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This article is written by Prachi Gupta, pursuing Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho.

Introduction

Artificial Intelligence (AI) is no longer related to a two decades old movie of Steven Spielberg or a decade old wild child of some random startup. It has taken over our lives and is present all around us. The phenomenal speed with which AI is growing, from driverless cars to our phone voice assistants, is all set to take over the legal industry. 

AI is being increasingly adopted by various law firms and lawyers for mining documents, reviewing and creating contracts, searching for red flags and aiding in due diligence in, but not limited to M&A transactions. 

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The M&A market has continuously seen an upward trend in the past decades. M&A is no longer just limited to larger firms but smaller businesses are also increasingly, getting involved in M&A as a means to gain access to new products and markets and capitalize on economies of scale. The pandemic also could not affect M&A deals much. According to a PWC report, the M&A deals are expected to remain strong in the next half of the year. It also states that the deals are all set to outpace the previous year’s deal volume. Thus, M&A is a fast-growing sector of the legal industry. 

The process of due diligence in an M&A transaction has played a significant role in the success of the transaction in the past decades. It is such a process that can either make or break a deal. The integration of AI and M&A has made the process of due diligence time effective and has thus helped in providing cost-effective services to the client. It has automated the manual and laborious process of reviewing thousands of documents. 

Considering the significance of due diligence in an M&A transaction, it is of substantial importance to consider the risks posed by the automation of this process. Thus, in this article, I have tried to incorporate the risks posed by the use of AI in M&A due diligence.

What is artificial intelligence (AI)?

The term ‘artificial intelligence” is a vast concept that is used to describe a technology that enables machines to carry out tasks that require a human resource, in ordinary circumstances. To achieve this, AI requires the development of software through which a machine can copy the various intricacies of the human thinking process. 

Artificial intelligence is generally categorized into two types: 

  • Narrow AI 

Narrow AI refers to the ability of a machine to perform narrowly defined tasks by applying a limited artificial cognitive function. One such example of Narrow AI is the virtual assistant Siri. It has the abilities of speech recognition and browsing the web in response to queries. 

  • General AI

General AI is more advanced and is programmed such that it can take actions in situations that are different from the possibilities already programmed in its database by carrying out more sophisticated reasoning. Thus, General AI enables a machine to not only respond to predefined response triggers but also perform in situations that require high order thinking, which includes creativity, innovation and improvisation. 

AI and mergers and acquisition 

In the recent research by the Gartner Group, the average time in finalising a mergers and acquisition transaction has soared by more than 30% over the last decade. One of the most prominent issues with M&A deals are due diligence which involves reviewing thousands of documents, making it a time-consuming process. This is not only a manual and laborious task for lawyers but also requires highly skilled and experienced staff to repetitive, lower-value responsibilities when they could instead be contributing to other valuable tasks. 

However, law firms have been increasingly adopting Artificial Intelligence which has changed the whole scenario. With the use of AI, it is suddenly possible for lawyers to review over 3,000 documents in an hour which earlier was about 50-100 documents per hour. This has not only increased the efficiency of the process but also enabled lawyers to deliver the same work at a much lesser cost compared to the cost of the projects where the documents were reviewed manually. 

AI technology is nowhere near sophisticated enough to replace human resources but it can still add value. The M&A due diligence process, aids in automatically collecting and analyzing legal documents, redacting proprietary information and confidential HR information, etc. 

What is due diligence?

In order to decide if an investment or a business purchase would prove profitable in future, due diligence is carried out as it reveals any kind of potential liabilities or risks. 

Due diligence is a process that involves reviewing the documents of the target business and interviewing the employees of the business. This process concludes when a business or investor is interested in buying or investing in the target business. 

Due diligence investigation seeks details about the business to ensure that investment or purchase would be beneficial. The primary objective of this due diligence process is to reveal all important facts, risks and any potential liabilities. Once the facts are collected and analyzed, an informed decision can be made. 

Significance of the process of due diligence in M&A

Mergers and acquisitions (M&A) is a tool used for various strategic business reasons like diversifying products or services, gaining a competitive advantage in the market, increasing capabilities and reducing costs, etc. To achieve such strategic objectives through an M&A deal, a proper due diligence investigation is the most important part of this transaction. 

