Chapter 11: Governance of Funds and Due Diligence — Short Notes (Part One: Pre-Investment Due Diligence & Definitive Agreements)

This is Part One of the comprehensive study notes for Chapter 11: Governance of Funds and Due Diligence. To ensure maximum clarity, depth, and ease of learning, the chapter has been structured into three logical parts:

• Part One (This Section): Section 11.1 (Investor Due Diligence / Due Diligence Review) and Section 11.2 (Definitive Agreements).
• Part Two: Section 11.3 (Regulation on Governance Structure in AIFs).
• Part Three: Sections 11.4 to 11.7 (Role of Human Capital, Co-investments, Code of Conduct, and Industry Best Practices).

11.1 Investor Due Diligence (IDD) / Due Diligence Review (DDR)

In the context of Alternative Investment Funds (AIFs), Investor Due Diligence (IDD)—interchangeably referred to as a Due Diligence Review (DDR)—is a rigorous process of investigation and verification performed by the AIF’s investment manager on a potential investee company before finalising and executing an investment.

💡 Exam Alert — Terminology Clarification: Even though the term contains the word "Investor", in this specific context, the workbook defines IDD/DDR as the due diligence performed by the investor (the AIF manager) on the potential investee company.

The Trigger for Due Diligence

The due diligence process is highly structured and resource-intensive. Consequently, the due diligence process does not commence unless a preliminary Term Sheet has been formally executed by both the AIF manager and the target investee company.

The Three Core Components of Due Diligence (DDR)

To take an informed, risk-adjusted investment decision, the AIF investment manager conducts a comprehensive examination of the target company's facts, representations, and internal affairs. This review is categorized into three specialized pillars:

Deep-Dive: The Financial Due Diligence Review (DDR)

The Financial DDR acts as a comprehensive financial health check of the target entity, typically spanning at least the past three financial years. Its core objectives include:

• Verifying Accuracy & Fair View: Ensuring that the books of account and financial statements present a true and fair view of the target’s financial position.
• Information Memorandum (IM) Validation: Verifying all oral and written financial representations made by the company's management in its IM and marketing materials.
• Unearthing Hidden Liabilities: Identifying undisclosed material financial information, off-balance-sheet exposures, or historical discrepancies that could adversely affect the fund's investment decision or the agreed-upon business valuation.
• Vetting Projections: Vetting the target’s forward-looking financial forecasts and setting realistic, verifiable financial milestones for future capital payouts.
• Comprehensive Tax Audit: Reviewing the company’s direct and indirect tax records, filings, and assessments. This evaluates potential exposures to impending tax demands, penalties, or active tax-related legal proceedings.

Deep-Dive: The Legal Due Diligence Review (DDR)

Legal DDR ensures that the AIF is fully protected from regulatory infractions, ownership disputes, and contract breaches. The scope primarily encompasses:

• Intellectual Property Rights (IPR) Protection: Verifying the ownership, validity, and registration of patents, trademarks, copyrights, and proprietary software/processes.
• Contractual Relationships: Examining the legal implications of material contracts, joint ventures, and agreements entered into by the company with third parties.
• Outstanding Litigation: Identifying active, pending, or threatened lawsuits and estimating their potential financial and reputational impact on the target company.
• Statutory Compliance & Defaults: Checking for defaults under corporate, labor, environmental, and securities laws, and assessing the robustness of the target's compliance mechanisms.
• Note: Compliance and regulatory checks may occasionally be delegated to a practising company secretary or integrated within the Financial DDR scope.

The Practical Workflow of Due Diligence

Step 1: Ingestion via the Virtual Data Room (VDR)

The investee company initiates the process by uploading highly confidential corporate and financial records to a secure digital repository known as a Virtual Data Room (VDR). The IDD teams review a broad array of documentation:

• Constitutional & Governance Records: Memorandum and Articles of Association (MoA & AoA), board meeting minutes, and corporate resolutions.
• Financial & Tax Files: Detailed segment financial information, books of account, tax returns, historical audited financials, invoices, and purchase orders.
• Operations & Assets: Owned and leased property agreements, and intellectual property (IP) documentation.
• Human Capital Records: Employee lists, payroll statements, and key employment agreements.
• Regulatory Filings: Statutory filings with registrars, tax authorities, and other sector-specific regulators.

Step 2: Management Discussion & Brainstorming

The IDD team establishes a consultation schedule with the target company's officers. Under the supervision of investment bankers, follow-up due diligence calls are conducted with executive and non-executive management to clarify anomalies. The deal team uses these findings to brainstorm critical issues, identify risks, and structure necessary Conditions Precedent (CPs).

