The Art of M&A - Due Diligence
An excerpt from The Art of M&A by Alexandra Reed Lajoux
Editor’s Note: A growing number of M&A professionals are pursuing the Certified M&A Specialist, or CMAS™ credential. To support CMAS® candidates preparing for the CMAS® exam, we are pleased to continue our feature column, CMAS® Corner, by noted author and expert, Alexandra Reed Lajoux. Each edition includes directly relevant content derived from the capstone Fifth Edition of Ms. Lajoux’s industry leading book series, The Art of M&A: A Merger, Acquisition, and Buyout Guide (McGraw Hill, 2019). Every column covers one or more likely CMAS® exam questions and help you accelerate completion of this important career credential. In March we covered cybersecurity. This issue’s topic is due diligence.
When does due diligence begin?
The due diligence process begins from the moment a buyer senses a possible acquisition opportunity. The buyer then starts to examine the information that is readily available at this early time about the company. For public companies, this information is usually derived from public documents—including press reports, filings with securities regulators, and any debt or equity offering memorandums the company or its bankers might have prepared for potential buyers.
This initial stage of due diligence review based on public documents usually starts during the strategy, valuation, financing, and structuring phases. During these phases, the acquirer has asked and answered four opening questions:
- Is it in our stockholders’ long-term interests to own and operate this company?
- How much is it worth?
- Can we afford it?
- How should we structure this acquisition?
When the parties are ready to go forward and to set a tentative price and structure for the deal, the buyer should engage attorneys and accountants to conduct a more thorough study of the company to be acquired. This “dirty linen” phase of the due diligence inquiry—discovering what’s wrong with the company—can never start too early. Buyers often neglect this phase, because they do not want to offend sellers, but they must proceed. Buyers need to ask and answer the tougher questions such as:
- Do the firm’s financial statements reveal any signs of insolvency or fraud?
- Do the firm’s operations show any signs of weak internal controls?
- Does the firm run the risk of any major postmerger litigation by the government or others?
Two milestones marking the official onset of due diligence are the signing of a confidentiality agreement and a letter of intent to buy the company. Formal due diligence usually does not begin until these two documents are signed. More details are specified in the acquisition agreement.
What does the acquisition agreement typically say about due diligence?
Among other items, the acquisition agreement should:
- State the time available for due diligence
- Promise the buyer access to the selling company’s personnel, sites, and files
Here is sample language about due diligence from an acquisition agreement:
Investigation by Buyer. The Seller and Target shall, and the Target shall cause its Subsidiaries to, afford to the officers and authorized representatives of the Buyer free and full access, during normal business hours and upon reasonable prior notice, to the offices, plants, properties, books, and records of the Target and its Subsidiaries in order that the Buyer may have full opportunity to make such investigations of the business, operations, assets, properties, and legal and financial condition of the Target and its Subsidiaries as the Buyer deems reasonably necessary or desirable; and the officers of the Seller, the Target, and its Subsidiaries shall furnish the Buyer with such additional financial and operating data and other information relating to the business operations, assets, properties, and legal and financial condition of the Target and its Subsidiaries as the Buyer shall from time to time reasonably request. Prior to the Closing Date, or at all times if this Agreement shall be terminated, the Buyer shall, except as may be otherwise required by applicable law, hold confidential all information obtained pursuant to this Section with respect to the Target and its Subsidiaries and, if this Agreement shall be terminated, shall return to the Target and its Subsidiaries all such information as shall be in documentary form and shall not use any information obtained pursuant to this Section in any manner that would have a material adverse consequence to the Target or its Subsidiaries. The representations, warranties, and agreements of the Seller, the Target, and its Subsidiaries set forth in this Agreement shall be effective regardless of any investigation that the Buyer has undertaken or failed to undertake.
The first paragraph of this clause is called an investigation covenant. It ensures that the seller will cooperate with the buyer by granting access and logistical support for the buyer’s due diligence review of the seller and its subsidiaries. This is one of the most valuable parts of any acquisition agreement.
The second paragraph, sometimes nicknamed a burn or return provision, may help allay the seller’s fears about confidentiality. Note, however, that the seller will often require the prospective buyer to enter into a separate confidentiality agreement.
The third paragraph makes a statement that removes the burden of perfect investigation from the acquirer. Without such a statement, the seller can avoid liability following a breach of contract. The seller can disclaim responsibility for representations, arguing that the buyer could have discovered the breach during the investigation of the seller’s company.
Who conducts due diligence?
Typically, outside counsel to the acquirer directs the due diligence review with help from a team of professionals employed or retained by the acquirer. As mentioned, the review has financial, operational, and legal aspects. Each of these parts can benefit from specialized attention. The financial and legal sides each have separate and distinct responsibilities, although they may, and indeed should, communicate with one another. The financial statement review requires attention from the acquirer’s financial and accounting personnel, such as the chief financial officer and, if the company has one, the chief internal auditor. The operations review will involve risks inherent in the company’s conduct of its business—for example, weak defenses against cyberattacks. The legal compliance review requires external and, if available, internal counsel. The acquirer may also bring in asset appraisers, cybersecurity experts, environmental experts, and a host of other professional talent during the review. The party directing the review should be clear from any conflicts of interest. Any party paid a contingency for the completion of the transaction—for example, an investment banker having such an arrangement—may have a conflict of interest, and that fact should be considered in the acquirer’s decision as to who should direct the review. Also, if a firm has a financial relationship or consulting engagement with the company it is studying, it may also have a conflict of interest with respect to the transaction. This would include any audit firm that has financial, employment, or business relationships in addition to the audit, among other conditions that may suggest lack of independence.1
The definition of auditor independence is found in Title 17, Chapter II, Part 210, Section 210.2-01, https://www.law.cornell.edu/cfr/text/17/210.2-01. Note that on May 2, 2018, the SEC issued a proposed rule to clarify the rules surrounding auditor independence with regard to loans and creditor-debtor relationships (proposing the elimination of arrangements that arguably do not affect independence). http://www.sec.gov/rules/proposed/2018/33-10491.pdf.
Lajoux, Alexandra Reed with Capital Expert Services. “The Art of M&A, Fifth Edition” A Merger, Acquisition, and Buyout Guide. United States of America: McGraw Hill, 2019,pp. 456-460. Print.
You can learn more about the book at: https://www.artofma.global/ or for a complete list of references/notes within this article please call the M&A Leadership Council at 214-689-3800.