DUE DILIGENCE

Due diligence is basically a research in M&A and

it helps in the valuation process, arms length
price and other negotiation, test the accuracy in
representation and warranty contained in the
merger agreement, facilitates disclosure
requirements to investors, and augments
information to the planners of post merger
integration.
 CONCEPT
 It’s 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.”
 Black’s 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?

Validate assumptions of Information

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

Identify
Negotiation Potential Adjustments
Potential Risk/Exposures
Valuation Off balance sheet exposures
 WHY - DUE DILIGENCE?
IdentifyInformation not presented
Legal Non-Compliances

Shock Absorber Incorrect Representations/Information Mem

Reduce Surprise from becoming Black hole
Red Flags

Identify exclusions to be mentioned in

 Final Agreement
Deal Structuring/ Exclusions – Ownership encumbra
Shareholders Agreement
Agreement Contingent liability
Indemnity/Warranties
 Identify structuring issues – e.g. Leas
 WHY - DUE DILIGENCE?

Identify Growth Drivers and USP

Enhance Analyze Present Key Business Drivers
Review bottlenecks
Understanding Strategy for future
Systems & Personnel - information
SCOPE OF DUE DILIGENCE

Scope of Due Diligence varies depending upon

the kind of Transaction
Unlike a statutory audit, there is no defined
law / process by which the due
diligence has to be conducted, it has evolved
by practice and requirements of
the transaction
SCOPE OF DUE DILIGENCE

􀂾 Licences and Approvals

Contd.
􀂾 Properties – Owned and Leased
􀂾 Financial and Taxation records
􀂾 Exchange Control (FEMA aspects)
􀂾 Loans and Borrowings and Guarantees extended
􀂾 Investments
􀂾􀂾 Intellectual Properties
􀂾 Litigations
􀂾 Employees and Personnel
􀂾 Insurance Coverage
􀂾 Miscellaneous
A T i A. Typically, in a 100% acquisition of shares, Joint Ventures, Private Equity
Transactions, the following is the scope of coverage of the due diligence
exercise
􀂾 Background and business overview of the target company
􀂾 Constitutional Documents and Corporate Records
􀂾 Share Capital – Clear title of shares to be acquired
􀂾 Details of the directors, auditors and bankers
􀂾 Corporate Governance
􀂾 Details of Shareholders
􀂾 Agreements and Contracts
SCOPE OF DUE DILIGENCE

B. In case of an Asset acquisition / Business / Undertaking

acquisition

Contd.
In such acquisitions, the focus is the on Asset(s) Business
Undertaking to be acquired instead of the Company / its
shares
􀂾 Assets – their title and ownership
􀂾􀂾 Encumbrances on the assets
􀂾 Agreements and Contracts – related to assets
􀂾 Approvals with respect to the use of the assets
􀂾􀂾 Intellectual Property
􀂾 Litigation on the use and ownership of the assets
􀂾 Employee Matters, Trade Union and Labour
􀂾 Health, Safety and Environment Laws
􀂾 Insurance Coverage on assets
SCOPE OF DUE DILIGENCE

C. Specific caution in case of due diligence of a listed company

Contd.
􀂾 Confidentiality Agreement / Non-Disclosure Agreement is executed with the
parties involved in the transaction
􀂾 Standstill provisions to be agreed with various parties – restricting them from
dealing in shares of the listed company while in possession of unpublished price
sensitive information
􀂾 Generally, no disclosure to the stock exchanges when the due diligence is
undertaken
􀂾 Disclosure to stock exchanges when the transaction is finalised and executed
􀂾 Dissemination of confidential information to the exchanges before closing the
deal
SCOPE OF DUE DILIGENCE

D. FCA and Anti-Corruption Issues

Contd.
􀂾 Mostly required by MNC (US Companies) as significant portion of the due diligence
􀂾 FCPA allows for payments (speed money / facilitation payment) made to government
official for routine with requisite disclosures
􀂾 Prevention of Corruption Act, 1988 is stringent in India and prescribe for
imprisonment
and penalties for offences committed under the law . Does not permit any form of
payment, not even facilitation payment
􀂾 These payments are difficult to track – they are mostly unrecorded
􀂾 Even if tracked the reason for these payment informed that these payments are quite
prevalent
SCOPE OF DUE DILIGENCE

E. Specific and Industry Focused Areas of Diligence

Contd.
􀂾 Telecom
􀂾 Information Technology
􀂾 Export Oriented Units
􀂾 Healthcare
􀂾 Metals & Mining
􀂾 Insurance
VARIOUS TYPES OF DUE DILIGENCE

 There are various types of due

diligence processes performed in
structured ways, these are:

1. Financial
2. Legal
3. Tax
4. Environmental
5. Commercial
 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
Examination of existing contracts.

Identification of legal problem areas.

Clarification fo legal compensation
issues.
 Protection of persons and institutions.
 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.
 TAX DUE DILIGENCE
Development of optimum tax structure.

Asking about tax burdens or reliefs and

special taxes..
ENVIRONMENTAL DUE DILIGENCE

Environmental due diligence check the

followings:

Adherence to existing regulations and

approvals.
 Operational environment management
Ecological product risk.
 Insurance cover.
 COMMERCIAL DUE DILIGENCE

 Examination of future market position.

The organization of business process.

