Due diligence gets commercial
Market, or commercial due diligence as it tends now to be known, is increasingly biting into the pot of advisory fees put aside for a private equity transaction. Lisa Bushrod finds out why.
Given the growing plethora of due diligence services being pushed at the private equity market, it’s probably quite useful to examine commercial, or market, due diligence in the context of what it is trying to achieve. James Stewart, director at ECI Ventures, says: “Financial due diligence is internal facing to test the financial prospects of the business and reviewing financial forecasts whereas commercial due diligence is effectively externally facing and tests the business from a market perspective. The trick is to look at the two sets [of diligence] and from them form a clear view on the prospects of the business.”
Simon Wildig of Close Brothers Private Equity clarifies yet further: “I would say in many ways the commercial due diligence is more important because you can check numbers endlessly but if you have not got the numbers in the correct market context you’re wasting your time. The commercial due diligence kicks off first because you want to get feedback from that before the financial guys get rolling, so they are doing their work in the proper context.”
Don Perrott, associate director private equity group at KPMG, says: “From an investor’s point of view it’s really about getting to grips with the risks of a transaction, which ones are they happy to live with and getting comfortable with that.” This meets with agreement from Stewart. “Clearly [commercial due diligence] is absolutely necessary and we always would use it. It’s an opportunity to test what we believe and we can develop a feel for the business through customer referencing, market dynamics and competitive analysis,” he says.
Use of commercial due diligence services, however, varies widely throughout the private equity investor spectrum. Ven Balakrishnan, director strategic finance services Ernst & Young, says: “Some PE houses are quite general and will invest opportunistically and those houses will tend to rely more on the commercial due diligence aspect. Other houses are a lot more focused on particular industries and have pretty good understanding of those industries.”
But it’s not even possible to generalise about the approaches of particular houses or segments of the private equity market, as Charles Honnywill, partner Ernst & Young, explains. “It depends a lot on the size and complexity of the transaction and the size of the house. If they are putting in an MBI team, again the risks are in theory a little bit higher with the PE house having to do more diligence to get comfortable. If it’s an auction process, you have got to have all the justification you can to bid enough to win,” he says.
Why the current explosion?
There are almost as many theories put forward to explain the growth in commercial due diligence usage as there are practitioners offering the service in the market. While it’s difficult to quantify, partly because of the fragmented and diversified nature of the purveyors of commercial due diligence and partly because no formal record is kept of commercial due diligence advisors involvement in the market, those in the market interviewed for the purposes of this article were, without exception, experiencing year-on-year growth and struggling to hire suitable additions to their team fast enough to cope with their increased work flow.
Balakrishnan of Ernst & Young for one suggests some of the growth is down to a sea of change in the industry. “[The PE industry has] moved away from financial leverage to thinking about how you can drive growth,” he says. Others are less sure, feeling that while this is true for some houses and some deal structures, particularly at the larger end, for the most part growth has been part of the private equity story for the last decade or so and the days of riding a good economic cycle are largely gone.
David Ramsey, associate director strategic and commercial intelligence KPMG, argues that much of the impetus may in fact be coming from the banks. “One of the real drivers of the [commercial due diligence] market is that the PE process is becoming more and more professionalised. Houses are developing more and more processes. But a key driver at the end of the day are the banks, it’s clear that they are not go to go into a deal without a third party opinion in all transactions over a certain size, typically €20m/30m enterprise value,” he says. Few would disagree that a formalised commercial due diligence report has become a standard part of the list of things banks expect to tick off during their credit approval process.
Victor Chua, co-founder and healthcare practice leader at Candesic, the independent management consultancy, says: “We tend to be of the most value to PE firms that tend not to be very sector focused.” His experience mirrors that of other practitioners.
But David Walsh, director in the transaction services strategy group at PricewaterhouseCoopers, suggests the growth can in part be attributed to the remit of commercial due diligence itself being widened. “The market for commercial due diligence is likely to grow, not just on back of increased deal activity, but also because [PE houses are] getting us involved at an earlier stage in the deal process. Equity houses are increasingly trying to find an angle when doing a deal so they increasingly look to us to help them in that regard. That means the product is expanding,” he says.
Simon Wildig raises the issue of scarcity of resource within private equity firms, faced with an increasingly global market place for their investee businesses. “It is something that has always been done. In years gone by quite a lot of it we did ourselves. As business has got more global, you just can’t do that,” he says.
What Walsh and Wildig’s observations also highlight, however, is the fact that commercial due diligence is actually an old staple of the private equity investor, despite the gloss currently being applied by some practitioners. Long standing private equity investors note that there is an element of reinventing the wheel, and a costly reinvention at that. There is also a suggestion that the private equity market can be seen as a bit of a honey pot by the advisory community, which if true is a perception that may have been reinforced by the fact that the private equity community was one of the few segments of the M&A community to consistently generate advisory work during the recent economic slump and will remain an important part of the market now that other sections of the market, such as corporates, have started to return to the market.
How the market splits
As already alluded to, the market for commercial due diligence services is highly fragmented and diversified. It splits in terms of practitioners from the world class strategy consultants such as McKinsey, Bain and Boston Consulting Group, which concentrate on transactions involving enterprises in the €1bn+ category, through to the accountancy firms and boutiques, which predominate in the mid market, and one man band operations at the bottom of the scale.
