A Primer on Buyer Due Diligence in a Merger & Acquisition (M&A) Transaction

I’ve been thinking…Just what is the meaning of buyer due diligence in an M&A transaction?

Buyer due diligence in an M&A transaction is the investigation process performed by the buyer and its advisors to reasonably understand, among other things, the accounting, financial, business and legal aspects of the seller, or target, in order for the buyer to have a reasonable basis to believe in the accuracy and completeness of material information relied on in negotiating and approving the terms and conditions of the merger agreement.  In the case of a public company, the buyer should also have a reasonable basis to believe in the accuracy and completeness of material information relied on in preparing and distributing required disclosures to the buyer’s shareholders in the so-called proxy statement in order for the buyer to solicit shareholder approval of and close the merger.

Broadly speaking, buyer due diligence is the evolving and iterative investigation process used to ensure that the buyer is aware of potentially material information regarding the target.  M&A due diligence, which continues through the close of the transaction, is typically performed by the buyer’s key executives and selected legal and financial advisors.  While the buyer may reasonably rely on the work of qualified advisors, the ultimate responsibility to conduct a reasonable due diligence investigation remains with the executives and Board of Directors of the buyer.  The notion of bring-down due diligence is extremely important, because facts and circumstances often require that results of earlier due diligence investigations must be reasonably re-examined on a timely basis to assure that earlier information obtained in due diligence has not materially changed before the closing of the M&A transaction.

Different skill sets are required to perform particular M&A due diligence procedures (e.g., construction of financial models versus evaluation of accounting internal control systems), and different compensation/fee arrangements are common (e.g., legal fees, which are based on hourly rates, versus investment banking fees, which are based on so-called success fees and linked to the total consideration in the M&A transaction).  Moreover, the services of attorneys, investment bankers, accountants and/or other professional advisors are often used in M&A transactions to provide expertise (e.g., accounting/auditing firms providing support to the buyer in the information gathering process called accounting and tax due diligence) and also to provide advice/opinions on which the buyer may reasonably rely (e.g., a fairness opinion from an investment banker, a tax opinion from accounting/auditing firms or tax counsel).

Financial advisors to M&A buyers typically provide advice on the following matters: analyzing the businesses and operations as well as the financial performance and position of both the target and the buyer, including analysis of expected synergies; advising on strategy, structure and financing alternatives; assisting on negotiation of terms and conditions, including price; assisting with communications to shareholders and the market, including preparation of proxy materials; and meeting with and advising the Board as required, including delivering a fairness opinion, if requested.

Buyers often engage the services of accounting/auditing firms to conduct accounting due diligence and to prepare written reports of their findings, including, for instance, a report of the target’s quality of earnings and an assessment of the target’s compliance with GAAP and SEC regulations.  There are instances where accounting/auditing firms (versus investment banking firms) have been engaged by buyers to conduct what is described herein as financial due diligence in an M&A transaction (e.g., stress-testing of financial models).

In M&A transactions involving public companies, buyers will invariably engage the services of a financial advisor, typically an investment banking firm being paid a success fee.  A due diligence investigation for an M&A transaction involving a public company, where a shareholder vote will be taken, requires in part (i) that the buyer’s due diligence investigation obtain as much accurate and complete information as reasonably needed such that the buyer has a reasonable basis to believe that the risks and rewards of moving forward with the contemplated transaction were reasonably assessed by the buyer and appropriately reflected in the terms and conditions settled on by the parties in the merger agreement, and (ii) that the buyer’s due diligence investigation obtain as much up-to-date accurate and complete information as reasonably needed such that the buyer has a reasonable basis to believe that material information disclosed to the voting shareholders in connection with the M&A transaction is accurate and complete in all material respects.

Specific aspects of due diligence investigations vary depending on the type of transaction being investigated as well as the individual facts of the transaction.  For example, the diligence required to invest in a secured debt instrument of a particular firm is generally more focused on the cash flows, ability to service debt, and collateral.  In contrast, the diligence required to enter into a merger transaction with the same firm is generally more focused on growth and profitability drivers, post-merger integration and staffing as well as detailed diligence on potential liability related to a merger (versus an asset purchase transaction).  In short, the particulars of a due diligence investigation are transaction-specific: what is reasonable in one situation may not be reasonable in another.