A comprehensive due diligence exercise is crucial to a successful M&A deal. Sourish Mohan Mitra details the key elements
Mergers and acquisitions (M&A) began to gather pace in India about 15 years ago when large ticket transactions came into prominence. In a typical M&A transaction the acquirer enters into a preliminary agreement, usually through a term sheet, letter of intent, or memorandum of understanding, which allows it to conduct due diligence of the affairs of the target company. The target is obliged to disclose documents to the acquirer through the due diligence carried out by the acquirer’s advisers including lawyers. The laws applicable to an M&A transaction depend on the type of transaction, industry, etc. Mergers require the approval of the National Company Law Tribunal, which recently replaced the jurisdiction of high courts. Mergers may also come under the purview of the Competition Act, 2002, if the thresholds under it are attracted.
A strong foundation
Various aspects of a legal due diligence make it an important element in the lifecycle of an M&A deal. Chances are that the fundamentals of the deal are shaken if it goes wrong.
Understanding the target company. Due diligence is the first step to understand the target company and its business. The company’s documents, such as financials, corporate compliances, agreements, leases, litigation matters, licences and registrations, which could be available internally or in the public domain, provide a starting point to determine the focus areas of the target’s business, its core business strategies, strengths and weaknesses, growth plans, etc. After obtaining initial documents, either through a physical or virtual data room, the next step is to ask questions and, clarifications from the target’s management. The due diligence process leads to digging deeper into the target’s affairs. The rosy picture provided by some target companies at the time of signing the preliminary agreement is dispelled when core inner issues pertaining to the target are brought to the fore.
Identifying issues. This is the crux of a due diligence exercise and should produce analysis on issues that are vital to the acquirer who is keen to know how the business will fare if it goes ahead with the acquisition.
The review of documents provided by the target followed by further probing helps in getting to the bottom of the target’s issues and non-compliance areas. When such an exercise is conducted in India, the chances of finding some non-compliance – especially in areas such as corporate compliances, stamping of instruments and employment law related compliances – are always high.
In cherry picking issues it is possible to miss out on areas that could be vital for the acquirer. An analysis of all the non-compliances will allow the in-house team of the acquirer to consider those which are critical for its management.
Building support
External lawyers who are brought in to support an acquirer’s in-house team can add considerable value. The in-house team is responsible for equating the issues identified with the acquirer’s business feasibility and it is interested in a variety of angles and perspectives, such as how the post-acquisition integration will be carried out.
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Advisers typically include many caveats while answering in-house questions. It is understandable that this is done to ensure that incorrect advice is not given about a possible future event, but such caveats impair the in-house team’s ability to sign off on solutions to the issues identified.
The due diligence report should provide practical solutions rather than hypothetical responses that the acquirer may not be able to implement. The constraints faced by the acquirer could include limited finance, competition with other potential acquirers, and urgent need to enter a new territory or product line.
While it is normal to highlight the law relating to a particular non-compliance, it is equally essential to carve out how much of that is practically enforceable in the country. There is hardly any company that fully complies with the law in all areas. In situations where an acquirer can live with some of the non-compliances, it is helpful that external lawyers involved provide realistic advice in response to in-house queries and clarifications.
Collaboration with other advisers. An acquirer’s in-house team is required to coordinate with various advisers to ensure that all the components of a deal are captured. There may be some overlaps among the observations of multiple advisers and a difference of opinion between advisers on a contentious issue is problematic. There is a need to iron out differences through meaningful discussions in such a scenario, which could often throw up new situations or lead to the discovery of new documents. Further, the observations of other advisers in the documents provided to them could have a bearing on legal aspects. This may require a relook by external lawyers at the observations in the legal due diligence report to suitably reflect the altered position or newly obtained documents.
Timelines and valuation
Every M&A deal is envisaged to be completed within a specified timeline and the timely completion of the due diligence process goes a long way to close a deal. Very often advisers face problems in procuring documents from the target despite sharing an exhaustive information request list. If the progress of the due diligence is hampered, it is prudent to alert the acquirer’s in-house team. Often non-availability of documents is not communicated to the acquiring company during the review period. The in-house team in such a situation will only get a partial review report that may not be of much use. This will have a cascading effect on the acquisition where either the acquirer will decide to go ahead with the risks of limited information or will put more pressure on the target to release the required documents. It is a lose-lose situation for the acquirer in either case.
While non-cooperation by a target is an indication of how they do business, the lack of information sharing could also mean that there are significant non-compliances that the target is attempting to hide. This should set off alarm bells for the acquirer.
Arriving at final deal valuation. The commercial value of a deal is arrived at through a combination of various elements. The result of the due diligence exercise is significant as the financial implications of non-compliances are considered in arriving at the deal value from the acquirer’s perspective, which may not match the valuation provided by the target. The due diligence report is a powerful tool in the hands of the acquirer while negotiating on the deal value. It serves a dual purpose as it helps to reduce the deal price and to extract commitments to rectify some of the critical non-compliances.
Transaction documentation. Issues identified in the due diligence report are typically shielded against with suitable protective clauses in the transaction documentation. The acquirer seeks representations and warranties from the target for most of the areas of non-compliance. Suitable indemnities are moreover included to ensure that such non-compliances do not come to bite the new owners and management after the takeover is complete. The onus of any past action or inaction is put on the outgoing owners and management until the cut-off date as agreed by both parties.
Post-transaction integration. After the transaction documents are signed by the acquirer and target, the issues and non-compliances pointed out in the due diligence report need to be resolved. When the acquirer gains control over the target and has direct access to the target’s documents, the in-house team commences the process of integration of the target into the acquirer’s fold. If the due diligence exercise has been effective the integration process becomes very smooth and can be completed in a time bound manner. However, if the report has gaps, it will be an uphill task for the in-house team as it will need to do the analysis all over again and precious time and money is lost in this avoidable exercise.
From the above aspects it is amply clear that the due diligence exercise provides a vital means to gain as much knowledge about the target as possible in a limited time. The success of the entire deal hinges on this critical exercise and it must be done with a very high degree of care.
An acquirer can be saved from a potentially bad deal if all the red flags concerning the deal are identified and a true picture of the target’s affairs is presented to the acquirer’s management. A successful M&A deal may likewise have much to be grateful for to the due diligence process for its effectiveness. Due diligence acts like a pair of eyes to enable the acquirer to see elements which otherwise would not have been discovered in the course of the deal.
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Sourish Mohan Mitra is an India-qualified lawyer and works in the in-house team of a global technology research and advisory firm in Delhi. The views he expresses are personal.
