Buyout Firms Give Deal Diligence Its Due –

With valuations low and private equity firms flush with cash, the LBO market has seen plenty of acquisitions over the last six months. But unlike the heady days of the late 1990s, this time around the spending spree isn’t coming without countless hours of due diligence, a process that’s always been part of the acquisition process, but has arguably become a higher priority in the last year.

The combination of a tough economy, negative fund returns and a nearly impossible exit market has forced private equity firms to spend more time and money on their portfolio companies, many of which are in a rehabilitation mode. Simply put, they don’t want to add more problems to their portfolio by rushing into a transaction.

“The operating and balance sheet failures of recent years underscore the importance of a thorough analysis of a company’s potential operating plans and its ability to meet debt requirements,” said Rodney Goldstein, a principal at Frontenac Company. Added David Moross, chairman and CEO of Falconhead Capital: “It’s the most critical part of the whole deal.”

While no firm will admit to ignoring or underestimating the process during the late 1990s, the time it takes deals to get done nowadays is clear evidence that buyout shops are taking a closer look at where they’re putting their money. “The late 1990s saw a lot of momentum buying, and there will continue be a shakeout from that,” said Jay Jester, a senior vice president and director of marketing at Audax Group,

To be sure, due diligence is no small task, as estimates in the length range from three to four months, with a bill anywhere from $100,000 to more than $1 million. One pro said the cost can vary widely based on what the company looks like, and when you include the in-house man hours and a possible market study, diligence can get very expensive, and unfortunately there are no shortcuts in getting it done.

But given the senior lending community’s conservative stance, as well as LBO firms’ justifiable fear about adding a bad investment to an already troubled portfolio, general partners say it’s well worth the time and money. “The [due diligence] process has definitely gotten longer. It’s more of a trickle down, as banks need to do more work before they’re comfortable,” said Chris Pike, a partner at Advent International.

Pressure On Returns

With the recent decisions by CalPERs and UTIMCO to make public their private-equity investment performance, the pressure to produce returns has never been more acute. Also, with firms contributing a greater equity portion into acquisitions than in the past-and even higher multiples for certain companies-LBO shops today have a lot to lose if an investment goes sour.

“No question [due diligence] is harder to do now,” said Philip Canfield, a principal at GTCR Golder Rauner. “When you look at instituting operating improvements, you’re trying to understand a what-if scenario, which is much more difficult than just looking at past info. The companies themselves rarely even look at it that way.”

“There is clearly a trend toward increasing due diligence [in private equity] – it has become more thorough,” said Mike Marcon, president of insurance services provider Equity Risk Partners. “It has coincided with more competition among funds, and a higher price being paid for acquisitions. Principal investors are seeing that there is less margin for error.”

Meanwhile, the breadth of due diligence has expanded far beyond number-crunching, to include background checks on the target’s officers, environmental risk assessment and even succession risk. Jim TenBroek, a managing director at Wind Point Partners, said today due diligence engulfs everything that his firm does. “Because of our active investment strategy…due diligence is as much getting started on our value creation plan as it is validating what’s being said by the sellers,” he said.

It’s All in the Approach

Buyout shops are using a number of different methods to accomplish due diligence. While the legal and financial areas of the process still require outside assistance, there are a number of different ways to tackle some of the qualitative homework.

Firms like GTCR Golder Rauner and Frontenac first partner with a management team consisting of industry experts, and then target companies within the selected industry. This in-house knowledge of a particular sector will often give firms that pursue a management-backing strategy a leg up on dissecting a business.

Canfield said the CEO-backing strategy “is core to GTCR’s value proposition.” He added, “Our CEOs could forget more about a business in a day than we could learn [about that business] in two weeks.” Michael Salim, a partner at Brazos Equity Partners, agreed, saying, “If it’s a new industry for us, we’ll want to associate ourselves to leaders of that industry.” He cited his firm’s investment in National Surgical Care as an example.

Other firms focus on just one sector for all of their investments. Leeds Weld & Co. provides an example of this, as it only targets companies in the education industry. This rigid focus also provides the benefit of proprietary deal flow as well, as the sellers know who to go to when they’re looking to sell.

Jeffrey Leeds, co-founder and partner of Leeds Weld, commented that when it comes to due diligence, “We think we have a real head-start,” noting that since their concentration is focused on just one sector, “It’s an ongoing, everyday matter for us.” Leeds also noted that his firm will often tap the CEOs of its portfolio companies to help them “appreciate other opportunities in the sector.”

Another approach is to capitalize on the experience of your co-investors, and in essence combine the financing and due diligence processes. Roger Knight, a principal and managing director at Ardshiel, said, “Over time we have come to the realization that we no longer can put as much weight into our intuitive understanding of the businesses we invest in. Given the challenges today, we’ll try to find a mezzanine group or co-investor that has some experience in the industry and we’ll use the relationship for their industry knowledge, as well as their financing.”

Also, industry consultants continue to be a popular alternative for buyout shops to gain market knowledge. “Firms are using consultants much more heavily than in the past,” said Rick Rickertsen, COO of Thayer Capital Partners.

“People want to know if there’s a bear behind the tree and also if customers are going to separate their dollars from their wallets,” added Rafi Musher, CEO at market research firm Stax. “Firms will also call on [market research companies] for deal triage, to gain knowledge to win an auction or prepare themselves to meet the management team.”

No Room For Loafers

While not doing the homework on an acquisition may ultimately come back to hurt the uninformed buyer, it can also end up hurting other bidders. “The toughest competitors in an auction are those that don’t do the diligence,” said Audax’s Jester. “Someone out there that’s done less work will often just throw a number out. They will overpay just to win the auction, and they will either ruin the company or pull back from the offer.”

Market pros agree that a certain level of due diligence needs to be standard for all buyers in order to maintain the market’s integrity and further its maturation. “The buyouts industry has changed from somewhat of a cottage industry, with just a few players, to a new, second phase of professionalization,” said Geoff Smart, chairman and CEO of ghSMART & Co., a management assessment firm. “This new phase means having more formal processes around the things that matter.”

The good news is that the current environment, which is clearly more restrained than the late 1990s, allows firms now to take more time in their investigations. “The world’s slightly less competitive. The deal process today favors the buyer, and any time that’s the case, the buyer can mandate the timing of the process,” Canfield said.