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Due Diligence



This guide describes the steps, processes, and scope of Due Diligence.


1. Due diligence concept


Due diligence, in addition to being an unequivocal expression referring both to activity and its consequences, is a process that consists of reviewing the financial and legal situation of the company (as well as, if applicable, its subsidiaries) to assess its degree of compliance with both the legal system and its financial commitments in the areas covered by the review.

In particular, due diligence, or legal audit, is the term's origin in commercial transactions and mercantile operations.


This expression has been extended internationally to include any investigation into the risks or contingencies that may be acquired in connection with implementing a financial instrument granted by a third party, financing, and pre-contractual studies in general. In short, due diligence is an investigation process necessary before contracting or carrying out any essential financial commitment or investment. The owing expression diligence refers to the information search process by a financial institution to evaluate the company's acquired risks and its economic and financial situation.


Due to the influence of Anglo-Saxon legal systems, it is becoming more and more frequent for financial institutions to carry out preliminary investigation activities to verify that the client does not conceal important data or circumstances related to the purpose of the implementation of financial services that could give rise to a significant loss of assets for the client or our institution.


Thus, the audit processes necessarily consist of limited analyses of the legal reality of the reviewed company, so it is essential to delimit from the beginning the scope and purpose of the review.


2. Due diligence finality


The purposes for which statutory audits can be carried out are many and varied:


  • As a management tool to deepen the knowledge of the company itself by its administrators.

  • To evaluate the advisability or otherwise of investment and determine how it should make it.

  • To complement the valuation of a company. As a review before a public offering for sale or subscription (given the responsibilities incumbent on the managing entities in such offerings).

  • To determine the consequences of a change of ownership of the company's shares/shares/assets, etc.


3. Due diligence purpose


The object of due diligence will always vary depending on various circumstances, for example:


  • The characteristics of the target since an industrial investor will not be the same as a purely financial investor.

  • The role of the financier in the transaction. Indeed, due diligence may be commissioned by the financing entities and the guarantors of the operation, each of these parties pursuing their objectives in due diligence.

  • The nature of the transaction.


In any case, the most common objectives of due diligence processes are the following:


  • Improve the understanding of the business concerning specific aspects of particular relevance.

  • To carry out a SWOT analysis of the company: this analysis consists of studying the competitive situation of a company in its market (external situation) and its internal characteristics (internal problem) to determine its weaknesses, opportunities, strengths, and threats.

  • To reveal the contingencies of the operation that may affect the viability of the process or the price (lowering the cost) and the guarantees of the function (increasing them).

  • Due diligence is nothing more than a review from a legal point of view of all the aspects and characteristics of a company to detect, identify and quantify possible improprieties, contingencies, and risks of sanctions or liabilities that may exist in the company.


4. Due diligence subjective elements


Due diligence processes should generally distinguish:


  • The company that is the subject of the review.

  • The audit committee is the final recipient of the statutory audit report, and the legal team is responsible for the inspection.


Each person or group has a specific function distinguished from the others.


4.1. The company


By the general rules of the legal system, the company's representatives have to provide all the necessary information to the beneficiary so that those appointed by the beneficiary can effectively perform their work and reflect a correct and accurate assessment of the existing situation in their final report. Therefore, it is essential to emphasize that the legal, due diligence process requires a transparent and complete performance of the company to make known to those in charge of its performance all the information, without any reservation, that is relevant for the realization of the corresponding diagnosis on the state of compliance by the company and the Law that applies to it.


The company must actively participate in the process by providing motu proprio, without the need to be expressly requested to do so, all relevant information, including, in particular, information on possible conflicts, non-compliance, risks, or contingencies such as in-depth knowledge of its activity.


4.2. Audit committee


It usually is the addressee of the report. The client is interested in knowing the company's legal situation, and this interest depends on the purpose of the process.


The audit committee will be the beneficiary of the information and is responsible for making the business decisions and risk assessments required for each transaction.


The audit reports represent one of the main tools of knowledge and decision making on specific aspects of the company and its subsidiaries, such as determining the necessary actions to optimize management, regularizing the legal situation of the company in those aspects in which it does not comply with current legislation, making a decision on the advisability of the investment, determining the best structure to carry out the acquisition, confirming or rectifying the conditions and guarantees to be required in case of formalization of the investment and identifying those relevant aspects that will require specific and individualized treatment in the manifestations of the contracts.


To this end, the company's information and the lawyers' conclusions must be presented clearly and considered based on the legal analysts' experience and specialized knowledge, without limiting themselves to formally transposing the consequences in the Law.


During the due diligence process, there must be a lively interaction and fluid communication between the audit committee and the company. As the different conclusions of the review, work becomes apparent. The audit committee can decide on the convenience or need to go deeper into a specific aspect, extending horizontally or vertically the scope of the due diligence and refining its approach.


4.3. Legal team


The legal team's work in charge of the material execution of the due diligence consists of analyzing the information received, processing, and providing, from this information, a tool adjusted to the needs of the finance company.


