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This article answers the following questions:
- What is due diligence?
- What is examined in the course of due diligence?
- What are the differences between tax, legal, and commercial due diligence?
- What are the stages of due diligence?
Besides an investment agreement, due diligence is one of the most important investment processes in the acquisition of a target entity. A thorough and accurate analysis of an enterprise allows potential buyers to verify the declarations of the vendor, properly assess any potential risks, and, in the event of finding any deal breakers, withdraw from the transaction.
The definition of due diligence
"Diligence" means care. This care is necessary most of all when collecting and analysing the data or documents for the purpose of determining the actual status of the target.
The origins of the due diligence concept with respect to financial entities can be found in the American Securities Act of 1933. This law imposed on entities offering securities an obligation to provide true and accurate information to stakeholders.
Currently, the term due diligence is mainly associated with thorough analysis, to the greatest possible extent, the purpose of which is to equalise access to information between the seller and the vendor. The basis for due diligence is independence, impartiality, and expert knowledge of the persons working on such a project. Adhering to such requirements makes it less likely that any of the parties to the transaction challenges the findings of due diligence.
It should be remembered that due diligence forms only part of the entire investment process. Depending on how it is carried out, the stages of the process (and related documents) may differ. Nevertheless, it is common that a letter of interest (LOI) is executed before the start of due diligence.
Due diligence is typically the final stage of pre-transaction activities, and after its completion, the parties negotiate the final terms and enter into an investment agreement.
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The rules of due diligence
Due to the placement of due diligence in the transaction process and asymmetry in access to information, it is important to observe the following rules:
- The persons involved in the due diligence process should be independent and impartial. Such experts which are not related to any of the parties to the transaction will present an objective view of the target. As a result, the likelihood of challenging the findings of the examination by any of the parties will be greatly reduced.
- Due diligence should cover a long time horizon. In practice, at least three past years are analysed as part of the due diligence process. Such a timeframe makes it possible to examine the target's status prior to the commencement of potential transaction talks.
- All information disclosed in the due diligence process typically constitute the target's secret and should be protected. It is vitally important to execute an NDA and preserve data confidentiality, in particular in the case of targets operating in sectors which are considered as prone to breach of data, or if the potential investor and the target operate in the same industry.
Types of due diligence
Due to the high complexity of many aspects of a target's activity, it might be necessary to perform multifaceted due diligence. There are several types of due diligence which may be carried out depending on the analysed issue.
The most common type of due diligence. The purpose of financial due diligence is to analyse financial data, key performance indicators (KPI), and changes in the analysed items within the period covered by the examination. The results of this analysis are used as the basis for the valuation of the target for transaction purposes.
The purpose of tax due diligence is to measure all tax risks, estimating the amount and the degree of likelihood of such risks.
It is viewed by many experts as the most important type of due diligence. As part of legal due diligence, the analysis focuses on the target's activities from the legal point of view, the validity of contracts executed or resolutions adopted by the entity, the correctness of entries made into relevant registers, and all other legal aspects. Legal due diligence often involves the preparation of transaction documents, such as a share purchase agreement (SPA) or a preliminary share purchase agreement (Pre SPA).
It consists in the analysis of the target's position on the market on which it operates. As part of commercial due diligence, experts prepare the description of that market and of other entities operating on it. The extent of this type of due diligence depends on the potential buyer (strategic investors, as opposed to financial investors, usually operate in the same industry, therefore, they know the market and the target's position on it and do not require any additional analyses).
As part of environmental due diligence, experts assess if the target is in compliance with environmental protection regulations and check whether or not its activity poses environmental hazards.
Operational due diligence focuses on the operations of the target, its process management, and its control of emergency processes and procedures.
The purpose of technical due diligence is to describe and review the systems, technology, IT software, and other technological aspects of the target's operations.
Who performs due diligence?
Regardless of its type, those responsible for due diligence should have specialised knowledge in a given area. In addition, experts performing due diligence should be independent of the other participants in the process, so that the findings of due diligence are accepted as reliable by both parties to the transaction.
Furthermore, due to the fact that the deadlines for completing due diligence are typically very tight, it is required that the due diligence provider have an adequately large team which may be dedicated to a given project.
It is best to instruct an advisory services provider or a law firm to perform due diligence. Nevertheless, it is important that the selected entity knows the industry in which the target operates.
When performing operational or technical due diligence, it is recommended to seek support of specialists in a given field. A strategic investor should take advantage of its knowledge of a particular market and establish an internal due diligence team to coordinate, supervise, and even perform due diligence themselves in areas requiring the highest degree of specialisation.
