2020 M&A Forecast - Due diligence: A green flag for 'Red Flag' reporting

The nature of New Zealand’s legal due diligence
is changing, and it’s about time. Throughout
2019 we have seen ever-more targeted due
diligence exercises, and shorter and shorter
due diligence reports.

‘Red flag’ reporting is fast becoming the norm and
we expect that this will continue in 2020. Given that one
of the main themes of this year’s forecast is that buyers
are becoming more cautious, this trend might seem
counter-intuitive. However, while ‘red flag’ reporting
may seem less thorough, if it is correctly carried out,
it is not.

Traditional legal due diligence reporting involves a full
review of all the relevant legal documentation made
available by the seller and then the preparation of a
report that summarises that information, regardless of
whether there are any legal issues.

This typically means the creation of an executive summary
highlighting material issues that have been discovered,
and reams of schedules detailing everything else. In reality,
most clients do not see particular value in anything other
than the executive summary and this is now being reflected
in ‘red flag’ reporting – where lawyers still review all the
documentation, but only the material issues that have
been uncovered are reported on.

Clients still have the comfort that a thorough exercise has
been carried out, but the shorter nature of the report has
some real advantages. There is significant time and cost
involved in preparing a fulsome report that summarises
non-material information already available to clients.
‘Reg flag’ reporting significantly reduces that cost (with
no corresponding increase in risk). It also shortens the
timeframes needed to get the reports to the people
who need them.

For ‘red flag’ reports to be of real value, there are
a couple of golden rules:

Rule 1: It is vital that the scope of the review remains
thorough and that this is accurately reflected in the
report. Readers need the comfort that all relevant bases
have been checked, even if the body of the report doesn’t
address them (i.e. because no issues were found). This
is particularly the case where warranty and indemnity
insurance is being purchased. Insurers will want to see
that a proper exercise is being carried out. They won’t be
phased by a short form report, provided that there is a
section outlining the scope of the review in detail.

Rule 2: It is important to be very clear about the level of
materiality that is being set for the report. Traditional
reports contain everything but the kitchen sink. A true
‘red flag’ report needs to be much more focused on
materiality and so there can be no ambiguity when it
comes to the client’s expectation about what will be
reported on and what will not.

While there are often very good reasons to conduct more
detailed reporting on specific, identified issues, we think
that in the majority of cases, ‘red flag’ reports provide
significant and cost-effective comfort. We expect to
prepare more ‘red flag’ reports in 2020.

We also expect due diligence exercises to more often
include environmental, sustainability and governance
(ESG) reviews, particularly in larger transactions.

Read the Full Merger and Acquisition Forecast

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