Corporate (M&A)

Exercise 1

Due Diligence (1)
(Answer & Tips)

Key Point Checklist

1. Auditor Change

☐ Identified that the Target switched from a reputable international auditor to a smaller, local firm.
☐ Questioned the timing and reasoning behind the auditor change.
☐ Considered whether the new auditor has sufficient expertise and independence.
☐ Evaluated whether the change could signal disputes over accounting treatments or attempts to avoid scrutiny.
☐ Assessed how this impacts the reliability of the financial statements.

2. Corporate Guarantee

☐ Noted the existence of a corporate guarantee issued to a related party.
☐ Questioned the nature and purpose of the guarantee (e.g., why the Target is assuming this risk).
☐ Investigated the financial health and creditworthiness of the related party.
☐ Considered whether the guarantee presents a material liability for the Target.
☐ Assessed potential post-acquisition financial exposure for the Buyer and whether this has been factored into the valuation.

3. Intragroup Transactions

☐ Identified that key assets were transferred to other entities within the parent group.
☐ Requested supporting documentation to understand the nature and purpose of these transactions.
☐ Questioned whether the transactions were conducted at arm’s length and fairly valued.
☐ Considered the impact of these transfers on the Target’s valuation (e.g., loss of revenue-generating assets).
☐ Investigated compliance with applicable laws and regulations, including related-party transaction disclosure requirements.

4. General Considerations

☐ Verified whether all liabilities and obligations (e.g., contingent liabilities, guarantees) have been disclosed.
☐ Assessed whether the materials provided (e.g., financial statements, transaction schedules) are complete and accurate.
☐ Flagged any potential risks that could affect the Buyer’s decision to proceed or necessitate renegotiation of terms.

Model Answer


Issues to be spotted:
Auditor Change

The change in auditors raises significant concerns. Moving from a reputable international firm to a smaller, local auditor may indicate:

  • Disagreements over accounting treatments or reporting standards, which could suggest irregularities in the financial statements.

  • Attempts to avoid scrutiny of certain financial or operational matters.

  • Cost-cutting measures, which could signal financial strain.

Given the importance of reliable financial reporting, the Buyer should:

  • Request clarification from the Target regarding the reason for the change.

  • Assess whether the new auditor has the expertise and independence to properly audit the Target's business.

  • Consider commissioning an independent audit of the financial statements to ensure their accuracy.

Corporate Guarantee

The corporate guarantee issued to a related party presents a potential financial risk. Without information on the financial health of the related company, the Target may be exposed to significant liabilities if the related party defaults. This could directly impact the Buyer post-acquisition.

To address this:

  • The Buyer should demand full disclosure of the financial health and obligations of the related company.

  • Conduct creditworthiness checks on the related party to assess the likelihood of default.

  • Include warranties or indemnities in the purchase agreement to cover potential liabilities arising from this guarantee.

Intragroup Transactions

The transfer of key assets to other entities within the parent group is a red flag. These transactions may indicate value leakage, particularly if the assets were not transferred at fair market value. This could artificially inflate the Target's profitability or reduce its asset base, affecting its valuation.

The Buyer should:

  • Request detailed documentation on the nature, purpose, and valuation of these transactions.

  • Ensure that the transactions were conducted at arm’s length and were properly valued.

  • Evaluate how the asset transfers impact the Target's operational capability, revenue generation, and overall valuation.

  • Consider legal and regulatory compliance regarding related-party transactions to avoid post-acquisition issues.

General Considerations

The absence of disclosed contingent liabilities or material risks in the financial statements should be scrutinized further. The Target’s insistence on financial strength without adequate supporting documentation might indicate:

  • Omitted liabilities or risks.

  • Overstated financial health.

To mitigate these risks:

  • The Buyer should conduct a more detailed review of the Target’s financial position, including off-balance-sheet items.

  • Undertake forensic due diligence to uncover any undisclosed risks.

  • Renegotiate the purchase price or include contractual protections (e.g., indemnities, warranties) to address any uncovered liabilities.

Common Mistakes

  • Failing to investigate the reason for an auditor change, especially when switching from a reputable auditor to a smaller firm.

  • Overlooking the significance of corporate guarantees and not assessing the financial health of related parties.

  • Ignoring the implications of intragroup transactions, such as asset transfers, and whether they were conducted at arm’s length.

  • Accepting financial statements at face value without verifying their accuracy or completeness through independent audits.

  • Not considering the impact of undisclosed liabilities or contingent risks on the valuation and post-acquisition financial health.

  • Failing to flag potential regulatory or legal non-compliance in related-party transactions.

  • Neglecting to account for the potential post-acquisition financial exposure resulting from guarantees or undisclosed liabilities.

  • Relying solely on management representations without corroborating evidence during due diligence.

  • Not including sufficient warranties, indemnities, or contractual protections in the acquisition agreement to mitigate risks.

  • Underestimating the importance of forensic due diligence when red flags are identified.

Professional Tips on Due Diligence

  • Sometimes when you identified risks, it doesn’t mean the deal should be called off. Instead, you can address them by adjusting the purchase price, negotiating stronger warranties and indemnities, or implementing post-deal corrective measures.

  • Always prioritize risks based on materiality and their potential impact on the client’s strategic objectives. Not every issue is a dealbreaker, and it’s essential to focus on the big picture.

  • Intellectual property ownership is critical. If there are issues, such as missing assignments from contractors, these must be resolved before closing the deal to avoid long-term consequences.

  • In cross-border transactions, regulatory compliance (e.g., data privacy, anti-corruption laws) is often underestimated. Ensure the Target is compliant in all jurisdictions to avoid penalties or reputational harm.

  • Use the acquisition agreement to allocate risks effectively by negotiating robust warranties, indemnities, or escrow arrangements for unresolved issues.

  • Reputational risks, such as unresolved customer complaints, product defects, or data breaches, can have a disproportionate impact post-acquisition. Assess carefully how these might affect the Buyer’s brand and relationships.

  • Due diligence is a team effort. Collaborate with specialists such as IP lawyers, IT consultants, and accountants to uncover risks from multiple perspectives.

  • Identifying risks is only the first step. Develop a post-acquisition integration plan to address issues such as IT compliance, data protection, and customer service improvements.

  • Be flexible in your approach. Every deal is unique, and it’s important to adjust your strategy based on the facts and the client’s risk tolerance.

  • Communicate clearly with the client. Sometimes the client is willing to take some risks and continue with the deal - ultimately it is a commercial decision to be made. Avoid unnecessary legal jargon and provide practical, actionable advice that aligns with their business goals.