Acquisitions: Buyer’s Due Diligence Process

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WHAT IS DUE DILIGENCE?

Due diligence by an intended buyer of a target company or business incorporates a thorough review of materials about that target made available to the buyer by the seller. It also involves the buyer asking particular questions of the seller about the target. The buyer then prepares a report on its findings which is used to help determine whether or not to proceed with the acquisition and, if it decides to proceed, the basis on which it will do so.

There are advantages to both the buyer and seller in doing this. For the seller, it reduces the risk of claims being made against it by a buyer who is unhappy with what it has bought. For the buyer, it is preferable to identify any issues or concerns with the target in advance so they can be addressed as part of the transaction, or (in some cases) the buyer can walk away from the transaction.

ROLE OF PROJECT/TRANSACTION CO-ORDINATOR

The Project/Transaction Co-ordinator should prepare a Due Diligence Brief for the transaction and the due diligence team.  That brief will form an essential initial part of the due diligence process and should address the following:

  1. Composition of Due diligence teams
    1. Project/Transaction
    2. Business/ Integration
    3. Finance
    4. Commercial
    5. Legal
    6. Human Resources
  2. Any specific due diligence focus areas
    1. Stand-alone issues
    2. Transaction issues
    3. Integration issues
  3. Due diligence schedule
  4. Key objectives of the due diligence
  5. Materiality guidelines

In broad terms, the Co-ordinator’s role in a due diligence process is to ensure that the members of the due diligence team review documents made available by the seller (usually by way of a data room) that relate to their area of expertise, that questions necessary to enable a proper understanding of the target’s circumstances regarding the area of expertise are answered, a record of the documents and information reviewed is kept, the process is carried out methodically so there are no overlooked aspects, and to report on the results of the investigations and make any appropriate recommendations. 

PURPOSE OF BUYER’S DUE DILIGENCE

Buyers will have wide ranging reasons that motivate them to undertake due diligence before any acquisition, however the main intention is to identify material issues associated with the transaction target and its business that:

  • the seller will need to address before the buyer proceeds with the acquisition
  • the buyer can plan for and address promptly following the acquisition
  • might affect the terms and conditions upon which the buyer is prepared to commit to the acquisition of the target
  • might affect the price the buyer is prepared to pay for the target
  • might cause the buyer to decide not to proceed with the transaction.

Material issues identified in due diligence are often addressed in the Sale and Purchase Agreement (SPA) for the transaction.  This is generally by way of:

  • appropriate conditions to the transaction proceeding being included in the SPA
  • the SPA including specific contractual clauses which specify how the parties will deal with those issues
  • the SPA including warranties that support information provided or answers given in the due diligence process
  • the SPA including indemnities granted by the seller in favour of the buyer in respect of the relevant issue.

In order for any material issues to be appropriately addressed as part of the transaction, they need to be properly understood.  Accordingly, once an issue is identified as part of due diligence, it is important as an ongoing part of that due diligence to obtain sufficient detail about the issue and its potential consequences.  Doing so then enables the buyer’s management and its advisers to determine, on an informed basis, how to best address that issue as part of the transaction.

MATERIALITY – WHAT IS A MATERIAL ISSUE?

Not every “issue” with a target or its business is significant enough that it will impact the basis upon which a buyer is prepared to proceed with the acquisition.  General it is only “material” issues or concerns that will have that effect.

For the purposes of a specific transaction, a quantitative materiality threshold is usually set at a dollar value.  Accordingly, if an issue is expected not to have a quantitative impact on the buyer or the target equal to or greater than this amount, it is not material enough for it to be identified by you as a relevant issue as part of this due diligence.

However, not all relevant issues can be measured in quantitative terms – some are qualitative.  There is no simple rule for what might constitute a material qualitative issue.  In these instances, adopting a “CEO’s shoes” approach can be useful. That is, when considering the materiality of an issue, put yourself in the shoes of the CEO and anticipate what might be their reaction should they find out about the issue either after they have signed the SPA or after they have completed the transaction.  If you anticipate that if that occurred the CEO would be materially troubled by it, it is likely to be a material issue that needs to be raised and addressed prior to finalisation of the SPA.

