DUE DILIGENCE

Prof.C.S.Balasubramaniam

CONCEPT
Its a proactive management tool.
Taking every reasonable precaution.
It is essentially an investigation to manage risks.
Systematic, structured research effort to
ascertain and accumulate facts necessary to
make an informed investment decision.
In common parlance, a care that a reasonable
person or organization exercises under specific
circumstances to avoid harm to themselves or
others.

DEFINITION AND MEANING OF DUE

DILIGENCE
A measure of prudence, activity, or assiduity, as is properly
expected from, and ordinarily exercised by, a reasonable and
prudent man under the particular circumstances.

Blacks Law Dictionary with Pronunciations, sixth edition 1994, p. 457

Due Diligence is a process of investigation undertaken by

various lenders including banks and financial institutions for
assessing the performance of business.
The process of investigation performed by investors into the
details of a potential investment such as examination of
operations and management and the verification of material
facts.

HISTORICAL BACKGROUND OF DUE

DILIGENCE
The term Due Diligence was first used under US
Securities Act, 1933 as Due Diligence Defence.
Due diligence defense is generally used by
brokers-dealers for inadequate disclosure to
investors.
Initially, Due Diligence was restricted to Initial
Public Offer (IPO) only but overtime Mergers
and Acquisitions etc. also found the place.
Due Diligence helps to get the realistic picture
of business today and tomorrow.

OBJECTIVES OF DUE DILIGENCE

To spot out the evils, which may invite some
unanticipated liabilities in future.
To forecast the future performance of an
organization by analyzing the potential risks
and threats.
To help in identifying liabilities, negotiate a lower
price, avoid lawsuits and costly mistakes and top of
all to make good business and financial decisions.

WHY DO YOU CONDUCT A DUE

DILIGENCE?
Essential to determine the hidden risks which are
attached to the transaction as it may result in the
transaction being aborted or affect the purchase
price or terms of the agreement.
Transactions involve substantial financial obligations.
The need for Due diligence is sought to unearth the
secrets which every business tend to have one.
Good Corporate Governance
DUE DILIGENCE

WHY - DUE DILIGENCE?

Investment
Risk Assessment

Negotiation
Valuation

Validate assumptions of Information

Memorandum
Understanding Investment Return & Ris
Profitability /Performance Ratios
ROCE vis--vis Cost of Capital
Cash Flow analysis

Identify
Potential Adjustments
Potential Risk/Exposures
Off balance sheet exposures

WHY - DUE DILIGENCE?

Identify

Shock Absorber

Information not presented

Legal Non-Compliances
Incorrect Representations/Information Memoran
Reduce Surprise from becoming Black holes
Red Flags
Identify

Deal Structuring/
Agreement

exclusions to be mentioned in
Final Agreement
Exclusions Ownership encumbrances
Shareholders Agreement
Contingent liability
Indemnity/Warranties
Identify structuring issues e.g. Lease & buy b

WHY - DUE DILIGENCE?

Enhance
Understanding

Identify Growth Drivers and USP

Analyze Present Key Business Drivers
Review bottlenecks
Strategy for future
Systems & Personnel - information

DUE DILIGENCE vis--vis AUDIT

Due Diligence is far beyond the
financial analysis. Audit is concerned
with the truth and fairness of historical
financial statements only.
Due Diligence can be conducted by any
of the professionals whereas Audit is to
be conducted mandatorily by the
Chartered Accountants.

STATUTORY AUDIT & DUE DILIGENCE

REPORT (DDR) A COMPARISON
Statutory Audit

DDR

Scope

Defined

Tailor Made

Legal
Requirement

Mandatory

Non-Mandatory

Focus

Historical focus

Historical and
futuristic focus

STATUTORY AUDIT & DUE DILIGENCE

REPORT (DDR) A COMPARISON
Statutory Audit

DDR

Appointed by the Appointed by either the

Appointment
buyer or the seller
company
Attitude

Watch-Dog

Emphasis

True & Fair

Investigator
Commercial Aspects
Issues concerning
Term sheet

TRADITIONAL V/S VIRTUAL DATA

ROOM
Traditional Due Diligence
Data Room Data is
available in a
lawyers
office or conference room
Virtual Due Diligence Data
Room Data is accessed
through the internet.

