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Due Diligence Standards

SOURCE - Financial News Magazine (Efinancial Subsidary)

The level of scrutiny to which buyout targets have been subjected by lenders and acquirers has increased in the past year, placing a premium on due diligence as a means to reassure buyside parties.

Jon Moulton, founder and managing partner of UK buyout firm Alchemy Partners, told the UK Treasury Select Committee

Banks recognised that the level of due diligence was deficient last year, according to Moulton. Due diligence is increasingly being divided into three distinct areas: commercial, financial and environmental.

Commercial

The commercial due-diligence process, where factors such as forecast revenues, market growth and competition threats are examined to ascertain a company’s prospects, has changed in the past five years to become a more penetrative one, according to Alan Gasson, a partner and head of the M&A strategy team at financial services provider Deloitte.

Gasson said: “In the past, the bank’s role was risk assessment.” He said, however, banks have become more interested in a private equity firm’s ability to go “above and beyond” sustaining a business’ value and demonstrate how it intends to grow a company and enhance its competitive edge. Commercial due-diligence teams are asking more specific questions and looking in greater detail at pricing strategy, marketing and research and growing the salesforce.

The change comes as banks increase their involvement in commercial due diligence as passing loans through credit committees becomes more complicated, according to Don Perrott, associate director of advisory firm KPMG’s private equity group.

Perrott said: “Banks’ focus has been on cashflow but we have seen a greater emphasis on understanding performance in a downturn. Clearly they need to understand other risks surrounding each deal but the shaky economic outlook has had a significant impact on the scope of work we are asked to perform.”

Financial

Whatever a potential buyer’s risk threshold might be, the typical lender’s is certain to be lower; banks are more demanding of financial due diligence than buyers, particularly in current conditions. Interrogating an acquisition target’s balance sheet to check for hidden liabilities or potential issues has become more important.

Charles Honnywill, head of the European transaction services group at consultancy Ernst & Young, said: “People part with equity only after doing the requisite due diligence. Debt is harder to secure and it has become more expensive in terms of time and effort to persuade banks to part with it.”

Charles Silcock, a transaction services partner at accountancy and advisory group PwC, said: “Financial due diligence is absolutely crucial. The key to a successful deal is to understand what you are buying, the value it brings and to understand the risks for which protection is needed from the vendor.

“A high proportion of failed deals arise because buyers have not done their homework.”

Chris Grove, head of transaction services at advisers BDO Stoy Hayward, identified a trend away from analysis and interpretation towards the provision of what he said was little more than data packs. This had been exacerbated by the proliferation of vendor due diligence, a pre-prepared due-diligence pack given to potential acquirers, designed to streamline the process.

Environmental

One of the most significant changes to the private equity industry over the past three years has been the establishment of environmental consultancy as a major link in the value-creation chain.

Greater emphasis on corporate social responsibility, fuelled by a consumer culture which demands better levels of environmental husbandry, are causing private equity firms to seek advice from a specialised group of consultants when they are buying and selling businesses.

Sadek Wahba, chief investment officer and global head of Morgan Stanley Infrastructure, said: “It is essential to have a third party looking at green issues. This can also drive value – you cannot assume that the greening of a project is something which can be ignored. It is a variable people can’t simply pay lip service to.”

Demand for environmental consultancy appears to be unaffected by the credit crunch. John Simonson, global M&A director of consultancy Environmental Resources Management, said: “The market slowdown offers the opportunity to look in more detail at how a business could benefit from a more strategic environmental, social and health and safety focus.

“This can cover resource-related issues, such as energy use, waste and emissions, to wider areas, such as trading carbon credits and the geographical location of key facilities.” last week that many investors in buyout debt last year failed to undertake any due diligence on the companies serviced by that debt. He said as a result, as many as 30 UK companies could face problems paying interest on their debt.