In this blog post, Srishti Khindaria, a student of Amity Law School, Guru Gobind Singh Indraprastha University, Delhi, analyses the concept of M&As and due diligence and why due diligence is important in M&A transactions with the help of examples from contemporary times.
What is an M&A?
Mergers and Acquisitions (M&As) have become a common phenomenon throughout the country ever since the introduction of New Economic Policy (NEP) of 1991 which lead to liberalization and the opening of Indian markets to the foreign ones.
The merger is a combination of two companies, where one company merges itself into the other and loses its identity, while the other prominent company gains greater importance and consolidates itself with or absorbs the other company.The term ‘amalgamation’ has been used synonymously with a merger in The Companies Act, 1956 and both these terms are used interchangeably, but both are not precisely defined.
In an acquisition, there is an acquiring company and an acquired company. The acquiring company purchases the interest of the acquired company’s shareholders. Thus, a merger is an arrangement through which two or more companies are brought together, and their control is vested in one company. Here both companies pool in their interests. While in an acquisition the ownership of one company is bought in tangible or intangible assets by another company in ways such as purchasing the controlling interest in share capital or the voting rights. In a highly competitive environment globally, mergers and acquisitions have turned out to be one of the fastest ways for companies to gain a competitive advantage.
What is Due Diligence?
Due diligence refers to any reasonable person/business entity must take before entering a legal contract or business transaction. Performance of thorough due diligence before any investment or acquisition is made by the business is a fiduciary duty entrusted with the officers of companies
Due diligence is a through and through examination of all the critical aspects of business. Every aspect of the business must be examined through due diligence- financial, operational, tax, commercial, tax, IT, integrity, social, environmental, health and safety, regulatory, etc. It is seen as a comprehensive appraisal of the business by a prospective buyer to evaluate the assets and liabilities and other factors of business.
Role of Due Diligence in M&As
Mergers and Acquisitions involve a reasonable amount of due diligence by the buyer as before committing to the transaction it essential for the buyer to know what it will be buying and what all obligations it will assume with the purchase, the nature, and extent of liabilities of the target company, litigation issues, intellectual property issues, etc. This is particularly important in the case of private companies where the target company has not yet been subject to the scrutiny of the public and where the buyer has very little ability to obtain information that it could ordinarily obtain from public sources.
Thus it can be said that the basic function of due diligence in any merger or acquisition is to assess the potential risks involved in the proposed transaction by inquiring into all relevant aspects of the business to be purchased in its past, present and predictable future.
The four core areas of due diligence in a merger transaction are as follows;
- Financial statements review: This is done to confirm in the balance sheet the existence of assets, liabilities, and equity, and analyze the income statement of the company to determine its financial health.
- Management and operations review: This is done to determine reliability and quality of financial statements, and to gain a sense of contingencies which exist beyond the financial statements.
- Legal compliance review: This is done to review and check for potential legal problems that could arise in the future stemming from the target company’s past.
- Document and transaction review: This is done to ensure that the paperwork of the deal is in proper order and that the transaction structure is appropriate.
In 2008 Bank of America’s acquisition of Countrywide Financial for about $4 billion serves as a perfect example as to why due diligence is important.[1] Countrywide Financial has been a key player in subprime mortgage market through the 21st-century real estate boom.
A subprime mortgage refers to those mortgages which are given to borrowers who have less than perfect credit score. Analysts discover years after the deal took place a lack of oversight on the part of employees and brokers- who had financial incentives in the way of commissions backing their actions- who pushed through mortgage approvals on overvalued properties that the borrowers may have trouble repaying.
Subprime mortgages held by major financial institutions such as Lehman Brothers, Countrywide Financial and Bear Stearns, in the form of securities. However as these securities had no market price and were illiquid, the firms were not able to value them on a market-to-market basis and subsequently went on to value them for many times their actual worth. Countrywide Financial too had a large inventory or such securities on its books, and they were valued using spurious methods.
When Bank of American acquired Countrywide Financial, while conducting due diligence, its officials failed to recognize that these subprime securities where worth much less than stated and as a result along with the $4 billion purchase price there was over $40 billion attached as a liability that Bank of America was unaware of.
Another example to showcase the importance of due diligence would be that of the deal between Dai-Ichi Sankyo and Ranbaxy. Initially, Dai-Ichi Sankyo paid Ranbaxy $4.6 billion for 63% of its share however late wrote down the acquisition’s value by $3.6 billion. The reason being that they were never fully aware of the extent of the Food and Drug (FDA) Investigation into Ranbaxy when it was asked to shut down all its pending and future drug applications from its Ponta Sahib plant in 2009. The first-to-file atorvastatin which was the greatest attraction for Dai Ichi was fraught with many problems. As Dai-Ichi failed to conduct adequate due diligence, they ended up suffering huge losses.
“Only Fools Rush”
Why is due diligence important for any M&A transaction?
Though a slightly time-consuming process due diligence is essential before any M&A is undertaken. And the companies entering into an M&A must make sure it is conducted in a proper manner as it is essential to investigate the affairs of business as a prudent person would.
The other advantages of Due Diligence are as follows;
- It helps assess the risks and opportunities that shall be present in the proposed transaction and reduces the risk of unpleasant post-transaction surprises.
- It confirms all material facts of the business and that the business is exactly as it appears without any discrepancies.
- Due diligence helps create a relationship of trust between two otherwise unrelated parties.
- It helps identify potential deal killers and defects in the target business that help avoid bad business transactions.
- It helps gain information which would be useful for valuation of assets, indemnification and also negotiation processes.
- It also helps verify that the target business has bene complying with norms of the industry and identify potential “red flags.”
- Lastly, due diligence also helps in analyzing the target before a controlling interest is acquired in it.
As it has been said, “Due diligence is not judgment making it just bringing out all facts to the fore.”[2]
Conclusion
A comprehensive due diligence process is essential for the success of any merger and acquisition transaction. The fundamental purpose of due diligence is to validate assumptions on identification and valuation of risks. It must be ensured that the scope of investigations is tailored to the nature of the transaction. Due diligence is of utmost importance and it cannot be emphasized enough that most deals fail due to nothing more than inadequate due diligence due to which the buyer ends up overpaying or experiencing major integration problems or assuming unknown liabilities.
Footnotes:
[1]http://www.investopedia.com/ask/answers/010615/why-due-diligence-important-company-acquisition.asp
[2]http://www.assocham.org/upload/event/recent/event_1096/Pavan-Kumar-Vijay.pdf
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