TRADITIONAL V/S VIRTUAL DATA

ROOM
Location - A traditional data room is usually located at a
nearby lawyers office to increase security. This also increases
costs. A Virtual data room is located on a secure server at a
third party data center.
Effort - Traditional data room will require the printing and
indexing of many electronic documents, financial spreadsheets
and contracts. While many paper documents must be scanned
to create the electronic images for a virtual data room all of the
electronic documents can be processed online.
Security - With a lawyers office the security is only as good as
the paralegal who is in the room taking care of the documents.
If implemented correctly a virtual data room can be more
secure than a lawyers office. You can restrict who sees what
documents and who can copy what documents.

TRADITIONAL V/S VIRTUAL DATA

ROOM

Cost - A Traditional data room is not as cheap as the Virtual data

room after you add up the labor to copy and index all the
documents plus the legal office space to manage a multi week
data room effort.

Record Activity In a Traditional data room you cannot record

who sees what document, wherein in a Virtual data room,
however, one can have daily reports of who viewed at which
documents.

Document Reviewers In a Virtual data room one can keep

track of who reviewed which documents, on the other hand such
an advantage is lacked in a traditional data room.

Lower Investor Risk There is less investor risk involved in the

case of a Virtual data room as compared to a Traditional data
room.

TRADITIONAL V/S VIRTUAL DATA

ROOM
Multiple Bidders - A Virtual data room by its
nature can allow all users to access the same
documents concurrently and in private.
New Info Distribution - Bidders will often submit
questions and request additional data. With a
Virtual data room is very easy to add new
documents to the data room and notify everyone of
its posting.
Restrict Access In a Virtual data room the access
to the information may be restricted to specific /
authorised people.

VARIOUS TYPES OF DUE

DILIGENCE
TYPES
BUSINESS
FINANCIAL
LEGAL
SECRETARIAL

BUSINESS DUE DILIGENCE

Business Due Diligence aims to ensure that the buyer gets all the
material facts required to make a fully informed decision and
assessment of the true condition of the business while not disrupting
the sellers business unduly.

Timing is critical. It is best to work out some type of planned schedule

in advance so everyones expectations are met and we do not have
disagreements or unnecessary delays.

It includes:
Operational due diligence
Strategic due diligence
Technical due diligence
Environmental due diligence
Human Resource due diligence

FINANCIAL DUE DILIGENCE

Financial
due
diligence
analyzes,
qualitatively
and
quantitatively, how an organization has performed financially
to get a sense of earnings on a normalized basis.

It includes:

Review of accounting policies

Review of internal audit procedures
The quality and sustainability of earnings and cash flow
The condition and value of assets, liabilities and potential
liabilities
Accounting systems and controls
Tax implications of deal structures
Examination of key operational processes
Examination of information systems to establish the reliability of
financial information

LEGAL DUE DILIGENCE

Legal Due Diligence is about the management

of risk.

The Legal Due Diligence covers two aspects

intra-corporate transactions and inter-corporate
transactions.

Legal Due Diligence investigations give the

most complete picture of a company.

LEGAL DUE DILIGENCE

The investigation or inspection would cover:

Compliance with local laws

Securities or other regulatory violations or disciplinary actions

Extensive litigation and/or bankruptcies assessment of

feasibility of pursuing litigation

Financial statements

Unpaid tax liens and/or judgments

Past business failures and related debt

Fraudulent or exaggerated credentials

Misrepresentations or character issues

Discoveries and disclosures

Assets real and intellectual property, brand value

Reputation and goodwill

Cross-border issues double taxation, foreign exchange

fluctuation, sovereign risk, investment climate, cultural
impact on human resources.

SECRETARIAL DUE DILIGENCE

Secretarial Due Diligence ensures that
the targeted company has duly complied
with the corporate laws and regulations
and other applicable provisions, if any.
It refers to the secretarial audit of the
company.

