The New Age of Due Diligence — Virtual Roundtable

In this week’s virtual roundtable, nine Axial members gathered to discuss what the due diligence process looks like in a post-coronavirus world. Participants discussed the high-level changes that are being made to the due diligence order of operations, specific tactics that business owners and buyers are utilizing to creatively bridge gaps in the process, and how business owners can better prepare for an efficient transaction experience.

Thank you to the following Axial members who participated in the discussion:

Anthony Bahr, Managing Director, Strategex

Steve Boehm, Managing Director, Janas Associates

Stewart Carlin, Director, Bundy Group

Noah Cutler, Managing Director, North Fork Partners

Paul Greywall, Director, Trinity Consultants

Brett Hickey, Founder & CEO, Star Mountain Capital

Stephen Jakob, Founder & Managing Partner, Osprey Capital Partners

Christopher Parisi, Managing Director, Carl Marks Advisors

Jay Remington, Managing Director, Business Capital Exchange

Video

Audio 

Show Notes 

Introductions 00:00 – 7:17

How COVID has changed due diligence – 7:17

• PPP funding creating some unknowns for businesses, which is a shorter-term impact
• There will likely be more of an emphasis on validating the stakeholder model and this will likely be longer lasting
• It is even more important to understand the state of your top revenue generators and how they’re generating their cash flow to help ensure your business stays healthy
• Looking at agreements between your customers (are there purchasing minimums, will there be exceptions made to contracts) is very important
• Ex: Merger of an oilfield services company — obviously a sector that is under a lot of stress — was previously 70M revenue; they are currently under LOI and are trying to move as slowly as possible because both businesses received PPP funding, but they need to wait until both businesses have their PPP loans forgiven before the deal can close to keep employee numbers the same as they were when both received the loan
• It’s tough to have a set timeline in place when it comes to resolving PPP concerns; you really just need to wait to get the green light from accountants
• Does this mean that the future of LOIs is going to be structured less around specific dates and more around specific events?
• There is no travel between US/Canada until at least the end of July as of right now, which makes cross-border deals more difficult
• Carl Marks is working with a consumer products company that has more than 50% of sales online so they’ve grown through the pandemic. They’re under LOI but there are now questions from the buyer about the validity of their growth due to COVID.
• The issue becomes: businesses get penalized because their business is down because of the pandemic, but they’re also being penalized if business is growing because of it.
• North Fork provided a bridge loan to a content aggregator, who now wants to upsize the facility because growth has skyrocketed; however, in this case, it is clear that the growth is because everyone has been sitting at home watching TV
• We know technology evolves quickly and the world is changing so rapidly right now that there is a lot of complexity around figuring out what is a short-term trend versus a long-term change and what will that mean for different sectors

Valuations – 20:45

• The amount of money available to invest in the private market won’t go down much
• If anything, businesses that are performing well should be able to hold their valuations fairly well because there will be fewer of them
• If a business has taken a hit due to COVID — as long as it truly was just COVID-related — then they may see a small valuation dip, but if it goes too low, those businesses will just pull off the market for a year, and then buyers lose all of that inventory

What should business owners be ready for? 23:00

• A lot of business owners automatic response is to pull off the market
• Business owners should do a “COVID audit” to have information ready for buyers
• They should be prepared for the use of an earnout in many cases
• On the debt side there will likely be continued caution
• One of the businesses that Carl Marks is working with didn’t miss a beat when they hit a COVID block (no on-site visits) — they filmed a tour of their offices and put it on YouTube
• Ideas and innovations like the above may help to drive valuation up because it shows adaptability of a business
• The introduction of virtual data rooms 20 years ago made it easier to drive a competitive process, which in turn ended up driving valuations up
• For the above company, they posted their YouTube tour for a strategic buyer who loved it and that diligence item is fully checked off the list now (no site visit needed)
• Bundy Group had a client execute an LOI on a pharmaceutical services deal a few days before COVID hit and have been navigating the the process with video and phone calls
• The business has a podcast series where they have always included a lot of team members (from management down to the operators and managers) and listening to this series bridged a gap for the buyers because they were able to get a feel for a lot of the employees through listening to the podcasts
• While the buyers still wanted a face-to-face interaction, using the podcast was able to provide a stop gap for them and make them comfortable moving forward
• Those same buyers are actually flying to visit the business next week and are going to have “socially distant” meetings — individuals will be placed in different conference rooms and then the buyers can go in one-by-one to have conversations with different team members in different rooms

