What is Due Diligence (DD)? 

Due diligence is a widely used term. In business, it refers to the process of investigating and verifying information relating to an individual, company, potential transaction or investment opportunity. The aim of due diligence is to confirm facts about the party in question, mitigate risk and uncover potential issues before entering into any sort of engagement with them. Ultimately, due diligence helps people and businesses make informed decisions about potential relationships and adhere to relevant laws and regulations. 

In this guide, we will discuss the following:

• Why is Due Diligence Important?

• When Should You Use Due Diligence?

• Types of Due Diligence

• Background to Due Diligence

• Emerging trends in Due Diligence

Why is Due Diligence Important?

The purpose of due diligence is to thoroughly assess and verify all relevant aspects of a potential transaction, investment, or decision to ensure that risks are understood, opportunities are accurately evaluated, and informed decisions are made. 

Specifically, due diligence aims to:

Identify and mitigate risks

The main aim of due diligence is to uncover any possible risks associated with the partnership, investment or transaction. This can include financial risks, such as hidden liabilities or debt; legal risks, such as pending litigation or non-compliance with regulations; and operational risks, such as supply chain vulnerabilities or management issues. By identifying these risks early, due diligence allows the involved parties to make informed decisions about whether to proceed, renegotiate terms, or abandon the deal altogether.

Validate information

Due diligence aims to verify the accuracy and completeness of the information provided by the other party. Whether it's financial statements, legal documents, or operational data, ensuring that all details are accurate is crucial for making a sound decision. This verification process helps to confirm that the transaction or investment is based on solid, reliable information, reducing the likelihood of unpleasant surprises later on. This also ensures that decisions are based on thorough analysis rather than assumptions and information which may or may not be true.

Assess value

Another critical aim of due diligence is to determine the true value of the transaction or asset in question. This involves evaluating all relevant factors, including financial performance, market conditions, and potential for future growth. By accurately assessing value, due diligence ensures that the price or terms of the deal are fair and reflective of the actual worth of the asset or business, protecting the interests of the buyer or investor.

Ensure legal and regulatory compliance

Due diligence is a strategy for avoiding legal complications and financial losses. By uncovering potential legal issues, hidden liabilities, or irregularities in financial statements, it ensures compliance with applicable laws and regulations. This proactive approach helps prevent legal disputes and financial setbacks, protecting businesses from unnecessary risks.

Improve negotiation leverage

Once armed with information from due diligence, parties are in a stronger position to negotiate terms which might be more favourable to them. This could include adjusting the purchase price, renegotiating contract terms, or securing additional collateral. 

Avoid future conflicts or legal disputes 

Due diligence helps to identify and address potential issues before they escalate into disputes or legal conflicts. By ensuring that all aspects of the transaction are clearly understood and agreed upon, due diligence minimises the risk of misunderstandings, contractual breaches, and future litigation.

When Should You Use Due Diligence?

Due diligence is usually conducted before entering into a business relationship, investment or transaction, and so is necessary for a wide range of scenarios. The most usual scenarios are included below: 

Investment decisions

Investors carry out due diligence on a company or asset to assess its financial performance, the potential returns on their investment, and any risks associated with the investment. Conducting due diligence prior to making an investment can also inform investors as to whether the company or asset abides by all relevant regulations and laws so that the investors are not subject to fines or legal action once they’ve completed their investment.

Mergers and acquisitions

When a company is considering merging with another organisation, the company performs due diligence to understand the other party’s history, financial standing, assets, operations and workforce. The aim of this due diligence is to identify and assess any risks associated with the merger, such as unpaid debts, and determine whether the merger is likely to benefit the company. 

Entering into a business partnership 

A business or individual considering a partnership or joint venture with another business conducts due diligence to understand all aspects of the potential partner and their business, including reputation, financial stability, and adherence to compliance and regulations.

Employment screening

Employers may carry out due diligence on a potential candidate to verify their suitability for the position and assess the risk associated with hiring the candidate. This may include verifying the candidate’s identity, employment history, employment eligibility and qualifications/education; and also conducting credit checks, criminal background checks (e.g. DBS checks), and assessing their social media and online presence. 

Compliance and regulatory audits

Compliance due diligence can be carried out by a range of parties, including the company itself, government agencies, investors, partners, banks, and third-party auditors. It entails the thorough investigation, audit, or analysis of a company’s compliance with regulatory bodies, both governmental and non-governmental. It essentially seeks to establish whether the company operates within legal and ethical boundaries.

Financial transactions

Any financial institution that lends money or credit lines, including for e.g., a bank reviewing a mortgage application, is required to conduct due diligence on the borrower’s credit history, income and assets, to determine whether the borrower can afford the repayments on the loan, and the level of risk associated with providing credit to the borrower.

New vendor/supplier relationships

A business which is considering a new supplier or vendor relationship may conduct due diligence on the potential partner to assess their suitability as a supplier and detect any risks associated with them such as exposure to litigation, unethical practices, regulatory violations and anything which may impact the continuity of the suppliers operations in the future.

Types of Due Diligence 

There are numerous types of due diligence to consider prior to finalising an investment, partnership or transaction. Some of the main types of due diligence include legal, financial, commercial, human resource, operational, tax, customer and intellectual property evaluations. These are summarised below:

Legal due diligence

Evaluates the legal aspects of a transaction or partnership, including contracts, legal liabilities, compliance with laws, and any ongoing or potential litigation.

