Steve Hacking

1
Due diligence survey
June 2006
Steve Hacking 68 Charlotte Street London W1T
4QF 020 7637 3330 steve_at_latitude.co.uk www.latitud
e.co.uk
2
QUESTION

• How can due diligence be used to improve
  investment performance?

3
BASIS

• Interviews with 20 investment professionals

• Experience of 100 deals at 26 companies

• Participants range from early stage tech houses
  to large LBO funds

4
AGENDA

• Context performance of invested companies
• Commercial due diligence other commercial
  reviews
• Management due diligence
• Conclusions

5
PORTFOLIO PERFORMANCE

• Investment performance vs. requirements

Performance vs. business plan
Above
At
Below
20
65
15
VC
90-100 behind plan
22
32
46
LBO
80-90 behind plan
6
Reasons for.
PORTFOLIO PERFORMANCE Reasons

• Over performance

Under performance
Other

• Making right or wrong call on market and
  management is critical to investment performance
• Expectation that market will change and
  management need to adapt business to this

Market development
Management
7
PORTFOLIO PERFORMANCE Timing and action

• How soon do things go wrong?

Why?
Solution
17

• Need to perform quickly in much tighter financial
  situation
• Performance stakes usually raised
• Management distracted during deal

gt18 months

• Strong relationship between active early
  involvement and investment success
• Consistently most effective improvement method
  major changes to team

33
6-18 months
50
lt6 months
8
AGENDA

• Context performance of invested companies
• Commercial due diligence other commercial
  reviews
• Management due diligence
• Conclusions

9
CDD OTHER COMMERCIAL REVIEWS Process overview
Screening
Bidding
Due diligence (exclusive)
100-day Planning
Performance management
Preparation for sale

• Sector reviews

• Pre-bid review

• Commercial due diligence
• Strategic prioritisation

• Strategy workshop/ plan support

• Sustainability review of under performers

• Vendor due diligence
• Strategic plan development

10
CDD OTHER COMMERCIAL REVIEWS Use of 3rd party
Screening
Bidding
Due Diligence (exclusive)
100-day Planning
Performance management
Preparation for sale

• Commercial due diligence (all gt20m deals)

Historic use of external providers
11
Deciding content of CDD
CDD Content

• Mental model of what makes investments or
  businesses successful. Generally fairly standard
  but supplemented by learnings from painful
  experience (38 mainly formal, company-wide 62
  mainly experience based, individual)
• Develop investment hypothesis using at-hand
  expertise (internal or expert contacts)
• Create shortlist of issues to test hypothesis
• Review issues to test with broad range of parties
  (internal and external)
• Settle on 3-4 (virtually always) what needs to
  be true for this investment to be successful
• Brief provider with issues to test (but not
  necessarily the full investment hypothesis)

Tighten brief

• Expand scope to cover checklist factors (formal
  or informal)
• Often also required by bank
• Have characteristics of we dont know if this is
  a problem but we need a quick look-see anyway
• Scope then expands during CDD as issues and
  worries arise

Expand brief
12
Importance versus coverage
CDD Content
Always
Covered in CDD
Often
Sometimes

• Generally not covered
• Cost saving opportunities (covered in ops DD)
• Cost and performance benchmarking

Unimportant
Critical
Importance to investment success
More important in VC
13
CDD Selection of provider
Bidding
Due diligence (exclusive)
Invested capital
lt5m

• Predominantly internal

• Default internal
• Use of external support determined by
• Investor knowledge of sub-sector
• Target complexity
• Fundamental questions about nature of demand

10-20m

• Some use of external
• Quick and dirty from industry expert
• Some retainer-style relationships with CDD houses
• Pseudo-CDD project for larger deals

• Default external
• Usually CDD consultancy team
• Individuals for specific issues or grey areas
  requiring specialist knowledge

gt500m
14
Which external provider?
CDD Selection of provider
Described priorities
Common behaviour

• Sector expertise
• Issue expertise
• Trusted provider know to PE professional
• Knowledge of PE/house style
• CDD brand (large deals only)

• Trusted provider known to PE professional
• Quality perception
• Price perception
• Sector expertise

15
Ideal provider
CDD Selection of provider

• Individual from sector
• Knows issues in sector
• Knows problems with target organisation
• Sage source of advice to management

VC

• Usually individual from sector who knows issues
  immediately without research major benefit of
  house sector focus

Pre-auction

• Consulting team of
• Sector expert
• Project leader experienced in CDD who knows house
  style
• Youngsters for data research and analysis

LBO exclusive
16
CDD Ideal process
Bidding
Due diligence (exclusive)

• Process
• Identify major issues that dictate
  success/failure, hit them early, flag up
  important points early to PE
• Detail and comfort factors later that lead to
  bulk of report
• Frequent clear communication for continuous
  reassessment and review of issues

• Expert view
• Identify opportunities and issues early
• Quantify effect on financials
• Recommend plan for change

• Reporting
• Short, summary assessment prioritising risks and
  potential profit pools
• Opinion, not just facts
• Wrapper and nice report for bank

