Transactions
The value of everything
15 Jan 2025
Insight
Global
4m read
Due diligence processes in 2024 were shaped by capricious market conditions and less-structured sale processes. The time taken for due diligence exercises has become noticeably longer and data room providers are reporting record volumes of documents being disclosed in data rooms. Without the pressure of hotly-contested auctions, and needing to find ways to straddle valuation hurdles, many buyers are taking the time to dive deeper into target businesses, allowing them to gain a better grasp of how they operate and the risks they face.
What buyers care about
Environmental, social and governance (ESG) due diligence continues to come into increasing focus for buyers as they seek to navigate a continually evolving ESG regulatory environment and face increased public scrutiny of governance and organisational culture (particularly at management level). Similar attention is being given to regulatory risk more generally, as well as areas such as reputational risk and operational integration (indicative of the prominence of trade buyers in the current market).
The due diligence toolbox
To test these areas, both buyers and sellers are turning to a combination of different due diligence formats – the former to understand the target business better, the latter to smooth the path of the transaction. More practical due diligence methods such as management presentations, site visits and social engagements, which have not been common in recent years, are now being used to great effect. Buyers are supplementing customary data room document review with methods which offer a closer understanding of the business and matters which cannot be gleaned solely from words or numbers. Whether target management will be a good cultural fit within a trade buyer's existing business or are considered worth backing from the perspective of a private capital buyer, and what is the most effective path to integrating the target business, are insights best obtained by speaking with those closest to the business.
Sweetening the deal
The approach to addressing issues raised in due diligence has also changed, shaped largely by market pressures in the form of lower levels of competitive tension and already-wide valuation gaps. In an effort to keep transactions alive, the trend towards more buyer-friendly protections has continued.
Historically viewed as aggressive and unattractive in the context of competitive auction processes, sellers are accommodating with greater frequency specific indemnities over matters uncovered in due diligence. Terms largely unheard of in a highly competitive market, such as protections relating to counterparties' change of control rights under material contracts, may be used by sellers as a way to secure a deal.
Some sellers are flagging matters such as regulatory issues at an early stage, and, in exceptional cases, being on the front foot in offering indemnities in the first draft of transaction documents. In some cases, this will be to provide reassurance to the buyer to avoid the matter becoming a deal-blocker. In others, it is strategic – the seller accepts that offering protection is inevitable in the current market and wants to set down a marker as to its expectations on the substantive and financial parameters.
However, we would caution sellers against seeking to pre-emptively implement a 'solve' to an issue without considering the wider implications. Where issues are practical or structural in nature (and solving them could, for example, involve a corporate or asset reorganisation or restructuring key operating arrangements), there is a risk that a solution implemented without prior buyer consultation could have consequences which are undesirable for, and may even deter, a particular buyer. Costs involved could also be significant and with little gain in practice if the solution does not appeal to bidders.
In terms of deal certainty, there is an uptick in buyers insisting that sellers resolve issues identified in due diligence as a condition to completion (or even prior to signing). The steps required may range from obtaining necessary shareholder consents or amending constitutional documents, to carrying out internal restructures and carve-outs.
So long, farewell
Ultimately, in some cases, matters identified in due diligence will be beyond the appetite of the buyer and looking at executed deals only tells one side of the story. Many potential transactions aborted during the course of 2024 as a result of matters uncovered by the buyer in due diligence. In some cases, this has been purely due to risk appetite or the impact of an identified issue on the ability to achieve targeted rates of return (in the case of financial sponsor buyers). In other instances, the issue was of an operational nature or relevant to the buyer's integration exercise. Without a practical fix, the only option for parties who are unable to agree an acceptable price adjustment is to part ways.
Outlook for 2025
The ways in which parties resolve issues raised in due diligence will move with the market. More rigorous, holistic due diligence processes and emerging areas of enquiry are here to stay.
W&I Insurance
The proportion of transactions using warranty and indemnity (W&I) insurance remained consistent in 2024 (and, if anything, increased, particularly in markets where it is a newer tool such as Southeast Asia). On the demand side, this was driven, in part, by growing sophistication in the corporate community and their advisers as to the availability (and utility) of transactional risk products as well as lower premiums.
In terms of supply, the insurance market continues to maintain good appetite and flexibility in providing coverage solutions. This is in spite of growing claims books as the use of transactional insurance products matures.
However, W&I is not (and must not be) a substitute for quality due diligence or a tool to plug gaps – depth and quality of diligence continues to be an area of scrutiny for underwriters and perceived gaps in diligence ultimately result in gaps in coverage. W&I processes which are initiated early, when there is time to consult and design a diligence exercise with insurance in mind, are often the most successful. And it is important to remember that coverage of some risks, such as condition/adequacy of assets, liabilities for cyber/environmental risks, secondary tax liabilities and sanctions, remains unavailable or unaffordable, so diligence of likely exposures is key.
Insurers generally remain open to negotiating policy terms (including narrowing exclusions and committing to potentially lifting coverage restrictions post-signing if clean diligence can be provided at a later stage). However, such terms are unlikely to be offered voluntarily, so it will remain important for policyholders to obtain input from specialist brokers and legal counsel to optimise their coverage outcome.
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The contents of this publication are for reference purposes only and may not be current as at the date of accessing this publication. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on this publication.
© Herbert Smith Freehills 2025
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