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Kicking the tires

In conducting legal due diligence, throwing more people at the problem is rarely cost effective and can adversely affect the quality of the report desired. To the extent possible, plan the diligence exercise in advance, be clear about the desired results and monitor the diligence team throughout the process.

Angus Miln is a senior European consultant in the corporate group at international law firm Bird & Bird. He can be reached at angus.miln@twobirds.com.

It may sound like heresy from a corporate lawyer but, in common with a growing number of my clients, I find myself increasingly questioning the value of voluminous and generic legal due diligence reports.

I am not arguing that the world would be a better place without due diligence. But I do think that there are some long-overdue improvements to be made to the way that most law firms conduct due diligence and many clients could and should do more to ensure that their legal advisors deliver a cost effective service that adds genuine value to the transaction process.

No business can be bought risk-free; the role of due diligence is therefore to manage the risk to levels where the purchaser is satisfied that the price paid is fair and reflects an accurate understanding of the business being bought and the opportunities and risks that it brings.

For the purposes of this article, we will consider purchaser, rather than vendor, due diligence. There are, however, significant benefits for a seller in conducting a vendor due diligence exercise, not least because it is an ideal opportunity to get one's house in order and it reduces the risk of offers being reduced (often at the eleventh hour) as a result of a purchaser's due diligence continuing into the later stages of the transaction.

Turning though, to purchaser due diligence, most private equity firms will be only too familiar with the call from the vendor's advisors: ?You've made it through to the short list. The data room opens tomorrow. Send a team.? What's the first reaction? To impress.

The temptation is to get on the phone to the lawyers and demand that a huge team be immediately dispatched to the data room, wherever it might be. While this demonstrates commitment to the deal, it is often inefficient and disproportionately expensive. It frequently results either in the production of a cumbersome report that adds little commercial value, or to a more focused report that is the result of ?layering? (tiers of lawyers working from materials produced by junior colleagues) ? a process that is inefficient and carries risks.

Often, the ?big battalions? approach means that large numbers of relatively junior, inexperienced lawyers or paralegals are dispatched post haste with little or no understanding of the deal or the client's needs. The unfortunate result can often be that the client gets the worst of all worlds: a large bill reflecting many days of labor and a due diligence report that, although produced on a timely basis, lacks focus. Remember that, contrary to popular opinion, lawyers are human, and most young lawyers will err on the side of caution if they are simply told to report back on ?change of control issues and other things that might be important.? As a consequence, everything gets reported (at least in the first instance) but little value is added.

Such an approach often results in a second team back at the ranch conducting an equally time consuming process of distilling the unfocussed information ?dump? produced by those who have actually reviewed the documents in attempt to provide some focus to the diligence report itself. In addition to the additional (and significant) cost implications, this process carries a risk of information being misinterpreted or other mistakes being made.

Know what you want
So how does one avoid these pitfalls? It is essential that rather than making snap decisions, you spend time with your lawyers to make sure that they genuinely understand the brief; the clearer the brief, the better and more concise the report you are likely to receive.

Too often due diligence becomes a formulaic ?check-the-box? exercise.

This is not what the process should entail. If you tell the lawyers what you want the diligence team to focus on, what your key concerns are, where the value in the business you are buying lies (which frequently involves an explanation of how you are valuing the business), what you already know about the business you intend to buy which helps to minimize unnecessary work, and what, in particular, is underpinning your decision to acquire the target, then they should be in a position to conduct a meaningful due diligence exercise and add real value to the process.

Rather than saving time at the briefing process, save time at the end by agreeing in advance the format of report that you want to receive. If it's something that you will read on your BlackBerry in an airport lounge then you need a good executive summary. But, if that is all you want, you may have to accept more risk than you would be happy to justify to your investment committee or board. If you want the comfort factor of something more akin to a telephone directory (or you are going to seek to enable the lending banks to rely on the report) say so. After all, it's your report.

