Part III: Due Diligence
This is the third article in our series on “Closing a Private Equity Transaction.” In Part I, the benefits of preparing for a transaction were explained, along with how best to prepare. In Part II, the letter of intent (LOI) was discussed, and key terms were identified and explained. Next, we walk through the due diligence process, which begins immediately after the parties execute the LOI.
Due diligence is used by both the buyer and seller to confirm the decision to proceed with an ultimate closing. Typically, the buyer’s examination of the seller’s business will be comprehensive and include information covering the past three to five years. This is necessary in order for buyer to understand what it will be purchasing, in terms of profitability, operations, business relationships, and potential liabilities.
Unless the seller is making a complete exit, the seller can obtain information equally as valuable as the actual purchase price through the due diligence process. “Reverse due diligence” allows the seller to evaluate its compatibility with the buyer, and the probability the buyer will deliver on its promises made during the earlier negotiations. Sellers should consider inquiring as to:
- The buyer’s “Culture, and how it’s consistent with the seller’s “culture”;
- The experience of other sellers who entered similar transactions with the buyer;
- Whether the buyer has been involved in regulatory investigations and/or litigation;
- The buyer’s plan to reach its profitability and growth goals; and
- The buyer’s success to date with expansion, growth in value, and other exits (in the same or similar industry sector).
The buyer’s formal due diligence process begins by sending the seller a written detailed due diligence request. The request will be divided into categories, such as corporate documents, all material agreements, tax returns and financial statements, employee benefits, and information and documents related to regulatory compliance. The buyer will utilize a team of experts to assist in the review of the materials, which may include healthcare regulatory lawyers, medical coders, and auditors.
Due diligence can be the most time consuming and tedious aspect of a transaction. The more structured and organized the process, the smoother it will go, and the less risk of confusion, delays, and spooking the buyer. To manage the process, the buyer will setup a secure data room where all responsive information will be uploaded. This will ensure that the information shared is protected, tracked, and easily accessed by all parties when needed. There will be a temptation to avoid the hassle of uploading documents to the data room, and instead respond directly to individual requests for information from the buyer’s representatives. However, this will make it challenging later when they will need to be referenced in schedules required for an ultimate purchase agreement.
Generally, the seller can expect the following once the due diligence process starts:
- Most buyers begin the due diligence process focusing on the financial information necessary to confirm the seller’s earnings. This will involve reviewing the financial statements, coding audits, compensation methodologies, and sources of revenue.
- Material contracts are usually the next priority. These include payor agreements, employment agreements, leases, loan documents, software licensing agreements, other vendor agreements, and insurance policies. The buyer will be looking to confirm the agreements have not terminated, the financial terms, how and when they can be terminated, whether there are exclusivity or non-compete provisions, and what is required in the event of a change of control.
- Next, the buyer will focus on any past and/or present investigations, disputes, settlements and current liabilities (such as loans, letters of credit, tax liabilities).
- Lastly, the buyer will want to understand how well the business is doing in the area of healthcare regulatory compliance.
The seller should not be concerned with issues arising during the due diligence process. This occurs on every transaction, whether the seller is a large or small business. The buyer will identify areas of concern, and the buyer and seller will work together to agree on how they will be resolved. This can include: cleaning up corporate documents or agreements with third parties, adjusting the purchase price or amount placed in escrow, making a disclosure to a regulatory agency, or pushing back the date of closing.
While due diligence can be time consuming and anxiety producing, it serves the important objective of ensuring the transaction is a successful investment for both parties.
Next in the series will be a discussion of the healthcare regulatory issues that arise in private equity transactions.
For more information on preparing for a transaction, contact a member of the Husch Blackwell Healthcare Law team.