Private equity firms typically use a combination of internal and external resources to execute their due diligence on acquisition targets.  These professionals focus on various elements of risk and opportunity throughout the due diligence period, and thereby inform decisions on valuation, how to treat key elements of the purchase agreement that cover various economic terms and ultimately leverage their insights into post acquisition value creation plans. It may not be obvious at first but there are certain elements of due diligence that can substantially aid both equity and credit investors, create alignment and compel a greater sense of partnership.  A key premise of this post is that the areas which equity investors typically focus on during due diligence also contribute value to their lenders (for both ABL and Cash Flow loans).

This post includes:

• A general introduction to how due diligence informs decisions related to financing through three illustrative scenarios
• A framework for how specific types of credit financing rely on information that PE firms typically gather during due diligence
• Ways in which financial sponsors and their advisors can help lenders understand investment dynamics with the aim of creating win-win outcomes

By virtue of their deep involvement in the analysis of receivables, inventories, supply chain dynamics, customer agreements, and a focus on the underlying (un-levered) profitability of target acquisitions, investors position themselves to provide key data and insights needed for their investment and for those of their financing partners.

Due Diligence Scenario 1:  Growth Equity Transactions

• Equity investors are focused on understanding the growth and profitability plans of the target company.  In particular, they are typically concerned with the specific strategies for pursuing market new opportunities, the end markets themselves, and figuring out how to mitigate certain risks associated with growth and the timing of certain investments or capability builds.

• Lenders are focused on similar issues however they are concerned with the capital intensiveness of expansion, the time required to generate returns on investment, the expected return on invested capital and the impact on liquidity across a number of potential growth scenarios.  Given their “downside focus”, they are usually most focused on risks associated with execution of the base/existing business.  Lenders will focus on various metrics that depend on EBITDA levels, such as a net leverage ratio covenant, which takes into account net debt (total debt less cash) divided by EBITDA.  Lender are also keenly focused on the company’s “cost to grow” in the form of additional working capital and fixed capital investments that may be necessary as revenue grows.

Due Diligence Scenario 2:  Carve-out Transactions

• Investment firms will be focused on the costs and amount of time required to extract carve-outs from their parent company and establish the business as a stand-alone organization.  The costs and time required to do this can be substantial and also place stress on the operating business and its management team; failure to execute well can put the business at significant risk.

• Lenders are focused on the same items and will typically include a basket of funds that are specifically excluded from the credit agreement EBITDA calculation used to determine covenant compliance.  These “baskets” or exclusions are typically discretely identified during the underwriting process and are based on costs that the equity sponsor identifies.  This means that investors must be thoughtful about not only the quantum but also the timing of carve-out costs and ensure that management is equally aware of assumptions made in the debt underwriting process.

Due Diligence Scenario 3:  Turnaround Transactions:

• Investor’s efforts will be focused on determining the path for returning the business to profitability, as well as the timing of likely substantial swings in cash flows.  Elements such as cyclicality or seasonality will have to be carefully considered so that covenant levels are set appropriately, and sufficient liquidity is maintained. Further, the cash flow profile of the business should be reviewed in detail as banks may allow for a period during which interest or principal payments can be made “in kind” vs. “in cash”, reducing the strain on liquidity as the business returns to performance (or provide alternatives like amortization holidays etc.). It is critical to understand the company’s anticipated path towards profitability and build some hedge or contingency into the cash flow planning.

• Lenders that support turnaround investments are generally very sophisticated and their due diligence efforts often mirror those of an equity sponsor.  On crucial difference between debt and equity investors is their degree of focus on downside risk vs. upside potential.  Equity investors typically retain most, or all of the upside benefits associated with investment performance while credit investors are most focused on what can put their initial capital at risk (that is, downside scenarios).  In fact, many creditors will conduct liquidation value assessments during their underwriting process in case they eventually find themselves taking ownership of the asset and determining the best course for optimizing their returns.  Transparency and frequency of communication early in the process is critical to ensure that financing parties understand the assumptions being sued to forecast various levels of profitability. 

Due Diligence, LBO financing and borrower operations:

Most leveraged buyout (LBO) transactions rely on two types of financing in order to obtain the funds necessary to complete a transaction:

• Asset Based Lending, in which case the lender is highly focused on the value of collateral being lent against (typically working capital assets, but also sometimes machinery and equipment, or other assets)
• Cash Flow Loans, in which case the lender is highly focused on the underlying cash generation capacity of the business and its ability to repay the interest and principal of the loan.

Asset Based Lending:

These loans typically rely on a formulaic calculation of a borrowing base, which is the amount that can be borrowed against a collection of assets that the lender views as collateral for their loan.  The borrowing base is usually determined by a lender’s willingness to lend an amount expressed as some percentage of the borrower’s accounts receivable and inventory.  A typical formula for determining availability of funds against working capital could be 85% of net accounts receivable and 50% of the borrower’s net inventory.  This, however, is a gross oversimplification of the process and is meant for illustrative purposes only.  Some additional factors or levers to consider for an ABL are:

1. Advance rate variability
2. Exclusions from the borrowing base

Accounts Receivable:

Lenders know that all accounts receivable (AR) are not created equal and that they must analyze the balances, their aging profile, geographic make-up and customer concentration.  Lenders will be concerned bout the countries where the customers generating those balances are coming from, the creditworthiness of those customers, the historical rates of loss associated with collections activities and the overall concentration of accounts receivable.

