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Due Diligence During COVID-19: Key Risks Buyers Must Assess Before Signing M&As

posted 1 year ago

Prasenjit Chakravarti and Nitish Goel

Assessing the impact on a target company due to COVID-19, the lung disease caused by the new coronavirus, is one of the critical focus areas of any due diligence as part of a merger and acquisition (M&A) transaction. Even for ongoing transactions, buyers are now looking more closely and re-assessing potentially impacted areas such as the target company’s supply chain, contractual risks and information technology systems.

In this environment, a detailed review of the troubleshooting measures adopted by target companies are important to assess their plan of tackling the current crisis. The sellers should also appreciate the buyers’ sensitivity and should proactively gather information regarding any impact due to COVID-19 and the measures taken to counteract the same. This will go a long way in giving comfort to any potential buyer. 

Procedural issues

There are several procedural hurdles which the parties need to overcome to conduct a smooth due diligence. Almost all countries have closed their borders and domestic travel is also restricted. This makes physical meetings, site visits and inventory checks a remote possibility.

Also, bulk of the documents including statutory registers and returns, title deeds related to immovable property are usually maintained in physical form. Data may not have been digitised, which can lead to gaps in the information made available to a buyer. Further, specialised due diligence exercises such as verification of title to lands and environmental due diligence may have to be deferred.

Due diligence issues

Apart from the usual focus areas in due diligence, certain additional issues should be closely probed while performing due diligence on a target company in the current scenario. Buyers could also keep in mind these tips to evaluate and mitigate these risks. 

1. Corporate governance: Buyers should evaluate the policies implemented by the shareholders and directors of a target company to tackle business disruption. This will be important to gauge the target company’s preparedness when faced with adversity.

Tip: Review the COVID-19 contingency plans and business continuity plan adopted by the target company to revive business once the effects of the pandemic start waning.

2. Expired licenses and registrations: Some of the key business and operational licenses of a target company which require annual renewal and compliances may have expired.

Tip: In certain cases, the regulatory authorities have given additional time to comply with statutory requirements. The target company’s eligibility to avail such reliefs and extensions should be reviewed.

3. Access to capital / solvency: Short-term and long-term financing arrangements of a target company should be carefully analysed to check for access to sufficient capital to continue business operations at the pre-COVID level. The target company’s ability to service existing loans despite business interruption should also be reviewed to ensure that it is insulated from any insolvency risk. 

Tip: Cash burn rate analysis should be undertaken, and alternative ways of increasing working capital should be explored such as deferring short-term liabilities and advancing collections.

Some press reports suggest that the Indian government may temporarily suspend initiation of fresh insolvency proceedings under the Insolvency and Bankruptcy Code 2016. However, there is no relief as yet and the target company should be required to maintain adequate cash reserves to ensure timely servicing of existing loans.

4. Contracts: Terms of material agreements entered into by a target company have to be reviewed to assess if the COVID-19 crisis has caused or is likely to cause any material breach in the commercial agreements. The target company’s right to suspend performance and exposure to liabilities due to suspension or failure to perform should also be analysed. 

Tip: The target company should be required to modify existing arrangements to the extent feasible and modify the templates of material agreements to protect its interest in force majeure events.

5. Supply chain management: Excess dependence on a limited set of vendors can severely impact a target company in the current situation. Also, geographical diversity and ability of a company to find substitutes at a short notice should be determined. 

Tip: The target company should be required to mitigate supply-chain disruption by proactively vetting and getting on board alternative suppliers from markets which are comparatively less affected. The additional costs that may be incurred for setting up alternative supply chains should be borne by the target company as it will provide long-term incentives.

6. Workforce management: The target company’s compliance with government directives regarding payment of wages, avoiding layoffs or termination needs to be reviewed. It is also pertinent to assess any threatened complaints or litigation from the workforce if a company has unilaterally downgraded the service conditions. If a company is running its operations, then compliance with safety measures and protocols that need to be implemented must be examined. 

Tip: Some government directives have a force of law while others are recommendatory in nature. Practically, it may not be possible to monitor compliance with all government policies. However, broad compliance checks can be undertaken by planning an unscheduled visit to factories and offices.

7. IT systems: Remote working and work-from-home have become the norm and a strong IT infrastructure is a prerequisite to implement the same. A target company’s ability to ensure stability in operations and least disruption should be evaluated.

Tip: The target company should conduct employee awareness sessions and training programmes to ensure that employees are well-equipped and well-trained to deliver results in a timely manner.

8. Confidentiality of data or data privacy: In sectors where voluminous data are stored and / or processed, ensuring data privacy is a challenge. The exposure is higher in case of storing and / or processing of sensitive personal data or information. Also, since employees are remotely working and invariably accessing data from their personal laptops, confidentiality of data may be compromised. The target company’s cybersecurity practices and preparedness to deal with breaches should be critically evaluated. 

Tip: The target company should be required to implement robust security protocols including virtual private network, restricted and monitored access to prevent data leaks and any incidents of data breach.

9. Adequate provisioning: Accounting experts should assess whether the financial statements of a Target company present a true and fair view of the state of affairs of the company by making adequate provisions to factor in the impact of increased bad debts, delay in collection of receivables and loss of business.

Tip: Since some industries (such as aviation) have been impacted more than others (for example, information technology), provisioning should consider such industry-specific impact. Excess provisioning may depress the profits in the short term and may affect the morale of the stakeholders involved.

10. Insurance: Insurance policies of a target company should be analysed to ascertain the possibility of mitigating any losses through existing insurance policies, such as coverage for business interruption and losses due to force majeure events. Also, it is important to assess if the company’s workforce is covered by a comprehensive group health insurance policy that covers healthcare costs. 

Tip: In case the target company does not have any alternative means to mitigate business losses, the purchase price should be adjusted to factor in such losses. The feasibility of procuring adequate insurance policies to cover business risks resulting from force majeure events should be assessed and appropriate policies should be obtained.

Conclusion

The buyers and sellers should be prepared for a broad-based scope of due diligence. This will result in an expanded timeline for completion of due diligence.

The buyers should involve sector-specific experts for conducting specialised due diligence on a target. The transaction documents should address all concerns related to COVID-19 including specific representations and warranties and indemnities from the sellers. The buyers should consider procuring a robust ‘representation and warranty indemnity insurance’ which can cover potential loss to the buyer. 

The sellers should insist on appropriate knowledge and materiality qualifiers, resist any forward-looking representations and warranties, and carve out breaches or inaccuracies known to the buyers before closing, from their indemnity obligations. The sellers should also consider making extensive disclosures to the buyers to adequately protect themselves.

posted 5 hours ago

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