A due diligence process is not an investigative process searching for hidden information. It is impossible to assess or foresee factual situations due to data or documentation that does not conform to reality. However, it is possible to determine the information obtained from the point of view of its material consistency.


The different thing is that, as a measure of prudence and due diligence in the performance of their duties, the work methodology obliges the legal team to delve into the information received to obtain a clear picture of what is presented to them, also guiding the company's representatives, with their specialized knowledge, on those aspects that are of most interest in the framework of the review and focusing the channeling of the information through the appropriate channels.


Since legal reviews often cover legal aspects from very different fields, due diligence is usually carried out by multidisciplinary teams within the legal team.


Coordination and exchange of information among all team members are essential. This is the way to optimize the resources of the legal team (avoiding unnecessary duplication in the development of everyday tasks), offering a consistent image of integration and collaboration of the group (repetitive repetition of documentation previously requested by another team member should be avoided). This results in the practical analysis development, warning of possible risks and contingencies that may impact other areas.


4.4. Method importance


It should be emphasized that the legal team's work is not a result but an exercise. In other words, what is expected of the legal team involved is that they apply a particular methodology that guarantees the review and coverage of all the aspects included in the scope of the due diligence wholly and diligently. In other words, it is impossible to guarantee the infallibility of the persons in charge of the analysis of the company (since there are elements beyond their control, such as bad faith and deceit on the part of the company's representatives in concealing or distorting the information). Still, it is necessary that in the performance of their duties, the most diligent and appropriate actions have been observed and put into practice to obtain a correct evaluation of the company based on the information provided. The importance of the method lies in this fact, together with the previous work of advising and directing the review.


6. The method to be applied in all due diligence


6.1. Description


The experience and know-how of specialists in this type of procedure have led to standardizing specific primary and general processes when carrying out due diligence.


Any method is susceptible to improvement and, in any case, should be adapted and updated to the specific conditions of each transaction.


6.2. Initial information and due diligence planning


As a starting point, it will be necessary to make the first approach to the company through the assignment that the financial company defines the purpose for which the report is required, delimiting the scope and format (detailed information or summary of contingencies) of the word, and identifying the aspects that are of most interest to the company.

Following this, it will be necessary to introduce the people who will make up the audit team and designate the person responsible for coordinating and supervising the work.


It is also essential to define the model document on which all team members should work, establishing the format criteria and style guidelines in agreement with the company.


6.3. Collection and analysis of public information


Even before the first contact with the company's representatives, as far as possible and to be able to make an initial adaptation of the audit list to the company's activity, it is advisable to collect and study all the public information that exists on the company (information from physical and virtual public records, publications, communication published on the Internet and other media).

6.4. Initial request for information

It should make through the well-known audit lists or checklists in which areas of Law list the documents necessary to review the company.

Checklists often cause an adverse reaction in their recipients as they are documents that must be exhaustive and try to cover all the points that, at the outset, will need to be reviewed.

It was evident that, due to the generic nature of this type of document and the preliminary stage at which it is usually sent, in many cases, it contains references to points that are not applicable and omits the request for certain specific documentation whose need for review arises from the particular knowledge of the company's business or activity.

It is, therefore, necessary to attach to these initial lists of documentation an accompanying letter in which, from the outset, the preliminary nature of the request and the possibility (almost certainty) that the list as mentioned above is only the starting point of the successful bids that are chained together during the process are explained.


The information must be provided through the most suitable means and media, using interviews with the persons in charge of the corresponding areas or the delivery or provision of the relevant written documentation.


At the end of the due diligence process, the company must confirm that it has provided all the information necessary for its performance by the principles expressed above and that it has not concealed any data or circumstance that could affect the scope of the review carried out.


7. Provision of information and documentation available

The documentation/information may be made available to Cahero Capital and its advisors using different methods:

The first and most convenient method is the direct making available by sending the requested documentation so that the advisors and Cahero Capital can analyze it freely and without any restrictions other than due confidentiality.


The second method consists of making the documentation available in a limited way (temporally and spatially) through the organization of the so-called data room. In these cases, the information is accumulated in a specific space, either within the company itself or in an external location expressly set up for this purpose, for its supervised analysis.


In this type of data room, it is common for there to be procedural limitations on the analysts' activity (accreditation and registration requirements, a time limit on attendance with a specific schedule and dates for the review, a limit on the number of attendees, a prohibition on photocopying or other types of document reproduction, and the presence of a "supervisor" appointed by the owner of the information, among others).


These rules are usually presented systematically in a compendium of "data room rules" to which Cahero Capital and its advisors must subscribe, respect, organize, and order the legal review process.


On the other hand, it should be noted that thanks to new technologies, it is expected that the review through the data room is carried out virtually by computer. In this case, access is gained through a web page to the documentation required for the examination after the web page administrator has granted a password. However, procedural limitations are similar to those mentioned above in these virtual reviews since the password will expire after a certain period. The web page will be prepared, so the documentation cannot be printed. The study must be done by reading the documentation directly from the computer screen, with the consequent inconvenience generated. The use of one or the other method typically responds to each transaction's circumstances.


