No one in the private equity industry is in any doubt about the importance of financial due diligence and in today’s market, where it is difficult to access increasingly expensive debt, it has become even more integral.

 

Whatever the potential buyer’s risk threshold, the putative lender’s is certain to be lower; banks are even more demanding of financial due diligence than buyers, particularly in current conditions.

Charles Honnywill, head of the European transaction services group at consultancy Ernst & Young, said: “People part with equity only after doing the requisite due diligence. Debt is harder to secure and it has become more expensive in terms of time and effort to persuade banks to part with it.”

As a core part of the industry’s staple diet, anyone doing a deal can be expected to commission financial due diligence. Any buyer failing to do so will have no one else to blame should horrors start to emerge from under stones that were left unturned.

Just as every deal is different, however, so is every buyer and it is the risk threshold of the would-be buyer that determines the scope of the exercise.

Mo Merali, a transaction advisory services partner at accountancy Grant Thornton, said: “Knowing your client is very important because you know what they want and what they look for. The mark of quality due diligence is not just the identification of relevant issues but the articulation of the problems they pose and the accompanying solutions, whether it is to renegotiate or restructure the deal, withdraw from the deal or a post-deal solution.”

Honnywill described financial due diligence as the basis of all due diligence: “Everything ties back to the numbers. It is at the heart of the process. If you can’t crystallize the cashflow, you can’t make an investment decision.”

Charles Silcock, a transaction services partner at accountancy and advisory group PricewaterhouseCoopers, agreed. “Financial due diligence is absolutely crucial: the key to a successful deal is to understand what you are buying, the value it brings, and to understand the risks for which protection is needed from the vendor. A high proportion of failed deals arise because buyers have not done their homework,” he said.

Chris Grove, head of transaction services at advisers BDO Stoy Hayward, said the role of financial due diligence had evolved from a simple box-ticking quasi-audit process into a more sophisticated form, adding value to the purchase process.

“Attitudes towards it need to adjust accordingly in the interests of boosting ultimate profitability, he said.

“A lot of private equity deals have been successful because investors have been able to ride the market. The ability to drive value at the operational level has assumed new significance: financial due diligence should be geared to this,” he added.

But Grove identified a trend away from analysis and interpretation towards the provision of what he described as little more than data packs. This had been exacerbated by the proliferation of vendor due diligence, a preprepared pack given to potential acquirers designed to streamline the process.

Grove said: “In the wrong hands, financial due diligence could become virtually meaningless. Handled properly, vendor due diligence can be perfectly viable, but there is frustration in the market that it is being diluted.

“We have had instances where vendor due diligence done by the sellside advisers is nothing more than an adjunct to the information memorandum.”

This creates opportunities for buyside advisers to provide an independent service to question the assumptions and projections contained in the vendor’s report.

Markus Golser, a senior partner at mid-market buyout firm Graphite Capital, said: “We complement vendor due diligence, which we encounter in about 80% of possible investments, by commissioning our own accountants to perform additional financial analysis. We also do our own in-house analysis and modelling work on the figures and projections.”

Kevin Grassby, managing partner at private equity firm Bowmark Capital, said: “We won’t commission work just to replicate vendor due diligence but we will ask for a tailored review involving significant senior-partner level input, to focus on what we want as an investor.

“In addition, we regularly use an independent seasoned finance professional at the back end of the process to discuss the finance-related issues and challenges with the company’s senior management.

“As well as avoiding the obvious pitfalls, we want to make sure that reality relates to the projections. Mostly it does.”