Q and A: Due diligence

What are the major changes you have seen to due diligence in the past 12 months?

Due diligence has fallen of a cliff recently, following a peak in activity in March 2008, when the capital gains regime changed. We expected a hiatus after the peak but post summer activity failed to materialise due to the lack of debt and the fact that prices hadn't fallen to match investor expectations. Investors are always wary of catching a falling knife as the market continues to drop.

Changing market dynamics have impacted due diligence. Firstly, with debt in short supply, banks have taken more control of the due diligence process. There has been a realisation and an acceptance by equity investors that they now need to get banks involved earlier in the transaction process. Banks are also being more selective, dealing with private equity houses with which they have a track record - they are diligencing the private equity house as well as the transaction.

Secondly, market dynamics have changed: it is a buyer's market and they are calling the shots. Buyers are pushing back when advisers attempt to drive a process hard and transaction timetables have extended as investors seek to de-risk deals even further. Inevitably, more deals fail and those that do complete will take longer.

Lastly, whilst over-supply is driving diligence pricing down, demands on advisers have increased. We are being pushed harder for clear opinions and recommendations. It's a tough market for advisers at the moment.

What is the biggest challenge for due diligence advisers in this new environment?

The biggest challenge is the level of comfort around the achievability of projections and forecasts being demanded by investors. This goes not only to price but the investment rationale and is a big part of what is holding deals up at the moment. Unfortunately, no-one has a crystal ball.

We've also seen a shift in the assessment of the investment rationale. Investors can't expect substantial returns merely riding a bull market and relying on the ability to financially re-engineer a business. Value has to be generated through operational gearing and enhancing the sustainable profits of a business. This has increased the focus on the operational and business improvement aspects of due diligence.

Do you think that a large part of what is going on now is a result of inadequate due diligence?

I think it is difficult to blame it all on due diligence. I think that, in some cases, due diligence undoubtedly took a bit of a back seat. Investors had deal fever and simply went through the motions of the transaction process, as potential challenges were not welcomed. Enhanced concerns around risk management have also contributed to bland due diligence reports where there is much analysis but little interpretation and few opinions, which are ultimately what investors pay us for.

What can be done for ailing companies now?

Stakeholders need to face up to reality. Identification of potential issues and early communication are fundamental; banks are responding positively to early conversations. Facing up to challenges early, before the equity is under-water, provides a greater chance of equity investors being prepared to follow their money. Leave it too late and options will be limited. The world has changed and management teams need to assess if they are the right people to lead their business through this challenging period. Navigating a business through a recession is a very different challenge to leading a business in a booming economy.

External advice is vital because few management teams have the expertise or the experience to deal with the challenges businesses will face in these unprecedented times.

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