Against a backdrop of heightened economic and political risk, coupled with increased ESG pressures, DD providers discuss navigating significant complexities to maximise value for their PE clients.

At the table:

• David Andrews, LDC
• Martim Avillez, Limerston Capital
• Bruce Douglas, Confidas People
• Fleur Hicks, Palladium
• James MacLeay, WestBridge
• Val Monk, Montagu 
• Josh Nunn, Vaultinum
• James Smallridge, Soho Square Capital
• Martin Summers, Flint Global
• James Tetherton, Graph
• Moderated by Nicholas Neveling on behalf of Real Deals

Q: The backdrop for private equity dealmaking has completely changed during the last 12 months. There has been a double-digit decline in deal activity, and the deals that do progress are taking longer to close. Has this changed the way sponsors and providers are scoping and conducting due diligence (DD)?

David Andrews: Despite softer trading and a tougher market, there are still deals to be done and it is important to get due diligence right. We have always scoped DD on key questions and hypotheses so we remain focused, and our approach hasn’t changed.

Everyone recognises that it is more difficult for businesses to prepare for a sale when the macroeconomic picture is volatile, but thorough due diligence means you can get the right deal for all parties.

In our conversations with advisers, we are picking up that the timeline from appointment to prepping a business for sale and launching a process is extended when compared to a year ago. However, we know that a strong-performing, well-prepped business can still transact quickly.

Martim Avillez: Demand from GPs for high-quality advice has increased significantly, and the expectations from GPs are higher. That means that there is much more back and forth between GPs and DD advisers, so due diligence is slower.

Val Monk: In addition to changing deal process dynamics, the scope of the diligence that dealmakers have to cover is widening and becoming more complex.

ESG due diligence is an example of this. The rules and standards for ESG best practice are still maturing and not always clear. The lack of a stable ruleset for ESG is a challenge for GPs when it comes to DD. GPs must understand potential risks and, in a more cautious market, may spend some additional time assuring themselves of the quality of a business.

James MacLeay: Complexity and extended timelines have also become a feature of acquisition finance markets. Liquidity is tighter, so sponsors go out to a broader pool of lenders who they maybe haven’t worked with before. Lenders want to understand who they are working with, as well as having more stringent diligence and sectorial views, and build a relationship, so the process does take a bit longer.

James Smallridge: The only point I would add is that in this more difficult market, a number of sale processes are starting off as less formal fireside chats that then lead to smaller, bilateral discussions. The seller won’t have the full pack of vendor due diligence (VDD) ready to go at this point. They are almost testing that there is a market and interest before pruning the list of interested buyers down to three or four, rather than 16 or 20. Only then will the seller commission the VDD and launch an actual process.

Josh Nunn: We specialise in software DD, covering everything from IP and cybersecurity to scalability. Twelve months ago we were submitting reports to GPs and there would be less in-depth follow up questions where there was no high-risk vulnerability found. A few queries on red flags and how an asset could scale and that was kind of it.

Now we are being asked to go back and spend a week digging into a certain aspect of IP or a certain aspect of cybersecurity. GPs are definitely taking a more granular approach and we are being given more time to dig deeper into very particular items.

One area where there has been particular focus is on the human capital element of a software company. Buyers want to know who has written the code, whether those people are still with the firm and what their roles will be if the sponsor has plans to make bolt-on acquisitions or expand into other geographies.

Martin Summers: The market for political and regulatory due diligence has shifted in the last few years. On the one hand, we are often used much later in the process, when a deal is in exclusivity, rather than during bidding rounds. At the same time, however, we are also doing significantly more work very early on, helping GPs with origination and building comfort around particular sectors.

The increase in early-stage work is interesting. In a market with lower deal volumes, investors are looking for ways to widen their pipelines and explore new sectors or countries that they don’t know much about.

Across all sectors we also see that the amount of political, regulatory and institutional complexity is much higher. Dealmakers increasingly have to factor in trade policy, FDI policy and competition policy. Questions that used to require an understanding of one or two government departments or regulators now might involve three or four or more. It is more complex and we sense that dealmakers want to build that understanding early on before moving forward.

Avillez: To echo what Martin has outlined, the regulatory and political uncertainty during the last five years has been just enormous. You expect the policy to go one way and very quickly everything moves in the opposite direction.

