Private Equity's Critical Season: Mastering the Fall Deal Rush

[00:00:00] Lloyd Metz: Get ready to peer behind the curtain of the private equity universe with each episode of Best But Never Final. Hi, I'm Lloyd Metz, joined by Doug McCormick and Sean Mooney. Together, we'll navigate the corridors of private equity, revealing the uncommon knowledge, Challenges, successes, and lessons that drive the world of private equity and business forward.

Let's go.

[00:00:35] Sean Mooney: Hey everyone, this is Sean. I have a quick interlude here. today we're going to do a special encore episode based upon the timeliness of what's happening right now in private equity when we published this episode. So as we speak. We're in what we call the second half stretch, which means this is the time when a huge volume of deals typically hit the market post labor day to December 31st, where every private equity firm is really, really hustling to review new deals that are hitting the market.

that are trying to close by the end of the year for good or bad. There's just a lot of seasonality in PE and right now is go time and private equityville. So in this episode, Doug Lloyd and I talk about the tools of the trade. Here's what PE firms are using to efficiently, effectively assess opportunities and inform value creation plans.

So whether you're a junior member of a PE team, this is your first fall deal rush, whether you're an investment banker, You're an executive at a portfolio company that's doing an add on or selling in the process This will be a great and timely episode to let you know what private equity firms will be doing while they conduct due diligence and why they're doing it. Enjoy.

It is great to be back here with Lloyd and Doug.

[00:01:53] Lloyd Metz: Hey guys.

[00:01:54] Doug McCormick: Good to be here, Sean.

[00:01:55] Sean Mooney: So we have another very interesting topic in terms of demystifying the world of private equity and maybe refining some of the shades of gray for those who are newer to it. So today we're going to talk about the tools of your trade in terms of conducting diligence On third party.

So, oh man, this is where the bills start racking up guys, where you start having heart palpitations and you're going, dear God, if this deal does not close, we got to cut some checks. This is the topic of when I was back in your shoes, where you would have this. Sick to your stomach moment when you knew a deal wasn't going to go forward and suddenly a lot of money goes out and it doesn't go for shares in a company.

Sean, but arguably best money ever spent. That's right. 1, 000 percent because it helps you not only understand what the company is, but what it could or should be. And so let's talk about what these are and then we'll talk about how to go through it. So. The major categories that private equity firms and specifically we're talking about the things you'll use third parties for to help you assess and understand and verify a company as it's been represented to you and then hopefully also inform what it can be.

Are things like a quality of earnings review, a market study, management assessments, legal work, IT diligence or technology work, and then insurance. And there's a whole myriad of others, but these are kind of like the big pillars that you all are doing. And so maybe as we get into this, What do you all think is the best way to kind of work through the list?

There are so many things, right? Because in diligence, we, the private equity professionals, are also doing business diligence and other aspects of diligence. And so these third party providers are important members of the team, so you almost have a role of project management with these, I guess you laid out six.

I'll just throw it out to you guys. Which one of these 60 things is the most important? Let's start with that.

I think it's a really good question. I think the answer in part depends on the size and stage of the company. So if this were a founder owned company that is maybe doing more what I would call entrepreneurial accounting, it's probably cash accounting or they don't have audits or not maybe a sophisticated finance function.

I would put the Quality of Earnings Review first, and maybe let's talk about what that is. A Quality of Earnings Review is a study conducted by a third party accounting firm that will look at the financials of a company and say that they accurately reflect the true performance of the business under what's called Generally Accepted Accounting Practices or GAP.

And what's really important to know about a Quality of Earnings Study is The first word in gap or generally accepted accounting practice is generally accepted. So there's a range of what's true and accurate, not a point in time, but very often what happens in entrepreneur or founder owned business, they're doing what's called cash accounting or they're doing something that's kind of gap, but kind of not.

And so it's not necessarily accurately representing the performance of the business by matching the revenue with the timing of the expenses together. And so with that in mind, often entrepreneurial companies can have. A wildly kind of varied performance depending on when they cut the tape and measure their performance.

And so I think for a lower middle market company, that's the most important first one, because then you can know what the earnings you are ostensibly buying are. I think it's less important as the big company becomes more sophisticated, bigger, has been audited for years. But I would throw out the quality of earning stays the number one kind of precursor activity, you know, within those ranges of tools that I would do first.

What do you all think about that?

[00:05:47] Lloyd Metz: Sean, just curious, the way you described this quality of earnings report, how is it different from an audit, right? So what if it's a company, lower middle market, but it has audited financials. What you described, aren't those the same thing? It's

[00:06:00] Sean Mooney: a really good point because what an audit does, and that's something that's really important.

You get a third party account that says, we believe that your numbers are true and accurate, but it doesn't cover everything. It's not exactly a deep dive. Sometimes the auditor has various degrees of sophistication, and sometimes I would say certain auditors are open to persuasion within that range of generally accepted accounting practices.

Doesn't mean they're doing something that's unethical or immoral, but they might be bumping The range towards the positive in a way that is going towards the edge of generally accepted. And so what a quality of earnings review will do is not only validate the work that has been done on the audit to say, yeah, this is something that we think meets the private equity grade level of standard, but very often what happens in an M and a process is the sellers will also say there are these one time items, extraordinary expenses that will never happen again.

