It is a new era in private equity – where cheap leverage is no longer a ubiquitous tool to generate attractive returns. The impact of rate hikes on private equity in H2 2022 and H1 2023 has been stark: UK deal volumes have declined 55% and 61% in H2 2022 and H1 2023 respectively, from highs in H1 2021 (Unquote)1. Although there is a record amount of dry powder, having reached $3.7 trillion at the end of 2022, up from $3.2 trillion in 2021 (Bain 2023)2, where best to deploy these funds is less clear. There is a particular squeeze on the lower- and mid-market, as larger funds are commanding a greater share of incoming capital in an uncertain and more risk-averse atmosphere. The share of global fundraising in 2022 that went to the largest 25 performers increased by 11% and the tranche of firms ranked 26-250 only saw a 2% decline in their share (McKinsey)3, meaning that it was the long tail of smaller investors, who suffered the worst effects of the constriction in available capital.
Those celebrating their fiftieth birthday this year were in their early teens the last time interest rates in the UK followed such a sharp upward trajectory, while many of today’s private equity Investment Managers and Investment Directors had not even been born. The majority of people in the UK private equity industry are therefore navigating these headwinds for the first time, and good commercial due diligence is the compass that is keeping them away from the reefs and the rocks.
As part of our 10th Anniversary celebrations, Fairgrove Partners surveyed the UK mid-market private equity and corporate finance community to explore its approach to purchasing Commercial Due Diligence (CDD). By examining the perspectives and practices of industry professionals within this inaugural Fairgrove CDD Survey, we aim to provide guidance on how to maximise the value of CDD and ensure its effectiveness in informing investment decisions.
Key Survey Findings:
- Good CDD should address the company’s strategy (as well as the achievability of its plan) to ensure investors generate the returns they need to justify the acquisition price, especially in auctions and competitive processes.
- The strong consensus among PE professionals is that buy-side CDD is a strategic investigation with long-term value. Sell-side CDD serves as more of an information control and education tool for vendors but should offer the same benefits as buy-side CDD to the acquirers.
- When selecting a provider for CDD, both those on the buy- and sell-side value sector-specific experience the most, whereas brand strength is weighed much higher on the sell-side. This highlights the greater importance of an advisor’s reputation on a sale.
- To ensure CDD is valuable, consultants need to live up to their ‘strategic advisor’ status. A good CDD report is lean, targeted and off-the-fence.
Thank you to everyone who took the time to share their views with us earlier this year. We had 64 respondents in total from a very balanced sample of investment professionals (see Figure 1 below), and look forward to repeating the survey annually. Please read on for a detailed discussion on the results.
Figure 1: “What is your role?”
1. While CDD is commonly purchased, it is not used as frequently as other advice, such as financial DD or legal DD. Management and insurance DD trail CDD in frequency of use but remain important risk mitigation tools for PE. Due to the ongoing and increasing penetration of technology across all sectors, it is no surprise that the use of tech DD is increasingly prevalent across deals in the last three years.
Figure 2: “Approximately how often do you commission each of the following third-party due diligence services?”
2. Beyond the high-level goal of evaluating the attractiveness of the business, buy-side CDD is most commonly commissioned to confirm (or seek input into) the target company’s strategy, or to acquaint investment teams with unexplored markets. As one might intuit, this made CDD more likely to be commissioned when the target is broad ranging in terms of markets, geographies or product/service lines, or when it operates in an unusual or changing market. With the cost of debt rising and auctions no less prevalent, investors need to work ever harder to generate the returns necessary to justify their entry price – an outcome that will only be achieved if the company they are backing has the right strategy.
Figure 3: “What are the key drivers behind requiring a third-party provider of buy-side CDD?”
Figure 4: “Under what circumstances does commissioning third-party buy-side CDD become more likely or necessary?”
3. On the sell-side, corporate finance professionals view having greater control over the sales process and educating potential investors as by far the primary drivers for commissioning VCDD.
Figure 5: “What are the key drivers behind commissioning third-party VCDD?”
4. As you might expect, corporate finance professionals view themselves as having the greatest influence over when to commission the VCDD of an asset, indicating the confidence in their abilities to best position an asset for sale. Private equity respondents take an opposing view, and feel they are most influential by a considerable margin. We’ll leave them to discuss that particular survey result among themselves!
Figure 6: “Who has the most influence on the decision to commission VCDD?”
