The dog ate my homework

Managers continually profess they always protect their downside risk. But with time pressure increasing, is due diligence being compromised?

A credit fund manager once opined that the easiest way to make money was to not lose it in the first place. Others have expressed similar sentiments that in their simplest form can be explained thus: a firm is only as good as the credits it invests in.

A cornerstone of debt investing is, of course, doing your homework – conducting thorough due diligence and exhausting all available avenues that allow a firm to get its figurative arms around any given credit. But the timeframe fund managers now have to accomplish that task is drastically shrinking, market sources tell PDI.

One source working at a firm that invests in the mid-market – which it defines as $10 million-$50 million of EBITDA – says this time slippage is reflected in the diligence period going from months to weeks.

This person’s firm lost out on a transaction because it insisted on a quality-of-earnings report. The source says the private equity sponsor buying the company told the credit manager that fulfilling such a request would simply take too long.

Sponsors are feeling pressure to put together comprehensive bids by the letter-of-intent submission deadline rather than waiting until the final bid deadline, another market source says. This person’s firm has passed on deals because the diligence timeline was just too tight.

It is particularly noticeable if a firm is vying for a position in a lender syndicate. The amount of diligence provided will be “higher level and more filtered”, the second source says – if a deal is oversubscribed and one firm passes, another manager will step in.

While the time allowed for diligence has been shrinking for years, the source adds, it appears that competition and mounting dry powder – which between buyout funds and direct lending vehicles has advanced into the hundreds of billions – have exacerbated that shrinkage further.

At least some private equity sponsors may be keeping their wits about them.

The fund manager that lost out on a deal because of insisting on a quality-of-earnings report was aware of another sponsor that spotted a rather aggressive term sheet for a separate deal in the media sector. The lender that provided the term sheet did so in a matter of days and had no resident expertise in the media industry, giving the sponsor pause on the underwriting.

With survey after survey showing that large numbers of limited partners plan to allocate more to private credit than other alternative asset classes, it’s getting easier to raise money. Capital has become a commodity, and managers continue look for ways to differentiate themselves. Why not through due diligence? Those claiming the dog ate it may win the deal –  at the expense of long-term performance and respect.

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