And if they're represented by an intermediary or banker, let's just say their incentive is to throw everything in the kitchen sink into that. So, so a big part of what your Q of E doing is saying, is this really something that's extraordinary that will never happen again? Or are we getting earnings before all expenses and all expenses are had back as if you could go back in time and recreate the world as you wish it to occur.

Is that kind of a fair representation, Lloyd?

[00:07:25] Lloyd Metz: I think that's right. We'll get to that later, but there's become a lot of artistry that's entered into the world of quality of earnings reports, Doug, which is most important in your book.

[00:07:37] Doug McCormick: Yeah, boy. So there's a lot to unpack here. First of all, I think the way Sean described it as.

The maturity of the company matters in terms of what's most important. I think the bigger a company gets, the more mature it gets, the more diversified its customer set gets, the more this is a pricing exercise. And so you want to understand what the ongoing earnings is. And the lower you get in the lower middle market, where you're really trying to understand the opportunity and the quality of the business model, I think it's a little bit less important.

And I think in that case, we find more conviction in understanding the market opportunity because the market will be so big relative to the state of the business today. So, I would probably say market opportunity first drives conviction in my interest in the business and pursuing a consolidation strategy, followed by Q of E, which informs my view of value.

And I would say, I think there's a couple things that Q of E does that I'd highlight relative to how Sean discussed it. The first is, it's not just what's the normalized earnings of the business at a point in time. I think it's also acknowledging that sellers are smart enough to know they're never going to sell when the business performed poorly, right?

So they're picking a good place in terms of the financial performance of which they're going to capitalize the business. And I think some of the analysis of a Q of E is where did the profits come from? Are they likely to be sustainable? Or did we realize some ridiculously good cost position or margin position?

Or did we have a way big one time sale? And so it kind of helps you see through what the events are that happened unique to that year. And then the last thing is to Sean's point about adjustments. We all look at those adjustments with a cynic's eye. Having said that, I think there's also, that's where you can create competitive advantage, right?

If you can see things that are opportunities, either because the company didn't take advantage of them or you believe the adjustments. That allows you to be competitive in a process where some may not. I think those are great points.

[00:09:27] Sean Mooney: Lloyd,

[00:09:27] Lloyd Metz: how

[00:09:27] Doug McCormick: about you?

[00:09:28] Lloyd Metz: If I had to rank them, I would put management assessments as number one and follow that up with the market study and then third Q of E.

So we basically disagreed unilaterally. No, no, no. It's not about disagree or not. I agree with everything you guys have said about the QOV, and that does affect value and valuation for sure, but you can bridge that, right? You can negotiate that, and maybe you get kicked out of a process, or maybe you can't come to terms with the founder or the family.

You can work through that. The market study, I agree, with you, Doug, is very important, super important, but a lot of that, Maybe not as detailed work, but a lot of that work, we're trying to do more of that before we find the specific company. And so that's why I put management assessment as number one, because a mediocre management team can cost you MOIC.

So multiple invested capital turns of return. It can cost you, it can cost you IRR points. And so if you know that going in and you know what functions or people you need to upgrade or replace, or you know how to work with Doug better, right, as the CEO of this new company that you've invested in, that saves you time and helps you make more money.

And so getting that right sooner, I find is pretty critical.

[00:10:55] Doug McCormick: Just one tangent to follow that line of thinking. So I think this is an interesting discussion because you and I have slightly different strategies in terms of how we're trying to. Deliver return. So in many cases, we're driving consolidation where we're going to leave with a much bigger business we started with.

And so we understand that there will be management team deficits relative to the end state we're trying to build. But I would say alignment with management or alignment with owners is different than management assessment. So I'm looking for situations where the entrepreneur sees the same vision That we see in terms of dramatic transformational growth, and we all agree we're gonna have to make investments in the team and the organizational capabilities to get there.

But so for me, the hard stop would be gotta be aligned, gotta be willing to take that journey with us. Don't necessarily have to have the team in place to execute it.

[00:11:43] Lloyd Metz: Agreed. And so part of the assessment is, does that leader have the self awareness? And the personality and the temperament allow you to bring in new talent that may push them, that may.

Do things different than what they're used to and be okay with that, right? Because it's all in the objective of achieving the alignment that you've agreed on, right? The business growth initiatives or whatever it is.

[00:12:10] Sean Mooney: Yeah, and I think what we've gotten to here very quickly are the big three things that matter, right?

It's the market, it's the team, and do they make money with the products they sell ultimately that can generate something called cash flow? Which is back in Vogue. Maybe before we jump into this, for those of our listeners who are less involved in the industry, let's turn back the clock a little bit. So Doug, can you tell us exactly what a market study is, or what's otherwise known as a commercial due diligence in private equity?

[00:12:38] Doug McCormick: Yeah, it's essentially helping you understand the sandbox that you're going to compete in, right? So a market study will tell you things like how big is the market? What are the components of the demand profiles for the market? What's new build versus maintenance or installed base or recurring revenue?

It'll talk about growth rates for that market and in some cases we'll talk about competitive landscape So, you know, who are you competing with? Are you advantaged or disadvantaged? And so really, it gives you a sense of how attractive is this market to whatever your strategy is, whether it be organic growth or position growth.

