This roundtable was originally published by Real Deals and features WA’s Head of Investor Services, Lizzie Wills. Please find the original here.
The Covid-19 pandemic has certainly changed the way we work, and this is no different for private equity managers and their DD providers. While technology has hugely assisted remote working, what hurdles are in the way of managers’ DD of potential targets? What can and cannot be done remotely and how has PE firms’ approach to DD changed in the post-Covid world? A group of industry experts discuss.
Lizzie Wills director & head of investor services, WA Communications
James Prebble co-founder & director, Palladium Digital Group
Matt Farnsworth technical director, sustainable business, ESG & transaction advisory, RPS Group
Chris Goodall founder, CG Consultancy
Paddy Woods Ballard partner, Fairgrove Partners
Andrew Ferguson partner, Baird Capital Partners
Bernard Dale managing partner, Connection Capital
Moderator Talya Misiri, editor, Real Deals
In a recent Real Deals roundtable, experts from across the industry discussed the evolution of due diligence, the shift in manager focus on DD pre-deal in a post-Covid era and what will be the new normal DD agenda.
How has the pandemic changed how DD is carried out? What can and can’t be done on a desktop? Which types of diligence can only be done properly in person? Andrew from your perspective, what has continued at Baird and what challenges have you faced?
Andrew Ferguson: We’ve made five investments this year, three of which were top-to-toe completed in lockdown, in a virtual environment. And I would say, in many respects, that the diligence process is pretty similar to what it was pre-Covid. The industry has adapted very quickly using the technology tools available to it. Virtual data rooms and various video conferencing facilities. I think we’ve had to evolve fairly quickly to become highly effective in a remote environment.
Pre-Covid, the industry had evolved a very sophisticated approach to diligence, linking to the key business activities, risks and mitigants and market drivers of the target company and I don’t think that will change. The DD process and considerations have remained largely unchanged in our experience.
The key challenge for PE has been how you build a relationship with a team and how you understand them in this virtual format that we’re now having to operate in. But, on a more positive note, the ability to access video conferencing platforms has facilitated, in our experience, more face time.
Bernard Dale: I think on new deals, what we’re finding is that the expectation that change is coming in the Capital Gains Tax regime, combined with the reduced ability to have face to face meetings with the advisor community, is really compressing the timetable at the early stage of an investment. That’s all doable, but you get left with a load of unanswered questions and not the bond of relationship with the management team that you want to have at exclusivity. So, we’re finding now that with some transactions, we’re really not as advanced in relationship or company knowledge as we would have been a year ago.
We said at the beginning that we were never going to make an investment without meeting the management team. I think we’ve become more comfortable with online meetings as time has gone by, though it is still a prerequisite for us.
The interesting thing about the DD is I don’t think it has changed, but what has changed is the way it is done. Typically, if you were undertaking a financial or commercial DD exercise, you would have a huge day-long meeting with the management team, go away with a pile of paperwork and then as you compile the work, you would pick up the phone to follow-on. Now, some managers are having fixed daily meetings with management and it has created a more efficient process for all involved as a more exploratory approach is being formed to suit the access constraints, with the process becoming a little more collaborative.
Post-Covid, how will the DD process change? What types/ areas of DD are managers putting the most emphasis on and how has this changed? Has the uncertain landscape meant that DD is taken even more seriously?
Paddy Woods Ballard: In terms of what people are interested in in this post-Covid world is firstly, how Covid has impacted the productivity of firms and firms’ ways of working? Secondly, we’ve also spent a lot of time looking into firms’ customers and their endsector exposure. If businesses have exposure to hospitality or retail or travel, for example, you really need to understand how those end-sectors may evolve.
We’re also doing more modelling work. Thinking through if different scenarios take place, how the business will evolve. We’ve also spent more time working with businesses that haven’t had a management plan together and off-market deals.
In terms of the process, the move to communicating on Teams and Zoom, etc. has been very effective and I reiterate the point on the quantity of management calls and meetings that we’re having has helped the process in a number of ways. The bit we do miss out on, however, is assessing the culture of a business, it’s harder to do this virtually.
Lizzie Wills: Understandably, investors have been turning to us over the course of the pandemic to get clarity on what the government is doing in terms of business support schemes, and its likely fiscal response in the short and longer term. We’ve been supporting investors to think a bit further down the line than they may have done previously about what the Government’s response will look like, and what the implications for the UK’s economic performance might be. Clearly this will impact existing portfolio businesses, and the sectors investors are looking to make acquisitions in.
It has been difficult as things have been moving so quickly, but the value that we have been able to add, in addition to gathering and synthesizing the masses of information coming out of Westminster, has been in helping firms to take a step back and look at the longer-term implications of the Covid-19 pandemic on government decision making. Helping investors scenario plan in a thoughtful way and making sure they understand all of the different political dynamics affecting their investment decisions has been where we’ve been most invaluable.
