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

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:
 

• The recession will cease at different times in different sectors.  Market research carried out by the CDD investigator into the sources and drivers of demand can provide information and data which will help to validate the relative strength of the recovery, including the expected phasing or cyclicality of demand within the addressable market relevant to the company.
• Can an old business plan be effectively resurrected to take advantage of the upturn or is it a case that even an upturn cannot revive a tired formula?  An external business plan review can determine whether or not the revenue and margin projections made by company management are realistic in keeping with the company’s ability to recover from earlier market collapse.
• What will be the impact of returning business volumes if industry pricing remains an issue? Competitor analysis can determine if a company’s rivals might aim for a ‘land grab’ from which margins are ‘trampled underfoot’.
• Inflation is a persistent threat.  Can rising costs be pushed through the industry supply chain?  An examination of the relative strength and positioning of suppliers/buyers/middle men can help assess how easily raw materials and other costs can be passed onto the market

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
david.mcclelland@carlton-advisors.co.uk
www.carlton-advisors.co.uk