TIPS FOR THE REVIEWERS OF DOCUMENTS AND RESPONSES

These are the key considerations relating to the review of data room documents and responses to questions of the seller:

  1. carefully consider the information that is provided to you by or on behalf of the seller
  2. ensure that you are considering the potential impact or consequences that that information might have on or for the operations of the target and its business, or on or for the buyer
  3. if you identify that information that you are reviewing might also be relevant to another reviewer’s area of expertise, let the Project/Transaction Co-ordinator know so that they can ensure that the other reviewer also considers that information
  4. if the responses from the seller are unclear, trigger further questions in your mind or highlight new issues to you, ask follow-up questions of the seller in order to resolve those matters. 
DUE DILIGENCE QUESTIONNAIRE

The purpose of a due diligence questionnaire is to request the information required to understand the status and operations of the target. The legal and financial advisers to the buyer will typically prepare their own questionnaires that will address the scope of topics within their responsibility, but it may be that other questionnaires are prepared with respect to specific commercial or operational issues that are important to the buyer.

The questionnaires are then submitted to the seller with a deadline for response by the seller.  The seller will likely answer some of the questions in the questionnaire itself and also make available for review in a data room documents relevant to the questions asked by the buyer.  If the seller makes relevant documents available via its data room, the seller will be asked to record adjacent to the relevant question in the questionnaire the name of the document and the fact that it is attached or uploaded to the data room (including specific data room reference number).

DATA ROOM

A seller’s data room is an electronic storage site in which documents relevant to the target and its operations are stored and made available for review by the buyer and its advisers.  Generally documents in the data room are ordered or grouped by subject matter in various electronic folders, and each document is referenced with a unique index number.  Documents are generally added to the data room as the due diligence exercise progresses, and a daily update provided to the seller as to the documents that have been added in the past 24 hours.

The Project/Transaction Co-ordinator should allocate each document contained within the data room for review by one of the buyer’s due diligence teams.  It is important that a record is kept of each document in the data room which is updated to show who it has been allocated to for review and the status of that review.  This should ensure that no important materials are overlooked, as well as enable the progress of the due diligence exercise to be effectively monitored.

We recommend that reviewers keep appropriately detailed notes on all document reviews undertaken, and that those notes are cross-indexed to the data room as appropriate. This will ensure that if something needs to be revisited, it can be done efficiently. Your legal advisers can provide examples of a due diligence review summary documents and useful templates.

VETTING QUESTIONS

Where a review of a data room document leads to further questions, typically there will be a formal Q&A process whereby those questions will be submitted into and answered through the data room.  The Project/Transaction Co-ordinator will review and vet all questions before they are submitted, ensuring that:

  1. Only material questions are asked
  2. Questions do not duplicate questions previously asked (including by another part of the due diligence team)
  3. Questions include references to data room document numbers, where applicable.
REPORTING

Each team will be required to prepare a report, to be submitted to the Project/Transaction Co-ordinator by a specified date. Reporting will generally be on an “exceptions” basis only.  This means that you should report only on issues of concern that you identify that are “material” in the context of the proposed transaction (as detailed above). 

To ensure consistency we recommend that each team section report ought to:

  1. Include an executive summary
  2. Identify material issues of concern, and give them a priority rating (high, medium, low)
  3. Where appropriate, make a recommendation in relation to those issues of concern. Examples of recommendations include:
    3.1.  to be dealt with in the SPA including by way of a warranty, indemnity or undertaking, or an
            adjustment to price
    3.2.  to be rectified before completion
    3.3.  ask a question of management, legal, finance etc
  4. Append all supporting materials (eg. your document review summaries).

Where appropriate, those reports will be consolidated into one or more larger reports.  Ultimately the material findings of the due diligence exercise then need to be reported to the management team, the buyer’s board and also to the buyer’s legal advisers so that any relevant issues can be appropriately addressed in the negotiation of the SPA and other transaction documentation.

ALERTING OF MATERIAL ISSUES

Material issues of concern should be notified to the Project/Transaction Co-ordinator immediately and progressively, so that they can be alerted to management, the board and advisory team at the earliest opportunity.  It is important that the transaction team has as much time as possible to work through and address any issues identified before the SPA and other Transaction Documentation is finalised and signed.

Any material issues previously reported to the transaction team must still be included in the final due diligence section report.

RISK REGISTER

The Project/Transaction Co-ordinator should maintain a risk register of all material issues raised so that their status and resolution can be monitored.

READY FOR MORE INFORMATION?

If you require advice and assistance relating to an acquisition due diligence, merger or other business matter, please feel free to contact Gary Thomas, Principal – Grondal Bruining..

Gary Thomas - Principal - Grondal Bruining

 Phone: +61 8 6500 4375 | Mobile: +61 414 858 584

 Email: gary.thomas@grondalbruining.com.au

Disclaimer: The contents of this article are general in nature. You should seek specific advice in relation to any transaction you might propose to undertake.

Liability limited by a scheme approved under Professional Standards Legislation.