Due diligence guide: A European perspective

With the recent turn of events in the global economy, due diligence has regained its former place of prominence among many investors in private equity.

During the boom years, many investors were more concerned with gaining access to top managers or to those managers perceived to be top.

Often, fundraisings were conducted within a short period of time, allowing investors scant time for detailed due diligence. For those investors that were relatively new to the asset class, this often resulted in suboptimal analysis of the inherent risks of an investment opportunity.

Post-crisis, this has changed. Today, thorough due diligence, sometimes overcompensation and proactive discussion about terms are forefront in everyone’s minds again. While the basic framework for a detailed due diligence process should feature the same broad outline irrespective of the region in which the due diligence is performed, it is critically important to consider regional aspects as well as the economic cycle and its impact on the region in order to conduct successful due diligence.

In essence, due diligence should equip investors with the ability to select successfully those opportunities with the potential to generate future top returns. While this sounds straightforward, it also points to a central component of any due diligence, namely, that good due diligence needs to extrapolate the future success of a manager based on historic data.

There are four principle dimensions along which this analysis must be performed. The analysis of the team, the market and its environment, and the investment strategy need to be satisfactory, both individually and taken together as a unit. The fourth dimension – the track record – then must demonstrate above-average returns through adequate benchmarking. It must also illustrate how closely the stated approach of a manager and actual implementation are congruent.

Overall, in situations where team, strategy and market aspects integrate into a consistent story which can be substantiated through a track-record analysis, and where the market shows attractive potential that can be captured by the team, the prerequisites for attractive future performance are met.

Furthermore, it should be understood that any due diligence combines both qualitative and quantitative analysis. Experience has shown that ultimately, the analysis of the qualitative aspects is more important, while the quantitative analysis is mainly used to identify issues and inconsistencies that then need to be analysed further. This interplay between the qualitative and quantitative is also the main reason why score-based investment decisions are highly questionable and should be substituted by judgmental decisions taken by experienced investors with a solid track record of successfully investing and working together.

Team

The most critical aspect of any due diligence is a thorough understanding of the team. Often, the biggest threat to a successful fund investment is a team that is dogged, sometimes to the point of breaking apart by friction and infighting. It is thus paramount to understand each team in particular and to get very familiar with each key member.

Vital to consider are the team’s skills, operating expertise, stability and evolution, alignment of interests, possible conflicts of interest and quality of its network, as well as the chemistry between team members.

It is crucial that every team feature a balanced set of skills. Buying a company, improving and building it over a period of three to six years – often through and impacted by different economic cycles – then selling it successfully and profitably is a highly complex process that requires very diverse skills.

When evaluating a team, it is important to keep in mind that each successful investment is the result of a long and complex process that involves the effective sourcing of investments. This is achieved through a combination of elaborate business community networks and intermediaries, and the proactive approach of target acquisition companies– all supported by a recognised brand in the market.

During the acquisition, it is important to perform solid and detailed due diligence, as well as to possess the negotiating strength and experience to intelligently structure the transaction with the appropriate financial instruments suitable for the size and complexity of the transaction.

During the holding period, the focus should shift to effectively guiding the companies and/or improving them operationally and growing them through holding one or more board seats. This phase often includes improving or changing management, making geographic expansions, and revising and redefining the company’s core business processes.

Ultimately, a company must be sold at a profit to maximise return, which is accomplished either by selling to a strategic or other financial buyer, or by listing the company on a public stock exchange.

Properly executing each step along the acquisition and sale process of a company directly impacts the success of the investment and the ultimate return. It is unrealistic to expect that any one individual could possess the skills necessary to excel across the diverse requirements that make an investment a success. It is thus paramount that a team consists of individuals with complementary skill sets, who can nevertheless work together effectively and capitalise on each other’s strengths.

In a European context, several aspects are particularly relevant. Europe, albeit moving closer together, is still a collection of individual countries, with different languages, business practices, legal systems and sensitivities. Much of the deal flow in Europe comes from family-owned businesses.

Many of these owners prefer to conduct business in their native languages with those who are familiar with local customs, which puts those teams without those capabilities at a disadvantage.

Such a disadvantage automatically reduces the deal flow of those teams, with a potentially negative impact on returns.

Furthermore, the team’s banking relationships need to be fully understood. Across Europe, the banking market remains more fragmented than for example it is in the US. Particularly for smaller investments, lenders are typically members of the local banking community rather than large global institutions. Consequently, it is important for any team to have good access to local lenders and a proven track record with those lenders.

This partial chapter is one of 19 in The Definitive Guide to Private Equity Fund Investment Due Diligence:  Perfecting your due diligence ability for top-quartile returns, a new book from PEI Media.