In this month’s column we would like to talk about the benefits of due diligence in M&A transactions. The reason that we take up this basic issue is that we have seen quite a few Chinese clients who have only remotely heard of the term due diligence, while others knew it to be a necessary step in an M&A transaction but tried to avoid it anyway because they conceived it only as a cost factor, without any benefit.
What is due diligence?
Generally, due diligence refers to the care a reasonable person should apply before entering into an agreement or a transaction with another party. In an M&A transaction “due diligence” stands for a structured process where the seller discloses confidential information about the target to the buyer for review and evaluation.
It serves to disclose all commercial, financial, tax and legal facts and properties of the target to enable the buyer to properly assess the risks and chances associated with the target and, consequently, to gain a better understanding of its value. Usually buyers engage advisers to do the financial, tax and legal due diligence, which, of course, adds to buyer’s transaction costs.
What does the client pay for?
The information to be examined for the purpose of due diligence is mainly the data made available by the seller in a physical or virtual (electronic) data room. The larger or older the business, the bulkier the data. That is why advisers cannot give any fee estimates for due diligence work before having an idea of the scope of the data room.
In addition to the advisers’ manpower spent in the data room, the buyer pays for their due diligence report, which may, at the buyer’s option, comprise a synopsis of each file reviewed and the analysis of the respective risks it involves (descriptive report), or only a summary highlighting and analysing the qualified risks of the envisaged transaction (red-flag report). Descriptive reports are more expensive because it takes more time to draft them.
During the due diligence process, the seller will aim to be as open and transparent as possible, while still protecting the interests of the business. Care needs to be taken, above all, if potential buyers include the seller’s direct competitors. Besides, the deal may at any time fall through or be called off.
Extremely sensitive information may therefore be held back and will only be disclosed at a later stage of the sales process. Expert advisers know what critical data are missing and can request them from the seller in a structured process called “Q&A” (questions and answers).
Hire a lawyer from abroad. We have seen Chinese clients asking us – i.e. Swiss lawyers – to conduct legal due diligence on a target located in another European country, and we have witnessed lawyers from China conducting legal due diligence at a budget price in Switzerland. Why is that dangerous?
The answer is simple. Normally, the target’s company documents and contracts are drafted in accordance with local law.
Lawyers who are not trained and experienced in the law of the respective jurisdiction are just not able to assess the legal risks they are supposed to identify. A lawyer abiding by professional standards would, therefore, never agree to conduct due diligence in a foreign jurisdiction.
Proper due diligence
Just want a pro forma due diligence. Some Chinese clients wonder why we have to go to the expense of painfully reviewing all documents and writing a report, rather than just confirming that everything is fine. Nevertheless, asking a law firm to do a pro forma due diligence is like saying, let me bid for the gain and you take over my risks. Obviously, this would not be a reasonable business proposition for advisers.
Conflict of interest
Share a legal counsel with the seller. In the past, we have also been asked to act as the counsel of both the seller and the buyer in the legal due diligence procedure, so that the seller and buyer may share the legal fees.
Nevertheless, as in any other sales transaction, the interests of the seller and the buyer in an M&A transaction are opposed, and serving both would put the adviser in an obvious conflict of interest, which would not best serve the client and be against any professional standards.
Do warranties make due diligence redundant? Some Chinese clients believe that negotiating extensive warranties is a way to avoid expensive due diligence. Nevertheless, they overlook that sellers usually offer warranties only for what was not disclosed. For risks disclosed they are, however, usually ready to negotiate an indemnity (thereby avoiding front-end purchase price reductions).
Therefore, not reviewing the data room and abstaining from the Q&A means the buyer is unaware of the matters exempted from warranties, and misses the opportunity to negotiate an indemnity or purchase price reduction for disclosed risks.
Speculating is dangerous
Speculating that the seller will provide a disclosure letter allocating the data room disclosures to each warranty is dangerous, as the negotiation of the transaction agreements usually occurs after the due diligence is completed. Consequently, it will be too late for the buyer to catch up on a missed due diligence if the seller then refuses to provide a disclosure letter.
As a result, such buyers are unable to negotiate a purchase price reduction or indemnity for the relevant risks which may cost them many times more than what they saved by instructing their advisers not to review the data room.
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