[00:13:12] Sean Mooney: That's

[00:13:12] Doug McCormick: spot on.

[00:13:13] Sean Mooney: And so Lloyd, maybe in the same vein, what is a management assessment and what does that do within private equity?

[00:13:20] Lloyd Metz: Big picture. It is a. An informed view, usually by someone who's experienced in psychology, industrial psychologist, and they have conversations with the leadership team, oftentimes the CEO and their direct reports.

And what they will come back to us and give us a sense for is how's the CEO wired, what's their temperament, what's their makeup, what's their experience. How do they handle different situations? And then the same for each of their direct reports. And then how does that group interact? So the organizational dynamics are also important.

Is the CEO a tyrant and all of their direct reports? Yes, people. In which case you won't get debate, you won't get dissent. So that's dysfunctional, right? And there's a whole bunch of theories around and profiles of how teams can be dysfunctional. But trying to suss out what are the dysfunctions of that leadership team and what changes do you need to make or ultimately can you work with them or not?

Because if they're very dysfunctional and the leader, the CEO is dysfunctional or problematic in many different respects, then that would be something that we might walk away from. Thank you.

[00:14:33] Doug McCormick: On this one, I would say of the three that we've talked about, QAV, market study, management assessment, in my mind, management assessment, it's broader than assessment.

It's management, it's org design as well. It's the one that's the most art of all three of them in terms of there are generally no right answers. It's different opinions in terms of what the core competencies are required for success. And so I find it the one that's most challenging, the one that I think you'd get the most conviction just with repetition.

It's about pattern recognition after seeing this stuff for a while.

[00:15:05] Lloyd Metz: Oh, now we'll say, Doug, we do try to take some of the artistry out of the assessment because a lot of times what we're trying to compare against is the leadership team's stated objectives, right? Because they're saying we want to consolidate the industry or we want to double or triple the size of the business and here's how we want to do it.

So you kind of take the components of what they aspire to do, what their plan is. And then you talk to them about it and figure out how do they think about it? How are they planning? How are they anticipating the needs or not, as well as their previous experience, right? So we try to align it as close as we can to what they say they're aspiring to do.

[00:15:48] Doug McCormick: I would say it's like any multifaceted problem. The more you can break it down into its component factors and isolate what's really important versus not, it's helpful.

[00:15:58] Lloyd Metz: That's right.

[00:15:58] Doug McCormick: If I could just introduce a slightly different way to think about this topic. As I think about this discussion, I think we're missing one key important angle.

Lloyd, you started off saying, Hey, we're going to engage these specialists to help us drive conclusions. And I do think this program management role that the private equity sponsor plays is a really critical one because you've engaged all these specialists. That's like specialist doctors, right? To assess a certain issue.

And then the private equity firm needs to consolidate that into a cohesive view. And I think there are two other things that happen there. One is I think that the private equity sponsor owns the assessment of business model, quality of business model. And you don't get that by any of these reports individually, but I think in aggregate you get a sense of.

How attractive is the business model? And then the other thing that happens is I think good firms are developing their value creation playbook during the diligence period. And that's also outcropping of this set of work streams so that when you do get the deal done, you're not just betting on their forecast, you're betting on their forecast plus things you think you're going to bring to the table.

And so I think Understanding that programmatic rule and then understanding what we retain for ourselves to own in terms of assessment's important.

[00:17:12] Lloyd Metz: Yeah, Doug, I'm glad you brought that up. Cause I would hate for our listeners to think that we kick back, put our feet up on the desk, outsource everything, and then wait for the reports to show back up.

And then. Opine on whether we move forward on a deal or not.

[00:17:25] Sean Mooney: Do you do that before or after you're getting on the G5?

[00:17:30] Lloyd Metz: What's a G5?

[00:17:33] Sean Mooney: A big Gulf Stream that apparently everyone thinks everyone in private equity flies on, but I've never been on one. For me, it's called Southwest Airlines. It's a

[00:17:43] Lloyd Metz: avoid the middle seat.

[00:17:45] Doug McCormick: It's not even a G wagon. It's a geo.

[00:17:50] Lloyd Metz: This episode is brought to you by HCI equity partners, a lower middle market, private equity firm focused on partnering with family and founder owned manufacturing service and distribution companies, ICV partners. An innovative private equity firm supporting management teams of leading companies at the lower end of the middle market and BluWave, the business builders network, connecting the most proactive business builders in the world with the best of the best service providers for critical variable on point and on time due diligence and value creation needs.

Now back to the episode.

[00:18:32] Sean Mooney: I think those are spot on observations and maybe to frame this up a little further. What I'd love to dig deeper into is how do you sequence these and maybe for our listeners let's frame it this way. These are very expensive products, right? And so you're going to sequence them really in kind of a natural order of gaining conviction.

So quality of earnings review where you're doing the accounting assessment at the low end that can be in the 50, 000 to 60, 000, maybe a little bit lower, but those can go into the hundreds of thousands of dollars. A market study, it can be at the low end, 100, 000 to many hundreds of thousands of dollars.

