How AI is Reshaping the Due Diligence Process

The biggest force reshaping the due diligence process may be the rapid advancements in technology. Tech-enabled dealmaking, perhaps the most fundamental change in the due diligence process, is the way data analysis has taken center stage in recent years. Sophisticated technology that allows business owners to dive into minute details about their operations is equally valuable to buyers when conducting due diligence. “The thirst for data and insights into the operations of companies is ever-growing,” says Mitchel Nakken, managing director and head of transitions and transformations at PalmTree, an M&A consultancy.

He believes the growing adoption of data-driven M&A strategies has been a key tailwind for his business and the wider M&A landscape. Deloitte’s global head of M&A insight Sriram Prakash concurs. “Potential buyers, particularly the private equity sector, are ever more demanding and scrutinize the data more minutely during the diligence process,” he says. This wasn’t always the case. “In the early 2000s, buyers were opportunistic in the industries they were investing (e.g., very little industry focus) and were largely reliant on financial engineering to generate a material percentage of their investment returns,” says Sean Murphy, managing director and head of Houlihan Lokey’s transaction advisory services.

He says buyers shifted their focus to operational efficiency in the latter half of the 2000s and early-2010s. This required a greater emphasis on “data-centric knowledge.” “The most surprising aspects of M&A-related due diligence over this period [is] the ascension of both industry expertise and data & analytics to the crux of transaction evaluation,” says Murphy.

Nakken believes most small and mid-sized companies aren’t fully prepared for buyers when critical data is requested. “A lot of middle-market companies, in particular, lack significant insights into the performance of their company,” he says. “They don’t have thoughtful KPIs (key performance indicators), or detailed forecasts models, or supporting schedules for their financial performance.”

Traditionally, intermediaries and consultants like PalmTree plug this gap and arm sellers with the data they need to go to market. However, a new technology is revolutionizing this process too. Breakthroughs in artificial intelligence have already had an impact on several industries, including M&A. “We’re currently employing AI tools to gather information on companies, backgrounds of the people, and competitors,” says Brent Beshore, the founder of Permanent Equity, an investment firm with a 13-year track record focused on small- and mid-sized private companies.

He weighs the future potential of this technology against its current limitations. “We’d love to have AI do more analysis, but we haven’t been able to train the technology properly quite yet. We’re nowhere close to relying on them solely but playing around with them and adding interesting tidbits that are uncovered.”

Entrepreneur Jordan Evans was also impressed while playing around with this revolutionary technology. He recently experimented with OpenAI’s ChatGPT to act as an “expert M&A advisor” on a hypothetical deal. On Twitter, he described the process of identifying target industries, finding potential acquisition targets, seeking out business brokers’ contact details, analyzing financial documents from sellers and even drafting letters of intent with the tool. “AI is definitely a super cheat code in SMB (small- and mid-sized business) acquisitions,” he says. “I’ve done 4 acquisitions in the past 5 years because of the right people on the team. [AI] has earned a spot on my team and is going to save me time and [money] on the next deal.” Meanwhile, mega-corporations have already integrated the use of large language models – the technology underlying AI platforms such as ChatGPT.

Thomson Reuters’ document intelligence has new AI-powered features that automate much of the “grunt work” involved in the due diligence process. The platform apparently helped one user save $4 million on a deal, Thomson Reuters says.
Deloitte’s M&A analytics platform iDeal goes a step further by helping with negotiations and post-merger integrations. The platform is powered by AI and machine learning that allows users to simply ask natural language questions like “How successful is this company in retaining its customer base?” or “Does this pursuit warrant a counteroffer?”

Similar natural language processing from fintech platform SESAMm has helped the Carlyle Group with deal sourcing, diligence, and portfolio company value creation efforts for several years before the private equity firm became an investor in the France-based startup.

AI-powered tools could make fundraising easier too. In a recent survey by Clarify Capital, a New York-based company that helps small and mid-sized business owners secure financing, investors said they found pitch decks generated by ChatGPT-4 twice as convincing as ones generated by humans. They also said the AI-generated pitches were clearer and higher quality than the human-made ones, indicating that AI-powered tools could potentially find applications on both sides of a deal.

