Transaction support services at the large accountancy firms have been evolving in recent years to meet the needs of private equity clients and the big four say transaction support is increasingly geared to finding ways of adding value to deals. But some in the private equity industry are wary that bundling in extra services can mean higher fees than initially anticipated. Patrick McCurry reports.
Transaction support services offered by the large accountancy firms, and particularly the big four (Deloitte & Touche, Ernst & Young, KPMG and PricewaterhouseCoopers), are not new but they have evolved significantly over the past five years to encompass a greater diversity of services. These practices have also had to become more focused on the particular needs of private equity clients, compared to the firms’ traditional corporate clients. To what extent they have succeeded depends in part on whether clients are persuaded by the argument that having all the various deal support services under one roof makes more sense than seeking different suppliers.
“The practice has evolved from a financial and tax-driven process to something that we call deal support, rather than due diligence,” says Ernst & Young partner Neil Patey. He adds: “Five years ago most private equity clients were going for financial due diligence, tax, and probably IT due diligence. Today we offer due diligence on commercial, operational improvements, human resources, pensions, and separation and integration planning. We’ll also do the sale and purchase agreement and can provide sector experts.”
Accountancy firms are taking advantage of the fact that most PE houses are fairly lean organisations that outsource some or all deal support services. According to Patey, probably around 75% of buyout houses will outsource pretty much all transaction support services, enabling them to focus purely on originating and carrying out deals: “Some of the bigger houses will be more self-sufficient when it comes to sector expertise or operational improvements, with some houses having operational partners who focus on operational improvements in businesses. But for most houses it’s not cost effective to employ those people themselves.”
Simon Havers, managing director at private equity house Granville Baird Capital Partners, says historically the big accountancy firms had due diligence and lead advisory activities in separate silos. Lead advisory teams made money acting for vendor businesses or management teams, charging a circa 2% fee if the deal happened. Due diligence, on the other hand, was more audit-focused and charged on an hourly rate. The due diligence traditionally focused on the financials but expanded into areas such as commercial, as firms like PricewaterhouseCoopers acquired commercial due diligence consultancies and integrated them into their services.
As the big accountants looked for further services to expand into they latched onto operational due diligence. This, points out Havers, requires a quite different set of skills and personnel than commercial or financial diligence: “Operational is the people who are able to go round a factory floor looking at better ways of doing things.”
Some firms, such as Grant Thornton, have also successfully diversified into offering management due diligence.
In the 1990s, says Havers, lead advisory teams, in addition to identifying vendors to sell businesses and supporting management teams in buyouts, also began offering transaction support, or deal support; services not related to due diligence. These other activities included project management services, spreadsheet modelling and arranging debt finance. Today the transaction support offered by the big accountancy firms is often a combination of these various strands.
For a firm like Granville Baird it works well, says Havers, because it can become a mutually beneficial
relationship. It means there are more opportunities for private equity houses to work with lead advisory teams, he says. “For them, that means more fees. For us, when they come across a new project and are instructed by a vendor to come up with short list of potential buyers, they’re more likely to think of us.”
Granville Baird has taken the radical step of eradicating the middle layer of managers, who would normally do the lead advisory-type work, which means the business is essentially composed just of its directors. Some other, larger PE houses have gone down a similar road, says Havers.
As long as using the accountancy firm for due diligence helps generate lead advisory opportunities Havers says he is happy. Being able to run the business without a middle layer of managers is an advantage, he says. These are staff at associate level, who generally have a couple of years’ experience after an MBA or accountancy qualification, and whose role includes arranging meetings, liaising with debt providers and other legwork.
“Dispensing with the middle layer also releases directors from having to manage the career aspirations of these managers, who often think they’re capable of moving up and leading deals, when they’re not,” says Havers. He adds that PE firms with a substantial middle tier argue that they are training the directors of the future: “But to be honest we’ve never found it a problem to hire the people we need, when we need them.”
Not everyone has such a positive view of the transaction support services of the big accountancy firms. James Stewart, a director at mid-market house ECI Partners, argues many in the private equity field are unimpressed with the bundling up of services by the big accountancy firms, as they attempt to cross-sell to clients. He acknowledges there is a good level of demand from PE houses for not only traditional financial and commercial due diligence, but for a particular focus on issues like costs and productivity and more specialist areas such as IT and debt structuring.
Stewart says private equity clients need to constantly remind themselves that transaction support is fee-driven. He says: “Clients need to predetermine what they require to meet due diligence objectives and a good adviser will keep the client well informed, not only as to any additional services that may be provided but also the ongoing costs of the main transaction support.” As a result, he says, the accountancy firm will need good project management skills as well as technical knowledge.
A key challenge for transaction support teams is to be able to provide private equity clients with input on the competitive advantages of the business under consideration. Stewart says: “That knowledge is unlikely to come from the data room but rather from other sources, such as talking to management, and in general financial and commercial due diligence need to be more proactive and be able to see the wood from the trees.”
ECI, he says, prefers to pick and choose, rather than using one firm for the whole transaction support service: “We don’t have a panel of preferred suppliers but tend to work with individuals we know and trust, who often happen to be working at different firms.” The PE house does some of the deal support work itself, such as spreadsheet modelling, but uses outside suppliers for many of the other services, says Stewart.
One of the areas where the big accountancy firms can truly offer value add is when it comes to multi-jurisdictional deals. “With the growth in investments across different countries a higher degree of technical expertise is required by PE houses,” says Stewart.
