Legal Due Diligence in Private Equity Transactions – Best Practices

Private equity (PE) transactions generally involve significant financial investments in portfolio companies. These infusions of financial support can enable rapid business growth and diversification. However, they are not without risk, as investors take significant equity in a new portfolio business. Risk mitigation requires robust planning and execution.

One of the most critical components of this process is legal due diligence. A comprehensive review can evaluate the legal risks associated with an investment and lay the foundations for informed decision-making. It can also uncover hidden liabilities, mitigate risks, and ensure compliance, making it a cornerstone of successful PE deals. Here are some suggested best practices to follow:

1. Clearly scope the due diligence exercise

Legal due diligence should be tailored to the transaction’s specific context and objectives. A minority investment may require less extensive due diligence than a full acquisition. It is important to define the key focus areas based on the target company’s industry or sector, operational scope, and regulatory environment. Prioritise identifying issues that could impact valuation, deal structure, or post-transaction integration.

2. Assemble a Skilled Team

Legal due diligence requires expertise across various domains, including corporate law, industry domain, intellectual property, employment law, and regulatory compliance. Utilising a multidisciplinary team of legal professionals ensures a robust examination of all critical aspects. Collaborating with specialists who are familiar with the target company’s industry and jurisdiction ensures that operational risks are being properly addressed.

3. Assess Material Contracts

Material contracts form the backbone of a company’s operations and revenue streams. Care should be taken to review key agreements with suppliers, customers, distributors, and other stakeholders. Some important areas of focus include:

• Whether the contracts are properly enforceable and compliant under applicable laws;
• Any unusual terms that could harm the business post-acquisition; and
• Clauses related to assignment or change of control, which may be triggered by the transaction.

Additional focus should be given to e.g. loan and financing agreements, leases, and licensing agreements to ensure a good understanding of the target company’s rights, obligations and risk profile.

4. Evaluate Regulatory and Compliance Risks

Regulatory compliance is a critical focus area to be understood. The target company may have residual or unidentified regulatory risk which should be highlighted. Specific areas of regulatory application may include manufacturing and engineering industry standards, export and import requirements, and specific jurisdictional laws and regulations (e.g. local content). It is important to have an assessment of whether the target company adheres to relevant laws, regulations, and standards. Non-compliance can lead to fines, legal disputes, or even operational shutdowns, all of which could significantly impact the deal. Common areas of review may include:

• Environmental compliance;
• Data privacy and cybersecurity;
• Anti-bribary and corruption; and
• Licensing and permitting.

5. Understand if there may be employment Issues

Employment and labour matters can pose significant risks in a transaction. It is important to review employment contracts, collective bargaining agreements, retention and bonus clauses and policies related to benefits, equity incentives, and termination. A compliance or process audit may be important to seek to identify any potential liabilities, such as pending litigation, regulatory violations or issues with workplace safety standards.

6. Protect Intellectual Property Rights

For many companies, intellectual property (IP) is their most valuable asset. So it is critical to understand if the target owns or has valid and ongoing rights to its IP portfolio, including patents, trademarks, copyrights, and trade secrets. It is equally important to understand the marketplace in which the company operates and whether competitive IP positions are aggressively enforced and defended as this can have a significant financial and operational impact on a business. A weak IP position can reduce a company’s valuation and competitive edge.

7. Focus on Litigation and Dispute History

Assessing the target company’s history of litigation and disputes provides insight into potential liabilities. Review pending, ongoing, or past legal disputes, and analyse their impact on the business. Pay special attention to settlements, judgments, or unresolved claims that could resurface after the transaction.

Legal due diligence is a complex but essential step in private equity transactions. Used properly, it can be a very powerful tool in understanding and evaluating a prospective transaction at an early stage. PE firms can highlight potential risks, negotiate better terms, and make informed investment decisions. A diligent approach to legal due diligence not only protects the investor but also lays the groundwork for a successful and sustainable partnership with the portfolio company.

To discuss any of the points raised further, please contact a member of our Corporate law team here.

The information and opinions contained in this blog are for information only.  They are not intended to constitute advice and should not be relied upon or considered as a replacement for advice.  Before acting on any information contained in this blog, please seek solicitor’s advice from Gilson Gray.