Delving into the private lives of individuals is probably not uppermost in the minds of venture capital firms when they consider making an investment, but many hire the services of reputational due diligence providers to do just that. Since the collapse of Arthur Anderson, the burst of the high tech bubble and corporate scandals at Enron and Worldcom, it is tempting to suggest that investor groups have adopted this new layer of hawkishness. But investigative firms have been around for a while. Nigel Layton, chief executive of Quest, a firm which among other things uses publicly available information to construct databases to screen the probity of any party to an investment, explains: “Enron was less of a trigger than the collapse of Arthur Anderson, which really raised concerns about probity. The increase in demand for services such as ours existed before the collapse of Enron and more importantly Arthur Anderson, but these events have provided certainly a catalyst.”
Fittingly, this investigative strain of due diligence originated in the US, where Layton estimates it is commissioned on 50 per cent of all transactions. In the UK, he puts it around the 30 per cent to 40 per cent mark. It has long been required in large M&A deals, and was a feature of hostile takeover activity in the 1980s, where sharp practices involved digging for dirt on executives prior to leaking it to the press. But Layton’s work is more forensic, and not for public consumption. “We are approached on a confidential basis, and absolutely respect that confidentiality. We act on wishes of the private equity house, which may have heard a rumour about a specific individual, may be dealing with a completely unknown management team, or may simply have a gut feeling that something is not quite right. We are not there to scupper the deal. Most of the time, the report we produce does not cause a deal to collapse, but I would say in approximately 10 per cent of transactions the terms of the deal may change on the basis of our findings.”
This is the more edgy end of due diligence, but it underlies the vital importance of knowing as much as possible prior to a deal being done. In an ideal world investors will have access to every relevant piece of information to ensure they are making a sound investment. Their access to this information will be cheap to obtain and not delay the completion of the transaction. In order to expedite this ideal process, VCs will turn to the services of an accountancy firm because with one or two exceptions, they can provide all the solutions under a single roof. This ideal scenario does not exist, not only because accountancy firms cannot cater for every single type of due diligence enquiry, but because the world no longer works in that way.
While the importance of an auditor’s report has not receded, or any of the other tools of financial intelligence required to do the job, VCs now must be able to run the rule over all aspects of the business, from the suitability of management to the viability of the company’s technology platform.
With accountancy firms having spun off their consulting arms, there is less of an opportunity for them to cross-sell their consulting, tax and other technical abilities. But the general whiff of scandal around Anderson has not materially changed the attitude of chief executives towards hiring one firm to perform a series of often conflicting assignments. Hugh Baird, head of UK professional services for W&S Transition, a pan European interim management company, comments: “We have not seen our own business benefit directly from the recent scandals themselves but there may have been a slight shift in perception. However, I believe that there is more caution and a desire for deeper levels of information and comfort delivered independently and without the risk of conflicting interests because the world has changed and we are in a more challenging economic climate.”
In other words, the welter of negative publicity has made investors more hawkish, not about the suitability of accountancy firms, but about whether the business they believe they are investing in actually stands up to the closest possible scrutiny.
Traditionally, cross-selling by accountancy firms has been most prevalent in the UK because of the culture of closeness between a main board and its auditor, which may have developed a wide range of services as an adjunct to a core auditing function. Baird continues: “This has come from the fact that UK boards appear to have a tendency to refer any issues to their auditors with whom they have a close relationship first rather than have to be seen to admit to others e.g. external specialists – that they have an issue. The latter course almost seems to be felt as washing dirty linen in public’ and so is very much a last resort in some organisations’ view. Thus accountancy firms have historically been able to leverage their position at the board table by offering a broad range of non core services on the back of an existing relationship”
Despite the range of services provided by the big three, there are gaps in their expertise which smaller specialist providers can plug. This has little to do with Enron, and more to do with the fact that audit firms are less equipped to provide highly technical, industry and product-specific advice which is the domain of smaller firms. For example, Cambridge Design Partnership has an established reputation as a consulting firm working in consumer, medical and industrial product development. Many of its products have emerged from universities and the company has spun off a couple of its firms. Its track record in developing new products, attracting investment for them, protecting the intellectual property and ultimately bringing them to market led to it establishing a due diligence arm. Mike Beadman, managing director of CDP, says: “We already have strong contacts in the VC community because they invest in our products. In 2000, we were approached by VCs to look at the underlying technology of an investment opportunity. There is a lot of expertise in market and financial due diligence, but less when it comes to evaluating whether the technology is the best possible available.”
This area was neglected during the tech boom because VCs tended to adopt a scatter gun approach to investing and back as many horses as possible. Equally, the desire by start-ups to secure early stage funding was at odds with the traditional development process. Beadman says: “The product development process which we follow with our own innovations is not always followed by others. In a medical technology development we prove it technically then get a small amount of cash in for clinical trials, then move to the next stage which is marketing. Not all firms are this rigorous for a variety of reasons, but technical due diligence can remove this uncertainty.”
