Following a quiet few months in the second quarter of 2020 when private equity managers turned their attention to portfolio management, deal activity quickly rebounded in the second half of last year and has remained bullish. But the challenges of getting comfortable with acquiring businesses led by management teams that sponsors do not know, at a time when they can neither visit company headquarters or sit down with owners across a table, have forced dealmaking to take on new dynamics.

As the longevity of the pandemic’s impact on travel and face-to-face contact became apparent, sponsors who had initially focused their dealmaking on companies they were already familiar with had to find new ways to due diligence opportunities virtually. Over the past 12 months, much has been achieved online that had never previously been thought possible – and a lot of it is here to stay.

On the legal side, virtual data rooms have long been a feature of almost all due diligence processes, but the removal of meetings has been transformative for service providers.

Ross Allardice, partner in the corporate practice at Dechert, says: “The route taken was that covid is here to stay, there is lots of liquidity in the market and lots of dry powder, so fund managers are going to have to take a view on management teams. The only answer was more Zoom meetings and more MS Teams meetings, to get connections and move things forward.”

Marshall Shaffer, corporate partner in the New York office at Kirkland & Ellis, adds: “Pre-pandemic you could have management sessions, particularly in auction processes, that were three hours at a time and involved multiple bidders, scheduled over several days, which could be a real drain on management resources. Now it’s all virtual, meetings are running quicker, it’s easier to schedule because you don’t have to coordinate travel issues, and you can put so much more information on the screen.”

Screen sharing, in particular, has brought many efficiencies and is a significant benefit acclerated by covid cited by many service providers previously used to lengthy conference

“Much of this is hopefully here to stay,” says Shaffer. “I know a lot of people still want to look people in the eye in person but in many industries it may not go back. The pandemic really was the lighter fuel on the move to virtual diligence with respect to meetings. We were already there with documentation, but for meetings, this will probably change things long-term.”

Filling the gap

In addition to the fact that sponsors could not look management teams in the eye, the inability to make site visits and walk the floors of factories or other major real estate assets was a further challenge. Over time, innovations involved using drones to conduct due diligence of certain facilities or asking keyworkers that needed to be on site to conduct tours with video cameras.

Howard Eisen, head of fund services business development North America at TMF Group, says: “I’ve heard of people doing virtual site visits and touring factories virtually; I think the hurdles are pretty high to get comfortable that way.

“Managers are doing it for companies they have known and done due diligence on before, sectors they know exceptionally well or in markets where they have previously put capital to work. If the learning curve is not as steep or as long, then the comfort level may be achievable.”

The need to call on third-party providers for additional insights has been noticeable, and many in fund services have stepped up in the past year.

“People are relying much more on triangulation, and getting independent third-party information from mutual connections”
Patrice Lo

Patrice Lo, Singapore-based commercial director for fund services at TMF, says: “People are relying much more on triangulation, and getting independent third-party information from mutual connections. In Asia, investors have had to work hard to get to any data available, including the exact structure of ownership, because getting the books has been difficult. That information has often come through third-party service providers that are onshore, depending where the investment is.”

Technology also had to step up to fill those data gaps. Rosemary McCollin, a sales director at Vistra UK, says: “As we went back into lockdowns in the autumn of 2020, that’s when people started to consider long-term digital solutions to due diligence to keep the momentum going in terms of deals. Then, huge amounts of data went online as everyone got to grips with virtual due diligence and virtual investor meetings. People wanted much more granular insight from that data to make up for not being in person.”

How did the fund services industry facilitate that? “We used technology to predict the market,” says McCollin. “We used it to predict company revenues, which meant using it to understand a company’s outlook pre-covid, how that company and that particular industry had been impacted by covid, and then what could we derive by delving into that information to try to predict the future.”

As the situation continued to evolve, managers turned to data for scenario modelling to consider outcomes they might never have looked at before.

And today, the complexities keep on coming. “For a long time, everyone across the globe was equal,” says McCollin. “Now, you are starting to see certain industries obviously very distressed, so the opportunities there are no less interesting but the due diligence challenges are different when you have no idea what the market dynamics look like now.

