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The role of due diligence in private equity

March 16, 2012

As stakes get higher, PE firms seek outside help to assess deals

When due diligence is performed correctly, it can either dramatically deepen a private equity firm's conviction about an impending transaction, or save the firm a large amount of money by changing its mind, said Brad Henderson, AB '01, AM '01, partner and managing director of The Boston Consulting Group.

“The PE firm we were working with felt they were first in line for the deal and [that] it had to happen,” said Henderson, describing a recent financial outsourcing transaction he advised. But the PE firm's eagerness to buy was before Henderson's company found capability gaps “so profound that we took a no-brainer buy and made it a no-brainer sell.”

Henderson spoke during a panel that focused on the role of diligence providers - third parties who are hired to help assess deals. The discussion was part of the 11th Annual Beecken Petty O'Keefe & Company Private Equity Conference, a daylong event sponsored by the Polsky Center for Entrepreneurship and the student-led Private Equity Group at the InterContinental Hotel in Chicago on February 24.

Carl Rutstein, '94, senior partner at The Boston Consulting Group and moderator of the panel, said he asks the PE firms he works with to focus on the two or three biggest questions they want answered. “For example, when Blackstone was looking at Orbitz, one question was, what is going to be the growth of Are people going to migrate back to or” said Rutstein. “We just narrowed in on addressing that question very directly.”

Rutstein's work with PE firms is part of a growing trend within the industry to hire third parties to conduct thorough analyses of companies being considered for acquisition. Consultants like Rutstein offer their insights about particular businesses, both their shortcomings and benefits, and this expertise is becoming crucial to the success of firms seeking to win auctions in an increasingly competitive environment.

GTCR is one PE firm that spends time networking and developing partnerships with executives in advance of a deal, said Sean Cunningham, principal at the firm. “When we're looking at a company, we want somebody on our side of the table who has real domain expertise, who may have competed against the company, or who may have a member of his or her management team that was a part of the company,” Cunningham said.

GTCR prefers not to rely primarily on marketing materials prepared by a bank, shareholders, or the management team of a company that is on the table, he said. “They are obviously hired to present the company in the best light,” Cunningham said. “We want people on our side of the table who have unique insights. That's at the heart of how we start all of our due diligence.“

After a purchase has been made, said Chris McGowan, general partner at CJM Ventures, there are steps needed to initiate change at a company. He identified four key processes to act on during the first 100 days after a purchase:

  • Develop a “second or third derivative” of understanding between existing management and the new owners. “You have to get laser precision in thinking about the business the same way,” McGowan said. Refine the quality of information flow between shareholders and the company. “We spend a lot of time redesigning the type of things that are measured or recorded, so that we can spot issues early on,” he said.
  • Teach inexperienced management teams the boundaries of operating within a leveraged balance sheet. “While we put a lot of time and thought with management into tailoring each acquisition structure to fit a business and its opportunities, we must be disciplined to work within any restraints imposed by a leveraged balance sheet,” McGowan said.
  • Reinforce equity incentives, especially to those unfamiliar with them. “Many smaller businesses have management teams who have never had the benefit of equity ownership. For those new incentives to have a meaningful impact on thinking and performance, they should be explained and re-explained on a constant basis,” he said.
  • Begin executing your investment thesis as soon as possible. “In the first few months, we relocated the company's space-constrained operations to a larger facility to give [the company] the opportunity to grow, optimize material flow, and in-source some functions [that] we used to send to outside vendors,” said McGowan. These changes made it possible to “capture some material margin expansion,” he said.

The concept of developing a 100-day plan is relatively new to private equity, Henderson said. “Ten years ago the idea of a 100-day plan just did not seem important,” he said. “It's amazing how far the industry has come in terms of aligning management interests, bringing the right management team in, and having a clear view of the investment thesis.”

—Phil Rockrohr