DUE DILLIGENCE

ROLE OF DUE DILIGENCE IN THE M&A CYCLE

EFFECTIVE DUE DILIGENCE – BUY SIDE
OR SELL SIDE
During an M&A/investment transaction, it is necessary for the parties
to assess the appropriateness of each other. Given this scenario, the
due diligence can be commissioned by:
DUE DILIGENCE SERVICES – AN
INTEGRATED APPROACH
Financial and tax due diligence
Understand your business using industry experts on every engagement
Assess the valuation adjustments like EBITDA analysis and net debt
Identify representations and warranties for inclusion in the SPA
Analyze revenue and cost trends
Analyze margins and the impact of seasonality fluctuations on margins
Financial due diligence is a process to understand the financial position of an entity by the potential investor/acquirer
before its acquisition or investment in the entity.

The key focus areas of a financial due diligence are:

Quality of earnings, gross margin, and cash flows: If normalized earnings are significantly different than the reported
earnings, then the investor/ acquirer would like to optimize the valuation. Hence, this area has the maximum impact on
valuation.

Quality of fixed assets and working capital: The deal cost for the investor/acquirer would change significantly if there is a
requirement of substantial amount of investment in capital expenditure and infusion of funds to manage working capital.
This is likely to impact at the post transaction stage after paying the consideration to shareholders. This is critical in
manufacturing companies.

Net debt: Most transactions tend to be on a debt-free and cash-free basis. There is adjustment for debt and cash in the
books from the enterprise value of the entity, to derive the consideration payable to equity shareholders. Debt is reduced
and surplus cash is added.

Potential liabilities and commitments: Review of contracts and other activities of the company result in identifying off-
balance sheet commitments, liabilities, and onerous contracts that are not disclosed in the financial statements.
Investor/acquirer would need to negotiate a valuation adjustment for the potential liability, seek protection through
indemnification, or make compliance with these commitments that form a part of condition precedent to the closing of the
transaction.
Commercial due diligence
Market assessment and entry strategy
Analyze business strategy, profitability, channels of distribution, and
regulatory compliances
Competition analysis
Commercial Due Diligence (CDD) is usually carried out in the M&A deal cycle after shortlisting
of potential acquisition targets and is initiated at the strategic evaluation phase along with
financial due diligence and valuation of the target.
CDD aims to analyze the attractiveness and sustainability of the target’s business model with
reference to its external environment, which includes market, competition, margins, trends, and
forecasts.
CDD is important in the decision making process if an investment decision involves any of the
following:
Entry into new market
Launch new product/technology
Market or competitive uncertainty in areas such as new technologies, customers, trends, legislation,
and powerful buyers
Revenue/Earnings Before Interest and Tax (EBIT) projections appear to be very aggressive (relative
to historical performance)
Significant proportion of projected revenue/EBIT appear to be based upon the success of new
products, customers and/or markets
Environmental due diligence
The objective of an environmental due diligence is to provide an
understanding through a high level assessment of the existing and
potential environmental risks. The key focus areas of an environmental
due diligence include:
Phase I - Review all documentation including legal documents and
conduct on-site assessment to ascertain existing and potential liabilities
Phase II – Act as the facilitator in characterizing the nature and extent
of potential contamination
Share Purchase Agreement (SPA) advisory
Advising you on accounting aspects of SPA
Closing assistance

The SPA team coordinates internally with the financial due diligence
team and externally with the legal advisors and the client team.
Financial due diligence team
Identify pricing issues
Comment on cash and debt definitions
Determine a normal level of working capital
Determine judgmental areas where specific accounting policies may be required for preparing
completion accounts
Client team
Highlight key pricing criteria in the offer letter
Recommend appropriate accounting hierarchy/policies or leakage protections
Provide support in SPA negotiations based on due diligence findings
Assess normal working capital requirement of the target
Legal advisors
Assess the pricing mechanism set out in the SPA
Agree appropriate accounting warranties and indemnities
Consider the process for agreeing the completion accounts
Review leakage protection clauses
Regulatory and Background/FCPA due diligence
Review the relevant documents to assess compliance with various
enactments/regulations
Quantify, to the extent possible, the probable exposure on account of
non-compliances
Perform pre-deal investigative work on the background of the other
side
Background diligence
Companies can avoid serious legal complications and obtain information regarding the background of all
parties involved, along with the risks they present through effective pre-investment due diligence, vendor
due diligence, and background investigations.
Our investigators also help you by providing information on parties suspected of wrong doings. They also
search for conflict of interest and undisclosed business affiliations. Information is also procured on issues such
as any prior financial, legal, regulatory or criminal problems or links to organized crime, any political links
as well as any adverse business reputational issues.
Our services include conducting background information investigations, pre-investment due diligence, vendor
due diligence, litigation intelligence, and fraud investigation support.

