Laser-focused due diligence is needed now more than ever

Managing returns against the backdrop of market uncertainty requires conducting due diligence with the surgical precision that only detailed, real-time data analytics can provide.

By Steven Lee, Alvarez & Marsal

The market is currently filled with mixed messages, mixed signals and potentially missed opportunities.  Dry powder in private equity is at $1.2 trillion, down from its $1.5 trillion 2020 high. Interest rates are rising and growing regulatory pushback could lead to stricter oversight, longer timelines, and more bandwidth to challenge mergers. Concurrently, PE firms must deliver investment rates of return to limited partners, navigate the valuations gap between buyers and sellers and execute on their investment thesis strategies. While data analytics has always played an important role in buyside and sell-side decisions, the current environment demands a laser-focused approach to drive value across the deal lifecycle.

Steven Lee, Alvarez & Marsal

Managing returns against the backdrop of market uncertainty and volatility requires conducting due diligence with the surgical precision that only detailed, real-time data analytics can provide. It’s important to consider the factors amplifying the need for data analytics and how these factors may impact your ability to maximize investment returns.

Three areas come front and center: Buyers are all receiving the same data and timing for due diligence. The ability to deliver more analytics in less time can make or break the sale. Are you properly positioned to meet the growing data demand?

Data volume and complexity are growing as due diligence timelines are constricted. Do you have a targeted due diligence playbook to gain a competitive edge?

In the current, competitive deal environment investors are looking for the best value plays. Do you know how your portfolio companies stack up and do you have the data to demonstrate it during the sale process?

Valuation disparity

Data is also vital in helping PE quantify risk to valuation questions given the broadening gap between sellers’ expected valuations and those of buyers. It’s becoming more commonplace to see merger and acquisition transactions cancelled mid-process due to mismatched valuations.

Sellers and buyers are performing specific risk-to-valuation analysis that reflects their individual perspectives and concerns. In response to unprecedented inflation, sellers and buyers are performing what-if analyses as part of the due diligence process, which require in-depth data modeling.

The increased need for risk mitigation demands that due diligence processes involve scenario modeling to assess how rising material costs and corresponding changes in selling price would have changed the margin profile and earnings before interest, taxes, depreciation and amortization (EBITDA). Due diligence should also include sensitivity analyses to assess how potential changes in market dynamics, supply chain, freight costs and labor costs would drive sale forecasts and customer purchasing behavior.

Those who don’t take these considerations into account may be left with unrealized gains and margins that don’t reflect price-to-market realities. In specific circumstances, scenario modeling can lead to tens of millions of pro forma EBITDA adjustments, which when considering valuations at multiples of EBITDA can materially change valuations.

Buyers are also scrutinizing “what if” analyses and modeling for all scenarios that could impact their buy decisions. These scenarios that range across multiple concerns are generally industry agnostic and can be the catalyst for pulling the trigger or hitting the pause button.

Typical scenarios include, but are not limited to: What’s the impact if the labor market in this sector improves, worsens or remains the same? What’s the impact if commodity, raw materials, shipping and/or energy costs increase versus decrease? What’s the impact if the supply chain continues to deteriorate or, conversely, if it improves?

Heading for the exits

Equally important to note is data analytics’ impact on exit readiness. PE firms are now engaging six to 12 months in advance of the sales process. They want an early look at the business in relation to market conditions.

Early insights yielded from the data can help optimize exit timing amidst ongoing volatility. However, leveraging the benefits of data requires increased flexibility to ensure timely and targeted responses based upon the analytics. Sellers need to gauge whether they believe a market recovery is at hand or if an official recession is just a Fed rate hike away. Sellers need to recognize that valuations can turn on a dime given current conditions.

To better ensure exit readiness, sellers should assess their businesses through the buyer’s lens and with a buyer’s mindset. As more and more deals are put on hold due to performance concerns and/or misaligned preliminary bids, sellers should consider conducting an early assessment of the business and how it is trending. Are there red flags that will stand out to potential buyers?

Sellers should also establish real-time, business due diligence metrics monitoring. Sellers should work to have value propositions ready-to-go so they can quickly launch a sell side process to align with optimal timing. They should also develop robust marketing materials that accurately and comprehensively tell the company’s growth story and utilize key insights gleaned from the data. As the data analytics become more robust over time, the marketing materials should be updated accordingly.

Greater due diligence scrutiny, alongside the mounting need for detailed, real-time data analytics, will continue to shape buy-side and sell-side decisions moving forward. The knowledge derived from laser-focused data is key to unlocking value.

Steven Lee is managing director in Alvarez & Marsal’s Global Transaction Advisory Group and Global Practice Leader for the Global Transactions Analytics service offering.