As a result, I think political DD is going to become even more important over the next few years and particularly in the next few months as we start to unpick what the pandemic has meant for the economy and specifically for the investment environment in the UK.
James, on the digital DD side, how have the types of questions managers are asking DD providers changed? What exactly are they asking?
James Prebble: It really depends on the digital maturity of the business. We’ve seen a lot of ecommerce deals over the last 4-5 months, most of which have been done completely remotely, and the emphasis is on either the benefit or downturn in revenues due to Covid. So, the question that gets asked the most on this is “the benefits that I’m getting in reduced cost of customer acquisition, or the traffic bumps that I’m getting, the spikes that I’m seeing in sales, are they here to stay, is this the new norm or is this something that I have to factor in as a short term boost?”
We haven’t had enough time to see whether or not that curve has flattened out or whether that improvement is here to stay. So that’s been very difficult for investors to get their head around.
Conversely, the other thing we’ve been asked to look at a lot is almost like a mini-diligence post transaction. We’ve had investment managers ask us to look at assets and see whether it can trade through this period, whether it is as digitally mature as thought, can it scale its digital operation as it’s gone Conversely, the other thing we’ve been asked to look at a lot is almost like a mini-diligence post transaction. We’ve had investment managers ask us to look at an asset and see whether it can trade through this period, whether it is as digitally mature as thought, can it scale its digital operation as it’s gone from being a small part of a business to the entire part of a business. Trying to understand whether their infrastructure can be scaled and if it can support increased competition in a digital space, or jumping on some of the opportunities that have been created from Covid.
Finally, there have been a lot of requests around future scenario planning. Such as: “Should traffic fall to previous levels, what does that mean for my business? Should the advertising space harden up, how much will it cost for me to acquire customers and is that sustainable? How defensible is my position?” This has been a little different to normal where we might look a bit more forward in time. That has been an interesting development.
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?
Matt Farnsworth: What we saw pre-Covid was a general sway towards ESG matters. There was a steadily increasing focus on ESG and the impact that business has on the environment and society as a whole.
What we’ve seen throughout Covid though, are significant impacts on staff welfare, supply chain risk, climate action and internal governance matters. So, to complement the discussion about the governance of a business, not to mention the financial sustainability of a business and its viability, you’ve got to question, is the business model right in the first place? There’s more focus on that. We’re seeing investors wanting to get a much better idea of a company’s ESG procedures, its approach to risk mapping and its footprint.
Also, we’ve seen increased consumer pressures on plastic use, climate change, ocean waste and all of these issues have continued to intensify since the outbreak of Covid. As regulators and consumers drive forward the agenda, we’ll see increased investor focus on ESG going forward.
Chris, perhaps you could give your opinion on which areas of DD have taken a back seat or which sectors you think are proving more challenging for GPs?
Chris Goodall: We’ve had a number of tech DD assignments over the years in the travel sector, so I was surprised that we’ve also been involved with two during this period. The focus has been around assumed bumps in terms of Covid with more in-depth revenue and fiscal analysis. But, parking that to one side, can the target’s tech deal with those flexes in volume and traffic and being able to analyse the underlying technology to ensure that ideally it is cloud-based with some sort of flex in place to be able to cope with the fluctuations.
And Andrew, are there any sectors that are difficult to diligence remotely or are any types of DD taking a back seat at the moment?
Ferguson: Back to my earlier point, I think the issue with diligence is not so much the process, because the industry has adapted very quickly and there is no real drop in quality from providers. The bigger issue for me is the mediumto-long term implications of Covid on the targets that we were looking at.
The basic premise of diligence is that you start with a management’s business plan and the diligence is to test assertions, identify the risks and mitigants. Covid has added a new layer of risk and uncertainty to the process. That uncertainty can take a number of different forms. It might be the operations of a business, and its working patterns, additional costs, etc.
There will be winners and losers from the pandemic and finding out where companies will be by 2022/23 provides an additional challenge for the industry. For people-based businesses, the impact that Covid is having on their culture and workforce is unknown at this time. How we’re going to diligence this is an area of focus.
Prebble: To reverse the question, rather than what areas have taken a back seat, but rather those that have come to the fore. One of the most interesting findings is that in some respects it has been a busy time for us, as it has parachuted all elements of digital to the forefront of conversation. A few years back, we might have heard from an investment manager that “it’s not a particularly digital business, so we don’t need to worry too much about its digital footprint”, but this has changed. Now, the question is more like “we’ve got a financial services business that we’re looking at, professional services businesses, care homes, recruitment companies, etc”, and all of a sudden the question is “what role does digital play and how could digital play a role in this business?”. Subsequently, can a business be looked at from a digital lense.
