Managing Risk in M&A Deals – Investigative Due Diligence

Access to information is one of the keys to managing risk in an M&A transaction. Investigative due diligence (IDD) should be placed alongside legal and financial diligence as a critical component of a buyer’s diligence process. IDD allows deal teams to identify risks that may not be apparent from a review of materials in a data room or through interviews with the seller’s management team. Through a robust IDD process, acquirers can make more informed acquisition decisions about potential reputational, operational, legal or regulatory risks. 
 
Depending on the underlying industry and geography of the target company, these risks could range from:

• Significant undisclosed regulatory or litigation concerns

• Bribery or corruption in tendering processes

• Issues regarding corporate social responsibility deficiencies

• Workplace culture issues that include potential discrimination or sexual harassment

 
Failure to conduct adequate IDD in an M&A transaction may leave the buyer vulnerable to suffering the following:

• Reputational risks

• Financial repercussions such as successor liability

• Disgorgement of contracts possibly won through illicit means

• Impairment of the value of assets

• Remediation costs

 
The performance of comprehensive IDD serves to alert M&A due diligence teams to potential risk exposures that may impact the valuation or structuring of a contemplated transaction. 

What Is Investigative Due Diligence (IDD)?

IDD typically involves research and analysis performed as to individuals or entities to uncover information that, if not addressed or remediated, could leave the target company – and hence its acquirer - vulnerable to:

• Substantial monetary penalties or losses

• Damages to reputation

• Costs related to litigation

 
It can also take two paths. On one path, IDD performs background investigations as to the target company, its executives, and its key employees. On the second path, IDD focuses on some of the significant third-parties related to the target company. 

The First Focus of IDD: the Target Company, its Executives and its Key Employees            

IDD begins with a comprehensive review of publicly available information including, but not limited to:

• Corporate registration records

• Litigation filings

• Regulatory records

• Social media

• General internet and media research

 
For the principals of a target company, IDD includes a review and corroboration of the professional histories and biographic information of the individuals. In jurisdictions in which public records are sparse and unreliable, or in which the buyer is seeking more in-depth insight, the public record research may be complemented by gathering human intelligence. These source inquiries provide color and context around key individuals, significant transactions involving the individuals, and other important matters. Source inquiries tend to disclose areas of potential risk that cannot be fully understood through public record research alone.
 
Domestic M&A Transactions - Fundamental Concerns
For domestic M&A transactions, or in cases in which the target company has a limited international profile, a comprehensive review of publicly available information in IDD help develop a better understanding of the track record, reputation, and mode of operation of the current management team. One aspect of this analysis is developing insight into potential risk areas through understanding past business dealings. Understanding the litigation profile of a person may give rise to previous instances of:

• Conflicts of interest

• Allegations of fraud

• Potential self-dealing

• Undisclosed related party transactions

 
As an example, an ownership interest of an individual in another entity may result in findings of a potential conflict of interest, financial issues, or even mismanagement of funds. Activities of an individual outside of the target company possibly may lead to indications of some fraudulent behavior. Armed with insights about these past matters, deal teams may calibrate their work accordingly, and then focus on areas that may present a heightened area of potential risk.
 
When developing insights into the track records and reputations of the target’s executives, IDD makes reasonable inquiries into the credentials and professional licenses of these persons. Further, this could be particularly critical in the acquisition of professional services firms, such as physician practices, engineering firms, or licensed consulting practices. Contributions of funds by the individuals to other entities may be determined to be problematic. These contributions may be charitable or political in nature yet may violate tax or other rules that govern them. 
 
Cross-border M&A Transactions - More Complex Concerns
For cross-border M&A transactions, or in instances in which the target company has a significant operating presence outside of the U.S., IDD should include confidential interviews and analysis from a diverse set of sources.  These sources may include:

• Sector analysts

• Former law enforcement or intelligence types

• Former investigative journalists

• Sources who are familiar with the subject individuals from social circles

The deep research specialization developed through the public records research, coupled with the necessary cultural and political context, gives the buyer the proper framework through which informed business and legal decisions may be made about areas of risk. For example, interviews may offer a proper understanding of the political connections of the target company and how they are leveraged in pursuit of government tenders or other opportunities. This insight may direct M&A due diligence teams to scrutinize transactions connected to certain tenders or with certain third parties connected to these transactions.
 
