In a recent roundtable hosted by Real Deals, a group of due diligence professionals and fund managers discussed the evolution of DD in the last year and how DD assessments have a vital role to play in value creation.

SPEAKERS:

Lizzie Wills, WA Communications

Matt Farnsworth, RPS Group

Bruce Douglas, Confidas People

Tom Raymond, Armstrong

Fleur Hicks, onefourzero

Chris Goodall, CG Consultancy

Bill Prew, Indos Financial

Edgar Kolesnik, Abris Capital

Click here to listen to a summary of the discussion

After a year in lockdown, what have been the key learnings and changes made by DD providers and funds in due diligence processes?

Bill Prew: There have clearly been two periods. During the first six months post-lockdown everyone was adjusting to a new way of working. The market froze for several months. For investors in funds, they were conducting triage, asking managers about the implications of Covid on their operations and the funds they were invested in. We also saw a slowdown in capital being allocated to new managers, with investors preferring to invest with existing managers they knew.

Now, investors have shifted to a new way of working and because they have capital to deploy, they have gained confidence in using new tools, or new methods, and so on.

There have been positives and negatives that have come out of the pandemic. The use of technologies has meant that people can access more individual managers without having to schedule diaries and availability and people are traveling less, so they are more available.

Bruce Douglas: For us, it's been interesting, because we've always had an element of remote working in what we do and then probably only a couple of days on site with management. The face to face part of it has changed quite dramatically; it's become more efficient for the management teams, giving them a better experience, allowing them to schedule it into the rest of their work because diligence is such a busy time.

We have been able to jump on calls at seven in the morning or eight o'clock at night, maximising everyone’s time and to Bill's point, sitting with somebody for a few hours and getting to know them and forming an opinion might have a slight unconscious bias in it. Instead, these meetings have become more clinical with more detailed reports as a result of that. We have also been seeing more members of the management team than we normally would just because investors haven't been able to spend time with the team and get to know people as well. 

That's a really interesting point that you made around the unconscious bias. Are you suggesting that remote diligence has removed that unconscious bias?

Douglas: I think so. I think it's just become a more clinical process, which is great. We make our reports as evidence based and detailed as possible so they can lead to actions which add value.

Tom Raymond: I agree with what has been said around the key learnings. There's also been a separation of work into effective face to face work, and efficient work done remotely. The latter benefits from lack of bias, the clinical dispassionate approach, which is very useful for due diligence. I think we'll be carrying that forward and separating those two elements of work into efficient and effective in the future.

The key questions and topics that GPs are asking for have evolved substantially. You're absolutely right, in the first couple of months of Covid it was all about “will the business survive? And how do we make sure it survives in the best shape?" And since then, the response has been, how can the business adapt to Covid? And actually, beyond Covid? How can the business adapt to capture the positives, increasing access to skills through remote working and use of digital technology for efficiency? How can you capture those? That's on the supply side.

On the demand side, a huge challenge for every business is what is the new normal going to look like? Some businesses have had a torrid 12 months and some had a booming 12 months, but finding out what the new normal is, is a real challenge. And I think that's something that's usually one of the first questions that we're being asked at the moment. 

What areas are getting more attention today in comparison to before the pandemic? Lizzie

Wills: There are definitely a few things getting more attention than before the pandemic, for obvious reasons. A key thing from our perspective, is the long-term fiscal approach that the government is going to take, because it is going to have a wide-ranging impact on the whole country and on all businesses sectors.

The government has been very clear that it has been a tough 12 months for the public finances, that the black hole that we are now facing is going to have to be filled at some point and that "difficult decisions," in Rishi Sunak’s words, are going to have to be taken in due course.

The government decided that the Budget in March wasn't necessarily the time to introduce big tax rises or any long-term changes to its approach to public spending. But, that's not to say that that won't be coming down the line quite quickly, and it's definitely a case of when, rather than if, taxes are changed or raised. Given what the government has said about personal taxes, it looks very much like business taxes are going to be where the government looks to raise additional revenue. So certainly a lot of the DD that we've been doing is understanding how quickly those tax rises might happen, what they’re going to do to an overall burden of tax on businesses and how that affects the operating environment in the UK.

