Why Now More Than Ever
by Terry Stidham, President of Target Search Group
Many sellers are told not to worry about doing their own due diligence because the buyer will be doing it instead. This can be a big and costly mistake. The right time to identify problems or issues to be addressed is before going to market.
Sell-side due diligence is best described as a self assessment of a seller’s own financial position plus anything else deemed material to the sale. It enables sellers to proactively identify matters impacting value, negotiating leverage and speed to close, while minimizing uncertainty in the sale process. Note that sellers should also perform a level of due diligence on potential buyers to confirm their ability to purchase, as well as other items that could affect the purchased business or the seller after the sale. I have seen many sellers spend a tremendous amount of time and emotional energy in what was thought to be a deal, to only find out that the buyer could not even buy a cup of coffee. There are other times where the "buyer" has no intention of buying but is only there to gather intelligence on the seller's business. At it's simplest level, sell-side due diligence is identical to buy-side due diligence; it’s just performed earlier in the sale process. None of this is new to the sophisticated investment banking professional, who realizes sell-side due diligence can play a critical role in maximizing value from a deal. Exit activity is expected to be robust in the near term and private equity groups have a large backlog of portfolio companies that are well past the typical three to five year hold time according to PitchBook. A look at today’s deal environment emphasizes why sell-side due diligence is more important than ever: Dry Powder – PitchBook reports that in 2012, 47% of all exits were secondary, private equity to private equity buyouts. Three years ago, that figure was 25%. This trend will be exacerbated by the current capital overhang from vintage 2007 and 2008 private equity funds. These funds are reaching the end of their investment mandate, so investors may lose access to these funds after this year. The incentive for private equity firms is to put this money (dry powder) to work. 
Buyer Due Diligence Intensifies – Serial buyers are putting more capital to work
in each deal as valuations are being pushed upward. They are not only accepting
potentially lower returns but an equal or higher risk that a problem overlooked
could become a much larger one. An issue viewed as insignificant a year
ago can delay or derail a deal today. Buyer reaction is to intensify
their due diligence, focusing harder on historical earnings (searching for
negotiating leverage), forecast assumptions, working capital trends and
operational drivers of the target company.
Return on Investment – Sell-side due
diligence can uncover positive findings that improve the seller's financial
results. An EBITDA adjustment of $100,000 could increase purchase
price by $700,000 (assuming a 7x EBITDA multiple as the purchase price). The buyers might discover the adjustment in their discovery but it is up to the seller to let them know that they know.
Mutually Beneficial – Historically, a sell-side due diligence
project culminates in a written report that can be provided to a select number
of prospective buyers. Today, potential buyers are asking for more. In
addition to validating adjusted EBITDA (quality of earnings) and analyzing
working capital trends, management teams need a partner to assist them in
compiling and presenting data room materials, analyzing historical operating
performance, creating/validating assumptions used in a forecast and defending
information offered to prospective buyers. Sellers, management teams,
investment bankers and buyers all benefit from sell-side due diligence.
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