The global economic crisis, now in its fifth year, has changed the way in which private equity firms consider the role of due diligence in M&A transactions. Historically, the financial performance aspects of a potential target would be the primary focus when deciding which opportunities to pursue, which meant that details regarding the future operational plans for the target were often seen as secondary. Easily accessible credit markets also meant many PE firms were sometimes willing to pursue what would now be considered less attractive deals based on a financial due diligence review alone.
By comparison, today’s PE firms are regarding potential acquisitions with much greater scrutiny. Not only have tighter credit markets limited the debt financing which was freely available for larger leveraged buyouts pre-2008, but financial institutions now expect more comfort around the business case for the deal before providing funding to the PE firm.
Additionally with the decreasing trend in deal values and volumes post-2008, competition for the right deal has intensified. The scarcity of attractive assets has driven up valuations and so the acquiring PE firm needs to be sure that it minimises the risk of value erosion and identifies the incremental value enhancement opportunities in the pre-acquisition diligence phase. Potential upsides related to optimisation of the target’s operating model, performance improvement and capital investment returns are taking on a greater importance in justifying the deal rationale within the PE firm.
These considerations have shifted the way that PE firms employ due diligence towards a wider issues-led approach. At the pre-deal stage, the issues-led approach can assist PE firms in identifying the core business areas that need to be analysed – in detail, and holistically – during the proposed acquisition. These activities range from the purely financial to issues around operating model optimisation, IT as an enabler, capital expenditure and operational productivity, leading to key insights into both transaction risks and potential deal upsides.
All of these factors need to come together to form the basis for value optimisation when contemplating M&A activity. Of course, financial due diligence remains an important part of M&A, but the wider issues-led approach to due diligence gives PE firms the necessary visibility of the potential target that allows them to price competitively to secure the right deal and to optimise value creation post acquisition. Early identification of the key drivers and issues enables focus on value across a broader diligence scope whilst maximising the efficiency of the diligence process.
Ernst & Young and a PE client recently adopted the issues-based approach in the acquisition of a laboratory services business. This resulted in the appropriate resources being engaged from the start of the transaction process, culminating in the PE client being able to successfully support their internal equity investment case, exploit the potential upsides of the deal to win a competitive auction for the asset and subsequently realise the operational upsides in the post-deal phase.
In the current economic landscape, it is important that the value of a deal is preserved at every point in the transaction life cycle. An issues-led approach to due diligence can help PE firms secure the right deal at the right price. This approach offers the most efficient way of uncovering the real value drivers of the deal and the addressable upsides that will deliver sustainable value to the PE firm post -acquisition.
Michel Driessen is Ernst & Young's UK & Ireland head of operational transaction services.