Goodall: Adding to James’ point, we’ve worked in a distributed way in our business for 10-15 years with people spread out across Europe and this has been the way of working for a long time for us. But, what I’ve seen, certainly in the businesses that PE firms are investing in is that they’re adopting more agile processes. This includes recognised industry standard ways of working with teams, allowing for collaboration between small sets of teams within the organisation, it helps with the communication and companies have adopted new processes to keep teams connected.
Lizzie, from your perspective, how have the types of questions that you’re being asked changed and what exactly are they asking?
Wills: Unsurprisingly, the big questions we’re getting at the moment are what the impact of Covid is going to be on government decision making and in particular on its fiscal priorities. Given the Budget we were expecting at the end of the year has been cancelled, Government has bought itself crucial extra time to decide exactly what its approach to tax and spend is going to be – it’s also meant things like the expected changes to Capital Gains Tax have been pushed back, which has been a relief for a lot of investors, as the Government’s plans for CGT and carried interest have been a topic we’ve received a lot of questions on.
We’re also getting trickle down questions relating to Covid, and how that impacts the political agenda that we were expecting to play out over 2020/21. Irrespective of the government’s immediate policy response to tackling the pandemic, what does it mean for the mechanics of Government decision making? What are the knock-on effects on the Brexit negotiations? How does this affect the domestic policy agenda and what is or isn’t now being prioritised for delivery? How do these macro political agendas affect the sectors that PE is looking to invest in, and how well does the government’s longer term fiscal agenda support the investment environment?
Because the political and economic landscape is shifting at an unprecedented rate, many of the questions we are being asked are much more macro than they have been in the past. We’re still being asked to look at the technical, political and policy aspects impacting a business, but those bigger dynamics and how they interact and impact the macro picture have become that much more important to the investment thesis. And firm conclusions are clearly very difficult to come to in the current landscape. So, it’s about helping investors with detailed scenario planning and analysing what it means for their investment strategy.
And Matt, what types of questions are you getting around ESG? How has managers’ sustainability agenda or ESG considerations changed?
Farnsworth: I think there’s been consistency throughout this period. The questions that were being asked pre-Covid remained throughout. However, now there’s more focus on management procedures and culture and it’s well known that strong governance within a target business can be an excellent indicator of how successful a target will ultimately be.
There’s also been an increase in questioning around health and safety and staff welfare matters. As you’d expect with people being furloughed, there can be mental health issues to consider, as well as the obvious supply chain disruption that has accompanied the pandemic. So, putting these together, firms are examining how these ESG matters are impacting overall business performance.
When doing DD now, what types of Q’s are you asking?
Dale: In terms of DD priorities we’re definitely wanting to ensure a high level of cash headroom, but we are still wanting answers to the impossible question “Will the company hit its forecast?”. My first boss in PE said to me “forecasting is very difficult, especially with the future” and that is even more difficult than normal today, due to Covid! You have to come back to the big picture fundamentals of: How good is this team and fundamentally is this a business that is at a crucial place in its market environment; is it a business that’s product or service has to be used and therefore has some strategic value, or is it a business that is consistent and solid in cash generation without differentiation. These can be impossible questions for DD firms to answer, but we’ll ask them anyhow as the process of thinking about this is very useful in developing the strategic agenda.
Woods Ballard: Building on Bernard’s point, a key question is how is a business differentiated? We usually get the answer to that from customer interviews; to hear it from the customer why they work with this particular business and what makes it really stand out. This goes to the heart of good commercial DD.
What about the timing of DD, are managers beginning DD processes earlier? Are there certain types of DD that are being considered earlier or later in the deal process?
Prebble: I’m sure that all of us would say that diligence has never started early enough! I can only speak from the digital and tech perspective, and I would say there was probably a shift before Covid. I think there has been a maturing of the community at large and the tendency for most managers to lead with a tech-led business or tech-enabled to sharpen the focus.
I think financial, commercial and legal will always be a priority as they are extremely important to the process and to make sure everything is in order there. Certainly, we’ve seen digital coming in earlier, with time frames elongating slightly for us as we’re coming in at around the same time that commercial DD is starting. This is because tech DD can be a complement to commercial DD and can assist on the data front. So that has become a consideration earlier in the process. This is not across all assets, it depends on the vertical, but certainly in education, healthcare and financial services; it’s definitely coming earlier in the process.
Wills: To echo James’ point, I think it’s a sign of the maturity of the market that DD is being done much earlier on. It is certainly something that we’ve seen from the political and regulatory side in the last few years that we’re being brought in almost at the beginning of the process.
Something else we’ve seen in the last 2-3 months as the M&A market has got back on its feet is the need for short, sharp top-up pieces of work to follow on from larger pieces of DD that we did in Q1 of this year. We’ve been then asked to do a couple of weeks’ work to help investors to understand whether there have been any fundamental policy or regulatory shifts as a result of Covid, and whether the conclusions drawn in January and February this year have changed as a result.
