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Significance of Due Diligence: Pre Investment Stage

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Significance of Due Diligence: Pre Investment Stage

Due Diligence is a form of research or investigation conducted by an investor to ensure that the reasonable verifications and precautions are taken to identify or prevent foreseeable risks before they invest their money in the concerned Company or business. Due Diligence is basically a background check on the current status of the Company, the risks associated with it, and also a critical study on the consequences of the business. It is essential for the buyer to determine the genuineness and the legitimacy of the Company and the ownership of its assets and also the existing and potential liabilities he would be involving himself into by investing in the concerned business. However, Due Diligence is a two way street, meaning both the parties of the contract (i.e., the buyer and the seller) perform it. It allows the buyer to feel more comfortable that his or her expectations regarding the transaction are correct. In Mergers & Acquisitions (M&A) purchasing a business without performing due diligence increases the risk to the purchaser. From the seller’s perspective it allows him to maximize the probability of a successful outcome by preparing for the due diligence process.

Significance of Due Diligence in the Pre-Investment Stage
Due diligence is a very crucial step before stepping into a contractual transaction with another Company or business. For example, in case of a merger, one would want to know before merging if the Company they are merging with is the right one, what are the benefits they will gain by merging with the Company in question, if the Company is a potential Company, and what are the risks involved in merging with the Company and how to minimize them, etc.

Due Diligence plays a very important role in the pre-investment stage. Usually companies do not invest in businesses they have less knowledge of. When they are investing into a business, their decision should be taken carefully by critically analyzing all the factors required to understand if the business they are investing in is the right one or not. For this they will require some crucial information of the business. This information is gained through Due Diligence. The main purpose of due diligence is to confirm the investor’s initial understanding of the investment opportunity. It is to make sure that the investor correctly calculated the value of the opportunity and identified the risks and uncertainties which were initially not captured in its initial assessment.

The process of due diligence helps the investor to come to a different or a more better understanding of the business and he may decide to renegotiate if he finds something not going his way or even decline the investment opportunity. The procedure of due diligence is not uniform for all investments. It should be designed to address the specific circumstances which differ from business to business in terms of their type, nature, etc. In the course of due diligence first, a checklist has to be prepared. The checklist consists of all the parameters of the business that are to be investigated before investing in it. A typical checklist should consist of commercial, legal, and financial diligence which are the three main types of due diligence.

  1. Commercial or Business Diligence: It involves looking into the prospects of the business concerned and also the quality of investment. It also looks into the parties that are involved in the transaction.
  2. Legal Diligence: It mainly focuses on the legal aspects of a transaction, legal pitfalls and other law related issues. Along with the existing documentation, various other regulatory checklists are also a part of this diligence. Legal diligence also includes the Copy of Memorandum and Articles of Association, Minutes of Board Meetings for the last three years, Minutes of all meetings or actions of shareholders for the last three years, Licensing or Franchise Agreements, Third Party Service Agreements, Non-Disclosure Agreements (NDA) etc.
  3. Financial Diligence: It validates all the Financial, operational and commercial assumptions. This provides a huge relief to the acquiring Company. It provides a thorough understanding of the financials of the Company, including unaudited and audited financial statements and the Company’s projections and capital expenditure plan, debtors and creditors, etc. These are the main parameters but depending on the situation the due diligence may need to address even narrow and specific parameters like technical, environmental and regulatory. The parameters vary from business to business.

Foreign Companies which are interested in doing business in India should conduct a due diligence test on the concerned Company or business to identify if there are any risks concerned with it. Indian Companies have a responsibility to comply with different regulations and legal compliances. Due Diligence is required to make sure that the Company is following all the rules and laws and it has been providing accurate information about its status to the foreign Company. Through this process the foreign Company can access all the information regarding the finance, reputation, and liabilities of the business. It also gets to know about the risks associated with it and also the potential opportunities that the business has.

There are many cases where a foreign Company wanted to merge with an Indian Company and in the process of doing so, lost a lot of money because of the failure in performing due diligence.

Example & Illustration:
One such example is that of a deal between Dai-Ichi Sankyo, a Global pharmaceutical Company with its origin in Japan and Ranbaxy Laboratories, an Indian pharmaceutical Company. In November 2008, Dai-Ichi Sankyo entered into the Indian pharmaceutical industry by buying a majority stake in Ranbaxy laboratories for Rs. 22000 crore (50.1% of Ranbaxy). In 2009 the FDA started conducting investigations into Ranbaxy and also made it shut down its drug applications from two of its plants Paonta Sahib and Dewas suspecting practice violations at these plants. They also banned imports from these two branches. The investigation by FDA started in 2006 itself and according to the FDA report it was seen that the scientists took shortcuts while performing quality control on the stability tests and it was also seen that Ranbaxy kept many improperly stored samples of drugs in its factories in Paonta Sahib and Dewas and it had also submitted manipulative data in its application to market drugs to US. In the year after the acquisition Ranbaxy had a loss of INR 9,512.05 million. Daiichi also incurred a loss of Â¥215,499 million. The main reasons behind these losses were the poor performance of Ranbaxy because of the FDA ban. The reason for Daiichi’s failure in this investment is that it did not perform proper due diligence before investing. Daiichi should have estimated the legal risk arising out of the FDA letters and its investigation. They should have asked for the inspection reports of the 2006 FDA investigations.

Another case is that of the Summit Partner, a US based private equity investment firm who decided to invest in Krishidhan seeds, an agricultural biotech firm. In 2010 the PE firm invested $30 million in Krishidhan seeds. But some time into the deal, things were not going well when the fund managers and the promoters of Krishidhan seeds started having differences over corporate governance issues. Corporate governance issues are a part of what needs to be investigated during the course of due diligence. In 2012 Summit decided to settle the issue and approached a Mumbai-based law firm to do so and demanded that the promoter should buy back Summit’s stake. After this, Summit had exited krishidhan seeds. Owing to such an experience and also the inability to seal any new deals in India since 2010, Summit decided to wind up the operations in India.

Thus, due diligence plays a key role before the investments are actually made and helps the investor in securing his investments.
Authored By: Adv. Anant Sharma & Sanjana Akasam

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