Strategies for Independent Sponsors to Efficiently Structure & Stage Diligence

Staging of due diligence as an Independent Sponsor can be a tricky thing. It’s essential to identify the key risks and strategies early on before getting too far out in front of your spend. The Independent Sponsor Forum recently hosted a lunch and learn, sponsored by Exbo Group, that explored how to effectively stage this process to recognize risks while keeping spending in check. Read on for some actionable tips!

Surround Yourself with People Smarter Than You

Jeff Taylor, a Partner Mansfield Investment Partners, kicked the conversation off by noting that it’s helpful to surround yourself with operating partners – people who know the industry better than you. They can help give you the right questions – what needs to be true for it to be a good deal and what the critical KPIs are that you need to be focused on. That makes a huge difference in not wasting time and money on legal and other fees pre-LOI by knowing what questions to ask and red flags to look out for early in the process.

Griffin Gordon at Taurus Capital Partners agreed. “Time is the operative word.” He added. As an independent sponsor, your time is as valuable as money. The more you can vet pre-LOI to avoid wasting effort, energy and money the better off you are.

You need to have an actual investment thesis as well. You can’t just go find any deal and figure it out. You should be targeted on the types of deals you look for– what are you a good fit for?

Jeff and Gary Ran at Scooter Partners both use “Buy boxes” – checklists that deals must pass before they move further to the investment memo stage. That helps ensure you don’t just convince yourself it’s a good deal.

Make Sure Your Incentives are Aligned

Griffin noted that there’s an information asymmetry between owner and independent sponsor. As an independent sponsor you want the owner to have skin in the game post-close – that’s part of the diligence conversations.

Gary added that early owner discussions are very important. You have to discuss the post-close structure pre-LOI – do you use a rollover, note, earnout… what’s the role of the seller post-close? You need to understand how important the owner is to the operation – do you need to keep them on or hire them as an advisor, as it impacts your numbers. Being transparent about this can be difficult but it can kill a deal if you are not and create a lot of wasted time and expense if you get far into the diligence process and get hung up on this issue. You need to make sure your incentives are aligned.

Understand Your Leverage

Leverage can be risky – you can’t over-leverage – you need the right rollover participation. Jeff asks for at least 20% of seller skin in the game.

At the pre-LOI stage, the panel is already reaching out to equity and debt providers to get feedback on the deal – to determine if the leverage is too high or if they recommend no leverage. That early feedback makes a huge difference as an independent sponsor to determine if it’s worth moving forward.

Everyone agreed that approaching lenders and equity partners early is critical. As resource constrained entities, independent sponsors need to be thinking about raising money early in the process to ensure they are not wasting their time  on deals that they can’t ultimately fund.

The Deal is the Currency of the Land

Jeff discussed his strategy of approaching investors with just a thesis – with no asset yet. This helps him scope out ideas using a strawman approach so when he has an asset to bring to them he already has a good idea of what the deal needs to look like. You have to socialize the deals early to understand if capital providers will have interest before you have already spent more money on diligence.

Griffin noted that “The deal is the currency of the land.” By this he means that he may sometimes get an investment thesis that may not be accepted by an investor, but when you bring an actual deal to them, their views may change even though the deal mirrors the thesis. Sometimes timing and the reality of a “real deal” can change an investor’s perspective. But either way, as Gary stressed, it’s important to use that outreach to investors on theses and deals as a learning experience. You need to ask why they have concerns to learn from them.

When asked about support letters from investors, Jeff noted that he doesn’t use them often – that over time you build the credibility you need as you close deals. Gary likes to use them from existing lenders who then are likely to work with them on the deal.

Post-LOI Surprises

The panel noted that post-LOI is where the expenses – and often surprises – really occur. That’s when the Quality of Earnings {Q of E} work occurs.

Jeff said he does a scope of work first for a “flash” Q of E – things to confirm before he goes deeper on spend and effort. One such surprise area can occur around re-occurring revenue. Often that needs to be scoped out – customer retention and GAAP accounting on revenue being recognized at once when it should have been deferred – that is not an uncommon occurrence.

Lauren Hennelly, CPA at the Exbo Group pointed out there are nice-to-haves and requirements. What requires remediation – you have to identify those things post-LOI and that’s the job of an advisor.

Once such area is CEO pay. How is the CEO compensated – is it normalized within the cost structure you created or not? And what is it like if you replaced the CEO with another person? It comes down to what the CEO will ultimately be comfortable with post-close.

Yet another area of surprise involves staff pay and benefits. Has the staff gotten a raise – is it due one? Do they get/need benefits? And is the company understaffed – has it dropped staff recently to improve numbers but created a work environment that is untenable?

Being the Deal Sherpa

Owners are often not sophisticated in the M&A process. Griffin relayed a story of an owner who was concerned the diligence process acted like an audit that would catch the attention of the IRS. Most won’t know what a Q of E is. Gary discussed the need to explain to a seller that diligence advisors don’t work for the independent sponsor – they work for the deal. They are paid for by the independent sponsor but their job is forensic - to scope out diligence issues and offer recommendations. He noted that those recommendations may sometimes allow for sellers to get more compensation than originally anticipated.

In the end, as Griffin explained, due to the often lack of sophistication of the seller, independent sponsors have to be deal sherpas for them and explain to them why the process is what it is and what’s being looked at.

Author: Stephanie McAlaine, Executive Director, Independent Sponsor Forum