And is Brexit being considered? Has this taken a back seat?
Dale: The really scary point for me is if Covid wasn’t around, how much attention would we be paying to Brexit? At the moment, I’m not even thinking about Brexit, I’m thinking about Covid, which is quite a concerning position given its imminence and potential impact. Now, clearly, when you’re looking at an asset that is directly affected [by Brexit] then you would do something about it, but overall it probably is something we haven’t put enough thought into as an industry.
Wills: It’s interesting as Covid has completely overshadowed everything including Brexit. If you think about how it was being considered in February in comparison to the rest of the year, it’s as if Brexit has completely been put on the back burner. Then, it got to the end of August/ early September and suddenly people began to ask about Brexit. That’s been true right across private equity.
The introduction of the Sustainable Finance Taxonomy and Disclosure Regulation will affect a number of financial market participants over the next few years. How are firms responding to this in the marketplace? Has this also been overshadowed?
Farnsworth: We’ve seen an uptick in interest in our sustainable finance services, with investors continuing to make sense of what it means for their existing due diligence procedures and ESG risk management processes.
The Taxonomy Regulation doesn’t fully kick in for over a year. But other aspects such as the Disclosure Regulation will impact financial market participants sooner, from March next year.
Some are picking up the pace on that and certainly on the due diligence front, active funds are looking at longer term ESG performance monitoring and how changes can be introduced to more effectively engage during stewardship.
Outside of financial markets, a fair few aspects of ESG management will be affected, we believe. We’re seeing forward thinking corporates and industries starting to integrate ESG in a more formal way. This has been largely driven by pressure from banks and investors, which has led business management teams and their CEOs to rethink how they structure and approach corporate sustainability within their organisations.
Will a GP ever ignore a supplier’s recommendations and what does that mean for future relationships?
Woods Ballard: Sometimes recommendations you make as part of a DD might not be time critical or there might be elements to the recommendation that are outside of a GP’s control, so they won’t necessarily act on the recommendations there and then. For example, if you say this bolton would work really well with the target asset, that could be a longerterm recommendation, so obviously that may not happen immediately.
Also, areas where there may be conflicts are on sell side DD. Occasionally if management’s plans are too aggressive and we analyse them and talk to customers and cannot justify these plans, these may have to be reassessed. That’s possibly an area where you may have a difference in opinion between the CDD provider and client.
In this market, is it possible or more likely for different streams of DD to arrive at conflicting conclusions? How should managers assess this?
Goodall: Generally, we’ve always had some points that are raised where there is almost a debate around those. There are some key red flag items that you’d expect to be addressed, and there’s normally not any discussion around those. There’s probably some vagueness around the lower prioritised recommendations in the 100 day plan, where we try to work closely with the deal team to give some background around why those recommendations were there in the first place. But, 9 times out of 10, most of the recommendations in the 100 day plan are acted on, so we don’t generally see that as a blatant disregard for what we say, but it can happen. As long as it’s accurate information, I think that’s the important factor.
As our current environment is evolving at pace, what if the wrong conclusions are drawn? Should precursors or additional agreements be made to remove liabilities for incorrect diligence, predictions or assumptions?
Wills: Given the nature of the work that we do, we always provide our reports on a non-reliance basis. And that has always been completely accepted by the firm that is commissioning our work.
I think there is an understanding that when you are interpreting and analysing human behaviour, decisions and choices in a very fast moving environment, there is no way you’re ever going to be able to guarantee what things are going to look like in 5 years’ time. You need to help businesses get comfortable with the level of uncertainty, rather than trying to provide a concrete forecast.
Prebble: Similarly, everything we provide is on a non-reliance basis. We don’t have a crystal ball and we can’t see the future. We can only draw conclusions on the data that’s available. When we’re dealing with analytics and data points, you can get a little bit more comfortable on the data, but subsequently, when you’re looking at market sizing or competitor dynamics or broader customer behaviour, you’re dealing with sample sets and you’re modelling from that.
Pre-Covid, post-Covid and many years before, I think everyone has been quite comfortable that PE firms are paying experts who know these environments to draw their conclusions and only on what’s presented to them and what’s available. There’s no absolute certainty and I think everyone is in agreement with that. And, as such, the PE firm makes the final call.
Ferguson: As the GP on the call, I would love for the DD providers to underwrite the future and underwrite my return to make life a lot easier. The worst thing that a diligence report can do is not form a conclusion, and anything that takes away the ability for a provider to make a conclusion from the work they’ve done detracts from the usefulness of that report.
At the end of the day, investment is a risk business, it’s based on judgement and the buck stops with the GP. So I think even in these risky times, the process remains the same and diligence providers are doing the right thing in forming their view. What the GP does with the diligence output is up to them.