And for large companies, sometimes into the millions and then management team assessments can be in the tens to many tens of thousands of dollars. This is something you're not going to take lightly in terms of cutting checks. So. You're going into a process with a company. How do you think about, A, maybe doing some of this testing yourself first, and then for the big three anyways, in what order would you typically kind of bring in a quality of earnings review, a management assessment, a market study, et cetera?

And like, how do you think about, we're going to test first and then start spending some pretty big

[00:19:49] Doug McCormick: bucks? Yeah, Sean, maybe I'll take a stab at part of that. So I think a lot of this is process dependent. And when I say process, what is the banking? dynamic, right? So are they trying to run a broad auction where to be competitive, you need to do some of this ahead of an LOI?

Where we play in the marketplace, we feel like the businesses that we're pursuing, we know pretty well. And so we're pretty good at not giving false positives. We don't do much of this work for the LOI. When we realize we have a deal, then we're basically saying, okay, now we got 60 days to run hard, spend money to validate the assumptions upon which the deal was based.

So for me, I would say, If we get to an LOI, pretty high probability we're going to end up closing and we're going to kick off the Q of E in the market study almost immediately. Not necessarily because one's more important than the others, but because they're also relatively long lead time, especially the Q of E.

And so that's going to take you 30 to 45 days and then you got to use that to socialize it with the banks, et cetera. So I think that we would say there's a bright line starting point of the LOI. I do think we haven't talked about it much, but financing is also a big deal in this diligence stream. Not that it's a diligence process per se, but in many cases, the deals we're doing, we're financing half the purchase price with debt.

And so you're bringing a lender or lenders along in the process. To a different underwriting standard, but still you have to do their work as well.

[00:21:11] Lloyd Metz: Yeah, that's a good point, Doug. And again, people may think that the diligence is entirely for us. Not always, right. It's a lot of it's for the lenders, right.

To finance our deal. And I don't know if you bring in your LPs as co investors, Doug, but oftentimes if you do, you need your diligence reports and findings for them as well. In terms of sequencing, it's interesting, Sean, a good question. If you are in a process with investment bankers, what they want to know is, is there diligence outstanding for you to do that's going to affect valuation.

So make sure that there's nothing out there that could lower your price that you're offering or second, that will have you change your mind and walk away from the deal, lose conviction, lose interest entirely. So they want to make sure those elements of diligence are done. As early as humanly possible.

So I think that's where you've started to see the trend of sell side Q of these right where the company that's being sold hires the accountant to produce a report that is available to everyone. They'll do a sell side market study. Same thing, make legal documents and legal disclosures available earlier and IT reports from the sell side as well so that a prospective buyer just reviews all of these documents and it kind of cuts down the amount of time that you need to come to this firm of an offer or maybe it's an ironclad firm offer depending on your familiarity with the company and the industry.

[00:22:49] Doug McCormick: I see that in some deals as well. I still don't think it transfers the risk. But it transfers the transparency upon which the offer is made, right? So when somebody provides me all of those self signed prepared materials, I say, my bid is based on your materials. I'm going to go validate those. They've probably done a good job of making sure that they fully.

navigated and disclosed all the challenging points. They know what the hot buttons are going to be. So I do think it eliminates risk. I still think it's the seller's risk until the buyer gets to validate it.

[00:23:20] Lloyd Metz: I think that's right.

[00:23:21] Sean Mooney: And I think you're both your points around this idea of sellers wanting to compress time is really important, particularly investment bankers.

And so you're right. The thing that's been a huge emergent trend over the last five, maybe even 10 years has been this. Sell side report phenomenon. And why does that occur? And tell me if I'm off here and this might be a little bit provocative, but if you go back into like, I'd say the pre modern era of PE, and let's just call this like pre 2010 where the buy side had the leverage and the market much more so than those who are selling because there wasn't that much private equity out there.

Certain firms, and I think this is the exception rather than the rule, would use a quality of earning study to say, Whoa, your numbers are much differently and maybe advantageously. So, so they could retrain a price. And then, Oh, we found out your market size is smaller, or in the team is a little harder because to Doug point, that's more of the artistry.

And so what happened was the investment bankers started saying, well, we're going to take that opportunity to retrain off the table. So we're going to give you a quality of earning study Before you even show up to put your bids in, we're going to make it available to all the buyers. We're going to give you a market study, which came next in the evolution.

But then what happened is, then they've realized that if you are doing your own quality of earning study and your own sell side market study, You get to then take the line and move it to the farthest, most advantageous side of Gap. You get to say the market is the highest, so now the onus is on the private equity firms to go, whoa, whoa, whoa, whoa, whoa, whoa.

You paid another group just to take it to the shiniest story possible, so now we gotta bring it back. So there's always been this tension that exists between Sellers who have huge incentives to make this thing the best apparition of this business possible. Whereas the buyers are saying, no, that's not true.

So you can meet in the middle. And it's interesting how that pendulum That swung back and forth. And it's one of the biggest things that I think in the tension of the market, in the meantime, investment bankers are sounding like, I want you to close in 10 days, not 90.

[00:25:26] Lloyd Metz: That's right. Part of what we're talking about, what is the private equity firm doing with all these service providers out there?

