Due diligence is a complex and costly process, but if your proposed acquisition turns out to be a lemon, you will regret skimping on it. Mark Thompson explains why
Due diligence is increasingly becoming one of the most critical aspects of the acquisition process. Properly used, it is an essential instrument to enable decision makers to evaluate the benefits and risks of a proposed transaction.
Although the importance of due diligence in Europe has grown appreciably over the past decade, it has been a foundation of the American deal landscape for quite some time. The benefits of a properly constructed due diligence exercise, however, do not end with the completion of the deal itself. Due diligence and integration planning should go hand in hand to ensure a successful acquisition and a smooth transition to the new owners.
There are a number of factors that have contributed to the prominence of due diligence in transactions in recent years. Although some complain that the increased emphasis on due diligence is the result of the growing influence of the American style of transactions, there are, in fact, several factors that have contributed to its growth.
The increased scrutiny by shareholders, government entities, creditors and a variety of other constituencies that companies undergo when making acquisitions is a major contributing factor. This scrutiny is often justified. Recent surveys have demonstrated that over the last few years many acquisitions have had a negative impact on the acquiring company. The concern is that companies are making quick acquisition decisions in order to grow in size or prestige without understanding exactly what it is that they are buying or how the acquisition will be integrated into their existing businesses.
Not surprisingly, this issue is magnified further by the mounting liabilities that are commonly associated with acquisitions. In addition, as regulations increasingly expand to include successor liability in areas such as international trade, money laundering, the environment, and employment/benefits issues, acquisitive companies have been forced to examine their targets more closely. As a result, an acquiring company must be aware of the target company’s past problems, whether or not they have been corrected before the acquisition or will be corrected later by the acquirer, as they can potentially result in significant on-going liabilities.
The dominance of private equity funds in the acquisition market has also interestingly created a larger role for due diligence. Private equity funds have affected due diligence in their role as both sellers and buyers. As sellers, funds, particularly in Europe, have forced heightened due diligence because they have been increasingly able to get away with providing very limited claims protection to potential buyers.
Funds often try to structure their sell side transactions to mimic a public acquisition where there are no surviving warranties or indemnities. They are able to get away with providing limited recourse to buyers because, as the deal market has become more and more competitive with hotly contested auctions becoming the norm, sellers have been able to take advantage of very favourable deal terms. Although their principal argument for providing limited terms is that they cannot go back to their limited partners to cover indemnity claims, they are in reality taking advantage of an extremely buoyant deal market. Consequently, when buying a portfolio company from such a fund, the buyer must protect itself through diligence, because claims protection will be limited.
As buyers, private equity funds must be aware of every issue that can have an impact on cash flow. Since typical funds are reluctant to go back to their limited partners for more capital after an acquisition has closed, a fund does not have much room for liabilities that could cost more money than allowed for in their budgets. Even if a fund is covered by indemnification or claims protection in a transaction, they often cannot afford to find significant issues, post completion, that have an immediate negative impact on cash flow. In addition, as the credit markets start to tighten, diligence will become even more important as lenders will evaluate credit risks more carefully and acquirers must understand how the targets can cope with stronger debt covenants.
As those experienced in acquisitions know, due diligence is typically divided by function between the advisers and the acquiring company, often broken down to include business, financial, legal, accounting and tax. The acquiring company itself usually manages the business and financial diligence with assistance from investment bankers and legal and accounting. Legal due diligence is typically run by outside counsel with oversight by in-house counsel. Although sometimes run internally, accounting diligence is often handled by an outside accountancy firm. Lastly, tax is generally a mixture of outside accountants and legal advisers working together with in-house tax personnel.
“There are certain liabilities where indemnification cannot provide an adequate remedy
These major categories are often broken down further, with sub-specialists that advise on particular issues, often involving multiple outside advisers and firms. For example, environmental, employment and benefits issues frequently require specialist advice. On a cross-border transaction, this can often involve dozens of people and a handful of different organisations.
The result is that a complete diligence investigation can require input from a multitude of sources. Managing this matrix of individuals and advisers is the most important part of a due diligence investigation. To assist in coordination, it is helpful at the outset of a transaction to put together a due diligence plan and set of protocols that establish the lines of communication and working relationships among the participants.