Post 1999, there is more caution and start-ups are less able to talk technology up. Even so, the key to some of the more technical aspects of a due diligence audit remains in knowing where to look. A standard legal due diligence audit will protect the intellectual property (IPR), which is a cornerstone of high tech industry, and an issue which has furrowed many brows during the subsequent collapse of the sector. But the standard legal approach will not always be able to take into account more fundamental factors. Beadman points out: “Checking that patents are up to date confirms that a product is unique. But [it] does not necessarily mean that the product is built with the best available technology in the world.”
Evolution is another company with a due diligence business that capitalises on its expertise in the IT sector. Hugh Snelson, manager of the firm’s Investor Services division, which provides technical and operational advice and support on transactions, says: “A legal due diligence report does not always reveal all of what the company owns and what it doesn’t. During one engagement we looked at a target’s technology and realised that it had taken extracts of code from another company. Through no fault of their own, a legal practitioner would have been unlikely to have spotted this. If we had not identified this situation, there could have been legal problems down the line.”
There is a raft of services required by venture capital and private equity firms throughout the life cycle of the investment. The first relates to the initial scoping exercise required when the VC is considering opening its cheque book. Financial due diligence is conducted as a matter of course but it does not answer all of the questions which the investor faces. The investor is concerned with the ability of the existing management team to deliver the investment strategy; whether the company’s products can adequately support the business model; and whether the exit the VC is hoping for is deliverable.
In assessing the suitability of a management team, the VC needs to establish whether the executives in place have the experience to grow a business. Baird comments: “If the transaction in question is an acquisition, the existing executives may be used to managing 10 people perfectly well, but when that number goes to 100, a different set of skills may be required. This principle can be extrapolated across all facets of the organisation from finance functions, through HR, sales and into production.”
By hiring consultants, the VC will receive a written report which looks at the operational requirements of the business and whether management can deliver them. If the findings are positive, then the green light is given. If not, then the search is on for an executive with the requisite expertise. In many cases, the VC itself may know of a candidate with hands-on experience which can be parachuted into the role. If not, it can rely on search and selection firms which will match the candidate to the criteria of the investment house. Further still, the consulting firm will provide an interim solution in the form of an experienced manager, typically with a long track record in a particular industry. Baird explains: “We are geared towards the provision of short-term, hands-on skills. Chief operating officers, managing directors and other individuals who have held positions of final responsibility come in to provide extra management capacity and sort out short term issues.”
The interim solution is the best way forward when the VC faces a short-term issue. This is likely at a later stage; where the business may be preparing for an IPO, or where it has run into trouble. Baird cites the example of a major UK IT firm with offices around the globe which made an acquisition in the Netherlands. He explains: “Twelve months after the acquisition, the acquired company was proving a drain on company resources both cash’ and human’. Managers kept having to fly over from London to sort out problems, and the Dutch subsidiary was affecting the operating cash flow of the entire group. They needed an interim MD to run the Dutch operation, who went in for six months and turned it around. The client was delighted and has retained the Interim MD on a group wide advisory basis.”
This illustrates the flexibility of the arrangement. The interim manager is contracted to W&S and not the parent company. Thus W&S takes corporate responsibility, fees are agreed upfront and implementation is the watchword.
Rather than receiving a success fee, like other intermediaries, a company like W&S will be paid a flat fee based on the time it takes to complete the assignment. “We do not get extra fees simply for doing our job. We guarantee a level of performance we and the client are comfortable with then by performing, we get a fee. If however our performance is extraordinary there might in exceptional circumstances be a super-success fee’. Heavily weighted success fees run the risk of reliance on the performance of others and an over emphasis on some KPI’s [Key Performance Indicators], as well as being a symptom of the EBDIT philosophy which is becoming so discredited.”
This goes to the heart of the issue regarding whether due diligence adds value. Ideally, the various intermediaries will pool the knowledge they have garnered at the time they gather it so cross-checks can be made. This rarely happens. The VC will typically act as the hub for the entire due diligence process, collect the reports from different sources and decide whether or not to proceed. But the simple logistics of the process means that there are few opportunities – given the notoriously short time frames allotted to due diligence – for specialists to sit around the same table to cross fertilise’ their knowledge. Phil Herbert, managing director of Evolution’s Investor Services division, says: “In one case, when we did sit down with the legal team to discuss an IPR point, both sides discovered separate issues which would not have arisen had such a discussion not taken place.”
This should be a major concern because the more specialists work together, the more watertight the impression the VC can gain of the company. The negative corollary to this is that important issues slip through the net, and all this does is confirm VCs fears that hiring an inordinate number of consultants to pore over the business can be more a waste of money than a benefit. Equally, not all VCs will be responsible for hiring specialists. A firm with a weighty portfolio and a small ratio of directors to investment falls into this camp. These organisations tend to devolve more responsibility to the chairman of the investee company, who may be aware of the wealth of providers, but would be as equally likely to hire a former executive with a profound market knowledge. And in a sense, where the information comes from is not as important as whether it is correct. As Baird puts it: “Every additional piece of relevant information reduces risk.”