SELECTION OF A DUE DILIGENCE

CONSULTANT
Clarity of object
Size of the organisation
Key Concept to be kept in Mind

Avoid "Casual" Due Diligence Consultants

Consider an End-to-End Provider
Beware of Hidden Interest
Multi -Functional Expertise
Secure Long-Term Relationships with Your
Consultant

Selecting the Best Firm

DUE DILIGENCE

SELECTION OF A DUE DILIGENCE

CONSULTANT
Client base of the Consulting Agency
Meetings should be arranged
Terms & Conditions should be discussed before
hand
Consultant should be selected vigilantly

CRUCIAL FACTORS TO BE CONSIDERED WHILE

CONDUCTING DUE DILIGENCE

Be prepared with :
A detailed listing of the exact due
diligence steps to follow
A checklist of everything to complete in
each due diligence area
Specific due diligence tasks that need to
be completed
All of the materials you need from the
seller before you start

CRUCIAL FACTORS TO BE CONSIDERED WHILE

CONDUCTING DUE DILIGENCE
Allow yourself time
Information from vendors and customers
Analyse financial as well as following key factors:
The management teams past performance, roles and
talent
Organizational strategy and business plans
Risk management structure
Technological superiority
Adequacy of infrastructure

Internet Research

PROCESS OF CONDUCTING DUE

DILIGENCE
Planning

Preparation of Due
Diligence Report

Data Collation

Data Analysis

PLANNING
Scope and Core areas
Appointment
of
the
team
Skills/expertise
Clear and definite mandate
Defining the time schedules- how to deal
with challenges within agreed time frame
with available resources
Timely communication of information
requirements (Due Diligence Checklist)
28

DATA COLLATION
Research for data could be either
qualitative or quantitative
One on one interviews with management
from the target company
Data room and access to the room
Sources : Internet, Competitors, Industry
associations, Regulatory organizations
and databases which will include
searches of public registers, Customers,
Vendors etc.

DATA ANALYSIS
Understanding everything you can about the
company
It should be done keeping in mind the objectives
of Due Diligence
The analysis of due diligence findings is generally
a weighing of a variety of factors in order to
determine whether team should give a positive
recommendation
eg
:
business
criticality,
functional
complexity,
technical complexity,
infrastructure requirements etc.
DUE DILIGENCE

PREPARATION OF DUE DILIGENCE

REPORT
A summary of the scope of the review
A list of all the information disclosed by investigations
An analysis of the documentation and information
revealed
An executive summary which outlines the legal issues
identified and advises on the legal implications of
proceeding with the transaction (Risks and Liabilities)
Highlight the material issues arising from the due
diligence review and advice on the factors influencing
the price to be paid

ROLE OF PROFESSIONALS
INVOLVED IN DUE DILIGENCE

Professionals
involved in Due
Diligence
Company Secretaries
Chartered
Accountants
Cost Accountants
Advocates / Solicitors
Financial Analysts

Professionals should
have
Expert knowledge
Analytical
&
business
advisory
skills
Clarity of object
Confining to time
frame
and
deadlines

AREAS REQUIRING DUE

DILIGENCE
[A] MERGER, AMALGAMATION AND ACQUISITION

Due diligence is a comprehensive undertaking in cases of

potential mergers and amalgamation
Track record of the past as well as future prospects of the
company is required to know so as to identify the potential
growth of the company.
One should incorporate an element of objective self-analysis.
To complete the Due Diligence within a reasonable period of
time,
- either

outsource the Due Diligence task to a reputable research firm or

build an efficient in-house program within their legal, marketing, or
corporate security sectors.

A detailed assessment of the market and target of the proposed

acquisition should also be clear prior to closing a deal.

AREAS REQUIRING DUE

DILIGENCE
In
today's
fast-changing
business
environment, one should look into following
areas:

Financial
Research and Development
Intellectual Property
Material Agreements
Assets/Liens
Employment-related matters
Corporate Issues
Licensing and Litigation
DUE DILIGENCE

AREAS REQUIRING DUE

DILIGENCE
[B] PARTNERSHIP
One should conduct negotiations and investigation into
affairs of the entities before entering into partnership.
Different types of partnerships where due diligence
investigation is required to be done:
Strategic Alliances, Strategic Partnerships
Business Partners and Alliances, Partnering Agreements,
Technology and Product Licensing, Joint Development
Agreements, Technology Sharing and Cross Licensing
Agreements
Business
Partners,
Affiliates,
Franchisees
and
Franchisers.

AREAS REQUIRING DUE

DILIGENCE
[C] INTELLECTUAL PROPERTY
A detailed assessment of Intellectual Property (IP)
assets has become an increasingly integrated part.
Due diligence process involves investigation of a
partys ownership, right to use and right to stop
others from using the IP rights involved in sale or
merger.
Thorough internal assessment of its own assets can
enhance IP planning and management.
Acquiring or investing in a business that own IP
assets require the scope and depth of due diligence.