Well, part of what we're trying to figure out is what's most important. What might we possibly find out in a market study? What elements of the Q of E, what elements of management assessment Red flags, stop what you're doing, put your pencils down. We don't want to do this investment versus, okay, that's an issue.

It can be addressed through price or structure, or we can fix it later. And so it's something to note, but it's not a go, no go deal breaking kind of factor. And honestly, I think the same applies to legal, which we haven't talked much about it or insurance. But part of what you're trying to do is figure out what are the deal breakers or what's going to change our view on the opportunity, what's going to change our view as it relates to conviction.

The rest of it is what the bankers like to call confirmatory, make sure there's nothing completely missing or problematic or some springing liability or some lawsuit that hasn't been disclosed, all that kind of stuff.

[00:26:34] Sean Mooney: Well, let's get into legal and IT and insurance in one moment. One thing I'd like to do on just to round out these, the big three, if you will, is to talk about some of the considerations that any private equity firm has to use them.

I'll maybe pull back the curtain here on BluWave a little bit. These are three of the big ones that hundreds of PE firms calls for when they're doing diligence. And the number one every quarter for many years has been market study. Thank you. And the reason why we get called for commercial due diligence or aka market studies within a pretty large cadre of private equity is This whole concept of alpha and beta and what a lot of people don't know is the way that these market studies are done Is a market study will call what's known as an expert network and the expert network will bring in People who really know about something and they'll sell time an hour call to all these things are tremendously helpful And many private equity firms will also use these as well as a pre inform a perspective Before they even get to spending money and we use them extensively in my life and what happens is that If it's a generalist commercial due diligence group that doesn't have a specialized either vertical within that firm or significant experience, they'll call an expert network.

That expert network It's going to be the same expert network used by a, the other private equity firms that use them, but be used by the sell side, commercial due diligence. And so what happens is, is everyone's getting the same information and then both sides are paying hundreds of thousands of dollars for it.

And so one of the things that we've really evolved in this whole concept, and this goes really through the whole stack is this idea of like, they want specialized knowledge, because what we've talked about throughout this series of episodes here is. The need for alpha, meaning creating something better than what the market can do versus beta.

And so one of the things that I would just encourage people who are getting into this business or in it is. Seek the groups that know something that doesn't require having to speak to an expert network. Doesn't mean they shouldn't do it, but they already know the answer because they do a lot of that and they're in the boardrooms of those customers every day and they know exactly what's going on.

Then you're going to get alpha that's going to inform your value creation plan. And if you're paying hundreds of thousands of dollars for it, you should expect that. And so actually what's happening, a lot of the commercial diligence groups, they're building industry verticals. So that's important. And that extends to quality earnings too, but less so, right?

The numbers are kind of the numbers, but if you're in areas like healthcare or specific accounting nuances, like contract based accounting, those are areas where you want specialization. And then management study, that's artistry. So does that resonate with you all?

[00:29:12] Lloyd Metz: It does.

[00:29:13] Doug McCormick: Yeah. I think really what you're saying is the studies that have the most value is when you're paying, not for the smart people that did the work on your project, but the intellectual property that differentiated them when you hired them.

And it's that unique industry expertise or it's the management assessment. I'm a huge fan of working with firms that are doing management assessments where they have a body of work that allows them to benchmark. Here's what the assessment said. Here's what the. results would say in terms of what were the key indicators of success or failure?

[00:29:44] Lloyd Metz: Yeah, Sean, what you've touched on is honestly what we're all looking for. I think in most private equity firms, when you're doing diligence, what's that insight that'll give us an informed view different than the competitive field that we're up against? And honestly, sometimes the consultants that you hire for market studies, They can deliver insights, right?

Some can.

[00:30:04] Sean Mooney: And that's the whole point. It's like you hit it right on. It's because everyone, if you go back to economics 101, when we took that class in college or high school, right? It's supply and demand. If you don't know something different than anyone else, you're just buying in a near perfect competitive environment, which arguably private equity is getting into.

You're just buying at that intersection of supply and demand. If you remember those little curves with surplus being skimmed. And that would give me, I'd have to pop like a can of Tums, every diligence process. Cause I'm like, Oh, I'm getting Econ 101. And so it's this whole idea of like, I need someone who's going to give me something different.

And really where we start off in the beginning of this is, it's not only confirmatory diligence now, all these products are really geared about. Tell me something no one else knows, and I want to take that group off the table so no one else can have them. And so it's like, how do I have a different perspective in a way that I can bend shape and time that others can't because now my model looks different than theirs.

And then I can gain conviction that I should pay this price, which in a sane world, if you're beating 200 other private equity firms that are also really smart, You're like, how do I get conviction that I'm not just paying the highest price? And so that's why all this specialization that you both have talked about so much.

I think it's so important.

[00:31:21] Doug McCormick: Hey, Lloyd, congratulations. You just won the auction process. You happen to be the high bidder out of the other 200 guys who all believe this was a proprietary deal.

[00:31:32] Sean Mooney: And when you lose, you are the cover

[00:31:34] Doug McCormick: bid. You came in second. Don't worry. Story of my life. Hey, Sean, can I just highlight one nuance to the way you describe this evolution of sell side work product?

