Due diligence: Levelling the playing field

Since the market collapse at the end of what was already a relatively slow 2008, the European M&A market, and private equity in particular, has become accustomed to investment inactivity. Indeed, in the buyout space the first quarter value total of €1.9bn was the lowest recorded since 1994, while the second quarter has currently only racked up €978m worth of transactions and is on course to set an unprecedented low in the 17-year history of unquote" recording deals.

With the private equity community current awash with dry powder, the main stymie to transaction completion continues to be concerns over pricing. Partly due to the ongoing difficulties in the banking sector, which is keeping leverage multiples at low levels and larger packages off the agenda completely, buyers are short on confidence in terms of the value of assets, while for vendors of solid businesses it simply makes very little sense to sell in the current market.

The value of distressed
According to most practitioners this mismatch is likely to track the trend in the wider economy, meaning that there will not any tangible recovery until the first half of 2010 at the earliest. However, as has been observed on many occasions there are inevitably going to be a number of vendors in need of more immediate exit solutions, which will provide a number of opportunities in the coming months. Some of these will involve fundamentally sound assets being sold by a distressed owners; in most cases there will be at least an element of distress in the target itself.

Though these investments are obviously a far cry from those transacted on a more voluntary basis, the fundamental determinant of their success (or otherwise) similarly boils down to pricing. "In a normal sales process the key consideration is what price you can achieve. All deals come down to a combination of price, deliverability and timing: with distressed sales you don't have the luxury of time and therefore aspects of the process need to be streamlined," explains Gareth Davies of Close Brothers Corporate Finance.

Such timing and deliverability concerns mean that the nature of due diligence in these deals has changed, with the focus squarely on establishing common ground in terms of the short-term trading of the business in question. "There has been a switch from a focus on historic performance to a focus on cash-flow now and in the near future. The main metric is the ability to generate immediate revenues and the capacity of the company to resist additional downturn in its sector. Buyers are obviously taking a risk and this is reflected by a reduction in assumed price," says Eric Demuyt of Ernst & Young.

Adrian Balcombe of Alvarez and Marsal concurs, adding that the process of coming to an assumed valuation has become much more collaborative. In recent years the transaction process had evolved to a point where buyers would arbitrarily come up with an entry multiple, only conducting diligence to confirm the business' profit assertions - a system likened by Balcombe to a "sausage factory". In contrast, there are now questions over how best to base a valuation, will all parts of the advisory chain becoming important in order to define a method that will be universally agreed as the most reliable.

Bridge over troubled waters
Such distressed investments though, even despite the dire predictions of some analysts, are likely to occur in relatively small numbers. Private equity groups are instead focusing on restructuring operations for their own portfolio companies, with the financial press currently awash with high profile examples and predictions that this is merely the tip of the iceberg.

Advisory groups are therefore also refocusing their businesses towards services designed to facilitate these discussions, with many bolstering the size of their restructuring teams in recent months through both new hires and movements from other, less busy, divisions. "One major area where there is currently more business is in helping stakeholders to evaluate the state of their investment in a given company. Specifically this work involves conducting an IBR (independent business review) following a covenant breach - usually at the request of creditors but increasing on behalf of sponsors that are anticipating difficulties," confirms Alvarez's Colie Spink.

However, although these situations are very different from transaction due diligence, the specifics being examined are remarkably similar to those outlined above. "The techniques are similar to those in distressed deals, with an IBR simply being a more specific analysis of certain key issues, as the parties involved theoretically already know the target well," Demuyt states. Once again, then, cash is king. "Its all about integrating financial and operational due diligence to identify if the business can meet its business plan. Cash is now chapter one instead of chapter seven in the process: everything is based around a 13-week cash-flow forecast," Balcombe explains.

But while the process of an IBR may be similar to that of due diligence, subsequent negotiations are invariably much more complex due to the practice of debt syndication during the boom years creating multi-layered debt structures, comprising groups with very different agendas. "Fights between creditors can be immense. Some don't want to make write-offs and therefore the restructuring becomes merely an elastoplast solution; its like a World War I hospital and we'll see these walking wounded coming back around," argues Davies.

In essence, then, the goal of the intermediary in these deals is to bridge the gaps between the various stakeholders so that some kind of workable agreement can be reached. This is key not just because it will undoubtedly help save many businesses, but because it is essential to protect the value of investments for all stakeholders of companies that are not under threat of collapse, but that merely need to restructure their balance sheets. "Its all about establishing a platform from which all parties can begin a meaningful discussion and achieve their common goal. Both banks and sponsors are responsible for helping to find a solution for a business," Demuyt asserts.

Alignment of interest
The irony of the current market conditions are that while everybody is being affected by the same set of issues, the consequences vary widely from group to group. The net result of this is that the usual subjective interpretation of a given situation has been exaggerated and finding suitable compromises has become increasingly difficult. In the case of many potential new deals this has little effect except to delay the transaction, with both vendors and buyers likely to naturally find common ground when economic visibility is improved. However, there are obviously cases where the waiting game is not an option, either because a vendor is in need of an exit or because a business is in need of new money or a reduction in its debt levels.

In many of these situations some or all of the parties will have to take a hit in terms of the value of their interest, with failure to find a compromise in this regard invariably leading to larger losses or even complete write-offs and insolvencies. "The challenge is to get everybody pointing in the right direction so there can be a consensus view on why one deal is the best option," agrees Davies. Indeed, private equity's mantra of alignment of interest through value creation is often irrelevant in the current market, with the task rather being to apply the same principles to best protect existing value. In this regard, the importance of intermediaries to level the playing field has arguably never been more important, and has certainly never been more difficult.

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