This story originally appeared in Middle Market Growth’s Summer Issue. All Rights Reserved.
Modernization challenges every industry. Longstanding practices often linger for a reason, and their depth of use within any company can make them tough habits to break.
This is especially true when the stakes are as high as they can be in the due diligence process in private equity.
But for PE firms to gain an edge in the market, their due diligence process needs a digital upgrade—and a shift from risk mitigation toward identification of value-creation opportunities.
Even though automating financial models is a relatively cost-effective and straightforward endeavor, many PE firms continue to use the Excel spreadsheets they’ve been using for the past 25 years to build deal models and analyze data. This limits the inputs and lens through which PE firms evaluate investments versus expanding their aperture to take in new data sources.
West Monroe recently conducted a survey of 100 private equity leaders (half on the deal side and half on the operating side) on the state of due diligence today, along with their expectations—and predictions—for the future.
Respondents gave insights into how they view the evolution of due diligence in private equity over the next three years:
There may be some resistance to shift away from years of practices that have served private equity firms well. But the digital mindset can be engaged immediately by companies at any stage, creating instant value that can set them up for years to come.
We get it—it’s easy to simply say a process needs to be modernized and more effective. But let’s dig into some concrete steps that, if adopted, can help PE firms overcome the challenges they face:
Employing data and technology can help funds skirt the disadvantages of completing diligence in tight timelines. It can also help teams catch red flags that are more difficult to see remotely, by facilitating a holistic view of a business’s risks and opportunities. With that benefit in mind, funds should develop technology capabilities that allow them to quickly evaluate the types of targets they usually consider—and do it in a way that is repeatable from deal to deal, whether that means adopting (or creating) new software or leveraging a partner’s tools and capabilities.
When deal teams are accustomed to looking at the same diligence variables for each target, they get in a groove and tend to run on autopilot. But in evolving from evaluating risk to uncovering opportunities, some deal teams may need to fine-tune their skill sets or acquire new ones. To help move the process along, deal teams might consider creating a risk-oriented diligence summary and an opportunity-focused diligence summary, and then seamlessly transfer them to the operating teams when the deal is closed. We found this “transfer” happens less than half the time right now, representing a huge area of opportunity to realize more value from diligence.
Many deal professionals can expertly find investment themes and areas in which to invest. But after the deal closes, their firms often struggle to translate the value-creation opportunities found during diligence into action items. One way to address this challenge is to create new horizontal operations teams that specialize in applying technology and data to specific operational areas, such as revenue operations teams that work toward operational improvement in sales processes.
For years, sell-side diligence has been the standard in Europe, but only in the past 12-18 months has it caught on in the U.S. Sell-side reports, when trusted and comprehensive, can benefit both a buyer and seller by accelerating the process and allowing deal teams to focus more on value hunting than fact finding. However, a sell-side report provides context for a broad set of prospective buyers rather than directly answering the questions of any single buyer with an objective. Rather than as a substitute for diligence, buyers may use sell-side reports to gain confidence in the target company’s foundation and drive deeper-level diligence conversations on topics most relevant to their investment thesis and value-creation strategy.
Environmental, social and governance considerations may already be part of the PE playbook, with metrics increasingly measured and tracked for transparency and accountability. But ESG can go beyond a check-the-box exercise to something that drives value. Higher ESG scores often result in lower borrowing costs and discount rates for insurance as well as equipment repairs and warranties. An impressive ESG program can enhance a portfolio company’s brand reputation, which can attract more customers, employees and potentially more investors.
It’s challenging for a PE firm to spend time evolving its internal processes and investing in resources while the next deal is already upon them. But the ROI is real.
How to get there? Adopt a more digitized diligence process that focuses on analyzing data, not just gathering it, and leverages digital tools. This process isn’t just to increase speed and efficiency but to use the deal team’s time on more valuable work and jumpstart the new portfolio company’s value-creation plan.