7.1. Review of the documentation received


Regarding this aspect of due diligence, the most important for all parties, a series of parameters that we trust will help focus the documentation analysis are set out below.


7.2. Interviews: face-to-face and over the phone


Not all the relevant information for due diligence is included in physical support. To obtain this information, it is essential to conduct individual interviews with the people in charge who can offer precise and complete information due to their functions in the company.


These interviews and their conclusions must be detailed in the audit report.


8. Material aspects


The scope of the due diligence depends on the company's own needs. However, indeed, it is generally aimed at reviewing the financial projections, the annual accounts for several years, and the most relevant legal aspects, especially the company's corporate, tax, labor, real estate, administrative and environmental, competition, and contractual Law, with criminal compliance having recently acquired particular importance as a result of the criminal liability of legal persons.

Of all of them, it is advisable to include some mention in the corresponding report, either merely describing the current status of the matter (indicating that no contingency or liability has been detected) or, as the case may be, highlighting or making the corresponding comment about the contingency or liability that exists, the quantification of the risk involved, as well as the necessary actions to the investment operation in question.


9. The conclusions of the due diligence report


The review work must be reflected in documentary support adapted to Cahero Capital's needs.


The due diligence report may be complete and descriptive (reflecting each of the documents reviewed with an indication of their most relevant aspects), in which case it must be accompanied by a summary of contingencies or executive summary in which, precisely and briefly, all those facts and situations that constitute (or may constitute as a consequence of the projected transaction) a liability or contingency for the company, its shareholders/partners or simply those that by their nature should be highlighted, taking into account the purpose of the transaction.


More frequently, we require a summary of contingencies, saving time and costs in preparing the conclusions document. Still, it should not imply any difference in the review method or the due diligence process.


In some transactions, the following have been included as annexes to the due diligence report:


  • A list of the documentation was reviewed to delimitate the legal team's responsibility for carrying out the due diligence.

  • Descriptive sheets of documents or critical aspects of the transaction are of particular interest to Cahero Capital (for example, summary sheets of the lease agreements of the business premises held by the company).


The presentation must be precise without giving rise to misunderstandings. Still, it must be made from a realistic and constructive perspective, avoiding rigidly legalistic approaches that may transmit disproportionate concerns to Cahero Capital.


It is therefore advisable to highlight the fact or contingency that exists, the legal consequences that may arise from this situation, an assessment of the likelihood of this contingency materializing in specific damages, the quantification (where possible) of the risk involved, as well as the actions necessary to regularize the situation or to protect the investor about the transaction that has motivated the due diligence. It is also essential that these mentions indicate which of the problems highlighted can be regularized before signing the contract ("conditions precedent" or conditions precedent) and which of them entail a risk -uncertainty- for the company.


The latter should be duly reflected and treated individually in the representations and warranties of the corresponding investment contract if this is the purpose of the due diligence.


Suppose no documents or information are relevant to a specific issue or application. This should be expressly indicated in the report, requesting a formal statement to this effect from the company beforehand.


10. Impact of due diligence on the transaction


Due diligence is an indispensable instrument for risk assessment. It represents one of the main tools for gaining knowledge of the companies and helps make decisions on whether or not to carry out the transaction.


Thus, due diligence can impact the operation in the following ways.


10.1 Impact on negotiations


This impact can be manifested in two ways:


Withdrawal from the transaction occurs in cases where a risk or set of risks or contingencies not assumable by the investor is discovered. These assumptions are known as deal-breakers and constitute, in any case, a business decision on the part of Cahero Capital. Examples of these situations could be the following.

  • Necessary license for the activity that suffers from a defect of nullity/cancellability.

  • The Sum of contingencies results in an exceptionally high amount.

  • Litigation with possible adverse material consequences for the company.

  • Image damage (environmental, criminal liability).

  • Risks of change of control.

  • We are continuing with the operation but setting palliative measures, such as making price adjustments or requiring additional guarantees.

Impact on the transaction documentation: The transaction contracts will reflect the contingencies detected. In particular, it must be considered that the due diligence will affect the drafting of the representations and warranties of the company, and this is how:


  • The greater the scope of the legal review, the lesser the extent of the company's representations and warranties.

  • The greater the scope of the legal review, the more precise the wording of the representations and warranties (they will be less generic).


10.2 Disclosure letter


The figure of the disclosure letter as a mechanism to exempt the company's liability:


The contingencies detected in the due diligence and those additional ones that the company reveals to Cahero Capital will be included by the company's advisors in a document known as a disclosure letter which, based on the doctrine of hidden defects, is intended to exempt the company from liability in respect of contingencies detected and taken into account to determine the conclusions of the due diligence. Thus, in principle, the company is not liable for those facts or circumstances revealed by Cahero Capital, which may imply a reduction of the criteria to be agreed upon. Thus, this document is characterized by the following notes:


  • It is prepared by the company (beneficiary of the document) and its advisors.

  • It is based on the idea that the greater the legal review, the greater the scope of the exceptions.

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