Due Diligence (DD) Exercises (“DD Exercise(s)”) are essential to commercial transactions. The conduct of a DD Exercise is a continuous process right from when a transaction is conceived, discussed with the advisers up to the end of the deal. There are different types of DD which include financial due diligence, tax due diligence, commercial due diligence, technical due diligence and legal due diligence. The legal due diligence involves reviewing documents that define a party’s ability to fulfil its obligation in a transaction, identify the inherent risks, assess the risks, propose risk management measures to help the transaction bankable. Therefore, a DD Exercise must be factual, analytical, and structured. Often, a DD is adopted in acquisition, investment, and finance transactions.
A DD Exercise could be conducted on the company, shareholders, and assets of the Company. This article summarizes some of the key considerations in conducting a DD Exercise for assets/shares acquisition. In a DD Exercise, usually, the investor or buyer (the “Acquirer”) interested in buying assets/shares in a target company (the “Target” or “Seller”) is primarily responsible for carrying out a DD exercise.
A DD Exercise would involve a review of documents uploaded to a Virtual Data Room (VDR) and sometimes, physical visits to the offices of applicable regulatory authorities in the transaction. The process of a DD Exercise commences with preparing a DD checklist which lists the necessary information the Acquirer need from the Target or Seller. Upon the upload of the requisite information to the VDR, a Due Diligence Report (“DD Report”), which contains detailed information on the Target, is drawn up. A DD Report sets out, in detail, the necessary information and issues to consider.
The essence of a DD Exercise includes the following:
- It gives the Acquirer a better understanding of the Target/Seller.
- It helps professional advisers understand the actual state of affairs of the Target /Seller
- It helps to identify risks and how to mitigate those risks. Identifying the risks helps in the valuation of the Target/Seller to determine a practical purchase price. The greater the risks, the greater the likely discount to be sought by the Acquirer.
- It helps to determine the suitable structure for the proposed transaction. .
- It helps the parties in allocating risks in the representations and warranties.
Notably, the questions in a DD checklist vary depending on whether it is an asset or shares acquisition. Specifically, for an asset acquisition, general questions to be asked during a DD Exercise include the following:
- Title of the Target in the assets. This helps to determine whether the Target has a valid title to the asset, if the title is subject to a limited duration, or conditions and any encumbrances on the title.
- Whether there are existing, pending, contingent and threatened litigation(s) concerning the assets;
- The material contracts concerning the assets (such as the joint operating agreements, gas sale and purchase agreements, and production sharing contracts in the energy and power sector)
- Regulatory Compliance, licenses, approvals or permits (like environmental permits) required to operate the assets.
- Third-party approval and consents required to create or transfer any interest in the assets.
- The physical condition of the assets, where applicable.
For shares acquisition in a company, general questions to be asked during a DD Exercise include the following:
- General corporate information such as constitutional documents of the Target and details of shareholders and directors.
- Details of material contracts such as shareholders’ agreements.
- Finance, Banking facilities and Indebtedness status such as existing charges, mortgages and debentures.
- Regulatory Compliance, such as licenses, permits and approvals required for the Target operation, has been obtained from the relevant regulatory authorities. Regulatory Compliance also ensures that appropriate filings and returns have been done and the Target has what is statutorily required to operate as a legal entity in the country.
- Taxation like companies’ income tax
- Labour and Employment
- Intellectual Property.
- Real Estate.
- Material claims and litigation.
As earlier stated, apart from legal DD Exercise, it is not uncommon for DD Exercise to be carried out by other professional advisors like financial and technical advisers. Thus, financial due diligence is carried out to assess the Target’s relevant financial statements, balance sheets, business plans, feasibility studies, and cash flow statements. Financial due diligence helps to prevent a transaction from being a sinkhole at the end of the day. Technical due diligence is also carried out, particularly for energy investment, to assess the proximity of the energy source, the availability of needed machinery and plants, the availability of skilled workforce, the technology used, the civil and electrical design, the status of permits, licenses, and authorizations, visits to operating plants or sites, audits of equipment manufacturers, monitoring of asset construction, among other things.
Upon completing the DD Exercise (reviewing all uploaded documents in the VDR, enquiries/visits to the regulatory authorities and noting all necessary information), a DD Report is drafted. A DD report is the finalized report of the meticulous investigation and review process that characterizes the DD Exercise. It is meant to provide an as-is analysis of Target’s assets or the state of affairs of the Target. The DD report will include all necessary facts discovered during the DD Exercise and will proffer solutions to identified issues and how the transaction can be best structured.
A DD report should commence with an executive summary (which contains critical findings of the DD Exercise), and it is followed by succeeding paragraphs addressing each subject matter in the DD exercise (such as title, material contracts, litigations, insurance, intellectual property rights, general corporate matters, taxation).
Notwithstanding how thorough a DD exercise can be, some risks may not be identified during the DD Exercise. This omission could be due to inadvertence by the Acquirer, considering the large volumes of information and documentation involved during DD Exercise or wilful concealment by the Target. Thus, to guard against any error that might have occurred, the purchase agreements (of the shares or assets) will contain representations and warranties issued by the Target to the Acquirer and indemnity clauses by the Target or Seller to indemnify the Acquirer for any losses that may arise where the representations and warranties are incorrect. Usually, the representations and warranties include:
- The Target or Seller has a title to the assets/share, and the title is not encumbered.
- The Target is valid, incorporated, and existing under relevant laws.
- The Target has obtained necessary government permits, approvals, and licenses to operate the asset and they are valid and subsisting.
- That there are no existing, threatened and pending material litigation or governmental investigation against the assets and the Target.
- That all necessary taxes and royalties have been duly paid.
- That there it is in compliance with necessary environmental, health and safety regulations.
- That all material contracts necessary to the transaction have been disclosed, and there is no breach/default under the disclosed agreements.
DD Exercises are crucial to the success of any transaction/acquisition/investment. Therefore, DD exercises must be carried out thoroughly and extensively, bearing in mind the commercials and innovative ways to mitigate identified risks.