And have certain deals perhaps not gone ahead, because of the uncertainty around that, or what's the general private equity appetite?

Wills: I think it's been a bit of a tale of two halves. A lot of businesses were rushed to market because of a lot of rumours about an impending CGT change. So there was a peak of activity in Q1 that might have been more smoothly divided over the rest of 2021 had investors and management teams not tried to pre-empt a potential announcement. On the other side, I think a lot of businesses just said "look, we'll hold our assets for the time being until we get a bit more clarity about what's happening with CGT and what the overall fiscal position is looking like." So I think it's a bit of both.

Chris Goodall: I think there probably is more focus, certainly on the deals that we've done from the start of this year onwards, around digital transformation. And it varies between the type of business - whether it is a very tech-focused firm in the first place, or one that's adapting to new technology channels. From that, you can obviously assess efficiencies and automations and cut costs.

We've also had certain deals that have been in the travel sector where they've been quite constrained with budget for obvious reasons. So digitalisation and efficiencies have been at the top of their agenda.

Edgar, what areas of DD have been getting more attention on the deals that you've been doing?

Edgar Kolesnik: I had the opportunity to be on the buying side of an asset and then selling another asset and I would highlight three areas: ESG, quality of management talent and digital topics.

In the case of ESG sustainability topics, customers, employees and LPs are demanding more sustainable, socially-conscious corporate behaviour. And in fact, the firms that can deliver this in a credible way - win. At Abris, as with other private equity funds, we see ESG as a core part of creating value – it is not just there to mitigate risk. We include ESG areas in our due diligence as a must have and we have an advanced ESG scorecard, which is applied to measure our track record in value creation.

For management talent, it is extremely important that management is able to respond to unexpected events, and in any investment it's a prerequisite for successful management to execute the value creation plan in a very uncertain, unpredictable world. It's critical in any deal to have exceptional management talent who can grasp what is happening in the market, as opposed to just focusing on a defensive strategy. Management teams should look for opportunities for continuous growth.

Lastly, we focus more on how companies use data, digital and advanced analytics to be able to transform their businesses. We look at digital topics not as a defensive strategy but rather in terms of how we can use a digital approach as a competitive advantage.

Raymond: I'd agree that we're seeing more digital technology and ESG diligence and I think that's going to continue. To build on that, I think we're also seeing a lot more integration of findings from across the DD suite to actually move from just deal diligence into value creation. I think that's becoming a greater theme.

Prew: Widespread working from home in the pandemic has brought new risks to the fore. For example, communications and capture and compliance and audit of those, particularly for regulated businesses. The FCA has made it clear that managers really need to ensure that even though you are working from home, you don't let the guard down, and you have the right compliance and oversight processes in place. So, from a regulatory and operational risk perspective, remote working has presented more challenges. 

Fleur and Chris, how has tech and digital DD evolved? Where do you see it going?

Fleur Hicks: There's now a wider recognition of the need for digital and tech DD throughout a wider range of sectors and verticals.

Typically, it was considered in the consumer-led environment and perhaps tech-led businesses, something certainly with the word tech in its description or title. We might have been considered a kind of add-on DD option, perhaps less tech, but certainly the digital DD was kind of an optional extra. But now it's so integrated and integral to the wider commercial story that we're being brought in very much alongside the likes of Armstrong to help support those growth notions. As a result of this shift, our DD is less siloed.

And then, to echo some points that have been made frequently so far: one of the fundamental changes is actually that the DD reporting structure has now focuses much more on the value creation element. Not only strategic, but a tactical roadmap for 100 days and beyond, to help integrate some of these suggestions and processes.

Goodall: I agree. When we first started doing technology due diligence, around six years ago, we were already doing “technology audits”, the process was very similar. It seemed that the financial, legal and commercial DD were seen as the three main pillars and that tech would become probably the fourth very soon. And it certainly has; the importance is really growing. Last year was our busiest in terms of deal activity. And I think this year, if it carries on the way it's going, will be busier still.

In the last year, the uncertain landscape meant that DD was taken even more seriously, is this set to continue?