Be realistic about what you are prepared to spend on due diligence. While no deal can be made risk-free through due diligence, risk can be increased by failure to undertake sufficient work, something which can become more of an issue on a small deal as small deals don't always mean small risks. Be practical about the protections you want and are prepared to pay for, and work with your lawyer to agree where your money can best be spent and ? where possible ? share risks. Also, not every deal proceeds to completion so be clear about the arrangements that you want in place on a ?busted deal? basis. The sums involved can be meaningful, often a third to a half of the total legal costs on a deal, for example, £100,000 to £200,000 on a £500 million ($1 billion) acquisition, and multiples of this on very large deals, so a clear agreement up front is vital.

It is noteworthy that the disclosure process in the UK differs significantly from that in the US, where a schedule of specific disclosures makes clear the information on which you are entitled to rely and the extent to which the warranties you are being given are qualified. The UK's system of a disclosure letter, with the frequent requirement to accept bulk disclosure of all or a significant amount of the information which has been made available during the sale process, creates the scope for less clarity and higher risk for the purchaser.

It is essential that rather than making snap decisions, you spend time with your lawyers to make sure that they genuinely understand the brief; the clearer the brief, the better and more concise the report you are likely to receive.

If not properly managed, the disclosure exercise on a UK transaction can lead to a purchaser being faced with difficult issues to manage at the eleventh hour resulting from late disclosures. Frequently, issues or documents come to light too late to be properly reflected in the report, or the due diligence exercise is overtaken by the disclosure process which can undermine the (present and future) value of the due diligence report to the purchaser.

Equally important is the issue of redress. The UK's requirement for a purchaser seeking damages for a breach of warranty, to prove that the value of the shares acquired has been reduced as a result of a the breach, is far more onerous for the purchaser than the indemnity based US approach which simply requires the purchaser to approve the breach. If you are doing cross-border work then it is important to ensure that whoever is advising you understands these key differences and has spoken to you about the implications of each system.

Magnificent Seven
What then are the items to get right to ensure cost effective and value-added due diligence on your next transaction?

  • 1. Agree an appropriate and detailed scope of work in advance and try to avoid ?throwing bodies at the problem.? You (or, more probably, the seller's advisors) may feel reassured by the arrival of legions of lawyers but you need to know that they are going to be managed effectively and that you get value from the additional expense you will incur.
  • 2. Think beyond the materiality threshold. Avoid duplicating work and costs by explaining what your other professional advisors are (and are not) instructed to review and report on.
  • 3. Work with your relationship partner to agree a diligence team that is appropriate in terms of size and seniority. A partner might cost twice as much as a junior but can often add more than double his or her value in terms of commercial experience. A partner or senior lawyer ?on the ground? can also ensure that a diligence team is effectively deployed in the context of what is actually available in a data room (as opposed to what is supposed to be available).
  • 4. Watch out for ?churn? among the team that is working at the coal face. Changes in junior personnel are likely to result in increased costs and risk.
  • 5. Actively manage the process rather than waiting for the first draft of the report. Get involved early, stay involved and continue to monitor the work of your law firm. Daily due diligence calls can work well on large transactions. They keep you aware of what is being done; provide an opportunity to change the focus of the work and ensure that major issues are reported early (something which may impact the focus of the due diligence being done by your other professional advisors.)
  • 6. Be clear about the form of report that you will want from the start. Is it three lever arch files or just a spreadsheet? Do you need a focused executive summary and/or detailed recommendations? All are valid, but accurate planning will ensure that you will get the document that is the most useful to you. And finally,
  • 7. Make sure that your due diligence report gets signed off. Far too many reports remain in draft form, overtaken by events or late disclosures in the closing days of a deal. We are continually surprised at how many purchasers fail to ensure that they are issued with a final report they are able to rely on.
  • Ultimately, due diligence is there to help you manage your risk and maximize value. It's up to you to make sure that it does both in the most cost effective manner possible.