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Due diligence in corporate finance
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2 Due diligence in corporate finance
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Due diligence in corporate finance
CHAPTER OVERVIEW
2.1 The expression ‘corporate finance’ generally refers to the mechanisms and processes by which businesses raise capital or enhance capital values for operations and growth. Capital can be raised in a variety of ways, such as by the issue of shares or debentures, or the provision of loans or banking facilities. Capital values can also be enhanced or protected when businesses are merged, acquired or restructured. The mechanisms and processes can either be private or public in nature, depending on the objectives of the corporate finance exercise. The mechanism or processes by which corporate finance is provided, or the corporate finance transaction executed, as well as the nature of the transaction contemplated, will determine the level or type of due diligence required or available. For example, the level of due diligence required for a secured borrowing facility will be significantly less than that required for an equity investment. The lender will simply be looking to ensure: (a) the loan will be repaid together with interest over the term and that there is sufficient net cash flow cover to ensure repayment; and (b) the value of the security is sufficient to cover the loan to the value given. A highly liquid publicly traded stock will have a higher loan to value than an illiquid stock and certain types of real estate, such as development or commercial properties, will have lower loan to values than residential properties. On the other hand, an equity investor, such as a venture capitalist, will be concerned to ensure that the profitability and positioning of the business over the given investment time horizon will be sufficient: (a) to yield the required internal rate of return on the investment; and (b) for that return to be crystallised by an exit event, such as initial public offering of flotation, or a trade sale.
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The focus will therefore be more on the ability of the management to deliver the returns based on the forecasts or projections for the business. In some cases, the degree of due diligence available or required will be limited or restricted by the nature of the business or transaction contemplated. The offering circular or document of a publicly traded company which is subject to ongoing disclosure requirements to its shareholders, governing regulator or exchange will differ from that for a private company where there has been no such public disclosure. The due diligence available on a recommended bid for a company will also differ dramatically from that for a hostile bid, where the offeror company simply is not given access to the relevant internal financial and management information, and therefore has to subject the bid to a number of conditions, which it will have power to amend or vary subject to what is discovered or obtained by way of due diligence in the bid process. In each corporate finance situation, however varying or differing, invariably the same fundamental issues are being addressed: * What is the investment return available or the level of finance affordable by the business? and What risks are there which would result in the expected return not * being achieved or the financing not being repaid? The due diligence process will define the return or pricing of the investment or financing, the amount of the investment or financing to be made available and the structure of the investment or financing. Invariably too, the due diligence process is forcing an alignment of interests, of risk and reward, as well as expectation. There are competing interests. What a business or company may perceive as a fair return for an investment may differ substantially from what the investor or financier may require. Alignment of interests will not just address the issue of price, but also management commitment, focus and vision, and the ability to deliver the return based on the expectation created. There is also the issue of evaluating external factors, which will affect the return and reward, factors that are either systematic, such as interest rates, inflation and political events that are common to the business and industry as whole, or events that are specific to the business or industry itself and which can be compared to similar businesses. Risk can thus be defined and isolated and then appraised relative to the expected return – a process generally known as risk adjusted return. The weight given to the critical financial analysis tools used by lenders and equity investors alike will vary. A lender will be evaluating financial risk ratios such as interest coverage and interest coverage adjusted for cash flow and debt to equity ratios, whereas an equity investor will be more concerned with profitability ratios looking at return on capital and return on equity. Both will be concerned, however, with historical
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business information such as matters affecting the essential ability of the business to pay its debts as they fall due and to turn its inventory or assets over in a sufficient period of days to create cash flow and remain solvent and profitable. Of course emphasis on all or any of the financial ratios will vary from business to business. They also become subject to fashion trends. For example, many of these core financial ratios were dispensed with during the technology boom of the late 1990s when forecasts and projections were solely used as determinants of value and investment. And between 2003 and 2007, with the advent of large leveraged buy-out deals, the need to be nimble in capital raising and high liquidity levels, borrowers demanded a loosening of lending covenants and ratio tests, with the result of the popular ‘cov-lite’ lending deals. Inevitably, in mid-2007, this approach fell out of favour as lenders found themselves with inadequate security in a market downturn, caused by the collapse of the sub-prime market and plummeting liquidity levels. Often, for a corporate finance transaction there will be a mixture of equity or debt or variations of these, and this will give rise to an appropriate review as to what the mixture should be and how it should be priced. The weighted average cost of capital calculation would be a familiar calculation used to determine the correct balance of each and the risks arising. In coming to a conclusion as whether or not to invest or finance or to undertake the transaction and in evaluating the business or transaction as a whole, various factors will need to be considered. The critical due diligence process would be the assessment of these factors and undertaken by a team of professionals of varying disciplines to examine and investigate different aspects of the business or transaction. The due diligence process undertaken will vary considerably from one business or transaction to another, and the initial requests for information or the basis of investigation and research will have to be tailored to the business or transaction concerned. Whilst there are broad categories of information that are normally reviewed and requested, it would be a serious misconception to think that one size fits all. The due diligence process will be an important part of the evaluation and structuring process and decisive of the ultimate success or failure of the investment or financing proposed for the business or transaction. Depending on the business or transaction being proposed or considered, from a high level approach, the due diligence process will then reach down to a more detailed and distilled consideration of the various issues affecting the value of the business – often after combing through a myriad of legal, technical and commercial matters. These considerations will then form the basis of a report or reports on which ultimate investing or credit decisions are taken.
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A caveat, therefore, has to be made that, in discussing due diligence in corporate finance, it is very much an introduction and specialised professional advice will often be sought on various matters to be reviewed and analysed. This chapter therefore looks at some typical due diligence topics arising in corporate finance. It is certainly not intended to be a comprehensive checklist, rather a list of examples of due diligence exercises that might be undertaken and the type of issues addressed.
Due diligence process
2.2
The due diligence team would consist of various professional advisers: normally legal, financial, technical, environmental, insurance and actuarial experts working in tandem with each other. These advisers should be brought on board as soon as practicable to give them sufficient time to cover comprehensively the issues involved. The due diligence process is often driven by the lending institution or investment bank who will co-ordinate the due diligence team. The team that undertakes the due diligence exercise needs to be given clear instructions as to the objective of the exercise and its parameters. Understanding what the business or transaction entails, and what the exercise is intended to achieve will help the team to streamline the exercise, focus on the relevant issues and make it more time and cost efficient. If a company plans to acquire a target with the intention of developing and selling properties, starting or developing, for example, a hotel with a casino, it has to convey these ideas and strategies to the due diligence team. Whether these strategies are realisable and what complexities they entail are the answers that the investing company would wish to find out from the due diligence exercise. For example, before embarking on a proposed transaction involving the purchase, by loan financing, of a hotel operation in India, a first tenet would be to determine whether or not profits could be remitted from India to repay the loan and whether the lender could perfect security in India over the assets being acquired. It is often very surprising how advanced transactions may proceed before critical corporate finance issues are discovered. High level information overviews are therefore advisable from a very early stage. To highlight this point, an overview list of requested information with respect to the purchase of a regulated financial services business is set out in the Appendix to this chapter. At the core of this acquisition would be the regulated status of the business and its compliance with regulatory provisions. From the information disclosed, the basis on which the transaction is financed and structured, documented and completed can then be negotiated and finalised. The responses given to the detailed questionnaire would normally be expected to form part of ‘disclosures’ to warranties and representations to
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be made by or in respect of the business or transaction. Once disclosures are made, for instance, as regards pending litigation, breaches of overdraft facilities or arrangements with creditors, the liabilities would be quantified, the price adjusted or the purchase price deferred and the disclosures warranted as being complete and accurate in themselves, so that the extent of the liability is correctly provided for. An important part of the inception of the due diligence process is the exchange of confidential undertakings. These structure the environment in which often price-sensitive and valuable information relating to the business or transaction is passed by the business to lenders or investors securely without risk of leakage into the public domain and thereby potentially damaging the value and reputation of the business. Generally, the confidentiality undertakings will expressly refer to what is to be disclosed and how it is to be identified as confidential, usually by reference to the initial or subsequent due diligence lists or questionnaires, to whom it may be disclosed, for what purpose and how it is to be returned or dealt with if the transaction does not proceed. The undertakings may also extend to non-compete clauses and lock-up periods during which the negotiating parties agree to deal exclusively with each other for a certain time period with respect to the business or transaction concerned. This enhances confidence among the parties and creates a safe environment in which disclosure can take place. Creating the right environment is paramount as no less than full disclosure will determine the right analysis of the appropriate risk and reward. The due diligence team and its advisers will normally be ring-fenced, and each participant required to give its undertaking to be bound by the rules of confidentiality on which engagement takes place. Important issues to be borne in mind are: ● ● ●
who is keeping the master disclosures lists; who is co-ordinating disclosures; who is responsible for evaluating and analysing the disclosures given in the context of the transaction as whole.
