due diligence to minimise risk

due diligence has many meanings

It describes the process whereby the parties to a joint venture or an acquisition assess the risks they are taking. Risk itself has many interpretations. In Russia there is the old Russian saying "If you don't take risk, you don't drink champagne". By way of contrast, American General George Patton, who has acquired something of a "gung-ho" reputation, was actually more prosaic, saying "Take calculated risks, that is quite different from being rash".

In this article we discuss the balance between these two attitudes and focus on three points:

  • due diligence is about managing risk;
  • in order to minimise their risk and get the best terms, both the vendor and the purchaser need to take a proactive strategic approach to due diligence;
  • project management and new technologies can be used to improve the due diligence process.

due diligence is about managing risk

Risks in joint ventures/acquisitions

For the purchaser and his financiers, a range of risks exists, such as:

  • the political risk associated with the countries in which the target is based;
  • the accuracy of the past financial accounts of the target;
  • whether the target's key personnel, suppliers and customers will remain;
  • whether the target has good title to its assets; whether those assets are worth the value the target attributes to them;
  • whether there are any existing liabilities that may manifest themselves in the future to disrupt the operation or financial performance of the target.

These risks will be carried by one or both of the parties, some properly being the sole responsibility of the purchaser to assess, e.g. political risk. Others are conventionally considered the responsibility of the vendor, e.g. the accuracy of the past financial accounts. However, once identified, the majority of the risks are negotiable and the bargaining be­ tween a vendor and a purchaser will relate predominantly to the apportionment of these risks between them.

In conducting those negotiations, the purchaser is at a disadvantage since he does not have the data to identify and assess those risks accurately. Accordingly, one of the most important decisions that every purchaser has to make at the earliest stage of any transaction is the degree to which he wishes to redress the knowledge imbalance between himself and the vendor. Conversely, unless the vendor conducts his own due diligence in advance of selling the business, it is possible that the well advised purchaser will eventually achieve information superiority over him.

increased risk when investing abroad

Where the transaction takes place outside the home country, the purchaser's risks are increased because the entire polit­ ical, economic, social and business environment differs from the one he is familiar with. Not surprisingly, purchasers investing in foreign countries are much more cautious than when they are doing business in their own country.

the purpose of due diligence

The purchaser will wish to check that:

  • the assets have the value the vendor is giving them;
  • the vendor has good title to those assets;
  • there are no risks that reduce the value or use of those assets, e.g. another party having a right to use them;
  • there are no other liabilities that may adversely affect the target, e.g. taxation liabilities.

Although the vendor may provide warranties which give assurances on these issues, the purchaser will nevertheless wish to check them. This is not dissimilar from the "Trust but verify" attitude adopted by the Soviet Union during the Strategic Arms Limitation Talks with the United States in the 1980s.

The verification approach also reduces the potential for conflict because problems are identified early on. All too often, the vendor is not even aware of its own problems, until the purchaser discovers them during due diligence. Purchasers also recognise that warranties and indemnities given by vendors:

  • last only for a few years;
  • are limited by amount;
  • can be disputed;
  • can be difficult to enforce.

Accordingly, the due diligence process that has developed in many countries requires the vendor to disclose all relevant information. This enables the purchaser to evaluate properly the target and negotiate terms on a reasonably even playing-field.

establishing the purchaser’s strategy

The purchaser is on the offensive. Consequently, his strategy should seek to secure relevant and more detailed data on the target which will allow him to control the negotiations. Even though the purchaser takes the initiative, he does not have all the advantage. The vendor has natural advantage by virtue of his superior information on the target. The purchaser must overcome this in order to be, at least, on an equal footing in negotiations. He may wish to go further and use this data to improve the terms of the original transaction, by identifying real or perceived factors which may reduce the value of the target. His choice of action should be determined according to a pre-determined strategy.

To determine the right strategy, two major factors, inter alia have to be considered:

  • the key assets the purchaser wishes to secure;
  • the key risks to which the target is exposed.

benefits of a proactive. strategy

analogy of the transaction with warfare

The due diligence exercise is in many respects analogous to a military campaign. The purchaser is similar to the attack­ing army. He is on the offensive, trying to obtain as much data as possible on the target (i.e. gain territory) in order to enter negotiations (the various battles) to gain the most favourable terms (i.e. win the war).

The negotiation sessions between the parties will deal with a range of issues (i.e. dispositions on the fields of battle). As most of these issues deal with the business of the target, the party commanding superior knowledge of the target will hold the advantage (i.e. better battlefield positions).

benefits of thorough due diligence for both sides

Therefore, the due diligence process is more effective when each party pre-determines its strategic objective. The party that plans its strategy to gain superior knowledge on the target usually achieves negotiation advantage because he is able to:

  • measure with greater accuracy the cost of each risk;
  • determine with more precision those risks which he is willing to assume;
  • play up or down (as appropriate) the perceived cost (as opposed to its real cost) of the risks during negotiations

what are the key assets?

The key assets that the purchaser wishes to secure through the acquisition are at the heart of the development of its strategic objective. They are equally important to the vendor when setting its strategy. Typical key assets include:

  • client or customer base (and related contracts);
  • suppliers;
  • management or technical expertise;
  • brand name(s);
  • technology;
  • production capacity;
  • distribution network;
  • land and buildings.

what are the key risks?

The implication of the key risks to the target is also of prime importance to both parties, not least because the range of potential risks to which the target is exposed can be extensive. Their relative weighting will vary from country to country.

The multitude of potential risks to which every business is exposed will usually make it impractical for the purchaser to assess all of them. Accordingly, a profile can be developed of the key risks and their consequences, made up of the following elements:

  • the relevant industrial sector(s);
  • the geographical area(s);
  • the target's own activities.

risks related to the legal due diligence typically encompass:

  • regulatory risk
  • governance risk
  • reputation risk
  • contractual risk
  • litigation risk
  • resource risk
  • information security risk

In the next article we will discuss the vendor’s strategy.

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