Erring on the side of caution

The number of leveraged buyouts in the first five months of this year was down nearly 90% on last year's figure, from 92 in 2008 to just 13 between January and May this year. The values are down even more starkly, from more than £11bn in the five months of 2008 to around £400m this year, according to unquote" data.

Despite these dire figures, it is worth noting that half the buyouts (leveraged or not) occurred in the last two months - indicating that buyouts may be experiencing a gentle uptick. Anecdotal evidence backs this up: chats with advisers indicate increasing opportunities even in the last few weeks. But now, banks are proving more prudent in their approach to lending.

Back during the M&A boom, it was widely understood that due diligence took a back seat, with banks and private equity firms rushing through the process to stay competitive. The deal doers were reluctant to confront potential challenges. Needless to say, this had dire consequences.

"During the boom, private equity houses didn't always ask for proprietary commercial due diligence, and we would sometimes agree to piggy back on that," says Phill Lovett, managing director of credit structuring and training for the RBS Corporate & Structured Finance business.

As a result, many big-name banks would rely on vendor due diligence, but there is a danger that vendors can restrict the scope of due diligence, finesse the wording and spin the strap lines to seem more positive. "We would always ask for proprietary due diligence, but sometimes we wouldn't get it," says Lovett.

In today's market, however, it is a completely different ball game. Most private equity firms are now commissioning their own due diligence, both commercial and financial. The analysis is more forensic, detailed and covers a wider scope.

"In the current market, we will not accommodate deficiencies in the scope of due diligence and continue to expect all issues to be drilled into. We are taking a much more active role when it comes to scoping proprietary due diligence, ensuring that the resultant output is both comprehensive and detailed, analysing objectively all aspects of the company's financial performance, its market and legal position," asserts Lovett. He feels that when banks are ready and able to syndicate again, investors will be more likely to demand detailed proprietary due diligence and analysis - and therefore there will be less ability for vendors to "limit scope".

This demand for increased insight is widespread. "We are now keen to have the opportunity to comment on the scope of due diligence at an earlier stage and, if possible, before the work even starts," claims Andrew Mantle, director of leveraged finance at HSBC.

Mantle continues to say that on the financial analysis side, the modeling of downside scenarios has become an area of increased focus.

In fact, the standard of due diligence has become so important to banks that RBS has actually decided to step back from certain deals where it has been asked to cut corners.

Banks' increasing caution could be part of the reason why there has been so few take-privates these days, for which comprehensive due diligence is more difficult to attain. This is because buyers are expected to form opinions based on public information. Mantle says that it is more challenging to "get under the skin" of these companies, as there isn't as much access. But he is seeing a number of take-private opportunities coming across his desk, which have to be considered on a case-by-case basis.

The longer, the better

With all eyes on due diligence, time to complete deals is increasing. Longer periods of exclusivity are now quite common, with bidders and lenders taking their time to consider their decisions - not ideal for a vendor. Could this be the new hurdle to completing deals?

"The process was too rushed in the past. Longer completion times are not necessarily a bad thing. It is up to vendors to be patient if they want to get a fair value for their companies. This is what due diligence is there for - to identify potential risks and resolve these problems through appropriate structuring and negotiations," says Lovett.

But after long periods of due diligence, vendors may decide to wait until the market comes back to sell, as discovering potential problems in the company could mean a sharp decrease in its value. As investors seek to de-risk deals even further, inevitably, more deals will fail.

"Vendors have to come to terms with the fact that their businesses are worth less than they were," affirms Mantle.

Tracking the industry

Adequate diligence isn't the only thing on banks' minds. The lenders are analysing the private equity firms as much as the transaction. Buyout houses are being graded not only on their relationships and profitability, but also on their track record with deals gone wrong - how do equity houses react when companies get into trouble? How often have sponsors left lenders high and dry?

Lovett prefers to work with private equity sponsors who are more "hands-on" in terms of scoping due diligence and working with banks to deliver the financing package, as this allows for a more collaborative and robust approach to risk analysis.

Even due diligence advisers are getting the hard end of the stick. Banks are now looking carefully at trends and issues that emerge in the industry. Lovett says that pre-recession, a number of commercial due diligence providers had been overly optimistic in terms of supporting aggressive revenue growth assumptions - with sensitivities that have proven to underestimate the impact of the current recession.

Mantle believes that there will also be more of a demand for due diligence advisers that have specialist sector expertise and a proven track record in a particular industry. This could indeed be the case, as an economic downturn is an opportunity to consolidate sectors by buying complementary and competitive businesses at reduced valuations.

It seems like debt structures aren't the only part of the deal process that is changing. Due diligence has become rigorous and banks are now more choosy than ever when it comes to the quality of the buyout houses with which they work. As a result, deals are taking twice as long to complete, which could mean that the level of fast-paced activity that took place during the boom may never return.

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• UK / Ireland