A Practical Guide to Private Equity Transactions

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Due diligence

issues or areas of risk, typically arising as a result of disputes or non-compliance

with laws, the nature of which may be relatively insignicant or substantial.

For the practitioner, undertaking a controlled yet comprehensive review of

this nature can be challenging. By its nature, the exercise requires the involve-

ment and co-ordination of numerous specialist colleagues, and as a consequence

the process can have a tendency to run away with itself. However, a carefully

managed and timely legal due diligence exercise can not only facilitate the

transaction, but also add value to private equity clients and their investments.

Sometimes, the process of legal due diligence can become confused with

the process of disclosure.

There is similarity in subject matter, in that both

result in a fairly detailed document being prepared highlighting various legal

issues that may be of concern to the buyer. However, the distinction between the

two processes must be carefully maintained. The process of legal due diligence

is generally buyer-led, with the buyer’s advisers usually providing a question-

naire with comprehensive enquiries the responses to which form the basis of the

report. Even where a vendor legal due diligence exercise is undertaken (which is,

in itself, more rare than vendor accounting due diligence), the buyer will usually

reserve the right to ask more detailed or probing questions to supplement that

exercise. As a result, the adequacy of legal due diligence is entirely dependent

on the accuracy and comprehensiveness of the responses provided – if any such

responses are inadequate or misleading (whether through deliberate withhold-

ing, recklessness or otherwise), this will be reected in the quality of the due

diligence. In contrast, the disclosure exercise is seller-led, requiring the relevant

seller(s) to provide details of any material facts which give rise to a breach, or

potential breach, of the warranties. Therefore, whilst the exercises are distinct,

there is a continuing interaction between the two. The ndings of due diligence

will inform the warranties that should be sought in the sale agreement; equally,

the fact that formal disclosure is necessary to qualify those warranties means

that information either validating or supplementing the responses to the legal

due diligence enquiries is ushed out by that process.

Understanding the scope of the legal due diligence exercise is very import-

ant; such scope should be agreed with the client in some detail. Certain issues

which are material for a retail business will not be at all relevant for an engin-

eering business, and vice versa. As well as giving careful thought to the areas

which are of most importance to the business, it is usual to agree a concept of

materiality (typically, a nancial limit xed as a sensible proportion of the deal

size) below which issues need not be raised in the report. This limitation, and

any other limitations proposed by the lawyer in allowing addressees to rely on

the report, should ideally be approved by the bank funders as well as the equity

funders wherever that is possible.

By way of overview, the areas covered by legal due diligence include the

following matters.

15 For disclosure generally, see chapter 4, section 3.

The deal process and preliminary matters

(a) Constitutional matters and accounts

Copies of the memorandum and articles of association will be reviewed for each

group company, and cross-checked against those led at Companies House or

any relevant overseas registries. Details of all existing shareholders, option

holders and directors and ofcers will also be checked by reference to such

public records, and Target’s statutory books. Particular interest will be taken

in Target’s existing funding arrangements, and the documentation for any pre-

vious acquisitions and disposals, joint ventures or similar transactions.

(b) Contracts and trading

Legal due diligence should identify the basis on which Target carries on its

business in the ordinary course. Any material customer and supplier con-

tracts will be reviewed, together with standard terms of sale and supply. Any

contracts or arrangements which are outside the ordinary course will also be

carefully scrutinised, especially where they involve dealings with other group

companies or family members of the shareholders where relevant, to ensure

that the terms are at arm’s length and assess whether such arrangements should

continue or be altered.

It is important that due diligence identies any licences or consents that are

necessary for Target to continue to trade. Even assuming that the Target com-

pany is to be acquired rather than its business and assets (such that those

arrangements will be in the name of the correct legal entity that continues to

trade post-completion), there may be notication or renewal processes trig-

gered by virtue of the change of control, or any changes to Target’s board. Any

correspondence relating to the establishment or maintenance of any licences

or consents must also be reviewed.

(d) Assets

Target’s title to all material assets will be claried. This will include inspec-

tion of the xed asset register, and a review of any relevant hire purchase,

factoring, invoice discounting or leasing contracts.