The areas and scope of due diligence
It should be remembered that each due diligence process is unique, and its nature depends both on the target and the prospective buyer.
There might be not as many areas requiring examination with respect to a small enterprise or an investor operating in the same industry as there might be in the case of a large multinational group being acquired by a financial investor. Before starting their works, the due diligence team should identify the areas which require checking and set the timeframe for performing the analyses.
For teams comprising specialists from different advisory service providers and law firms, or various external experts in a given field, it is important for the investor to put together a team responsible for all the examined areas and for coordinating the works.
The stages of due diligence
After signing a letter of interest (or using a different method of confirming the intent), the investors can begin the due diligence phase. An important point of due diligence is to adequately plan the areas and scope of the examination. Next step is to prepare lists of required documents and deliver them to the teams responsible for the transaction on the target's part.
The documents delivered by the target should be reviewed with professional scepticism and verified against other sources. An important stage of due diligence is holding conversations with the management (management sessions) and with the heads of relevant departments (expert sessions) of the target. Due to the need to perform data analytics (and to find areas to discuss), these sessions are mostly held in the second half of the due diligence process. However, it should be noted that there is no rule concerning session dates, with the possibility of holding more than one meeting for a particular area – it all depends on the nature of the process.
The final stage of due diligence is presentation of the results of the analysis to the prospective investor. Here, the findings and computations included in the due diligence report as well as the observations and "soft" information which were obtained in the course of due diligence are presented. As mentioned above, the completion of all due diligence types just marks the beginning of further works on the transaction, such as negotiations of the conditions of the sale (including the price) and the closing of the transaction.
What forms can a due diligence report take?
The observations from and results of works performed as part of due diligence projects can be concluded in the following types of reports:
A red flag report is a summary report and is limited to the identification of risks / material issues existing in the target, along with the classification of particular risks. A risk can be quantified (if such a possibility exists) or annotated by means of colours (most commonly used are green, yellow, and red). The name red flag stems from the fact that the primary purpose of the report is to ascertain whether there are any warning signs against the planned transaction.
A full report is a report containing elements of a red flag report, extended to include analyses of certain aspects of company activities, appropriately to the type of due diligence. It is the most common report type, and it is the buyer who selects the team to carry out due diligence in this case. If there are multiple prospective buyers in the transaction, each of them organises their own team or teams to perform appropriate due diligence types.
Vendor due diligence refers to a situation where due diligence is commissioned by the vendor. In that case, instead of multiple teams working for multiple buyers, the target is examined by a single group of specialists. A report or reports on different types of due diligence compiled by this group contain a package of information delivered to prospective buyers. An advantage of such a solution is lesser involvement of the target's human resources, as one due diligence type is performed only once, as opposed to a situation in which several teams are involved in the same process, where one due diligence type is performed multiple times.
The main difference between a VDD and a full report is the fact that vendor due diligence must contain the analyses and description of all the issues which may be of interest to all buyers, regardless of whether those are strategic or financial investors. Therefore, as compared to a full report, a VDD report is more expanded and contains more analyses (e.g. of the market or the economic situation of the area of the target's operations). What is worth noting, however, is the fact that potential investors may prefer choosing a transaction advisor on their own, rather than using the services of one appointed by the target.
Covering due diligence costs
The amount of costs is influenced by many factors, with the major ones being the size of the target and the complexity level of the case. In addition, significant extension of the period of time of the analysis may also lead to price increase.
As a general rule, the costs of due diligence are incurred by the prospective buyer. This ensures that the advisors are independent of the examined target. However, there might be situations where the costs of due diligence are paid for by the target, for example, in the case of a vendor due diligence report.
Summary – What are the benefits of due diligence?
Due diligence allows for independent evaluation of a potential investment and assesses the risks present in the target or which may materialise in connection with the transaction. Furthermore, the analysis carried out by specialists makes it possible to confirm the accuracy of the declarations and data provided by the vendor at the beginning of the transaction. Lastly, the examination equalises the knowledge of the condition of the target between the vendor and the buyer, although it must be remembered that due diligence does not guarantee that all errors and risks will be detected.
Obviously, there are plenty of other benefits of cooperating with experienced advisors, with the possibility of tailoring each due diligence case to the individual needs of a given client. If you would like to learn more about our services and how we support our clients, feel free to contact our team – we are looking forward to answering all your questions.
