The most revealing diligence filter I've seen - COVID-19 and extreme events
Image: Cottonbro
The due diligence ‘reveal’ is essential in corporate finance.
Whilst a robust process can protect financial issuers and vendors, they don’t usually like doing it.
Investors and purchasers typically can’t live without it.
Fin-techs and reg-techs have tried to automate it.
Data room service providers charge for platforms which seek to streamline it.
Regulators have waxed and waned over who can rely on it.
Look at it through whichever lens you like - due diligence has become part and parcel of transacting (or not).
Today, COVID-19 and the ways in which governments have responded to it has challenged the viability of many businesses.
For most countries outside of Asia, it’s different to the SARS outbreak 15 years ago. SARS was not a near-worldwide, multi-speed lock-down. We did not have QE Infinity to artificially inflate valuations at that time, nor did we have digital disruption to the extent we do today.
As a result of today’s converging elements, COVID-19 has become the most revealing due diligence filter I think I’ve ever seen.
If you believe COVID-19 and other extreme events can no longer be fobbed off as black swan events, then it follows they should no longer be relegated to single line items, hidden in the detail of due diligence checklists.
Rather, future outbreaks of coronavirus, together with extreme environmental, social and technological events including outbreaks of terrorism must now become overarching filters that help define whether a business or industry is still going to be meaningful and viable, going forward.
Here are some further thoughts.
9/11, COVID-19, bush fires and Amazon have changed the way we live, consume and work.
From a diligence perspective, COVID-19 is more like a terrorist attack or an extreme weather event, than an economic shock such as the GFC.
When the GFC hit, due diligence checklists were adjusted, not just for banks but for all businesses, particularly those with debt.
A target’s ability to withstand a credit squeeze and liquidity crisis was all of a sudden under the microscope. Banks insisted on 3 year cash flows with explanations for each deviation, and net debt to EBITDA came down from 6x to 2-3x at best
Banks started to tighten lending, with many banks parking money with the central bank because lending became too risky.
Then came the worlds’ treasuries and central banks to the so-called rescue with bail-outs and fiscal largesse, and that was the beginning of QE Infinity. The punch bowl of Rohypnol turned into a lake which will not drain.
The point is that human behaviour remained largely unchanged since the GFC (that’s right, greed has been on the increase and debt has actually risen by another $80 trillion or so). But, it was an economic belt tightening/loosening scenario that did not directly threaten life and human/business interaction.
In contrast, 9/11, terrorist attacks, bush fires and similar animal and human life threatening events kill life and have a habit of changing human behaviour and the way we do business. From airport security to physical safety. From building design to mass social gatherings. From sustainable land management and traditional fire-proofing, to waste management. From explosives detection to immigration laws and new political parties.
Life changes. Products and services change, and the way in which they need to be delivered also changes.
Well, life and the way we do business and buy and sell and experience products and services is changing again because of our inability as a society and economy to deal with these all too often extreme events.
Myopic thinking isn’t particularly revealing.
Let’s get back to due diligence.
The typical due diligence process includes a master checklist and several documents which waterfall from it, along with a dedicated team, be it internal, external or a hybrid. I happen to prefer internal teams supplemented sparingly with external specialists because it’s the internal folk that need to live with the outcome and implement fixes for the still ‘open’ elements that inevitably exist after completion. Add to that a bunch of investment in time and money and thoughtful consideration.
However, all too often, participants see a completed checklist and commoditised report of the due diligence committee for filing, as the end goal.
Wrong. The end goal should be a useful tool for investors, buyers and underwriter’s, etc., to make a fully informed investment decision (one way or another), and which managers and implementers can use to track KPIs and remediate certain aspects of the business after completion.
This means that any diligence tool needs to consider what happens to an issuer/target, and possibly an entire industry, when there is a convergence of extreme health, weather, populist and technologically disruptive events.
I recently came across a checklist which included a solitary reference to COVID-19. It related to whether a COVID-19 response plan had been put in place, and it appeared as a line item in the OH&S section.
There was no mention of extreme weather events or climate change, although there was more than one reference to ESG, but with little instruction. As far as technology was concerned, it asked for a list of technology used in the business, but asked nothing about the target’s resilience to disruption.
My response? You guessed it, WTF! And, that’s what promoted me to write this morning.
Get yourself a COVID-19, 21, 23…..and extreme event filter.
My approach is different.
It’s not about re-calibrating the magnifying glass, it’s about re-calibrating your eyes with an extreme event filter.
As a strategy based financial advisory, all deals we look at must first pass through a strategic filter.
I’m not going to be drawn into whether culture eats strategy for breakfast, but with the greatest of respect to my tambourine bashing culture colleagues, the best culture in the world won’t save a fatally flawed airline from an extended pandemic or extreme technological advancement that renders a fleet pretty much obsolete, for example.
In light of COVID-19, extreme weather events, and cascading digital disruption, surely it’s time to answer a few key overarching questions before descending into the detail?
This is particularly so when looking at unsolicited investment opportunities and special sits investing.
Here are five gates that I think an investment, acquisition or merger target needs to pass through before descending into the boiler plate detail of the typically bland due diligence checklist.
Is the industry in which the target is exposed still meaningful and viable in a post-pandemic, extreme environmental event and digitally disrupted landscape?
If the answer to 1 is ‘yes’, outline the element/s of the business or revenue model embedded in the target that will allow it to remain viable, if extreme events continue to occur in the future.
Will demand for the target’s product or service increase, decrease or plateau during a similar extreme event, or a new wave of disruption?
If the answer to 1 is ‘no’, are there elements of the business that can be reapplied to another sector or industry, and if so, is the new model relevant for us, or for another investor or acquirer in a different sector?
What does the post-transaction competitive landscape look like for the target, and can the target develop a sustainable competitive advantage?
If you pump an airline through my extreme event filter, you’d probably walk away just like Buffet did. Unfortunately he was long airlines and needed to take a refreshing bath.
But, unlike Berkshire, you might be a large miner that wants to use part of the fleet as an in-house fly-in, fly-out supply chain. Taking it off P&L and onto the balance sheet might make sense if your volumes are sufficient to underwrite base load utilisation, cover costs and generate returns above your cost of capital.
If you then run video conferencing software or PPE through the filter, you might answer positively for most of the above questions, but if you cannot see a sustainable competitive advantage due to crowding or because you have a view the next wave of innovation will disrupt the current players, this might influence your view on valuation and associated risks. Alternatively, it may lead you to consider something else.
So, the answers to questions 1 to 5 will either expose fatal flaws in your investment thesis, or uncover some great reasons to get super excited about the target.
Either way, extreme events can no longer be line items hidden in the detail of mind-numbing due diligence checklists.
Rare, or old hat?
There are some obvious implications here.
You need to decide whether these life threatening and extreme events are (a) one-off events, or (b) events that are likely to accelerate in frequency and change the way we work and live.
If you’re thinking (a) you may be happy with the off the shelf chipper chicken view of life after a global pandemic. Good luck with your purchase.
Whereas, if you’re thinking (b) and that these extremely disruptive events are becoming commonplace, then your time will be best spent answering those overarching questions.
If you can positively move through those questions and into the checklist detail, you might be at risk of revealing a winner!
Using a magnifying glass when engaging in due diligence is elementary, but before looking through it, try putting on your extreme event filter. It’s going to save you a lot of time and money.
Mike.
NextLevelCorporate is a leading financial & strategic corporate advisory firm with a multi-decade track record that speaks for itself. Helping clients in all industries to prepare for, respond to and deliver transformative corporate finance strategies and transactions in and out of Australia, is our passion.