(e) Employees and pensions

The current terms of key employees will need to be reviewed. Usually, senior

staff will be party to stand-alone service agreements, which in the case of

the managers will be replaced with new contracts in a form acceptable to

the private equity investors on completion,

but the employment terms for

all employees should in any event be checked to ensure compliance with

laws. Supporting documentation such as staff handbooks, details of bonus or

16 See chapter 7, section 2, for more on the content of such service agreements.

Due diligence

prot-sharing schemes or other benets, and health and safety policies should

also be checked. The presence of trade unions adds a further complexity, where

there may be binding collective agreements to review and other customs and

practices to consider.

As mentioned above, legal due diligence will also identify the nature of

Target’s pension scheme(s), and will include a review of all relevant documen-

tation including, where appropriate, the trust deed and rules, latest actuarial

valuations and details of scheme members. The complexities of a transaction

with a nal salary pension scheme are considered in detail in chapter 8.

(f) Investigations, disputes and litigation

Details will be requested of any current, or pending or threatened, litigation or

disputes. Due diligence should distinguish between disputes that might be con-

sidered ordinary course (for example, minor employee disputes will be viewed

as inevitable in a business with a large workforce; likewise some degree of

customer complaint in a retail business) and those which are material either

because of the amount in dispute in itself, or the knock-on implications that

dispute may have for Target if it suggests an underlying aw in Target’s busi-

ness. This area overlaps with insurance due diligence (as the availability of

insurance to cover any such claims will be assessed), and also nancial due

diligence (as adequate provision for such liabilities will need to be included

within Target’s nancial records, and the Business Plan).

(g) Intellectual property

Details of both registered and unregistered intellectual property will be inves-

tigated. The former is relatively straightforward, as the responses to the pre-

liminary enquiries can be veried by searches the relevant public registries,

but understanding the ownership of unregistered intellectual property (par-

ticularly copyright) can be more difcult, particularly where external consult-

ants have been involved in the design of key brochures or literature, or bespoke

IT systems. Relevant intellectual property licences granted by the Target group

and those granted to it will also be reviewed.

(h) Property and environmental

Target’s title to any freehold or leasehold properties will be investigated. There

are two possibilities here: the buyer’s solicitors may investigate title themselves

and provide a report on such title to their clients; or, alternatively, the sellers’

solicitors might be willing to provide a certicate of title to the buyer and its

funders. Whilst a buyer generally resists accepting due diligence from the sell-

ers’ advisers, there can be particular advantages to this approach in relation to

property, as the solicitors in question may be very familiar with the title from

previous dealings (and this advantage is magnied if the Target has a large

number of separate properties, for example if it is a retail chain). In any event,

time is of the essence, as the investigation of title necessitates various searches

The deal process and preliminary matters

and enquiries with the Land Registry, local authorities and so on. It should

also be borne in mind that bank funders will be concerned to ensure that any

investigation of title to properties forming a substantial part of its security is

sufciently thorough.

Irrespective of whether the buyer undertakes specialist environmental due

diligence, the buyer’s solicitors’ questionnaire will ask for copies of any rele-

vant licences, consents and permissions, and seek conrmation that Target is

trading in a manner which is compliant with those documents, and otherwise

with current environmental legislation.

A criticism often raised by private equity and bank funders (and, regrettably,

often with some validity) concerning legal due diligence is that it can be dif-

cult to identify the actual advice that emerges from the exercise. Due diligence

reports are often lengthy, and a good executive summary highlighting the key

issues and concerns is essential. Even then, legal due diligence all too often

reports on the factual content of the documents or responses so as to highlight

the possible issue, but does not then go on to sensitise such issue or to recom-

mend the action necessary to deal with it. If an issue is so signicant as to be

a deal-breaker, or to require a fundamental change to the deal terms, then it

should be raised with the client without delay, rather than awaiting the conclu-

sion of the full, nal report. Where an issue is not so signicant, the legal due

diligence report should still distinguish those matters which must be addressed

before completion (for example, by seeking a suitable conrmatory warranty

in the sale and purchase agreement) from those which can be addressed after

completion (such as suggested improvements to Target’s standard terms and

conditions, which might be incorporated within the 100 Day Plan).

The overlap that exists between legal due diligence and other parts of the

buyer’s due diligence process has already been highlighted. One nal area

which needs particular care in its scoping is the subject of tax due diligence.