Hicks: Absolutely. I would echo Tom on two points. The first one being that uncertainty means the kinds of diligence that people are looking for up front is, in the first instance, a re-navigation of the landscape. So an understanding as to whom the true competitors, for instance, are now compared to 12, 24, 36 months ago is essential. Because the landscape has changed so much due to Covid and varying tech and deliverability advancements. And then secondly, it's about bringing that comfort to the future growth potential, which may be tainted by uncertainty. Comfort around the fact that technology and infrastructure is in place in order to see success of said assets across a whole realm of verticals, through the next 3, 4, 5 years, or well beyond the holding period, hopefully.

In order to understand that, you've got to look at the digital data sets, look at infrastructure, look at the managerial culture, around considerations of ESG, technology, workforce compliance, etc.

But I would also say that in addition to the uncertain landscape, the reason why DD demands, and serious consideration, are set to continue (particularly in firms where they wouldn't necessarily have procured it originally) is because of the competition levels.

There are so many assets coming to market, and there are so many firms looking for good assets, that actually early stage DD, to provide both comfort and a competitive advantage on the GP side in early stages is becoming ever more important.

Matt Farnsworth: Certain areas for us have faced increased restrictions, particularly the inability to visit certain assets in person. But there's been a greater focus this year on governance systems, ESG culture, and just responsiveness of an organisation and being able to be agile in this business context.

And as a Fleur quite rightly mentioned, it's all about those early stage conversations with a business. Are they adaptable and have they responded well to this pandemic?

That cultural and governance foundation is really important for gauging how a company's going to conduct itself over this period.

However, I would say some other areas have been neglected and taken less seriously. There was a report out by Refinitiv, that showed 43 per cent of supply chain relationships weren't being subject to any kind of due diligence at all during the pandemic. When you start looking at that, it introduces more regulatory risk. The possibility of bribery and corruption fraud goes up, ESG reputational risk increases, as well as the normal operational disruption that comes from having to change suppliers during these difficult times, particularly when a key supplier goes bust. So, yes, I think due diligence will be taken as seriously as it has been, but there are these other areas where investors will have to up their game.

Kolesnik: Businesses are experiencing unprecedented changes across all sectors, some companies are benefiting, some are completely disrupted. And, as Tom mentioned, due diligence is becoming more multi-dimensional, and much more integrated. Conclusions from commercial, technical, financial, legal, talent management and other streams are reviewed by us in a comprehensive and complex way.

Today's high valuations require GPs to generate much more growth. We have delivered strong results in the past, but it is clear that this time we will have to do it in a much more volatile and uncertain business environment. So, as opposed to just doing due diligence of past performance, we need to look much more at the value creation opportunities and how we exploit them.

Raymond: Stepping right back, there's a wall of capital out there, and with entry multiples being bid up, the margin of error for investors is getting narrower, which makes high quality buyside diligence more important.

It’s about taking today's insight and today's knowledge and converting them into tomorrow's value. The days of buy, hold and exit, and making three to five times money in three to five years have gone. Now you've got to fundamentally re-engineer businesses, you've got to transform them in some way. And a lot of that knowledge sits in the diligence report when you've had all those experts looking at the business.

Have any new areas/ sub-sectors of DD or new considerations in the DD of a business emerged from the anxieties caused by the pandemic and the last year?

Goodall: Leading on from previous points on value creation, one of the focus areas for us as part of the DD is certainly the data capability. This is an area where a lot of value can be unlocked. Observations from a number of the businesses we've looked at, over the last 2 months are that a lot of the IMs say that there's very clever AI capability. But again, nine times out of 10, when you really do some digging, it's advanced algorithms, as opposed to true machine learning and more advanced concepts of AI. So I think people are on the start of that maturity curve.

So, as part of the DD, we're looking to understand: are things prepared well for the future in terms of them really exploiting that data and unlocking that value (the data strategy), and then that leads on to that 100 day plan that you're hopefully going to be able to keep traction with once the deal is done. PE firms that really do grasp the outputs of the DD and then actually track the 100 day plan, once it is done, generally get a better outcome upon exit.