In a typical transaction, one would expect to see a combination of reports being assembled for review from the due diligence team. For example, financial reports including reviews of management accounts and forecasts, asset valuations, working capital and historical annual accounts, a legal report on regulatory and compliance issues and title to assets and the business, tax reports on the tax implications for the parties, actuarial reports on pension funds, environmental reports, and other specific valuations and project implementation reports – depending on the business or transaction and the nature of the corporate finance activity.
Anti-money laundering due diligence
2.3
A chapter on corporate finance due diligence would not be correctly balanced without discussion of anti-money laundering and terrorist financing due
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diligence. This is dealt with as a subject in much greater detail in the chapter on anti-money laundering due diligence (CHAPTER 3). Money laundering is now an essential prerequisite and integral part of the due diligence exercise for any corporate finance transaction in light of the now very extensive, stringent and punitive money laundering regulations that have been adopted by most countries. The scope of the regulations can be very wide. In the UK, for example, Money Laundering Regulations 2003 (SI 2003/3075)1 now cover any transfer, conversion, removal, concealment or disguise of funds which constitute the proceeds of crime. Terrorist Financing legislation prohibits engaging in financial dealings for the purpose of terrorism. This means that in looking at a business or transaction as a whole, it will need to be borne in mind that questionable accounting practices or possible tax evasion discovered as part of the due diligence exercise, and which is or could be a criminal offence, may then lead to independent money laundering disclosures obligations for the due diligence team. It also means (as a result of recent combatting terrorist financing legislation) looking more closely at what one might otherwise consider to be low risk transactions on the basis that funds are moving from a ‘clean’ source. First steps in any corporate finance transaction would be undertaking appropriate due diligence on the business owners or management, or ensuring that the proposed funds to be invested or lent to the business as part of the corporate finance transaction are clean. The exercise would then extend to evaluating the proper sources of funds coming into and out of a business operation. Where businesses have significant cash revenues, or operate on a cash-based system, this could give rise to a significant number of problems and potential disclosures. Moreover, the professional members of the due diligence team will usually have independent disclosure obligations and may be required to make disclosures to the regulatory authorities without reference to the client or other members of the due diligence team if they have concerns or suspicions. It could be a money laundering offence if an adviser who is regulated fails to detect money laundering when they should have detected or suspected it. The terms of any due diligence engagement should be very clear on this issue and certainly disclosure will be an exception carved out of any confidentiality agreements.
Financial due diligence
2.4
Financial investigations would typically be carried out with the help of a firm of accountants or an investment bank. The due diligence intends to verify whether all books of accounts and other financial records are up to date and have been accurately maintained. It also seeks to search out the current trading position and prospects of the business, which are not evident from
1
Augmented by the Third Money Laundering Directive implemented on 15th December, 2007.
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the historical or filed accounts. The fact that the books are audited provides some comfort, but usually this information will be significantly out of date. Businesses are dynamic and every day something may change that will affect the overall financial position of the company prior to conclusion of the transaction. For example, on a lending transaction, a lender will frequently require extensive drawdown (drawing of loan at agreed intervals) conditions under which very up-to-date information is provided on the company’s affairs prior to drawdown, for example up-to-date debtors and creditors lists, cash balances and reassurance that no material changes or events have taken place. There is much that can be gleaned from disclosed financial information and the accompanying financial ratios. However, there is still much that can lurk behind the figures, irrespective of the interpretation of the entries and calculations of financial ratios. The information identified from detailed investigation will be highly relevant in the ongoing negotiations for the cost of finance and its structure. At a minimum, accounts should be audited as required by best accounting practices, and should be in conformity with the local law. An important part of historical analysis is to look at any disclaimers or qualifications on the audit reports, or a frequent change of auditors. Equally, at a minimum, management accounts should adopt accounting policies and practices that are consistent with the audited accounts. A more vital review is that the accounting systems used to record information are robust, postings are accurate and properly posted, and the basis on which postings are made are consistent and reliable. Revenues need to be carefully reviewed. Contracts can be entered into and invoices raised even though there may be no underlying delivery or agreement as to delivery. There also needs to be a careful review that the true costs of revenues are shown – and not hidden so as to inflate earnings and profitability. Capital commitments have to be carefully considered for onerous or unusual payment provisions, for example, advance payments that do not necessarily oblige delivery or performance. Financial projections based on the projection of capital expenditures and sources of capital for the payment of such expenditure have to be matched against the reality of true cost, delivery and implementation. A capital financing proposed may merely be used to prop up working capital requirements and be insufficient to fund the capital needs of the business on which future growth hinges. Often management understate the true working capital needs in order to enhance earnings and returns. The inventory and the work in progress should be valued without including profit, but taking into account anticipated losses. It is important to examine the inventory physically to ensure that the stock and the raw materials are not obsolete or redundant, and the value is accurately reflected in the books. On-site stock checks on the closing of a transaction would not be uncommon. Contingent, disputed and other liabilities, including claims under contracts, should be specifically reviewed, as well as any default or cross-defaults occurring under existing borrowing facilities as a result of the financing, and the consequences of those defaults considered in detail. There should be a clear analysis of those accounting arrangements which are by definition subjective, for instance, provision for bad or doubtful debts,
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treatment of capital or revenue leases, off-balance sheet risks and liabilities, the use of favourable inventory methodology, treatment of capital expenses and recurrent expenses. For example, one of the key frauds leading to the collapse of the US telecommunications group Worldcom in 2002 was the capitalisation of costs that were clearly recurrent leading to a massive overstatement of earnings. In the USA, it is also worth noting that the Sarbanes-Oxley Act of 2002 (SOX) was enacted in the aftermath of the US corporate accounting scandals, necessitating revision of corporate governance standards and increasing the disclosures requirement to protect the interest of the investors. The statute establishes an oversight board to oversee the audit of the public companies, which are subject to the securities laws. Sections 302 and 906 require the Chief Executive Officer (CEO) and Chief Finance Officer (CFO) to certify that the information contained in the periodic report required to be filed with the US Securities and Exchange Commission (SEC) fairly represents, in all material respects, the financial conditions of the company and the adequacy of the internal controls. Any false certification will attract criminal liability. For further details on the SOX see CHAPTER 11. Oversight of critical financial issues in the due diligence exercise could result in a company investing in the USA, having a huge task of organising the target company’s books post-transaction to be able to make accurate quarterly and annual reports to the SEC.
Tax
2.5 Tax implications will vary depending on the country in which the business operates as well as the country of the lender or investor. Tax is a very important part of the due diligence process, and the tax consequences of a transaction or investment could have significant pricing implications, for example, the withdrawal of reliefs or crystallisation of charges previously held and the understatement or overstatement of deferred tax charges and tax assets as shown in the books of accounts. Historic tax computations will need to be reviewed and the impact of the transaction considered. This will often lead to the manner in which the transaction is structured in order to maximise tax efficiencies, for example, whether as a share acquisition or asset purchase or a financing by way of debt or equity, deferred consideration or instalments. The tax review would extend to the whole gambit of applicable taxes, for instance, income or capital gains taxes, estate or inheritance taxes, Valuedadded tax or sales or service tax and customs and excise duties and charges. In each case, an analysis would be necessary of the likely impact. For example, loans may attract withholding taxes on interest payable, asset purchases may attract a value-added tax and an overseas equity investment may attract a punitive exit charge as a result of foreign exchange controls. As part of any documentation following such review, it would be usual to see tax warranties and representations dealing with the issues of concern as well as full tax indemnities being given in respect of any liabilities or contingent liabilities likely to arise. For instance, the sale of shares may or may not attract capital
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gains tax. However, in case of the acquisition of a company by a purchase of shares, capital gains tax may be attracted when the underlying asset is then sold. Stamp duty or transaction duty on acquisitions by the purchase of assets can in some countries be as high as 8 times the stamp duty on the purchase of shares. Value-added tax (VAT) is generally not payable on the sale of shares. Special consideration should also be given to anti-avoidance laws which change constantly. Structures which may already be in place, therefore, may attract significant liability going forward. The linkage with anti-money laundering legislation also needs to be noted in this context. In most countries or jurisdictions, tax evasion is a criminal offence and therefore the flow of funds in and out of a business which is violating tax laws will or may also trigger equally punitive money laundering consequences. Explicit tax benefits may flow from the transaction for both parties. For instance, in some instances reliefs and tax deductions may be available on exiting the investment or financing. On other occasions, tax may be payable at a reduced rate as a result of group relief or applicable international treaty provisions.
Commercial due diligence
2.6
The focus of this aspect of due diligence is on the true business potential and impact of the transaction. The investor will concern itself with the market conditions, the competition, the brand value if any, the image of the products, the integration and interaction of the employees at different levels, as well as the cost of negotiations with any existing lenders or investors and the consequences (see also CHAPTER 6). It will be an extensive appraisal of the business plan in the context of these issues. The heart of the investigation will focus on assessing the true risk of the return.
