Due Diligence – Forerunner Of A Private Equity Transaction

Author – By Dikshita Damodaran

 

INTRODUCTION

Private Equity transactions have been on a constant rise in the past few decades, while the market in India is slowly adjusting to the increased injection of finances. It is a settled fact that there is no set definition to chalk out the frontiers of what entails in this process, yet, major facets involved are the venture capital, seed financing, bridge financing, distress investments, leveraged buyouts, and an overall feature of financial sponsoring for a return of stake in the said business.

The main investment increase was observed with the IT sector boom in the late 1990’s and the early 2000’s, which was followed with other sector slowly reaping the benefits for the same. The studies suggest that owing to the pandemic, the past year saw a slight dip in funds raised in the private equity (PE)/venture capital (VC) area. But, as this industry explored solutions for various aspects, the correction was speedy, and fundraisings happened over the course of 2020. The experts suggest the way ahead for the fundraising environment in the country in 2021, the opportunities coming up show a bright future for the PE/ VC funding.

For every PE transaction that is undertaken, the due diligence conducted to ascertain the benefits of such investment is extensive, a plethora of business insights, regulatory, financial as well as market trends are mapped for a successful investment. Another aspect of such investments is the concept of time involved, for they most commonly are long term, with higher leverage, and lesser liquidity. A due diligence process for a PE transaction is conducted to uncover issues related to the assets, liabilities and operations of the target company that can impact the return of the investments made. After the completion of the due diligence process, the risks and impediments detected and discussed are placed in the form of a representation and warranty or an indemnity in the definitive documents to ensure that the liabilities do not pass on the investor.  The various aspects for consideration to conduct a due diligence before entering into a PE transaction shall be explained henceforth.

Specific documents for a PE transaction

The basic documents that are entered at the primary stage of a PE transaction are the Term Sheets/ Letter of intent/ Memorandum of Understanding. Although a typical PE transaction does not witness entering into all these documents but either one of them, they are categorically entered to record the intention of the investor, the form of investment, the expected returns, the term period, and any other requirements as per the agreement between the parties. The intricacies of these documents, alongside the fine print has to be duly looked into before their finalization. The execution of these definitive documents is preceded by a thoroughly conducted due diligence exercise.

Due Diligence to be undertaken before entering into a PE transaction

A due diligence exercise is a precursor of any PE transaction. The due diligence exercise involves a complete background check of the investee company before entering into a PE transaction. The idea of such an exercise is to have a complete picture of the health of the target company by making a thorough analysis into its affairs, the compliances undertaken, the financial, legal, tax, operational and human resources risks involved to ensure return of profits for the investment made.

1. Major documents: The investor in its diligence exercise must request for all the pertinent documents from the target company including the complete details of subsidiaries (or) undertakings, nature of business, information of current products/services offered and the expected expansion or pipeline activities. The major list of documents includes the charter documents including the Memorandum of Association, Articles of Association which envisages the purpose and objects of the target company, information of the directors and the board, public releases for at least the last three years (including all communication with the shareholders), MCA records with respect to charges, filings with RoC, statutory books and records, list of creditors/lenders, material contracts, HR related documents, licenses/ approvals etc.
2. Legal aspects: This aspect involves probing into the legal affairs of the target company’s business. The diligence exercise involves the analysis and review of the existing material contracts and assess them for potential liabilities for the investor. This also includes looking into the ongoing legal disputes initiated by or against the target company, inclusive of adjudicated and resolved claims, pending claims and anticipated future claims to know if the investor is likely to face any issues due to unfavorable results of litigation. Any internal investigation initiated at the behest of the target company stakeholders or ordered by empowered authorities in accordance with the provisions of Companies Act, 2013 shall also form a part of the due diligence exercise.
3. Financial Matters: All accounts and audited reports of past years, including the names of the internal auditors, all details of the key financial indicators of the financial statements, as compared to the industry standards have to be properly analyzed. The target company’s financial diligence must be followed by the examination of the growth indicators and the margins maintained in the preceding years including the financial analysis of the debt, equity, leverage, and any cross-borrowings. This exercise determines the sustainability of the revenue and cash flow of the target company as a long term investment option with a potential of growth.
4. Debt arrangements: The Companies Act, 2013 and rules provides that a company requires the consent of each creditor/ lender for a proposed acquisition transaction. Therefore, it becomes imperative for the investor to understand the nature and extent of all borrowings, (both short-term and long-term), from financial institutions, inclusive of borrowings from stakeholders of the target company. The diligence exercise must also involve the review of the details of any guarantees extended or any contingent liabilities, either secured or unsecured inclusive of indemnities, payables on demand, any borrowed liabilities or other written communications of debts extended or received (letter of credit, contracts, leases, bonds, etc.)
5. Employee and employment information: The diligence exercise involves the review and analysis of the human resource related details and documents such as particulars of the top-level management, along with salary portfolios, bonuses, and all the employment/ retainer contracts The exercise must also include facets of employee issues that emerged within the last few years, including alleged wrongful terminations, violation of company policies, complaints as to sexual harassment etc.
6. Environmental regulations: It is always recommended that the due diligence team must give importance to the aspects of uncovering any potential environmental risks, on account of failure of eenvironmental clearances, from appropriate forums alongside the liability assessments, regulatory compliances (including audits), status of the current position of implemented/pending compliances.
7. Information Technology related due diligence: During the diligence exercise, the investor must assess the target company’s current IT framework and policies. This includes review of the privacy policy, data security, compliance to the provisions of the Information Technology (Reasonable security practices and procedures and sensitive personal data or information) Rules, 2011 etc. Under this phase of diligence, the target company may also focus on the security risks involved, user restriction related aspects of IT that must be mandatorily resolved before the investment is made in the target company.
8. Asset related details: When due diligence is undertaken, it includes looking into the leasing/ licensing arrangements entered into by the target company. This is to ensure that the target company has access to the property, facilities, machinery and equipment required to keep the business running post the investment. All freehold and lease property held by the target company, the location, name and details of lessor, contractual arrangements are looked into in detail to assess the risks involved. The MCA documents and records are also reviewed for the purpose of ascertaining any charge registration against such properties of the target company. The investors also request for the review of the documents for ascertaining the timely payment of the overhead expenses of the target company’s property which includes payment of utilities i.e. electricity, maintenance, water, etc.
9. Intellectual Property: The investor is to specifically conduct diligence with respect to the IPR owned or licensed by the target company. This step takes into account the details and documentary evidence of such holdings, and if any, arrangements entered into as a part of resolution or agreements. Any assignment/licensing/ownership/ details of the related IPR, furnished with the relevant documents form an essential component of any due diligence exercise.
10. Sector specific diligence: This form of due diligence is specific to the sector in which the target company operates. The due diligence of the sector of the target company is a very transaction specific exercise and has to be customized as per the requirement of the PE investor. The exercise involves knowing the sector in which the target company carries its business, its competitors and the market trends in general. The investor in such an exercise focusses as to whether the specific target sector is growing and how far the investment in such a sector be profitable. For instance, post 2020, owing to the pandemic, the investment in healthcare sector and related areas is expected to surge by a great margin.