There's also a number of businesses that we've done upfront work for, but then have remained as advisors as part of the portfolio. And we've really seen them progress and grow. It’s definitely a journey and not just the DD at the beginning,

Wills: The pandemic has understandably driven a huge amount of anxiety amongst investors. When they have been looking at the political and regulatory environment, that is absolutely true. We have had a pretty uncertain couple of years from a political standpoint anyway, and the pandemic has absolutely compounded that. One of the considerations that has certainly come to the fore over the last few months is a result of the realisation that the government is going to spend a really significant amount of time post-Covid, looking at where the structural impediments were to rapidly and effectively responding to the Covid crisis when it emerged. There's going to be a lot of thought about how structural changes are made to various parts of the economy to put in the UK in a more resilient position next time there is a Black Swan event. This focus on future economic resilience will inevitably mean a raft of new economic policies, and potentially some structural intervention, and understanding what this might look like will be key in making sure investors are in a strong position to capitalise on any opportunities.

Are GPs looking at certain types of DD earlier on in processes? How early on is digital DD now being considered?

Hicks: From our perspective, unsurprisingly digital DD is playing a big part in early stage considerations. This is from two perspectives: one to provide comfort around how Covid has been handled, and how the digital transformation process sits within a company to help prove case robustness. Secondly, digital data that we procure sits very well in an early stage market map type report, which is something we devised about 18 months ago, that has seen considerable pickup in the last 12 months, where people are really looking to assess the market landscape as it is now. It also serves to provide comfort around the demand from the end consumer, whether it be an actual consumer or a procurement manager, healthcare practitioner, etc. So the two themes within these new kinds of early stage market map reports are deliverability and demand.

Douglas: What we've seen at times is a split of our work into two stages with the management due diligence aspect, which would be the confirmatory part of our work, sometimes being brought in before exclusivity is signed with a couple of key individuals in the team. And then the human capital planning aspect - how to support the management team as part of value creation? How do you make sure you're adding to it? How do you make sure that you're getting the best out of individuals and the team? - is being phased as normal.

How has the dry powder in the market impacted vendor CDD over the last 12 months?

Raymond: The quality of vendor CDD in the last 12 months has got even worse. And that's quite an achievement really given the 400-page doorstop hagiographies that were in wide distribution anyway. And it's simply a result of the amount of dry powder out there chasing the relatively small number of high quality deals. It is a real shame, because vendor diligence in concept should be a helpful product.

I was talking to a senior partner of a large, mid-market private equity firm a couple weeks ago, for example, and he said he doesn't even read the vendor diligence anymore. He sent it to us and asked two questions. First of all, what does it not tell me, and how much is it going to cost me to get something decent building on what's already there? And the answer a lot of the time is we'd have to almost start again, which is a real shame.

I think the management teams end up going through all the pain and cost twice. And I think the thing that is going to change, and be the inflection point and move back to more quality work, is the thing that we've all been talking about today, which is the necessity of value creation, and the need to bring proper practical insight and value for tomorrow out of the diligence, rather than it being a tick box exercise.

Goodall: It's an interesting observation that Tom has made about the vendor commercial due diligence, because we've seen a bit more interest on the tech side for that. A few of our regular PE customers have been proactive in preparing when there's a business ready for exit and helping the target prepare for exit, but also to get a quality piece of tech VDD compiled. I think if it's done well, it can be very useful for the other side to get a good view up front. And it almost reduces your information requests from the buy-side going in. But I wonder if that's different with the commercial DD side of things where it might more salesy material.

How has investor behaviour changed when it comes to fund DD since the pandemic? What types of questions are they asking?

Prew: In the regulated funds space it’s important to remember that firms have a fiduciary obligation to continue to perform on-going oversight and due diligence of their investments. So they've had to adapt to new ways to conduct this due diligence.

Kolesnik: For many years, business continuity planning and risk management have been key areas of scrutiny by many institutional investors. At Abris, we had well-drilled BCP processes across our portfolio companies well ahead of Covid-19, as it is a key requirement of our corporate governance model, which is implemented with each portfolio company during the onboarding process.

Three areas we were asked about by investors in the last year include: how we protect employees at fund level and within portfolio companies, how we established emergency response teams, and how we can improve quality of engagement with investors through more in-depth communication. We responded to these questions via regular, comprehensive and consistent reporting packages, summarising with full transparency what was happening with the portfolio and with individual companies.

