The whys and hows of legal due diligence in private equity transactions

Conducting detailed legal due-diligence grants private equity players adequate visibility of the landscape they are looking to navigate.

The whys and hows of legal due diligence in private equity transactions

Friday July 07, 2023,

8 min Read

Private equity investments are crucial in the startup ecosystem since they bring in the all-important growth capital, essentially taking the company from 30 kmph to 100 kmph, whereas VC funding had helped it reach from 0 kmph to 30 kmph.

Since private equity funds invest larger sums of capital in companies that have already reached a certain size and scale, it becomes important to analyse more aspects of the company at a granular level to protect its interest.

Cases where legal due diligence was not conducted in-depth and with required zeal have often resulted in improprieties, disputes, and regulatory consequences popping up after the investment is made, thus negatively affecting the business and valuation.

In some cases, this has led to writing off of the investment or the investor being forced to take a haircut in an exit. Hence the need to be extra-vigilant and go in with your eyes open has become all the more important in private equity transactions.

Legal due diligence is the process through which private equity investors find out about the risks involved and red flags, if any, in a company they wish to invest in. In the world of private equity, legal due diligence plays a crucial role in assessing the risks and opportunities associated with an investment. The process involves a meticulous examination of legal documents and contracts to uncover any potential legal issues that might impact the target company's value or hinder the investment process.

Importance of legal due diligence in private equity

Private equity transactions involve substantial investments and inherently carry risks and conducting proper legal due diligence allows private equity firms to identify and evaluate potential legal pitfalls associated with the target company.

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By thoroughly assessing the legal landscape, investors can make informed decisions, come to a common ground regarding the valuation of the company, mitigate risks, and ultimately maximize returns on their investments. It also helps the company to clean up all the non-compliance and red flags and make the company ready for a future round and provide comfort to the current investors.

Legal due diligence covers various aspects, including corporate structure, regulatory compliance, litigation risks, real estate, insurance, intellectual property rights, tax, contracts, environmental and employment and labour matters.

Key components of a legal due-diligence

Corporate structure, secretarial compliance and governance: One of the key aspects to be analysed by a private equity investor should be the target company's organizational structure, ownership, and governance framework.

This includes analysing articles and memorandum of association, shareholders’ agreements, board and shareholders’ minutes and filings with the Registrar of Companies. Understanding the company's decision-making processes, the business it is legally permitted to do, appropriate and regular filings with the registrar, potential conflicts of interest, rights of the promoters and existing shareholders and any legal constraints is crucial while making informed investment decisions.

Regulatory compliance and tax: Compliance with applicable laws and regulations is paramount for any company, especially in a country like India where the regulatory framework is complex, and non-compliance can have heavy punitive effects.

Legal due diligence involves reviewing licenses, permits, certifications, and regulatory filings to identify any compliance gaps or potential liabilities, especially those which are core to running the business and especially those related to foreign direct investment if the investor is a non-resident.

Non-compliance can lead to fines, legal actions, or reputational damage, all of which can significantly impact the value of the investment and in some cases also curtail or limit the running of the business itself. Additionally, tax filings should be analysed including any disputes with the revenue authorities since many mines in the form of tax demands, notices, fines, penalties, etc. may be found, which could have serious monetary implications on the financial health of the company in the future. Hence ample attention needs to be accorded to this part of the legal due diligence.

Labour and employment: Compliance with labour and employment laws is one of the most important facets of efficiently running a company in India. This includes compliance with labour laws, both at the central and state levels, regular filings and payment of dues, etc. Non-compliance can have far reaching consequences, which could be monetary or criminal in nature as well, hence due focus needs to be given to this, especially if the private equity fund wishes to appoint a director on the board of the target company.

Litigation and legal claims: Examining ongoing litigation, past disputes, and potential legal claims is essential to assess potential risks and liabilities. This includes analyzing court records, settlement agreements, and any pending or threatened cases. Understanding the nature and potential impact of legal disputes is crucial for private equity firms to make informed decisions and work out appropriate safeguards.

Intellectual property rights: Intellectual property (“IP”) assets, such as patents, trademarks, copyrights, and trade secrets, can be critical for a company's success, especially in companies heavily reliant on own technology. Legal due diligence in this aspect involves verifying the ownership, validity, and enforceability of these IP assets and also includes the examination of potential infringement risks and analysis of licensing agreements, non-disclosure agreements, and any ongoing disputes relating to intellectual property.

Contracts and commercial agreements: Reviewing the target company's material contracts and commercial agreements is vital to understand its rights, obligations, and potential risks which may arise in the future. This may include customer contracts, supplier agreements, joint venture agreements, and partnership agreements. Legal due diligence focuses on identifying any unfavorable terms, termination, change-of-control provisions, or other contingencies that may impact the value of the company.

Loans and borrowings: Reviewing the target company's loans and borrowings-related agreements becomes crucial to get a sense of the liabilities of the company, charges created on the assets of the company, and whether a change in control provisions in the agreements may necessitate seeking prior approval of the lender for the investment.

Real estate and insurance: The documentation in relation to the real estate, owned or leased, is usually analysed to understand the ownership/right to usage of the same from the perspective of business continuity. Checking insurance for its assets, key personnel, liabilities, etc. taken by the target company is also important to ensure the value of the company is not eroded due to any unforeseen event.

Environmental laws: Depending on the business of the company, checking on compliance with environmental laws becomes crucial since authorities have the power to not only impose penalties, but also shut down the facility in case of serious or persistent non-compliance. This could seriously affect the running of the industrial facility and hence this becomes all the more important part of the due diligence process. 

Steps involved in a legal due-diligence

Due diligence team: Private equity firms would typically engage corporate law firms who have expertise in conducting legal due-diligences in the course of a transaction. The team would comprise of lawyers from different fields of law to ensure all aspects are adequately covered.

The due-diligence team would typically collaborate with the target company's management, financial advisors, and other stakeholders to gather relevant information and conduct the due diligence.

Document request list and data room review: The diligence team typically provides a document/data request list under various heads discussed above and is subsequently provided access to a data room by the target company, where they examine legal documents, contracts, corporate records, regulatory filings, and other relevant materials. These are analyzed to identify potential issues and gather deeper insights into the business of the company.

Interviews and management meetings: Interviews and meetings with key personnel of the target company help in clarifying legal queries, gathering additional information, requesting further documents, and help in uncovering undisclosed issues.

Due diligence report: Based on the findings of the document review and interviews/meetings, the due diligence team prepares a legal due diligence report with issues and red-flags placed in separate buckets based on risk and criticality to the transaction. It also suggests ways to address or mitigate such risks.

Outcome: Based on the discussions on the due diligence report with the private equity investor, appropriate conditions precedent (or conditions subsequent in some cases) may be built into the investment agreement to fix legal issues and non-compliances and additionally, adequate representations and warranties may be taken from the target company and its promoters with respect to the identified legal risks along with indemnities to back them. 

Conducting legal due diligence in a private equity transaction is a critical process that helps investors assess the legal risks and opportunities associated with a target company.

By conducting a thorough examination of legal documents, contracts, registrations and filings, private equity firms can effectively make informed investment decisions, negotiate better terms, and alleviate potential risks.

Engaging experienced legal professionals and following a structured approach are the key to effectively conducting comprehensive legal due diligence on the target company in a private equity transaction.

I would like to end this piece with the famous Latin maxim “Caveat Emptor” or “Buyer Beware”- private equity firms are well aware of the pitfalls of going blind into a company, hence conducting a detailed legal due diligence grants them adequate visibility of the landscape they are looking to navigate.

Edited by Affirunisa Kankudti

(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)