This article is sponsored by PwC.
What information are clients looking for in pre-deal due diligence and how is your scope of work changing?
Friederich von Hurter: Previously there were separate tax, legal, operational and financial due diligence books usually compiled by different advisors and the challenge was to combine all this information, identify dependencies, and how it is linked together. There has been a shift to developing a value creation story that ties all the information together and describes how change is possible. Deal due diligence is not simply about creating a picture of the company at one point in time. It now means collecting and interpreting numbers and providing advisory services to create and implement a future-proof plan.
This process runs in parallel with the deal. As a consultant, you check the usual hygiene factors and basic assumptions while developing your value creation hypothesis, which you then check is realistic with regards to dependencies and legal restrictions, etc. The value creation story is reflected in the final investment decision. The reports we deliver serve also as manuals for management by describing what to do in the future and how. That is why we say value creation begins in due diligence.
Filip Debevc: Pure due diligence work looks at historical performance and existing plans to identify issues and risks within the target’s business model and operations, in their go-to-market strategy and so on, and benchmarking. Typically, that work is completed and then stored. Now, as advisors, we are asked to solve problems and issues that have been discovered and to provide mitigation strategies for risks identified, as well as consider synergies and other benefits. The scope of due diligence is broadening. It is not just paperwork. It now includes the implementation path for a business plan of strategic value.
Where is the pressure for this additional insight coming from?
FD: On the buyside, we see very competitive auction processes. This enables sellers to supply limited documentation and unanalysed data. Usually, private equity buyers take this data and conduct the analysis work themselves to identify value creation potential. This is carried out without communicating their findings to the sellside or disclosing what they have priced into the transaction value. Conversely, we now see vendors preparing materials that spell out possible future improvements, which they have not pursued for whatever reason. This means they can price this potential into their target value.
FvH: Whether on the buyside or sellside, overall, the effort put into undertaking due diligence is increasing in order to gain a better understanding of complexity drivers, to argue a value creation story and to explain high multiples. From a sellside perspective, with larger businesses, vendors usually compile their own due diligence report. It is an opportunity for the seller to thoroughly describe the target. We are in bullish markets and as a lot of good targets have already been sold, vendor due diligence helps the seller to argue their price ambitions.
How frequently are commercial and operational due diligence included in the pre-deal process?
FvH: Each case is different. If the business does not have any operations, then clearly operational due diligence is not required. If it is a top line-driven project, then commercial due diligence comes into focus. The bigger the target and the proportion of the portfolio it represents, and therefore the risk to the investor, the more frequently these two are performed.
More recently, due diligence work has begun to stretch across different areas of expertise, from assessing EBITDA improvements and future profitability right down to the cash level, as well as including to look at topics such as legal entity footprint optimisation.
Are there specific synergies you typically identify?
FvH: Synergies differ depending on the industry. What is more important is that we have a structured approach to identify and value them by considering the entire value chain, starting at procurement and ending at after-sales services, and including support functions.
The interesting thing about synergies is that in order to understand them, you need to know yourself and the target. You need to know what to leverage the synergy from. In procurement, for example, if you want to combine two supplier contracts, you need to know your own and the target’s procurement arrangements to come up with an estimation.
FD: We recently worked on a transaction where the seller identified potential synergies with a prospective buyer after conducting outside-in work on the buyer. With a picture of possible synergies, the owners were able to tell the buyer that they believed the business was more valuable to them and therefore, they had to pay more. Sellers are becoming more informed earlier in the process because they know there might be additional value available to them.
In due diligence, identifying synergies now also includes how to implement them. This has become part of the investment decision and hence the financing decision. This means we now provide banks, as well as investors, with due diligence reports on potential synergies.
Compiling information on value drivers such as synergies requires access to sensitive data. How do you manage this?
