THIS is the seventh part of our ten-part article series on private equity in Tanzania, wherein we provide clarity on the due diligence exercise conducted by a private equity (PE) investor on the target company following the successful negotiation and execution of a term sheet. Remember, in the sixth part of the series we discussed the meaning, purpose and implications of the term sheet.
When negotiating a PE investment deal, the aim of the company’s shareholders and management is to persuade the PE investor that any investment he makes in the company will yield solid returns. And the investor, looking to acquire an equity stake in the company, will wisely want to know all about the material facts and potential liabilities about the company in order to make the right decision and understand the risk profile of his investment. This evaluation process is called due diligence—an exercise in risk management.
For shareholders and management, it can be taxing to hear that the PE investor is going to perform a due diligence exercise i.e. investigate their company by reviewing documents about every aspect of the company and interviewing people who are knowledgeable about the company.
Simply put, the PE investor’s team comprising lawyers, accountants and other professionals is going to ‘check them out’. Not understanding the components that constitute the due diligence exercise and not preparing for the exercise ahead of time to meet the expectations of the investor could mean the investor walking away and missing out on his investment.
There are different types of due diligence, including financial due diligence, legal due diligence, operational due diligence, commercial due diligence, etc. In the following paragraphs, we will briefly explain the core reasons for the legal due diligence exercise and the key steps involved in the exercise that shareholders and management can’t simply afford to ignore.
Legal due diligence is deemed very important by the PE investor because it helps the investor to: (a) to learn about the target company and structure the investment deal; (b) to determine the value of the company and thus know how much to pay for the equity stake; (c) to access factual information that is useful in drafting and negotiating the final agreements of the deal; and (d) to know how to allocate risk when preparing the company’s representations and warranties. In addition, the accessed factual information is crucial for the investor’s legal counsel when drafting a legal opinion at the close of the deal.
The task of conducting a legal due diligence is typically carried out at behest of the PE investor. Obviously, the investor wants to make sure that there are no undisclosed skeletons in the company’s closet that would deteriorate the value of the investment.
The core steps involved in the legal due diligence exercise include: (a) helping the PE investor to first understand the company in the broadest sense by providing digests about the company and the economic sector/s in which it operates; (b) being ready to provide copies of all key documents of the company and to interview with the investor; (c) as the exercise can take anywhere from 30 days to several months, being available until the end of the exercise when the PE investor is satisfied that he has spotted and analyzed the pertinent issues and obtained insights into the company; and (d) clarifying sensitives around costs and expenses for the legal due diligence exercise, although the findings of the exercise are only pertinent to the investor.
The takeaway point is that it’s up to the company’s shareholders and management to work hard as a team to ensure that the legal due diligence exercise is conducted efficiently and that the investment deal is closed successfully. However, while the exercise is intended to reduce risk for the PE investor, it also reveals the company’s trade secrets and other sensitive information to the investor.
If the deal doesn’t happen, the PE investor will have had access to the trade secrets. This can be neutralized by determining at the outset the level of seriousness of the investor, and then executing a non-disclosure agreement (NDA) that is not overly restrictive.