Information Economics and the Due Diligence Process

Due diligence is fundamentally an information acquisition process. Economic analysis of information markets provides insights into how this process should be structured and when additional investigation is warranted.

The Information Problem

Asymmetric Information

Sellers possess superior information about target companies. This asymmetry creates adverse selection risks—the possibility that sellers offer only lemons while retaining valuable assets.

Verification Costs

Information is costly to acquire and verify. The optimal level of due diligence balances the benefits of additional information against these costs.

Optimal Search Theory

Marginal Analysis

Due diligence should continue until the marginal cost of additional investigation equals the marginal benefit in terms of reduced risk. This principle, while simple in theory, requires careful application in practice.

Diminishing Returns

Initial due diligence efforts typically yield high returns as major issues are identified. Subsequent investigation faces diminishing returns as remaining issues become smaller and harder to detect.

Option Value

Due diligence creates option value by allowing buyers to abandon transactions when problems are discovered. This option is more valuable when uncertainty is high and abandonment costs are low.

Strategic Considerations

Signaling Through Process

A seller's cooperation with due diligence conveys information. Resistance to reasonable requests signals potential problems; excessive cooperation may signal desperation.

Competitive Dynamics

In auction processes, due diligence time is limited. Buyers must allocate investigation resources strategically, focusing on issues most likely to affect value.

Contractual Allocation

Representations and Warranties

R&W provisions allocate information risk between parties. Extensive representations shift risk to sellers; limited representations shift risk to buyers. The allocation reflects relative information advantages and bargaining power.

Indemnification

Indemnification provisions provide post-closing remedies for breaches. The scope and duration of indemnification reflects the parties' assessment of residual information asymmetry after due diligence.

Conclusion

Effective due diligence requires understanding the economics of information acquisition. Mechanical checklists are no substitute for strategic thinking about where information asymmetries are most likely to create value-relevant risks.