Legal due diligence is a standard component of the larger due diligence investigation that sponsors conduct on potential targets. But legal due diligence can vary greatly in how efficient it is and in whether it generates real strategic value or is just a rote exercise. Effective and strategic M&A legal due diligence has three objectives:
- to identify problem areas or obstacles for making the deal work or getting the deal done; and
- to obtain information regarding the assets and liabilities of the target so that an informed investment decision can be made;
- to mitigate or address those issues.
This article discusses eight guiding principles for optimizing legal due diligence practices for sponsor acquisitions.
- Build the due diligence strategy around the deal’s rationale and key risk areas.
Legal due diligence should be more than a risk mitigation exercise. Done properly, it can provide significant insight into valuation, identify potential impediments to closing early on, and refine post-close priorities. Achieving these benefits, however, requires that the due diligence strategy be shaped by the deal’s specific business thesis and value drivers, the contexts around the target, its market and its industry, and the sponsor’s plans for the target. There may be a specific plan for the target business (such as renegotiating all of the customer contracts, entering into a new geographic area, or expanding through M&A) or perhaps a particular litigation exposure or regulatory risk, which will be important to the valuation. Deal counsel should avoid approaching legal due diligence with a one-size-fits-all template and take the time at the beginning of the process to identify the value drivers.
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Prepare due diligence work plans.
The legal due diligence strategy can then be translated into a detailed work plan that sets out the key risk areas for the target and the specific documents or categories of documents or issues to be reviewed, as well as the substance of the analysis (such as provisions to be captured or concerns to be addressed).In addition to providing a roadmap for the due diligence process, a work plan helps ensure that due diligence is conducted in a resource-efficient manner, establishing a coordination framework for junior deal counsel who are reviewing the documents, and for senior deal counsel who are determining staffing needs and priorities. Often, a target will provide a large volume of contracts or other information that is not material, and materiality thresholds are important elements of most due diligence work plans. Sampling methodologies can be used to avoid reviewing large numbers of similar ordinary-course contracts. It is often efficient to structure due diligence work in phases, so that areas most likely to result in “red flag” issues with a go/no-go outcome are tackled first, with confirmatory due diligence on other issues to follow after there is greater deal certainty.
- When possible, establish early communication with the target.
When the sales process permits, we are advocates of a kick-off call with target personnel at the beginning of the due diligence investigation, before document review has begun in earnest, to discuss the transaction and core risk areas. An early call sets the foundation for a focused, results-oriented investigation. Understanding the target’s approach to evaluating and managing the risks facing its business and its perception of areas that do and do not require buyer attention provide a strong foundation for structuring an effective due diligence process. It is difficult to obtain this information solely through written Q&A without interaction in real time. A call also provides the opportunity for the sponsor to demonstrate at an early stage that it and its advisors are commercial and pragmatic. This initial call can be followed by conversations with relevant specialists and, if needed, a deeper dive into issues identified in documentary due diligence.
- Create customized due diligence request lists.
The due diligence request list should be closely tailored to the target and the target’s industry. It should reflect deal counsel’s review of the target’s data room (if already open), any marketing materials received from the target, and counsel’s own research and familiarity with similar transactions. The list should be designed to elicit the necessary information to meet the objectives of the legal due diligence process without creating burdensome busywork for the target. It is important that the request list be coordinated across the entire working group (including advisors beyond the legal teams) to avoid duplicative requests.
If timing allows, there can be some benefit to waiting to submit a due diligence request list until after the initial legal due diligence call, since potential lines of inquiry frequently can be addressed and eliminated on the call. As a result, the due diligence request list will be shorter and even more focused.
- Adopt a thoughtful approach to due diligence reporting.
Legal due diligence reports can vary greatly in length and detail (from long-form comprehensive reports to short-form “red flag” issue lists).The format chosen should take into account the expected use of the report among the deal team as well as by third parties such as lenders or representation and warranty insurers. While we see a trend toward shorter reports that focus on issues analysis rather than extensive document summaries, there are some situations (such as a target that has customer agreements with specific pricing formulas that are material to the business) where details may be important for the sponsor’s financial modeling purposes. In these situations, summary charts that capture these key economic provisions can be attached to the report. Obviously, material issues should be conveyed as soon as they are identified.
