Due diligence is sometimes referred to as a full proctological exam and rightfully so.
It is more than a buyer’s attempt to confirm the stated valuation given by the seller to the buyer.
It is much more than that. In very broad terms it provides a means for the buyer to get comfortable with operations, finance and marketing such that the buyer is able to understand the business from inside and out.
There are some common aspects that run through all the due diligence processes but private equity due diligence tends to bring certain challenges.
In many cases, the target company is not publicly listed and there is minimal information available on the company.
This is a huge challenge when conducting due diligence.
That said, since many private transactions are more financial than strategic in nature, the firm’s motive to acquire a company is to profit from it, so the perspective taken is different.
The principles and purpose of private equity due diligence are industry agnostic: undertaking the analysis of a target company to reduce risks for the buyer.
But because of the financial motive, there are some specifics that require further exploration
There are countless due diligence checklists available online, which can certainly be helpful in knowing which questions to ask and how to avoid missing items that may come back to burn a buyer later.
Contents
What is a private equity transaction?
A private equity transaction is an investment by a PE fund in the non-public, illiquid securities that are used by a proprietary company or it is the acquisition of all the shares of a listed public company followed by the delisting of that company.
The PE fund is often referred to as a buyer or sponsor who acquires the portfolio company to make a quick profit on the investment.
This fund will identify the ways to increase its EBITDA and build value in the company before generating a financial return and exiting the investment.
Purpose of Due Diligence
The idea behind due diligence is to reduce and allocate the risks and maximize the value for the shareholders.
There is a specific diligence plan for a private equity transaction that is driven by the private equity fund’s underlying strategy to help build value.
The fund will gather information about the seller and the business or the assets that are up for sale, they will then put together a structure, purchase price and have a business plan for the target company.
Through due diligence, the buyer can verify the business plan, operational capacity, targets, product line, customer relationships, workforce depth, identify the issues that may have an impact on its valuation, and analyze and confirm the buyer’s logic behind the strategy.
Private equity focus as a “financial buyer”
A private equity transaction will comprise various components and considerations that are different from the typical strategic acquisition.
The strategic buyer is already operating in the target company’s industry and considers the acquisition to improve, expand or change its own operations but a PE fund, which is often referred to as a financial buyer (see our separate article on strategic vs. financial buyers in M&A), will acquire the portfolio company to make a quick profit through the investment.
This is the reason why the private equity buyer’s due diligence will differ from that of a strategic buyer.
Both buyers generally review the same information and documents but the numbers are analyzed differently and some choose to focus on specific areas of the business. Let us take a look at the main areas of focus in private equity due diligence.
Industry research
The private equity firm will usually focus on the financial instead of the strategic aspects of the deal, which means they will not have the know-how and industry knowledge that an already operational company in the industry possesses.
So, in a private equity transaction, industry research is the most important. It may seem like a time-consuming process but gaining an understanding of the industry will help private equity buyers realize that the industry is more suitable for their investment criteria and they will be able to identify other target companies.
The buyer and their advisers will have to spend time and effort trying to understand the target company’s operations and industry.
It includes the legal, accounting, financial, and tax advisers. Instead of simply relying on the information shared by the seller and the target company, the private equity buyer will put together a complete analysis of the target and its industry.
This is followed by advisers’ industry diligence where the buyer will understand the position of the company in the industry.
This will help spot the issues or concerns in the due diligence review and advisers will be able to help the buyer with regard to the terms and conditions of the transaction.
Quality of Earnings assessment
A private equity buyer will make an investment to generate returns on it in the long term.
This leads to focusing on the earnings capability of the company.
In private equity due diligence, there is more focus on the ‘quality of earnings’. It will estimate what the target company can earn on a consistent basis by extracting the extraordinary expenses and revenues from the historical income and expense statements.
This step will enable the buyer to get a real idea of how the company is growing and its potential to continue with the growth.
It separates the portion of the company’s earnings that are attributable to the objective and repeatable factors from the portion that will result from taking specific accounting positions or one-time events.
The assessment will help the buyer prepare a realistic business plan and set projections to offer the best purchase price.
The buyers will also be concerned to ensure that the target company will have enough cash flow to service the acquisition debt.
Private equity legal due diligence
A business plan for a transaction usually includes selling off the assets, workforce cuts, terminating contracts, or closing the business units.
Although the idea is to grow cash for the business, some decisions are taken as a consequence of legal issues.
Therefore, there is a different form of legal due diligence between private as well as non-private equity transactions.
This legal due diligence will look into the legal impact of a change in leadership in the firm, regulatory restrictions in the company, purchase or supply agreements, and contractual agreements with the current suppliers, vendors, and customers.
Operational private equity due diligence
The purpose of the transaction is to drive operational improvements in the company and raise its value before exiting the investment.
Hence, the legal advisors will look into all the opportunities that exist in the target company.
Such improvements could be closing the underperforming stores, adding new marketing and sales channels, cutting the non-profitable product lines, and opening contracts with new companies that belong to the same industry.
Operational due diligence can help gain an understanding of the target company’s operations and the risks, it also helps identify the gaps and potential improvement opportunities.
Private equity exit strategy due diligence assessment
It is important to keep in mind that the idea behind the transaction is an attractive exit multiple.
While due diligence can help achieve this but even a company that has streamlined all its business operations and managed to improve sales will only be as valuable as the buyers in the market.
This is why it is important for the buyer to assess all the possible ways to exit the portfolio company investment.