I think that's true, but I think it only makes sense for relatively big assets, right? So if you're a hundred million dollar EV business, enterprise value, and you spend a million bucks on sell side prep, it always makes sense, right? But if you're a 20 million, you're a 10 million, you're a 30 million, I think it's very debatable.

And I would say the other thing. That the sell side prep work does, which can be a value, is back to this compression of time. I think one of the consistent themes we see in the marketplace is the combination of entrepreneurial optimism, inexperience, and a banker who wants to drive for maximum value often results in over optimistic short term forecasts.

And I see so many sellers who get themselves in a situation where they believe in the business, they have long term conviction, and I believe it's true, but they've signed themselves up for something that is probably too ambitious in the near term. And all these processes take longer than everybody thinks.

And so then they sign something up under LOI and there's time and that time represents the opportunity to miss, right? And so I think that's like one of the big gotchas out there. And I don't think it's intentional. I just think it's experience in how these processes work. Lloyd, you're laughing. What's going on?

[00:33:01] Lloyd Metz: I'm laughing because you don't think it's intentional. I think the compression of time by bankers is exactly to address that

[00:33:07] Doug McCormick: point. I think that is, I think people get themselves into the circumstance of writing a check they can't cash without

[00:33:13] Lloyd Metz: intention. Yeah, I get that.

[00:33:15] Doug McCormick: And that

[00:33:16] Sean Mooney: was the story of the M& A markets last year.

So Doug, I think your point is like spot on, like we're going to lead with our hearts, not our brains on our forecasts. And we're trying to get it. Yeah. Process after process after process last year just crumbled under the weight of exactly the topics you're talking about, Doug. So I think it's really good advice and observation.

[00:33:37] Doug McCormick: It's a little counterintuitive, right? But leave some money on the table, give yourself a forecast that you're going to hit with 95 percent probability, and you may have earned a little less, but you did it with much more certainty.

[00:33:48] Sean Mooney: I'm an arithmetic and algebra person. If I could do calculus, I would have become a hedge fund guy.

So there's this great concept of just very simple, expected value. The size of the outcome times, the probability of success. And to your point, it's like, you could go big and like swing for the fences, but you're only going to one in how many at that. So you're going to hit that. And so it's like, try to get a single,

[00:34:10] Doug McCormick: get on base.

And guys like me and Lloyd are bidding off LTM EBITDA until you miss your forward.

[00:34:18] Lloyd Metz: Absolutely. Doug, keep that down. I

[00:34:21] Sean Mooney: think we did a good job covering the big three, if you will. So let's talk about, you've kind of figured out you've gained conviction on market. You've gotten confidence in the team. You've gained confidence in the numbers.

Now what comes next? You're under LOI and you're running for the finish line here. What are you doing during each of legal IT and insurance? Why are you doing it? What does it give you?

[00:34:47] Lloyd Metz: So a couple of things, depending on the nature of the business and the business model, back to Doug's point about private equity professionals are supposed to be diligencing the business model.

If technology is an important element to the business model, either currently or in the near term, then IT diligence moves up. For example, in one case, we invested in a company and we moved IT diligence up to pre close because we had a view, we'd had the. Either rebuild, rewrite, or both the existing system that the business was running on for a variety of reasons.

And we actually wound up doing it post close, but we did that assessment and diligence pre close. Other than that, IT diligence can run after the big three, as you put it. Legal winds up being meaningful because you don't know what you don't know. You want to make sure there's, whether it's benefits, HR, employee matters, underfunded pensions, if that is out there, there's a whole range, tax issues, state tax nexus, or.

Unpaid taxes or who knows what you want to cover all those bases just to make sure there's nothing out there that'll come up and bite you. But you're also starting to do work on the purchase agreement and that's where you start to factor all those things in. But I think a lot of people spend time, money, and emotional energy around a purchase agreement, or I'm not so sure that's necessary, right?

The way the markets evolve, purchase agreements don't last very long and risk. Is laid off onto insurance companies. So I don't think you really need to spend a lot of time with purchase agreements. It's a credit agreement that you got to live with for five years. And that's worth spending some time on from a legal perspective.

So that's how I think about legal and it.

[00:36:38] Doug McCormick: I think legal is the area where if you don't have lots of experience in the business is the most likely to get away from you for anybody that's ever built a house. It's kind of like. an architect firm, right? Like, before you know it, you've spent a ton of money on a really complicated house build, and it's maybe not so practical.

The other challenge with the purchase agreement is, it's the most collaborative document here between buyer and seller, and so there are multiple iterations and multiple points of discovery, right? So, we draft the purchase agreement, seller tees up the first set of schedules, We didn't know a bunch of stuff that's on the schedules, which now impacts the purchase agreement.

Then we got to argue about what disclosures on the schedules occur. So it is a time intensive process that is probably, it's often not the most important, but the long pole in the tent to getting something done, just given that iterative nature.

[00:37:27] Sean Mooney: And to frame things legal for everyone, that can be in the hundreds of thousands of dollars by the time you get done to, depending on the size and complexity of the asset, in the millions, and the firm you're using, none to be named.

And so, It's big money, but it's really important, and it's hard to do, and you're right, it can get away. We used to spend so much time just basically assigning lawyers to be on and off calls because you knew. The clock spins very quickly in

[00:37:55] Doug McCormick: that. Sean, I think this is an area where good experienced private equity investors can really differentiate themselves.