Foreign corrupt practices consulting

Our anti-corruption investigative and consulting specialists have the experience to identify a range of
questionable activities when approaching potential business partners in foreign markets. These include
identifying unusual payment patterns or financial arrangements, abnormally high commissions and
management fee, lack of transparency in expenses and accounting records and refusal to provide
audit/inspection rights or anti-corruption, and FCPA certification.
In addition to providing legislatively compliant investigation support on a global scale, we also help design,
implement, and monitor anti-corruption policies, procedures, and internal controls.
HR due diligence
Determine how the target disseminates information, internally and
externally
Analyze compatibility between the two sides of the transaction
Understand reward programs and benefits offered to employees and
the synergy with investor company
Human resources (HR) due diligence in an M&A process identifies the synergies between the workforce of the investor
and the target in terms of the composition of the workforce and the benefits provided to them.

The key focus areas of a HR due diligence are:

Review the HR strategies and identify gaps in the alignment with the overall corporate strategy post transaction

Assess risks and abilities of the leadership and the cultural framework

Identify compensation, benefit, and insurance risks and liabilities

Estimate one-time costs and optimal steady state HR design and cost structure

Define clear goals and exit criteria for the incumbent staff post transaction

Plan transition of key talent and workforce

Plan for “Day One” readiness

Integrate HR functions, programs, and policies including cultural integration

Integrate target’s insurance program into the Investor’s master insurance program

Ensure the operational readiness of the HR team to manage the combined operations of the company post transaction

Set protocols and procedures to ensure clear and consistent employee communications
Regulatory due diligence covers the following key legislations, regulations,
and commercial obligations:
Company law
Review charter documents, organization and management, promoters and group
companies/ventures promoted, capital structure, annual reports, statutory
registers/filings, government/statutory and other business approvals, licenses,
ratings, indebtedness, material contracts, litigations, disputes, etc.

Foreign Exchange Management Act (FEMA) and Foreign Direct Investment

(FDI) policy
Review the level of compliances of inbound and outbound investments, trade-
related transactions comprising export and import of products/services, and other
remittances. It also includes repatriations from or into India and notices from
Reserve Bank of India, Foreign Investment Promotion Board, Enforcement
Directorate, etc.
SEBI laws

Review the level of compliances of listing agreement, SEBI takeover code, insider trading regulation, investor grievances, and
effectiveness of redressed mechanism and litigations/show cause notices from stock exchanges/Securities and Exchanges Board
of India/Securities Appellate Tribunal, etc.

Employment and industrial laws

Review the level of compliances relating to provident fund, employees state insurance, bonus, gratuity, other employee benefits,
Labor Welfare Act, Factories Act, Shop & Establishment Act, Contract Labor Act, Minimum Wages Act, Trade Union Act, etc.

Intellectual Property Right (IPR) laws

Review the level of compliances of Trade Marks Act, Copyright Act, Patent Act, Design Act, litigation and pending disputes
related to passing-off and infringement, etc.

Environmental, health, and safety

Review the level of compliances of Air Pollution Act; Water Pollution Act; Environmental Protection Act, handling of hazardous
substances and public liability insurance.
IT due diligence
Understand existing IT/ERP systems and assess their capability to meet
IT requirements of the business
Assess IT infrastructure in terms of future investments that may be
required
Assess IT function in terms of overall structure, team capabilities, and
approach to IT governance
IT due diligence
IT due diligence provides an understanding and high level assessment of the current IT infrastructure and
systems at the target organization for future integration; it also assists the acquirer to evaluate the potential
capital and operating expenditure in the business plan. The key focus areas of IT due diligence include:
Understanding the major business systems and IT platform providing support and automation to the core
operating processes
Understanding whether the systems, ERP, and their respective hardware platforms have the stability and
scalability to support the management’s current and future business plans
Assessing the adequacy of these systems in-use to capture and report on key operational and financial
parameters, and the broad assessment of reliance that could be placed on these systems
Analyzing significant capital intensive (current and planned) Information technology projects. Understand the
IT infrastructure components and carry out a high level assessment to identify gaps and steps being taken
by the management to resolve any deficiencies
Evaluating key IT operating policies and procedures including security, (physical and logical), vendor
management and business continuity planning in terms of the IT systems being able to sustain and support
business over the next few years
Assessing the IT function in terms of the overall structure of the IT organization, IT leadership, position of IT
in the overall organization structure, capabilities of the IT team to implement the proposed/in progress IT
projects and the overall approach to IT governance
 Tax due diligence addresses the typical tax-related challenges faced in the M&A domain.
These include taxation of indirect transfer of assets, General Anti Avoidance Regulations
(effective 01 April 2015), restricted debt push-down options and interest deductions, and
existence of high tax compliance. The tax laws are highly complex and the environment
substantially litigative.

