due diligence roadmap · 2016. 8. 11. · overview of session due diligence roadmap: • what is...

Due Diligence

Roadmap

James Hutton, Partner, Minter Ellison

Overview of session

Due diligence roadmap:

• What is due diligence and why do we do it

• Due diligence transaction dynamics

• Objectives of due diligence

• Due diligence perspectives

• Scoping and methodology (including materiality issues)

• Value added due diligence

Translating due diligence to the sale agreement:

• Due diligence and warranties

• Completion balance sheet adjustments

• Warranty and indemnity insurance

Mergers & Acquisitions

Introductory comments: transaction lifecycle


Approach

Due Diligence team of commercial,

legal, accounting and tax experts.

Develop an M&A strategy consistent with business direction and operational objectives

Identify acquisition candidates based on specific criteria to create value for the acquirer

Plan and manage the integration process to capture the anticipated synergy value

Execution

Close Announcement Pre-announcement

Phase 1

M&A Strategy

Phase 2 Target

Screening

Phase 3

Transaction Execution

Phase 4

Integration

Master the details of transaction execution, making effective use of transaction “experts” to incorporate accounting, tax, organizational and cultural fit into the financial picture

What is due diligence?

• A risk minimisation exercise described as:

– exercising reasonable care

– taking all reasonable precautions

• Acquisition due diligence: the process by which you establish that you are actually

getting what you think you are getting

• Vendor due diligence: the process designed to remove any surprises arising from the

transaction, and to minimise exposure to unappreciated risks


What is due diligence? (cont)

• The due diligence process involves:

– collating, investigating and reviewing legal, financial and operational data and material

– using appropriately skilled people to:

• carry out investigations, and

• confirm correct financial, commercial or legal position (eg profit results or good title to

assets) at appropriate level of materiality for that transaction

– identifying areas of risk/concern (eg capital requirements, customer relationships,

litigation or onerous contractual terms), and

– identifying appropriate management of target business post acquisition

• Independent investigation of independent source material

• Warning: garbage in, garbage out


Due diligence transaction dynamics:

public versus private M&A

Type Number of

Prospective

Purchasers

Who controls Due

Diligence

(typical)

Level of Due

Diligence

(typical)

Private M&A One Purchaser By agreement - formal

Private M&A More than one Target Fairly expansive.

Potential for Vendor

DD.

Public M&A

(Friendly – Scheme of

Arrangement or Merger)

One Target Fairly expansive.

Careful management

of price sensitive

information.

Public M&A

(Hostile)

More than one Target None. Target may

offer DD opportunities

to 3rd parties.


Typical auction sale process


Phase 2A DD – black box

Purchaser

determines price

and other offer

terms

Phase 1 DD -

preliminary

Vendor’s teaser

Vendor opens

data room to

bidders

Vendor’s

information

memorandum

Purchaser’s final

offer

No offer by

purchaser

Purchaser’s

indicative offer

Purchaser’s

initial binding

offer

Vendor shortlists

bidders

(2-3)

Purchaser’s

confirmed

binding offer

Vendor selects

preferred bidder

Purchaser’s

expression of

interest

Vendor and

purchaser – non

disclosure

agreement

Vendor and

purchaser -

transaction

documents

Phase 2 DD - sensitive

Objectives of due diligence

• Assess the merits of proposal (SWOT analysis)

• Identify appropriate structure for transaction

• Assess impact of regulatory issues

• Validate acquisition/sale price

• Assess target’s financial and operational position post transaction

• Eliminate surprises: find the skeletons in the closet

• Identify key issues for commercial deal:

– ‘deal breakers’

– allocation of risk, and

– key drivers


Due diligence perspectives

• Different levels of due diligence:

– not limited to ‘deal breakers’

– lesser problems can be resolved by:

• price adjustments

• revising commercial terms

• warranties and indemnities

• From purchaser’s perspective:

– warranties form part of due diligence

– reject argument that warranties should be a test of knowledge rather than a test of accuracy

and confirmation of value

• Due diligence is not a substitute for proper warranties and indemnities. They are

needed because comprehensiveness of investigations often shaped by information

made available by other side

• Warranties and indemnities are not a substitute for due diligence: look at collapses of

the 80’s, 90’s and today!


Scoping and methodology

First questions to ask:

• Why are we doing this – what sort of due diligence is this

• What are we buying – assets, shares, cashflow/leverage? – get the IM if available

• How is the deal to be structured and documented

• How are we buying – what are we paying with?

• Why are we buying?