Right, because a lot of times the risks that you get presented with, I would argue, are kind of esoteric. And it's very scary theoretically, but practically it's not, and a seller confronted with this for the first time is going to really struggle with understanding what it means to them. And I think good practical private equity buyers just go, yeah, that's not a risk I'm really worried about.

And so I think. Pragmatism on this part of the transaction, which is really just risk mitigation and to Lloyd's point, in many cases is insured. I think it's key. It's a huge point.

[00:38:34] Sean Mooney: Very often, depending on your advisor, they're hammers and everything looks like nails. Everything's equally scary. And particularly when you get into tax diligence, where anything could be scary and you can't get a straight answer.

So that's one of the best persons you could ever hire in my experience has been a really good tax attorney who's practical. The only thing I'll add to that point on these next two on it diligence, this is another area where we're seeing specialization become so important because there's software in almost every company now.

And if you're not careful about that, you can get in a lot of trouble. Go into a company and you look at the code and it's a jumbled mess and it's in different languages and no one at that company speaks any of those languages because they outsourced it over years. It could be millions of dollars of recalibrating a driver of the business, particularly in tech businesses, but tech enabled businesses.

And then the other thing I would just make sure that everyone's really mindful of today, which is cyber risk. So often these small and mid sized companies in particular don't know that there are barbarians well past the gates and they're looking at everything and they're waiting to pounce on the treasury.

And then when private equity comes in and a big check hits, particularly if they top up the cash to do some things right out of the gates, it can disappear in a moment. And so I would just say that's something that a lot of people are being really serious on because. BluWave our Friday at five call is we've been hacked.

And then we say, well, don't call us, call your insurance provider because they have a say in it. Does it resonate?

[00:40:05] Lloyd Metz: You totally beat me to it on the it more and more technology transformation is going to be part of a value creation plan, regardless of the industry that you're in. And so we are frequently using it diligence.

To obviously check the basics, but then, okay, what kind of condition are the information systems of the company and what could they be? What do they need to be? How easy will it be to transform this business, move to a different ERP, move to the cloud, whatever it is, we're trying to develop that point of view and diligence to inform the value creation plan.

[00:40:40] Doug McCormick: Yeah. Shauna just to put a point on one thing you said. So when you do a transaction, By definition, you have become a much higher risk of cyber attack, right? The event itself raises your profile in a way that you should be prepared for that.

[00:40:53] Sean Mooney: Very well said on both accounts. Let's bring it home. And the last one, and it's not necessarily last or certainly not least, but it usually kind of gets brought in at the end is what's called insurance due diligence.

What is that? Why is it used within the context of the transaction process that you are managing to get to a finish line?

[00:41:11] Doug McCormick: I think it's two things. One, it's a general review of what insurance is appropriate for the business that you're working with. And so that could be DNO insurance. It could be other kinds of practice insurance for the business.

And then there's often transaction insurance. And so that's rep and warranty insurance, which essentially is a product that ensures some of the risk owned by buyer or seller that's been allocated in the purchase agreement in a way that it becomes less controversial between buyer and seller. I think that is a helpful product, mitigate thorny issues between buyer and seller that do arise in the purchase agreement.

For the more novice listeners,

[00:41:51] Sean Mooney: rep and warranty insurance is something that's, I think, been a tremendous evolution in terms of speed and certainty of a transaction. What happens in a transaction is a seller has to make what's called representations and warranties, where the buyer is going to say, You need to certify in writing that all these things about your business are true or not.

And if they're not, you got to put them in this schedule and fess up. What used to happen is you would put amount of money to backstop those promises in representations you made. And it would always be really thorny afterwards because if something happened, usually because of act of God or they didn't know, then the seller of your business that you bought, who's also an owner of your new business, because they rolled over, you're going to say, you have to give us a lot of money back.

In the vast majority of cases, that seller was not doing something intentionally untruthful. It's just sometimes things escape. And so there's been this advent of insurance companies will say, okay, we'll look at this. And if there is something that. It wasn't fraud, we'll pay for it. And so that's been a really, I think, great product that's evolved that takes that tension out and then helps you close a lot faster and not leave money on the table.

Is that a fair way of describing it?

[00:42:57] Lloyd Metz: Yeah, that's a reasonably good description. Now, Doug, on the insurance front though, where we tend to focus more, it's not like we found a whole lot of tangible value for closing, but it's made us more aware is on the healthcare benefits, that part of the insurance diligence.

To figure out what are we dealing with and our healthcare costs, our insurance costs, are they likely to run up a lot or a whole lot going forward? And so to the extent they can suss that out, that's actually pretty useful. I find.

[00:43:31] Sean Mooney: I totally agree. And. The healthcare area is one that I, a real quick prior story as we'd come in and our broker would say, Hey, you gotta, we're going to change your benefits in this structure, or we're going to bring in a whole new network, not even change the benefits, but better than United healthcare.

We like XYZ healthcare. That's part of our ecosystem. So you move them there. And then day two, after you've closed a transaction, everyone's high fiving, you get 50 calls from really angry employees because they got to switch doctors, right? No, no, it's the same benefits. You know, we got you the same stuff.