Financial due diligence

This involves reviewing a company’s financial statements, assets, and liabilities to ascertain its financial performance, economic viability, and to identify any financial risks.  

Commercial due diligence

Assesses a business’s market position, competitive landscape, customer base and strategic viability in order to evaluate its commercial potential.

Human resource due diligence

Particularly used in mergers, acquisitions, or partnerships, human resource due diligence involves a thorough examination of the company’s workforce, including employment practices, employee contracts, compliance with labour laws, and overall culture of the workforce.

Operational due diligence

Involves examining the operational aspects of a business, including supply chain, production processes, IT systems, and overall efficiency. This type of due diligence ensures that the company’s operations are stable and sustainable, and set up for success post-transaction.

Tax due diligence

Involves reviewing a company’s tax structure and compliance with tax regulations, to understand what taxes it will be liable for if it conducts an M&A transaction, i.e. if it is combined with another company.

Customer due diligence

Banks and other financial institutions are required by law to implement CDD processes, but any organisation that could be used to facilitate money laundering may use CDD checks. This type of due diligence involves verifying the identity of a customer, assessing their risk profile, and ensuring compliance with relevant laws and regulation relating to money laundering, fraud and terrorism financing.

Intellectual property due diligence

Involves an in-depth assessment of a company’s intellectual property assets, including the evaluation of patents, copyrights and trademarks. This type of due diligence aims to prevent IP disputes and ensure that IP assets are secured.

Background to Due Diligence 

Legal roots: The phrase ‘due diligence’ originated in the 1930s, however the process itself has been around since at least the mid-1400s. The term’s legal roots are in the United States, where it is defined as “reasonable investigation” in the US Securities Act of 1933. This act was enacted after the stock market crash in 1929, and its main purpose is to ensure that the buyers of securities, such as stocks or bonds, receive complete and accurate information about the securities they are investing in. The act established regulations against dealers who fail to provide sufficient information to investors/buyers. Around the same time, businesses began to recognize the importance of scrutinising financial, legal, and operational aspects of potential partners or targets. 

Development into business practices

Over time, due diligence evolved from a legal concept into a standard business practice. It became essential in transactions such as mergers and acquisitions (M&A), investments, and partnerships to ensure that parties conduct thorough investigations before finalising deals.

Integration with regulatory and compliance frameworks and impact of globalisation

As regulatory and compliance frameworks developed in the late 1900s and early 2000s, the importance of due diligence was further emphasised. Companies and businesses started to implement structured and formal due diligence processes to adhere to compliance rules, laws, manage risks and comply with regulatory requirements. Additionally, international transactions and cross-border partnerships require a more comprehensive understanding of global regulations and compliance requirements. 

Technological Impacts and Advancements 

Online databases 

The development of digital technology has greatly impacted due diligence processes. Businesses now have access to vast amounts of information and greater means to perform in-depth analyses,  which means the thoroughness and efficiency of due diligence has greatly improved. For example, the internet, which did not exist when due diligence first originated, has transformed how much data we can access through online databases.

Social media and online presence analysis

The development of social media and online presence provides new layers of information about companies and individuals to examine, and can help evaluate a company or individual’s reputation, customer feedback, and any potential reputational risks from questionable online content or public perception.

Use of artificial intelligence

Artificial intelligence and advanced data analytics has resulted in due diligence technologies which can process huge amounts of information, identify patterns and predict risks for investors and businesses. 

Emerging Trends in Due Diligence 

Focus on environmental, social and governance (ESG) factors

As there is an increasing emphasis on environmental impact, social responsibility and governance practices across the globe, businesses and investors are becoming more aware of the long-term benefits and importance of having good ESG performance. This trend is also driven by developing ESG regulations, such as, for example, a company’s climate risk analysis

Digital and cybersecurity considerations

Although digital technologies can aid the due diligence process, it also means businesses need to perform due diligence on a company’s cybersecurity measures, data protection processes and overall IT infrastructure to prevent data breaches and cyberattacks. 

Regulatory and compliance due diligence

Due to a heightened regulatory scrutiny across various sectors, there is a stronger focus on assessing compliance with laws, regulations, and industry standards. This includes assessing a company’s anti-corruption measures, anti-money laundering (AML) practices, and adherence to international trade laws and labour laws, particularly in cross-border transactions.

Growing complexity of sanctions regimes 

Due to geopolitical conflicts, human rights abuses and other global issues, various countries and organisations have imposed sanctions on other countries, entities or individuals, meaning engaging with sanctioned parties is typically illegal and would result in fines or restrictions for the business which engaged with them. For this reason, conducting due diligence to understand whether a party is subject to sanctions or has any affiliation with sanction entities is crucial. 

Conclusion

Due diligence is a fundamental process in making informed decisions across a variety of business contexts. By examining and verifying information related to investments, transactions, or partnerships, due diligence can uncover potential issues early, thus enabling businesses and investors to reassess their potential engagement or renegotiate the terms. Emerging trends, such as the growing focus on ESG factors, cybersecurity considerations and new regulatory structure and global sanctions regimes, further emphasise the need for robust due diligence processes.