Prior borrowing arrangements
2.7
The prior borrowings, including debentures, overdrafts and loans made available to the business, and the terms of the loans should be carefully reviewed. Any new borrowings made available should not exceed the permitted existing facilities, and the total borrowings and the new debt should be within the borrowing limitation prescribed by the constitution of the business. If not, the constitution will need to be amended before extending the additional facilities to the company. The existing facilities should be in continuity and in force. The terms of the existing facilities should be vetted to ensure that default provisions of the facilities and the implications of amendments are well understood. Additionally, covenants must be taken to the effect that the business has not breached any of the provisions of the existing facilities and relevant disclosures should be obtained if it has. Where new debt is to be made available in addition to existing debt, it may be necessary to subordinate the existing debt or ensure the prioritisation of the existing debt as part of the transaction. If the existing or new facilities are to
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be subordinated, subordination arrangements will need to be entered into. Avoiding the triggering of default or cross default provisions under existing facilities as a result of the new investment arrangements or transaction will be a primary concern. Change of control is often an important event of default which is triggered by a corporate finance transaction, as well as the breaching of important debt-to-equity ratios as well as cash flow and interest coverage covenants.
Commercial contracts and arrangements
2.8
The business would have entered into other various commercial contracts that would typically include its suppliers, distributors, marketing agents and export agents. These contracts may be key to business operations and sales. It therefore becomes important to ensure that these contracts are valid and existing, ascertaining the obligations under each of them, and to ensure that the business is not in default nor would be in default as a result of the transaction. In particular, outstanding obligations would need to be considered, such as monies owed or payable. If the entire business is being acquired, contracts may need to be either assigned or novated (substituted with the agreement of all parties). The consent of the contracting party will be required if liabilities are to be novated, or the assignment otherwise requires consent. This could be quite a cumbersome and time-consuming process. Termination provisions of the contracts may also be unfavourable, may have lengthy notice periods and may be activated upon a change of control. Special care will also have to be taken if the business has issued any guarantee, surety or indemnity in favour of any third party for the obligations of a group company or otherwise. Powers of attorneys, option agreements, indemnities, agreements granting pre-emption rights, comfort letters, credit extensions or credit grants or any offer or tender or such other document which could be converted into an obligation for the business as a result of the transaction should be carefully examined. If there are contracts or arrangements, the benefit under which could be assigned to a group company or to a third party, suitable covenants should be taken to prevent the business from doing so if this were to be against the investor’s or lender’s best interests. All the contracts in which the directors are interested or are not of arm’s length may also have to be renegotiated.
Licences and intellectual property rights
2.9
Many corporate finance transactions place value on the brands or licences of the business. If so, the licensing arrangements and the protection afforded to the intellectual property rights should be investigated in detail to ensure value is preserved. For example, a licence may stipulate termination if there is a change in control of the business, or a company may have exclusive or nonexclusive rights to the technology or may have rights exclusive to a particular area or country. The licences should be valid and in force.
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If the intention is to acquire the assignment of the license, one will need to ensure that the licence is not personal to the party in whose favour it is given, in which case it may not be capable of being assigned or sub-licensed. Intellectual property rights (IPRs) capable of registration can be ascertained from the records maintained by the Patents and Trademark Office in the relevant country of use. It is important to bear in mind that registrable IPRs may be territorial and not global. Again, what can be registered and what cannot may differ from country to country. According to the UK Patent Office, computer software may be capable of being patented if it results in a ‘technical effect’, generally interpreted as resulting in an improvement in technology, and it has to be essentially in the technology sector. Whereas in the USA, as acknowledged by the UK Patent Office, the approach taken is more liberal and the software that would be allowed to be patented would not necessarily qualify for registration in the UK. It is important to establish the source from where the IPR emanates. Warranties and representations should be taken particularly where the IPRs are not registrable. Some jurisdictions may require registration of ownership – license or sub-license of the IPRs may have an additional requirement of registering it within a particular time period. Care must also be taken that the technology or information employed by the business does not amount to infringement of third party IPRs and that the business is authorised to use such technology or confidential information. Employees dealing with confidential information should be bound by confidentiality agreements.
IT
2.10 The business should have an IT system in place, and have trained support staff to ensure proper handling, operation and monitoring of the business hardware and software. The system should be geared to handle disaster recovery of the date ensuring that the hardware or the software can be replaced or substituted without material disruption. However, it is prudent to have insurance to cover data loss risk. The company should have the benefit of a comprehensive support and maintenance agreement with appropriate confidentiality clauses. Software and hardware licences will also need to be validated as well as compliance with any data protection requirements (see also CHAPTER 9).
Real estate and business assets
2.11
The business may hold real estate as an owner or as a lessee. If title is registered, it should be relatively straightforward to check the title of the business and any encumbrances on the land as all these are registered with the land registry and will be a matter of public record. For unregistered titles, there will have to be a title investigation to ascertain the quality of the title held. Equitable charges are not required to be recorded as the title deeds are in possession of the chargee, which should serve as a notice to a potential purchaser or charge holder. If the transaction results in the transfer of the property,
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the stamp duty implications may be significant. Many transactions may therefore be structured to be subject to anti-avoidance laws so as to mitigate the stamp duty charge. Stamp duty laws of the relevant jurisdiction will have to be considered before choosing a structure. If the property is mortgaged or otherwise encumbered, depending on what the intention of the transaction is, the provisions of mortgage should: (a) allow transfer of the mortgage to the new owner; and (b) not trigger an event of default, or acceleration. However, if the intention is to seek a first charge or a subsequent charge on the property the existing mortgage will have to be amended with the consent of the existing lender. Planning permissions should permit necessary extensions or alterations if that is essential to the transaction. If the business is a tenant, all necessary protections under the tenancy statute must have been procured. If tenancies and licences cannot be registered with the land registry, the relevant agreements will determine the right of the business to the property. The tenure of the tenancy or the licence would in that case assume importance. The property should have all the essential utilities and the outgoings should not be prohibitively expensive. For a transfer of business assets, plant and machinery and the stock in trade may have stamp duty implications. In most jurisdictions plant and machinery capable of delivery is exempt from stamp duty. In addition, real estate will need to be properly appraised, insured and title certificated. A business or transaction that is development or property focused will also, of course, require a much higher level of due diligence with respect to any real estate and properties being developed or built (see also CHAPTER 1).
Employees, consultants and directors
2.12
Normally, applicable regulations will protect the rights of the employees when a business, whole or part, is transferred to another. The employees are automatically transferred on the same terms and conditions. Transfers that do not involve the transfer of business will not be attracted by the provisions of such regulations. Therefore, the transfer of shares will not be affected by the regulations as the employer entity stays the same. Under a business transfer, the new employer assumes all the rights and obligations arising from the employment contracts, including all the collective agreements made on behalf of the employees, but not the benefits relating to occupational pension schemes, which would have to be transferred separately. Redundancy of any employee as a result of the transfer of business may be deemed unfair dismissal unless the reason for the dismissal is an economic, technical or organisational reason entailing changes in the workforce. Regulations may apply irrespective of the size of the undertaking. Consultation with trade or employee union representatives will also need to be considered as part of any transaction which involves a change of ownership.
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It is also important to check the restrictive covenants in the employment contracts. The restrictive covenants would be covenants relating to noncompetition, non-disclosure and confidentiality. It would therefore be essential to confirm if the employment contracts have a clause relating to the assignment of the covenants and whether such assignment would be valid in the state where the contract is executed. Service agreements with directors would likewise need to be reviewed as well as consultancy arrangements. The human resource factors affecting a business need careful evaluation, including staff turnover, codes of conduct, performance reviews and complaint handling procedures. The employment base is a critical and valuable business asset: it’s very life and organ. Very recently the Founder and CEO of Starbucks has confirmed that the value of this business has been achieved through its values of integrity and authenticity that also permeate through its workforce. Breaches and violations of socio-employment laws, covering areas such as racial, religious or sexual discrimination or harassment, could have very harmful reputational and valuation impacts on a business’s prospects (see also CHAPTERS 7 and 8).
Pension arrangements
2.13
An actuarial expert will advise the company on various financial aspects of the pension arrangements such as: (a) debts of the business to the pension scheme; (b) contributions to be made to the pension scheme; (c) projected increases and losses to the pension scheme. In one case, it was discovered that the target’s subsidiary had a pension plan since 1976, which it had not accounted for, and the liability under the US Generally Accepted Accounting Principles (GAAP) treatment amounted to US$20 million. Employee benefit liabilities in the other subsidiaries, which were originally estimated to be US$25 million, turned out to be nearly US$200 million [1]. In the UK, a company is obliged to provide comparable pension arrangements to the employees. In the case of a business transfer, it will also have to ensure that the employees who were members of the pension scheme are transferred to the new pension scheme, and that they are properly advised and given complete information on the new pension scheme (Transfer of Undertakings (Protection of Employment) Regulations 1981 (SI 1981/1794)).
Insurance
2.14
The insurance cover should be as comprehensive as possible and cover all the assets and risks of an insurable nature – the key to which would be ascertaining the exposures and the risk involved. This in turn will determine the types and the amounts of the insurance covers. Insurance policies generally do not cover terrorism risk, which would require payment of an additional premium. The loss payee provisions and the assignment of the policies are a key in
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securing a debt and hence it is crucial that the laws of the local jurisdiction do not prejudice the investor or lender.