When beginning to put together a due diligence exercise, the first step is to establish the goals and objectives of the investigation. Put simply, what information do the decision makers need to determine whether or not to proceed with the transaction, on what terms and at what price? Although there are many issues that are common to all diligence investigations, every company will have different sensitivities in a diligence exercise. This is often the case because various participants in the transactions may have been burned on particular issues in prior transactions.
It is important for the leaders of the due diligence exercise to understand these sensitivities early on in the process. For example, some companies are more sensitive than others to employment or labour issues, while others may be more focused on potential environmental or corruption liabilities. Surprisingly, this step of understanding particular sensitivities is frequently overlooked as advisers proceed with an ostensibly standard due diligence investigation without taking into consideration what their client really needs.
Although every company has specific sensitivities, there is an important distinction between strategic buyers and private equity funds. It is important not only for advisers to understand this difference, but sellers should be aware of it as well as it will help them prepare for and understand what to expect in the due diligence process.
As previously discussed, private equity funds are focused on cash flow and, consequently, the sources and uses of capital. Their financial models may not contain much leeway to deal with potential liabilities, even if they are ultimately indemnified down the road. As a result, it is critical for them to understand any issues that could have a negative impact on cash flow, prior to completion. This enables funds to build such contingencies into their financing models as well as ensure that they will have the flexibility to deal with such issues under their debt covenants without the need to request any waivers.
Although strategic buyers are similarly concerned about potential liabilities and the impact that they could have on financial returns, they are typically more concerned about identifying issues that impact on the longer term success of integrating the target business. For a strategic buyer, problems with integrating an acquisition can be more costly, with less potential for redress, than potential short term or one time liabilities in the target.
In addition to establishing the goals and objectives of the due diligence investigation, the chain of command for reporting the findings must be effectively and efficiently organised. Regardless of how effective the diligence team has been in gathering information, if the results of the diligence do not reach the appropriate individuals, the entire effort may have been wasted.
“Many acquisitions have had a negative impact on the acquiring company
The larger the diligence project, the bigger a problem this coordination can be. It can be particularly problematic in large, cross-border transactions with multiple advisers in a variety of disciplines. A well organised diligence team will develop at the outset a set of protocols or guidelines that establish the reporting chain as well as the timing and format of the reports.
Diligence reporting should be well organised and include an executive summary setting out the important issues in an easy to follow format. The process should be set up to bring significant issues to the attention of the decision makers in real time so that they do not get delayed or lost in the preparation of the final diligence report. The reporting process can vary depending on the sophistication of the acquiring company, as well as their technological aptitude. For example, some diligence reports are done entirely on an online, internet based system, while others rely on physical diligence reports supplemented by telephone conversations and e-mail. There is no one right way to do it, and any method can be successful as long as the information gets into the correct hands.
The integration team should work closely with the diligence team in creating a diligence report so that it can be useful post completion. The integration process will run more smoothly if the integration planners have access to the diligence before the closing. If the integration and diligence are not done in a coordinated manner, diligence will often be duplicated after completion and valuable time will be lost in the integration process. Not surprisingly, this sounds easier than it actually is in practice. While some companies are good at integration on their own, many companies look to their advisers for assistance in this area.
In order to reduce the scope of a diligence exercise or the intrusiveness on the target, it is sometimes suggested that due diligence can be eliminated by protecting the acquirer with warranties or indemnity protection. Even when a seller is willing to offer such protection, it is an extremely risky alternative.
The obvious risk created by such approach is that due diligence can turn up liabilities or issues that could cause the acquirer to walk away from the deal or, more commonly, alter the pricing. In addition, diligence is important to the process of drafting the acquisition agreement. It is frequently the case that the most important representations, warranties and indemnities are specifically crafted to deal with issues uncovered during due diligence. Simply stated, if you do not know what is out there, it is difficult to protect yourself effectively.
Further, there are certain liabilities where indemnification cannot provide an adequate remedy, particularly if market caps and limitations are applied. For example, indemnification may not be able to cover fully damages or loss of potential income arising from the failure to identify restrictive covenants affecting the target.
Diligence is also very important in identifying areas where successor liability may be an issue. For example, when a US company is the acquirer, liabilities from violations of the Foreign Corrupt Practices Act by the target company, or parties contracting with the target company, can pass through to the acquiring company, even if such illegal activities cease after completion. Similarly, liabilities relating to issues such as money laundering, the environment, and pensions raise important successor liability issues that should be addressed by diligence.
