Management due diligence: getting under the bonnet

"Around 15 years ago, the amount of money spent by private equity on management due diligence was a fraction of the amount spent on financial, commercial and legal due diligence," says Bill Priestley, chief investment partner at Epiris. "Industry professionals would all agree that management is the most important resource, so why wouldn't you focus more on it?"

Priestley says that times have changed, and though more intense diligence processes have been around for some time, they have gone from being the exception to becoming the norm. Indeed, a 2017 report by Unquote sister publication Mergermarket and US executive advisory firm Kilberry provided a more balanced picture. The research found that, on average, private equity executives believed that the quality of management at a portfolio company contributed 31% towards the success of an investment, with the company's operating model accounting for 37% and the underlying products 32%. It also found that 44% of private equity investors believed external assessments are the most important formal method for evaluating a management team.

"The management due diligence process used to be a case of referencing, in addition to spending time with a team to form an assessment of who you were backing," says ECI Partners managing partner Sean Whelan. "There was little involvement, beyond the referencing process, from third parties." Since then, he says, the products offered by such parties have become more refined as an increasing number of fund managers have sought external counsel.

If management due diligence is positioned in terms of value creation, it is likely to be more acceptable to management teams" – David Silver, Baird

Silverfleet Capital managing partner Gareth Whiley also says that the process has become increasingly sophisticated, particularly in terms of appraising aptitude and skill sets. "Referencing is still important, but ideally we would like to conduct some psychometric testing on teams and these are tools that have increasingly been used over the past 10 years," he says. "Typically that is not possible pre-deal in a competitive process, but we will at least look at composition of and interaction between the board."

Despite the increased desire of private equity firms to undertake more extensive diligence on management teams, more crowded and competitive processes tend to limit the level of pre-deal access to management teams at prospective portfolio companies, according to Priestley and Whelan. "If management due diligence is positioned in terms of value creation, it is likely to be more acceptable to management teams," says Baird managing director David Silver. He stresses, however, that much depends on how management-friendly the potential private equity buyer in question is perceived to be.

"If you do have access, you can turbo-charge the process by working with third parties who conduct highly structured interviewing that may be supplemented by quantitative analysis or psychometric testing," says Whelan. "We don't insist that management teams go through third-party diligence, but we have found it useful in the past and where possible we try to do it."

Team dynamics
Whelan, Silverfleet's Whiley and Baird's Silver all agree that, rather than purely being about scrutinising the existing team, the modern-day management due diligence process is about assessing how an existing team might perform, what skill gaps there might be and who might be the right fit to bring in to supplement it. Whiley argues that it enables GPs to move beyond simply appointing a non-executive director who has a specific skill or track record, but helps identify which type of character would complement the existing team. With this in mind, Priestley argues there is a strong case for private equity board representatives themselves to undertake the same tests in the interest of providing a more comprehensive picture.

We don't insist that management teams go through third-party diligence, but we have found it useful in the past and where possible we try to do it" – Sean Whelan, ECI Partners

In an environment where entry multiples are high and many are predicting an impending downturn, the emphasis on operational improvement is particularly acute. "Private equity firms are looking for ways to either differentiate themselves in a process, or identify value that others might not yet have identified," says Silver. Management due diligence at the point of entry is one method of ensuring the greatest chance of success in a given investment, but there is a case for the process of evaluation to be more of an ongoing affair.

"You can over-systemise people and it is important to be sensitive to that," says Whiley. "But there is nothing scary about knowing what your skills are – or indeed those of everybody else around the table. It means we can all be aware of where we might need to move the group. And if there is a problem with how a board is performing or interacting further down the line, you can intervene with consultants who are particularly good at assessing team dynamics. We have done that to great effect before."

Furthermore, Whelan argues that the continued involvement of third parties can help build a healthy relationship with managers at portfolio companies. "One of the most important parts of the due diligence process is developing a relationship with the team," he says. "Quite often, it is useful to have the person that conducted the detailed work on the way in carry that journey on throughout the life of the deal. Of course, at that point it morphs into a different product."

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