What due diligence looks like after COVID-19
Physical access to businesses is a key part of due diligence for financial services. Journalist Jonathan Minter looks at how firms are adapting to the changes brought by COVID-19.
Due diligence is a basic tenet of assessing companies as part of transaction, and as such forms a vital cog in virtually any modern market economy.
Yet COVID-19 has played havoc with markets.
Between February 20th and March 23rd, the FTSE all-share index fell from 4150.19 down to 2727.86 as panic spread.
Although the market is recovering, performance has remained extremely choppy with some sectors suffering a great deal more than others, and values overall remain a long way from the pre-Covid peak.
Social distancing and lockdown rules have provided new challenges to businesses, and people across the globe have had to get used to video calls supplanting in person meetings. Although lockdown restrictions appear to be easing, the process may be slow, as the Government remains wary of a second wave of the virus.
Due diligence changes
Despite market volatility and the lockdown measures, due diligence remains as important as ever – even if the type of work being done has changed.
Unsurprisingly, non-distressed M&A activity has slowed significantly since the lockdown began – especially in sectors notably affected by it, such as the leisure industry.
Tom Macdonald, a partner in Deloitte’s Financial Advisory Transactions Services team explains: “A seller wants what something was worth yesterday, and the buyer wants what it's worth today. And unless there is some impetus on the seller, that gap may not get bridged.
“As a result, we are frequently seeing that vendors who have the option to are holding off for now until the market stabilises, hoping that values will increase.”
Tarun Mistry, a former partner at Grant Thornton and founder and managing director of T. Mistry & Associates, adds that one piece of due diligence he began working on before lockdown but finished during was for a transaction which was ultimately not completed due to the buyer taking a pause in order to fully assess the impact of the current situation.
However there remains a solid flow of companies looking to prepare for a future potential sale.
Perhaps unsurprisingly there has also been an increase in the number of those looking for distressed sales – where the gap between buyer and seller valuations can be bridged by the seller needing to sell quickly. This trend appears set to continue as the economic difficulties continue.
Working from home has not proved a huge challenge to firms in most regards. Easy to use software such as Microsoft Teams and Zoom has made interpersonal communication possible without going into the office, and there is a widespread view that, even after the lockdown, some firms will take a more flexible approach to working from home.
At the same time, visiting clients in person has traditionally played a part in carrying out due diligence work – initial meetings with clients, having access to management, and observing their site can all form important parts in the process.
These days most of the data work can be done remotely. However, Mark Benka, a Partner in Smith & Williamson’s transactions services teams, adds that, while 95% of the work can be done virtually or over the phone, it can become a problem if there is a complex issue or a topic which lacks good data. “Then those meetings are really important”, he says.
“One needs to get around it by spending more time with the key people, and more time with a variety of people on the management team to get their perspectives.”
In most cases, video conferencing has been described as good enough for the time being, to get a feel for the management team during lock down, even if several accountants and fund managers ICAEW spoke to say they plan to revert to meeting face-to-face as soon as possible.
Remote working will affect some businesses more than others. For example, individuals the due diligence team want to speak to may have been furloughed or may have poor internet access. Also, depending on the sector, sometimes a site visit can be used to verify or question management responses.
Mistry says teams conducting due diligence work that encounter such issues may need to revisit their approach or scope of work, or include caveats stating that procedures normally performed on site were carried out remotely.
The current landscape has slightly altered aspects of due diligence reports. Dan Perkins, Managing Director at Great Point Investments and Glen Stewart, Head of Intermediated Capital Raising at Committed Capital, both agree that detailed cashflow analysis and forecasting have become even more crucial, as a result of lessons learned during the crisis.
Stewart adds: “With regards existing investee companies, we update our due diligence each time we undertake a further investment round. This has become more detailed since the start of COVID-19 to ensure that companies are cost cutting as appropriate to respond to a constricted or potentially constricted revenue environment.”
Matthew O'Kane, Managing Director of Nexus Investments, agrees. O’Kane works with early-stage, founder led companies, and says that, in the short term at least, importance will be placed on how founders react to conversations about the realities of post-COVID valuations.
Outside of this, non-financial metrics have been given greater recognition than before. Benka notes his team are spending more time looking at areas such as dependency on key suppliers and their resilience, IT adequacy, cyber security, and HR, for example.
Jenny Batchelor, Tax Partner at Smith and Williamson, adds that government rescue packages mean that tax due diligence now requires additional considerations for international companies. These companies will need to consider different country response packages, raising additional complexity for filing deadlines.
She says: “With filing much more fluid and payments being different, does that put us in a different position and make it more difficult to get a sense of a business complying?’
This hints at a wider problem facing due diligence providers. In an increasingly globalised economy, with businesses operating across multiple jurisdictions, COVID-19 has not affected all regions equally or at the same time. Government reactions have varied from country to country, and different regions have found their infrastructure’s ability to cope with a pandemic stressed.
So, while UK based employees may have been able to cope with working from home with minor disruption, the same may not be the case for a client’s employees in other parts of the world.
Although the cost management imperatives which drove companies to outsource initially will not change, Macdonald suggests contingency planning may become more important:
“In 'the new normal' many companies will likely want to develop more granular contingency plans that they can roll out in case of a future pandemic or similar disruption and dislocation, which could include a higher cost but nearer shore option.”
The saying goes, ‘history is the only true teacher,’ and past crises have left their impression on economies. Arguably we were still learning lessons from the 2007 financial crash when COVID-19 hit. Looking even earlier, Benka points out that Enron resulted in a heightened focus on revenue recognition.
Due diligence teams have already learned several lessons which will be applied once the current situation is eased.
Benka suggests: “People might look at business continuity planning in greater detail, for example, and scope for any MAC (material adverse change) clauses and being able to implement force majeure”.
O’Kane, Perkins and Stewart all agree that economic events such as these further focus the mind on more granular cash flow analysis, increase the frequency of marketing strategy reviews and illustrate the importance of continued market and customer diversification.
Once the crisis has passed, Mistry says teams will gain greater clarity about how markets are set to perform in the future, and how viable business models will be in a post-COVID world. An example he gives is how a transport business might react to any societal shift towards staff increasingly working from home, or not being able to travel as much, if some restrictions remain.
While this might indicate that some parts of the due diligence report will see more attention being paid to them than before, the fundamental use case, and therefore requirements of such a report will likely remain the same.
MacDonald notes that, at its core, a due diligence report looks at value drivers and economic prospects, and risks (for example gaining confidence around governance). He suggests: “Those two fundamental topics are the reason why somebody should want due diligence, to get happy with the value they're paying and the risk that is attached. While some of the dynamics change, these fundamentals do not.”
Regardless of how much the format changes, the general consensus is that the next nine to 12 months or so will see an increasing amount of M&A activity as companies that held back in the crisis look to buy or sell in the ‘new normal.’
About the author: As well as freelance work, Jonathan Minter is senior editor at Intelligent Partnerships. He was formerly group editor of The Accountant and International Accounting Bulletin, as well as car finance title Motor Finance.