One of the biggest risks of relying solely on warranty and indemnity protection is the practical matter of the credit worthiness of the party providing the coverage. Protections can be neutralised because the party providing the protection is effectively judgment proof. This is particularly true if the vendor is an individual.
On many transactions, the safe approach is to consider any individual seller as being ‘judgment proof’. Even if the acquirer is able to obtain a judgment or arbitration award, such actions can take significant time and expense and, particularly in cross-border transactions, can be hard to enforce.
“What information do the decision makers need?
Insurance can be useful in mitigating these types of risks, but is not, however, a substitute for due diligence. In many cases insurance is extremely helpful, particularly if there is a gap between the acquirer and vendor in the cap on claims protection. The insurer will, however, want to conduct its own diligence investigation and often review or rely on the acquirer’s diligence report. It is unlikely that an acquirer would receive a reasonable insurance policy proposal unless the acquirer has already gone through a complete due diligence process.
Although insurance is good at bridging gaps between the parties, it is important when using insurance in a transaction to review carefully the exclusions to the policy. It can be the case that the very risks about which the acquirer is concerned may be excluded from the policy. In our experience, insurance can be most effective when employed in conjunction with diligence to cover specific risks uncovered in the due diligence process.
Knowing about the business
The final argument for doing diligence as opposed to relying on contractual protections comes down to knowledge. Due diligence provides the acquirer with the opportunity to learn everything there is to know about the target’s business before completion, and it is often the case that the buyer knows more about the target than the seller. Whether the target is a stand-alone acquisition or will be integrated into a larger organisation, the acquirer will know what to expect after completion and get the business running more quickly.
It is important that the decision makers learn the results of the diligence investigation promptly and that all of the data provided by the vendor has been thoroughly analysed. In addition to being necessary for effective decision making, it is also important because it is possible for certain contractual protections to be voided if the acquiring company knew about a problem or a breach of a warranty before the execution of the purchase agreement.
In some jurisdictions, courts will not enforce contractual provisions allowing for a recovery of damages if the acquirer either knew about the problem before it committed itself to the transaction or, in some cases, if it should have known, based on the information provided by the other side. The theory is that if the acquirer had such knowledge before executing the agreement, it could not have relied on the violated warranty when it set the purchase price and proceeded with the transaction. In light of this, in addition to ensuring that the flow of information works smoothly, it is important from the acquirer’s perspective to include language in the purchase agreement that limits its knowledge in some manner or identifies the universe of information about which it will be accountable.
Knowledge limitations can take a variety of forms. On one end of the spectrum, the purchase agreement can provide that all information provided to the acquirer, or otherwise obtained or discovered by the acquirer, during diligence is held against the acquirer. Referred to as ‘anti-sandbagging’ provisions, some agreements include a provision that states that anything the acquirer learned prior to signing cannot be used as the subject of a claim or to prevent completion. An the other end of the spectrum, some purchase agreements state that the only knowledge an acquirer is deemed to have is included in the purchase agreement itself and the disclosure letter or schedules. Although in some jurisdictions it is questionable as to the enforceability of such provisions, these provisions provide the most protection for the purchaser.
A common compromise often limits the universe of information about which the acquirer is accountable, but also requires the acquirer to warrant that it has no actual knowledge of facts that amount to a breach of warranty or create a claim. Regardless of the language of the purchase agreement, however, acquirers should be aware that, unless known problems are specifically addressed in an indemnity, courts in a number of jurisdictions have held that knowledge of a potential liability prior to execution of the purchase agreement can prevent a successful claim, or potentially limit recovery, if such liability turns out to be a breach of a warranty. As a result, it is important for the diligence team to work with the negotiating team to ensure that everyone understands the implications of the diligence investigation and how it relates to the purchase agreement.
Due diligence is an important component of both the acquisition and integration process. As its importance has grown, diligence can no longer simply be a box checking exercise. It has a very real and direct impact on the negotiation process and the purchase agreement itself.
Mark Thompson is a corporate partner in King & Spalding LLP’s London office, Tel: 020 7551 7525, E-mail: firstname.lastname@example.org