Due Diligence

Due Diligence

Due Diligence

Any merger and acquisition have to be carefully planned and executed; therefore, before closing a deal and to make informed decisions, the buyer typically carries out specific agreed-upon procedures to address the agreement from commercial, financial, tax and legal standpoints. Besides critical economic issues, this involves a broad spectrum of tax and regulatory matters such as exchange control, indirect taxes, income taxes and capital market regulations. The agreed-upon procedures are generally described as a ‘due diligence exercise’. Therefore, due diligence provides a potential buyer with relevant information about the business/ target proposed to be acquired and helps manage associated risks. This article talks about Due Diligence and various aspects of the same.

Types of Due Diligence

Due diligence can be typically categorised into various types from two perspectives. Firstly, from the perspective of ‘who’ actually carries out the due diligence and, secondly, from the point of ‘what’ is being carried out as a part of the due diligence.

Primary Interest Perspective

Based on the fundamental perspective (i.e., ‘who’ carries out the due diligence or the ‘primary interest’ aspect), there are two kinds of due diligence:

  • Buyer Due Diligence
  • Vendor Due Diligence

Buyer Due Diligence

When one talks about ‘due diligence’, it typically refers to a buyer due diligence. It is the buyer or the acquirer who is interested in getting a clearer insight into the upsides or exposures of the target. Hence, it is in the buyer’s/ acquirer’s interest that he carries out the due diligence before closing the deal. Usually, all the buyers carry out due diligence before making the acquisition. The buyer generally appoints consultants for the purpose of carrying out the due diligence and to provide expert advice on the implications of the findings of the due diligence.

Vendor Due Diligence

In recent times, vendor due diligence is continually gaining popularity. This is when the management of the target entity carries out due diligence on the target. The target’s management appoints consultants to carry out the due diligence on the target on its own accord. The consultants would provide the management with its vendor due diligence report highlighting the exposure or upsides in the target. Vendor due diligence comes to use in cases where the target’s management invites more than one investor/ acquirer. The management would provide this vendor due diligence report to prospective investors/ acquirers. These potential investors/ acquirers place reliance on the vendor due diligence report and make their investment/ acquisition decisions. In some instances, the investors/ acquirers may want to investigate into a particular area that may be discussed in the vendor investors/ acquirers report to gain a better insight into the area.

Functional Perspective

Based on the second perspective (i.e., “what” is being carried out as part of the investors/ acquirers or the “functional” perspective), there can be various types of investors/ acquirers. Different situations may call for varying kinds of due diligence. In India, the most commonly carried out due diligence is as follows.

  • Commercial
  • Technical
  • Environmental
  • Human resource
  • Legal

Due Diligence vs Statutory Audit & Internal Audit

In India, companies are statutorily required to get their accounts audited by an independent Chartered Accountant. In some instances, companies are even required to carry out an internal audit relating to their process. Due diligence is quite distinct from internal and statutory audits. The critical differences between due diligence and statutory/ internal audit are tabulated below.

ParameterStatutory AuditInternal AuditDue Diligence
Appointed byShareholders of the companyManagement of the companyGenerally by the buyer and, in some instances, by the management of the target.
The reader of the reportShareholders, regulatory authoritiesManagementDeal-making parties
The extent of reliance on information provided by managementRelatively highRelatively highLow to medium; the information is first tested for its reliability.
MandatoryMandatorily required under the statute.Mandatorily required under the statute for certain prescribed companies.Not mandatory
ObjectiveTo report on the fairness and truth of the financial statements.To report on certain issues with the internal processes of the company.To highlight exposures and upsides of the target.
ScopeDefined by natureDefined by the managementNo specific scope; determined by the buyer or seller (in case of vendor-due diligence); the scope majorly depends on the mechanics of the deal and the agreement among the parties involved.
Perspective and focusFocuses on past informationAdopts a futuristic approachBlends both past and futuristic perspectives.
ConfidentialityLow; for listed companies, the audit report is publicly accessible.High; typically, only management has access to the report.High; only the deal-making parties have access to the report.

Due Diligence from a Tax Perspective

Tax is a material and unavoidable cost. Hence, tax due diligence plays a prominent role in M&A decision making, though the tax usually is not the primary consideration in the context of M&A transactions. Traditionally, tax due diligence is carried out to understand more about the tax profile of the target and to uncover and quantify any tax exposures. However, tax due diligence also comprises of identifying any tax upsides which may be accessible to the target. It also assists in identifying and developing an appropriate acquisition structure for the deal in question.

While carrying out tax due diligence, it is essential not only to identify and quantify areas of potential tax risk but also to ensure that there is an adequate protection mechanism for the buyer. In practice, the most popular form for tax risk mitigation is through tax warranties and indemnities in the deal. The buyer needs to balance while negotiating for the tax protection to ensure that it does not affect the commerciality of the transaction for the seller.

To summarise, a tax due diligence is customarily carried out to:

  • Validate the representations made by the seller at the time of pre-deal negotiations concerning tax matters.
  • Validate the tax assumptions made by the buyer in valuing the target.
  • Identifying any material tax exposures that may be residing with the target including characteristics of such tax exposures.
  • Identify any material upsides such as potential tax benefits that are being claimed by the target.
  • Structure the deal in a tax-efficient manner.
  • Assess the availability of tax losses, tax credits and other tax assets.
  • Ensure adequate protection mechanism for the buyer, i.e., warranties, indemnities, representations or value adjustments, etc.,

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Post by Chris John

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