“Similarly, on a country-by-country basis, the UK is doing well but we are starting to see some countries pulling away from others in terms of coming out of lockdown. We might get to a point where if you can’t travel to one country, but you can travel to another, the investment in the latter starts to look materially more attractive. There used to be common denominators but there is a lot you can no longer trust, including data you were using as
recently as last year.”

Deep dive

It is not just the approaches to due diligence, but also the priorities of those processes that have changed materially through the pandemic.

Jon Marston, partner at accounting firm WilliamsMarston in Boston, says: “The buyer focus is really on diving deeply into the drivers of 2020 performance in order to understand either what went wrong and how a company is going to fix it, or what went right and how sustainable that is going to be. Diligence is obviously a lot more about really digging into the results, understanding what changes have occurred in end markets, sales channels, cost structures, supply chains and so on, with tax changes being an additional driver.

“Because the ground has shifted, it is about getting back to basics and there’s certainly a renewed focus on what data is being provided and what it is telling us; assumptions going forward are critical. Then, you get the issue of translating that into a go-forward model. You need to look at a wide range of upside and downside scenarios and how, for instance, consumer behaviours might play out. All in all, diligence involves a broader set of priorities, and often it’s taking a lot more collaboration across the effort.”

“The buyer focus is really on diving deeply into the drivers of 2020 performance in order to understand either what went wrong and how a company is going to fix it, or what went right and how sustainable that is going to be”
Jon Marston

Shaffer at Kirkland says: “Overall the diligence priorities are probably the same as before with maybe two exceptions. The first one is now a stronger emphasis on looking at the impact of covid both historically and forward-looking, both on the business and the market more broadly. We are looking closely at events of default during covid, the remedies employed for those breaches, issues that may occur and the remedies that might be available.

“The second thing people are more focused on is what happens the next time there’s a major catastrophe and thinking outside the box on that. That means looking at the business top to bottom, including at the supply chain, and modelling how it can withstand a cataclysmic event.”

As we move through 2021, environmental, social and governance considerations have also moved markedly higher up the list of due diligence priorities for private equity managers and their investors alike. Allardice says: “There is now a lot more focus on ESG. A lot of sponsors now have their own ESG teams in-house and we have seen a growing demand for legal due diligence reporting on ESG, which is something we have developed over the past year. Funds are really focused on that review as part of their investment committee processes.”

Due diligence has probably been given a long overdue shake-up in the past 12 months, with suspicions about virtual processes that existed pre-pandemic tackled head-on. The long-term impact just might be more technology-based approaches that enhance both efficiency and rigour, drawing even more on the services of third parties and the skills of data scientists.

Certainly, a bullish deal market in Q2 2021 shows no signs of being slowed by virtual due diligence, and in fact online meetings and working from home appear to smooth the processes.

“After the initial set-up period, deals have been going forward at the same speed as always, and often slightly faster, with more expectation that everyone is at home and available 24/7,” says Shaffer. “On the legal side, I think we are probably in closer contact with clients than ever before and there is just less of that formality that comes with being in the office. At all points of the process I am getting more involvement from clients and to clients, which is a real positive.”

Service providers have found themselves to be much more critical cogs in the wheels of the transaction process. At TMF, Eisen adds: “On the equity side, the lead time you get for deals is all over the place. Sometimes you get a call from a client saying we have got a deal, we need to set up an entity in X location and be ready to move cash, and it never happens. Another time the same call requires the same thing in a really tight turnaround. Some of that is a result of dislocation in prices; some of it, dislocation in markets generally, worldwide.

“Service providers have stepped up exceptionally well. Critical investor focused services and accounting pivoted to home working in the blink of an eye; the industry made a superb job of that pivot.”

While face-to-face meetings will certainly make a comeback, large in-person meetings and overzealous international travel looks confined to the history books as managers learn to take more of the comfort they need from behind their screens.