Lenders will also seek to understand certain operating factors such as if the borrower’s customers can purchase similar products from other suppliers or if the borrower’s customers are dependent upon it for the products they purchase.  Understanding this will help the lenders determine the probability of AR collection under stress, and thus the advance rate or exclusions that they will apply against the total receivables. ABL lenders will examine AR closely.

Inventory:

Similar to accounts receivable, lenders will analyze inventories in a way that aims to understand how easily they can be converted to cash.  For example, considerations such as how customized or commodity-like the inventory is will weigh into that calculus.  The categories that are most likely to be monetized are raw materials and finished goods.  As is the case for accounts receivable, the lender will concern itself with the location of the inventory (that is, can they obtain liens against the assets), its quality (that is, the freshness or frequency of turnover) and the number of outlets for its sale in the event of default.  ABL lenders will scrutinize Inventory closely.

Asset based Loans (ABLs) can be used in a number of ways.  They can often be an inexpensive source of debt given the collateral that stands behind them and readily used to finance a transaction or periodic swings in working capital.  ABLs enable managers to keep relatively small amounts of cash on the balance sheet and use the ABL to mange intra period fluctuations.  Given the relatively low undrawn fees associated with ABLs, it makes sense to maximize the amount of ABL funding offered.

Cash Flow Loans:

Cash flow loans are usually larger traches of debt than ABLs.  While both may be part of a post-acquisition capital structure, lenders of cash flow loans are usually less concerned with the physical assets of a business and more focused on the underlying profitability and cash flow generation capacity of a business.  While ABL facilities are provided on the basis of the lender being able to recover whatever amount is drawn in the case of default (typically done via liquidation analysis), cash flow loans are made on the basis of the borrower’s ability to sustain the generation of a certain amount of cash flow in order to cover interest and principal payments.

Cash flow-based loans do not require the borrower to have the cash flow generation capacity to service the borrowed amount immediately post acquisition.  In fact, with sufficient insight into the target company’s operations and the private equity firm’s turnaround or carve-out plans, a lender may make concessions that allow management teams the time they need to execute their plans, even if that requires a 12 to 18 month period during which significant amounts of cash are consumed along the path to profitability.

When obtaining financing for a carve-out or turnaround transaction, investors can be particularly valuable in the process of explaining the costs and paybacks associated with initiatives related to the restructuring or one-time costs associated with the carve-out.

Carve-out transactions:

Similar to restructuring plans, investors must put together detailed plans relating to the costs associated with executing the carve-out of a target.  These plans typically include but are not limited to:

• Costs associated with relocating facilities
• Some amount of cost associated with hiring or recruiting a management team or key members
• May include costs associated with separating from shared logistics or manufacturing operations
• Rebranding or marketing costs associated with the establishment of a new corporate identity
• Financial costs such as stand-alone audit and tax fees, or the development of functions previously managed by the parent company such as treasury
• Replacement of other functions formerly handled by the parent company, which can range from a handful of people performing legal or accounting functions to warehousing, manufacturing and selling headcount previously shared between two or more businesses. 
• ERP/IT systems are another key area to examine and can have the highest costs and take the longest to execute.
• The cost of advisors or consultants contemplated to execute the carve-out

Again, by sharing these due diligence generated plans with lenders, borrowers can jointly craft important provisions of the debt agreements alongside lenders to 1.) develop a credit agreement that provides the private equity sponsor and management flexibility and 2.) gives creditors the protection and comfort they need to determine the point at which the carve-out (or restructuring efforts) will be complete and the result will be a successful standalone company.

Turnaround Transactions:

Let us begin by defining a turnaround candidate as a company that is underperforming against peer benchmarks by a significant margin, has seen recent substantial deterioration in its fundamentals requiring operational or strategic changes or is in financial distress.  During the initial stages of a transaction the company is typically generated low or negative profit margins and may require a cash intensive restructuring to begin moving its financial results in the right direction. Large ABL loans may be the only way to finance money-losing turnarounds in the short term.

Investors work alongside management during the due diligence process to put together plans for how the restructuring will be executed, usually with increasing detail as the deal progresses.  These plans typically contain:

• An amount of severance associated with labor restructuring
• Non-labor restructuring in the form of costs to exit/consolidate facilities, decommission or move capital equipment, exit or extinguish unfavorable contracts, etc.
• Funding operating losses until the turnaround is expected to be complete
• Evaluate the existence of need for bringing underinvested assets up to acceptable condition (cash starved businesses typically constrict Capex and thus in effect defer it for a future buyer)
• Many of the same items as were listed in association with carve-out transactions.

By providing the above details, a lender will be able to understand the quantum and timing of expenditures and construct a customized credit agreement for the borrower.  It is usually best practice to err on the side of detail for the benefit of bringing lenders into the process with you and making sure that they understand how or why results deviate from time to time because they will have had the benefit of understanding the base case plan.

Conclusion:

Regardless of the state of the borrower, pre-acquisition or post-acquisition, investors and borrowers can leverage many of the same elements of information to create win-win outcomes.  Increasing the transparency between investor and lender (if the lender is indeed partnership minded and the investor is acting in good faith), can result in a case that benefits management and investors (both debt and equity) in the event of unforeseen circumstances.   Accomplishing all of the above takes the understanding and communication of operational elements in a clear manner with assumptions articulated well for the benefit of all.