Equity investors are re-emerging from the UK down-turn as backers of companies with promising growth prospects

By David McClelland

Posted: 15th January 2014 09:20

CDD can deliver a comprehensive understanding of the health and character of a potential investment business, allowing equity investors to navigate the transaction process and determine deal attractiveness.
Private equity investors are re-emerging from the UK down-turn as backers of companies with promising growth prospects that have weathered the previously muted trading conditions well and have limited market and operating risk.  But with lenders still reluctant to allow PE borrowers to leverage up too far, PE firms need to commit more equity to the deals they are contemplating in the current investment cycle.  In this environment, CSA believes PEs who are choosing to invest need to work harder to judge value in the companies they are seeking to support or acquire.  First and foremost, they need to sharpen their CDD process.
At a time when many trading companies as investment targets are still finding market conditions very ‘tippy’, the scope of a due diligence project may be required to recognise a number of scenarios relevant to the target-co’s trading position.  In the present economy, these may be characterised as follows:
  Due diligence, as a process, is a matter of the advisor’s ability to engage in close ‘question and answer’ dialogue with the target-co’s senior management team from which the information that is forthcoming can be crossed referenced and subsequently validated.
An internal analysis of the company will examine views held by the management team about core competencies and prospects, for example.  A programme of external customer referencing can identify how well the company is able to satisfy vendor threshold criteria in the context of strengths and weaknesses relative to alternative suppliers as market rivals.
Taken further, the target-co’s overall competitive standing in the market can be qualified in a model of commercial risk vs likelihood of occurrence or industry attractiveness vs competitive strength in those markets.
A more quantitative analysis might seek to determine the probability of success of a given activity planned by the company against its value if implemented successfully in a timeframe relevant to the business plan and the investment case.  By allocating a measure of weighted probability towards new product introduction and customer uptake, for example, it becomes possible for the reporting consultant to model revenue build-up on a line-by-line ‘grass-roots’ basis and to ascribe a level of confidence in the forecast that is of comfort to the investor.
At this level of analysis, CDD often dovetails with the separate and more numbers driven analysis carried out by a financial due diligence team commissioned by the PE investor, but with a shorter forward time horizon in mind.  Taken together, the level of confidence in the revenue forecast demonstrated by the CDD can be sensitised by the FDD with relevance to the company’s forward cash flow position and therefore its ability to comply with the terms of covenants laid down by a lending bank in partnership with the equity investor in a post-deal environment, for example.
In summary, in a phase of the economy when trade companies may not have much ‘wool on their backs’, CDD can be seen to help investors in their assessments of the risks and opportunities contained in the business plans proposed by target companies and which underpin the equity investment case.  CDD can provide a distinctive view of a deal’s upside potential and downside risk – proprietary risks that once qualified gives the PE investor better ‘ballast’ to structure a deal favourably.  Ultimately, what an equity investor does not want to see is a previously hidden surprise emerge in the post-deal environment.
Of course, one investor’s risk is another’s opportunity.  The trick for the CDD reporting advisor is to view the transaction through the eyes of the equity client; aware about what factors in the make-up of deal will make the client comfortable or nervous about wanting to continue.  It is the advisor’s ability to read the flow of the transaction and identify the principal issues in addition to establishing the supporting evidence and communicating final, written opinion that differentiates effective CDD and creates investor value.
Carlton Strategy Advisors provides commercial due diligence and portfolio support services to financial investors and PE backed businesses. 
David McClelland, Director
Carlton Strategy Advisors Limited
+44 (0) 208 947 5108

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