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DUE DILIGENCE
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Contents Meaning of Due Diligence
Review (DDR)
Due Diligence What is it?
Scope of DDR Who Conducts DDR
Situations calling for DDR
Types of DDR
Introduction to Financial DDR Types of Financial DDR
Process involved in FinancialDDR
Areas covered in FinancialDDR
Practical Situations in DDR
Findings and their Impact Impact of findings from other
Due Diligences
Limitations
Risks Involved Steps to Mitigate Risks
Reporting
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Meaning of DDR Dictionary Meaning of Due is Sufficient & Diligence
is Persistent effort or work.
It is an investigation into the affairs of an entity prior toits acquisition, flotation, restructuring or other similartransaction
Due Diligence Review is a process whereby an individualor an organization seeks sufficient information about a
business entity to reach an informed judgment as to itsvalue for a specific purpose.
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Due DiligenceWhat is it? The process by which information is gathered
about:
A target Company Its Business; and
The Environment in which the target companyoperates
Objective: To ensure that prospective investors make and
informed investment decision
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Due DiligenceWhat is it? It is a business oriented analysis not an accounting
analysis
A fact gathering exercise with focused analysis ofinformation
Understanding the industry of the target
Reasonable level of enquiry on the affairs havingmaterial impact on the prospects of the business
Evaluation of business model and key business practices
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Scope of DDR Scope is determined by the client.
The degree of diligence requiredin any given review cannot beprecisely defined.
Purpose for review defines whatis due or sufficient diligence.
Extent of the review required is ajudgment call.
Engagement letter with the clientis important.
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Who conducts a DDR Chartered Accountants
Investment Bankers
Attorneys Lead & Co-Investors
Corporate Development Staff
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Situations Calling for DDR Firm considering a potential
acquisition
Investment banker considering
underwriting a public security Banker considering the grant of a
loan
Venture Capitalist considering an
Investment Seller of a business commissioning a
DDR
Lead Investment Banker in case ofIPO as per SEBI Norms
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Business Due Diligence
Legal Due Diligence
Tax Due Diligence
System Due Diligence
Environmental Due Diligence
Human Resource Diligence
Financial Due Diligence
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Types of DDR
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Business Due Diligence A review of the market for the company's product
A background check on the founders and key management team
Analysis of the Company's competition
Existing Market Share
Expansion plans
Analysis of Comparative Profitability & reasons for deviation ifmaterial
Discussions with the Company's key customers
Review of management structure
High dependence on single customer/supplier
High dependence on Government policies10
Types of DDR
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Legal Due Diligence
Looks at identifying issues related to contractual obligations
which have not been fulfilled by the Company. Review of key contracts related to customers, suppliers,
employees and services.
Review of agreements/filings related to patents, copyrights,
trademarks, intellectual property rights, etc Compliance with the Companies Act and various other statutes
applicable to the Target
Review of Litigation for and against the Company.
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Types of DDR
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Tax Due Diligence
Identifies and quantifies areas of tax risk to the extent possible
and assesses future tax implications Deals not only with historical liabilities but also assesses future
tax implications and finds opportunities to minimize tax
Tax implications of the various possible structures
Tax DDR is a key ingredient in assessing whether to proceedwith a deal
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Types of DDR
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System (IT) Due Diligence
Confidence that the IT assets supporting the business are up to
the task Review the framework for hardware and software
Review of the Disaster Management Plan
Coordination that all the softwares are working in sync and
there is no conflict between any of them. Advise on system integration with the acquirers information
system
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Types of DDR
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Environmental Due Diligence
Environmental due diligence is the systematic identification of theenvironmental risks and liabilities associated with an organisation'ssites and operations
Provides the acquirer with a detailed assessment of the historic, current andpotential future environmental risks associated with the target organisation'ssites and operations.
Review the environmental setting and history of the site
Assess the site conditions, operations and management
Confirm legal compliance and pollution incidents from regulatoryauthorities
The internal environmental norms of the acquirer are met
Review contractual and other associated risks14
Types of DDR
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Human Resource Due Diligence
Human resource due diligence attempts to evaluate how people aremanaged between the two companies
How do we continue to maximize the value of human resource capital?
What is the appropriate mix of pay and benefits for the neworganization?
What incentive programs are needed to retain essential personnel after
the acquisition is announced? How are employees rewarded and compensated by the Target Company?
How does base pay compare to the marketplace?
Review of comparative pay scales and designations between the acquirerand target company.
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Types of DDR
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Financial due diligence has the highest significance the finaldecision, for an investor, would be in the form of financial termsand information. It is therefore imperative that the results of all
kinds of due diligence should be translated in monetary terms.
