2021 was defined by a flurry of deal activity, where new deal value and exit records were broken repeatedly. However, since then, the private equity market has experienced a fundamental shift. Today, it’s less about what you can get with an asset than what you can do with it in the medium and long term—investors are keen to purchase assets with plenty of value creation potential.
How Have Diligence Approaches Changed?
Now more than ever, an integrated approach to diligence is vital. Target assets must be viewed holistically to identify suitable value creation opportunities, and these opportunities should be outlined and modelled in diligence.
So, Where Does Value Creation Come In?
In the current climate of economic uncertainty and geopolitical instability, the number of divestments has increased as firms seek to unload underperforming assets. Additionally, higher interest rates are lowering asset valuations. After a decade characterised by increasing private equity activity, growth through the number of acquisitions isn’t enough in the current economic climate. Instead, private equity firms must unlock asset value by focusing on key value creation drivers, which in the current market often centre around digital transformation and ESG.
Digital capabilities
Until relatively recently, an asset’s digital capabilities were often seen as a cost to be carefully controlled and managed. Today, however, digital capabilities (or the potential for them) are often the driving force behind a transaction, with the potential to unlock a huge amount of value with efficiency on spend.
However, some firms take unnecessary risks by not properly assessing assets’ digital capabilities, including infrastructure, as well as teams and culture. For example, pre-deal IT and cybersecurity assessments can often be overlooked. Instead, the diligence process may focus on operations or pure commercial performance. Even today, when digital capabilities have the power to make or break a business, some firms still see technology due diligence as a box-ticking exercise.
Technology due diligence
Technology due diligence can provide an invaluable roadmap for firms looking to acquire new assets which have significant untapped potential that would be accessible during the hold period. The insights can allow firms to identify gaps in the target’s technology which can either represent risks or upsides post-investment.
ESG
ESG will play an increasingly important role in creating value. A strong ESG proposition can lead to higher returns, reduce risk and legal intervention, encourage growth and expansion, reduce costs, and increase investment. Today, ESG is an essential value driver for firms and a key priority for socially conscious investors. In the current economic climate, a strong ESG proposition may seem like an unnecessary cost. However, identifying the measures required to improve the scorecard (and therefore potential exit valuation) for a potential investment should factor into the investment thesis and model. Several organisations are putting this into practice, as nearly half of CFOs are planning to increase investment in ESG initiatives.
Final Thoughts
As the private equity market evolves, so does the due diligence process. While traditional financial and operational due diligence is essential, investors are increasingly using due diligence to identify future value creation opportunities.
As a result, private equity firms that currently conduct more traditional diligence must be prepared to adapt their priorities accordingly, for example, by paying more attention to future value creation opportunities, such as digital capabilities and ESG. By understanding the changing dynamics of the market and preparing for them, private equity firms can position themselves for success in the years ahead.
Onefourzero supports investors and brands throughout the entire M&A lifecycle. Our data-led, tech-enabled approach to commercial and digital diligence enables us to deliver robust and reliable diligence to give you comfort around an asset. From market mapping to full commercial diligence, we blend high-volume alternative data with traditional consulting to help validate all commercial aspects of a potential investment. Contact us today to discuss our diligence process in more detail.
