Commercial Due Diligence for Private Equity Investors

Transcription

1 Westminster Business School alumni events Commercial Due Diligence for Private Equity Investors Marc Kitten London, 10 May 2011

2 Due diligence is the process of investigation conducted by parties involved in a business transaction Source: T. E. Edens, Collector 1

3 Private Equity finances most firms, particularly in their early years FROM THE FIRM LIFE CYCLE POINT OF VIEW Capital Markets Debt securities Private Equity IPO Capital increase Convertibles Bank loans High yields Angel round/vc Pi Private equity Corporate lifecycle (time) Expansion Start up Growth Maturity Source: Paul Achleitner in Frank Bancel Investment Banking January

4 Private Equity investors both benefit and bear the risk of too much leverage TYPICAL FINANCING STRUCTURE FOR LARGE LBO BEFORE 2008 % Of which ca. 10% held by management Equity 30 Mezzanine 10 Subordinated debt 20 Choice of high yield over mezzanine can be led by Market conditions Pricing Ease of issue Possible need to refinance Senior debt and revolver 40 Financing must also pay for fees and expenses (typically 5%) Source: Bloomberg; Candesic 4

5 Private Equity investors are typically reluctant to take management risk MOST INVESTORS PREFER TO KEEP THE MANAGEMENT IN PLACE 5

6 The competition between LBO funds has been growing exponentially GROWING COMPETITION IN THE PE INDUSTRY PE funds raised > USD 1bn* 1989 Kohlberg Kravis Roberts & Co. (USD 5,600) Forstmann Little (USD 3,000) Morgan Stanley (USD 1,500) Merrill Lynch Capital Partners (USD 1,500) Lehman Brothers (USD 1,250) Five funds 1995 Forstmann Little (USD 2,100) Warburg Pincus (USD 2,000) Kohlberg Kravis Roberts & Co. (USD 1,900) Morgan Stanley (USD 1,825) Goldman Sachs (USD 1,750) Hellman & Friedman (USD 1,500) Clayton, Dubilier & Rice (USD 1,500) Blackstone (USD 1,270) Thomas H. Lee (USD 1,000) Apollo Advisors (USD 1,000) DLJ (USD 1,000) Stonington Partners (USD 1,000) Zell/Chilmark (USD 1,000) Cypress Group (USD 1,000) 2005 JPMorgan Partners (USD 7,700) Blackstone Capital Partners (USD 6,500) Thomas H. Lee Company (USD 6,100) Permira (USD 6,300) CVC Ltd. (Europe) (USD 5,800) Cinven (USD 5,500) Apax (USD 5,500) CSFB/DLJ Merchant Banking (USD 5,400) Warburg Pincus & Co. (USD 5,300) GS Capital Partners (USD 5,300) BC Partners (USD 5,200) KKR (USD 5,100) Madison Dearborn Partners (USD 4,300) Texas Pacific Group (USD 4,100) Welsh, Carson, Anderson & Stowe (USD 4,000) Forstmann Little & Co. (USD 4,000) The Cartyle Group (Americas) (USD 3,900) Apollo Management (USD 3,800) KKR (Europe) (EUR 3,700) Bain Capital (USD 3,500) Clayton, Dubilier & Rice (USD 3,500) Candover (USD 3,400) Charterhouse (Europe) (USD 3,400) Morgan Stanley Capital Partners (USD 3,200) Providence Equity Partners (USD 2,800) CSFB Equity Partners (USD 2,700) CSFB Global Opportunities (USD 2,700) 3l Group (U.K.) (USD 2,700) funds Industri Kapital AB (USD 2,600) Advent International (USD 2,600) Vestar Capital Partners (USD 2,500) EQT Partners (USD 2,500) 14 funds Bridgepoint Capital (USD 2,500) 3i Group (Europe) (USD 2,400) Hellman & Friedman (USD 2,200) 200) Silver Lake Partners (USD 2,200) Summit Partners (USD 2,100) Oaktree Capital Management (USD 2,100) Blackstone Communication Partners (USD 2,000) CVC Ltd. (Americas) (USD 2,000) GTCR Golder Rauner (USD 2,000) Lehman Brother Private Equity (USD 2,000) Spectrum Equity Investors (USD 2,000) TA Associates (USD 2,000) Capital Z (USD 1,900) Quadrangle Group (USD 1,800) J. W. Childs (USD 1,800) PAI (USD 1,800) Hicks, Muse, Tate & Furst (USD 1,800) AIG Investment Corp. (Asia) (USD 1,700) Berkshire Partners (USD 1,700) Terra Firma (USD 1,700) CSFB/Sprout Group (USD 1,600) Oak Hill Capital Partners (USD 1,600) Bear Stearns Merchant Banking (USD 1,500) Hicks, Muse, Tate & Furst (USD 1,500) Kelso & Co. (USD 1,500) Lindsay Goldberg & Bessemer (USD 1,500) Mid Ocean Partners (USD 1,500) Nordic Capital (USD 1,500) Wachovia Capital Partners (USD 1,500) GSC Partners (USD 1,500) Thomas Weilsel Private Company (USD 1,300) Leonard Green & Partners (USD 1,200) Behrman Cpital (USD 1,200) Ripplewood (USD 1,200) Gilbert Global (USD 1,200) The Carlyle Group (Europe) (USD 1,100) JP Morgan Partners (Asia) (USD 1,100) TH Lee Putman Ventures (USD 1,100) Whitney & Co. (USD 1,100) AIG Capital Partners (USD 1,000) VS&A Communications Partners (USD 1,000) AEA Investors Inc. (USD 1,000) Charterhouse (Americas) (USD 1,000) Code Hennessey & Simmons (USD 1,000) Fox Paine (USD 1,000) Joseph, Littlejohn & Levy (USD 1,000) Stonington Partners (USD 1,000) The Jordan Co. (USD 1,000) Source: * In case of European funds value converted from EUR in USD with the average exchange rate of 2005 Allianz Capital Partners 100+ funds 6

