Due Diligence In M&A: A Detailed Overview – M&A/Private Equity

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.