GPs have relied on due diligence to get to the bottom of what is going on and provide some comfort or confirm a decision to back away from assets where regulatory and political risk is high.

Q: Have other participants seen a shift to GPs mainly using DD providers either in exclusivity or for early, broad, sector-level work?

Fleur Hicks: We cover commercial, digital and technology DD, and what we have seen is that the digital and technology due diligence is really only coming later in the process.

On the commercial side, however, we have also noted a meaningful uptick in early-stage commercial due diligence work, including market mapping, snapshot reports and even educating investors on market dynamics in new territories. This work probably constitutes about half of our due diligence revenue at the moment.

Another development we have seen is a bit of a delineation between VDD and exit preparation, particularly on the digital and technology front. We have been asked to do things like technology horizon scanning and management plans stress testing, well before work on the formal VDD pack begins. The work is to support exit preparation but the scope is less than for VDD. It is an interesting nuance coming into the market.

Nunn: Fleur’s observation on exit preparation and VDD is interesting. We find that we are not being called in the three months building up to an exit, but more on an underlying basis. So, every six months we will run industry comparisons and benchmarking on all software assets to track growth and market improvement. Having the time to track assets over a long period presents a different dynamic and approach to exit planning, and ultimately increases exit price.

Andrews: As we think about prepping businesses for sale, we are absolutely looking at technology, data and digital early on. Before progressing into a full-blown VDD exercise, we want to make sure there aren’t any value drags or any red flags to a potential buyer. You’re not going to fix everything but you do fix the things that absolutely have to be fixed before a due diligence process starts. It also means that there is a plan in place for the next buyer or investor plotting a company’s technology strategy for the next five years.

We have taken a similar approach to ESG. It is so important to evolve portfolio companies and make sure that the ESG piece is in place to support an exit in the future.

It’s also true that ESG is very important when going into deals now, as you’ve got to evolve those businesses to make sure they can cope with an uncertain regulatory future. We are investing in that area with our own in-house resources, and we are also using third parties to make sure that our businesses are ESG future-proofed.

Q: How has the shift in the macro backdrop changed private equity thinking around management teams specifically, and whether a management team is fit for purpose?

Bruce Douglas: The reliance is always on the management team to deliver and, as such, they are under a lot of scrutiny, but investors who want to back people are understandably very reluctant to go into a deal thinking: “We’re going to sack the CEO.” That’s not the ideal scenario.

What we have seen is that 18-24 months ago, we used to complete our work, send a report and have a call with the investor to lead the deal – and that might be it.

Now we are also presenting to investment committees and being asked to expand the scope of the project in certain areas. GPs are taking their time and doing more work to get comfortable with things that 18 months ago would have felt very straightforward.

On the point about changing management teams, we used to do what we call a management reset around once a month and then five or six management due diligence projects for new deals. That balance shifted for a few months as economic conditions became tougher and we were doing more management resets, and slightly fewer new deals for a while.

There is an element of sponsors getting more hands on with the portfolio when there is less new dealflow around, but I think it is fair to say that there are some cases of investments not working out quite as expected and sponsors calling us into evidence what’s happening, separate fact from fiction and find a solution going forward.

Q: How are GPs and providers filtering through the current market uncertainty and deciding what is actually important?

James Tetherton: The market now is massively more complex than it was two years ago, when advisers could set up a four-week process with almost no management access and still generate a great result.

In terms of commercial due diligence (CDD), we see a strong move away from cookie-cutter approaches to project scoping. This has led to an explosion in different types of work. The work can range from really early-stage mandates where the sponsor is still a year away from the exit but wants to understand market dynamics and build an exit strategy, or it can be a small piece of work to support fireside chats, where the firm doesn’t want a full sell-side piece of work but needs a few nuggets, like customer referencing, to gauge buyer interest.

The other really important thing is that everyone knows DD can be all-consuming for management teams. In a tougher trading environment, you don’t want management to be distracted and people are being careful not to overwhelm a team by bombarding them with DD requests that take their attention away from running the business.

Q: When the world is more complex and unpredictable, does due diligence naturally start to focus more on mitigating downside risk than laying the foundation for the post-deal growth plan?

Monk: You are always going to see ambitious plans and strategies to make sure those plans are delivered and, even though the market is tougher, I don’t think that has softened.