Environment
2.15
In an age of awareness of increased risk to ecosystems due to global warming and environmental pollutions, the regulatory authorities have endeavoured to keep the environmental pollution in check by forcing businesses to comply with the environmental laws. If the business requires authorisation to conduct any of its business activities, such authorisations should be valid and existing. Also, increased focus on compliance by a business with ‘social responsibilities’ and ‘carbon foot-printing’ will inevitably follow through in the future as an important ingredient of any due diligence process (see further CHAPTERS 4 and 12 in particular).
Warranties and indemnities
2.16
While due diligence reveals information on the operations of the business, it does not necessarily address the concerns raised by the due diligence exercise. Following a due diligence exercise, a lender or investor may then seek to get extensive warranties and representations from the business owners and management which can be relied on and form part of the risk return analysis. These are generally heavily negotiated and can often make or break a deal as they go to the heart of the apportionment of liability, and the balance of the risk–reward analysis. The warranties may take the form of indemnities which are undertakings that reimbursement or the making good of a loss will be made if a specified liability should occur. Indemnities are invariably taken in case of tax liabilities on sale of shares, litigation claims, environmental risks, doubtful claims, third party liabilities and any other matter, which has the likelihood of it resulting into a liability. As due diligence is an integral part of an acquisition or investment or borrowing, it should be approached with a clear purpose. The purpose will depend on the strategy of the investor behind the investment, or simply the perceived lending risks. The emphasis should be on ascertaining the true risk and reward equation. A KPMG survey on global deals [2] reveals that the priority accorded to due diligence has increased significantly with 35% of the respondents citing it as the most important pre-deal activity. Identification of key issues, clear guidelines and accurate analysis and interpretation of the findings is what the due diligence exercise achieves. It is an invaluable tool in a deal if employed properly.
Litigation
2.17
A review of current, pending and/or potential litigation is a vital component of pre-deal legal due diligence exercise. A cause of action may be derived
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from design defects, manufacturing defects or a failure to warn. Product liability has emerged as perhaps one of the greatest sources of ‘doomsday’ risk particularly, but not exclusively, for manufacturing firms. Product liability laws may differ substantially from one jurisdiction to another. In some countries product liability law may be based on strict liability and it may, therefore, not be necessary to show negligence. Potential liability to firms may be capped. Although the majority of high profile cases have taken place in the USA, it is worth noting that pending changes in law within the UK and indeed the rest of the European Union EU may expand the scope for the substantial litigation and potentially multi-million dollar awards often seen in the USA. Litigation risk is not limited to product liability. Indeed litigation may arise for any number of reasons, some of which may be associated with the proposed transaction and others which may be wholly unrelated. Below is a list of high risk areas (some of which have also been covered elsewhere in this chapter), which should be considered in any legal due diligence exercise: ● ● ● ● ● ●
Negligence; Product liability; Contractual disputes; Employment; Regulatory; and Environmental.
Regulation
2.18
Regulation, in addition to posing a potential litigation risk (as identified above), is a substantive issue in its own right to be considered in any due diligence exercise. This is particularly relevant in the case of M&A transactions, where (a) the acquirer and/or target are in a regulated industry and/or (b) the potential transaction itself gives rise to competition issues. In either scenario a transaction may well fail if the relevant regulator does not consent. The recent case of the attempted GE-Honeywell merger, which was abandoned after it became apparent that the required regulatory approval would not be obtained, is an example.
Risk management
2.19
The use of complex financial instruments by multinational trading firms has made risk management an increasingly important aspect of day-to-day operations. As such, a review of a firm’s risk management practices and procedures may comprise a significant part of a given due diligence exercise. Formerly this would be seen an exercise only pertinent to transactions involving banks, insurance companies, asset managers, hedge funds and other financial institutions. High profile failures such as Enron and Parmalat, however, have demonstrated that this is clearly no longer the case. Trading firms may be just as exposed to financial market turmoil as financial firms.
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Often firms may seek to hedge against a risk to which they are heavily exposed. For a manufacturing firm, it may be the price of a commodity which is a raw material in a given product. Hedging may take place through the use of a variety of contracts (e.g. futures, forwards) which seek to guard against adverse price movements. This may even become a profit centre for firms. Critical to any risk management review is a basic understanding of the firm’s risk model which may be extremely complex. It is then considered prudent to perform some form of stress test on a given model to ascertain the validity of underlying assumptions, that is, the likelihood of loss and the ability of a firm to withstand abnormal events.
Reputational risk
2.20
This chapter would not be complete without a short reference to reputational risk, which has become a priority area of risk according to many experts including the Aon risk survey referred to in CHAPTER 7. A business or transaction, however financially attractive, will not necessarily be attractive to the business or organisation as a whole if the association with the potential new business or source of financing would diminish or lower existing brand or management business values. This may be analysed through a simple SWOT analysis, but clearly it is a matter which the vision and values of the leadership of the business or organisation as a whole will determine.
References 1. Warner, E., Acquisitions Monthly (supplement), 33–36, October 2003. 2. Pratt, W. and Issitt, M., Acquisitions Monthly (supplement), 12–15, October 2003.
Appendix Example of initial due diligence list for the purchase of a regulated financial services business Definitions Company
ABC and each of its subsidiaries Directors and compliance officer and other personnel having supervisory responsibilities for regulatory purposes
Regulator
Financial Services Authority (UK)
Accounts date
31 December
Valuation date
30 June
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1. Individuals/owners: 䊊 due diligence on each of the individuals/owners (e.g. passport, two utility bills/bank statements showing proof of address and professional reference letter); 䊊 confirmation of regulatory good standing and any material disclosures made to Regulator in respect of Individuals. 2. General information on the company (includes each of its subsidiaries) including financial information, tax, business arrangements and corporate governance: 䊊 full accounts of the company for the five years prior to valuation date; 䊊 management accounts of the company for the period from the last accounts date to the valuation date; 䊊 management forecasts produced prior to the valuation date; 䊊 the proposed use of any cash balances in the balance sheet; 䊊 any significant additional bank borrowings anticipated; 䊊 capital commitments; 䊊 anticipated capital expenditure, not committed; 䊊 memorandum and articles of association; 䊊 shareholders’ agreement; 䊊 estimates of property and investment valuations; 䊊 details of property leases (particularly to estimate liabilities such as dilapidation), service property commitments, and capital or operating lease obligations in respect of assets and equipment; 䊊 details of any assets not shown on the balance sheet, such as intellectual property rights; 䊊 details of key directors and employees contracts including any consultancy contracts or arrangements as well as all service, benefit and pension or bonus arrangements proposed or made; 䊊 tax computations for the same periods as accounts, as well as confirmation that no outstanding tax obligations or liabilities exist; 䊊 full disclosure of material non-recurring items; 䊊 copies of minutes for board, remuneration committee, audit committee and risk and credit committee; 䊊 details of all pending or threatened litigation or dispute matters; 䊊 details of any surplus assets; 䊊 details of all computer software and hardware, licences and dealing platforms and data feeds and any plans to update or replace these; 䊊 full details of aged: – debtors; – creditors outstanding as at the valuation date and all book debts written off or provided for; 䊊 full details of all professional indemnity and other insurance cover and any claims made; 䊊 details of all material trading exposures and positions at valuation date; 䊊 details of all bank borrowings and banking facilities; 䊊 full inventory, asset and investment lists as at the valuation date;
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full details of any dividends declared or proposed subsequent to valuation date; 䊊 full details of shareholder resolutions recently passed or made since valuation date; 䊊 details of all joint venture and other business associations or agreements; 䊊 group structure chart and group organisation charts; 䊊 compliance or operating manuals; 䊊 full copy of customer documentation; 䊊 full details of all agency and commission arrangements. 3. Regulatory position and standing: 䊊 details of all licences, permissions and consents issued by Regulator, and confirmation that all remain good standing and have not been revoked, qualified or modified; 䊊 details of all material correspondence with Regulator, site-visit reports, external audit and management reports and steps taken to resolve and satisfy Regulator on any issues arising; 䊊 details of any customer complaints and notifications to Regulator and steps taken towards resolution; 䊊 evidence of compliance in last 12 months of all capital adequacy and/or solvency or liquidity requirements imposed by Regulator or under governing regulation and law. 4. The Company’s current trading position (including each subsidiary) and prospects: 䊊 breakdown of revenue generation prior to valuation date and after accounts date: – fees; – commissions; 䊊 revenue forecasts prepared prior to valuation date for next six months; 䊊 major clients and fee income or commissions representing greater than 5% of revenue; 䊊 major contracts being performed, for example, funds under management or being managed; 䊊 major future contracts anticipated at the valuation date; 䊊 capital expenditure either incurred or anticipated that would have an effect on revenue; 䊊 sales brochures, giving an understanding of the product, for existing or new products; 䊊 details of any new products or services likely to come on stream in the near future; 䊊 spending on technology, etc. for instance for the previous three years; 䊊 details of any changes of the business in recent years, such as the closure of a division; 䊊 is there any new legislation or expected legislation likely to affect the business? 䊊 details of proposed hiring and recruitment of new employees or directors; and 䊊 details of establishment of new divisions or operating subsidiaries. 䊊
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2 Due diligence in corporate finance
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Due diligence in corporate finance
CHAPTER OVERVIEW
2.1 The expression ‘corporate finance’ generally refers to the mechanisms and processes by which businesses raise capital or enhance capital values for operations and growth. Capital can be raised in a variety of ways, such as by the issue of shares or debentures, or the provision of loans or banking facilities. Capital values can also be enhanced or protected when businesses are merged, acquired or restructured. The mechanisms and processes can either be private or public in nature, depending on the objectives of the corporate finance exercise. The mechanism or processes by which corporate finance is provided, or the corporate finance transaction executed, as well as the nature of the transaction contemplated, will determine the level or type of due diligence required or available. For example, the level of due diligence required for a secured borrowing facility will be significantly less than that required for an equity investment. The lender will simply be looking to ensure: (a) the loan will be repaid together with interest over the term and that there is sufficient net cash flow cover to ensure repayment; and (b) the value of the security is sufficient to cover the loan to the value given. A highly liquid publicly traded stock will have a higher loan to value than an illiquid stock and certain types of real estate, such as development or commercial properties, will have lower loan to values than residential properties. On the other hand, an equity investor, such as a venture capitalist, will be concerned to ensure that the profitability and positioning of the business over the given investment time horizon will be sufficient: (a) to yield the required internal rate of return on the investment; and (b) for that return to be crystallised by an exit event, such as initial public offering of flotation, or a trade sale.
