in this exercise, to safeguard the confidential information.
3.2. Data Collection – A repository of data is to be created which can be accessed by the team performing the DD exercise, a virtual data room may be created for this purpose. This may include legal, financial, and contractual documents of the amalgamating company.
3.3. Analysis – The legal and financial documents are required to be analysed for the processing of data collected in the previous steps. It includes the in-depth review of any document, such as, to assess the effect of any contract on the amalgamating company. Any document posing any risk may be flagged for the risk assessment in the next step.
3.4. Risk Assessment – The analysis of documents in the previous step, may uncover the risks associated with the proposed transaction and whether the risks can be dealt with. This allows the investor to assess, whether the risks are acceptable or pose a serious threat to their investment. The risks may be classified as red, yellow and green. Red stands for a risk, which would require immediate attention and may pose a threat to the investor. Yellow stands for a risk which may require attention but can be addressed and may not affect the proposed transaction. Green stands for a risk which does not require immediate attention and does not affect the investment decision.
3.5. Verification – The data provided by the amalgamating company is to be verified and cross-checked to authenticate its veracity. It involves the verification of the financial statements, legal documents, etc. to cross-check the true position of the target company. This exercise is crucial for an informed decision and to foster trust between both parties.
3.6. Report & Resolution – A Report is prepared based on data analysed and the assessment of risks in the above steps, namely the DD report. The report provides a comprehensive review of the legal, financial and operational health of the proposed M&A. Any future discussions and deliberations between the investor and the amalgamating company will be based on this report.
4. Conclusion
DD is a multifaceted process that requires a methodological approach. It plays a crucial role in helping investors make informed decisions. This necessary exercise acts as a shield against any potential pitfalls or adversities that may arise from an M&A transaction. As highlighted above, a DD report lays the groundwork for any future negotiations related to an investment. Thus, it can be concluded that DD is not merely a formality; it is the cornerstone of a responsible investment decision and has the potential to make or break a deal.
Footnotes
1. Ss.232, 233,244 of the Companies Act, 2013.
2. OECD Guidelines for Multinational Enterprises.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
