Joanna Gant talks to advisers involved in unearthing the truth surrounding a potential PE investment and finds the arsenal of transaction support tools is growing, as are the number of providers.
Mindful that a little knowledge can be a dangerous thing, no self-respecting private equity (PE) investor these days goes into a company armed with anything other than a comprehensive, full strength, pre-purchase report. This increasing need for more and better target information has, over the last decade, been met by a rapid expansion in transaction support (TS) products and providers.
Together with a growth in specialist boutiques, the major accounting firms have increased their TS service lines to include operational and commercial due diligence (CDD), tax structuring, insurance and pensions reviews, IT and human resources (HR) alongside standard financial due diligence. Some of the
major firms have also created dedicated private equity support functions to help clients with their strategic, deal and portfolio management issues. “Ahead of deals far more research is now being commissioned with new products, new angles and new players,” says Ian Durrans, partner at PricewaterhouseCoopers.
“While we are employed, essentially, to make sure the numbers ‘work’; increasingly we are being asked to bring additional skills and know-how to the party,” says John Cole, partner at Ernst & Young. “The weight of PE capital and intense level of competition for deals is such that our clients need to find ways of squeezing more value out of an operation,” he says.
PE deals are also getting ever larger and multi-jurisdictional with firms more frequently investing in countries or sectors new to them or in industries more technically demanding, such as financial services, or people-based sectors with less solid asset backing.
And while investments used to be held for a relatively short time, some portfolios now have investment horizons stretching into the middle distance. PE firms need to know they genuinely will be able to add value to businesses over the longer term. “There is often a real need for us to involve other parts of the firm, particularly when it comes to the ‘what next’ scenarios; what needs to happen with a business going forward to justify the price which has been paid,” says Cole.
“We might ask our reconstruction practice to help with working capital issues, for example. A business doesn’t have to be ailing to benefit from their cash management approach,” he explains. “But it is not clever or appropriate to simply bundle up various services and try and randomly cross-sell them to clients,” Cole says.
“Clients want us to offer more than just straight financial due diligence. They actively seek a broader service line and so, even if we are commissioned to do only the financial due diligence, there might well be a case for consulting our functional experts and/or industry sector specialists,” says Durrans. PricewaterhouseCoopers has 60 non-accountants on its operational due diligence side, mostly ex-industrial line managers. “They can go into companies, examine particular industrial situations, look at productivity issues and ways of taking out costs, and the larger the deal the more we, as advisers, are required to do this,” Durrans says.
“But this integrated approach will only work if we can offer the right level of expertise. If we haven’t got the right skill sets then the client will go elsewhere,” he says. According to James Stewart, director of ECI, bringing in other specialists, particularly sector or IT experts, is helpful in negotiations as a bid situation crystallises. “But a criticism, and it is undoubtedly a conflict, is that TS is fee driven. So you really need to know exactly what you are trying to achieve and what outside expertise you need in order to achieve it,” he says.
“But a good adviser will keep the client clearly informed about taking on additional services. It is then up to the buyer as to what extent they wish to use them,” Stewart says. “We usually know what we will require and if it involves additional services then we are advised of this at the outset, not on an ad-hoc basis,” he says.
Of all the TS services once perceived as optional add-ons to traditional financial and legal due diligence, CDD has become the one most central to the investigative process. “Investors need to have a much deeper understanding of the target business than ever before and its strategic context is vital,” says Allan Gasson, founding partner of the strategy consulting firm Burlington Consultants. Gasson observes that until the mid 1990s most PE deals were, essentially, a bet on management. “Investors regarded most due diligence as a tick box exercise, done to satisfy the banks. But this approach has now changed fundamentally,” he says. “The days when an investment decision could be based on the opinion of management have long gone,” agrees Denzil Rankine, founder and chief executive of the CDD consultancy AMR. “Now PE investors really need to get inside companies and find the competitive advantage,” he says.
The auction process is also a driver of greater due diligence demand. “The data room won’t tell you about the pulse of a business, its dynamics or the culture of the management team,” notes Gasson. “Bidders have to do this off their own bat or risk falling over in the first round.”
While it is acknowledged that TS can be crucial to reducing transaction risks and maximising value, Marco Compagnoni, a partner in City law firm Lovells, warns it has to be used and managed properly. “It is possible for more time and money to be wasted on due diligence than on anything else with huge spends racked up, particularly in a competitive bid situation, for no result. Investors need to be clear and get their advisers to look, initially, at the high strategic risks in a company. ‘Materiality’ should be uppermost and it is absolutely critical that advisers are instructed to look at specific trigger aspects in a deal. Confirmative due diligence need only be done if the exclusivity phase is reached,” Compagnoni says.
