Every private equity investor conducts due diligence on a target before the transaction is finalised and the documents are executed. Through this, a third party (and even the target entity itself) is able to know its actual position vis-a-vis the standards in various sectors.
With a legal due diligence, an investor wants to:
– ensure that the information provided by the target (and which forms basis for the investment) is accurate;
– find out any additional information the advisors should have been told, but were not;
– probe into the assumptions in the business plan and evaluate the possibility of achieving the targets set;
– identify the principal risks to the business and chalk out a mitigation plan; and
– conduct a more detailed analysis of the current state of the company.
There are several types of due-diligence, such as legal, financial, operational, and environmental. As lawyers advising on a private equity transaction, your focus area will be on the legal due diligence.
The term ‘legal due diligence review’ (“LDDR”) refers to the evaluation of whether the target entity has compied with various laws in letter and in spirit. This helps in identifying the major legal risks faced by the investor. Let us look at the steps involved in an effective LDDR.
Step 1: Prepare and circulate the LDDR checklist
An LDDR checklist will note all the possible documents needed from the target entity and to sub-divide them, they are typically grouped based on the areas of law.
For example, you will need the incorporation documents of the target, the details of the shareholding and transfers made, the contracts that the company has entered into with third parties, environmental compliances, certificates of payments made under the Payment of Bonus Act and so on. You can accordingly sub-divide the LDDR checklist into main sections such as “General Corporate”, “Shareholding”, “Material Contracts”, “Finance”, “Employment”, and “IPR”. These sections can then be further sub-divided.
For instance, the general corporate information required from the target can include:
– the company’s certificates of incorporation and commencement of business and the memorandum and articles of association, along with all amendments that have been made so far;
– the addresses of the registered office of the company, other office(s) of the company, and other locations from which the company operates;
– the legal structure of the group of which the company is a member, preferably in the form of an organisation chart, stating the names and addresses of all the companies in the group with the percentages of participating interest and describing the relationship between the company and other affiliated group companies, partnerships, and (un)incorporated business associations within the group;
– a summary of the history of the company;
– a brief description of the company business, for example, the business areas, the main products in each, and geographical presence;
– the details of any alliances entered into or to be entered into by the companies including copies of the agreements;
– the details of any branch, agency, place of business, or any permanent establishment of the company outside India including address, brief description of business carried on and numbers of personnel involved;
– the copies of all documents relating to any scheme, merger, amalgamation or restructuring, asset transfer, or acquisition involving the company or any of the group companies or subsidiaries.
The intention, as you can see, is to obtain as much information as possible.
Step 2: Know all the applicable laws
For an effective LDDR, the legal advisor should be aware of all the laws applicable to the target’s business. It is important to assess whether the target has complied with all thse laws and the consequences of any non-compliance. These consequences may pose risks for the target company and therefore, the investment as well.
For example, if the target is required to obtain a particular license prior to manufacturing a product and if it has not been obtained, there is a risk of having to cease the manufacturing activity. This may lead to immense losses to the target and therefore, the investor. Unless you know that this license was required, you will not be able to assess whether the company has complied with this legal obligation.
It is also important to understand the application of local laws. Land laws, for example, vary from state to state. Depending on the state in which activity is carried on, all applicable local laws should be identified.
Step 3: Review and comprehensively analyse documents
After circulating the LDDR checklist, a representative of the target entity, usually their lawyer or company secretary, will assess the applicability of each point. The relevant documents are then provided to the investor’s legal advisors.
These documents should be reviewed in detail by the lawyer and all possible outcomes should be analysed. For example, in case of an outstanding term loan shown in the books of the target, you should analyse all the restrictions in the term loan agreement such as whether any further funding (by the investor) is permitted, whether there are restrictions on the payment of dividend to the investor, and whether the charges are enforceable. If these activities require the prior permission of a lender, it may not be easy to recoup the investment. If an outstanding loan is shown in the balance sheet, for instance, all relevant documents should be obtained from the target in order to assess any restrictions on the investment, the enforceability of any charge, and the value of secured assets.
To take another example, agreements that reflect the business of the target need to be obtained and evaluated. Often, agreements have not been entered into and some times, such contracts have been entered into with related parties. This can be seen from the corporate details provided by the target. If there are any related party agreements, you should check whether all the required provisions have been complied with.
Since the LDDR is an investigative activity, it is important to keep your eyes and ears wide open. Often, attempts are made to hide information that may be detrimental to an investment. A glaring example is the Ranbaxy transaction. Important information was concealed during the due diligence and as a result, the joint venture party incurred losses. You may need to request the target for clarifications and seek further information backed by documents before you are satisfied on all the issues.
Step 4: Think about what can be done to mitigate risk
After the review of all the documents, you will often notice that further action is required to mitigate the investors’ risks. Usually, they belong to the following categories:
(i) obligations that have to be fulfilled as a condition precedent to closing the investment;
(ii) representations and warranties backed by indemnity;
(iii) creation of escrows; and
(iv) conditions subsequent.
For instance, after the review of loan documentation, you may conclude that prior permission is required before additional funding is brought in. It is your duty to make your client aware of this stipulation and then include it among the conditions precedent to closing the transaction.
Similarly, if the target is facing litigation with respect to an event prior to the investment, the investor should not be required to bear its costs. The amount of potential loss should either be set aside in an escrow or adequate representations and warranties backed by indemnity should be stipulated in the transaction documents.
Step 4: Draft and finalise the LDDR report
The outcomes of an LDDR exercise are usually set out in a report. Depending on your understanding with the client, it may either be a long form report or a report setting out only the main issues.
You should bear in mind that the report should be structured in a manner that all sections are classified and organised in the order of importance. Issues should be clearly identified and all risk mitigation solutions should be clearly set out.
In my next post, I will discuss the transaction documents in a typical private equity investment.
Angira Singhvi is a principal associate with Khaitan Sud and Partners and handles general corporate, joint ventures and private equity investments.