PE Q&A: BDO’s Ryan Guthrie Discusses Due Diligence in the Current PE Market
June 26, 2014
Q: What’s your view on the current state of the market? From our vantage point, valuations are obviously pretty high right now, but deal flow hasn’t subsided too much, at least in the middle market, so it seems that investors are looking past the price tag on some of these deals.
A: I think you’re right; it’s pretty frothy from a valuations standpoint. Buyers have been thirsty for deal flow, and you’re seeing a flock to quality companies with no shortage of buyers, certainly, and a bidding up of valuations. This is partly due to the resurgence in cash-flow lending, so you’re seeing high leverage multiples, as well.
On a related note, are any of these high valuations having an impact on due diligence, particularly on the buy side?
With higher valuations, I think there’s perhaps a need for even more thorough due diligence. If you’re paying the price for a solid-gold brick, you’re going to want to make sure that it’s really solid gold. This includes thorough analyses around the operations of the business to determine what’s really driving its growth and to make sure that your return assumptions can hold up. There might be sensitivity around findings that impact earnings as well, because if you’re paying a high multiple of earnings and there’s a negative adjustment to earnings as a result of diligence, then that multiplier effect would exacerbate because of those findings.
Another trend we are seeing, and it’s related to the current competitive environment, is the lack of exclusivity when doing due diligence. Today, buyers are required to do due diligence without exclusivity. Sellers can make such demands given the demand in the market. We’re also seeing more due diligence being done pre-bid and pre-letter of intent (LOI), which means buyers are either taking a more phased approach as well as committing to doing diligence before locking up a deal.
Are these high valuations bringing about more broken deals?
No, and I think the reason for that is that there’s no shortage of buyers and there’s no shortage of cash. The processes that are typically run to sell a business are efficient in either closing the deal with the primary buyer or a secondary buyer. That’s why you’re seeing processes that don’t have exclusivity for one buyer all the way to the end.
Regarding all the new healthcare-related regulations coming in, especially connected to the Affordable Care Act, how are those new rules affecting due diligence on the buy-side?
We are seeing a lot of consolidation on the provider side and a more defensible healthcare model that deals with regulations that will lower reimbursement or reduce profitability. So, in that vein, due diligence has been geared to address ongoing costs to provide services and the changing environment for these providers.
Are there any sub-sectors of the healthcare industry that are getting more private equity attention at the moment?
What we’re seeing from private equity investors is a push toward investments in companies that can either improve the quality of care or reduce the cost of healthcare, such as companies that are consulting with healthcare networks or employers, benefit management software or alternative healthcare services.
How do you see the second half of 2014 shaping up?
I think the second half is going to be very busy. We have a strong indicator for that as we provide due diligence for both buy- and sell-side activity. We’ve been inundated with proposals for sell-side work, with about as many sell-side engagements right now as we have buy-side engagements. These are obviously preparation-phase proposals for deals that will come to market over the next month or two. PE buyers will see those companies and will work to close those deals in the second half of the year. Overall, I think the market has a ton of momentum right now.
Additionally, private equity groups that believe valuations are out-of-line or too frothy are focusing more attention on what they have in their portfolios that they can sell. In essence they have become net sellers, and exits of these businesses will help fuel the second half of 2014 deal flow.