It is usual for the legal due diligence questionnaire to request some funda-

mental tax information such as copies of tax returns, details of any audits,

investigations, discussions or disputes with tax authorities, a history of reliefs

and exemptions claimed and so on. However, it is nevertheless more usual for

a detailed assessment of the tax position of Target to form part of the nancial

due diligence exercise rather than legal due diligence. That said, the relevant

members of the legal and accounting teams should ensure they are in direct

contact as soon as possible in the transaction process, to ensure that the infor-

mation they are receiving is consistent, and the scope of their respective roles

is understood (to avoid unnecessary duplication or, worse still, areas of inves-

tigation being missed altogether).

4.4 Financial due diligence

The key aim of nancial due diligence is to support, validate, challenge or

modify the nancial data, assumptions and assertions made in respect of

Due diligence

Target and its business in the Business Plan. As for legal due diligence, a com-

prehensive scope is prepared by the relevant accountancy rm and agreed with

the investors prior to the com mencement of the due diligence exercise. The

relevant information is then compiled by Target’s directors or employees and

reviewed by the accountancy rm, with the ndings ultimately being com-

municated in a report format, with a draft report usually being issued towards

the end of the initial due diligence stage of the process, and a nal report being

issued prior to completion (or, if a vendor due diligence exercise is undertaken,

the rst draft report is made available in the data room, with a nal ‘top up’

report being provided at completion).

The key elements of the nancial due diligence exercise include the fol-

lowing matters.

(a) Historic trading and net assets

Historic trading and net assets are typically reviewed over a three-year period.

The key areas of review include the sustainability of revenues and prots, driv-

ers of growth, product or customer reliance, prot margins, working capital

and cash ows. Work in this area forms a key input into the evaluation of fore-

cast trading and cash ow assumptions (see below).

(b) Business operations

A review is undertaken to understand the nature of Target’s customer base (and

associated contracts), key sales and production processes, products, suppliers

and marketing methods. Again, such diligence will inform the evaluation of

trading and cash ow forecasts.

The procedures for nancial reporting, and accounting policies, will be

reviewed to assess whether the nancial information is reliable or sufcient to

allow an accurate understanding of the performance of the business. The con-

sistency with which accounting policies have been applied will be a key area,

as well as compliance with generally accepted accounting practice – inconsist-

ent application or changes in policies can have a signicant impact on trading

results and future reported performance. As with legal due diligence, adverse

ndings might impact on the deal structure, including price, or highlight areas

requiring attention post-completion. The latter is particularly relevant if a

Business Plan envisages expansion, which may put strain on the continued

adequacy of the systems in place.

(d) Management/staff review

Financial due diligence will look to identify those employees who are key to the

business – whether due to technical knowledge, marketing expertise or signi-

cant customer or supplier relationships. Consideration will be given to whether

such individuals will be adequately motivated to remain in the business and

The deal process and preliminary matters

support its growth post-acquisition which, in turn, will have a bearing on the

allocation of equity amongst members of the management team, and possibly

within a tier beneath that team.

(e) Tax due diligence

As mentioned above, the nancial due diligence exercise will usually include a

detailed review of the tax history of Target, and an analysis of the implications

for the buyer of acquiring Target from a tax perspective.

As we saw in chapter 1, the nancial model forms an integral part of the

Business Plan. Financial due diligence looks to understand the key risks in

the future trading of the business, both by challenging the forecasts them-

selves (and the assumptions behind them), and by establishing the appropriate

sensitivity tests that should be applied to the model in order to understand the

impact of particular circumstances on trading performance and cash ows.

Those sensitivities should then inform the setting of appropriate nancial cov-

enants with the debt funders to the transaction.

As well as understanding the ways in which the ndings from nancial due

diligence may impact on the content of the legal documentation, lawyers may

become involved in debates concerning the possible exposure of the account-

ancy rms involved to legal claims. In the leading case of Caparo Industries

plc v. Dickman,

it was established that auditors owe a duty of care to the

company itself, and not to its present or future shareholders, unless particu-

lar circumstances exist such that the auditors are aware or intend that another

party will rely on the report. This decision led to an increasing anxiety on the

part of accountants to limit their exposure (as we have seen in relation to the

negotiation of accountancy rms’ engagement letters generally).

A particular area in which a lawyer may become involved in a nancial

due diligence context is the agreement of a hold harmless letter with Target’s

existing auditors. It is common for the investigating accountants appointed

to conduct nancial due diligence to request access to those working papers

which were prepared by the existing auditors of Target for the purpose of pre-

paring the most recent audited accounts. Access to such papers will make the

process far more efcient and cost-effective. However, auditors are generally

concerned that providing third parties with access to such papers may expose

them to an additional litigation risk. As a consequence, the auditors will there-

fore request a hold harmless letter from both the proposed buyer (often the

private equity rm itself, as a Newco may not have been created or will only

be a shell company), and the nancial due diligence provider, to ensure that the

basis on which such papers have been provided is clear.