The key focus areas of tax due diligence are:

Understand the target (includes aspects like examining the target's legal structure, its cash flow
mechanism, and its business and operational strategy)

Assess the current tax position (includes aspects like status of the most recent income tax return
filed, possible disallowances, and consequences of past tax audits)

Assess the historical tax exposures (includes aspects like status of pending tax litigations, tax
positions adopted in the past, which are considered aggressive and their possible consequences like
disallowances and interest and/or penal exposures)

TAX DUE DILIGENCE

Assess the tax impact arising from “change in control” of the target (like eligibility to carry forward
past tax losses/unabsorbed depreciation, availability and/or continuity of tax holidays/ concessions,
etc.)

Ascertain the status of the tax benefits and adherence by the target to the conditions specified for
such benefits
CASE STUDY 1 – PROJECT TULIP

Background
This project involved due diligence services to an overseas client
engaged in the manufacture and sale of building related
infrastructure.
The client was considering strategic expansion in the Indian market by
way of acquiring a majority stake in a target company in India which
was into similar line of business which complemented its existing
business in India.
The target specialized in design, fabrication, and installation of
building related infrastructure; it had undertaken projects across India.
Deloitte chosen to address the client's business challenge

Our capabilities to support the client’s multiple requirements for financial diligence, tax diligence,
commercial diligence, environmental diligence, HR diligence, and integrity assessment along with the
“As One” approach to the assignment – in which a lead engagement partner and lead engagement
director were responsible for project execution with clear communication protocols – resulted in
Deloitte India being appointed for the complete gamut of services.

Client’s key focus areas as part of the diligence, which were addressed by Deloitte India included:

- Financial: Review of the financial position of the company, business pipeline opportunity,
order book revenue recognition and profitability of various projects, project management and
control.

- Commercial: Manage commercial aspects including status of key projects, deviations from
contracts and procurement issues.

- Taxation: Manage exposures arising from assessment of the direct and indirect tax positions
of the target and regulatory compliances.
Solution
The timelines of execution of the above services were decided based on mutual
consultations with the client, keeping in view time-constraints around the
negotiations of the transaction, nature of services and geographical spread of
operations of the target. The project was carried out in a phased manner, which
helped the target to facilitate the data flow to ensure complete knowledge
transfer to the client.
The client was updated on key observations and issues on regular basis through
conference calls. The final deliverable reports comprised Deloitte India’s thoughts
on key issues, detailed information on the various processes followed by the target
and the adjustments, which could be considered by the client in their valuation of
the target’s business.
Our ability to analyze various issues from different standpoints, including financial,
accounting, tax and commercial perspectives, arising from the cross-functional
team deployed on the project, provided valuable insights to the client in its
evaluation of the proposed transaction.
CASE STUDY 2 – PROJECT ORANGE

Background
Deloitte India and other offices collaborated to support a client with
M&A services including financial and tax due diligence, tax
structuring, financial modeling and regulatory valuation services in
connection with their planned acquisition of a controlling equity
interest in a large consumer business group in India.
The transaction was important for the client as it formed the core of its
strategy to have a range of products in the regular and premium end
of the market in India along with pan India manufacturing facilities,
which is an important aspect given our existing tax structures and
regulations around manufacture and sale in India.
Deloitte chosen to address the client's business challenge
The client was in discussions with the promoters of the target for the past
few years, but could not embark on a transaction given the divergence in
expectations between the parties. After the two principals arrived at a
mutually acceptable proposition and paved the way for extensive due
diligence and fine tuning of the negotiations with an intention to culminate
the transaction, Deloitte was engaged to complete the diligence exercise
over a period of nine weeks. Deloitte then continued to support the client
through the signing of the definitive agreements and, thereafter, as the
client pursued through the regulatory clearances to finally acquire
controlling equity interest in the target.
While Deloitte was in conversation with the client for a number of services,
on this particular transaction, knowledge of the industry and a deep
understanding of the target, given our past association with them, was a
key attribute for the client to commission the work to Deloitte.
Solution

Deloitte India leveraged on its experience and knowledge of the industry, and the relationship with the target’s key
management team to present an extensive analysis and understanding of the drivers of revenue, costs and profitability to the
client’s deal team. This was instrumental in their decision making and financial modeling exercise.

The work involved understanding the operating performance of the business by product category by individual brand and by
respective states in India where the target had its operations.

Deloitte provided the client team with detailed inputs on volume and prices of the individual brands by individual states that
should be factored in the operating business model.

Deloitte was also able to provide detailed insights on the following:

- Outsourced manufacturing, raw material and packaging material sourcing base of the target, including the financial support
that was provided to its vendor base.

- Brand promotion arrangements that the target had tied up with broadcasting companies, sports asset owners, and sports/film
personalities along with insights on committed forward spends for the next few years.

- Distribution arrangements in the individual states along with risks and cost.

- Extent of tax litigation that the company was exposed to and the strength of the company's arguments for litigating each of
the individual issues.