Following the introduction of SFDR, are there any particular areas that require greater attention by PE firms and their ESG DD providers? And has the introduction of the regulation increased PE firms’ assessment of ESG within potential targets?

Farnsworth: Lots has definitely changed over the last year or so. The UK is now largely out of scope until the Government develops its own domestic green taxonomy and ESG disclosure regime. But, the EU regulations are still set to disrupt a lot of companies, particularly the ones that are multi-jurisdictional financial market participants, as well as ones that are marketing their own services into EU markets.

There are 32 mandatory environmental and social factors to disclose, as well as 18 voluntary ones. And I suppose a lot of companies are going to have to redefine how they're reporting on those, not to mention for their specific financial products that might have an ESG tilt to them.

While the private equity sector has been historically good at looking at the environmental issues over the last few years, one key aspect of the SFDR templates is that they include for the reporting of social metrics, and the policies and approaches behind some of that. So, we're seeing increased enquiries on how to cover off these newer social aspects and particularly, how to quantify them.

How are investee companies responding to ESG requirements? What are the key areas of focus at the moment?

Kolesnik: Initially ESG started with boring topics - risk mitigation and compliance issues. And now, as we mentioned several times during this discussion, is that it has been taken to the next level, which is value creation. This is because stakeholders of all kinds, customers, employees, financing institutions, banks, want companies to be more sustainable, socially conscious and well governed. And ESG is now being used as a way to differentiate from competitors, on the fund level, and as well, on the portfolio company level. It is currently seen as a key item to sharpen due diligence, build stronger value creation plans, and prepare the most compelling exit stories.

Wills: Certainly one of the things that we are hearing a lot from GPs in terms of ESG is that they are increasingly aware of what good corporate citizenship means, and how they can make sure that the businesses that they are investing in, or the businesses that are currently in their portfolio, meet those responsibilities, much more fully than perhaps they've been expected to in the past. I think the last 12 months has really brought this into focus - companies are more keen to actively demonstrate the role they are playing in meeting the big social and economic challenges the UK faces, whether its services provided during the pandemic or delivering much needed quality services in sectors facing high demand.

Matt, how has this increased pressure from investors on GPs changed the way in which you work with firms and how are PE firms responding to these pressures?

Farnsworth: What we're actually seeing is a change in the culture and approaches of the investee companies as a result of this. We've seen a solid uptake in corporates and people who already have an investor base coming to us and they're asking questions about what they can do to prepare for the ESG questions from their investors. Certainly the disclosure regulations might be driving some of that demand but the investees are keen to keep investors invested in their business and they recognise that having access to finance and funding is quite critical going forwards. Ultimately, the point of difference between investee firms that are all vying for the same funding pot may naturally come down to ESG performance.

It’s acknowledged that companies have been looking at ESG in some way through existing sustainability and CSR programs for a long time. But they're now flipping this around and honing it down so that it's very much focused on what the investors need; to position themselves favourably. Some of the things we're hearing about are: How do we develop a Net Zero Carbon programme? How do we get our sustainability or ESG reporting solidly set up? How do we approach diversity and inclusion so that it’s meaningful?

Definitely, it's been positive to see in the last year or so private equity firms engaging with these broader social issues. To conclude our discussion, what is the DD landscape set to look like going forward?

Raymond: Everyone's had to adapt in some way over the last year, some of that's been better than expected and I think in the future, there will be more of a hybrid way of working and balancing efficiency and effectiveness. The future for us is all about more integration of DD, more translation of that into value creation plans and we're not seeing a subsidence in the wall of dry powder multiples anytime soon.

Douglas: Yes, the joined up approach from different diligence providers to contribute to value creation is important, and understanding management capability and potential is at the heart of that. Delivery and execution comes from management teams who are the key to any successful investment.

Farnsworth: This period is a golden opportunity for all of us. We've each worked with increased digitisation and cut down on our travel. We’ve all shown that it is possible to work efficiently from afar and with forthcoming changes to UK Net Zero targets we've not only got a moral obligation, but a statutory one to keep those emissions down, learn from the lessons of the pandemic and keep doing more of what we've been doing.