FvH: Previously, advisors on the buyside would simply process data supplied by the vendor, like a fact book shared in a data room. Nowadays, almost every project has a dedicated ‘clean team’ that has access to commercially sensitive, confidential data that has typically not been shared previously. This team needs to have the ability to calculate value drivers such as synergies, which they would not be able to do if they were limited to publicly available data. We used to see a clean team on about 10 percent of transactions. Now it is more like 60 percent. Their presence is proof of the growing complexity of the due diligence process.
The deal is signed. Then what happens?
FvH: In phase two, you bring the plan to life. In any transaction, you need a deal captain to guide the process from the beginning. This is someone who understands all aspects of the extended due diligence and has the ability to convert it into value creation, while keeping an eye on the bigger picture. After the deal closes, it is crucial that deal leaders, the operating partner or portfolio team member and advisors stay on the deal as long as possible to leverage the insights gained and mitigate the risks identified.
FD: Most of our private equity clients are aware of the benefits of this enhanced approach to due diligence. If they stop the process as soon as the transaction is signed, they lose traction. Private equity firms do not want to directly manage a company, but they are also buying the management team, so it is very important they have a good one. In our experience, this team, which has moved from being on the sellside to working for the new buyside owners, is very happy to receive the observations and ideas that came up in due diligence, including the books and models. For instance, in one deal, we had a chief information officer who was not aware of cyber security risks that were included in our report. That was a quick win. We have also seen this apply to mid- and long-term improvement measures.
From the sellside perspective, even if you decide not to proceed with a disposal, you can take advantage of this approach. Earlier this year, a client decided to pull back and not divest a business. Typically, all of the work we had carried out would have been viewed as sunk costs but that was not the case. Through due diligence and the identification of potential improvements, our client learned a lot about themselves. They started implementing the proposed solutions and mitigation actions.
What skills does an advisory team need to execute this work?
FD: You cannot perform analysis on a value creation approach by simply conducting desktop exercises. You need to have implementation experience, interact with clients and lead integration work. If you do not, post-merger integration projects and synergy estimations cannot have a profound impact. That is why we are not a pure due diligence team, but also have staff with operational expertise who can switch roles to contribute to the implementation of the plan.
What contribution can ‘Big Data’ make to value creation?
FD: Consultants, advisors and investors are increasingly realising that by overlooking data some value is being left behind. There could be much more forward-looking analysis done with digital tools that we see in the market today. However, you cannot use this tool if the data is not available.
Almost every company is allocating a significant amount of manpower and budget to increase data collection and analysis to better understand procurement and manufacturing processes, or generate improved predictive maintenance analytics, for example. During a transaction, companies in particular industries, like tech startups, typically provide a good amount of data that we can use to understand value drivers such as the strength of a business’s client base and the rate of sales conversion. Yet some traditional industries still lag behind. Businesses are aware that the data exists, but it is not being taken into account and sufficiently analysed. From a sellside perspective, this means they are not aware of the value potential of the data they hold. From a buyside perspective, they are not putting the data on the table and scrutinising it.
What are the key growth drivers?
Friederich von Hurter: It is case by case, however, in nearly all cases there is low hanging fruit. A fresh perspective can identify drivers that management and the owner do not have on their agenda. Surprisingly, there is very often scope for improvement in procurement. Rebooting established relationships would generate better results. You do not have to adjust much in the operating model or implement many changes because this involves people and contracts can be quickly changed. It is more of a value driver than people expect.
We are also sometimes surprised by the lack of digitisation. We know because we implement them, that there are digital tools available that are easy to implement. Related areas in IT where we typically see improvement potential include software applications and licence management. People are not taking sufficient care. For example, they buy a licence and do not terminate applications that are no longer used, or they do not conduct a strategic cost review of their IT landscape.
Another factor is cleaning up the legal entity landscape. Sometimes an international business has built up a large footprint of legal entities that require tax, auditing, and regulatory filings in each jurisdiction, as well as cash management. Deciding to close some of these offices results in complexity reduction, which can ultimately lead to cost improvements over two to three years. The impact of this is hugely underestimated.