All the possibilities for exiting the investment should be considered initially because the buyer will not be able to predict the circumstances at the time they want to exit the investment.
The legal advisor will have to consider the potential issues that may restrict or prevent the exit and the actions that are required to be taken to prepare for the exit.
Business goal alignment due diligence
Early involvement in the business in a private equity fund will help them understand the client’s goals for the business.
The return generated by the PE fund will be realized on the exit from the investment but will also depend on the actions and business plan of the company before the exit. Such actions could include closing locations or selling off parts of the business.
It helps to understand the buyer’s intention about the portfolio company before starting due diligence.
When understanding the terms of the agreement and reviewing the target’s contracts, the advisor must consider the change of control clause, assignment, and termination of the contract.
There are more specific areas that legal advisors need to look into like the terms and conditions of the vendor and customer agreements, the regulations in the target company’s industry, as well as the restrictive provisions that could impact the future operation of the business.
After the legal advisors have an understanding of the drivers behind the deal, they can use the same to approach the due diligence process.
Reliance on existing management
The private equity buyer who is looking to acquire a portfolio company will also be interested in the quality of the management team or their business plan.
The buyer will not invest in a company unless it believes that the portfolio company has an excellent management team.
In order to align the interests, the buyer will expect senior-level management team members to invest a significant amount of capital in addition to the fund.
The management will play a big role in the success or failure of the fund’s portfolio and the buyer can set a direction or suggest improvements but it is the management that has to implement the changes.
Thus, the private equity buyer will seek quality management teams to help them build value and implement incentive equity and other tools to align the interests of the team to the interest of the buyers.
Indebtedness and high leverage
All private equity funds vary in how aggressively they use leverage and many private equity transactions are financed through a high debt to equity ratio, as long as debt service coverage ratios are met.
It offers a higher rate of return on the invested capital than that can be generated on an investment made only with a cash equity investment by the private equity fund.
The private equity buyer will have to understand the historical cash flows and understand the target’s projections, the advisers should also review the current financing of the assets and include the agreements and documents of outstanding debts to anticipate issues that might be of concern to the lenders who might be financing the acquisition.
It is important to watch out for any provisions in the agreements that need to be looked into before structuring the financing of the business post-completion of the deal.
How long should private equity due diligence take for a merger or acquisition?
That depends, are you the business seller or company buyer?
Buyers naturally want due diligence to last as long as humanly possibly, while any seller would like rapid due diligence.
The arguments on both sides are valid. Fast due diligence for sellers can be used as a means to obfuscate real business issues from the eyes of the buyer.
On the other hand, slow and protracted due diligence on the part of the buyer can be used to find more skeletons and ultimately put the screws on company’s valuation.
Due diligence should be as long as necessary for the buyer to obtain all the requested items.
Any elongation of the process is usually unnecessarily disingenuous to the seller.
Typical common knowledge would state that
time kills all deals, even the good ones
Because time is no one’s ally in deal-making, sellers should be aware of the length their due diligence should and could take to get a deal done.
Buyers (typically) want it long, sellers want it short
From personal experience, any due diligence period past 90 days is a recipe for disaster.
As my parents used to say, “nothing good happens after midnight,” so too in due diligence, “nothing good happens after 90 days.”
Whether its attempted deal re-trading or the inevitable deal breakup because of something found (or not found) in the virtual data room, the length of the due diligence does matter, especially once you go exclusive with a given buyer.
Exclusivity precludes the seller from any further talks while the buyer has unfettered access to all the most personal and intimate details on the company.
Due diligence timelines that are reasonable are especially important for deals where a buyer may have won the auction and is looking to potentially pay a premium.
Many bidders may submit the “best and final offer” on a business only to re-negotiate in due diligence once they inevitably find something that may have bloated the numbers or concealed some internal transgression.
In today’s competitive private equity world where the best deals are often bid-up, I have seen buyers that live (and frequently die–especially in reputation) with a slash-and-burn deal mentality in competitive bidding situations.
Truncated due diligence is never going to be acceptable by a buyer, but when a seller is seeking a premium, you can most certainly expect to have a more exhaustive (and likely stressful) due diligence period.
A note to company sellers
Sellers, do not be the due diligence bottleneck.
If the due diligence is extended past 90 days and it’s your fault, then that is another matter.
It is best to work with your investment banker to ensure you’re covering all the requested items on your due diligence request list to ensure you are not the reason the deal has not closed.
It is best to insist on due diligence of 90 days or less and then push your internal team to deliver on 100% of the requested items within the first couple of weeks, where possible.
This will give buyers no excuse when it comes to delaying the close based on something you may have failed to do.
I fully understand that smaller companies often do not have all the data requested to them from sophisticated buyers, but sellers should prepare–as best as possible for impending due diligence requests which truly may feel like a visit to the proctologist.
Internal Communication of Due Diligence Findings
As we have seen and noted here, private equity due diligence can take time.
Before working on the diligence review, it is important that the legal advisers understand the method of communication of the findings and at what frequency.
If there is anything significant, it should be raised immediately so that the client can decide how to proceed or whether to continue with the transaction.
Before the due diligence begins, it is important to establish the scope of review with the client and decide on the type of report required, the deadline of due diligence, whether outside consultants will be engaged, or if certain areas should be a primary focus.
Private due diligence is a comprehensive and time-consuming process.
It may take a few weeks or even longer than a month for the advisers to complete the diligence.
Since it involves different parties and a significant amount of finances, it should be carried out by expert professionals and legal advisers who understand all the aspects of a business.
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