Conclusion

A due diligence exercise in any PE transaction has the potential of either making or breaking a deal. The impact of an unfavorable due diligence report can result in the decreased valuation of the company, change in the initial terms of the deal, reduced consideration or even in the discontinuance of a transaction in its entirety.

It has to be understood that the majority of the due diligence exercises are undertaken to remove the anomalies in the target company to make the investment profitable for the investor. The list provided under this article is not exhaustive, but is a general overview as to how a target company has to be probed with respect to the business, regulatory, environment and financial issues/intricacies/technicalities by a PE investor. Through a plethora of case studies, it has been concluded that conducting a proper and in-depth due diligence process ensures that there is a more successful outcome in the transaction reaping long term profitability.

References

1. K. Jain & Indrani Manna, ‘Evolution of Global Private Equity Market: Lessons, Implications and Prospects for India’, retrieved from, https://rbidocs.rbi.org.in/rdocs/Content/PDFs/2RKSN010210.pdf
2. https://www.livemint.com/companies/news/future-is-bright-for-pe-vc-fundraising-11620840229684.html
3. https://vc-list.com/startup-investment-due-diligence-checklist/
4. https://taxguru.in/company-law/checklist-due-diligence-company.html
5. https://www.indiafilings.com/learn/checklist-for-due-diligence-of-company/
6. http://www.streetofwalls.com/finance-training-courses/private-equity-training/private-equity-investment-criteria/
7. https://www.winston.com/en/thought-leadership/update-covid-19-checklist-of-considerations-for-private-equity-funds.html
8. https://groundfloorpartners.com/due-diligence-checklist-for-business-buyers-and-investors/
9. http://jupiterlegal.in/images/LEGAL%20DUE%20DILIGENCE%20CHECKLIST%20IN%20RELATION
   %20TO%20%20INVESTMENT%20IN%20VENTURE%20CAPITAL%20UNDERTAKINGS%20OR%20BUSINESS%20ENTITIES
   %20BY%20VENTURE%20CAPITAL%20FUNDS,%20STRATEGIC%20INVESTORS%20-CS%20-%20DEC’%202013.pdf
10. Shrivastava, A., & Garg, A. (2017). Private Equity in India and Indian Promoters’ Perspective: A Primer. The Journal of Private Equity,20(3), 68-75. Retrieved February 10, 2021, from http://www.jstor.org/stable/44397525
11. Dhankar, R., & Malik, K. (2016). Flow of Private Equity and Growth of Corporate India: A Review of Literature. The Journal of Private Equity,19(2), 60-65. Retrieved February 10, 2021, from http://www.jstor.org/stable/44396796
12. K. Batra, Due Diligence, (1^st Edition, 2019), Eastern Book Publishers, New Delhi.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.