Commercial Due Diligence Consulting in Private Equity

Private equity investing has grown significantly in the last twenty years, as have the consulting practices that serve private equity. When Stax started working with PE funds in 1997, there were about four to five leveraged buyouts closed per week in the US. According to Pitchbook, that average today is more like 20 LBOs, and another ten or so private equity transactions of other types per week. At a median LBO deal size of $100M+, the pace of private equity investment is strong, if down somewhat from its recent peak.

Private equity has matured with strong historical growth attracting significant capital and leading to greater efficiency and competition for deals. Consistent high returns are more difficult to achieve. Even so, fundraising has remained strong, with over $2.5T raised in US PE funds over the last ten years — from both new and traditional sources of capital. Consultants serving PE have thrived in this environment, particularly the strategy firms that address commercial due diligence and portfolio company profit growth.

In today’s environment, what is consulting worth? What is the value of commercial due diligence from a strategy consulting firm? Are consultants worth less or more to private equity investors than they were ten or fifteen years ago? Under what circumstances is consulting worth more, or worth less? At Stax, we can provide quantitative answers to such questions.

There are established frameworks for understanding the value of information. Investing is a probabilistic endeavor, and consulting information can be evaluated in this context. Using this approach, we can quantify the value of consulting information in private equity deals.

There are two primary ways for a strategy consultant to increase returns for investors:

1) help the investor to make better investment decisions. 2) improve portfolio company performance post-investment.

We look at the investment decision portion and specifically at the commercial due diligence offering. In commercial due diligence, consultants vet the market and competitive position of a target, the likelihood of achieving management projections for profitable growth and the risks and potential accelerators to that growth. Here we consider a simple investment scenario with a target company with $15M EBITDA, where we assume no multiple expansion, a set of simple assumptions around the structure of a deal with three potential outcomes and probabilities associated with each (see Figure 1).

FIGURE 1: Simplified Outcome Model

In our simplified scenario, there are only two potential investment paths — buy or don’t buy — illustrated in Figure 2. In this scenario, we can calculate an expected value of the “buy” branch of about $10M to investors (ignoring the time value of money in our approach).

FIGURE 2: PE Decision — Expected Value with No Information

Note that even though two out of the three outcomes are bad (stagnation or outright failure) and the probably of a win in our scenario is only 35%, even with no information the expected value of the “buy” branch is substantial. This of course makes sense. You can’t get returns without making investments.

Now assume we have perfect information and can compare the expected value of another “perfect information” branch of the tree where we only invest when we know we have a winner and otherwise we don’t invest. In this case, the expected value of the “perfect information” branch is about $17M, or $7M higher than the no information buy branch. So, the value of perfect information is high (no kidding you say). In our scenario, it turns out the value of perfect information is about 45% of EBITDA and scales linearly with EBITDA, all else equal. That provides a ceiling to information value. Perfect consulting information in our scenario is worth about 40–50% of EBITDA, or about 6%–7% of total deal value.

Consulting, like all human endeavors, is not perfect so we need to look at the value of imperfect information. Consider a consulting firm that is only fairly good, as illustrated in Figure 3. We assume that 70% of the time, the consultants correctly identify a winner, 75% they correctly identify a sideways and 80% of the time they correctly identify a loser.

FIGURE 3: Consultant Accuracy (Assume the Consultant Makes the Right Call 70%–80% of the Time)

If we assume that the investor follows the “fairly good” consultants’ recommendation, we can calculate the probability of each outcome and the expected value of the investment decision with imperfect consulting information/recommendation included. The information from consulting in this scenario is worth about $1M, or about 6% of EBITDA.

So, the value of consulting information (even highly imperfect from our only “fairly good” consultants in this case) is high, but it is much lower than the value of perfect information. We also examined the distribution of that value, and see that the value of consulting information accrues to both LP and GP, but falls disproportionally to the GP (as do some of the costs).

We then look at our simple scenario under a range of different input assumptions to examine the sensitivity of consulting value. We see that the value of consulting is higher in more difficult markets, as represented by going-in multiples compared to exit multiples. In markets where there is no multiple expansion, or where there is multiple contraction, the value of consulting information goes up significantly. Conversely in the rare situation where there is high probability of multiple expansion, consulting information can have negative value. In this scenario, executing deals is the value driver, and even at low error rates, consultants will keep investors out of some deals that would have been winners.

That brings us to consultant accuracy. It matters a lot. What might be surprising is that the specifics around the type of accuracy are crucial. Figure 4 shows sensitivity around the two types of accuracy: 1) keeping investors out of bad deals and 2) getting investors into good deals. The base case is the boxed cell in the middle of the page with “keeping investors out of bad deals” accuracy increasing as you go down the page, “getting investors into good deals increasing” as you go to the right and the color representing the net value of consulting information.

Keeping investors out of bad deals has high value. That value is lost though if the consultant cannot also help investors develop conviction around winning good deals. This is best illustrated with the extreme case; as a consultant, you can have 100% accuracy in keeping investors out of bad deals by simply hating every opportunity and emphasizing risks and reasons for failure in every case, regardless of the facts. In this way, you can be guaranteed never to have a “false positive” error. But in this case, you would also be guaranteed to be value destructive to your investor client. At the bottom of Figure 4 — even at 95% “keep out of bad deal” accuracy — unless the consultant can spot winners significantly more often than not, he actually destroys value for the client. This brings us back to the simple idea that to generate returns, you must make investments.

To drive significant value, consultants must be able to balance the ability to spot risk with the equal ability to spot opportunity and strength. In Figure 4, the estimated net value of consulting information grows by a factor of almost six with an increase from 70% to 90% accuracy in developing conviction around good opportunities.

FIGURE 4: Consultant Accuracy

Independence and objectivity are critically important. True open-mindedness to the facts is extremely difficult, and without a clear focus on this above other factors, bias can creep in.

Since bias ruins consulting value, investors should turn to consultants who minimize it. To minimize bias, valuable consultants focus on the current work, rather than prioritizing the next sale. They are open minded to facts, even (and especially) when the facts prove their incoming hypotheses and expert opinion false. A truly independent perspective is invaluable.

There is a premium on balance and accuracy. Consulting information is most valuable when risks and downside can be appropriately identified to avoid bad deals and when a consultant can help investors quickly develop conviction to pursue good deals, grounded in facts. Connecting on good opportunities disproportionately drives returns, so to be valuable consultants must deliver low error rates for both false positives and false negatives. And they must do it quickly.

For due diligence, speed has value — not just the ability to complete the diligence in advance of milestone dates, but the ability to build investor conviction faster than others in a competitive process, when the underlying opportunity is strong. Every day and every hour matters in a competitive process, and consultants need to recognize this fact and have the capability to deliver twenty-four hour resources to maximize value.

As in all pursuits, perfection is not possible. Accuracy, independence, objectivity and the ability to rapidly assemble the fact base necessary to develop conviction — or get out — make all the difference.

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