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The focus will therefore be more on the ability of the management to deliver the returns based on the forecasts or projections for the business. In some cases, the degree of due diligence available or required will be limited or restricted by the nature of the business or transaction contemplated. The offering circular or document of a publicly traded company which is subject to ongoing disclosure requirements to its shareholders, governing regulator or exchange will differ from that for a private company where there has been no such public disclosure. The due diligence available on a recommended bid for a company will also differ dramatically from that for a hostile bid, where the offeror company simply is not given access to the relevant internal financial and management information, and therefore has to subject the bid to a number of conditions, which it will have power to amend or vary subject to what is discovered or obtained by way of due diligence in the bid process. In each corporate finance situation, however varying or differing, invariably the same fundamental issues are being addressed: * What is the investment return available or the level of finance affordable by the business? and What risks are there which would result in the expected return not * being achieved or the financing not being repaid? The due diligence process will define the return or pricing of the investment or financing, the amount of the investment or financing to be made available and the structure of the investment or financing. Invariably too, the due diligence process is forcing an alignment of interests, of risk and reward, as well as expectation. There are competing interests. What a business or company may perceive as a fair return for an investment may differ substantially from what the investor or financier may require. Alignment of interests will not just address the issue of price, but also management commitment, focus and vision, and the ability to deliver the return based on the expectation created. There is also the issue of evaluating external factors, which will affect the return and reward, factors that are either systematic, such as interest rates, inflation and political events that are common to the business and industry as whole, or events that are specific to the business or industry itself and which can be compared to similar businesses. Risk can thus be defined and isolated and then appraised relative to the expected return – a process generally known as risk adjusted return. The weight given to the critical financial analysis tools used by lenders and equity investors alike will vary. A lender will be evaluating financial risk ratios such as interest coverage and interest coverage adjusted for cash flow and debt to equity ratios, whereas an equity investor will be more concerned with profitability ratios looking at return on capital and return on equity. Both will be concerned, however, with historical
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business information such as matters affecting the essential ability of the business to pay its debts as they fall due and to turn its inventory or assets over in a sufficient period of days to create cash flow and remain solvent and profitable. Of course emphasis on all or any of the financial ratios will vary from business to business. They also become subject to fashion trends. For example, many of these core financial ratios were dispensed with during the technology boom of the late 1990s when forecasts and projections were solely used as determinants of value and investment. And between 2003 and 2007, with the advent of large leveraged buy-out deals, the need to be nimble in capital raising and high liquidity levels, borrowers demanded a loosening of lending covenants and ratio tests, with the result of the popular ‘cov-lite’ lending deals. Inevitably, in mid-2007, this approach fell out of favour as lenders found themselves with inadequate security in a market downturn, caused by the collapse of the sub-prime market and plummeting liquidity levels. Often, for a corporate finance transaction there will be a mixture of equity or debt or variations of these, and this will give rise to an appropriate review as to what the mixture should be and how it should be priced. The weighted average cost of capital calculation would be a familiar calculation used to determine the correct balance of each and the risks arising. In coming to a conclusion as whether or not to invest or finance or to undertake the transaction and in evaluating the business or transaction as a whole, various factors will need to be considered. The critical due diligence process would be the assessment of these factors and undertaken by a team of professionals of varying disciplines to examine and investigate different aspects of the business or transaction. The due diligence process undertaken will vary considerably from one business or transaction to another, and the initial requests for information or the basis of investigation and research will have to be tailored to the business or transaction concerned. Whilst there are broad categories of information that are normally reviewed and requested, it would be a serious misconception to think that one size fits all. The due diligence process will be an important part of the evaluation and structuring process and decisive of the ultimate success or failure of the investment or financing proposed for the business or transaction. Depending on the business or transaction being proposed or considered, from a high level approach, the due diligence process will then reach down to a more detailed and distilled consideration of the various issues affecting the value of the business – often after combing through a myriad of legal, technical and commercial matters. These considerations will then form the basis of a report or reports on which ultimate investing or credit decisions are taken.
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A caveat, therefore, has to be made that, in discussing due diligence in corporate finance, it is very much an introduction and specialised professional advice will often be sought on various matters to be reviewed and analysed. This chapter therefore looks at some typical due diligence topics arising in corporate finance. It is certainly not intended to be a comprehensive checklist, rather a list of examples of due diligence exercises that might be undertaken and the type of issues addressed.
Due diligence process
2.2
The due diligence team would consist of various professional advisers: normally legal, financial, technical, environmental, insurance and actuarial experts working in tandem with each other. These advisers should be brought on board as soon as practicable to give them sufficient time to cover comprehensively the issues involved. The due diligence process is often driven by the lending institution or investment bank who will co-ordinate the due diligence team. The team that undertakes the due diligence exercise needs to be given clear instructions as to the objective of the exercise and its parameters. Understanding what the business or transaction entails, and what the exercise is intended to achieve will help the team to streamline the exercise, focus on the relevant issues and make it more time and cost efficient. If a company plans to acquire a target with the intention of developing and selling properties, starting or developing, for example, a hotel with a casino, it has to convey these ideas and strategies to the due diligence team. Whether these strategies are realisable and what complexities they entail are the answers that the investing company would wish to find out from the due diligence exercise. For example, before embarking on a proposed transaction involving the purchase, by loan financing, of a hotel operation in India, a first tenet would be to determine whether or not profits could be remitted from India to repay the loan and whether the lender could perfect security in India over the assets being acquired. It is often very surprising how advanced transactions may proceed before critical corporate finance issues are discovered. High level information overviews are therefore advisable from a very early stage. To highlight this point, an overview list of requested information with respect to the purchase of a regulated financial services business is set out in the Appendix to this chapter. At the core of this acquisition would be the regulated status of the business and its compliance with regulatory provisions. From the information disclosed, the basis on which the transaction is financed and structured, documented and completed can then be negotiated and finalised. The responses given to the detailed questionnaire would normally be expected to form part of ‘disclosures’ to warranties and representations to
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be made by or in respect of the business or transaction. Once disclosures are made, for instance, as regards pending litigation, breaches of overdraft facilities or arrangements with creditors, the liabilities would be quantified, the price adjusted or the purchase price deferred and the disclosures warranted as being complete and accurate in themselves, so that the extent of the liability is correctly provided for. An important part of the inception of the due diligence process is the exchange of confidential undertakings. These structure the environment in which often price-sensitive and valuable information relating to the business or transaction is passed by the business to lenders or investors securely without risk of leakage into the public domain and thereby potentially damaging the value and reputation of the business. Generally, the confidentiality undertakings will expressly refer to what is to be disclosed and how it is to be identified as confidential, usually by reference to the initial or subsequent due diligence lists or questionnaires, to whom it may be disclosed, for what purpose and how it is to be returned or dealt with if the transaction does not proceed. The undertakings may also extend to non-compete clauses and lock-up periods during which the negotiating parties agree to deal exclusively with each other for a certain time period with respect to the business or transaction concerned. This enhances confidence among the parties and creates a safe environment in which disclosure can take place. Creating the right environment is paramount as no less than full disclosure will determine the right analysis of the appropriate risk and reward. The due diligence team and its advisers will normally be ring-fenced, and each participant required to give its undertaking to be bound by the rules of confidentiality on which engagement takes place. Important issues to be borne in mind are: ● ● ●
who is keeping the master disclosures lists; who is co-ordinating disclosures; who is responsible for evaluating and analysing the disclosures given in the context of the transaction as whole.
In a typical transaction, one would expect to see a combination of reports being assembled for review from the due diligence team. For example, financial reports including reviews of management accounts and forecasts, asset valuations, working capital and historical annual accounts, a legal report on regulatory and compliance issues and title to assets and the business, tax reports on the tax implications for the parties, actuarial reports on pension funds, environmental reports, and other specific valuations and project implementation reports – depending on the business or transaction and the nature of the corporate finance activity.
