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What investors look for in a potential M&A transaction. A synopsis on due diligence

There is no such thing as a “safe investment”. Buying a business is a serious and risky affair, and investors that are considering a merger or acquisition must devote considerable time and energy, work and research before sealing the deal.

The business perspective: key elements

Important players usually rely on key elements to indicate if the potential investment is worth their attention or not:

  • Industry and Concept – when buying a business, investors normally seek to purchase a proven concept in an industry that integrates in their portfolio and, depending on the market request and financial indicators, will continue to evolve.
  • Location and Customer base – location is always important, and usually dictates the potential of the business, which depends also on the particularities of the local regulatory and permitting background. As concerns the customer base, the ideal in any such venture is for a consistent customer base to have been already set-up.
  • Market conditions and Development stage – it is important to investigate why the target company is being sold – because of competition, declining growth opportunities, market constraints? This is part of the market research and preliminary business due diligence that any potential investor should perform at an early stage.
  • Growth potential – it is one thing for the target company to have reached a level that made it attractive for investors, and quite another the available growth opportunities after investing. Any investor generally wants to know that the business has room for development at a sustainable rate.
  • Skeletons in the closet – this is where a team of various professionals (e. attorneys, tax analysists, experts and other consultants) come in to perform the due diligence exercise that generally determines if investors will go through with the bid/ offer/ transaction or not.

The legal perspective: the sine qua non due diligence investigation

Due diligence is a detailed review of a company/ business, generally from a legal, financial and business standpoint (and potentially from other perspectives as well), that determines whether representations (legal, financial and otherwise) made by a seller are accurate and complete, and whether there are weaknesses or undisclosed issues that would affect the value of the business or of the deal.

The due diligence is a must-have for any investor, revealing the key factors – “red flags” – which, depending on the seriousness, make an investor buy or pass.

Depending on the findings of the due diligence investigation, if the investor wants to go through with the deal, the due diligence exercise gives him the basis to negotiate the consideration and indemnification to be included in the transaction documentation, as well as appropriate mechanisms (i.e., warranties, other indemnities) that would protect the investor from being held liable for damages or claims arising after the deal is done.

What it involves

Such an exercise usually starts with a head of terms stating the general terms in which the due diligence will be performed, laying down also confidentiality and potentially exclusivity obligations (if not provided through another confidentiality agreement).

A documents checklist is then sent to the target company, requesting the specific documentation and information for the purpose of the due diligence exercise. Such is generally slightly different depending on the type of contemplated transaction – share deal or asset deal.

Once the framework is established, a data room is set-up, containing the requested documents for the due diligence, which should enable the potential buyer to easily access and conduct the investigation.

Alternatively, the target company starts by making available to potential investors a vendor due diligence report and a data room documentation, to be “double checked” by the investor’s team.

The most commonly used solution is the virtual data room. Apart from being much easier to use in a digital era, it also resolves the issue of not alarming the target company’s employees about the potential sale.

Depending on the type and size of the targeted company, the due diligence may take from a few days to even months and involves a team of professionals that perform the analysis of the required documentation.

Types of due diligence

As preliminary stage of any potential venture, the business due diligence requires the analysis and review of the target company’s strategic and business plans, customer base and range of products, market and competition. It is an assessment of whether the target company is a strategic fit for the investor’s portfolio and whether it would integrate well in its overall business plan.

The financial due diligence is about analysing the financial history of the target company (generally, at least 3 years back) and understanding whether there are any existing or potential financial liabilities. This overview can also show whether the margins for the business are expanding or deteriorating, the extent of the investments needed to grow the business, and also reflect if EBITDA has been properly calculated or if any adjustments are necessary.

The legal due diligence deals with the other aspects of the business, that the investor should know about before committing to the potential transaction. In brief, a due diligence exercise deals with the following main aspects:

