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Enterprise & Market Resilience COVID-19 India Forum: Changing Landscape of Due Diligence and potential impact on Deal Structures

COVID-19 pandemic will change the business outlook of companies globally, across industries. As businesses revive post the global unprecedented event, Mergers & Acquisitions (M&A) activity is also expected to rebound but the investors will wear a changed lens - Companies with robust and sustainable business models will be sought after.

Historical performance may have reduced significance in certain cases where the recent month may be more important than the trailing 12 months to evaluate the relevant trends that will show how a target company will weather the current environment. Sustainability of businesses to grow in the "new normal" business environment and their ability to build operational efficiencies through automation and technology enhancement will be the key.

In the new outlook, buyers will be more careful in their approach and sellers will need to prepare for increased review and analysis through due diligence.

Protiviti on 24 July 2020 partnered with leaders from top private equity, venture capital and fund of funds to conduct a webinar on ‘Changing landscape of Due Diligence and Deals’ to obtain their valuable insights on the changes in the due diligence approach in the current business environment, growing significance of emerging due diligence areas including Environmental, Social and Governance (ESG) and potential impact on deal structures and valuation.

    Some key takeaways

  • Fund raise and M&A will depend on the kind of business disruption faced by the companies – whether the disruption is temporary in nature or permanent. Nature of disruption will also have an impact on the valuation.
  • Forensic due diligence on companies and integrity checks on promoters / founders is likely to find increased significance amidst / post COVID-19. The scope / coverage of integrity checks may also extend to extended families and related parties in some cases.
  • In the case of early stage and growth stage companies, the focus is likely to shift from customer acquisition and scalability to quality of revenue, unit economics and profitability.
  • Social media sentiment analysis will gain significance where the positive and negative mentions and feedback about the business / products will be analyzed and reported.
  • Vendor due diligence will be a preferred approach considering the increase in the overall deal closure timeline and likely increase in the scope of diligence. DD service providers will need to continue to exercise increased caution and independence in their engagement delivery – Investors will place high reliance on the due diligence professionals.
  • Given the presence of multiple global ESG frameworks at present, standardisation of an ESG framework in India will go a long way in facilitating larger adoption by companies and comparability of ESG performance among peers.
  • Cash will always be King. Overstated / overvalued assets including inventories, plant and machinery and trade receivables will be the focus areas in case of financial due diligence. Ability to repay the debt post the moratorium period will be closely looked including company’s ability to continue as a going concern.
  • Investors will need to evaluate the risks emerging for the seller from the pandemic and seek detailed warranties.
  • Structure of purchase consideration will have a bend towards variable pay-out and convertible shares, to cap the down side risk.

Fundamentally strong companies will continue to see investment interest considering the paucity of good companies in the current market. Given the impact on current valuations, some of these good companies may not wish to pursue deals immediately and may want to postpone the deal in anticipation of more stability in the market. However, if there is need for capital, such companies are advised not to lay too much emphasis on valuation and rather focus on the larger opportunity for long term growth.

Fund raise and M&A will also depend on the kind of business disruption faced by the companies – whether the disruption is temporary in nature or permanent. Deal discussions is more likely to be called off in the event the impact is envisaged to be permanent in nature. In the case of companies with temporary disruption, there is a likely to be impact on valuation where the uncertainty aspect can be covered with earn-out arrangements where the additional component will be linked to meeting of pre-defined performance thresholds.

From a sectorial point of view, there is growing interest in Fintech, healthcare, education and food. These sectors have been the leading sectors in 2020 in terms of investments.

In the case of existing portfolio of a GP, where a follow on investment is being evaluated in one or more portfolio companies, since the GP is already familiar with the portfolio company and its founders / key management, subsequent due diligence will play a limited role and may not be as challenging to undertake in the current COVID-19 crisis too. However, in a case where the GP is trying to establish new relationships with new companies, due diligence will be more critical as well as difficult to execute as well given the current restrictions on travel and the view that the historical performance cannot serve as a proxy for evaluation for the next two to three years.

Forensic due diligence on companies and integrity checks on promoters / founders is likely to find increased significance amidst / post COVID-19. The scope / coverage of integrity checks may also extend to extended families and related parties in some cases.

The forensic integrity check service providers will be expected to integrate new and advanced technology tools (or artificial intelligence) into their procedures to check for revenue leakages, circular transactions and related party transactions not at arm’s length.