It's just moved it. Like, Nope, my kids now have to get a new. Pediatrician, you're like, Oh, that's

[00:44:09] Lloyd Metz: not good.

[00:44:11] Sean Mooney: And the only other inside baseball thing I would say on this, just because we see these things across large populations is insurance is also the big area where I think there's still inefficiencies in some parts of the market.

And so there are some brokers that do this. They typically provide this diligence for free. And the question is if you're getting for something free, it's like Facebook, you are the product. And so sometimes. The vast majority of the brokers will go out and they will do a competitive process and say, what is really the market for these types of coverages?

There are some that we'll use as an opportunity of kind of upcharging on certain coverage areas. And so I would just encourage, particularly for CEOs who are doing this and doing this type of diligence into their process, just to make sure that whatever you're doing is part of a competitive process that gets you.

At least where the market is, you don't want to be a premium. And like I said, it's 80 percent of the market is really good at this, but there's going to be 20 that may give you some premium pricing on some stuff. I

[00:45:12] Lloyd Metz: think that's right, Sean. And not to say anything negative about all of our service providers, but the nature of private equity being on the clock and sensitive to time and trying to get things done faster, I think.

It's easy to be charged a premium for any of these services if you're not careful. And I think the insurance brokers and insurance diligence folks, they factor that in because we usually give them days to figure this stuff out. And so they charge a lot.

[00:45:42] Sean Mooney: And that's a very fair point. If there's anyone, you know, the concept of like smoke jumpers where they got to come in at the last end, it's the insurance people who are brought in at the very end.

And that is a tremendously hustle and bustle. service that's very

[00:45:56] Doug McCormick: important. So I think that's a very good point as well. I guess I'd ask Sean and Lloyd. So we talked about all these different work streams that go into the diligence process. So Lloyd, with all that work, how predictive is the work to the underwriting?

[00:46:10] Lloyd Metz: I'm thinking back to Investments that have performed well, despite what we underwrote, performed well, and tracked to the underwriting, underperformed underwriting, and oftentimes these elements of the diligence actually turned out pretty accurate. I can think of like one exception, which we talk about tail risk.

We caught that tail risk for sure. Other times it's largely been a function of. the organization, the leadership and the execution for both overperforming and underperforming.

[00:46:44] Doug McCormick: You know how we said that the management assessment is the art of the business? For me, I think the other art is translating all the work streams we just did, which I think give you a great picture to as is, and then using that to forecast what will be.

And I think that's really hard because you're doing it under a compressed timeline and a competitive dynamic, limited access to management team, maybe because you've got a good banker that's managing. That depth of interaction. And so I think just two things we think about in mitigating that challenge is one, this whole concept of optionality.

We hate businesses where there's one way to make a lot of money. And if you miss that one way, everything else is kind of inconsequential. So we think about like optionality and there's three or four things we think could really drive the growth of the business. And then I can't tell you how many times we've done consolidations where the first one we did okay.

But then the second or third or fourth acquisition, we hit it really well. And it was almost like, I wish I could have avoided that first one, but I couldn't have gotten the third one had I not made the investment in the first one. And so it highlights the difference between underwriting the thesis versus the asset.

[00:47:53] Lloyd Metz: Great points.

[00:47:55] Doug McCormick: I

[00:47:55] Sean Mooney: think those are both really well said. And it kind of goes back to like the whole premise of this podcast here. It's like that best but never final. You can understand maybe 8 percent of that picture, but it's the 20 percent that gets you. And then it's tenacity, grit, turning left and right.

And you're just always going to be improving and something will always like some black swans, always going to kind of swing right across your face. So I think you're a thousand percent right. Well, I think we have covered another really foundational episode of the how and why of private equity in terms of doing what it does, but Well, so acknowledging you do all this work and then guess what?

Everything wasn't Mike Tyson said, uh, everyone's got to plan until they get punched in the nose. And then, and then you begin a new, so another great episode, gentlemen, thank you so much.

[00:48:44] Lloyd Metz: Thanks, Sean.

[00:48:45] Doug McCormick: Thanks, guys. A special thanks to HCI Equity Partners, a lower middle market private equity firm focused on driving transformational growth through consolidation strategies by partnering with family and founder owned manufacturing, services, and distribution companies.

Learn more at hciequity. com. ICV Partners, an innovative, Lower middle market, private equity firm supporting management teams of leading companies at the lower end of the middle market. Learn more about ICV at icvpartners. com. And finally, BluWave, the business builders network connecting the most proactive business builders in the world with the best of the best service providers for critical, variable, and On point and on time due diligence and value creation needs.

Learn more about BluWave at BluWave. net. For further information on HCI, ICV and BluWave and relevant topics discussed here in the episode, please see the episode notes for links.

[00:49:47] Sean Mooney: The views and opinions expressed in this program are those of the individuals presenting and do not necessarily reflect the views or positions of any other persons or entities including those referenced herein.

Join Doug McCormick from Oridian Capital Partners, Lloyd Metz from ICV Partners, and Sean Mooney from BluWave as they explore timely private equity topics and offer their seasoned perspectives on crucial areas of focus within the industry. Gain valuable insights from these industry experts in this engaging podcast tailored for PE professionals.