Transcript DUE DILIGENCE

DUE DILIGENCE
CA. Rajkumar S Adukia
B.Com(Hons.) FCA, ACS,MBA, AICWA,
LLB ,Dip In IFRS(UK)
[email protected]
www.carajkumarradukia.com
9820061049/9323061049
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DUE DILIGENCE
CONCEPT
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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.”
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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 brokersdealers 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 & Risk
Profitability /Performance Ratios
ROCE vis-à-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 Memorandum
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 back
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-à-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
Historical focus
Historical and
futuristic focus
Focus
STATUTORY AUDIT & DUE DILIGENCE REPORT
(DDR) –A COMPARISON
Statutory Audit
DDR
Appointment
Appointed by the
company
Appointed by either the
buyer or the seller
Attitude
Watch-Dog
Investigator
Emphasis
True & Fair
Commercial Aspects
Issues concerning
Term sheet
TRADITIONAL V/S VIRTUAL DATA ROOM
 Traditional Due Diligence Data
Room – Data is available in a
lawyer’s 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
lawyer’s 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 lawyer’s 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
lawyer’s office. You can restrict who sees what documents and who can
copy what documents.
TRADITIONAL V/S VIRTUAL DATA ROOM
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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.
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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.
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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.
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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 seller’s business unduly.
 Timing is critical. It is best to work out some type of planned schedule in advance so
everyone’s expectations are met and we do not have disagreements or unnecessary
delays.
 It includes:
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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.
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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 – intracorporate 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
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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:
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The management team’s 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
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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)
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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
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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,
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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:
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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 party’s
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 team’s 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)