A recent New Zealand case has highlighted the need for prospective purchasers of a business to have an understanding of the industry in which a potential target operates before making an acquisition. While the majority of purchasers will undertake financial and legal due diligence in relation to a target, such enquiries are usually limited in scope and focused exclusively on the operations of the relevant entities rather than general industry issues. For due diligence to be truly effective, it is important to be aware of any practical issues that may not be evident from a review of the written documents and financial reports provided as part of a formal due diligence process.

In the New Zealand Court of Appeal case, a purchaser had no recourse against the seller of a wholesale liquor distribution business where a significant component of the target business effectively disappeared shortly after settlement. The target business supplied liquor, including beer, directly to a range of bars. A number of these bars had exclusive arrangements with a major beer manufacturer which prevented them from acquiring beer from other suppliers. The beer manufacturer had granted a number of these bars waivers to permit them to acquire products from the target business.

Shortly after completion of the transaction, the beer manufacturer withdrew these waivers and sought to enforce the exclusivity of their arrangements with the bars. As a consequence, the bars were unable to acquire further products from the target business which instantaneously and significantly reduced the value of the target business. The purchaser was unsuccessful in its claims against the seller for breach of warranties on the basis that these arrangements were not disclosed during due diligence. The issue for the purchaser was that the target business was not a party to the contracts in question and the court accepted the seller's evidence that it had no knowledge of the exclusive arrangements.

While the seller may not have been aware of the arrangements, the court noted that these arrangements were relatively common in the industry. If the purchaser had a greater understanding of the industry, the risk that customers of the target business were tied to exclusive arrangements with third parties could have been identified earlier and dealt with during the transaction process.

Due diligence is the process of investigating a business so that a prospective purchaser can make informed decisions as to:

  • whether to proceed with the purchase
  • the price to be paid, and
  • the structure of the transaction.

The example in the above case is the type of issue that can be easily overlooked during a due diligence process as it would be generally beyond the scope of inquiries that a purchaser would instruct its advisers to undertake. It demonstrates the importance of understanding the industry in which a target business operates to enable the identification of the key risks to the ongoing success of the business.

Effective due diligence is an important step in any acquisition but it can be a very expensive and time consuming task if it is not properly scoped before the process commences. From a legal perspective, it is important to focus on issues that are material to the operation of the particular business to ensure that the due diligence conducted is cost effective and the results are relevant and useful.

Engaging advisers (both financial and legal) that have an understanding of the industry in which a business operates will ensure that the process is as efficient and cost-effective as possible. However, any such due diligence needs to be supplemented with a degree of commercial/industry due diligence to be truly effective and to ensure the results can be seen in context.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.