The private equity industry's resilience in the face of a global pandemic can be celebrated. However, there is one aspect of due diligence that should not be overlooked. Due diligence efforts focus on the details of a company's operations, including financials, legal and corporate documents. These documents provide a solid understanding of the business. Management due diligence is often overlooked and undervalued. This gives insight into the management team of target companies and how it would be like to work with them. The authors interviewed 50 executives from the North American PE industry, including 25 middle-market managers and 25 members of target company management teams that were owned previously by PE firms. They offer the following fundamentals to help establish productive and successful PE partnerships based on their research questions.
The turn of the decade marks the emergence of private equity (PE), after a turbulent and unpredictable start. McKinsey's annual report found that private market fundraising reached an all-time high at $7.3 trillion in 2020. PE was responsible for 61% of this growth, despite initial volatility. PitchBook's analysis of the U.S. showed that exits and deals in PE are poised for record-setting years in 2021.
Prospective PE investors must do their due diligence before making any purchase. This is similar to a pre-purchase inspection of a home, which can reveal red flags or reasons to not buy a property. However, these inspections can reveal hidden value and issues that can be fixed.
The resilience of the PE industry in the face of a global pandemic is something to be proud about. However, there is one aspect of due diligence that is not being addressed. Due diligence efforts focus on the details of a company's operations, including financials, legal, patents and corporate documents. These documents provide a solid understanding of the business. Management due diligence is often overlooked and undervalued. It provides insights into the management team of the target company and how it would be like to work together.
Deals and mergers are ultimately about people. Problems can almost always be resolved early by having a good understanding of all the parties involved. This means that PE investors need to find investment-worthy businesses and management teams that align with their goals. Management teams must also evaluate whether the investor is a good fit for them and their work style. It is crucial for both sides to do thorough due diligence to determine if the match is good and to make sure they are able to meet their expectations.
No systematic research has yet to uncover these expectations. This presents an opportunity to highlight this crucial aspect of due diligence and to contribute to the surprising lack of research on due diligence generally. Research by economists and accountants has shown that more than half of the firm's value cannot be explained by its finances. This highlights the importance of intangibles like management abilities and personalities for the success of PE transactions.
We surveyed 50 executives from North America's PE industry. They included 25 managers of middle-market companies and 25 members of management teams of target companies previously owned by PE firms. There are many problems that come with managing business relationships. The principles for creating and maintaining successful partnerships are universally applicable. We offer the fundamentals of creating productive and successful PE partnerships by answering the three research questions.
What is the view of sellers and investors on management due diligence?
First, investors are not aware of the benefits and do not take due diligence. They believe that all aspects of a PE deal are equally important, including products and operations. However, they tend to favor the latter two.
Investors make incorrect assumptions about the way sellers view management assessments. One in four investors interviewed said they don't use external assessments as it could cause friction between the relationship and the seller. However, two-thirds (or more) of the sellers interviewed found the experience positive. The rest however see it as neutral.
Investors often believe their investment is sound after completing extensive operational and business due diligence. They then assume that there is no need for them to examine the management team. Investors should be reminded that every component of a successful PE transaction deserves equal attention. Investors may think that due diligence in management can hinder the development of a relationship with sellers. In reality, the process is beneficial for sellers.
What are the characteristics that each party seeks in a partner?
First, sellers and investors define successful entrepreneurs/CEOs in a different way. A surprising result emerged when sellers and investors were asked to rank the most important characteristics for managing a target company. Openness to input was rated by investors at 32%, 8% and 4% respectively. The opposite is true for sellers, 28 percent rated openness and learning more important than investors (4%)
Second, successful PE investors are defined differently by sellers and investors. There was more agreement between investors and sellers than there was with management ratings. However, there is still a discrepant pattern. For example, 20% of investors considered entrepreneurial mindset most important. However, no sellers thought so. Similar to the above, investors did not rate ease of working together being most important. Sellers rated it as most important at 12%.
These findings, taken together, highlight the importance of a dialogue between investors and sellers that aligns success and articulates the value they bring to the partnership. This alignment must be established early to ensure that both sides know what to expect, and to establish a foundation for the future.
Which aspects of the partnership are most important to both partners?
Three important insights were revealed by the data from the third question. They highlight the opaque relationship between sellers and investors.
The paradoxical finding for sellers was first that they found a paradox in the list of aspects both sides value and find challenging. Although they cited improvements in management techniques as their most important benefit, sellers pointed out disagreements about the management responsibilities that are the greatest challenge. Sellers are not looking for a lot of help in running the company. However, this suggests that they won't be able to give up on trying to do everything themselves. It is crucial for investors to find the right mentorship zone that suits your portfolio company.
The second reason is that both sellers and investors (44% each) have left deals. Poor leadership skills by sellers' management teams are two of the most common reasons investors leave. It is important to have a conversation with both sellers and investors about the definitions of a good CEO.
Investors wanting too much control over the day of the deal are the main reasons sellers walk away from deals. This is contrary to what sellers value the most in a partnership. As noted above, this highlights the importance of finding the right balance between investor mentorship as well as management autonomy. A mismatch between investors and sellers has also led to sellers walking away from deals. This highlights the importance of sellers being clear about who they are looking to partner with, not just the financial resources.
The majority of research on PE deals comes from investors' perspectives. For example, how do they select companies to replace CEOs or innovate? It can be hard for sellers to understand what it is like to partner up with a PE company. We focused on sellers because the literature doesn't reflect their perspective. We asked them what aspects they would like to see more of and what they wished they knew.
Securing additional partnerships is the number one activity that sellers desire more of. This indicates that sellers do not only want financial capital but also need access to investor networks. Sellers want more help in developing company strategies, but they also wish they knew about investors' aggressive strategies to reach growth targets and reduce costs. Investors need to be able to explain why they choose the best strategies to grow their company and how to align them with management expectations. It is not surprising that sellers want less involvement from investors in the day-to-day operations.
Understanding the critical, yet often overlooked aspect of managing due diligence is more important than ever as the PE industry continues to set records. The research results reveal three key principles for creating productive and successful PE partnerships.