7 Private equity deals account for a significant proportion of all M&A VALUE OF PE DEALS AS % OF ALL M&A % 40 US World Europe Source: Thomson Reuters 7

8 In Europe too, considerable funds have been raised for LBOs TOP 20 DIRECT PRIVATE EQUITY FIRMS BY AuM IN EUROPE* January 2008, bn ESTIMATES Assets allocated to European acquisitions Assets or commitments outside Europe KKR Apax Permira CVC Terra F Firma BC Part artners Blacks kstone EQT Cinven 3i Carlyle Charterh rhouse Bain Capital Goldman Sachs Bridgep epoint PAI Partners Industri Kapital AXA PE Barclays ays PE Doughty Hanson Alpin pinvest * Doesn t include funds of funds Source: Candesic PE database

9 Increased competition and pressure on leverage fuel the need for thorough due diligence INVESTMENT PROCESS OF PRIVATE EQUITY FIRMS Fund raising i Deal sourcing Acquisition iti Post- Acquisition Exit Management Investment strategy Investors hunting Set up of funds Networking Identification of investment opportunities Preliminary investigation Prioritisation of opportunities Cash flow modelling Structuring, set up of ffinancial i structure Valuation Due diligence Documentation Investment e decision Portfolio Monitoring Portfolio and company management to add value Optimisation of operations Reorganisation M&A Strategic review Partial or total divestment through IPO Trade sale Secondary sale Write-off Source: Candesic 9

10 Any form of financial or operational risk justifies the need for due diligence WHO HAS TO CARRY OUT DUE DILIGENCE? Arguments for hiring outside professionals Lack of stability of target or industry disruptions Predictability & size of cashflows Non-trade buyer Industry knowledge Leverage Risk sharing Source: Candesic 10

11 Due diligence is both about improving the upside and reducing the downside WHY LBO FUNDS CARRY OUT DUE DILIGENCE? Maximise value creation Identify possible deal breakers Minimise price to pay Patent Litigation Accounting error, difference or inappropriateness Key account Key man Unhedgeable operational risk Challenge optimistic forecasts Sales figures Costs, depreciation methodology Terminal value, discount rate Reduce volatility of valuation inputs Identify levers for value creation Growth opportunities Synergies Restructuring opportunities Source: Candesic analysis 11

12 Due diligence can encompass a large number of specialist areas SCOPE OF DUE DILIGENCE MAIN AREAS So ources External Internal Commercial Legal Financial Environment IT Different sources and methods produce different types of information and insight Pension Historic Future Source: Due diligence, D. Rankine; Candesic Performance 12

13 The official due diligence typically happens after the initial negotiation DUE DILIGENCE IN THE ACQUISITION PROCESS A preliminary review is often worth conducting at that stage Month 1 Month 3 Month 4-5 Month 6 Information Buyers Due Negotiation provision meetings diligence Information memorandum (IM) and buyers research Buyers meeting with management Valuation, future roles, legal issues and transaction structure Financial, Commercial, Legal, IT, Pensions, etc. Key buyer documents Confidentiality agreements (NDA) Indicative offer Offer Letter Heads of Agreement (Letter of Intent) and exclusivity Sale and purchase agreement Source: Due diligence, D. Rankine; PwC; Candesic analysis 14