Step 3: Reporting & Communication

Upon completion, the external agencies present formal, confidential DDR reports to the AIF investment manager.

• Confidentiality Rule: A copy of the formal DDR report is not shared with the target investee company.
• Clarification Lists: If discrepancies are found, the manager extracts relevant sections or compiles a separate observation list for the investee company to respond to and discuss.

Post-Due Diligence Actions

1. Refining the Financial Model

Armed with realistic, verified data from the DDR reports, the investment team refines its valuation and financial models. They replace aggressive management projections with realistic assumptions based on key business drivers, such as:

• Price and sales volume.
• Raw material costs.
• Number of operating branches or active customers.
• Customer renewal and retention rates.
• Fixed vs. variable cost structures.

This granular model provides the AIF manager with a clear framework to establish key performance deliverables, monitor execution, and maximize exit returns.

2. Re-negotiation of Terms

DDR disclosures frequently reveal misalignments, which prompt the AIF manager to re-negotiate the original term sheet. Typical areas of re-negotiation include:

• Revising the company's valuation downwards.
• Demanding additional disclosure statements.
• Strengthening Representations and Warranties (R&Ws) from the company's founders, promoting shareholders, and key management team.

The renegotiated and newly executed final term sheet forms the legally binding foundation for drafting the definitive transaction agreements.

11.2 Definitive Agreements

Once the due diligence process concludes and terms are finalized, the parties execute Definitive Agreements. These are legally binding, comprehensive contracts signed between the target investee company and the AIF investment manager (acting on behalf of the fund) to complete the transaction.

Key Definitive Agreements

The core transaction suite consists of several highly negotiated documents:

1. Share Subscription/Purchase Agreement (SSA/SPA): This is the primary transaction document executed in equity-based investments. It details the mechanics of how the AIF subscribes to new shares or purchases existing shares from selling shareholders, including the pricing, tranches, and payment terms.
2. Subscription Agreement: A legally binding contract executed to finalize the fund's capital contribution and allocation of securities in the investee company.
3. Shareholders’ Agreement (SHA): Defines the relationship between the AIF and the founders/other shareholders, governing key rights such as board seats, veto rights on critical decisions, right of first refusal (ROFR), tag-along rights, and exit covenants. (Note: While standard in venture capital and private equity, further operational clauses of the SHA are not explicitly detailed in the provided workbook passages).

Key Risk Mitigation Tool: The Ratchet

Definitive agreements often incorporate protective financial clauses to shield the AIF from valuation risks. A key mechanism is the ratchet, which protects the AIF from a future "down round" (a subsequent funding round at a lower share valuation) by automatically adjusting the AIF’s conversion ratio or allocating additional compensatory shares to prevent equity dilution.

Key Terms & Exam-Relevant Definitions

• Due Diligence Review (DDR): A comprehensive investigation of a target business’s financial, commercial, and legal standing conducted by a potential buyer/investor before executing a transaction.
• Virtual Data Room (VDR): A secure online repository utilized for storing and sharing sensitive corporate documents with due diligence teams during an M&A or investment transaction.
• Conditions Precedent (CPs): Legal conditions that must be fulfilled or waived by the target company before the investor is obligated to transfer the investment amount.
• Representations and Warranties (R&Ws): Highly negotiated, formal statements of fact made by the founders and target company in the definitive agreements regarding the state of the business, finances, and legal compliance.
• Ratchet: A contractual anti-dilution provision designed to protect an investor’s equity stake from losing value in subsequent lower-priced financing rounds.
• Down Round: A private funding round in which an investee company raises capital at a lower valuation per share than in its previous funding round.

Key Takeaways

1. Term Sheet First: Due diligence cannot legally or practically begin until a preliminary, non-binding term sheet has been signed by both parties.
2. Multidisciplinary DD: A robust DDR must evaluate commercial, technical, financial, and legal aspects concurrently. While commercial/technical DD is often handled in-house, financial and legal DD are typically outsourced to specialized firms.
3. Financial DDR Depth: Financial DD must review a minimum of three historical financial years and rigorously validate both past statements and future tax exposures.
4. No Direct Report Access: Target companies are never allowed access to the full, confidential DDR report; they are only provided with specific observation lists or extracted queries.
5. Refined Models Over IM Projections: Smart AIF managers always rebuild the target's financial model using realistic cost and revenue drivers unearthed during the diligence process.
6. Binding Transaction Documents: Definitive agreements (such as the SSA, SPA, and Subscription Agreement) replace the non-binding term sheet and are heavily modified by IDD findings, including the incorporation of anti-dilution ratchets.