17
CDD Rating of providers

• PEs generally satisfied, but not ecstatic, with
  providers
• No analysis of provider performance
• Major criticisms
• Large amounts of data and lists of issues but
  little additional insight
• Reported speech without so what
• Excessive focus on downside vs. potential upside
• Incrementalist miss major industry shifts
• Cost (not confined to CDD)
• Criticism tempered by understanding of short time
  frame

18
CDD Impact of CDD
Value of CDD
Killing deal by uncovering black holes
Supporting review of plan projections
pricing/valuation
Strategic insights that increase business value
Increasing investor confidence and knowledge of
the target
19
CDD Impact of CDD

• How often CDD results in not investing
  (post-exclusive only)

• Low rate of aborts as expected by investors
• Generally already decided to do deal (CDD as
  box-ticking)
• CDD used to identify problems to fix later
• Most work done pre-bid in LBO
• Can review price and bid lower
• FDD a more common cause of abort
• Excludes loss of auction where CDD influenced
  bidding

7
gt25 deals
13
10-25 deals
72
lt10 deals
58
28
22
Never
investors (LBO only)
investors (all deals)
20
CDD Impact of CDD - changing projections/valuatio
n

• How often CDD results in changing terms

Bidding
Due diligence (exclusive)
Themes

• Identification of additional profit opportunities
  to justify price premium
• Scaling down market opportunity in emergent
  market (business plan upsides)
• Competitive position never better than IM
• Usually incremental changes

17
gt75
Occasionally
20
17
50-75
Rarely
40
33
25-50
Never
40
lt25
33
CDD contributes along with other reviews to view
of and valuation of business and therefore bid
price
CDD projections consistently more conservative
than business plan but only occasionally changes
valuation captured by investors discount
21
CDD Impact of CDD strategic insights

• How often does CDD generate a major insight that
  increases the value of the company?

Sources of strategic insight

• Self-fulfilling closely correlated to how PE
  house briefs provider
• More common in immature businesses and markets
• Insights generally confined to PL, i.e. working
  capital and asset management rarely reviewed

Hardly ever
Creative
Analytical
44

• New product or market opportunities

• Prioritisation of existing opportunities
• Identification of profit improvement

20-50 of the time
56
?
?
22
CDD Impact of CDD
Value of CDD
Killing deal by uncovering black holes
Supporting review of plan projections
pricing/valuation
Strategic insights that increase business value
Increasing investor confidence and knowledge of
the target


?
?
?
? ? ?

• Results in perceived high value of increasing
  confidence and knowledge of target
• Combine with perspective from other DD
• Used regularly in business planning (90-day and
  2-year plans)

Some value, subject to situation and nature of
briefing
23
CDD Market under performance
Why does CDD miss market under performance?
Addressable?
24
CDD Trends
Dominant trend auction creep
Impact
25
AGENDA

• Context performance of invested companies
• Commercial due diligence other commercial
  reviews
• Management due diligence
• Conclusions

26
Reasons for.
MANAGEMENT DUE DILIGENCE

• Over performance

Under performance

• Management is number one reason for under
  performance
• Poor management inability to handle change in
  the company or inability to anticipate and
  respond to changes in the market

Other
10
23
11
Cost
Market development
38
33
Management
52
33
27
MANAGEMENT DUE DILIGENCE Approach

• No two interviewees described same process for
  MDD
• Broad range of approaches
• From taking references and 2/3 management
  meetings (auctions)
• To regular one-to-one group meetings,
  psychometric tests, head-hunter references,
  hand-writing tests
• Uniformly most useful PE investor spending lots
  of time getting to know individuals and team
• Trend to head-hunter referencing and personality
  tests, but unsupported by results (both 50
  accurate in retrospect)
• Team analysis restricted to skills mix, little
  assessment of team dynamic
• MDD approach under review by numerous investors

28
MANAGEMENT DUE DILIGENCE Post-deal management
issues

• Management weaknesses become apparent within 6
  months
• Pressure to improve on historic performance
• Living up to business plan claims
• Reporting demands

• At least one of senior team changed within one
  year of deal in average 30 (range 10-70) of
  cases. FDs most vulnerable before deal and in
  first 6 months, CEO most vulnerable thereafter
• Weak people consistently identified beforehand,
  but not changed as part of deal in 50 of cases
• Difficult in auctions
• Uncomfortable cannot specify why
• Cannot wait for perfect team
• Every case where weak person was changed no
  negative team fallout resulted

29
AGENDA

• Context performance of invested companies
• Commercial due diligence other commercial
  reviews
• Management due diligence
• Conclusions

30
CONCLUSIONS

• Management and market performance explain most
  variance in investment success

• Core of successful investments and avoiding under
  performance appears to be using CDD MDD to
  understand the business and take an early active
  approach, including early review of plan and
  early changes to management

CDD
MDD

• CDD is generally considered adequate but often
  features missed opportunity and overlooked
  downside

• Management diligence is critical but performed
  inconsistently
• Spending time with management is considered the
  single most effective approach
• Management ability to perform under pressure,
  handling rigours of PE ownership is the key
  Achilles heel to test and critical area to
  support
• Follow your instinct and be clinical about people
  you suspect to be weak

• To get the most out of CDD providers
• Be clear about what you want they do what
  theyre told but little else
• Play to their strengths of rational analysis when
  looking for additional profit
• Ask for their honest opinion and protect them
  from going native