  • Corporate History and General Corporate Matters – more relevant in a share deal, this analysis is important for confirming these main aspects: (i) the title over the shares in the target company, (ii) the authority of management, and (iii) the validity of the organizational status of the company.
  • Material Contracts and Top Customers – a critical aspect of the due diligence exercise, it implies reviewing certain agreements that are deemed material to the business, due to their value or the counterparty. Also, it is standard practice to review a limited number of agreements (g., 20) concluded with the top customers of the target company.
  • Related Party Transactions – this includes an analysis of any agreements or arrangements between the target company and any “related party” such as directors, managers, stakeholders, employees, in order to check if they could hinder or impact the contemplated transaction or the activity subsequent to the transaction.
  • Real Estate – an essential part of any due diligence exercise, it implies analysing the title over the property owned, leased or otherwise used by the target company in its activity.
  • Banking and Finance – assessing the details and terms of any guaranties, loans, credit agreements, equipment lease, leasing etc.
  • Regulatory and Permitting – it involves investigating if the target company has obtained all necessary permits, licenses, authorizations, and other regulatory approvals necessary for its activity and obtaining confirmation that they are valid and up-to-date. Also, it involves analysing the steps needed if the transaction goes through in terms of transfer, amendment or reissuance thereof. This is particularly relevant in highly regulated sectors, such as banking, insurance, energy, oil and gas, waste, pharma, IT, etc.
  • Environmental Issues – depending on the industry, the environmental aspects may play an important role, from a liability perspective (depending on historical aspects) and from a permitting point of view (if authorizations/ permits need to be transferred, amended or reissued, etc).
  • Employment Matters – it implies the analysis of various components related to employees, such as review of the standard labour agreements, compensation plans and incentive schemes, internal regulations, management organization and other related aspects.
  • Intellectual Property (IP) and Information Technology (IT) – as any type of business has an IP/ IT component, any investor is interested to know that all software, patents, trademarks and other intellectual property assets are validly owned and/ or used by the target company.
  • Competition and Antitrust – if the target company activates in a regulated industry, competition restrictions generally apply. So, it is important to see whether the agreements observe such restrictions, and how the contemplated transaction would trigger the need for an antitrust or regulatory approval from the local regulatory authority to be obtained.
  • Insurance – in any type of deal, the investor will want to review the key insurance policies related to the target company’s business.
  • Data Privacy – a hot topic these days, given the entry into force of the General Data Protection Regulation (GDPR) in May 2018, this analysis is important to check observance of the legal obligations imposed on companies, and bring to surface any potential issues in this respect.
  • Litigation – consists of an overview of any pending or threatening litigation or arbitration proceedings involving the target company.

The Due Diligence Report

The conclusions of the due diligence investigations are included in a Due Diligence Report. While some investors prefer descriptive reports, that present not only the identified issues, but also an extensive description of the target company and business, the conception has changed in the last years, and the tendency is for investors to be more practical, requiring that the reports be as straightforward and brief as possible, in the form of so-called “Red Flag Reports” or even “Confirmatory Reports” vis-a-vis the Vendor Due Diligence Reports made available in the context of the intended transaction.

Considering the gap between the time the analysis is performed until the actual implementation of the bid/ offer/ transaction, the report is generally regularly updated to always reflect the up-to-date status of the target company.

Final call – deal or no deal

Experience dictates that strategy and information are key elements to successful business decisions.

As the due diligence can uncover a wide variety of weaknesses and potential liabilities regarding the target company, we consider paramount for any investor to collaborate with a professional team of legal, financial, business and – depending on the nature of the target company – technical advisors, properly trained to do just that – dig up any aspects that could adversely impact the transaction and diminish the target company’s value.

Ultimately, it’s the investor’s decision. Based on the Due Diligence Reports however, the decision becomes an informed and well-founded one, as it may determine if the identified issues are insurmountable or may be mitigated or covered through the transaction documentation.

Practically, the due diligence process is designed for the investor and his transactional team to be able to determine these key elements: (i) whether the acquisition should be made, (ii) if so, for what price (especially in a competitive situation with multiple potential buyers pursuing the target company’s business), (iii) how the transaction should be structured, and (iv) finally, what are the post-acquisition legal, financial/ accounting and operational implications.

Business perspectives in Romania

Romania continues offering multiple interesting investment opportunities.

According to available data and estimates, real estate and industrial sector investments are particularly attractive, mostly due to Romania’s strong industrial tradition, low cost of labour (although it has increased compared to previous years, it remains one of the lowest in the region), low taxation (on 1 January 2018, additional tax reductions came into force). Also, Romania has one of the largest markets in Central and Eastern Europe.

According to 2018 Doing Business Report issued by the World Bank, Romania ranked 45th out of 190 economies. Considering the distribution of foreign direct investment by sector, the industrial sector appears to lead, with a focus on the metallurgy industry. Other attractive sectors are construction, wholesale and retail, banking and insurance, energy, and telecommunications.

Recent changes in the legislation aimed at increasing investment projects, such as regulating an improved version of public-private partnerships (PPPs) and bringing new funding for major investments in Romania, make us strongly believe that the 2018-2019 trend in Romania should be on the rise.

The geographic position helps Romania, but also forces it to keep up the investments pace. Also, the obvious needs, e.g. regarding infrastructure development, should be met and foreign investment will be involved in the process.

Sandra Frunzulica, Senior Associate at D’Ornano Partners

Cristina Gavrila, Partner at D’Ornano Partners

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