17 See also chapter 7, section 5.

18 [1990] 2 AC 605.

19 See section 3.2 above.

Due diligence

Historically, the Institute of Chartered Accountants in England and Wales

(ICAEW) had drawn up a standard letter for accountants to use for this pur-

pose. The original example dates back to 1995, and was drafted in a manner

which many private equity rms felt placed unreasonable and onerous obliga-

tions on the buyer. As a consequence, this standard hold harmless letter inev-

itably became a very contentious issue, with signicant delays being caused to

the transaction process as such terms were negotiated. As the precedent was

effectively ICAEW approved, many rms were extremely reluctant to accept

any amendments to its terms – with the effect that on many transactions pri-

vate equity bidders were left with the choice of either accepting what they

considered to be an unreasonable level of risk in order to have access to the

working papers, or alternatively conducting the due diligence exercise without

such access (making such due diligence less reliable, and causing additional

delay and expense).

After further consultation between the ICAEW and the BVCA, and other

related parties, an updated standard hold harmless letter was released in 2003

which supersedes the previous version. The provisions in this letter are gener-

ally viewed in the industry as more reasonable (in fact, the standard reects the

nal position which was often negotiated between private equity rms and the

accountants from the starting-point of the previous version), and therefore will

usually be acceptable to bidders. The letter provides many detailed provisions

seeking to limit the auditors’ liability, but the key provisions are as follows:

(a) an acknowledgment by the buyer and the investigating accountants that

they are not owed any duty of care by the auditors as a consequence of the

working papers being released to them;

(b) a requirement that the buyer and investigating accountants keep the con-

tents of such working papers, and information derived from them, con-

dential, save that the investigating accountants and buyer may disclose and

discuss the same with the Target company to obtain further information

or verication in relation to the proposed due diligence report, the buyer’s

legal advisers, or otherwise as required by a court or by statute;

that they will not bring any action, proceedings or claims against the audi-

tors arising from their use of, or reliance on, the information provided or

the audit reports contained in Target’s nancial statements;

(d) nally, and crucially, the buyer will agree to indemnify and hold harmless

the auditors against any claims which may be brought as a consequence of

the failure of the buyer or any of its advisers (including the investigating

accountants) to comply with the terms of the letter.

Later in the nancial due diligence process, the issue of the accountant advis-

ers’ liability may again arise in the delivery of the nal report. It is usual

20 See ICAEW Release Audit 04/03.

The deal process and preliminary matters

for management to be asked to review the report, and, as we will see, the

investors will also ask the managers to warrant the content of that report in

the investment agreement.

What is also becoming increasingly common,

however, is for the accountants undertaking the nancial due diligence exer-

cise to require the managers to sign a side letter which effectively warrants

the content and truth of the due diligence report directly to those accountants.

Managers and investors should both be wary about the signing of such letters.

Ultimately, if there is an error in the nancial due diligence, investors may be

prevented from making a claim against the accounting advisers if, in mak-

ing such a claim, there is a real prospect of the managers being joined into

any action. Where a letter is necessary to procure the release of the report, it

should be reviewed by the lawyers acting for management and for the inves-

tors, so that the implications of the conrmations requested in that letter can

be understood.

4.5 Other due diligence

In addition to the nancial and legal due diligence carried out by the account-

ants and lawyers respectively, the following types of due diligence may also be

conducted:

(a) Commercial due diligence. A rm of consultants are instructed to assess

and validate the market analysis and strategies set out in the Business

Plan.

