Due diligence mitigation strategies Pierre Magnan Firm: Osler, Hoskin & Harcourt LLP

M&A due diligence – mitigation best practices
Most due diligence investigations will result in the identification of several potential problems, which the acquiring companies must address before the deal can be completed. Pierre Magnan, a business law partner at Canadian firm Osler, Hoskin & Harcourt LLP, explains some of the mitigation strategies available to corporate counsel.

In a typical transaction, how many problems will a due diligence investigation uncover?
Almost every due diligence review conducted in connection with a M&A transaction will result in between 10–15 due diligence issues being identified by the various functional groups conducting the due diligence – operations, environmental, accounting, legal, etc. Not all of these issues will be considered “material” by the client, but most will have to be addressed in some way, or accepted as part of the valuation model, before the deal can proceed.

Due diligence issues are usually addressed by deal structuring, risk allocation or purchase price adjustments. For example, the deal could be structured as an asset purchase, which leaves unknown liabilities behind. Risk allocation in the definitive agreement will typically involve using “conditions to closing” or indemnities. A purchase price adjustment will reflect diligence findings that affect the target’s valuation.

Describe a typical due diligence reporting process.
In a typical transaction – if such a thing exists – the external law firm advising the acquiring company will produce a report of possible legal problems with the M&A transaction. This report will be considered by the client in concert with reports from tax advisers, accounting firms, investment bankers, business principals, and specialist consultants – essentially, each of the company’s functional areas. Together, these reports form the basis of a “master list” of all material findings or issues. This master list can then be used to identify appropriate risk mitigation strategies for each of the findings.

The acquiring company’s legal advisers have an opportunity to add value by suggesting mitigation strategies, even where an identified risk originates from other consultants. In most situations, the final decision of whether a risk mitigation strategy is acceptable will ultimately be made by a senior executive of the client.

What types of due diligence issue are commonplace?
Litigation risk is a common example of a due diligence finding. Specific litigation risk can be mitigated by making it a “condition to close” that the lawsuit be settled. In private company acquisitions, the acquiring company will often expect to receive a “make whole” indemnity in the event of an adverse outcome.   

In other situations, the vendor and purchaser may agree to share some risk, with the vendor liable for an initial sum. The vendor’s total aggregate liability will typically be based on a percentage of the value of the transaction. 

For private company M&A transactions, 10 per cent of the purchase price will frequently be “held back” in an escrow account as security for the indemnification obligations of the vendor in respect of potential liabilities. This gives the purchaser a pool of money to draw from in the event that any new claims emerge in the first year or two after the transaction is completed.

What structural mitigation step is the most effective?
The first rule of an M&A transaction is that you prefer to buy assets and sell shares.

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