Mergers & Acquisitions and the Importance of Due Diligence

Companies contemplating Mergers and Acquisitions (M&A) understand the need to avoid acquiring potential legal and financial liabilities. While there may be significant financial and strategic benefits in an acquisition it also brings risks that need to be identified and analysed. Due diligence is used to identify deal breakers, set negotiation parameters and assess risks. Undisclosed risks and hidden liabilities are buried in most acquisitions and may be difficult to detect if a comprehensive due diligence has not been carried out.

According to Thomson Reuters data, M&A activity in Oman and elsewhere in the region is expected to increase this year up from 2014. A prolific increase in M&A activity is expected in the real estate, energy, power, mining and healthcare sectors of the economy. In 2014 outbound M&A activity in the GCC increased 67 per cent and the total value of inbound M&A activity increased by 53 per cent over 2013. Key factors that will continue to create M&A activity include: (i) a host of economic and legislative reforms by GCC countries, notably liberalisation of foreign investment; (ii) the active presence of sovereign wealth funds and pension funds; (iii) an abundance of liquidity; and (iv) a decline in the cost of financing which is the result of intense competition by regional banks and other financial institutions.

Why is Due Diligence Important?

M&A’s are considered failures for a variety of reasons including: (i) ineffective due diligence findings; (ii) the seller ‘puffing up’ the target; (iii) acquirers being overly enthusiastic or feeling pressured into closing a deal; (iv) inability of companies to integrate; and (v) changes in the market. Acquirers also base deals on unrealistic growth targets and persist with acquisitions notwithstanding negative or incomplete information.

Due diligence is a critical component of any successful investment strategy. Top executives however, have repeatedly raised their concerns on the inherent limitations on performing meaningful due diligence on a target company in Oman and elsewhere in the region. These concerns are based on the following:

1. A general lack of accurate data about a target company;
2. A uniform paucity of valid public information about a target and publicly available information not being substantive;
3. Unwillingness or inability of the target or seller to provide undisclosed information to the acquirer due to confidentiality contracts with third parties, thus making the due diligence exercise long drawn, expensive and to an extent futile;
4. Lack of published legislation or regulations in the business sector and a lack of depth in existing regulations which creates a degree of uncertainty in how they will be applied and consequently leading to an uncertain risk factor;
5. Lack of corporate governance imposed on the all forms of companies through the legislation, consequently leading to disorganized record maintenance within companies;
6. Complex ownership structures of target companies;
7. Difficulty in assessing anti-bribery or corruption exposure of the business;
8. Lack of interpretive regulations in the business sector;
9. Difficulty in performing due diligence because of time constraints in the deal process;
10. Restrictions imposed by the sellers and the target making it cumbersome to undertake the due diligence exercise by the acquirer; and
11. Due diligence costs are borne by acquirers and given the competitive market for performing due diligence work, acquirers put pressure on providers to lower their fees. In order to do so time spent on the project will be reduced potentially reducing the effectiveness of the due diligence exercise.

How to carry out effective Due Diligence?

Some of these problems can be avoided with effective pre-acquisition due diligence. The difficulties in a due diligence may be substantially overcome, though not completely, through:

1. Entering into a non-disclosure agreement between the target and the acquirer and to include employees and service providers;
2. Documents and information provided to the service providers of the acquirer to be returned upon completion of the due diligence exercise, thus making the target more comfortable while disclosing information and documents;
3. Signing an MOU between the seller and the acquirer to express commitment on the part of the acquirer;
4. Target and the seller providing accurate and up-to-date information and not concealing information relating to all the company’s records such as, the financial statements, internal controls, management accounts, budgets and forecasts, contracts with employees, suppliers, customers and others, insurance policies, etc.;
5. Target appointing a single point of contact for all information to be provided to the acquirer, especially if there is more than one acquirer;
6. Ensuring that uniform information is made available to all acquirers during the due diligence process; and
7. Obtaining representation and warranties from the seller for any false or undisclosed information.

Adopting some or all of the above options will improve the quality of due diligence for the acquirer, the seller and the target.

Conclusion

As companies enter into M&A transactions, they should carry out due diligence of their target company in order to: (1) confirm that the business is what it appears to be; (2) identify potential defects in the target company; and (3) collate information that is useful for valuing the target’s assets. Whilst there is no guarantee that an effective due diligence programme will result in a successful business transaction, by following the points above, a company may help to eliminate potential risk.