Anti-money laundering due diligence
2.3
A chapter on corporate finance due diligence would not be correctly balanced without discussion of anti-money laundering and terrorist financing due
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diligence. This is dealt with as a subject in much greater detail in the chapter on anti-money laundering due diligence (CHAPTER 3). Money laundering is now an essential prerequisite and integral part of the due diligence exercise for any corporate finance transaction in light of the now very extensive, stringent and punitive money laundering regulations that have been adopted by most countries. The scope of the regulations can be very wide. In the UK, for example, Money Laundering Regulations 2003 (SI 2003/3075)1 now cover any transfer, conversion, removal, concealment or disguise of funds which constitute the proceeds of crime. Terrorist Financing legislation prohibits engaging in financial dealings for the purpose of terrorism. This means that in looking at a business or transaction as a whole, it will need to be borne in mind that questionable accounting practices or possible tax evasion discovered as part of the due diligence exercise, and which is or could be a criminal offence, may then lead to independent money laundering disclosures obligations for the due diligence team. It also means (as a result of recent combatting terrorist financing legislation) looking more closely at what one might otherwise consider to be low risk transactions on the basis that funds are moving from a ‘clean’ source. First steps in any corporate finance transaction would be undertaking appropriate due diligence on the business owners or management, or ensuring that the proposed funds to be invested or lent to the business as part of the corporate finance transaction are clean. The exercise would then extend to evaluating the proper sources of funds coming into and out of a business operation. Where businesses have significant cash revenues, or operate on a cash-based system, this could give rise to a significant number of problems and potential disclosures. Moreover, the professional members of the due diligence team will usually have independent disclosure obligations and may be required to make disclosures to the regulatory authorities without reference to the client or other members of the due diligence team if they have concerns or suspicions. It could be a money laundering offence if an adviser who is regulated fails to detect money laundering when they should have detected or suspected it. The terms of any due diligence engagement should be very clear on this issue and certainly disclosure will be an exception carved out of any confidentiality agreements.
Financial due diligence
2.4
Financial investigations would typically be carried out with the help of a firm of accountants or an investment bank. The due diligence intends to verify whether all books of accounts and other financial records are up to date and have been accurately maintained. It also seeks to search out the current trading position and prospects of the business, which are not evident from
1
Augmented by the Third Money Laundering Directive implemented on 15th December, 2007.
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the historical or filed accounts. The fact that the books are audited provides some comfort, but usually this information will be significantly out of date. Businesses are dynamic and every day something may change that will affect the overall financial position of the company prior to conclusion of the transaction. For example, on a lending transaction, a lender will frequently require extensive drawdown (drawing of loan at agreed intervals) conditions under which very up-to-date information is provided on the company’s affairs prior to drawdown, for example up-to-date debtors and creditors lists, cash balances and reassurance that no material changes or events have taken place. There is much that can be gleaned from disclosed financial information and the accompanying financial ratios. However, there is still much that can lurk behind the figures, irrespective of the interpretation of the entries and calculations of financial ratios. The information identified from detailed investigation will be highly relevant in the ongoing negotiations for the cost of finance and its structure. At a minimum, accounts should be audited as required by best accounting practices, and should be in conformity with the local law. An important part of historical analysis is to look at any disclaimers or qualifications on the audit reports, or a frequent change of auditors. Equally, at a minimum, management accounts should adopt accounting policies and practices that are consistent with the audited accounts. A more vital review is that the accounting systems used to record information are robust, postings are accurate and properly posted, and the basis on which postings are made are consistent and reliable. Revenues need to be carefully reviewed. Contracts can be entered into and invoices raised even though there may be no underlying delivery or agreement as to delivery. There also needs to be a careful review that the true costs of revenues are shown – and not hidden so as to inflate earnings and profitability. Capital commitments have to be carefully considered for onerous or unusual payment provisions, for example, advance payments that do not necessarily oblige delivery or performance. Financial projections based on the projection of capital expenditures and sources of capital for the payment of such expenditure have to be matched against the reality of true cost, delivery and implementation. A capital financing proposed may merely be used to prop up working capital requirements and be insufficient to fund the capital needs of the business on which future growth hinges. Often management understate the true working capital needs in order to enhance earnings and returns. The inventory and the work in progress should be valued without including profit, but taking into account anticipated losses. It is important to examine the inventory physically to ensure that the stock and the raw materials are not obsolete or redundant, and the value is accurately reflected in the books. On-site stock checks on the closing of a transaction would not be uncommon. Contingent, disputed and other liabilities, including claims under contracts, should be specifically reviewed, as well as any default or cross-defaults occurring under existing borrowing facilities as a result of the financing, and the consequences of those defaults considered in detail. There should be a clear analysis of those accounting arrangements which are by definition subjective, for instance, provision for bad or doubtful debts,
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treatment of capital or revenue leases, off-balance sheet risks and liabilities, the use of favourable inventory methodology, treatment of capital expenses and recurrent expenses. For example, one of the key frauds leading to the collapse of the US telecommunications group Worldcom in 2002 was the capitalisation of costs that were clearly recurrent leading to a massive overstatement of earnings. In the USA, it is also worth noting that the Sarbanes-Oxley Act of 2002 (SOX) was enacted in the aftermath of the US corporate accounting scandals, necessitating revision of corporate governance standards and increasing the disclosures requirement to protect the interest of the investors. The statute establishes an oversight board to oversee the audit of the public companies, which are subject to the securities laws. Sections 302 and 906 require the Chief Executive Officer (CEO) and Chief Finance Officer (CFO) to certify that the information contained in the periodic report required to be filed with the US Securities and Exchange Commission (SEC) fairly represents, in all material respects, the financial conditions of the company and the adequacy of the internal controls. Any false certification will attract criminal liability. For further details on the SOX see CHAPTER 11. Oversight of critical financial issues in the due diligence exercise could result in a company investing in the USA, having a huge task of organising the target company’s books post-transaction to be able to make accurate quarterly and annual reports to the SEC.
Tax
2.5 Tax implications will vary depending on the country in which the business operates as well as the country of the lender or investor. Tax is a very important part of the due diligence process, and the tax consequences of a transaction or investment could have significant pricing implications, for example, the withdrawal of reliefs or crystallisation of charges previously held and the understatement or overstatement of deferred tax charges and tax assets as shown in the books of accounts. Historic tax computations will need to be reviewed and the impact of the transaction considered. This will often lead to the manner in which the transaction is structured in order to maximise tax efficiencies, for example, whether as a share acquisition or asset purchase or a financing by way of debt or equity, deferred consideration or instalments. The tax review would extend to the whole gambit of applicable taxes, for instance, income or capital gains taxes, estate or inheritance taxes, Valuedadded tax or sales or service tax and customs and excise duties and charges. In each case, an analysis would be necessary of the likely impact. For example, loans may attract withholding taxes on interest payable, asset purchases may attract a value-added tax and an overseas equity investment may attract a punitive exit charge as a result of foreign exchange controls. As part of any documentation following such review, it would be usual to see tax warranties and representations dealing with the issues of concern as well as full tax indemnities being given in respect of any liabilities or contingent liabilities likely to arise. For instance, the sale of shares may or may not attract capital
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gains tax. However, in case of the acquisition of a company by a purchase of shares, capital gains tax may be attracted when the underlying asset is then sold. Stamp duty or transaction duty on acquisitions by the purchase of assets can in some countries be as high as 8 times the stamp duty on the purchase of shares. Value-added tax (VAT) is generally not payable on the sale of shares. Special consideration should also be given to anti-avoidance laws which change constantly. Structures which may already be in place, therefore, may attract significant liability going forward. The linkage with anti-money laundering legislation also needs to be noted in this context. In most countries or jurisdictions, tax evasion is a criminal offence and therefore the flow of funds in and out of a business which is violating tax laws will or may also trigger equally punitive money laundering consequences. Explicit tax benefits may flow from the transaction for both parties. For instance, in some instances reliefs and tax deductions may be available on exiting the investment or financing. On other occasions, tax may be payable at a reduced rate as a result of group relief or applicable international treaty provisions.
Commercial due diligence
2.6
The focus of this aspect of due diligence is on the true business potential and impact of the transaction. The investor will concern itself with the market conditions, the competition, the brand value if any, the image of the products, the integration and interaction of the employees at different levels, as well as the cost of negotiations with any existing lenders or investors and the consequences (see also CHAPTER 6). It will be an extensive appraisal of the business plan in the context of these issues. The heart of the investigation will focus on assessing the true risk of the return.
