PracticeConsultingDUE DILIGENCE – It pays to be diligent

DUE DILIGENCE - It pays to be diligent

Technical due diligence is a normal part of any serious funding exercise by banks and equity houses and it can take at least three different forms. First, there is the requirement to ensure that applications for funding for new technology projects involving new, high tech hardware and/or software products, are sound. This comes down to a combination of product evaluation and market evaluation. Second, in just about any acquisition these days the financial backers will be interested in whether the target company's IT systems and strategy "fit" with those of the acquiring company. Third, there is the rich seam of e-business-based projects for funding, where commercial due diligence requires an examination of the infrastructure proposed for the new company.

As Richard Kilner, an industrial advisor at 3i explains, there is now a significant and probably irreversible trend for major finance houses like 3i to focus on technology investments, however conceived. These are seen to hold the promise of premium returns. This has pushed the finance houses to place far more emphasis on technical due diligence.

“We have several major sources to draw on for technical due diligence. Our first port of call is our own internal expertise. Second we have a wide network of businesses in which we have some investment stake. This gives us a very extensive pool of expertise across a range of market sectors. On top of this, we use external due diligence providers, and the Big Five figure quite largely in this,” Kilner says.

“We are probably the biggest procurer of technical due diligence in Europe. We have a database which lists external sources we can draw on, broken down into sectors and areas of expertise, and it makes it very easy for our finance teams to locate the appropriate technical expert for the job,” he says.

Neil Patey, a partner with Ernst & Young’s corporate finance division, is accustomed to dovetailing in with IT technical consultants from the firm’s IT Information Systems division on due diligence projects. “We see a number of projects for venture capital or senior debt that are based on software or hardware products. Obviously, part of the process is to ensure both that the product is likely to find the market the company anticipates, and that it does what the company claims it does.”

He says that, increasingly, technical and market due diligence work go hand in hand. “If you take the dotcom companies, market due diligence is of prime importance. There are loads of ideas out there, but you need to know that the market is prepared to pay real money for the idea in question.” Where the idea rests on a new piece of software or hardware, Patey reckons that it is almost obligatory now for the product to have reached a testable “see it, feel it, touch it” stage. “Very few private equity players will back a venture to get a technical idea up and running. They want to see the real thing in prototype at least. Then we can come up with technical specialists who can speak to its strengths and/or weaknesses.”

John Gilligan, head of Deloitte & Touche’s Venture Capital group, disagrees. Gilligan is specifically concerned with early stage digital IT and sees a fair number of “concept-stage” proposals. Concept funding is perfectly possible, he says, provided the right case can be made for it. He concedes, however, that the venture capital community is subject to rapidly changing fashion trends and that early start-up funding is a highly volatile market.

“Today everyone is excited by optical switching, six months ago it was dotcoms. Technical due diligence is very difficult here but this does not mean you can’t do it.”

If no prototype exists there are still two approaches available at the concept stage. First, you look at the pattern of how similar technologies generally evolve, and you form a view on the narrative supplied by the applicant. Then you form a judgement on the credibility of the team.

“People who have started significant businesses do have common characteristics. They tend to be very energetic with a strong belief in themselves. This manifests itself as a capacity to do difficult things. We believe that entrepreneurship does not consist of inventing a better ashtray. It consists of getting things done. If the team look as if they can achieve things, and their narrative holds up we’ll be interested,” he says.

The fact that it is not even at the prototype stage won’t kill things off. It just makes it that much more imperative for the firm to generate technical judgements on the product’s feasibility and the reality of its potential markets. “If you can’t understand how the product or the idea is going to enter its prospective markets, you’re not even at the starting blocks. That something is useful is not enough. Lighthouses are useful but it is very difficult to get ships to pay for them. We need to see a real link with the market,” he says.

Establishing that link will often be the joint province of whomever the firm assigns to do the technical due diligence work and the market analysis.

Gilligan has technical and sector experts who are non-corporate finance people in his own team who specialise in providing expert views on one or another technology area or market sector. If they can’t do the job, he will call on the firm at large. Failing this, for specific niche proposals, the firm will widen the net and look for qualified technical expertise wherever it can be found.

Given the considerable in-house resources of the major equity houses, is it worth consultancy firms actively marketing their technical competencies for due diligence work, then? According to 3i’s Kilner, it definitely is. “We actively encourage firms to make it known to us if they have specialist in-house skills,” he says.

Generally though, he believes, the consultancies with the greatest credibility in this arena will be smaller firms that have specialised in particular niche markets and have a long history there.

E&Y’s Patey takes a somewhat more tangential view of the matter. Due diligence work should probably be seen as a service the consultancy firms provide for the IT industry, rather than as a substantial fee earner in its own right, and as a trailer for new business, he says. “The real payback in such work is that the practice gets an early introduction to a promising company. If it is successful, and achieves the rate of growth its directors hope for it, then the consultancy gains a valuable client for a range of services, including audit, tax and investment advice,” he notes.

Drew Stevenson, a director in PricewaterhouseCoopers’ Transactional Services and a co-leader of the firm’s Scottish group, says commercial technical due diligence on systems compatibility in acquisition work is now almost universally viewed as a critical part of the overall due diligence work.

Stevenson says that in almost every case where the acquisition of one company by another fails to deliver on expectations, the faults come down to incompatibilities in gritty areas such as IT resources, systems and processes.

“Industry has learned the hard way that where nuts and bolts issues, such as the ability of the two companies’ IT systems to talk to each other, are not examined in sufficient detail, they cause major problems when the companies try to bed down together. Management Information Systems (MIS) work used to be a tag-on part of the due diligence process. Now systems compatibility is seen as absolutely key, and is right up there along with cultural compatibility, as an issue that concerns boards,” he comments.

The results of an investigation into a prospective acquisition’s IT systems would be unlikely to bring about the abandonment of the acquisition. What the firm would be looking to achieve, he says, is a report that prioritised the steps that would need to be taken in the post acquisition period.

“The additional work may well result in additional fees for the firm carrying out the due diligence work, but this cost pales into insignificance by comparison with what the acquiring company can save in the post acquisition phase through effecting a smoother, faster transition.”

Stevenson reckons that the fee earning potential of technical due diligence should not be underestimated. “It’s not right up there at the 30-40 percent of fee revenue level, but it is not down at the 5 percent level either.

This tends to be a service led by senior people and is a high risk area in a transaction. Substantial sums are spent on due diligence. Plus, if we did the technical due diligence, we would hope to get the integration work as well. The information that we get to carry out due diligence puts us in a very privileged position. We already have a substantial understanding of the nature of the integration issues involved,” he notes.

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