If anything, in a more challenging market you have to be really sure that the commercial offering is strong and you’ve got a solid foundation.

But I would add that there is more awareness around the risk on the downside, whether that is regulatory, reputational or operational risk. Sponsors are wanting to uncover exactly what the position and response is on everything from GDPR and cybersecurity to supply chain and IP.

That means the sphere of due diligence is broad and sophisticated. You are understanding the risk, how it is being managed and the impact that could have on the plan assumptions.

MacLeay: As GPs, we are always going to focus on appraising the growth plan and delivering the upside for our investors, while balancing this with the associated risks.

In a bull market, GPs can become overly focused on the exciting upside plans. As the market turns, that balances and shifts focus on downside protection returns.

In terms of prepping work, there’s certainly more work going in earlier to understand a market, compare assets and look into any situations where things have gone wrong in the same or similar sector. GPs want to be as prepared as possible, because there is going to be more scrutiny when it comes to the investment committee and when firms are out fundraising. As well as acutely appraising the risks, you need to be able to evidence that you have thought about all the risks and addressed them.

Monk: The ESG space is an interesting example of how the dynamic between the upside and downside can shift.

Historically, ESG was often seen entirely as assessing downside risk, but there can be an upside to ESG.

There is an upside in the supply chain because often the companies that are better at ESG are just better companies. There is also a customer upside because of the growing importance of ESG in government and corporate procurement and tender processes. There is a potential upside in debt ratchets, meeting investor expectations and exit due diligence. In addition, some businesses may well find new markets in the ESG space.

Q: When everything is so fluid, what are GPs looking for when hiring providers?

Hicks: We have found that GPs want a provider to come in really early but often won’t disclose what the target asset is. Our sense is that mandates are being positioned to be interrogative of all potential assets, and that GPs want to gather a broad range of views early and avoid disruption when deals go into exclusivity.

We have also found that GPs will also ask us to put together three- to five-year plans rather than the usual 100-day plan. There is genuine interest in longer-term forecasts and horizon scanning much earlier in the deal process. This reflects how everything is a bit shaky at the moment and that nobody has any clear visibility on short- to mid-term performance.

Douglas: We are solution focused. When you are referencing management teams, critical things are going to emerge. You don’t want to wait until the project is finished to flag that to the client. When feedback is critical, we like to go to the client straight away to share what we have learnt and then look into it deeper, and when appropriate, have the other DD providers look at the issue too.

We don’t just do basic reference work that is simply confirmatory. We like to understand the value creation plan, what the team is required to do to deliver it and whether the team has done something like it before. Is the way the team is set up today able to drive the transformation and growth the GP wants to make? If not, we need to make recommendations to get to the place where the team, structure and individuals are set up for success as quickly as possible.

Summers: I think a lot of clients now also want to understand institutional dynamics – how organisations reach decisions on regulation, competition policy, national security and procurement, etc.

In terms of what we’re trying to present to clients, the key issue is triangulation. You cannot make a really robust assessment having spoken to just one government department. You often have to gather insight from people with trade, competition policy and national security experience, and from regulators, and then triangulate these perspectives.

What GPs find challenging is not gathering insights from expert networks, but knowing how to triangulate these individual insights and confidently reach a decision. It is difficult for an investor to do that on their own.

Nunn: Our approach when we go in is to give the most detailed map of the software asset, surrounding the team and the technology organisation. What we want to produce is a piece that provides a view of how the business has grown so far, if the technology decisions make sense and if the business has the platform in place to scale in the way that the GP wants it to scale.

All our recommendations are very much data-led, and we like to be very clear on why we have made a recommendation and then have a discussion with the GP about why they may or may not disagree.

Tetherton: There’s always a balancing act. People don’t want a diligence provider who just blindly blesses every deal, but you also can’t be so overly focused on downside risks that you start to see danger around every corner.

Equally, as a CDD provider, I’m always very conscious that we are only one of the workstreams – there might be a great technology reason or a great management reason why the GP loves the deal, and that might offset any commercial risks.

Our job is to be really transparent on how we’ve developed our point of view, by following a clear process and presenting as much evidence as we possibly can to help the GP make a decision. And also being really clear on where we are presenting facts and where we are presenting opinions.