The work these groups undertake differs as would be expected and is primarily driven by the expertise and capacity within each firm, with the larger end serving the multi-jurisdictional, multi-million euro businesses across a variety of sectors and mid market offerings often hooked on sector expertise in particular areas. The one-man band end of the spectrum is also all about sector specialisation and typically involve ex industry personnel or ex investment bankers that were once deeply entrenched in a particular sector. Needless to say, as the size of the practitioner moves up through the scale from the one-man band operation, so do the fees incurred.
Given the choice available, when choosing where to go for commercial due diligence support Stewart of ECI Ventures says: “You are looking at a number of parameters. First is experience and knowledge of the sector that you are looking at and second is experience of private equity and understanding the perspective of the private equity investor. And to some extent you work with people you know and have found their past commercial due diligence to be accurate.”
Wildig of Close Brothers Private Equity comments: “The people we tend to use are very financially literate, assessing markets and opportunities in a financial context.”
Sector specialisation is a theme that runs through all commercial due diligence practices, whatever their size. Walsh of PricewaterhouseCoopers says: “The key thing that has changed over the past two to three years is the emphasis on sector specialists. The very fact that the commercial due diligence industry is more fragmented than financial due diligence is testimony that [PE houses] look for sector experts and they are quite right to do so.”
But Balakrishnan of Ernst & Young, himself from a consulting background, warns: “The downside of a sector specialist is that he or she is a sector specialist that has grown up with this mental model. Whereas a broader strategic person, because they have seen a lot of different industry models and sectors, brings that experience to bear to challenge the assumptions [of specific sectors].”
“The market is getting more sophisticated. I think the days where you said you were an expert in everything is over,” says Chua of Candesic. Although as an ex-McKinsey consultant, Chua is careful to make an exception for top tier strategy consultants such as this.
One thing on which both practitioners and private equity investors agree is that relationships are key to successfully operating in the commercial due diligence space, despite all the brand name consultancies and accountancy firms involved in it. Balakrishnan of Ernst & Young says: “Brand only gets you in the door in the first place. After that, because the assignments tend to be very short and sharp, personal relationships get to be quite important.”
While the one-man bands are by necessity specialists in a particular field and often their insights can make or break a deal, they have their weaknesses. In one sense the weakness is inherent, in that many are experienced managers from within a particular sector and not trained consultants and therefore while they can articulate well, often when it comes to putting together a coherent consultancy report they fall short of the mark. While this prima facie should not present a problem, when a deal is dependent on bank funding they will need to deliver a consultancy-style commercial due diligence report.
“In 1993 we used a couple of one man bands to do market due diligence on a deal but I had a bit of a battle with the banks persuading them that it was okay. Ten years on I would probably not get away with that,” says Johnson of Legal & General Ventures.
Probably being the key word here. As always, individual circumstances can lead to interesting outcomes. When Duke Street Capital bought Esporta in a public-to-private transaction during 2002, the hostile nature of the deal prohibited the firm from accessing the sort of data that would have made for a standard commercial due diligence report so a number of one man bands were employed who carried out customer-style commercial due diligence on an unaided basis. Duke Street subsequently reported not only that the financing banks were happy to rely in part on this judgment but that the quality of the work turned out enabled the firm to put a credible forward strategy plan in place for when it owned the business, and all at a fraction of the cost that a formalised commercial due diligence process would normally have cost them. It was an eye opener.
Kinds of CDD
While practitioners involved in commercial due diligence are split by size, both theirs and therefore the size of deals they can comfortably accommodate, they also differ in the kind of commercial due diligence packages they offer.
This ranges from what’s typically referred to as the integrated or holistic approach, to two separate reports being commissioned (one for financial and one for commercial due diligence and not necessarily by the same practitioner) to what practitioners tend to refer to as the tick box exercise. In short the latter means the private equity investor is commissioning the bare minimum to satisfy a third party, usually the financing banks. This isn’t necessarily a negative thing, as Ramsey of KPMG points out: “Some houses get completely up to speed themselves and then get a tick box exercise to validate and verify findings for the banks.”
On the subject of the integrated approach, which is mainly offered by the accountancy firms, Perrott at KPMG says: “There are PE firms that really like the integrated offering, but some PE firms are not attracted by an integrated offering.” Ramsey at KPMG says: “Most of banks prefer integrated offering.” Presumably because reading one report is less time consuming than reading two from different practitioners that the banker will need to do a lot of cross referencing on.
Wildig of Close Brothers Private Equity says: “I prefer segregation between the two. You do need a totally objective view on the market place.” Given that the commercial due diligence findings will make or break a deal, objectivity should not be compromised at any point. “With an integrated approach one organisation ends up having significant fees riding on a transaction, and how does that impact on its objectivity?,” asks Johnson of Legal & General Ventures.
The integrated approach aside it is worrying that some practitioners are prepared to work on a no win no fee basis, although many simply refuse outright. But when commercial due diligence mandates are rumoured to have been won on a no-deal-no-fee or deal-three-times-fee basis, this must push objectivity to its ultimate test.
For now the commercial due diligence market is heating up primarily in the UK, which has always traditionally been the best-, or some would think over-, advised financial market in Europe. But those firms with a multi-jurisdictional reach have their sights firmly set on the continental European market place, although everyone is aware that some market norms, such as Roland Berger’s predominance in Germany, will take considerable time and effort to circumvent. But strategies are in place, as Perrott at KPMG indicates. “It is vital to have people on the ground. What we have found over the last two years is that we are winning a lot more work by having people on the ground,” he says.