 The know-how of management and
employees.
Synergy effects.
 DUE DILIGENCE PROCESS
• Constituents of the Process
Two separate aspects of the due diligence process:
– Formal Process
Review and analysis of data provided in the form of documents review and
analysis based on interviews with representatives of the Target to get clarity on the
missing links
• – Informal Process
Significant information regarding the Target is obtained through discussions,
informal meetings with key persons of the Target
 PROCESS PRE DUE DILIGENCE
Agree with the Client on Scope and Timelines
PRE-Step-1
• Scope
- Areas to be covered
- Manner of maintenance and collection of data
- Final work product
◦ Due Diligence Report
◦ Only Executive Summary
◦ Comprehensive Bible with Executive Summary,
detailed report on all segments, data sheets
• Timelines
- Time within which the exercise is to be complete
 PROCESS PRE DUE DILIGENCE
Getting Ready
PRE-Step-2
• Obtain copies of Information Memorandum, MOU, draft transaction
documents, if any.
• Draw up your wish list / checklist for circulation to Target and team
• Circulate information, if any, about the transaction including
available documents to the team, divide up responsibilities
• Identify major issues concerning the transaction
• Set out process and expectations
 PROCESS PRE DUE DILIGENCE
Step-2
Getting Ready
• Pick the members of the Team based on expertise required for the various
components of the due diligence
• Assess whether you need any outside consultant / expert for any aspect, e.g. labor
related issues, real estate issues
• Make sure that the consultant has the same level of transaction overview as the rest
of the Team and understands the scope of his work clearly
• In case a Non-Disclosure Agreement is to be executed by the client ensure that the
consultant executes the same
• Read all documents circulated relating to the transaction very carefully
• Read up on industry and regulatory issues that may be relevant to the Transaction
• Identify specific issues that may be relevant
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)

30
 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
 TARGETS ROLL IN DUE
DILIGENCE
 The use of the data room, gate-keeping rule,
and other rules of conduct should be
established in a preliminary meeting between
the diligence leader of the buyer and target.
INFORMATION TECHNOLOGY AND DUE
DILIGENCE
The due diligence team must address the
following IT infrastructure of the target:
 Adequacy of management information
systems(MIS), measured I n terms of
comparison between system capacity of the
firm and the best practices in the industry.
 Effectiveness of target’s IT department.
 Assessment of the IT compatibilities
between the target and the buyer.
 Post-merger integration of target with buyer
IT infrastructure and capability.
DUE DILIGENCE IN CROSS-BORDER
DEALS
Due diligence in the setting of a cross-boarder
deal should primarily address the following:
 .Exposure of foreign currencies.
 Exposure to foreign laws and regulations.
Impact of cultural differences between buyer
and target organisations..
Business practices, which include hours of
operations, vacations, coppenansation and
benefits, relations with customers, suppliers,
and governments.
 Adequacy of management and monitoring of
foreign operatins..
 HUMAN RESOURCES AND
ORGANISATIONAL DUE DILIGENCE
 Hunan resources due diligence will often have great impact
on the long-term success of an M&A transition.

 The leadership of both companies needs to be examined,

because it is from the leaders of the companies that the
company policies emerge an this the culture is derived.

 Due diligence in respect of the target’s human resources

and target’s organization should address:
 .Availability of talent and leadership.
 Workforce problem.
 Compensation and benefits.
 Exposure to benefits claims.
 Compatibility of Organization and HR policies with
buyer.
 CULTURAL DUE DILIGENCE
 Culture includes a wide rang of social qualities such as the
following:

 Beliefs, sense of mission, val-ues, norms, traditions.

 How victories are celebrated.
 Physical layout (for example, open vs. closed offices)
 How conflicts get resolved (for example, consensus vs.
command)
 Leadership style (for example , team-based vs. lone ranger)
 Communication style (for example candor vs. diplomacy and
speed vs. deliberation)
 Interpersonal practices ( for example , formality vs.
informality), and so on.
 Due diligence research on the target’s culture should aim at
assessing congruence on the following dimension:
 The health of an organization.
 Culture arise in response to demand in the market.
 DUE DILIGENCE ON ETHICS
 Diligence with respect to ethics should focus
on:

 Compliance with existing policies and laws

related to ethics.

 Exposure to liabilities arising from ethical

issue such as price fixing., bofus accounting
discriminatory hiring, false advertising, slip
shod product safety testing, product
misrepresentation, or copyright violation.

 Compatibility of ethics policies with buyer.

 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.

 EXCELLENCE IN DUE
DILIGENCE
 It is emphasised that due diligence research should be
broadbased, and it requires qualities of leadership and
management at many levels of the due diligence team. At
the core of excellent diligence is a research mind-set that
includes the following qualities:

 Fact-based.
 Inquisitive.
 Knowledge focused
 System focused
 Initiative
 Take enough time
 Diversity
 Avoid surprises
 Write in all down.
ACQUISITION DUE DILIGENCE
CHECK LIST
 The checklist is exhaustive and is organized in three
sections:

 Business overview.
 Financial review.
Acquisition candidate information
 ACQUISITION DUE DILIGENCE
CHECK LIST
 Business overview.
 Company background and organisation.
* Obtained an understanding of management’s. This
includes :
- Company’s competitive advantage and any barriers to
competition.
- 3-5 year business plan.
- Overall financial strategies, criteria, and goal.
- Corporate development activities.
* Ascertain significant external events and
developments that a major impact on business.
* Identify any agreements that may limits the ability
of the company in a business. Or in a geographical area.
* History of the company including major transition.
 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