Customer churn is a great example. The rate of churn is fact-based analysis – you’re either losing customers or you’re not. But understanding what’s driving the churn will always require interpretation and involves conversations with management and customers to build a picture and come to a conclusion. And ideally, lots of conversations with the GP as well to explain our thinking and really probe the answers.

Ultimately, the uncertainty in the markets means judgement calls are important. We know we’re working with very smart people who have good experience and good reasons to make decisions. Our role is to provide the evidence and the opinion to get as much conviction as possible.

Hicks: Our role really is to present the opportunities and the risks, but you do have to be sensitive about how you present that because some GPs may have been tracking an asset for years, believe in the deal and want to get it through the investment committee.

But ultimately, if there is evidence – even at an early stage – of a red flag, then what we do is encourage the GP to triangulate our view with a supporting specialism that we’ve identified within the red-flag assessment. We’re in an environment whereby people are naturally looking at downside risk, so we have to flag risk when we see it.

Of course, we always want to look at the opportunity as well. If there is a red flag, is it fixable and what will it cost?

Avillez: When I think about what we look for when engaging DD providers, we come at it from a very different standpoint, as almost half of our team are operating partners who are heavily involved in diligence, origination of bolt-ons and platform deals, as well as portfolio management.

We invest in sectors that are aligned with the expertise of the operating partners and, when they are commissioning DD, they are less concerned about the generic market overview and sector dynamics. Instead, they go in with very specific questions that they want the providers to answer.

Everyone thinks of private equity as homogenous but there are many different ways that firms and investment teams work, and it helps when diligence providers recognise that and can adapt to what the GP wants.

Q: Do the providers notice the differences between managers when it comes to scoping projects?

Douglas: Some clients that we have worked with for a long time are happy to let us crack on with our usual process. Others will have a really specific set of questions about the management team they want us to probe in more depth.

So it’s very much case by case and it’s definitely not a consistent thing. Sometimes we get to see early investment papers and teaser decks, and that is really helpful. But equally, if there are less obvious concerns upfront, the brief can be more generic and then the focus of the project can evolve out of the initial phase of the work.

Summers: The scope will vary depending on how well a client knows a sector. A regular investor in a particular industry will usually have very pointed, specific questions, whereas a manager that is relatively new to a sector will want a broader overview of the political, regulatory and institutional landscape.

MacLeay: When you have a good relationship with the due diligence provider, it adds significant value. Yes, there is the report, but often the real insight comes when you are able to have an hour debrief call and talk through their opinions or get them to chat to the investment committee.


Q: So, as a GP, how do you actually pull all the data, conversations, research and reports together to build your view on whether to ultimately do a deal or not?

Smallridge: It is a good question and I wanted to ask the providers whether they are instructed in an isolated environment where they don’t know about the rest of the deal or the investment thesis.

When we instruct advisers, we are always completely open with what we think about the business, what our investment thesis is and who else we are working with on DD. Then, we ask them to answer three or four structured and focused questions in as much detail as possible, rather than just boiling the ocean in isolation.

Tetherton: Some firms are very good at bringing all the workstreams together and building a collaboration between the various due diligence providers, but we certainly don’t see everyone doing it.

Smallridge: We have always seen the value in pulling all the providers together. There are certain streams that cross over. A services asset with a tech angle is going to have crossover with tech-specific DD, so it makes sense for all the providers of the various streams to at least talk to each other to make sure that they are not asking management the same question three times. You also want to avoid the situation where the question that you really want to answer falls between the cracks.

We make sure in the brief that everyone knows who’s working on what, and then sometimes we actually get people to look at other people’s reports in draft format to make sure everything is covered. For us, the process has to be collaborative.

Andrews: Ultimately, the investment decision sits with the investor, who brings all the due diligence together to take a view. What we don’t want is for someone to just go away, look at the evidence and present the evidence back to us without a view. You want your providers to present a balanced viewpoint. At the end of the day, we’re backing a management team to deliver on their ambitions and making an assessment of whether that is deliverable. That doesn’t mean we can say we’ve done all the DD and everything’s going to go to plan.

What we are trying to uncover in due diligence is when the market has changed in the past, how did management respond and how did the business perform? Pull together all the information points to understand that is what builds conviction to go across the line. We know we don’t have all the answers but, on balance, we believe the opportunity is there and we’re backing the right people to execute on it.