Social media sentiment analysis will gain significance where the positive and negative mentions and feedback about the business / products will be analyzed and reported.

While the due diligence process is likely to remain the same, the methodology may witness little changes. In the case of early stage and growth companies, while earlier the focus was customer acquisition and scalability, the focus may shift to quality of revenue, unit economics and profitability going forward for short and medium term.

Financial due diligence should carefully examine whether the financial statements of a target company reflect a true and fair view of its state of affairs. Specific areas that will need attention will include the following:

  • ‘Cash is king’: Recoverability of inventories and debtors will be crucial to evaluate
  • Impact of carrying value of financial and non-financial assets (potential impairment) Impact of renegotiation of terms in borrowing agreements on the financial statements Ability to repay the debt post the moratorium period will be closely looked including company’s ability to continue as a going concern.
  • Impact of renegotiation of other onerous contracts entered with customers and suppliers on the financial statements
  • Effective working capital management: Opportunities in working capital to identify balances that can be liquidated and ensure cash is released quickly (for example – refund of taxes)
  • Related party transactions – ageing of balances receivable and payable to them

ESG considerations which was previously considered ‘good to have’ is now turning out to be a ‘must have’ in a company’s ERM. Based on feedback received from the PEs, management of existing portfolio companies understand the importance and need for adopting ESG are hence are open to implementation of ESG policies and processes amidst and post the COVID-19 crisis. Hence, significance of ESG will increase to ensure long-term sustainability and attract investor confidence.

However, one of the challenges faced by the Indian companies at present is that there are multiple guidance frameworks and standards available to choose from for ESG implementation and reporting such as UN SDG, UN PRI, SASB, GRI, IFC Performance Standards, TFCD, IIRC, etc. Introduction of some standardization in India will go a long way to facilitate quicker adoption of ESG by companies, measurability of ESG performance as well as its comparability with peers.

In-person meetings with founders is important for an investor to gauge the personality and capability of the founder. In absence of such meetings and site visits given the current travel restrictions, there is a significant slowdown expected in closure of deals.

Given the potential increase in timelines for conclusion of a buy side due diligence, in the case of a deal where are multiple investors involved, the sellers may look at carrying out a vendor due diligence in advance. VDD service providers will need to continue to exercise complete independence regarding reporting of key issues – and strike a good balance between sellers and investors and earn their trust alike. In certain cases where a vendor due diligence is already carried out, a buyer in order to derive more comfort, may also initiate a top-up due diligence.

Events like the COVID-19 pandemic has tested the resilience and character of the key management / founders. Some founders proved to be agile and were quick to adapt to the changing scenarios. Such nimbleness on their part helped them to swiftly turnaround their companies efficiently and in some cases even scale up vis-à-vis the pre-COVID performance levels.

Investors will need to evaluate the risks emerging for the seller from the pandemic and seek detailed warranties. Sellers need to consider whether it may need to provide disclosures that have or will sufficiently address the risks and potential impacts as a result of Covid-19 irrespective of whether included in the buyer’s draft of the share purchase agreement.

On account of the impact on business operations and consequent change in valuation, purchasers / investors may evaluate structure involving acquisition through a mix of equity shares and compulsorily convertible preference shares and / or earn-out arrangements where the additional component will be linked to meeting of pre-defined performance thresholds to cap the downside risk.

No major changes or additions expected to the conditions precedent (CPs) in the term sheets or share purchase agreements.

Overall, all panelists were of the view that the deal activity will take time to rebound and companies that are able to innovate, demonstrate strong governance especially in their dealing with related parties, showcase a strong resilience to the changed business outlook will continue to attract institutional capital. The significance of a robust due diligence will continue to grow and given there may be some new areas for investors to gain comfort on, a right balance will have to be reached between the extent of diligence and level of comfort desired. The time to complete diligence process and closure of deals is expected to increase.

Read more about the panel discussions from our earlier resilience forums sessions in the series

Protiviti India Member Private Limited is the India Member Firm of the global network of Protiviti firms, a group of independent consulting firms helping companies solve problems in finance, technology, operations, governance, risk and internal audit.  Protiviti Member Firms are separate and independent legal entities, are not agents of other firms in the Protiviti network, and have no authority to obligate or bind other firms in the Protiviti network.

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