Diligent deal doers

Nathan Williams
01 September 2008

Tweet
Facebook
LinkedIn
Google plus
Send to

At the height of the liquidity bubble the due diligence process was being squeezed by all parties involved on a deal, from vendors to banks, advisers to LPs, as firms battled to get deals on their books and investors rushed to access funds. Now the market has cooled, director at SVG Advisers Sam Robinson believes the diligence process is reverting to pre-crunch conditions and that "GPs may respond in two ways: Some may feel that, as deal flow slows, there is less time-pressure and they can take their time fundraising. However, others may try to ensure they have LP commitments tied up before the market falls any further."

One investment executive at a European fund-of-funds claims that the diligence on funds that closed in Q4 last year or early this year was "some of the most difficult I have been involved in. We were in un-chartered territory and no one knew from day-to-day where the market was heading. As a result private equity houses were in a hurry to get funds closed in some cases and in a panic in others." A larger LP with greater resources to dedicate to the process was under less pressure: "We are constantly diligencing so that we are ready to make a decision quickly when the fund comes to market," says John Gripton, head of investment management for Europe at private equity asset manager Capital Dynamics. Generally speaking, an LP is considering re-upping it will already have an established relationship with the manager, which makes things more straightforward. "That said, we would have to know a manager exceptionally well to complete diligence in one week," explains Gripton.

As the market settles down in Europe, LPs will have more time to assess opportunities and could use the slowdown as an opportunity to rebalance relationships with GPs. A common complaint from LPs over the past few years has been the shift in the balance of power away from LPs and towards GPs. With private equity houses able to raise capital at speed and with relative ease, LPs had little scope to reign in GP demands. In an environment where raising capital will become more difficult, LPs may look to take advantage of GPs' reduced bargaining power and drive down management fees. "It is true that there is more of an opportunity now to re-balance but it is important that a relative balance is kept. A pendulum effect, where this balance is swinging back and forth, is not healthy," says Gripton.

However, Gripton explains that it was not the fees per se that were the problem but the sheer size of funds: "In many cases the GPs had not increased the percentage of the committed capital that is charged as a management fee but were simply managing so much more capital, hence the significant rise in management fees. Were these fees justified? Well some buyout houses are extremely large organisations these days." Robinson believes that "management fees become an issue when the management reduces the amount they are putting into the fund and how much carry they are re-investing." LPs must also take a less technical approach to the diligence process and assess the "invisibles." As Robinson says, "it's not just about the money. You have to look into the whites of their eyes and see if they still want to do deals."

The credit crunch has presented LPs with diligence challenges not seen in some time. With the market for deals over £1bn+ closed, there is anecdotal evidence that employees at some big buyout houses are getting frustrated at their lack of deal action. "We were recently hiring for an investment executive. We had around 70 applications and 12 were from Apax employees. They just want to do deals," one UK-based European mid-market investor reveals. "The turnover at associate level we do look at but we are more focused on the turnover of the senior investment professionals. However, turnover can have its good sides too and is not always unhealthy," believes Gripton.

Another diligence challenge for LPs related to the economic downturn concerns the potential for increased workload at a private equity house. "The due diligence questionnaire will ask a number of probing questions. The workload analysis will look at how stretched the team is, how many board seats they hold, the state of the portfolio, which companies require less work and which require more work," says Armando D'Amico, managing partner at placement agent Acanthus Advisers. With the economy slowing and portfolio companies coming under strain, GPs - those companies ticking the "more work" box - will inevitably rise. Private equity houses will have to show existing and potential investors they can manage with an increased focus on portfolio health without comprising its ability to do fresh deals.

On the deal side, the due diligence process was squeezed as corporate financiers set tight deadlines and firms rushed to get diligence done and win the deal. "Short-cuts were taken in some cases but clients were prepared to take a view as to what was acceptable and what wasn't," says Paul Abrey, director at real estate due diligence adviser DTZ. Co-exclusive diligence, whereby a small fee was paid to enter the bidding process and conduct diligence on a target, became a process some were not willing to enter. "Some clients were not willing to risk time and capital on co-exclusive diligence. They would prefer to focus on doable deals," says Timo Tschammler, director at DTZ. Getting co-exclusivity for a small lump sum was one thing, but getting exclusivity on a deal at the height of the diligence process took deep pockets. "In order to get exclusivity on a deal, buyers were being asked to put down a non-refundable deposit payment which regularly ran into seven figures. This is not happening now," reveals Tschammler. An investment executive of a European buyout house says the quality of information has deteriorated in recent years. "Without question, diligence quality eroded because of competition for deals and the tight deadlines set by banks and advisers. I have seen surveys in the data room that were so thin it was of no help in assessing whether to bid for the company" (See box, Data room).

"There was more process pressure a year ago to take short cuts. There is always going to be some pressure but it has come off since last year," says Paul Marson-Smith, managing partner at UK firm Gresham Private Equity. The danger with hurried due diligence is that problems do not get flagged up because the acquirer does not have the time to take apart projections and test risk models as thoroughly as it would like. "The fees being asked (by diligence advisers) have shot up dramatically and the quality of the output can be difficult to judge as they are reluctant to give opinions. You end up paying more for less," says Daniel Finestein, partner at UK private equity house Infinity Asset Management, which has its own in-house financial and commercial due diligence team (See box, In-house).

Due diligence pressure will always be there but as with the rest of the market, a peak was reached from which market players are now coming down. As covenant-lite was the high-water mark on the debt side, so non-refundable seven-figure payments may come to be seen on the diligence side as the sign of a market that had lost sight of where the boundaries lay.

Data room

The use of data-room software to facilitate transactions is a relatively new phenomenon. "It enables you to track buyer behaviour, see who is digging deepest on a deal and is thus the most interested, and allows things to be done at distance. The technology is relatively new and has not yet extended through the market," says Andrew Pearson, managing director of EMEA at Intralinks, a virtual data room provider. Data room software has been implicated as a cause of the credit crunch due to the ease with which it allows banks and others to conduct trades. Pearson says that Intralinks "provides compliance technology but the compliance process is the responsibility of the individual organisation. If someone really wants to break the speed limit, they will always find a way."

Emerging markets

Due diligence in emerging markets is a different challenge and one which was made all the more difficult due to the wall of cash that was looking to be invested over the past few years. "In emerging markets, it was difficult for buyers and sellers to get top tier advice because people were so busy that the capacity wasn't there. This meant settling for a lower-tier adviser which can carry more risks due to the quality of the advice," says Paul Abrey of real estate due diligence adviser DTZ. Less developed markets also present other problems regardless of the economic cycle. "In less mature markets you need to look at the political stability. On an individual level you need to check if people have political affiliations with undemocratic regimes. You would scroll the list of countries the US has sanctions against and see how that would impact the business. In these markets you hear a lot from your people on the ground more than anything else," says Una Barrett at corporate intelligence firm Quest.

In-house

"An in-house process is less painful for the target because there is only one party going through the documentation; it tends to be more closely focused and is generally quicker, which helps put you in a stronger negotiating position with banks. It is also cheaper, although this is not a major driver," says Daniel Finestein, partner at UK private equity house Infinity Asset Management. If the coming months throw out as many distressed opportunities as some are predicting, the speed with which a deal can be put together will prove crucial. This is where an in-house team can really prove its worth. "If something is coming out of administration you may be given a week by the insolvency practitioners to put together a bid. If you are contracting third party advice doing it within a week is very difficult," says Finestein.