14 Due diligence will give a better understanding of the cash flow generation CASE STUDY: BUSINESS HIRING OUT HEAVY PLANT EQUIPMENT Accelerated depreciation quickly leading to low value of certain assets Declining capital expenditure Artificial improvement on cash generation, hence profits Source: Due diligence, FT Prentice Hall; Candesic 16

15 Furthermore, due diligence will often contribute to reduce the valuation differences VALUATION SUMMARY REVISED MARKET VALUE OF EQUITY m Improved Increased 40 sales cost base projections Choice of more appropriate multiple 30 [23-28] DCF P/Sales P/EBITDA P/EBIT P/E Source: disguised client example; Candesic analysis 17

16 The various advisors focus on specific sources of data WHAT IS THE TYPICAL DATA TO ASSESS AND REVIEW Financial statements Fina ncial Com mmercial Source: Candesic Legal Other The latest available management accounts, including the company s cash/debtor positions and investments Bank facilities and leasing agreements Pensions funding Forecasting techniques and accuracy of past forecasting Assumptions on which financial forecasts are based Competitive environment Stability of client base Key employees skills, backgrounds and agreements Employee contracts Commercial agreements and contracts, patents Other material contracts t (office and equipment leases, software, etc) Management information systems and other IT Regulatory and tax environment Environmental issues, etc. 18

17 With some experience, each advisor knows where to focus their research EXAMPLE: POTENTIAL ISSUES IN FINANCIAL DD Changes in the shareholders Changes in the management Insufficient investment Dependence on or dispute with key supplier Dependence on key customers Change of control clauses in key contract Seasonality in the business Competitive threat Quality control Source: Due diligence, FT Prentice Hall 19

18 Most advisors will find most relevant data in a physical or virtual dataroom THE DATAROOM If there are several potential buyers, especially in an auction, the seller may put together a data room where financial and commercial information about the target business is collected together. This will allow to: Give potential buyers rapid access to basic data to decide whether to put indicative bids and maybe get invited to the next round Deal more efficiently with a high number of potential acquirers and their numerous questions Provide fair and equal treatment to all potential acquirers Source: Candesic 20

19 As for the CDD, most of the data is to be found outside the company PRIMARY INFORMATION SOURCES Suppliers Competitors New entrants Regulators Distributors Target company Shareholders Senior management Other management Operational staff Sales force Subsidiaries Customers Former employees Industry observers Specifiers Source: Due diligence, D. Rankine 21

20 The commercial due diligence typically lasts only three weeks EXAMPLE OF COMMERCIAL DUE DILIGENCE PROCESS Terms of reference Frame problem Develop hypothesis Interview experts Synthesize results Final report Timing 2 days 3 days 2 weeks 3 days Objectives Tease out what you have to believe for the investment to be successful Prioritise and lay out roadmap for testing assumptions Test key findings with key opinion leaders, regulators, stakeholders, and customers Summarise learnings from all available data and make recommendations Get buy-in from stakeholders Activities Source: Candesic Interview key members of management Review company s existing data Discuss with investors Review external and company papers Conduct press and industry report research Write interview guides Set up interviews Interview experts, key opinion leaders and regulators Synthesize key reports Summarise learnings and highlight potential obstacles/ opportunities Document evidence for our view Suggest ways to mitigate deal breakers and/or refine data Discuss with management and investors 22

21 ...Three weeks to uncover and quantify every major risk or opportunity EXAMPLES OF KEY QUESTIONS TO ANSWER IN CDD Uncertainty Risk Potential upsides The market is set to accept this new technology and take off, but will users commit now, having already hesitated for a number of years? The company to be acquired has a subsidiary in an unrelated business area, which the buyer would like to dispose of, but how will it fare and will it turn out to be an unattractive, unsaleable asset? The business is more profitable than competitors, yet it has no structural reason to be so. How can one be sure it is sustainable? Much of the success of the business depends on the successful launch of a new version of its key product. Will the launch achieve what management claims? The business is less profitable than its competitors and the acquirer wants to improve margins, but is this achievable? The US market is ripe for exploitation and it will just take national distribution deal to achieve penetration. How realistic is that? Source: Due diligence, D. Rankine 23