Prior borrowing arrangements
2.7
The prior borrowings, including debentures, overdrafts and loans made available to the business, and the terms of the loans should be carefully reviewed. Any new borrowings made available should not exceed the permitted existing facilities, and the total borrowings and the new debt should be within the borrowing limitation prescribed by the constitution of the business. If not, the constitution will need to be amended before extending the additional facilities to the company. The existing facilities should be in continuity and in force. The terms of the existing facilities should be vetted to ensure that default provisions of the facilities and the implications of amendments are well understood. Additionally, covenants must be taken to the effect that the business has not breached any of the provisions of the existing facilities and relevant disclosures should be obtained if it has. Where new debt is to be made available in addition to existing debt, it may be necessary to subordinate the existing debt or ensure the prioritisation of the existing debt as part of the transaction. If the existing or new facilities are to
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be subordinated, subordination arrangements will need to be entered into. Avoiding the triggering of default or cross default provisions under existing facilities as a result of the new investment arrangements or transaction will be a primary concern. Change of control is often an important event of default which is triggered by a corporate finance transaction, as well as the breaching of important debt-to-equity ratios as well as cash flow and interest coverage covenants.
Commercial contracts and arrangements
2.8
The business would have entered into other various commercial contracts that would typically include its suppliers, distributors, marketing agents and export agents. These contracts may be key to business operations and sales. It therefore becomes important to ensure that these contracts are valid and existing, ascertaining the obligations under each of them, and to ensure that the business is not in default nor would be in default as a result of the transaction. In particular, outstanding obligations would need to be considered, such as monies owed or payable. If the entire business is being acquired, contracts may need to be either assigned or novated (substituted with the agreement of all parties). The consent of the contracting party will be required if liabilities are to be novated, or the assignment otherwise requires consent. This could be quite a cumbersome and time-consuming process. Termination provisions of the contracts may also be unfavourable, may have lengthy notice periods and may be activated upon a change of control. Special care will also have to be taken if the business has issued any guarantee, surety or indemnity in favour of any third party for the obligations of a group company or otherwise. Powers of attorneys, option agreements, indemnities, agreements granting pre-emption rights, comfort letters, credit extensions or credit grants or any offer or tender or such other document which could be converted into an obligation for the business as a result of the transaction should be carefully examined. If there are contracts or arrangements, the benefit under which could be assigned to a group company or to a third party, suitable covenants should be taken to prevent the business from doing so if this were to be against the investor’s or lender’s best interests. All the contracts in which the directors are interested or are not of arm’s length may also have to be renegotiated.
Licences and intellectual property rights
2.9
Many corporate finance transactions place value on the brands or licences of the business. If so, the licensing arrangements and the protection afforded to the intellectual property rights should be investigated in detail to ensure value is preserved. For example, a licence may stipulate termination if there is a change in control of the business, or a company may have exclusive or nonexclusive rights to the technology or may have rights exclusive to a particular area or country. The licences should be valid and in force.
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If the intention is to acquire the assignment of the license, one will need to ensure that the licence is not personal to the party in whose favour it is given, in which case it may not be capable of being assigned or sub-licensed. Intellectual property rights (IPRs) capable of registration can be ascertained from the records maintained by the Patents and Trademark Office in the relevant country of use. It is important to bear in mind that registrable IPRs may be territorial and not global. Again, what can be registered and what cannot may differ from country to country. According to the UK Patent Office, computer software may be capable of being patented if it results in a ‘technical effect’, generally interpreted as resulting in an improvement in technology, and it has to be essentially in the technology sector. Whereas in the USA, as acknowledged by the UK Patent Office, the approach taken is more liberal and the software that would be allowed to be patented would not necessarily qualify for registration in the UK. It is important to establish the source from where the IPR emanates. Warranties and representations should be taken particularly where the IPRs are not registrable. Some jurisdictions may require registration of ownership – license or sub-license of the IPRs may have an additional requirement of registering it within a particular time period. Care must also be taken that the technology or information employed by the business does not amount to infringement of third party IPRs and that the business is authorised to use such technology or confidential information. Employees dealing with confidential information should be bound by confidentiality agreements.
IT
2.10 The business should have an IT system in place, and have trained support staff to ensure proper handling, operation and monitoring of the business hardware and software. The system should be geared to handle disaster recovery of the date ensuring that the hardware or the software can be replaced or substituted without material disruption. However, it is prudent to have insurance to cover data loss risk. The company should have the benefit of a comprehensive support and maintenance agreement with appropriate confidentiality clauses. Software and hardware licences will also need to be validated as well as compliance with any data protection requirements (see also CHAPTER 9).
Real estate and business assets
2.11
The business may hold real estate as an owner or as a lessee. If title is registered, it should be relatively straightforward to check the title of the business and any encumbrances on the land as all these are registered with the land registry and will be a matter of public record. For unregistered titles, there will have to be a title investigation to ascertain the quality of the title held. Equitable charges are not required to be recorded as the title deeds are in possession of the chargee, which should serve as a notice to a potential purchaser or charge holder. If the transaction results in the transfer of the property,
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the stamp duty implications may be significant. Many transactions may therefore be structured to be subject to anti-avoidance laws so as to mitigate the stamp duty charge. Stamp duty laws of the relevant jurisdiction will have to be considered before choosing a structure. If the property is mortgaged or otherwise encumbered, depending on what the intention of the transaction is, the provisions of mortgage should: (a) allow transfer of the mortgage to the new owner; and (b) not trigger an event of default, or acceleration. However, if the intention is to seek a first charge or a subsequent charge on the property the existing mortgage will have to be amended with the consent of the existing lender. Planning permissions should permit necessary extensions or alterations if that is essential to the transaction. If the business is a tenant, all necessary protections under the tenancy statute must have been procured. If tenancies and licences cannot be registered with the land registry, the relevant agreements will determine the right of the business to the property. The tenure of the tenancy or the licence would in that case assume importance. The property should have all the essential utilities and the outgoings should not be prohibitively expensive. For a transfer of business assets, plant and machinery and the stock in trade may have stamp duty implications. In most jurisdictions plant and machinery capable of delivery is exempt from stamp duty. In addition, real estate will need to be properly appraised, insured and title certificated. A business or transaction that is development or property focused will also, of course, require a much higher level of due diligence with respect to any real estate and properties being developed or built (see also CHAPTER 1).
Employees, consultants and directors
2.12
Normally, applicable regulations will protect the rights of the employees when a business, whole or part, is transferred to another. The employees are automatically transferred on the same terms and conditions. Transfers that do not involve the transfer of business will not be attracted by the provisions of such regulations. Therefore, the transfer of shares will not be affected by the regulations as the employer entity stays the same. Under a business transfer, the new employer assumes all the rights and obligations arising from the employment contracts, including all the collective agreements made on behalf of the employees, but not the benefits relating to occupational pension schemes, which would have to be transferred separately. Redundancy of any employee as a result of the transfer of business may be deemed unfair dismissal unless the reason for the dismissal is an economic, technical or organisational reason entailing changes in the workforce. Regulations may apply irrespective of the size of the undertaking. Consultation with trade or employee union representatives will also need to be considered as part of any transaction which involves a change of ownership.
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It is also important to check the restrictive covenants in the employment contracts. The restrictive covenants would be covenants relating to noncompetition, non-disclosure and confidentiality. It would therefore be essential to confirm if the employment contracts have a clause relating to the assignment of the covenants and whether such assignment would be valid in the state where the contract is executed. Service agreements with directors would likewise need to be reviewed as well as consultancy arrangements. The human resource factors affecting a business need careful evaluation, including staff turnover, codes of conduct, performance reviews and complaint handling procedures. The employment base is a critical and valuable business asset: it’s very life and organ. Very recently the Founder and CEO of Starbucks has confirmed that the value of this business has been achieved through its values of integrity and authenticity that also permeate through its workforce. Breaches and violations of socio-employment laws, covering areas such as racial, religious or sexual discrimination or harassment, could have very harmful reputational and valuation impacts on a business’s prospects (see also CHAPTERS 7 and 8).
Pension arrangements
2.13
An actuarial expert will advise the company on various financial aspects of the pension arrangements such as: (a) debts of the business to the pension scheme; (b) contributions to be made to the pension scheme; (c) projected increases and losses to the pension scheme. In one case, it was discovered that the target’s subsidiary had a pension plan since 1976, which it had not accounted for, and the liability under the US Generally Accepted Accounting Principles (GAAP) treatment amounted to US$20 million. Employee benefit liabilities in the other subsidiaries, which were originally estimated to be US$25 million, turned out to be nearly US$200 million [1]. In the UK, a company is obliged to provide comparable pension arrangements to the employees. In the case of a business transfer, it will also have to ensure that the employees who were members of the pension scheme are transferred to the new pension scheme, and that they are properly advised and given complete information on the new pension scheme (Transfer of Undertakings (Protection of Employment) Regulations 1981 (SI 1981/1794)).
Insurance
2.14
The insurance cover should be as comprehensive as possible and cover all the assets and risks of an insurable nature – the key to which would be ascertaining the exposures and the risk involved. This in turn will determine the types and the amounts of the insurance covers. Insurance policies generally do not cover terrorism risk, which would require payment of an additional premium. The loss payee provisions and the assignment of the policies are a key in
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securing a debt and hence it is crucial that the laws of the local jurisdiction do not prejudice the investor or lender.