Tim Mahapatra, head of transaction support at Deloitte, agrees there has been a significant shift to providing services across borders. Deloitte, he says, has around 200 professionals focusing on private equity, from a mainstream transaction support perspective to specialist areas that complement this. While European operations are headquartered in London the firm also has practices across Europe covering core financial due diligence, tax, commercial post-merger due diligence, as well as industry specialists, audit and consultancy.
Mahapatra says: “Over the last five years because of the sheer volume of activity we’ve been forced, not unwillingly, to look at private equity almost as an industry to be serviced and that’s meant structuring the way we work to meet clients’ needs.”
A key factor, he says, has been the growth not only in cross-border deals in Europe but also European PE houses setting up in Asia Pacific. “These clients expect us to be able to provide expertise in those geographical areas and that brings its own challenges because the big four have traditionally had their expertise concentrated in New York and London. To meet this challenge we’ve had to move people around geographically, either within Europe or between Europe and Asia, and to develop our secondment programme.”
As well as extending its geographical coverage, transaction support has had to be tailored to the demands of non-European based funds, says Mahapatra: “A decade ago the PE market was relatively narrow, with 20 to 25 major players coming from similar backgrounds and routes, but now a lot of US houses have arrived in Europe and they have their own preferred approach to financial due diligence, which is perhaps more of a technical accounting focus than the European houses.”
As well as the particular needs of US-based houses, other types of private equity client have their own specific needs, such as hedge funds and specialist PE funds, such as those focusing on distressed companies.
KPMG private equity partner Stephen Cole says one of the key aims of transaction support is still financial due diligence, but has spread to other disciplines to give the client a competitive edge. High on the priority list to achieve this is the accountancy firm’s view on normalised EBITDA, whether the target is a proprietary business or a larger corporate that has been through numerous restructurings. “That’s done not just through financial analysis but also by bringing in other areas, such as commercial and operational due diligence,” says Cole.
A view on normalised working capital and coupling that with cash flow is needed to understand how the business is being run, what working capital is required and therefore what the commercial opportunities are for the private equity purchaser. Cole says: “Allied to that is taking a view on the normalised level of debt and what may not be treated as such in the financial statements, such as on pensions deficits.”
He says: “When we’re looking at normalised working capital and EBITDA we’re looking at the operations and how effectively the business is being managed, how are its products viewed in the market place, and so on.”
In an auction situation, he says, the focus of the transaction support adviser needs to be on finding any skeletons in the cupboard but also on helping the client win the deal. “We’ll be looking for where value can be created and that may not be obvious at first glance,” says Cole: “It may be about discovering that the business is using more working capital in a particular area than the industry standard and that therefore there is potential for cutting costs.”
Private equity focuses a lot more on these issues than a corporate buyer, says Cole, because a PE house does not have the internal personnel to manage the businesses and so outsources the management. “That means the PE house must ensure the incumbent management or the new managers are aware of all these issues and can tackle them.”
Unlike other big accountancy firms, KPMG supplies its transaction support services under the umbrella of a private equity group. Cole says: “We set up a dedicated private equity group in 2002. The lead partner on transaction support for a private equity client could come from transaction support itself, or perhaps from corporate finance, tax or audit.”
It’s not just the kind of services the big accountancy firms provide that has evolved, but also the way they interact with private equity clients, argues Ernst & Young’s Neil Patey. He notes that in the past transaction support teams were more reactive: “People would wait for the phone to ring when there was a transaction in process, whereas today we’re much more proactive in speaking to people before deals begin or when we identify potential deals.
Ernst & Young and other big firms are constantly scouring the market for potential deals, or deals at early stages. Patey says: “When we spot something we think a particular PE house will be interested in we contact them and talk about our knowledge of the company, our relationship with management and so on, something that shows we can give them an edge.”
“It’s not about delivering a 300-page report at the end, but much more about being in touch with the private equity house on a daily basis and discussing what we’re doing on the deal,” says Patey.
Deloitte’s Mahapatra agrees there is more communication with the client today and, given the ubiquity of auctions, more focus on finding ways clients can extract value from the target asset. “Auctions dominate today’s market, whereas in the past it was more about relationships with corporate management teams and there were more proprietary-type deals,” he says.
A key service in the transaction support package that can help clients get better value from deals is input on what to do with the business after the acquisition. “We have a team focusing on post-merger actions, as these are often businesses that are being spun out from a conglomerate. It’s also about help on the operational issues, such as realigning the supply chain,” says Mahapatra.
There are a number of differences between private equity clients and corporate clients when it comes to what to do with acquisitions, says Mahapatra, noting that the two groups have different time horizons and that private equity has a bigger focus on cash issues and, in some areas, does not face the same constraints as public companies. “Listed companies are constrained by market pressures, such as having to deliver consistent earnings, while private equity funds have more freedom to take dramatic, innovative action.”
Of course, the prevalence of auctions means there will be many occasions where a private equity client will not win the business. “Obviously PE houses don’t want to pay a lot for transaction support in the early stages, so we try to focus on the really key issues,” says Patey.
Contingency payments, in which the accountancy firm only gets paid if the PE house wins the deal, are not that common because such arrangements can lead to a conflict of interest for the adviser. “Most clients want honest advice and if a firm knows it will only get paid if the house makes the last round there’s a potential conflict of interest,” says Patey. Also, any company with a US SEC link is prohibited from such contingency payments.
What generally happens is the bigger PE houses often pay a discounted rate regardless of whether or not they win the deal, while smaller houses pay a discounted fee only in the case of not winning an auction. Patey says: “It’s really about developing long-term relationships with clients and over time things even out, even if there are ups and downs along the way.”
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