Data-driven approach – 31:45

• Star Mountain has closed six deals since COVID — they’ve done this with a very data-driven approach using dashboards, KPIs, very clear weekly reporting around customer concentration, trends, etc.
• A lot of firms always have a data-centric approach — it is not specific to COVID — but when it comes to looking at upticks or downturns, when you have a lot of data to look at and are able to see longer-term trends and concatenate different things, you’ll be in a much better position
• Strategex isn’t asking for any new/different data than they always have, just putting more scrutiny on EBITDA adjustments and balance sheets 

Embracing technology for diligence – 35:38

• When you have a small firm and try to keep costs down/use your resources very wisely, you may have shifted to technology for a lot of diligence items a long time ago
• Business Capital Exchange has always done their kickoff meeting with the client virtually, and has been doing all of their banker diligence virtually for years; a lot of management presentations have been virtual starting a few years ago
• Having video tours of different sites in the virtual data room is helpful to have along the way, even if the buyer ultimately wants to come to one (or more) in person
• For a Business Capital Exchange client who had video tours, when the buyer flew to multiple locations around the country, they ended up saying: this is pretty much the same as what I saw on the video

How will firms proceed with timelines and order of operations going forward? 37:45

• Is it conceivable that the order of operations will shift permanently?
• A lot of the digital items are being frontloaded and the in-person meeting is becoming the final step in order to streamline the process and keep things moving. Is deferring the in-person meetings something that will continue?
• For a banker, there is a feeling that the management team is what sells a company in a lot of cases, so they’d like to see management in front of the buyers earlier rather than later (this can theoretically be done with technology)
• It is very plausible to think that video tours of facilities and other videos could be frontloaded and linked into the CIM rather than being done in management meetings
• A big part of diligence in the future is likely going to include looking at how businesses handled the pandemic — not necessarily performance-related, but how they adapted and came back from it
• Trinity Consultants will usually try to meet with a management team upfront and then regardless of how long a transaction takes (sometimes it could be a few years down the line if the fit wasn’t good at the start) because then they have the rapport and can move forward more easily regardless
• A lot of items that have historically been on the buyside checklist may actually move over and be on the sellside list instead
• Sellside Q-of-E reports have helped to mitigate some of the risk in the underwriting process and it pulls some of the diligence items forward and bring more serious buyers to the table sooner
• While the business owner pays out of pocket for their own Q of E, the investment is nominal if you’re able to potentially get a deal closed sooner or push valuation a bit higher because you’ve helped to streamline the process for the buyer and made things easier for them
• The buyside will still usually do their own Q-of-E, but when you’re able to connect the two firms who put together the buyside & sellside reports, there are fewer disagreements about EBITDA and there is reduced volatility in the transaction

Raising capital (and the LP climate more generally) – 53:00

• It is easier to raise money right now when you have long standing and trusting relationships with your LPs
• A lot of firms have had a really tough time finding capital and have been missing targets by very high percentages
• There may be a lot of zombie funds that come out of this
• It’s really all about communication, transparency and your ability to be a storyteller (and this is the same for business owners looking to raise capital or sell)

The bandwidth of strategics versus financial buyers – 58:05

• Strategic interest is high right now
• Strategics have more time to spend looking at and diligencing businesses
• Larger strategics are starting to look at M&A add-ons to help them navigate the post-COVID environment
• They also may be widening their searches and looking to get into end markets that they wouldn’t have looked at prior to COVID

Status of the debt markets – 1:03:30

• Some people say they can’t get any interest from debt markets, but others are leaning in
• A lot of the banks say they’re open, but as soon as you have a conversation with them, they tend to shy away
• Getting things over the goal line is still tough right now
• Investment bankers are pushing back on buyers who say they can’t close on a deal because they’re still waiting on debt — if you mention that you’re considering opening the process back up if they can’t find the money, they usually find it (it may be more expensive, but it is there)
• Some buyers are saying they’ll do the deal 100% in equity now and then will refinance later this year or in early 2021
• If a strategic buyer has a credit facility, they just need to stay within previously agreed-upon criteria and there is no issue getting the money