• Everyone on the team must know the basis of the deal


Scoping and methodology (cont)

• Scoping ensures the investigations fit the circumstances and there is proper planning

• Main things required:

– knowledge of deal

– understanding of industry

– guides as to materiality

– teamwork

– common sense

• Reasons for proper scoping:

– adds value – ie concentrate on critical areas of enquiry

– reduces costs and removes inefficiencies



Materiality

• This is the key – there are judgment calls as to materiality that are taken by every

member of the due diligence team

• The materiality thresholds must be agreed and communicated to the team

• More than just a due diligence checklist

• Examples: impact on profit and loss; impact on balance sheet; length of agreements;

supply and customer agreements as percentage of costs or sales; etc



• Communication is one of the keys:

– must have interaction between all advisers and investigators

– share knowledge of potential risk areas (eg regulatory issues)

– need to institute policies and procedures which facilitate communication (eg contact

lists, email protocol, standard reporting formats etc)

– ideally all investigators and advisers should be involved in regular update meetings

and should exchange draft reports, and

– interim results of investigations must become known to appropriate executives

(especially negotiators of transaction documentation)


Case Study – Acquisition of Eco-Friendly

– Recycled Product Manufacturing Business

• Assembly of team

• Scope of due diligence enquiries

• Report issues

• Outcomes for the sale negotiation


Value added due diligence

• Warning bells! Be sensitised to:

– dependence on key executives (brains walk)

– reactions of other employees to the transaction

– reactions of customers to the transaction

– reactions of suppliers to the transaction

– who owns the assets

– prior ranking securities/encumbrances over assets

– regulatory impediments harming economics of deal

– poison pills

– litigation on foot

– environmental issues

– unanticipated tax exposures


Key messages

• Understand acquisition drivers

• Align due diligence activities to acquisition drivers:

– transaction vs integration

• Meaningful materiality criteria drives more useful investigations

• Ultimately due diligence informs valuation:

– filtered by remediation strategies and risk weightings

• Plan your process

• Use checklists/questionnaires and material issues papers

• Supervision is important

• What are the real risks

• Identify existing systems

• Formal documents should reflect due diligence


Translating

due diligence

to the sale

agreement

Due diligence and warranties

• Due diligence alerts you to problems before deal is signed

• Unsatisfactory due diligence results allow you to:

– renegotiate the deal, or

– decide against doing the deal

• Warranties provide comfort if represented state of affairs prove to be untrue but:

– warranties cannot put you in a position you would have been in had you known the

problem giving rise to the warranty claim before the deal was signed

– it is then too late to undo the deal (breaches of warranties after completion do not

permit you to terminate or unwind the deal)

– the value of warranties is limited to the creditworthiness of the other party

– it involves a drawn out legal bun fight with no certainty of outcome

– Warranties v indemnities – what’s the difference?

– ability to claim is often affected by knowledge from due diligence


Due diligence and warranties (cont)

• Warranties are part of the due diligence exercise

• Warranties are important to support value of due diligence because other party

usually provides most of the information reviewed as part of due diligence

• Key warranties are:

– full disclosure of all material information, and

– disclosed information is true, accurate and complete

• Consider the interrelationship of warranties – consider whether the protection

you want is already provided to you before chasing additional warranties on

specific matters (eg warranty as to plant and equipment or stock take and the

warranty as to the balance sheet)

• Warranty time limits – typical periods for companies

• Lower dollar limits (minimum amount per claim and minimum aggregate claim)

(1-4% of purchase price trend)

• Maximum dollar limits (purchase price? – trending against)

• Conclusion: do due diligence and get warranties


Purchase price adjustments

• Objectives

• Types of approaches. For example:

– earnouts

– completion balance sheet adjustments (e.g. net assets)

– working capital

– specific adjustments (e.g. stock take, tax appeals)

• Importance of purchase price adjustment principles

• Who decides?


Warranty and indemnity insurance

• Removing deal breakers for share or asset sales

• Vendors – enhancing sale price or enabling a sale to proceed

• Purchasers – enabling acquisition to proceed, reducing risks assumed

• Both parties – negotiation dynamics

• Vendor perspective:

– transfers liabilities to insurer

– vendors utilise proceeds at completion

– institutional investors exit without discount

– protect balance sheet from claims and share price against impact of claims

• Purchaser perspective:

– full set of warranties negotiated

– funds available to meet a claim:

• vendor insolvency

• funds moved off shore

– assignment of policy

– share price protected against impact of claims


Final observations

• Whatever form of due diligence (commercial, legal, tax, etc):

– understand the business economics of the deal

– assembling the right team for any given industry or country, remaining focused, and

maintaining open lines of communication with all other advisors

– tailoring the scope of work, as required

– executing procedures in a precise manner

– communicating results on a timely basis in a clear and concise manner

• When it comes to documenting the deal:

– use due diligence to influence the deal - that’s what it is for!

– soft skills – deal psychology (people, people and people)

– identify the real risks - ensure agreements protect against those risks

– brains walk – get lock ins and handcuffs

– price risk – clawbacks/escrow/ratchets

– accounts adjustments

– unknown – get warranties and indemnities with teeth

– warranty and indemnity insurance


due diligence roadmap · 2016. 8. 11. · overview of session due diligence roadmap: • what is...

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