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Introduction to Financial DDR
Identification of hidden risks & deal breakers
Ensuring that all liabilities, current and contingent, are considered
Establishing price adjustments / negotiation extent of dependency on
customers and vendors Off balance sheet financing
Identification of specific indemnities & warranties reqd. from target
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Buy Side Due Diligence commissioned by the acquirer
Focused on areas of interest for potential acquirers (financial orstrategic)
Reporting generally issue based
Dataroom < > exclusive
Sell Side (Vendor DD) Independent due diligence commissioned by the vendor
Key tool for maximising saleability of the business in a reducedtimetable through maintaining competitive tension
To identify potential issues and take corrective measures upfront
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Types of Financial DDR
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Limited Not equivalent to full scale due diligence
Focus on certain key areas based on the level of comfort desired bythe Client
Full Scale Focus on all major aspects of financial statements
Extent of detail is more as compared to limited due diligence
It is important to know whats driving value foryour clients
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Types of Financial DDR
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Methodology
QuickAppraisal
Terms ofReference
InformationChecklist
Field WorkIdentifying
IssuesReplies fromManagement
Preparation ofDraft Report
Discussion ofDraft Report
Issue of FinalReport
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Areas in Financial DDR This would typically assess the effect the external factors
have upon business. This when compared with theinternal strengths and weakness, provides a good
understanding of the state of business. External factorsgenerally include markets, competition, regulation andtechnology.
Business
Environment
This would involve understanding the business model of
the target and the value chain of its business. Other thanthe main value creating functions viz. procurement andits logistics, production, marketing and sales anddistribution logistics, attention is also given to thefunctions that support these activities.
CompanyOperations
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Areas in Financial DDR Evaluation of the build up of operating profits Identifying key sensitive parameters which would
adversely impact the profitability of the business
The rate of growth in sales, EBITDA and earnings Sustainability of earnings / cash flows Normalised EBITDA / Proforma financials
Quality of
Earnings
Analysing cash flows generated from operations and howthe same are employed
Understanding the level, stability, timing and certainty offuture cash flows
Analysis of working capital along with discussion onnormal, average level of working capital
Cash Flows
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Areas in Financial DDR Analysis of fixed assets -Capitalisation, depreciation
and replacement policies; Capex plan, capitalcommitments
Investments made, carrying value, valuationpolicies and potential diminution in the value of theinvestments
Receivables (ageing analysis, recoverability, baddebts and provisioning policy)
Inventory (ageing, valuation, write off/provisioning
policies) Cash balance and bank reconciliations Analysis of other current assets like loans and
advances, deposits, cash/ bank balances.
Balance SheetAssets andLiabilities
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Areas in Financial DDR Sundry creditors (ageing analysis, subsequent
payment of creditors dues)
Review of loan agreements to see compliancewith the terms of the lenders guidelines andalso if any conversion clause exists.
Review of all other current liabilities &provisions to see that all known liabilities arefully recorded and all provisions are made.
Shareholders agreement in case of companies Off balance sheet liabilities-bank guarantees,
commitments, legal claims and contingencies
Balance SheetAssets andLiabilities
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Areas in Financial DDR
This would involve various issues related to
taxation to ensure that no undisclosed liabilitiesaccrue to the target
Assessment and validation of losses / other taxattributes
Current compliance status; Tax benefits and their availability in future; and Commentary on any other outstanding tax
liabilities / material issues
Taxation Direct and
Indirect
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Areas in Financial DDR Review of various agreements / arrangementswith related parties and assessment of various
transactions with them Evaluation of commitments to / from relatedparties
Analysis of human resources with respect tohead count and provision for retirementbenefits in line with laws applicable to the same
Review of other arrangements necessary forconduct of business e.g. contractual labour,trade unions, etc
Other Areas
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Fixed Assets
Underused/obsolete plant & machinery
Assets carried at much more than current market valuedue to capitalization of revenue expenditure or foreignexchange fluctuation
Capitalization of interest in an expansion projectsubsequent to stoppage of the construction work
Litigated assets & property
Adjustments for capitalization of assets, softwareexpenses, etc
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Practical Situations
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Investments
Target co. sold subsidiaries/business & agreed to takeover and indemnify all liabilities of the same prior to thedate of transfer, which were not reflected in the targetsbooks of accounts
Investments carried at cost though realizable value ismuch lower
Investments carrying a very low rate of income/ return
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Practical Situations
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Working Capital
Uncollected/ uncollectible receivables
Obsolete, slow & non-moving inventories or inventoriesvalued above Net Realizable Value
Adjustment for Inventories with old names/logos in thecase of hotel industry
Group company balances under reconciliation, etcDeferred Revenue Expenditure
Deferred revenue expenditure included under advancesor not normally deferrable
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Practical Situations
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Taxes
Tax liabilities under Direct & Indirect taxes
Pending final assessment of customs duty whereprovisional assessment only has been completed
Non availability of TDS Certificates
Adjustment for possible liability arising out of non-
submission of Forms C & F Delays and non-payment of direct and indirect taxes
Liability on account of EPCG
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Practical Situations
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Other Claims
Environmental problems/claims, third party claims
Huge labour claims under negotiation when the labourwage agreement has already expired
Non-funded gratuity/superannuation/leave salaryliabilities
Non-compliance with enactments such as the Income Tax
Act, FEMA/FERA, Customs Act, etc. that could result inlitigation & levy of penalties
Product warranties, defects & other liability claims, productreturns & discounts, liquidated damages for late deliveries
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Practical Situations
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Off Balance Sheet Items
Target co. may not show any show cause notices whichhave not matured into demands as contingent liabilities.
