Q&A: The evolution of due diligence

1. Prolonged due diligence processes are said to be stretching deal timelines beyond the norm. What major changes have you seen with regards to due diligence?

The world of private equity has significantly changed post-crisis, and so has due diligence. Gone are the days of 80% leverage and rubber stamp reports for the banks. Investors these days, with a 50% equity ticket, have less leeway in their investment case to meet returns targets. Banks, no longer suppliant, have become more cautious and more critical. Hence, more than before, due diligence is expected to pressure-test the core beliefs of the investment thesis. Questions include: How did the target perform in 2009 and what are the lessons learned? Has the industry changed fundamentally post-crisis? How volatile are the end-user markets going to be? How sustainable is the target's business model and strategy in the the current environment? How attainable is the management plan and what are key sensitivities? What are realistic growth and margin expectations?

If the seller is well prepared to answer these questions, due diligence does not necessarily have to end in a drawn out process. When we act as sell-side M&A adviser, this type of thorough preparation is one of our key tasks. Yet, we observe an increasing number of processes, especially in primary buyout situations of privately held businesses, which lack the required level of preparation and tend to stretch well beyond the normal timeline.

2. So what exactly are the main reasons for drawn out due diligence processes?

Typically, it is a combination of high valuation expectations and insufficient or even poor preparation by the seller. To name but a few examples: the target's business model and its competitive advantages are not sufficiently described; the business plan lacks convincing assumptions or is not credibly linked to strategy; tangible initiatives are missing; sometimes, even the financials are not prepared in a consistent manner.

It is important to note that professional buyers embark on those situations only if they strongly believe in their investment thesis, negotiate on a quasi-exclusive basis and feel they can strike a good deal.

The potential buyer then typically adopts a two- or three-stage due diligence process, which may well extend over several months. This includes a pre-due diligence based on management meetings and an initial set of company data, followed by a red flag report addressing the critical core beliefs and possible deal breakers. In case the report is considered to be fine, the financial, legal and tax due diligence can begin. Finally, there is a full-fledged bankable due diligence.

3. As a provider of commercial due diligence, do you observe a certain cyclicality of demand by private equity houses?

In general, the demand for commercial due diligence closely follows the overall buyout activity. Hence, the market strongly declined in late 2008. It did not come to a standstill though, as many private equity houses saw the crisis as an opportunity for add-on acquisitions to their portfolio companies. In addition, we conducted a number of commercial due diligences for refinancings and bank negotiations. Moreover, there was an increasing demand from our private equity clients for strategy projects, performance optimisation and long-term exit preparation, which helped us to compensate the decline in "classical" due diligence work.

With banks returning to the stage, demand has picked up strongly again in Q1 2010, at least in the small- and mid-cap segment. We expect a further leap in commercial due diligence activity in the fourth quarter this year, when the first wave of delayed private equity exits will make its way to the market based on 2010 preliminary financial figures.

4. Has the role of commercial due diligence changed in the past couple of years?

The role has significantly changed post-crisis. Commercial due diligence has become the backbone of the buy-side process and the key basis for the investment decisions, as investors and banks keep telling us.

Moreover, the nature of the process has changed. Beyond the traditional aspects of the market, environment, positioning and business plan assessment, we are increasingly asked to provide an in-depth analysis of the target's business model, an outline for the post-acquisition full potential programme (including stand-alone initiatives and add-on opportunities) as well as exit considerations and potential buyer spectrum.

Last but not least, vendor due diligence has gained more importance in the small- and mid-cap segment, as they are a key lever to retain more interested parties (and banks!) in the process, achieve better deal results and avoid drawn out processes.

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