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Acquisitions Due Diligence

(Purchasers Perspective)
JULY 2006

What is a Pre-Acquisition Review/Due Diligence Investigation?


A "due diligence investigation" simply means a pre-contract or pre-completion check (i.e. a

pre-acquisition review) on a range of factual, financial, legal, accounting, business and other
matters relating to the target business. The review aims to ensure, as far as possible, that the
purchaser knows what it is getting, should it proceed with the purchase; or to assure the
purchaser that the business is indeed as represented by the vendor, before the purchaser
commits itself to go forward.


The term "due diligence" is coined from the requirement of a company and its officers as a
matter of good practice and responsibility (to shareholders) to exercise due diligence in
verifying the state of the purchase it is about to make, before making it. As indicated above,
the diligence exercise can be divided into a number of different areas, determined by their
subject matter, with each discrete area being investigated by those experts who have the
relevant specialist expertise. Although the terminology may vary, the broad categories of
review are:

Legal due diligence. On any significant acquisition, the prospective purchaser will
want to be sure that the vendor, and (in the case of a share purchase) the target
company, have good title to the assets being bought and to know the full extent of any
liabilities it will assume. Accordingly, legal due diligence is carried out by lawyers
and focuses on matters such as contracts, compliance with law, corporate structures
and governance, anti-trust, exchange control, litigation, employment, pensions,
intellectual property, real property and tax.


Business due diligence. Business due diligence looks at broader issues such as the
market in which the target business operates, competitors, the business' strengths and
weaknesses, production, sales and marketing, research and development, etc. The
aim of business due diligence is to test the assumptions that the purchaser will have
made in its acquisition plan and to identify the management action required by the
purchaser to take effective control of, and reduce risk in, the target business once the
deal has closed. The team carrying out the business due diligence will include or
involve the purchaser's own personnel, as only they will be able to make effective
judgements as to the commercial importance and potential risk brought to light by the
information uncovered.


Financial due diligence. As part of the due diligence process, the purchaser will
usually instruct accountants to prepare a report (the accountants' report or long-form
report) on the financial aspects of the target business. This financial due diligence is
not the equivalent of an audit and the accountants' report will make this clear.
Financial due diligence focuses on those areas of the target's financial affairs that are
material to the purchaser's decision, so that the purchaser can assess the financial
risks and opportunities of the deal and whether, given these risks and opportunities,
the target business will fit well into the purchaser's overall strategy. Financial due
diligence may also help quantify:

potential synergies;


the best acquisition and financing structure;


the impact of the acquisition on the purchaser's performance statistics; e.g.,

where the purchaser's accounting policies are more conservative than those


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followed in the target business, it may be necessary to make appropriate
adjustments in order to measure the true impact.
Part of the accountants' investigation will be to review the target's audited accounts.
Where the purchaser is a listed company, depending on the size of the acquisition,
and depending on local regulatory requirements, it may need to give shareholders
certain financial information about the merged group. Again, accountants will need
to review the target's figures in order to provide this information.

Other due diligence. Depending on the nature of the target's business, the purchaser
may instruct other experts, such as environmental experts, surveyors, IT or other
relevant specialists. For example, the acquisition of a manufacturing or processing
company, or one whose assets include land currently or previously used for industrial
processes, will raise questions about potential responsibility for any clean-up and
liability generally in relation to environmental damage. To answer these, some form
of environmental due diligence will be required.

The Role of the Legal Pre-Acquisition Review


The aim of the legal pre-acquisition review is to enable the purchaser to understand the
target's business and structure from a legal viewpoint. It should also provide the purchaser
with the information necessary for it to assess the target business and make its final decision
whether to invest on an informed basis. The review should enable the purchaser and its



to identify any procedural, legal or contractual problems associated with effecting the
transaction, e.g., necessary exchange control consents, foreign investment approvals,
government and other regulatory approvals, third party consents, stock exchange
requirements, anti-trust or merger referral issues, etc.;


to understand the type and extent of the risks and liabilities attaching to the target and
its business, e.g., product liability exposure, warranty exposure, litigation exposure,
environmental liabilities, etc.;


to verify the accuracy of any representations or warranties already made by the

vendor in a signed acquisition agreement, or identify suitable representations,
warranties and indemnities for a prospective acquisition agreement and, if
appropriate, any adjustments to the purchase price.

The results of the review may have a major impact on the perception of the transaction; e.g.,
the purchaser may decided to proceed with the transaction on the basis that its advisors have
given the deal a clean bill of health; the purchaser may pull out of the transaction altogether;
the purchaser may renegotiate the deal; the purchaser may reduce the price; the purchaser
may exclude part of the business; the purchaser may move from a share purchase to an asset
purchase; or the purchaser may restructure the transaction in some other way.


