Preventing Pitfalls

The importance of Due Diligence in Mergers & Acquisitions

Publication
May 30, 2023

In the fast-paced realm of mergers & acquisitions (M&A), one crucial practice stands out as a beacon of success - due diligence exercises. The significance of these exercises cannot be overstated, as they not only increase the chances of a transaction’s success but also equip the parties with informed perspectives, revealing hidden weaknesses and untapped opportunities.

At its core, a due diligence exercise entails a meticulous review of a target company or target group, typically conducted by an independent third-party firm. This comprehensive analysis delves deep into the intricate workings of the business and its operations - unearthing weaknesses, key risks, and potential "red flags" that might otherwise remain hidden.

Such due diligence exercises can be conducted from either the buyer's or the vendor's perspective. In the former case, a buyer's due diligence may serve as a crucial opportunity to confirm information, validate expectations, and identify any potential defects. This empowers prospective buyers, fostering a sense of assurance and confidence in the proposed transaction. On the other hand, a vendor’s due diligence allows sellers to proactively address existing risks and weaknesses while offering potential buyers a level of trust. This comprehensive assessment of the target company's operations and risks sets the foundation for warranties and indemnities eventually included in binding agreements between the parties.

Typically, the due diligence process is initiated when both parties have reached a preliminary agreement but have yet to sign a binding contract, besides the standard non-disclosure agreement. It is often that at such a stage there would only be a Letter of Intent or a Memorandum of Understanding between the parties, mainly outlining the intent to proceed with the transaction.

Within the realm of M&A transactions, several key types of due diligence exercises come into play, each serving a distinct purpose. Let us shed light on some of the most critical forms:

Legal Due Diligence
Financial Due Diligence
Fiscal Due Diligence

Legal Due Diligence

A legal due diligence exercise assumes centre stage, focusing on all legal aspects surrounding the target company or target group. Its primary aim is to identify any significant legal risks that could potentially impact the transaction. By comprehensively examining the target company's relationships with stakeholders, contractual obligations, and compliance with statutory requirements - a legal due diligence ensures a thorough understanding of the current state of affairs of the target company. Furthermore, it also assesses the consequences of the proposed transaction and highlights any necessary conditions precedent, including obtaining consent from relevant authorities and third parties.

The scope and depth of a legal due diligence exercise depend on the preferences of the parties involved and are tailored to the specific business operations of the target company or target group. Areas typically scrutinised during legal due diligence include corporate aspects, key contractual matters with third parties and related parties, financing arrangements, real estate holdings, data protection protocols, employment matters, ongoing litigation, and regulatory and licensing compliance, where applicable.

By engaging in this meticulous legal examination, legal practitioners ensure that all critical legal components are thoroughly analysed, risks are identified, and potential hurdles are navigated. Armed with this knowledge, lawyers can provide invaluable guidance and strategic advice to their clients, enabling them to make well-informed decisions and negotiate favourable terms during the M&A process.

Financial Due Diligence

Financial due diligence provides peace of mind to both corporate and financial investors, by analysing and validating the financial, commercial, operational and strategic assumptions being made. It uses past trading experience to form a view of the future earnings, key value drivers, and inherent risks in the business and confirms, to the extent possible, that there are no gaps and/or ’black holes'.

Buy-side due diligence is a full and thorough review of the target company that a buyer wants to acquire. In this instance, a buyer would need to get a full understanding of the target company and the situation it is in. Buy-side due diligence runs through all the key business areas of a company. Through this due diligence process one analyses and validates the key assumptions underlying a deal. This allows you to understand what you’re buying, modify your valuation, negotiate terms, structure the deal, and start to plan the integration post-deal.

On the other hand, when a company is being sold or is selling off one of its parts, it may also provide an independent in-depth report on its financial health to potential buyers. This is referred to as vendor due diligence and is a comprehensive assessment of the business to be sold, commissioned by the vendor at the beginning of the sale process, and it is addressed to potential purchasers.

Fiscal Due Diligence

Whether it is an acquisition and/or sale of shares or business, it is important to understand the tax risks associated with any such transaction, as these could be an important component of the deal-making.

The primary aim of a fiscal due diligence is to primarily, get an understanding of the existing tax structure and to identify any tax risks that could potentially impact the transaction.

During a fiscal due diligence, an advisor would typically look at (but not limited to):

significant business/company historical tax risks,
tax compliance history, which includes an understanding of the tax liabilities,
historical and/or current tax audits,
unutilised tax opportunities,
The foreign tax environment, where companies would have a presence in other countries

In an M&A transaction, understanding the impact of such tax risks is key as it would enable the buyer/seller to negotiate the terms and conditions of the transaction, and serve as a tool to ensure that proper representations and warranties are included in the sale and purchase agreement.