PE investors must also be aware that if their advisers do produce a massive report then someone is going to have to wade through it to find out what’s important. “It can be a law of diminishing returns. So, good due diligence must be highly focused and implemented in a very pre-planned way. Accordingly, it really pays to sit down and spend a few hours planning what the TS people need to do and what they need to do it about, rather than uncorking 40 people and simply saying ‘go tell me what’s there’,” he says.
Ian Durrans finds some clients have a formalised instruction process and set out the risks and opportunities they want analysed. “Others are less prescriptive and there is a danger in not being able to see the wood for the trees. But it is rare for us to go into a company with a completely open brief,” he says. “In general, the key to a better level and quality of TS is careful planning and the ability of advisers to work at as detailed a level as the situation requires,” says ECI’s Stewart.
Stewart sees the main requirement of a TS exercise as providing a detailed and sensible valuation of the target, reliable projections over three or four years and a detailed review of the exit options. “We are also keen on interloper analysis; who we are competing against in a bid situation with details of the likely pricing and tactics needed to win,” he says.
Detailed financial modelling is also fundamental in helping investors put together the overall business plan for newco as the transaction moves forward. “It is our principal source of information for defining and refining what management has already produced,” Stewart says.
Then there is overall project management; coordinating the timetable and ensuring all the relevant issues are addressed at the correct time as well as having input into the negotiations and helping raise the senior debt. “A good TS team will be able to recommend which bank to go to and offer advice on the general strength and depth of the banking market,” says Stewart.
AMR recently took this aspect one stage further following its CDD assignment on the €500m LBO of the Dutch telephone directories business, Telemedia, for a consortium led by 3i and Veronis Sulher Stevenson. “Having worked with the management team to identify where growth was going to come from and to refocus the business plan we were asked to take part in the debt syndication road show, to explain the company’s potential upside to the participating banks,” Rankine says.
Marco Compagnoni believes CDD should really set the parameters for all the other strands of the pre-purchase investigation. “If a particular supplier or customer is key to a business then it feeds into the legal aspects of the deal, for example. Dealmakers need to focus on this and not be side-tracked by more peripheral issues,” he says. This is reflected in the growing trend for resources to be allocated away from plain vanilla financial due diligence. “PE investors are now focusing on what really matters and recognising that market and commercial issues are often much more important to the success of a deal than anything else,” says Denzil Rankine. “CDD helps both de-risk the deal and plan for the aftermath,” he says.
CDD is designed to focus on the broader market-based aspects of the target’s business such as its market profile, competitive position and management culture. As Calum Chace, director in KPMG’s strategic and commercial intelligence unit, explains: “CDD basically tells investors what they really need to know i.e. whether a firm’s customers are going to keep on buying.”
As well as the published information available about most markets, CDD providers talk to customers, past, present and future; as well as competitors, suppliers and industry observers. “It all goes into the melting pot. But it is the level of rigorous analysis which determines how good the CDD report ultimately is,” says Chace.
According to Rankine, good CDD should also uncover additional opportunities for the business that can be of lasting value post-transaction. “We will leave the management team with a valuable report that will feed into their business plan going forward, and not just be of use during the deal itself,” he says.
Curiously, although management and employment issues are often considered high risk areas in a deal, the least amount of resource is usually directed at these aspects of the pre-purchase process. But this, too, is changing with specialist HR consultancies and the ubiquitous accounting firms through their people solutions groups, vying to conduct management due diligence, leadership appraisals and to formulate appropriate human capital strategies. The aim, generally, is to encourage PE firms to cast off their traditional reliance on gut feeling and personal chemistry and to adopt a more systematic, formalised approach to a target company’s management, culture and general HR requirements.
While financial due diligence has consolidated around the major accounting firms, the market for other services, and CDD in particular, is far more fragmented but no less competitive. Of the independents, blue-chip strategy consultants such as Bain & Company will often be mandated to analyse the strategic and market aspects of the largest, trophy deals. Boutiques such as AMR and Burlington are also well entrenched, working on both bulge bracket and mid market deals.
Three of the big four accountants are active in CDD and each has taken a different approach to planting its footprint on the market. While PricewaterhouseCoopers has grown via the acquisition of the CDD specialist Coba three years ago, Ernst & Young has a joint venture with CIL and KPMG has grown organically.