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Scope of the Investigation and Report


Scope of investigation


The scope of a due diligence investigation will depend on a combination of some or

all of the following factors:

Purpose of the acquisition. For example, where two companies are looking
for a trade advantage or element of synergy through a merger, the
investigation will focus on matters such as economies of scale, marketing
advantages and competition issues;


Nature of the business being investigated. This will cover such things as,
the likely areas of concern and risk, geographical spread, and the major
operating components;


Purchaser's risk comfort level. Some purchasers will be comfortable with

higher potential risk exposure than others;


Expense/budget. Cost should always be borne in mind. The extent of the

due diligence exercise should be in keeping with the value and importance of
the acquisition to the purchaser and the potential risk;


Timing. The extent of the enquiry may necessarily be limited by the

timetable of the acquisition or because the vendor is sensitive about the
exercise. A full due diligence enquiry may not be appropriate where a quick
sale is a priority, e.g., where a long investigation might allow another
purchaser to outbid the initial purchaser; or where the delay, intrusion and
interruption to the normal running of the target business might be
unacceptable to the vendor, etc.

Scope of report/materiality


It is usual to attempt to restrict the scope of the due diligence by some form of
materiality test by reference to both:

amount, e.g., by putting a monetary floor on the value of contracts entered

into/matters where the sums involved are in excess of this threshold
(calculated by reference to market value); and


the nature or term of the obligation or asset, e.g., "major issues"; "material
contracts"; contracts entered into "outside the ordinary course of business",

To reflect these limits, reports are usually divided into one of two broad categories:

Full Report - which consists of a complete audit of the target business

including an in-depth summary of the target's material contracts; and


Exceptions Only Report - which focuses only on matters material to the

transaction and highlights exceptions to business or market practice.


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Ultimately, although it is the purchaser's call as to what is or is not material, or what

is or is not within the ordinary course of business, the scope of the actual
investigation to be carried out and the form of report to be made must of course be
agreed and clearly set out before any work is commenced.

Work Allocation and Team Composition


Work allocation and responsibility



Once the overall scope of the review and the level of reporting has been established
and the full due diligence team has been selected, the purchaser should define the
roles of each of the various advising teams. This is to minimise costs and overlap and
to clarify exactly what information should be reviewed by whom. Where a large
number of professional advisers are involved, it is imperative to clarify what the
reporting lines are and who is acting for, and reporting to, whom.


Often the purchaser and the target business will request the investigating accountants
and lawyers to cooperate in arranging and ordering the scope of the review,
particularly to avoid duplication of effort and expense.

Single or multiple reports

The purchaser may also wish to consider whether a detailed report from each set of specialist
advisers is appropriate, given the time available, the size of the transaction and the
information sought. For example, the purchaser may wish the legal advisors to produce one
report based on information supplied to it from all other due diligence team members
(although this would not include the investigating accountants report). There is no hard and
fast rule as to the allocation of each due diligence issue, and it will very much depend on the
nature of the transaction, the sophistication of the purchaser and the time involved.


Due diligence coordinator


To ensure a clear demarcation of the responsibilities of the various advisers, one

adviser is ordinarily appointed to co-ordinate the whole due diligence review
exercise. The co-ordinating role will usually be played by the adviser who is closest
to the commercial negotiations. It is one of the functions of the co-ordinator to
ensure there is no duplication of effort and that there are appropriate lines of
communication between the different due diligence teams.


The co-ordinator, in conjunction with the purchaser, should also determine whether
any due diligence team member's report or findings should be shared or reviewed by
the other members of the team. In particular, the purchaser's legal advisor's report
should be reviewed by the reporting accountants and vice versa. The team members
responsible for reviewing any property and environmental issues should liaise and
pool their information. Finally, the legal advisors drafting and negotiating the
warranties and indemnities should review the results of all due diligence
investigations. The key is good communication at all stages.


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Composition of the legal review team

It is essential that within the legal diligence team there are people with the necessary skills to
carry out the investigation in all of the areas which have been agreed as falling within the
scope of the legal review.

Sources of Information in the Due Diligence Process


Pre-Acquisition Review Questionnaire


The purchaser will need to ask the vendor for details and information about the
proposed target and its business. This request ordinarily takes the form of a preacquisition review questionnaire (the " Questionnaire") which is dispatched to the
vendor to enable it to produce the relevant documentation and information for review.
The Questionnaire is prepared by the purchaser's legal advisors, in conjunction with
the purchaser itself and its other advisors.