AREAS REQUIRING DUE

DILIGENCE
CORE AREAS OF IP:
(1) Significant patent issues
Scope of rights
Rights transferable
Issues raised by license agreements, other rights
transfer
agreements
Reviewing/evaluating all pending/threatened
infringement claims/enforcement opportunities etc.
(2) Significant copyright issues
Assignment and Registrations in Proper Order
Grants Effective
Rights Transferable

AREAS REQUIRING DUE

DILIGENCE
(3) Significant trademark issues
A list of all licenses, franchises, royalty
agreements, or similar
arrangements related to the target company
and/or products
Third party use
Policing/licensing

(4) Significant trade secret issues

(5) Significant domain name issues

AREAS REQUIRING DUE

DILIGENCE
[D]INITIAL PUBLIC OFFER (IPO)
Due Diligence plays a key role in an IPO.
Tool to optimize potential of the company,
thereby increasing its value to potential
investors.
Due Diligence is required to be conducted
by the Merchant Bankers.

AREAS REQUIRING DUE

DILIGENCE
Helps to identify any potential shortfalls in
Corporate Governance issues or financial
reporting procedures so that the company is
able to take corrective action prior to listing.
Pre-IPO Due Diligence process will result in a
gap analysis between the present status of
the company and the company that should
be floated.
It identifies the weaknesses and strengths of
the company.

AREAS REQUIRING DUE

DILIGENCE
Provides
comfort
in
preparing
a
prospectus
in
accordance
with
Securities Markets Act.
Allows the management and lead
manager to assess the reasonableness
of the statements made in the
prospectus as required by law.
Helps the lead manager to understand
the business of the corporation and the
main risks associated with it.

CAUTIONS
Sensitivity by seller / issuer access of
confidential data to investors, especially
when the latter are existing competitors.
Confidentiality
Agreements
:
Limited
disclosure to counter-party and its advisors
with an obligation to return data in case
deal falls through.

DUE DILIGENCE

BOTTLENECKS
Psychological Issues
Information Overload
Delay in reply to important queries divert
attention
Information provided in bulky format Hard copies
with unimportant details

Practical Commercial Issues

Financial & Accounting Scandals
Non financial angle to weak areas
DUE DILIGENCE

BOTTLENECKS
Disapproval from the company.
Outcome of the Due Diligence Process may be
consciously or unconsciously tainted by
owners, managers and researchers who stand
to benefit personally or professionally from the
proposed activity.
Due Diligence is a difficult and extensive
experience.
It is complex since more negatives may be
established or envisaged.
DUE DILIGENCE

CASE STUDY
A major US Company intended acquiring an independent BPO
Company in India. The BPO Company as per their claims had an
excellent line up of clients and credentials. They also claimed
large business activity in Singapore.
The US Company wanted the due diligence team to find out if the
acquisition candidate was indeed as sound as was made to
believe, before they began any discussions with them.
The teams investigations found that the BPO Company had
started performing well only in the recent past, and that they
were a group of companies and not one company, one of the
companies of the group which had the same set of Promoters and
Directors, had been sued against in the US for Product Liability.
DUE DILIGENCE

DD is a Mind-Game between Seller

and DD Team!!!

TIPS FOR EFFECTIVE DUE

DILIGENCE
Exhaustive list of requirements.
Look for contradictory information or replies.
Ask questions where the intentions / objectives are
disguised so that the replier cannot manipulate the reply.
Look at comments of Internal Audit Reports.
In case of resistance in providing information try to figure
out why the information is being withheld.
Track the time period within which the replies are provided.

TIPS FOR EFFECTIVE DUE

DILIGENCE
Is the tone of reply defensive or attacking.
Look at transaction post Letter of Intent (LOI) and pre
Due Diligence Report (DDR).
Look for deferment or expedition of transactions.
Review transactions with related parties and Transfer
Pricing Policy for group company transactions.
Scrutinize the legal and professional charges.

CONCLUSION

"Due Diligence" is simply a phrase used

to describe what are generally, business
investigations. It is commercial jargon
for the detailed analysis and risk review
of an impending commercial transaction.

Adequate Due Diligence helps the buyer

to
ascertain the current business
conditions
status on pending litigations
negotiation of purchase price
decide on the proposed investment

CONCLUSION

FOREWARNED IS
FOREARMED
CAVEAT EMPTOR
(LET THE BUYER BEWARE)