Defence M&A – Navigating due diligence

Introduction

With the UK Government committing to increase investment in the defence sector, private investment in deep technology and defence firms is likely to see a significant rise in the coming years. This, coupled with direct Government investment in start-ups and scale-ups; a ringfenced budget for UK defence innovation; and a commitment to investment in new technologies, is likely to result in buoyant activity in the defence sector. You can read more about this in our ‘Investment in defence and security – The lay of the land’ article here.

Due diligence is a key component in any corporate transaction, allowing buyers and investors to make an informed assessment of target company’s value, and to identify and quantify risks. The process involves the sharing and reviewing of financial, operational and legal information and is often carried out by specialist advisors.

For transactions in the defence sector, the sensitive nature of the information involved can add a layer of complexity to the process, and whilst many prospective investors will have prior experience in the defence industry, careful consideration to any sensitivity restrictions should be given at the outset of the transaction process.

Due diligence in the defence sector

Customer and supplier contracts form a core part of any operational and legal due diligence, as these arrangements typically inform the revenue and profitability of an acquisition target. Legal due diligence will also be carried out on core contracts to identify any potential liabilities or risks. In the defence sector, such contracts (along with employee details, systems data and intellectual property) may be highly sensitive and not readily disclosable.

In the UK, government bodies use the Government Security Classification (“GSC”) system to manage classified information. The GSC has three levels: OFFICIAL, SECRET, and TOP SECRET. Additional security regimes may apply, such as Facility Security Clearance (“FSC”).

As a result of such security regimes, the sharing of certain documents and information may be restricted during the course of due diligence, with only those individuals with the appropriate security clearances permitted to access (and therefore review and advise on) sensitive information or documents. Anyone operating under such regimes will need to be cognisant of their (and their advisors’) compliance with any security obligations during the course of the transaction process.

Dealing with sensitive or classified information during the due diligence process can be managed in a number of ways:

Restricted sharing: Documents may need to be withheld or redacted to prevent unauthorised sharing of sensitive information. It is important that this process is carried out with a high degree of care and by a security-cleared person, which may be a time-consuming (and expensive). It may also impact the prospective investors’ ability to adequately diligence key information. Similarly, a seller’s ability to fully and fairly disclose against the sale warranties may be hindered by confidentiality restrictions. It is important that prospective investors, particularly those without prior experience in the defence sector, are aware of these limitations and the impact it will have on their due diligence.

Clean teams: Classified information may be shared with specified persons holding the requisite security clearance allowing for controlled, limited due diligence. A “clean team agreement” should be put in place to set the boundaries for secure-sharing of sensitive information.

Secure sharing: If a virtual data room is being used, specialised security measures may be required (such as encryption, security protocols and access restrictions). In some circumstances, the sharing of information electronically (even through a secure virtual data) may be prohibited and physical onsite reviews, carried out by security-cleared personnel in a secure environment, may be required.

Vendor due diligence: If the buyer or its advisors are unable to review and report on sensitive information, the seller may prepare a vendor due diligence report in a form that can be shared. A buyer or investor is likely to request reliance on the report, and the level of reporting will be restricted by the applicable confidentiality restrictions.

Specialist advisors: Advisors who hold the appropriate security clearances, and have compliant IT systems and security protocols, should be engaged in connection with defence M&A. This will allow for more robust due diligence on sensitive information whilst ensure adherence to the applicable restrictions. Parties entering into a transaction process should check, prior to instructing professional advisors, that they have the requisite security clearances and expertise.

W&I insurance: Considerations in defence M&A

Warranty and indemnity (“W&I”) insurance policies are increasingly popular in UK transactions, allowing vendors to achieve a “clean break” and providing comfort to buyers and investors that there is sufficient covenant strength behind warranties and indemnities.

In sectors where due diligence and disclosure is limited due to confidentiality restrictions, there are additional considerations when taking out a W&I policy:

Coverage: Underwriters will typically only cover areas which are shown to have been subject to robust due diligence and disclosure. This can be challenging where, as set out above, the sharing of information is limited by security restrictions. Ensuring that steps are taken to allow, where possible, thorough due diligence to be carried out will be key to securing a high-level of W&I insurance coverage. The warranties and indemnities will also need to be carefully tailored to reflect to limitations of the disclosure process. Where full policy coverage cannot be secured, sellers may be asked to stand behind certain warranties or, if the buyer/investor is experienced in the sector, they may be willing to proceed with more limited warranty protection.

Validation of claims: Insurers are likely to only pay out under a W&I policy where they can validate a warranty claim. This may be challenging where the subject matter of the claim is sensitive and cannot be readily disclosed in a litigation process. Those negotiating the sale warranties should be mindful of this and the W&I insurer should also be asked to confirm whether they have access to, and are willing to engage, professional advisors with the requisite level of security clearance in the event of a claim.

It is important to discuss the above limitations with the W&I broker early in the process, to ensure that the due diligence process and limitations are understood and agreed, the warranty coverage is sufficient and any other concerns of the underwriter are addressed early to avoid delays in the transaction.

Conclusion

Burges Salmon has extensive experience in the defence sector, providing legal advice to both governments and private organisations. Our expertise spans across maritime, air, land, and communications & cyber domains. We offer specialist legal advice on UK Government defence contracts, defence procurement law, defence infrastructure, mergers and acquisitions, investments and regulatory matters.

If you would like any further information, or advice related to any of the information in this article, please contact Alex Lloyd, Chris Doherty or your usual Burges Salmon contact.

Here is the first and second articles in our mini-series.