Private Equity Due Diligence: How to Set Your M&A Up for Success
Change is hard. If you’ve been through a merger or acquisition, you know how many challenges can arise when you’re going through a transition. And, while it’s imperative that you conduct comprehensive due diligence before you invest in a new company, today’s competitive landscape often requires the completion of due diligence faster than ever before.
As an executive at serial acquirers Textron and ITT, I played a key role in significant transactions on both sell and buy sides. I’ve evaluated, negotiated, closed and successfully integrated M&A deals. As a Six Sigma Black Belt, I’ve learned to embrace the power of data, statistics and the inferences that can be drawn from them and to employ that knowledge to inform decision-making. Through trial, error, and real world experience, I’ve developed due diligence practices that could help you make better acquisitions, and more effectively market portfolio businesses when its time to sell..
Regardless of whether you’re a Corporate or Private Equity (PE) buyer, the short-term goal is the same: Earn a high return on investment by rapidly improving operations, revenue, and profits.
To help you achieve that goal, consider these due diligence practices I’ve employed with success:
1. Don’t Stop at the Surface.
Whether you’re a corporate or PE acquirer, in-depth due diligence is crucial. Too often, due diligence stops at the surface, relying heavily on financial analysis and interviews with senior leadership for insight into operations. Often these efforts fail to reveal potential issues or opportunities within a company’s structure or market.
To ensure you have a thorough understanding of the state of a business you’re acquiring, it's imperative that you dive into these two areas:
- Organization - It’s efficient to stop your corporate or private equity due diligence process with a high-level overview of organizational structure and financial data. But, if you’re committed to success, you need more than the Reader’s Digest version of an organization.
I've witnessed numerous acquisition and company sale efforts, both successful and unsuccessful. Once while leading the sale of a business I managed as President, one potential buyer set a very high standard for thorough due diligence. They sent 26 functional area experts to assess my organization, from customer acquisition to performance management to daily operations. They didn’t stop at conversations with C-suite executives; they studied every aspect of the business and interviewed employees in all functions at all levels.
This company used the knowledge gained to justify a bid of $75 Million more than expected by our investment bank, closed the deal and, 10 years later, still counts this as one of the best deals they have ever made.
When you dig deeper into the people, processes, and culture of a company, you’re able to identify aspects of the company that make it work, as well as aspects that could prove problematic in the future.
- Market - A common challenge acquirers, especially private equity firms, face is a lack of knowledge about an acquisition’s target industry and specific market. A private equity firm called several years ago for assistance with an acquisition they had already made in the commercial finance market. Admitting they kept their due diligence on a high level, they had failed to educate themselves sufficiently about how the company they acquired sourced and priced deals, so they missed a major flaw in the company’s customer acquisition and profitability model. They also misunderstood how a fast growth loan portfolio ages over time and gradually reveals imbedded credit losses/flaws in decisioning that can eventually sink the company.
While you may have a working knowledge of an industry, that isn’t the same as having a robust understanding of how a company operating in a specialized segment of that industry might succeed or fail. Bringing in objective expertise early in due diligence can help avoid expensive mistakes.
2. Don’t Forget the People.
Most companies tend to emphasize the financial side of corporate or private equity due diligence, focusing more on spreadsheets and data than the people producing the results those numbers represent. Before you acquire a company, you’ll benefit by turning your full attention to the people who keep the business operating each day.
“Back the jockey, not the horse.” That’s a common approach acquirers take, placing their trust in the company’s leader or leadership team without much analysis of the company as a whole. This can be problematic as many business owners, especially in small companies, are experts on the technical aspects of their business or industry. The CEO of a plumbing company, for example, is typically expert in the work that plumbers do. They’re usually less knowledgeable when it comes to management and leadership functions like marketing, HR, strategic planning, financial management, attracting and retention of talent, etc.
When the Buyer’s goal is to take the company to the Next Level, that can frequently require a transformational leader that may or may not be part of the current group. Rather than backing the Jockey in the hope that he/she is that leader, a more comprehensive effort to understand the culture, capabilities and capacities of the people in the entire organization will be a more accurate predictor of success.
Invest time in getting to know employees at all levels, and how they function within the organization. Look at personal records and talk to managers about who the high-performance employees are, and ensure that these key people know that their contributions are recognized and will be valued appropriately in the new company.
3. Don’t Rush the Process.
It’s tempting to simply skim over corporate or private equity due diligence, since you already know the business owner and leadership team. But, diving in prematurely could be a grave mistake. Slowing down the due diligence, closing, and transition processes will ensure you’re not missing any important signs that could lead to acquisition failure. When you fail to conduct private equity due diligence thoroughly and effectively, you could easily overlook red flags that would otherwise deter you from making a faulty purchase.
Ensuring the due diligence process isn’t rushed doesn’t just help the buyer, it helps the company being acquired, too. Change is never easy, especially when there is a no transparency regarding a transition. In fact, studies show that employee disengagement increases 23% after a company changes ownership. To prevent that eventual dip in engagement, it’s important that people are prepared for a transition before it occurs. Employees may think that their jobs are at risk or major changes are looming. While changes may come eventually, it’s important that you communicate projected milestones and timelines in advance, and avoid making sweeping changes too quickly.
Before acquiring a company, a significant investment of time and effort in due diligence should be a key part of your playbook. This will help ensure your new business is positioned to become a key contributor to your portfolio, and will eventually provide an impressive capital gain for the investors in the business.
Want more insight on how to properly conduct private equity due diligence? Schedule a free consultation with Keith Boudreau or another Newport Board Group partner now.