When compiling the Questionnaire, the purchaser and its advisors should consider the
following issues:




What information is already available? The Questionnaire should be tailored

so as to exclude questions relating to information that the purchaser or its
advisers already have, as duplication of information wastes time and costs.


Is the Questionnaire to embrace all types of due diligence enquiries? For

example, if the purchaser has appointed investigating accountants or other
professional advisers, then consideration should be given as to whether such
advisors will want to submit their own questionnaires, or whether a combined
list is to be submitted. If each set of advisors is to submit a separate list, care
should be taken to avoid duplication of enquiries, as this can antagonise the


What is important? The Questionnaire should be drafted in the context of the

objectives that the purchaser used in selecting the target and its postacquisition strategy, as well as the existing knowledge of the purchaser.

It is clear, therefore, that drafting the Pre-Acquisition Review Questionnaire

appropriately is a key to starting off the due diligence process in an efficient manner.
Making enquiries of matters that are irrelevant or a duplication of requests only serve
to increase the time the due diligence process takes and the costs involved. An initial
meeting between the purchaser and its legal, financial and other advisors to produce a
tailored Questionnaire is always a recommended first step.

At the same time as preparing the Questionnaire or even beforehand, the purchaser's advisers
should consider which external searches they would like to make with respect to the target
business. While these will not be mentioned expressly in the Questionnaire, verifying facts
by conducting appropriate searches of public registers is an important part of the review. A
detailed examination of the searches that may be carried out is outside the scope of this
document, but as a minimum, the following searches should be considered:


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Companies Registry In any transaction, whether it is the acquisition of shares in a

company or the acquisition of assets from a company, a company search (or its
equivalent) should be made against:

the target;


all subsidiaries of the target;


the vendor of the target business; and


any guarantor.

Company searches may reveal the constitutional documents of a company, its latest,
filed audited accounts and any encumbrances that there may be over the assets of a
company and possibly the insolvency of any company. However, as many registers
are often out of date and are dependent on the accuracy of the information filed by the
relevant company, care must be taken not to place too much reliance on results.



Insolvency An insolvency search should be made to ensure that no winding-up or

administration petitions have been presented against the vendor, the target or its


Intellectual Property Searches may be made of the trade marks registry and patent
office or their equivalents.


Real Estate/Property Searches Where available, searches may be made at the Land
Registry, Land Charge Registry or their equivalents.

Data rooms

In order to control the delivery of information, preserve confidentiality and limit the
disruption to the target business or its personnel, the vendor or its advisers may use a
data room. In some cases this is done prior to marketing the business, often under
cover of an internal review or audit. Essentially this involves the vendor bringing
together and cataloguing or indexing the important documents relating to the business
(i.e., all contracts, title documents, licences, accounts and other records commonly
reviewed in a due diligence investigation). This is generally done with the assistance
of its lawyers. The documents are then made available to the due diligence team for


There are several advantages to this from the vendor's viewpoint:


it can be done offsite, to avoid rumour or loss of secrecy about the potential


it can allow for review but without allowing copies to be taken, hence the
need for a particularly detailed index;


it can be used to make the information available to a series of potential

purchasers, or contemporaneously to a number of interested parties where the
business is being disposed of by a form of controlled auction/tender process;


it limits the exercise by definition to what is contained in the data room.


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Whether this process will be wholly acceptable to a purchaser will vary from case to
case. It will generally be satisfactory as a preliminary exercise to determine for the
purchaser if it should proceed further and to enable it to generate more tailored
representations and warranties, but a significant benefit will be lost if the opportunity
for interviews with personnel and clarification of issues by responses to requests for
further information are not also made available.


While a great deal of the pre-acquisition review will be taken up with reviewing
documents elicited by the Questionnaire or in the data room, some of the most
valuable information may be obtained from interviews and discussions with the
vendor's and/or the target's advisers and personnel. These individuals will be able to
relate documents and issues to their context, to observe on relationships and morale,
to comment on things like warranty claims experience or on the likely outcome of
negotiations, disputes or proceedings, etc. and generally to fill in the picture behind
the documentary information reviewed.


The list of people who might be interviewed includes:


legal advisers;




actuarial consultants;


insurance risk managers or brokers; and


the target's personnel (i.e. chief executive, managing director, finance

director, tax controller, personnel manager and generally those in senior
positions with direct operational control and responsibility).