Tech-Enabled Risks

While AI is streamlining the due diligence process, other technological advancements have added some new risks and further complicated the process. Not all tech is advantageous. Advancements in AI and data analytics have been helpful for dealmakers, but advancements in cyberattack tools have conjured new risks that must be considered during due diligence. The proportion of SMBs who faced a cyberattack grew from 55 percent in 2020 to 76 percent in 2021, according to a survey by Connectwise, an enterprise software company that offers cybersecurity, backup and disaster recovery technologies.

Professional investors and institutional money managers are being increasingly targeted as well. Cybercriminals have also zeroed in on the large flow of capital during a merger or acquisition. In 2021, the FBI issued a warning that certain cyberattack groups on their radar were seeking out “time-sensitive financial events.” This usually meant holding up a deal for ransom or disrupting the process to extract money. The threat persists even after the deal has closed.

“If you’re a private equity firm, and you have a portfolio of companies, and you are rumored to be acquiring a small company or a mid-size company that may or may not have a sophisticated cyberinfrastructure to prevent attacks, then that company could be a conduit to the larger portfolio held by the private equity firm,” says Amy Gross, leader of private equity and mergers & acquisitions at insurance giant Liberty Mutual.

This threat to portfolio companies is pervasive, according to BlueVoyant, a cybersecurity specialist. The firm surveyed nearly 800 private equity-backed companies, most of which were based in the U.S., to find that 19 percent of these portfolio companies had vulnerabilities that were “easily exploitable by malicious actors.”

Liberty Mutual provides an insurance policy to safeguard against such attacks. Gross says she’s seen more private equity firms adopt these policies and review them during the acquisition process over the past three years. In fact, it’s become a vital part of the dealmaking process recently. “I think more people are uncomfortable doing a deal without reps and warranties coverage than five years ago or 10 years ago,” says Gross.

Outsourced Due Diligence

Besides insurance, another way dealmakers and investors have tried to mitigate risks is by outsourcing the due diligence process. This has had unintended consequences and has attracted the attention of regulators in recent years. The increased complications of due diligence have convinced some allocators to simply outsource the process.

An industry survey last year revealed that half of private equity firms had outsourced parts of their operations over the past 12 months. Back-office tasks like fund administration and accounting were traditionally outsourced, but this reliance on experts has now expanded across more operations within the firm.

For instance, a recent survey found that one-third of U.S. private credit funds were outsourcing research and due diligence on deals to lawyers, consultants, and other service providers. “What becomes institutionalized becomes normalized,” says Jason Pereira, a Toronto-based financial planner and consultant. He believes there are market forces pushing investors to outsource due diligence. “There’s more to do and things need to go faster, and the industry has simply grown too quick to ramp up those competencies.”

Another factor, Pereira highlights, is mismatched incentives. “No one gets fired for hiring a big brand consulting firm to do the work for you,” he says. “All they’re asking for is for someone else to do the research and give them permission to proceed with the deal. Because if it goes wrong, they can blame the consultant. I think of it as executive insurance.”

However, some deals fail so spectacularly that they attract attention from regulators and the media. Investment giant Tiger Global Management pays consulting firm Bain & Co. $100 million a year to research private companies.

One of the companies covered by this research was cryptocurrency platform FTX, which recently declared bankruptcy and wiped out Tiger’s $38 million investment. The U.S. Securities and Exchange Commission is now investigating whether venture capital and investment firms acted responsibly on behalf of their own clients when conducting due diligence on FTX. One official said the failure highlighted the need to reform the private placement process. Last October, the SEC proposed “a new rule under the Investment Advisers Act of 1940 to prohibit registered investment advisers from outsourcing certain services or functions without first meeting minimum requirements.

“Though investment advisers have used third-party service providers for decades, their increasing use has led staff to make several recommendations to ensure advisers that use them continue to meet their obligations to the investing public,” SEC chair Gary Gensler said in a press release. “When an investment adviser outsources work to third parties, it may lower the adviser’s costs, but it does not change an adviser’s core obligations to its clients.”

Looking Ahead

“I think the future of dealmaking will continue to be impacted by evolution,” says Houlihan’s Murphy. “The diligence process will need to be conducted in an even more timely manner and will need to marry third-party data sets with company-specific data sets.”

The ever-decreasing timeline will require firms to be integrated with the service offerings as clients will not have the appetite or bandwidth to manage multiple providers, and they will not tolerate the historical audit conflicts associated with the large accounting firms. Lastly, the impact of industry experience will increase. No longer will the mantra ‘I am a process expert and thus don’t need to know the industry dynamics’ suffice as there will be far too many valuation impactful points missed.