Whatever form they take, all reports should include an executive summary of material value items and legal issues (such as regulatory approvals) that will affect the timeline to closing for use in purchase agreement negotiations. The summary should also include concrete recommendations for next steps, assessments of implications, and any mitigating factors. The executive summary is the most important section of the report and the most challenging to write, requiring the application of general “deal sense” and experience from similar transactions to the facts, findings, and conclusions that have been identified or developed in the due diligence investigation in a specific transaction. It is thus important for deal counsel to involve seasoned dealmakers in the preparation of the executive summary.
- Maintain a tight connection between due diligence review and the purchase agreement and other deal documentation.
The goal of legal due diligence is to identify obstacles to deal execution or ongoing risks so they can be mitigated or addressed in the deal documentation. Examples of these obstacles include required consents, contingent liabilities, change of control triggers in employee benefits documents, non-competition agreements and other restrictions on doing business, and, in carve-outs, shared assets and liabilities. Methods to mitigate or address obstacles include requiring pre-signing or pre-closing cleanup of issues, modifying the economics of the deal (such as identifying debt-like items that will be deducted from the purchase price), shifting risk in accordance with findings (such as adding specific representations and warranties or negotiating indemnification rights) and changing the structure of the transaction.
Regular communication between the due diligence and purchase agreement teams at both the business and legal levels ensures that due diligence findings are appropriately reflected in the deal documentation. Due diligence teams should also be involved in disclosure schedule review to leverage knowledge of the target’s business that was obtained during document review and management interviews.
- Provide close supervision and guidance of junior lawyers performing due diligence.
An experienced attorney on the deal counsel team should be designated to coordinate legal due diligence efforts across all practice areas, supervise general corporate (non-specialist) due diligence, and assume primary responsibility for the due diligence report. The requisite experience level of the coordinator will depend on the complexity of the deal and the overall timeline.
Quality control of the due diligence input is one of the most important functions of the coordinator. It is not possible to produce a due diligence analysis that will achieve the overall goals of the process without accurate and complete due diligence findings. In other words, “garbage in, garbage out” or, for a more positive spin on this aphorism, “excellence in, excellence out.” For that reason, it is critical to ensure that the team of junior attorneys who are reviewing the documents understand the business expectations and desired final work product, are fully briefed on the due diligence work plan and deal structure, and maintain an open dialogue with more senior lawyers and the deal team on areas where it may be appropriate to modify the plan based on ongoing due diligence findings.
- Commit internal resources to foster excellence and efficiency in due diligence practice.
Beyond the best practices for the legal due diligence of a given deal, we recommend that regular deal counsel make a commitment to broader knowledge management and training by appointing a senior attorney to develop due diligence best practices, including approaches to data room review and management and disclosure schedules, and use of technology when cost efficiencies can be demonstrated. Ideally, the senior attorney will also work directly with junior attorneys in the trenches on transactions where doing so is justified by the complexity of the due diligence exercise, the pacing of the transaction, or both. In our view, the most useful models and organizational systems are derived from actual deal experience. The senior attorney should also be tasked with disseminating best practices to attorneys involved in the due diligence process through formal presentations, consultations on live transactions, and informal, on-the-job training.
The end product for legal due diligence knowledge management should be an extensive library of models, precedents, and practice guides (including sponsor-specific due diligence work plans, due diligence request lists, legal call agendas, due diligence review forms and due diligence reports).We have found that the most useful materials are industry- or transaction-type-specific that differentiate between private and public company targets.
These efforts require an up-front investment, but they pay off by allowing more junior attorneys to handle key diligence tasks efficiently and at a higher level of quality than would otherwise be the case—ultimately saving the sponsor time and money.
By following the above eight guiding principles, deal counsel’s M&A legal due diligence process will be a targeted, results-oriented investigation that is tailored to the sponsor’s business objectives and documented in a useful format. In addition, the due diligence process will enable the dealmakers to make an informed investment decision, to identify and mitigate or address problem areas or obstacles, and to successfully execute the acquisition.
Private Equity Report Spring 2025, Vol 25, No 1