These may be material & important
Target co. may have given Letters of Comfort to banks& FIs. Since these are not guarantees, these may not bedisclosed in its balance sheet
Commitments including long term contracts
Agreement to buy back shares sold at a stated price
Future lease liabilities
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Practical Situations
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Profit & Loss Items
Identifying seasonality in sales, dependency on customers
Assessing the impact of customers gained / lost on thebottom line
Dependency on customers/suppliers
Revenue recognition and cut off procedures
Items of one off / non recurring nature Impact of stand alone costs
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Practical Situations
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The DDR findings are then quantified for impact on the finalvaluation
Deal Breakers - Those issues which would impediment the
consummation of the proposed transaction Negotiation points - Those issues which would be necessary to
consider in the valuation of business / negotiation of bid price
Issues for Agreements - Those issues which would warrantindemnities and identify conditions precedent for happening of the
transaction
Commercial Override - Those risks and issues which areknowingly taken over as a calculated commercial decision
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Findings and their Impact
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The DDR findings from other due diligences mentioned beforealso need to be quantified for impact on the final valuation
Business Due Diligence Impact of dependence on single
customer/supplier, government policies, etc. Impact of expansionplans on future profitability of the company
Legal Due Diligence Any further liabilities/penalties arising outof non compliance/defaults with regards to Corporate laws likeFEMA, Companies Act, SEBI Norms (for listed companies), etc.
Tax Due Diligence Penalties for non-payment, delays in paymentof statutory liabilities. Liabilities arising on settlement ofassessments.
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Impact of Findings from other Due
Diligences
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System Due Diligence Costs involved in case migration of data.Issues related to strengthening of the information system. Issueswith regards to all necessary safeguards being in place when an
emergency occurs Environmental Due Diligence Penalties/liabilities with regards
to non-compliance of environmental guidelines issued by therespective authorities. Costs involved withaligning/synchronization the environmental guidelines of the
acquirer Human Resources Due Diligence Costs involved with aligning
the pay scales of acquirer and target. In case there is excess staff onthe roles of the target then severance costs to be looked into.
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Impact of Findings from other Due
Diligences
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Undertakings should normally cover the following:
Titles & ownership
Various Government consents / licenses
Correctness of all information supplied
Product / service warranties, damages & other claims
Contingent liabilities
Recoverability of all current assets Registration of Intellectual properties
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Undertakings from Management
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For Service Providers
Limited scope of review fixed by the client /acquirerTitles & ownership
Too much to see in too little time
For Acquirers/Investors
Inability to determine the scope Inability to ensure proper co-ordination between service
providers
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Limitations
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For Service Providers
Failing to meet the
needs of the partycommissioning a duediligence
Financial
indemnification of theconsequential loss
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Risks Involved
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For Acquirer/Investor
The investor may pay higher thanthe fair price for acquisition
The investment performance maynot be upto the expectation or mayperform badly
A bad strategic investment may
result in losing a considerablemarket share or reputation
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Risks Involved
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By Service Provider
Clearly understand the objectives& the complexities of the
assignment based on which thescope should be finalized
The DDR report should disclose allthe limitations of the assignment
A proper engagement reviewshould be carried out beforeaccepting the assignment anddeciding the scope
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Steps to Mitigate Risks
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By Service Provider
Schedule meetings with otherreviewers
Collect from the client reports ofall other due diligences
The due diligence team shouldconsist of at least one person who
is familiar with the industry, thetarget is involved in
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Steps to Mitigate Risks
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By Acquirer/Investor
Should ensure that the scope iscomprehensive
Proper coordination amongst allservice providers should beencouraged
An integrated service provider
may be hired
To ensure that the target providesall necessary information
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Steps to Mitigate Risks
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Identifying Issues
Identified issues to be discussed with Mgmt & otheradvisors
Replies from Management
Resolve issues identified
Preparation of Draft Report
Draft report submittedDiscussion on the Draft Report
Issue of Final Report
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Reporting Aspects
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Due Diligence plays an important role inidentifying, quantifying and reducing the risks of an
acquisition.
Although Due Diligence focuses on negativeinformation, the aim is not to raise obstacles to
transactions, but rather to facilitate transactions byidentifying problems and risks by devising solutionsto problems or devices to reduce or manage the risks
involved in corporate acquisitions.
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To Conclude ..
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