5. CDD reports are regularly referred back to throughout the hold period (97% of respondents refer back to CDD reports at least sometimes). This clearly demonstrates the strategic value that CDD has, as opposed to a point-in-time due diligence exercise pre-transaction.
Figure 7: “How often do you refer back to a commercial due diligence report post-transaction?”
This is corroborated by the fact respondents typically require a full scope CDD report most often.
Figure 8: “What level of third-party CDD do you typically require?”
6. Respondents highlighted sector experience as the most important selection criterion for CDD providers, whether buy-side or sell-side, with price and relationships also a crucial part of decision-making. Interestingly, clients place as much as three times more importance on the brand strength of firms when commissioning sell-side work vs. buy-side work. Working with a recognised brand such as Fairgrove Partners, which has worked with 55 PE funds and 13 corporate finance advisers, and which has been ranked the #1 or #2 CDD provider in the UK and Ireland (by volume of completed transactions advised) in 7 of the last 9 nine years (Unquote)1, adds credibility to the sell-side process and even the quality of the asset itself.
Figure 9: “What are your key selection criteria when choosing a third-party provider of CDD/VCDD?”
7. Commissioning CDD is not without its challenges, as certain issues pose a higher risk of deal abandonment. Customer referencing is the most frequent cause of an aborted transaction where the investor pulls out based on information from the CDD. Dissatisfied customers can quickly break a potential deal, especially if there are competitive alternatives and barriers to switching are low. On VCDD, potential buyers are most likely to pull out of a deal due to the provider’s business plan assessment. Interestingly, customer referencing was not mentioned as a reason for VCDD aborting, perhaps because businesses are unlikely to go through a sale process if they have a dissatisfied customer base. However, the fact that the CDD provider’s assessment of the business plan is such a key driver of an investor’s decision not to proceed with the transaction, refutes the occasionally-levelled suggestion that sell-side CDD lacks impartiality and merely rubber-stamps management’s projections. (This rather lazy and outdated criticism of sell-side CDD also ignores the possibility that the CDD may have forced a revision to the original plan and accompanying Information Memorandum in the first place).
Figure 10: “In your most recent transaction that aborted due to the findings of the commercial due diligence, which element of the CDD was the main reason for you not progressing with the deal?“
8. The most common frustrations with CDD reports among clients are:
- “Cookie cutter” reports that do not focus on the business itself (or key questions regarding it)
- Reports that lack impartiality
- Reports that fail to take a clear position
It is obviously important for CDD to be accurate – whether in sizing a market, analysing historical company performance or quantifying opportunities – but where findings are simply stated as facts (and not drawn together into ‘advice’), buy-side investors can quickly become frustrated with their vendors. CDD providers are typically not qualified to give direct investment advice (“You should/should not acquire this business”) but they ought to be giving a clear opinion on the assumptions in the plan and the relative commercial attractiveness of the business. This is what we strive to do with the Fairgrove ‘top-box’: the single, off-the-fence paragraph in our Executive Summary that summarizes our view on the business. As one client likes to tell us: “Whether we ultimately agree with you or not is of secondary importance; what matters is the quality of the discussion.”
Figure 11: “What are your most common frustrations with the CDD/VCDD workstream or its providers?”
Without a doubt, the difficulty of deal-making has increased over the last two years. Leveraged deals are inherently more expensive with increased interest rates, and fewer high-quality assets are coming to market with this in mind. Sorting the good from the bad (and from the ugly) is more important than ever, and in order to assist with this process, CDD is an important step in obtaining an impartial view of the business and its trajectory. We believe that CDD gives our clients confidence to make the crucial decisions necessary, and can allow them to win out over their competition.
Get in Touch
Fairgrove Partners provides growth strategy and commercial due diligence support to corporations, SMEs, private equity firms, and their portfolio companies, operating across the Business Services, Technology, Industrials, and Consumer sectors. To discuss any of the points raised in this article, please contact Patrick Woodrow or Paddy Woods Ballard.
Fairgrove will repeat its CDD survey of PE and CF firms each year, and will continue to identify and discuss key trends and best practices. Please look out for how to participate in our next survey in March!
Footnotes and Sources
1 Unquote – Deal Volume Data (September 2023)
2 Bain – Private Equity Outlook 2023
3 McKinsey – Global Private Markets Review 2023