Public diligence

Washington DC-based Allied Capital is a $4 billion publicly traded business development company that makes debt and equity investments in middle-market, private companies. With thousands of public shareholders to answer to, the firm sticks to a highly regimented investment process that moves through multiple stages from initial investment screening to sealing the deal. A key hurdle in the middle of this process is due diligence. After being given initial approval by the investment committee, the deal team on a potential transaction seeks to validate historical and projected financials, assess the competitive business environment as well as market trends, and performs background checks on management, among other forms of due diligence. Private Equity Manager spoke recently with Allied managing director John Fruehwirth about his firm's carefully considered approach to due diligence.

Does Allied tend to keep most of its due diligence capability in-house?
That's true. All the execution teams are staffed with people who have an extensive amount of experience and due diligence is among the most important parts of their jobs. We'll certainly augment that as needed with specialist outside parties.

Generally speaking, we'll take the first cut through the financial statements. We'll go out and meet with the company one, two, three times – whatever it takes. We'll go through multiple levels of management, typically starting with the executive management team. But prior to closing the deal you'll have met probably the second if not the third layer of that management team.

All of the financial information and internal work that the deal team does is then compiled in a binder that ends up being between two to five inches thick, typically. Then, as part of our peer review process, it would be my job as a monitoring partner on a given deal to spend three to four hours going through that information. We'll then meet as a team.

Yesterday, I sat down with the whole team [on a deal in progress] and said, ?Okay, p. 1, p. 7, here are my questions.? One of the things to have come out of that meeting, which was focused on the potential acquisition of a distribution company, was that I suggested a different way to look at the deal. I said, ?What if you cut their branch profitability this way? Would this give us a different look?? I also asked whether having call centers at all the branches was the most efficient model. We also talked about open issues on the litigation schedule.

After a deal team gets an initial approval, what happens?
At that point the team goes back into what I'll call bunker mode and starts digging in depth. Obviously, financial information is critical – both income statement and balance sheet items. Operationally, we'll really try to understand why the company is successful and try to identify barriers to entry. We're trying to understand why the company will exist not only in five years, when we may be able to refinance or sell it ourselves, but in 10 years, because we've got to leave something on the table for the next investor.

We have requirements for who needs to meet the team. If it's a buyout, you need three managing directors or principals to have met the management team. If it's a debt deal of less than $50 million, you need two MDs or principals.

The MDs and each of the deal execution team members know what an Allied deal looks like. They're not going to bring something to the investment committee if they think it won't get through. There's a pretty good self-policing job that happens at this point.

Who does background checks on management? Who calls customers?
We typically will hire an outside firm that we have on retainer to do background checks – criminal and things of that ilk.

We sometimes have used outside firms to do customer calls, but oftentimes we'll participate in those calls. Or we'll do them ourselves – it depends on the situation.

In general, your best information isn't going to come from the five guys the management team tells you to call. It comes from a supplier or customer or former employee and you ask them, ?Who are the three other people I should call?? You get a much more robust picture of the situation.

There was a deal last year where we went all the way down the road. But when we started digging into the customer calls, we found one customer who was about to pull a contract. And we found another situation where a customer said, ?We are so unhappy. We've had three conversations and if things don't improve in the next 60 to 90 days we're going to pull out.? We backed away from that deal.

There are whole sections of our diligence binder that are focused on customer, supplier and former employee responses.

What other forms of due diligence do you outsource?
Environmental is certainly one. Another perfect situation might be either state or federal tax. Because there are esoteric issues related to certain jurisdictions which we are not going to have any knowledge of.

Sometimes we hire third parties for accounting diligence to supplement our internal review. Oftentimes we'll get an accounting review. A lot of that is confirmatory, so it's looking at their systems and controls.

Here's another example – we did an insurance brokerage deal recently where we were the debt provider. We asked the sponsor to get an industry consultant because it was centered on one state, and we wanted to make sure we understood the regulatory climate for insurance in that state. I just wouldn't have that perspective.

But again, I think we've got a broad set of generalist experience here that we can augment with specialist knowledge in any given situation.

How does Allied Capital's approach differ from other firms?
The more talent you put against a given opportunity, the better the result you're going to get. Following due diligence, we have a managing director peer review process that is very critical. It's one of the things that really distinguishes us. Other shops may put one or two people on the deal up front. They may talk about [the deal] at a high-level at the Mondaymorning meeting, and then have a separate, disinterested third party come in at the tenth hour and tear things up to make sure they haven't gotten too excited about the deal.

Two years ago, I was working on a staffing-company deal. It turned out to do just fine. But at the time, another partner descended on the deal as part of the peer review. He had been burned once on a staffing company in a prior life, and he didn't ever want to do a staffing company again, and he told me the five reasons why it's a tough industry. Well, great. You know what – oftentimes, that's the person who you want as a peer reviewer. The partner who is most critical is the partner we typically pick to fly around the country looking at the deal. And if he still doesn't like it, it's his responsibility to bring it back in and have it out with the execution MD who's leading the deal, and make sure all the concerns are vetted.

Have you ever used insurance?
There was a deal recently that came through, where we wanted X, the seller wanted Y, and one of the potential solutions was to buy reps and warranties insurance to bridge the gap. That was a way for us to consummate the acquisition yet protect ourselves.

How has your due diligence process evolved lately?
I've been here three years, and I think we're doing a more efficient job than we did when I joined. We're getting much more access to information earlier, and digging in earlier. If something comes up in the diligence process, the deals hit a wall earlier. By the time it comes to the investment committee, you have a pretty robust view of the business and should be able to answer most, if not all, of the questions that get posited by the committee. The memos and model summaries need to be out between 24 and 48 hours in advance in order to give everyone time to review. People take this seriously. I work just about every Sunday night from 8 to 10 or 8 to 11 because I know we have the investment committee and I've got three to four things to read. Everyone else does the same thing.

When we sit down as a quorum, comprised of the CEO, the COO, CFO and at least four managing directors, we'll tear through the diligence, ask all the questions, make sure the team has thought of everything and addressed everything talked about in the initial investment committee meeting. If there are risks, we talk about what those risks are and how they might be mitigated, and what they might mean for the deal structure.