April 2022 | Signature Research

The Future of Diligence in Private Equity

Faster insights, higher quality, and digital

Introduction

For nearly a decade, dry powder within private equity companies worldwide has achieved record levels, climbing from $1.2 trillion in 2011 to $2.9 trillion in 2020. Competition for assets has been fierce, and that will likely continue. More investors are competing for a shorter supply of assets, and the management teams of potential targets are less willing or able to spend time and resources answering diligence requests. In response, PE’s approach to diligence is becoming more sophisticated, as firms increasingly use data and continue to explore how they can become more efficient with acquisitions.

At least partly in response to these changing market dynamics, sell-side diligence (also called vendor due diligence) has gained traction in the U.S. market. Today, many potential targets create one standard package of data that answers common questions and then hand it over to potential suitors to be analyzed. PE firms are finding, however, that it’s ever harder to get answers to their uncommon questions. Access to a target’s management team is often severely restricted—or not provided at all.

Where they are afforded some management attention, deal teams are using their allotted time to dig deeper on more interesting topics to better quantify the potential upside of an investment. But when sellers provide no access to management, most PE deal teams find it challenging to translate sell-side diligence into value capture opportunities absent deeper information or conversations. Many PE leaders understand that the best way to address these challenges is to adopt a more modern approach to diligence—one that leverages technology and sell-side diligence to move faster, data to increase confidence, and any precious time with management to uncover value-creation opportunities—all with an eye toward using the upside to underwrite investments.

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The Shift In Diligence From Risk To Reward

To better understand how the industry views the diligence process as it stands today—and its expectations for the future—we surveyed 100 members of PE investment and portfolio operating teams from U.S. firms. Our respondents confirm that taking a digital approach to diligence to uncover actionable insights more quickly than their competitors is top-of-mind. However, this approach has not come easily to most.

Put simply, it’s a wish but not yet a reality.

Based on our decades of experience conducting diligence for private equity firms as well as the survey data gathered, we offer an analysis of where the future of diligence lies, and a set of actions that PE companies can take now, including:

Tipping the balance of diligence toward a focus on value creation, less on risk mitigation
Embracing digital diligence to quickly generate actionable insight sand save precious time with management on value creation conversations, not data gathering
Better incorporating sell-side diligence into processes
Gathering ESG metrics with some uniformity, but tailoring the target’s ESG approach by industry, maturity, and value creation opportunities.

Together, these four actions explicitly address what companies need to do to improve diligence today and how firms can evolve their approaches to meet future due diligence standards.

The future of diligence is more digital

The due diligence process is a hallmark of private equity investment. We asked 100 private equity leaders about the state of diligence today—and how they’re adapting for a more digital, competitive future. Here’s what we found:

Market challenges have caused PE firms to rebalance risk mitigation and value creation

PE investors face escalating—though no longer novel—pains such as ever-higher valuations, competitive bidding dynamics, and sellers who are less willing to entertain prospective buyers’ questions. To address these challenges and justify higher valuations, PE firms have shifted their diligence approach. While risk mitigation will always be critical, leading firms are underwriting their investments based on future value creation, which means diligence is increasingly focused there.
Firms intend to apply more tech and analytics...

In the next three years, respondents told us they intend to use more data throughout the diligence process. They also report plans to use more technology and tools (rather than people) for diligence purposes. Specifically, automation is one critical way deal teams plan to make diligence timelier and more cost-efficient.
…and more sell-side diligence

Sell-side diligence, already a standard in Europe, is a strengthening trend in the United States. Using assessments commissioned by sellers is now a PE firm’s most accessible strategy to make diligence more efficient—at least for factual information. However, sell-side diligence is not enough, and not geared enough toward value creation. Many firms also struggle to build rapport with entrenched management teams when sell-side diligence is offered as a replacement to human interaction and discussion.
Firms that are eager to evolve the diligence process can take immediate actions
To deliver on the promise of making the diligence process more efficient and digital, firms will need to:
1. Embrace digital diligence, leveraging data and analytics technology to generate faster, more actionable insights
2. Incorporate sell-side diligence—the right way—into their processes
3. Anchor due diligence on value creation, to the extent it can underwrite investments
4. Improve ESG diligence through more consistent data collection and analysis

PE investors face escalating—though no longer novel—pains such as ever-higher valuations, competitive bidding dynamics, and sellers who are less willing to entertain prospective buyers’ questions. To address these challenges and justify higher valuations, PE firms have shifted their diligence approach. While risk mitigation will always be critical, leading firms are underwriting their investments based on future value creation, which means diligence is increasingly focused there.

In the next three years, respondents told us they intend to use more data throughout the diligence process. They also report plans to use more technology and tools (rather than people) for diligence purposes. Specifically, automation is one critical way deal teams plan to make diligence timelier and more cost-efficient.

Sell-side diligence, already a standard in Europe, is a strengthening trend in the United States. Using assessments commissioned by sellers is now a PE firm’s most accessible strategy to make diligence more efficient—at least for factual information. However, sell-side diligence is not enough, and not geared enough toward value creation. Many firms also struggle to build rapport with entrenched management teams when sell-side diligence is offered as a replacement to human interaction and discussion.

To deliver on the promise of making the diligence process more efficient and digital, firms will need to:

Embrace digital diligence, leveraging data and analytics technology to generate faster, more actionable insights
Incorporate sell-side diligence—the right way—into their processes
Anchor due diligence on value creation, to the extent it can underwrite investments
Improve ESG diligence through more consistent data collection and analysis

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Contributor Sean Adkins