In relation to the target's personnel, unless the rationale for the acquisition is known
to involve the wholesale removal of management from the target, managers are likely
to have every incentive to co-operate with their new owners by disclosing, often with
more candour than the vendor, the concerns about the business that they have. In an
amicable transaction, personnel who expect to continue in their posts after the
transaction is completed can be surprisingly frank and helpful. It is for this reason
that vendors, particularly on auction sales, will try to restrict access to continuing


In conducting interviews, care must be taken to comply with confidentiality

undertakings and also to assess the level of reliance which may be placed on the

Presentation of Information


Organisation of Reporting

Because of the fact that the due diligence report is often an integral part of fast
moving, pressurised negotiations, it is essential:


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to set up a method of clear reporting to both the purchaser and the negotiating
team of major issues in real time and


to ensure at the same time that all other issues and facts are brought to the
purchasers attention as quickly and efficiently as possible.

This is both as an aid to negotiations and because any one or more of the issues raised
might actually be a deal-breaker in the purchasers eyes.


The due diligence co-ordinator, in conjunction with the purchaser, must therefore put
into effect a reporting strategy and set up effective lines of communication to ensure
that major issues are reported quickly and decisions with respect to risk areas taken
promptly. In setting up lines of communication:

the co-ordinator should make it clear to whom the due diligence team
members (including local offices and foreign counsel) should be reporting;


the purchaser should select key members of its personnel who will be in a
position to receive the information presented to it by the team and to evaluate
and take decisions on issues that arise; and


the purchaser should also inform the team members whether or not the
transaction is confidential within its organisation and, if so, how the team can
safely communicate with it.

Format of Report


Clearly, for major issues immediate contact (by telephone, email or fax) is essential.
Otherwise the usual process is to build up over a period a report broken down into the
following broad sections:

Introduction - a description of agreed scope of report and qualifications and



Executive Summary - a bullet point list of major items cross-referenced to the

main report;


Main Report - a detailed sectionalised report generally following the order of

the Pre-Acquisition Questionnaire (see paragraph 5.1 above) broken down
into relevant jurisdictions (where appropriate) and cross-referenced to the
annexures; and


Annexures - copies of key source material, contracts, leases, etc. all clearly
indexed. A well ordered and indexed set of copies of the documents received
and reviewed should therefore be provided as annexures to the report as this:

enables the purchaser to refer to the source material for clarification

of issues cross-referenced in the report; and


gives the purchaser a readily accessible dossier of important

documents for future use and reference after the transaction closes.

The clear collation, management and indexing of the materials received or reviewed
is important for recording purposes, disclosure letter issues, and to enable ready


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access to the source materials. Putting proper systems into place at the outset of the
exercise greatly facilitates the process.


In practice, however, the report is likely to be prepared in draft outline and submitted
to the purchaser in draft as soon as there is a meaningful body of information on
which to report. The draft report is then updated as further information is received
and continues to be periodically supplied to the purchaser in draft form with major
changes arising from new or additional information duly highlighted.

Analysis of Results
As necessary, meetings may be set up between the purchaser and the due diligence team to
discuss issues in detail. These may be:


ad hoc to discuss major issues as they arise;


regular progress meetings to allow the purchaser to highlight issues which it

considers to be of concern in connection with the ongoing transaction and to
determine how these may be dealt with; or


a combination of the two.

Conflicts arising during the course of the investigation will need to be addressed on a case by
case basis in accordance with applicable conflict rules and will generally be surmountable.

Confidentiality issues impact on due diligence investigations in a number of ways.


Confidentiality of Negotiations. For various business reasons, the vendor and the purchaser
may wish to keep the fact that negotiations are taking place as confidential as possible for as
long as possible.

Vendor. The vendor may be concerned about the effects of premature

announcements on its share price (where listed), employees, key suppliers and
customers, outstanding negotiations for contracts of supply, etc. It will also be
extremely concerned at the effects on the target business of a potential purchaser
being seen to pull out of negotiations by reason of issues arising on due diligence.
The problem is compounded if the vendor, in trying to sell a business, has to go
through the due diligence exercise with a series of suitors. In addition, therefore, to
any confidentiality undertaking agreed between the vendor and the purchaser, the
vendor may seek to restrict the conduct of the due diligence investigation so that it is
routed through the vendor's financial or legal advisers or certain specific executives.
Alternatively, it may use a data room (see paragraph 5.3 above).


Purchaser. From the purchaser's perspective, it is crucial that its advisers not only
observe any confidentiality agreement, but also:


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discuss the possible use of code names and, if agreed, use them in all
documents and communications;


communicate only with personnel authorised to know;


communicate only with those of the vendor's personnel with whom they are
authorised to deal; and


do not send open communications (e.g., by fax) which might come into the
hands of unauthorised personnel.