Further, an understanding of the general macro-political environment may be necessary in jurisdictions in which business and politics could be inextricably linked. An example of such a potential risk could reside in a jurisdiction in which there may be a propensity for local regulators or officials to treat a new foreign entrant in a manner that could be detrimental to the viability of the entrant’s local operations.

The Second Focus of IDD: Third Parties  

M&A due diligence teams should develop a due diligence program that assesses the viability of the third-party anti-corruption and anti-bribery practices and procedures in place by the target company or the seller. Furthermore, the M&A due diligence team should conduct IDD on a certain population of high-risk third parties. The majority of U.S. Foreign Corrupt Practices Act (FCPA) investigations and SEC enforcement actions have involved the actions of a third-party intermediary in cases related to improper payments. Increasing regulatory pressures and recent government enforcement actions call for more knowledge about the entities with which the target company or the seller conducts business.  
 
Depending on the industry in which the target company or the seller operates, high risk third-party relationships may take the form of:

• Agents

• Vendors

• Suppliers

• Distributors

• Joint venture business partners

 
A risk-based methodology should be applied to assess potential exposures presented by these third-party intermediaries. This may include:

• Verifying ultimate beneficial ownership

• Gathering relevant background information

• Reading public records, including criminal and civil litigation (as available)

• Conducting adverse media checks (including local language checks)

• Reviewing sanctions and watch lists

• Considering past regulatory issues

• Identifying noteworthy political connections

 
While third parties have been highlighted in terms of potential exposure to corrupt business activities, there is an increasing awareness as to the risks third parties pose with respect to corporate social responsibility issues.  Whether the exposure relates to potential human rights concerns through abusive labor practices, or to environmental violations, IDD may assist buyers in the identification of areas of exposure that may have been introduced by third parties in the supply chain of the target company or seller. It is possible these potential exposures may be remediated before the issues cause long-lasting reputational and financial damage.  
 

How Does IDD Complement the Performance of Due Diligence?

Adding an IDD specialist function to the larger due diligence team involved in a contemplated transaction enhances the capabilities and performance of the overall team. The IDD function typically has tools, processes, specialized knowledge and techniques that other due diligence teams do not possess. The performance of IDD could fill a critical knowledge gap in assessing potential risks. The overall due diligence team leader may want to determine whether, and to what extent, other due diligence teams, such as the financial, human resources, or legal teams, may possess the wherewithal to timely and effectively perform this important aspect of due diligence. This may not be likely, however, given the demanding circumstances surrounding a contemplated transaction and the timeliness with which matters need to be identified and shared with those leading the due diligence efforts. 
 
The findings of the IDD team should be shared early and confidentially with the other functional leaders on the larger M&A due diligence team. These findings could serve to alert the financial, tax, legal, IT and human resources due diligence teams about matters that may call for their further inquiry and analysis. Knowledge sharing of IDD findings early in the due diligence process could influence the scope of the performance of procedures by the other specialists.  
 
In this respect, the IDD findings could lead to discussions between the buyer, the seller and their advisors to better understand the potential impact of the findings on the deal. Negotiations likely would follow about representations and warranties, indemnifications, and other protections for the buyer from the consequences of the IDD findings. Serious matters identified could lead to negotiations about purchase price adjustments, or to planning considerations to manage one or more of the IDD findings. 
 
Hence, discussions about IDD findings may impact deal terms, so it is better to address them earlier in the deal cycle rather than later. It is suggested IDD be performed not only by the buyer in buy-side due diligence, but by the seller for certain matters in sell-side due diligence. The performance of IDD by the seller could prepare the seller and target company to avoid surprises or better manage the responses to the potential IDD findings of buy-side due diligence.

Summary

IDD provides independent and objective insight into potential areas of risk not covered by traditional M&A due diligence. By proactively seeking to identify potential risks or areas of vulnerability before closing, a buyer or a seller can look to remediate issues of concern before they potentially cause a disruption. When significant issues that could have been identified through IDD are identified after a transaction closes, they might produce a crisis with a lasting reputational impact for both the buyer and the seller. Considerable time and cost may need to be expended to contest the payment of substantial monetary penalties, litigation damages or costs for the inheritance of potentially unknown issues. IDD should be a component of a thorough buy-side due diligence program, and it should be integral in certain circumstances in considerations as to: (1) the decision whether to walk away from a deal, (2) the price of the deal, or (2) the future management of the value of an investment.