Sourcing new deals has become more challenging due to an increased level of capital chasing a limited number of quality deals. As a result, lower middle-market companies have become more attractive to buyers. However, these companies tend to invest less in their finance and accounting operations, as well as their financial reporting infrastructure, and they have lean management teams. This can pose challenges for potential acquirers.
Sell-side due diligence is gaining traction with owners of middle market companies. The increasing number of transactions that collapse mid-deal or at a reduced valuation is motivating organizations to conduct sell-side diligence proactively to reduce the possibility of unwelcome surprises during the sale process that could derail the transaction.
Sell-side diligence is also gaining momentum with private equity firms as they get ready to go to market with their investments and try to maximize returns for their limited partners.
Here are some of the most common questions about sell-side diligence.
Does sell-side diligence add value?
Many times sellers leave value on the table because they fail to think like a buyer and don’t prepare adequately for the rigors of buyer due diligence. They do not anticipate buyer concerns, and are not prepared when confronted with difficult questions concerning operations, customer concentration and projections. There is much to be gained by sitting down and proactively analyzing the value drivers of the business to be shared with prospective buyers. For example, if the seller of a small manufacturing business who used tax-efficient strategies to value his inventory found out deep into the diligence process that had he properly addressed this before going to market, the potential buyer would not have had the leverage to negotiate a significant reduction in the purchase price.
A sell-side diligence report is an opportunity to showcase the company and provide a short-list of interested buyers with financial and operational information from which to thoroughly evaluate the business and make an informed offer. It enables the seller to maintain credibility, eliminate surprises, maintain control of the process, minimize disruptions and increase the likelihood of a successful transaction.
When there are numerous prospective buyers, having a consistent set of analyses for all parties can significantly reduce the burden on the seller to respond to multiple document requests and redundant queries. Sell-side diligence can also help identify serious buyers and weed out those early on in the process who are looking for ways to renegotiate purchase price or take advantage of a competitor.
Private equity firms, in particular, are discovering the many benefits of sell-side diligence. They are requiring their portfolio companies to conduct their own internal diligence as a way to prepare management teams for the sale process and for the questions they will be asked by buyers. Sell-side diligence is proving to be invaluable in educating those management teams and getting them comfortable with the presentation of critical financial information.
Does sell-side diligence replace buy-side diligence?
For buyers, the key advantage of sell-side diligence is the ability to save time and money. To the extent that buyers want to rely on that diligence, they can reduce their own costs and complete the sale process in a quicker time frame. More often than not, buy-side diligence process is not replaced. No matter how thorough the sell-side report, prudent buyers will not rely entirely on that document. They view it as a starting point and a framework for future discussions.
Are carve-out transactions good candidates for sell-side diligence?
The complicated nature of carve-outs makes them prime candidates for sell-side due diligence. Carve-outs often have unique challenges and difficulties. For instance, the financial statements of the business to be divested may be combined with other divisions, making it difficult to determine the true profitability of the carved-out business. Stand-alone costs, allocated costs, shared services and which systems and resources should move from the corporate parent to the newly independent company all need to be addressed. The buyer will demand clarity on all of these issues. Also, it facilitates identifying what functions are required in a transition services agreement and assessing the costs related thereto.
In the end, sell-side diligence can help buyers better understand the structure of a carve-out and eliminate uncertainties that could lead to a decrease in value.
Is sell-side diligence more important to international acquirers?
Sell-side diligence, more commonly called vendor diligence in Europe, is much more common outside the U.S. In the United Kingdom, for instance, deals are unlikely to move forward without the seller conducting a formal diligence process.
International acquirers also expect vendor diligence to be for their benefit. In the U.S., for instance, when a third-party firm helps the seller prepare its due diligence report, potential buyers that base their purchasing decision either solely or partly on that information cannot sue that outside firm if the acquisition turns sour. The third-party firm has no obligation to the buyer.
Overseas, the diligence provider has an obligation to the buyer, and if things go wrong, the buyer can recover damages from that third-party provider, although there is often a liability cap on what can be recovered.
International diligence is usually more exhaustive and expensive than its U.S. counterpart. U.S. sellers, especially those pursuing an international deal, need to consider whether they can produce a U.S.-based sell-side report or whether they should invest in more thorough, and costly, international vendor diligence.
Is sell-side diligence costly and disruptive to the seller’s management team?
First the bad news: conducting proper sell-side diligence takes time and money, especially if an organization hires a third-party provider. The good news is that sell-side diligence can more than pay for itself by attracting maximum value and allowing management to focus on running its business.
Small and midsize organizations, which often have lean teams and significant bandwidth constraints, are probably best served by partnering with a diligence provider that can roll up its sleeves, dive deep into the analysis and make sure no value is left on the table.
Outsourced diligence is less likely to be a disruptive process. When it is done right, management teams remain focused on the business and are not distracted by hundreds of questions.
Sharon Bromberg, CPA, CIRA, CFF, Claudine Cohen and Margaret Shanley are all principals of CohnReznick’s Transactional Advisory Practice.