Listed Companies. Where the purchaser or the vendor (or their holding companies)
are listed companies, extreme caution should be exercised with respect to the
dissemination of information relating to negotiations, and the execution of the sale
and purchase agreement, as such matters will often involve or constitute price
sensitive information.

Confidentiality of Information

Before the purchaser or its advisers are allowed access to the vendor's materials, the
purchaser will normally be required to enter into a confidentiality agreement. Often
these will require the purchaser to agree to procure that its advisers observe the
confidentiality agreement as if they were parties to it. Sometimes, however, the
vendor will seek to obtain a direct covenant from the purchaser's advisers. This is
especially the case where materials have been placed in a data room, as data room
rules will usually contain additional confidentiality provisions.


Such agreements also commonly provide for the return or destruction of all
documents supplied to or copied by the purchaser and its advisers, and any analyses
or reports prepared therefrom, if the deal aborts.

Relationship between the Pre-Acquisition Review and Representations and



Obtaining comprehensive representations and warranties is of course very much part of the
negotiation process. They are not, however, a substitute for an in-depth pre-acquisition
review, for the following reasons:

Whilst breaches of representations or warranties may, depending on the terms of the

agreement, give rise to a right of rescission if discovered before completion (or
immediately afterwards in some cases), they will generally only give rise to a right to
claim damages or an indemnity from the vendor after completion. Purchasers prefer
to know about problems before they are committed to proceed, rather than
discovering them after the event.


Representations and warranties will often be subject to awareness and/or materiality

qualifications, and to thresholds and de minimis provisions. Thus a particular breach
may not in practice result in any compensation to the purchaser.


Even if a breach is not covered by such qualifications, the vendor may not be able to
pay or may resist the claim (thus distracting the purchaser's management from other
activities and involving the purchaser in cost), or the breach may have such an effect


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on the business that the purchaser is unable to realise its plans or expectations for the

Although contractual protection in the form of representations and warranties is no substitute

for a thorough due diligence exercise, it may offer some comfort for the purchaser in relation
to those areas of the target business where it has not been possible, or would be impractical or
disproportionately expensive, to effect a full investigation, for example where time is short
and due diligence is limited. In these circumstances, the purchaser should at the very least
seek to investigate key issues so as to enable it, amongst other things, to:

ensure that warranties and indemnities are appropriately wide;


consider whether to negotiate a retention of the purchase price to cover potential

warranty claims;


propose a price adjustment; or


provide for particular sorts of problems to be solved as pre-conditions to completion,

e.g., the obtaining of consents to the change of control or waivers of other awkward
provisions in major trading agreements, etc.


Just as the strength of the contractual protection sought can be influenced by the extent of the
due diligence, so the extent of the due diligence exercise can be influenced by the contractual
protection offered. For example, where a large, solvent, vendor is prepared to indemnify the
purchaser for any liability relating to the pre-acquisition period arising in the target after the
sale, the purchaser might be prepared to carry out more limited due diligence.


Issues Arising On Cross-Border Acquisitions


Where the target business or part of it is located or operated in another jurisdiction, or

jurisdictions, further complications arise. Cross border transactions, by their very nature,
throw up a number of added risks and challenges. These fall broadly into four categories:

Legal. Purchasers should assess carefully the impact of a foreign country's law on a
transaction. It is essential at the outset to identify any governmental, investment,
legal or regulatory consents which might impact the feasibility, timing or costs of
effecting the transaction as it relates to the target in that jurisdiction or at all; e.g., do
the country's employment laws make the potential cost of a post-acquisition
reorganisation prohibitive? Does the nature of the target's business mean any
regulatory approvals would be required?


Practical. Some jurisdictions may impose timing and access constraints by reason of
bureaucracy or secrecy of government departments, language difficulties,
unavailability of the type of property and company registration details available
elsewhere, inability to carry out searches, etc.


Logistical. On a practical level, there may be difficulties relating to language, the

added number of people involved, time differences, and so on. In a multijurisdictional transaction, information technology may become a vital tool in
managing the due diligence process. E-mail communication may ease the process of
communicating with different locations and a transaction website or extranet could be


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used to make available relevant information such as instructions and weekly status

Cultural. In some jurisdictions, investigations of the level which have now become
good practice in the US or UK may be seen as damaging the spirit of mutual trust
between vendor and purchaser or even as a sign of mistrust or bad faith on the part of
the purchaser. Persuading the vendor to cooperate and obtaining both timely and
useful information may therefore require sensitive handling.


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