Are Private Equity firms buying the right due diligence?

Are their needs the same as those of corporate buyers?

Private Equity companies and Corporates tend to buy a very similar scope of acquisition due diligence services. They buy a huge financial due diligence (FDD) exercise, usually also containing a significant tax component; they buy legal due diligence; and they might buy a bit of operational due diligence (ODD), a bit of commercial due diligence (CDD), and maybe a bit of the supporting products such as IT due diligence (ITDD) and HR due diligence (HR). But Private Equity companies and Corporates have very different internal skill bases, and therefore need to buy different acquisition due diligence products. So why don’t they?

Before attempting to answer the question why, let us consider the differing requirements for acquisition due diligence.

Potential purchasers can be divided into three catageories:

  1. financial investors with little or no business beyond investment and money management
  2. investors with a business infrastructure (e.g. a finance and accounting department, an IT department, a purchasing department) but without operations in the same industry sector as the Target
  3. investors in the same industry, with operational capability that can be merged with that of the Target

Strategic investors

Taking the last category first, the (“strategic”) investor in the same industry will tend to know quite a lot about the Target and the industry in which it operates – since it is likely to be a competitor or supplier or customer. Therefore this investor is likely to know more than due diligence service providers about the business operations themselves, and therefore likely to have little or no need for ODD or CDD (exceptions might be due to confidentiality requirements, or the use of “clean teams” to circumvent anti-trust restrictions, or to provide foreign language skills). Occasionally a due diligence service provider will employ a genuine industry expert who is recognised as such by strategic bidders, and whose contribution to ODD and/or CDD reports is welcomed. But normally the due diligence service supplier’s ODD and CDD teams will have a broader but shallower experience, knowing quite a lot about many industry verticals, but not as much as a strategic bidder.

Where this strategic investor is much more likely to require support is in the areas of Financial Due Diligence, Tax Due Diligence, Legal Due Diligence, IT Due Diligence and HR Due Diligence.

Financial, Tax and Legal due diligences are well defined processes that can be understood by people working in finance, tax and law. However, the transaction timescale imposes immense pressure to review and analyze immense amounts of information in a short time. Therefore finance, tax and legal professionals working for the strategic investor are highly unlikely to have sufficient time to perform the necessary work themselves, unless the strategic investor is a serial acquirer and maintains a permanent DD team in-house. Furthermore, due diligence specialists have “been there, done that” and are able to perform the work far more quickly than finance, tax and legal professionals who devote most of their time to non-DD work.

IT and HR due diligences are more recent processes that are performed by DD suppliers with a widely varying level of expertise and consistency. However, there are important areas that can uncover “deal breakers” and requirements for significant changes to both the financial model valuation of the Target and the integration plan. Again, due diligence specialists (or at least those from the more capable suppliers) are able to perform this work more quickly and efficiently, although involvement from the bidder’s specialists is desirable, especially if the intended degree of integration of the Target is high and there is a need to assess compatibilities (e.g. of employment terms and conditions and pay scales or of IT architectures).

Other industrial investors

Investors from less-associated industry sectors are more likely than strategic investors to require the use of CDD and ODD services. These investors do not have the intimate industry knowledge of a strategic investor and whilst these investors might employ smart people, they do not tend to keep a team of CDD and ODD specialists.

The other industrial investors have a similar requirement to strategic investors for financial, tax and legal due diligence – they buy it from outside unless they are serial acquirers and maintain an internal team.

The case is also very similar for HR and IT DD, although some specific industry expertise is sometimes required (particularly for financial services) and therefore external assistance might be wise even when an in-house capability exists.

Financial investors

Financial investors most definitely need to buy-in industry expertise – although it is quite common that this is (partially) achieved by retaining the services of senior personnel who are between jobs. The financial investor’s own staff are not experts on the industry and cannot undertake CDD and ODD activities. Furthermore, financial investors tend to run very lean and do not maintain sufficient quantities of internal employees to perform due diligences themselves.

Financial investors look to financial, tax and legal DD services to support the financial investment case. Although financial investors see these services very much as commodities, they do not retain in-house teams and need to buy them from external suppliers.

Financial investors also do not maintain in-house HR and IT DD capabilities, and need to buy them, although they may buy these services from specialist providers that are different to the financial, tax and legal providers.

The actual situation

In practice, financial investors focus extremely strongly on the financial due diligence. Whilst this is critical to justifying the investment case, the financial due diligence is a level of abstraction away from the real business. The financial due diligence provides some links to what is really happening in the business through measures such as inventory turn, variability of sales, differences between sales forcasts and actuals, levels of WIP, etc. but financial due diligence specialists cannot delve deeply into the operational and commercial reasons behind these numbers. Furthermore, financial due diligence specialists are not in a position to comment in detail on projected figures, and whether or not they are achievable.

If sales are projected to rise say 10% per annum for five years, what comfort does the investor have that every element in the manufacturing process can support this growth? And, furthermore, as the investor plans for exit at the end of five years, is it able to offer a business that is not bumping up against production capacity limits and unable to grow without substantial capital investment?

Or are cost reduction plans achievable without an unacceptable operational impact? Linear relationships rarely exist between operations and finance, and to assume one is folly. One needs to investigate the link in detail, with operational specialists, before projecting cost savings and assuming that the production environment can implement them.

The financial projections contain implicit operational assumptions that are not articulated and rarely tested during due diligence. By allowing this disconnect between the financial metrics and the business operations, financial investors are running large risks that the investments will go awry.

Financial investors need to get out of their financial comfort zone and focus more effort on commercial and operational due diligence to reduce investment risk.

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