(b) Operational and IT/systems due diligence. This involves a review of the

operational aspects of Target to conrm whether the Business Plan is

achievable with the existing operational facilities when combined with the

capital expenditure identied in the Plan. Good operational due diligence

will also consider whether there is the potential for additional value within

Target by improving its operations. Operational due diligence may be car-

ried out by a rm of accountants (possibly the same rm offering nan-

cial due diligence), or by a consulting rm. A detailed review of Target’s

IT capabilities and infrastructure may be included within operational due

diligence, or may be carried out separately by a specialist consultant.

ing the adequacy of the current insurance arrangements of Target, and

making recommendations as to the policies which should be in place for

Target post-deal. Such policies are usually then arranged by those brokers

carrying out the review. There is an important overlap with legal due dili-

gence here, as the adequacy of insurance cover for any historic liabilities

identied will be of relevance to both parties in assessing who should be ‘at

risk’ for those liabilities in negotiations. It is also of particular signicance

in those buyouts involving the purchase of a subsidiary business from a

21 See further chapter 5, section 3.4.

Conclusion

larger group – such businesses will usually benet from wider group insur-

ance policies, and that cover will most likely not be available when the

business leaves the group, necessitating the arrangement of stand-alone

cover in anticipation of completion.

(d) Pensions due diligence. Where a dened benets pension scheme is in

place, a rm of actuaries will be instructed to assess the funding of the

scheme, and to advise on recommendations for dealing with that scheme

both before and after completion alongside the legal advisers. The spe-

cic issues that arise on the acquisition of a business with such a scheme

are considered in detail in chapter 8. Where a dened contribution scheme

exists, then such specialist advice may not be necessary, although legal and

nancial due diligence will investigate matters relevant to such schemes.

(e) Environmental due diligence. Again, there is signicant overlap with legal

due diligence here. Whilst the legal process will usually begin the assess-

ment of any specic environmental issues, environmental consultants

will often be brought in to at least carry out a desktop assessment of the

risks associated with the properties occupied by the business (where those

premises are limited to ofces or similar commercial properties) or, where

properties of a more industrial nature are involved, this may be extended

to a more detailed investigation including a site visit and even the taking of

ground samples.

(f) Management due diligence. It is now common for private equity rms to

require the individuals proposed for the management team to be subject

to a due diligence exercise themselves. This typically involves the comple-

tion of psychometric and similar written tests, followed by a comprehen-

sive interview and discussion, carried out by specialist HR consultancies.

The reviewer will produce a report highlighting the strengths and weak-

nesses of each individual in the team, and setting out recommendations

for their development during the life of the investment. Unsurprisingly,

the intrusive nature of this investigation often makes it controversial with

some individual managers.

On a successful transaction the individual due diligence processes form part

of an integrated exercise, and the outputs from all due diligence exercises will

inform the legal protections that the investors require in the key transaction

documents. The legal due diligence will usually contain the most immediately

relevant issues to be addressed, but there may be key recommendations in the

other reports which are equally, or possibly more, signicant.

5 Conclusion

In outlining the initial stages of a transaction process, and setting out an over-

view of the process as a whole, the importance of the relationships between

the parties and their respective advisers should already be apparent. Some

issues arise again and again on each transaction, whilst others vary according

The deal process and preliminary matters

to the particular deal. The recurring issues often relate more to process, rather

than the commercial terms or desired outcome from the transaction, and we

have noted the role played by the BVCA and relevant professional bodies in an

attempt to standardise an acceptable practice relating to the liability of advis-

ers and their engagement terms, and access to the audit papers of the Target.

This reects a consistent desire to remove the repetitive and avoidable process

issues common to many deals which are sometimes seen as of interest only to

lawyers or to insurers, and which have tended to delay deals and distract par-

ties from the buyout process itself. Industry norms cannot answer all the ques-

tions, but they can help the parties focus on the matters of relevance to them

and their deal. This initiative has been welcomed in the industry.

Due diligence plays a critical role in underwriting the Business Plan, and

ushes out those issues which the buyer and its advisers must consider. It is rare

for due diligence to have no ef fect on a deal – it may well lead to some price or

structuring change, or at the very least to the negotiation of bespoke warran-

ties, indemnities or other contractual remedies to address any concerns raised

but not resolved during the deal process. Sellers may attempt to limit this ero-

sion of the headline deal terms by the use of structured data rooms, vendor due

diligence and tight auction timetables. Whilst this has been effective during

stronger market conditions, at the time of writing the balance has undoubtedly

swung back towards more formal and comprehensive buyer-led due diligence,

in order to give the private equity investors and the banks more condence

to do the deal. It will be interesting to see if this process now favours trade

buyers, especially those who do not need new debt funds to close the deal. In

some cases, the sector knowledge of those buyers may enable them more eas-

ily to take a view on a matter raised in due diligence, or to cut due diligence

corners in a manner that a nancial investor or a bank would not be prepared

to accept in the present climate.