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Private equity due diligence: 3 ways strong relationships streamline the process

The private capital landscape in 2023 resembles one big boomtime hangover, with plenty of negative returns, falling post-money valuations, and a new class of zombie firms. As unfortunate as these conditions are, they’re a natural consequence of what Fortune journalists call the FOMO-driven check writing of the past 3 years. These conditions aren’t the result of a systemic brokenness, but rather a basal feeding frenzy.

This is good news for private equity, venture capital, and strategic acquirers, because it means deal sponsors can get themselves out of this problematic situation as easily as they got into it. Experts are already calling for behavior change in the form of improved, deeper, more comprehensive due diligence work. But to conduct better due diligence in 2023, you’ll need to build it on a firm relational foundation.

Too many dealmakers believe that relationship building in the private capital markets is solely for sourcing more and better deals, when in fact, better relationships also streamline private equity due diligence. Check out the top 3 ways building strong relationships can help you improve the private equity due diligence process.

1. Trust drives better cooperation from the target company for your due diligence checklist

When you’ve built a longstanding basis of trust, your target’s management team will give you the benefit of the doubt during the due diligence process, and will trust that your mutual goal is a fair valuation with no late-stage surprises.

A partner at a top VC fund noted that deals commonly fall through because, during the due diligence process, management teams either supply manipulated numbers or turn out to be reputational liabilities themselves. Strong relationships deter these pitfalls in two ways:

  • Neutralizing the motivations to lie — People put forth false information because they’re afraid of the blowback. Building trust attenuates that concern by counteracting fear. Target leaders know you well enough to know how you’ll respond when you learn of their weaknesses and past missteps. They’ll see you not as a threatening or judgmental critic, but as a partner who wants to help.
  • Revealing character flaws early on — The more contact you have with a person, the more opportunities you’ll have to explore their personal integrity. This allows red flags to show themselves earlier and more notably than without regular, ongoing contact. Your target will also recognize your group’s integrity and commitment to doing what’s right.

Put yourself in the shoes of your target’s leadership: Disclosing uncomfortable liabilities like pending lawsuits, obligations to third parties, data mismanagement, or unfavorable IRS audit results can feel torturous, because management knows that these “skeletons in the closet” will affect the deal’s value. Understandably, they hesitate.

But the earlier these menaces come to the light, the more profitable a deal will be — and not just for the buy side.

M&A advisors at Corum Group counsel private company leaders to disclose issues as early as the discovery phase to pave the way for a smooth transaction ahead. “Understand that issues that emerge late can damage trust and kill deals,” they write.

2. Rapport preserves goodwill from discovery to closing

Reflect on your relationship with your target’s founders and management team post-acquisition (or mid-integration, if the purchase is strategic). Is it amicable, or is it strained? The answer is largely influenced by the strength of your relationship in the discovery phase.

You need all the goodwill you can get from your target to make it through due diligence amicably. “It can be a highly intrusive situation for their business,” explained consultants at Pritchett. “Some [operators] are better than others about welcoming (or tolerating) your presence.”

To increase the number of targets that welcome your presence in “their business,” you must build stronger relationships early on in the process.

During the first few days of private equity due diligence, the due diligence checklist is usually not too invasive. A couple weeks in, however, and the annoyances usually begin. Founders (especially first-timers) are more tempted to hide or falsify value-changing details. If you don’t have a good relationship early on, you’ll feel that strain further in, when questions naturally and rightfully become more intrusive.

You must work right away towards building relationships that will preserve goodwill through the due diligence process and beyond. To help professionals understand how essential this step is, Chuck Davis, CEO of Stone Point Capital, compares the tedious, unglamorous work of building strategic relationship to training for a marathon.

“When the gun goes off at the start of the race, the race is basically over,” Davis said. “What you did or didn’t do in the last 6 months is going to dictate what happens in the next 2 to 4 hours.”

3. Strong relationships throughout the private equity due diligence process often generate more relationships

There are a variety of mid–due diligence scenarios that could unexpectedly expand and strengthen your network even further. When that happens, your private equity due diligence processes become well-oiled and more effective than before.

If you have a strong relationship with your target’s leaders, they’ll more readily point you in the right direction, introducing you to someone who can help with current or future issues.

For instance, imagine your target’s founder and CEO assigns their CFO to run point when collecting documentation for your due diligence checklist. The CFO comes up short on an answer, but puts you in touch with their trusted attorney, who happens to work for a top-notch sell-side law group you hadn’t known before. Collaborating on this one analysis created new connections.

In situations like these, be sure to nurture that rapport. Inform the group of your investment thesis, and ask them to keep an eye out for future deals that fall through — especially deals that might be a good fit for your team to continue and complete.

If an unfavorable surprise occurs during the private equity due diligence process, you’ll need to be able to navigate it nimbly: Building trust within your network can help you exceed expectations when handling situations like these.

Ron Williams, Operating Advisor at CD&R, recently told the story of a disconcerting discovery made far too late into the due diligence process. His group’s handling of the investigation, mitigation, and rectification of the issue relied on the deal sponsor’s established trust. This in turn generated even more confidence and attracted new customers and fresh talent.

“We discovered that the business had not been operated consistently with the correct compliance standards,” Williams said. “The fact that we self-identified these issues when we discovered them — [and] that we worked very diligently and aggressively, sparing no expense to correct the problems — rehabilitated the entity in that marketplace and maintained the continuity of customer relationships, ultimately cleaning up the historic regulatory issues.”

Williams also noted that the situation forced the group’s leaders to hire a skillset outside their usual wheelhouse, which ultimately improved future private equity due diligence work.

Leading private equity firms will build relationships to improve deal flow in 2023

When you build a thriving professional network just for business development, you sell yourself short: Strong professional friendships also benefit the due diligence process, which improves deal velocity. This velocity keeps deals inside the funnel moving, enabling optimal deal flow.

As in every downturn, dealmakers are taking stock to avoid a future repeat. This year, many are finding that their negligent due diligence has led to their current struggles. As a result, we’ll see a mass-recommitment to improved private equity due diligence — and we predict the most profitable deals executed this year will be transacted on the foundation of stronger, more trusting, confident relationships.

Intapp DealCloud is the only pipeline and relationship management system built specifically for private equity. To learn how your team can automate the tedious tasks involved in relationship building, schedule a demo today.