22 Due diligence initial purpose is to identify potential deal breakers CASE STUDY: PROPOSED 150M INVESTMENT IN MEDICAL DIGITIZERS* Penetration of PACS in first-world markets CONCEPTUAL 100% 15% Installed base of PACS systems 90% Sales of new PACS systems (proxy for sales of film digitizers) Sales of replacement film digitizers Vendors asserted that sales would escalate in line with PACS** revenues in the developed world. Most PACS are sold with a film digitizer to maintain compatibility with legacy film systems Detailed CDD suggested otherwise. After interviews with ~15 physicians and radiology experts, it became clear that film digitizers were not considered mission critical. In two teaching hospitals, use of the digitizer averaged one use per day A better proxy for medical digitizer sales was sales of new PACS systems rather than total PACS revenue. With this proxy, it became clear that digitizer sales would diminish after ~2008 The commercial due diligence could not support the valuation of the business. The transaction didn t happen Source: * Medical digitizers are used to convert physical x-ray and CT/MRI scan films into high definition digital format ** PACS = picture archiving and communications systems Candesic analysis; interviews 24

23 Due diligence cannot predict social and political disruptions but should at least identify likely scenarios ILLUSTRATION: LIBYA IN LATE 2010 In spite of the efforts of the last 5 years to promote an opening of the country, Libya is still a dictatorship with growing resentment and risk of violence A social movement orchestrated by the government was started in December 2009 under the name «Together Against Abusive Exploitation by Colonialists» and is targeting Westernowned companies in the country. The objective seems to be both to defuse the population s anger from the government and to punish Foreign governments suspected of trying to promote democracy in the aftermath of the recent unrest in the MENA region Source: Interviews, Press Research

24 Due diligence will also detail and precise the asset value. Here, there are 5 distinct clusters, only one of them justifies the price demanded ATTRACTIVENESS OF HARTZ HOSPITALS SANITISED $11m 2010 EBITDAR High Difficult clinics but with a real upside potential - needs further investigation The Zurich clinic seems to be well positioned in a very competitive region with St Gallen they have started to build a hub and spokes system Bern Zurich $15m <$3m Benghazi Improvement St Gallen Potential Basel Gstaadt Tobruk Closed or very little Misrata potential, should 11m be disposed ~ $0m quickly Geneva Low Montreux Villars Lausanne Aigle Tripoli Zermatt $13m Some of these clinics might be significantly improved by a professional management team The four clinics in Libya are in a socially and economically difficult region and could be left apart (e.g. carve out) Low Source: Dataroom, Management, Candesic Analysis Current performance (Revenues & Profits) High 26

25 The most thorough investigation may not suffice if the other party doesn t play fair CASE STUDY: TPG S ACQUISITION OF DUCATI FROM CAGIVA Issues uncovered by due diligence As a result of bad management rather than lack of demand, Ducati was likely to show negative EBIT in 1996 Severe manufacturing and financing i bottlenecks Accounts receivable : 90 days sales (should be 60) Inventory: 120 days sales (could be 40) Accounts payable : 100 days sales (squeezing suppliers) Complete lack of transparency of accounts, entangled with Cagiva s s, aswellassome some operations Need for a complex financing structure with risks from the Italian bankruptcy law Unexpected issues Cagiva repeatedly shopped around, even after finally signing an exclusivity agreement with TPG! Cagiva kept on reopening older issues that had been agreed upon long time ago The Castiglioni brothers from Cagiva didn t show a strong commitment: they failed to come to any single meeting in the entire e negotiation o Source: HBS case study 27 H

26 Whatever the outcome of the due diligence, sometimes, the incentive to invest is just too high... PE FIRMS WIELDED $1 TRILLION OF DRY POWDER Source: *Distressed PE includes distressed debt, special situation and turnaround funds Preqin 28

27 Thank you Marc Kitten 29

28 BIBLIOGRAPHY: PRIVATE EQUITY Vault Guide to Private Equity in Europe, Marc Kitten (Vault editions, 2009) Multi-Asset Class Investment Strategy, by Guy Fraser-Sampson, Wiley Finance Goldman Sachs/Frank Russell yearly report on alternative investments McKinsey Quarterly The Handbook of Alternative Investments, by Geoffrey Hirt, Thomas Galuhn and Paul Rice (ed. Darrell Jobman, John Wiley & Sons 2002) Note on Valuation in Private Equity Settings, HBSP ( ) (P) Barbarians at the gate (Acquisition of RJR Nabisco by KKR) Websites: and