Environment
2.15
In an age of awareness of increased risk to ecosystems due to global warming and environmental pollutions, the regulatory authorities have endeavoured to keep the environmental pollution in check by forcing businesses to comply with the environmental laws. If the business requires authorisation to conduct any of its business activities, such authorisations should be valid and existing. Also, increased focus on compliance by a business with ‘social responsibilities’ and ‘carbon foot-printing’ will inevitably follow through in the future as an important ingredient of any due diligence process (see further CHAPTERS 4 and 12 in particular).
Warranties and indemnities
2.16
While due diligence reveals information on the operations of the business, it does not necessarily address the concerns raised by the due diligence exercise. Following a due diligence exercise, a lender or investor may then seek to get extensive warranties and representations from the business owners and management which can be relied on and form part of the risk return analysis. These are generally heavily negotiated and can often make or break a deal as they go to the heart of the apportionment of liability, and the balance of the risk–reward analysis. The warranties may take the form of indemnities which are undertakings that reimbursement or the making good of a loss will be made if a specified liability should occur. Indemnities are invariably taken in case of tax liabilities on sale of shares, litigation claims, environmental risks, doubtful claims, third party liabilities and any other matter, which has the likelihood of it resulting into a liability. As due diligence is an integral part of an acquisition or investment or borrowing, it should be approached with a clear purpose. The purpose will depend on the strategy of the investor behind the investment, or simply the perceived lending risks. The emphasis should be on ascertaining the true risk and reward equation. A KPMG survey on global deals [2] reveals that the priority accorded to due diligence has increased significantly with 35% of the respondents citing it as the most important pre-deal activity. Identification of key issues, clear guidelines and accurate analysis and interpretation of the findings is what the due diligence exercise achieves. It is an invaluable tool in a deal if employed properly.
Litigation
2.17
A review of current, pending and/or potential litigation is a vital component of pre-deal legal due diligence exercise. A cause of action may be derived
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from design defects, manufacturing defects or a failure to warn. Product liability has emerged as perhaps one of the greatest sources of ‘doomsday’ risk particularly, but not exclusively, for manufacturing firms. Product liability laws may differ substantially from one jurisdiction to another. In some countries product liability law may be based on strict liability and it may, therefore, not be necessary to show negligence. Potential liability to firms may be capped. Although the majority of high profile cases have taken place in the USA, it is worth noting that pending changes in law within the UK and indeed the rest of the European Union EU may expand the scope for the substantial litigation and potentially multi-million dollar awards often seen in the USA. Litigation risk is not limited to product liability. Indeed litigation may arise for any number of reasons, some of which may be associated with the proposed transaction and others which may be wholly unrelated. Below is a list of high risk areas (some of which have also been covered elsewhere in this chapter), which should be considered in any legal due diligence exercise: ● ● ● ● ● ●
Negligence; Product liability; Contractual disputes; Employment; Regulatory; and Environmental.
Regulation
2.18
Regulation, in addition to posing a potential litigation risk (as identified above), is a substantive issue in its own right to be considered in any due diligence exercise. This is particularly relevant in the case of M&A transactions, where (a) the acquirer and/or target are in a regulated industry and/or (b) the potential transaction itself gives rise to competition issues. In either scenario a transaction may well fail if the relevant regulator does not consent. The recent case of the attempted GE-Honeywell merger, which was abandoned after it became apparent that the required regulatory approval would not be obtained, is an example.
Risk management
2.19
The use of complex financial instruments by multinational trading firms has made risk management an increasingly important aspect of day-to-day operations. As such, a review of a firm’s risk management practices and procedures may comprise a significant part of a given due diligence exercise. Formerly this would be seen an exercise only pertinent to transactions involving banks, insurance companies, asset managers, hedge funds and other financial institutions. High profile failures such as Enron and Parmalat, however, have demonstrated that this is clearly no longer the case. Trading firms may be just as exposed to financial market turmoil as financial firms.
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Often firms may seek to hedge against a risk to which they are heavily exposed. For a manufacturing firm, it may be the price of a commodity which is a raw material in a given product. Hedging may take place through the use of a variety of contracts (e.g. futures, forwards) which seek to guard against adverse price movements. This may even become a profit centre for firms. Critical to any risk management review is a basic understanding of the firm’s risk model which may be extremely complex. It is then considered prudent to perform some form of stress test on a given model to ascertain the validity of underlying assumptions, that is, the likelihood of loss and the ability of a firm to withstand abnormal events.
Reputational risk
2.20
This chapter would not be complete without a short reference to reputational risk, which has become a priority area of risk according to many experts including the Aon risk survey referred to in CHAPTER 7. A business or transaction, however financially attractive, will not necessarily be attractive to the business or organisation as a whole if the association with the potential new business or source of financing would diminish or lower existing brand or management business values. This may be analysed through a simple SWOT analysis, but clearly it is a matter which the vision and values of the leadership of the business or organisation as a whole will determine.
References 1. Warner, E., Acquisitions Monthly (supplement), 33–36, October 2003. 2. Pratt, W. and Issitt, M., Acquisitions Monthly (supplement), 12–15, October 2003.
Appendix Example of initial due diligence list for the purchase of a regulated financial services business Definitions Company
ABC and each of its subsidiaries Directors and compliance officer and other personnel having supervisory responsibilities for regulatory purposes
Regulator
Financial Services Authority (UK)
Accounts date
31 December
Valuation date
30 June
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1. Individuals/owners: 䊊 due diligence on each of the individuals/owners (e.g. passport, two utility bills/bank statements showing proof of address and professional reference letter); 䊊 confirmation of regulatory good standing and any material disclosures made to Regulator in respect of Individuals. 2. General information on the company (includes each of its subsidiaries) including financial information, tax, business arrangements and corporate governance: 䊊 full accounts of the company for the five years prior to valuation date; 䊊 management accounts of the company for the period from the last accounts date to the valuation date; 䊊 management forecasts produced prior to the valuation date; 䊊 the proposed use of any cash balances in the balance sheet; 䊊 any significant additional bank borrowings anticipated; 䊊 capital commitments; 䊊 anticipated capital expenditure, not committed; 䊊 memorandum and articles of association; 䊊 shareholders’ agreement; 䊊 estimates of property and investment valuations; 䊊 details of property leases (particularly to estimate liabilities such as dilapidation), service property commitments, and capital or operating lease obligations in respect of assets and equipment; 䊊 details of any assets not shown on the balance sheet, such as intellectual property rights; 䊊 details of key directors and employees contracts including any consultancy contracts or arrangements as well as all service, benefit and pension or bonus arrangements proposed or made; 䊊 tax computations for the same periods as accounts, as well as confirmation that no outstanding tax obligations or liabilities exist; 䊊 full disclosure of material non-recurring items; 䊊 copies of minutes for board, remuneration committee, audit committee and risk and credit committee; 䊊 details of all pending or threatened litigation or dispute matters; 䊊 details of any surplus assets; 䊊 details of all computer software and hardware, licences and dealing platforms and data feeds and any plans to update or replace these; 䊊 full details of aged: – debtors; – creditors outstanding as at the valuation date and all book debts written off or provided for; 䊊 full details of all professional indemnity and other insurance cover and any claims made; 䊊 details of all material trading exposures and positions at valuation date; 䊊 details of all bank borrowings and banking facilities; 䊊 full inventory, asset and investment lists as at the valuation date;
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full details of any dividends declared or proposed subsequent to valuation date; 䊊 full details of shareholder resolutions recently passed or made since valuation date; 䊊 details of all joint venture and other business associations or agreements; 䊊 group structure chart and group organisation charts; 䊊 compliance or operating manuals; 䊊 full copy of customer documentation; 䊊 full details of all agency and commission arrangements. 3. Regulatory position and standing: 䊊 details of all licences, permissions and consents issued by Regulator, and confirmation that all remain good standing and have not been revoked, qualified or modified; 䊊 details of all material correspondence with Regulator, site-visit reports, external audit and management reports and steps taken to resolve and satisfy Regulator on any issues arising; 䊊 details of any customer complaints and notifications to Regulator and steps taken towards resolution; 䊊 evidence of compliance in last 12 months of all capital adequacy and/or solvency or liquidity requirements imposed by Regulator or under governing regulation and law. 4. The Company’s current trading position (including each subsidiary) and prospects: 䊊 breakdown of revenue generation prior to valuation date and after accounts date: – fees; – commissions; 䊊 revenue forecasts prepared prior to valuation date for next six months; 䊊 major clients and fee income or commissions representing greater than 5% of revenue; 䊊 major contracts being performed, for example, funds under management or being managed; 䊊 major future contracts anticipated at the valuation date; 䊊 capital expenditure either incurred or anticipated that would have an effect on revenue; 䊊 sales brochures, giving an understanding of the product, for existing or new products; 䊊 details of any new products or services likely to come on stream in the near future; 䊊 spending on technology, etc. for instance for the previous three years; 䊊 details of any changes of the business in recent years, such as the closure of a division; 䊊 is there any new legislation or expected legislation likely to affect the business? 䊊 details of proposed hiring and recruitment of new employees or directors; and 䊊 details of establishment of new divisions or operating subsidiaries. 䊊
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