The level of scrutiny to which buyout targets have been subjected by lenders and acquirers has increased sharply in the past year, placing a premium on commercial due diligence as a means to reassure banks of a company’s future earnings potential.

 

Jon Moulton, founder and managing partner of UK buyout firm Alchemy Partners, told a UK Treasury Select Committee last week that many investors in buyout debt last year had failed to undertake any due diligence on the companies serviced by that debt. As a result, as many as 30 UK companies could face problems paying interest.

Banks have recognised the level of due diligence was deficient last year, according to Moulton. He said: “The work being done by banks on private equity deals is more than has been done for a decade.”

The commercial due diligence process, whereby factors such as forecast revenues, market growth and competition threats are examined to ascertain a company’s prospects, has changed in the past five years to a more penetrative one, according to Alan Gasson, a partner and head of the M&A strategy team at financial services provider Deloitte.

Gasson said: “Today, extracting value through sophisticated financial engineering is much more difficult because lots of people have access to debt. The real levels of value extraction are through optimising the operations and competitive position of the business in the market.”

The change comes as banks step up their involvement in commercial due diligence as passing loans through credit committees becomes more complicated, according to Don Perrott, associate director of advisory firm KPMG’s private equity group.

Perrott said: “Banks are operating in an environment where credit markets have been difficult and, in many larger buyouts, it’s been near impossible to syndicate the debt. While banks have always had strict credit committee approval processes, they’ve become more demanding in what they require from commercial due diligence. We’re also seeing banks being brought into the process earlier.”

The demands from banks include a greater focus on recession planning – predicting how a business would cope in a downturn – which has in turn led to bigger demands on general performance.

Gasson said: “In the past, the bank’s role was risk assessment. They would ask, ‘Can this business continue to trade successfully, what are the risks this business faces and are we likely to suffer as a consequence of this business not trading now?’”

But banks have become much more interested in a private equity firm’s ability to go “above and beyond” sustaining a business’s value. They want the firm to demonstrate how it intends to grow a company and enhance its competitive edge. Increasingly, commercial due diligence teams must ask more specific questions and look in greater detail at pricing strategy, marketing and research and growing the sales force, he added.

Perrot said: “Banks’ key focus has always been on cashflow but we’ve recently seen a much greater emphasis on understanding performance in a downturn and how this might affect headroom. They need to understand other risks surrounding each deal, but the shaky economic outlook has had a significant impact on the scope of work we are asked to perform.

“As commercial due diligence providers, we need to understand how well positioned the target is to weather the storm – has it got a premium product to offset pricing pressure or does it have the right channel strategy to maximise the opportunities that are there?”

The focus on deeper investigation has also highlighted the importance of due diligence teams with specialist sector knowledge. Gasson said the extra work and the increased competition for deals meant firms were beginning due diligence earlier in the auction process.

However, greater complexities and challenges mean some good news as a longer deal process gives commercial due diligence teams the option to spend more time on their investigations, said Paul Mullins, a partner and managing director of consulting firm Boston Consulting Group.

He said: “It’s the silver lining. When debt was available on easier terms, less of the return was driven by underlying performance. Now terms will be driven more by operation improvements and therefore due commercial diligence will be relatively more important.”

Private equity houses have remained proactive in spotting investments at an uncomfortable time for the industry and an even greater focus on commercial due diligence will help them gain a better understanding of their targets, secure financing and win auctions.