A due diligence process is an investigation process in which the lawyers of the acquiring company review several documents of the target company with the principal objective of identifying any liabilities, risks or opportunities acquiring or merging with the target company. 

Due diligence can encourage such a transaction, prevent it or even ruin it, as it has been seen in thousands of M&A deals. The process of due diligence is significant because it enables the stakeholders in understanding the synergies and the potential scalability of the business after the merger/acquisition. 

Issues arising from the usage of AI in M&A due diligence 

While AI is considered a blessing in the process of due diligence, it is not without a set of risks. 

Technical shortcomings

If the documents are not highly standardized and unambiguous, failure of the algorithm or inadequate machine learning can result in errors and misrepresentations. 

Security risks

Cybersecurity risk is unavoidable with the adoption of any kind of new technology. In the process of due diligence, there are documents with highly confidential information and in an M&A setting potentially highly market-sensitive stored in the data room which could be exposed in case of a cybersecurity breach. 

To avoid such risk, the M&A would have to add AI to their informational technology due diligence list. It would be a must to ensure the security and sophistication of AI technology. This would include not only the ones implemented by the target company but also the AI used by its vendors, suppliers and sometimes even customers. This is because, in a business ecosystem, all the systems interact with each other. Any kind of Ai technology being used in the supply chain can have an impact on the target and thus, the acquirer. 

With the recent introduction of the European Union’s General Data Protection Regulation (GDPR), there have been significant changes in the importance of data protection compliance with respect to M&A transactions. Therefore, the process of due diligence of a target company needs to abide by certain new requirements and standards. In case of any breach in complying with the GDPR regulations, buyers may face serious repercussions.  

The repercussions of non-compliance are not just limited to fines but also include associated costs, such as legal fees and litigation costs. Such instances of non-compliance can also lead to potential reputation damage and an impact on the market standing of the business. Moreover, such non-compliance can also lead to lawsuits and claims by individuals for material and immaterial damages, which can be as equally expensive as the fines levied by the regulators. This is a consequence of the potentially large number of individual claims. The authorities also have significant powers like on-site GDPR audits and the issuance of public warnings.

Breaches of privilege

In various jurisdictions, the review by AI of certain documents could amount to the breach of attorney-client privilege. This risk is of substantial importance in the case of cross border M&A deals. 

AI also poses certain questions like who is to be blamed in case of erroneous document review? In case of any missing clause, mis-referenced definitions, incorrect references/price predictions, all risk claims. In such a situation, a client will always look to their lawyers. This would require law firms to have contracts with the third party-tech company to bear the liability. Moreover, does the tech company have substantial resources and insurance to compensate for the losses?

Due diligence requires extensive review and investigation of documents. An overreliance on AI could lead to situations wherein certain information is missed in the process of extraction of information from the documentation. This will not only lead to poor quality outcomes but have grave consequences and risk clients to huge losses. 

Conclusion 

Over the years, there has been a substantial increase in the number of M&A deals across the globe and so has the complexity of such deals. To deal with such complexities, businesses have seen greater adoption of technology and innovative software in order to facilitate the deal-making process. There has also been a significant increase in technology acquisitions aimed at gaining digital capabilities. The M&A field also witnessed the adoption of such technology in the form of AI to ease their cumbersome due diligence process.

Due diligence is plausibly the most important and time-consuming process in an M&A transaction. Sourcing, supplying, and gathering thousands of documents manually is a huge task. The incorporation of AI has helped in adding speed to this process. However, the risks through such automation cannot be ignored. The automation of due diligence has posed issues like erroneous results in case of any error in the software, breach of contract between client and attorney in case of any leak of confidential information of the client, cybersecurity risks, etc. Not only this, AI technology is intense in the use of capital and human resources. Therefore, one not only needs to incur the expenses of the software but also, the human resources. 

Thus, considering the issues and expenses in the integration of AI in M&A due diligence, it can be concluded that advanced technology cannot be considered a substitute for human resources. It is just a force multiplier that can help people turbo-charge their work and get deals done faster, more efficiently, and often at lower costs. 

References

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