A perennial question is whether the accounting firms, with their all-singing, all-dancing approach, are as well equipped as the specialists to deliver a market-based view of a business. Certainly while the integration of financial and commercial due diligence sounds appealing, there may be barriers to its success. “It is culturally difficult to mix financial and commercial due diligence; they require different approaches to working. And in strategy and commercial work you have to be able to apply a bit of flair,” Allan Gasson says.
“The accountants may regard CDD as their natural market but, in truth, it requires skill sets you won’t often find in an integrated house,” says Rankine. However, as one accountant counters: “We operate under a brand name and have a consistently high level of quality across the firm. I therefore know that I can stand up with greater confidence if my own firm is on other aspects of the diligence.”
Yet if the accounting firms and independent CDD professionals are to serve clients effectively they have to be able to work together effectively if mandated to the same deal. “For CDD to be successful our findings have to be thoroughly accepted by our colleagues conducting the financial due diligence. Unless there is complete trust and sharing of information between us then the investigation will not work,” says Calum Chace. “There is a powerful synergy between financial and commercial due diligence, what the finance people unearth can often send us down a different line of inquiry, and vice versa so we have to be able to cooperate,” he says.
John Cole of Ernst & Young says PE houses are sophisticated buyers of financial services. “They will buy the best in each class for what needs to be done,” he says. This is echoed by Marco Compagnoni: “While it can often make sense to put as much work as possible in one place, the PE firms will be looking to put together the right team for the right job. It becomes a case of balancing the needs of the investigation against the spectrum of potential providers. “And when you see a well-run process with all aspects of the investigation dove tailing into each other, you really appreciate how good transaction support should be done,” he says.
Allan Gasson believes in the pre-purchase phase PE firms need to play the part of integrator to their different breeds of adviser. “Because team work and collaboration are essential the deal leader must invest some time in simply getting everyone together in the same room to compare notes,” he says.
“The PE houses like to have one coordinating individual. But on all deals now we will sit down internally to brainstorm and identify the priority issues,” says Durrans. As Gasson points out, however, each deal has its unique pressures. “Sometimes the time-frame is so incredibly tight and everyone so focused on getting their own work done that there is a failure to look at the complete picture,” he says. “I’m a big fan of live time, interactive reporting and also roundups where the PE house meets with all its TS providers and sees what stage they are at,” says Compagnoni.
With regard to the TS process itself, preliminary due diligence is conducted at the pre-exclusivity stage. “With budgets tight the priority is to focus on finding an angle on the deal or an opportunity to improve the company and add value that no one else has spotted,” Calum Chace says. Once an agreement to purchase has been reached a more thorough exploration of the market, the company and its revenues are unleashed. “This helps the investors and lending banks get to the right comfort levels and quantifies potential value improvements,” Chace says.
The due diligence report will often then be used to prompt the PE backers to structure the deal differently, reduce the price or bale out altogether. “We are hired for our independence and objectivity and this includes our ability to say ‘no don’t do it’. There is no point being ‘yes men’ producing bland books of information. We are paid to spot weaknesses and sometimes we have to drive nails into the coffin,” says Ian Durrans.
The major PE houses usually have panels of preferred TS suppliers that work for them regularly on an agreed basis. “We like long term relationships and it does mean that we can be more tolerant on issues such as abort costs. If we are constantly having to pitch for business then it can waste time, pushes up our overheads and doesn’t necessarily get the relationship off on the right foot,” says John Cole.
The PE house usually hires the TS team although, increasingly, work is being directed at the lending banks which have been instrumental in raising due diligence standards among the PE players. “Our investigations are determined, to a certain extent, by the banks. But while the PE houses are generally focused on the upside the banks will usually want to know about the downside. So we need to review both the equity and the bank case, all our work is structured from this dual aspect,” says Durrans. “In a deal we typically see three reporting audiences; the PE investors, management and the lending bank. These are three quite different relationships with different agendas and need to be managed carefully,” says Rankine.
“It is always worth the lead investor trying to cover-off all the various due diligence consumers with one report. Although this requires taking several different angles it is far more cost-effective,” says Compagnoni. “But it needs to be agreed, upfront, that the report can be relied upon for these different interests and that the advisers will still accept professional responsibility for it,” he says.
In depth, investigative pre-purchase reporting on all aspects of a company’s performance is now well established. What is new is the growing ability among increasingly discerning end users to ensure not only that TS as a whole delivers on its promises but that the greatest amount of resource goes to the component services which add the most value.