Distressed investing—Step 3: Perform due diligence

Part three of our six-part series to guide you through the steps of successful distressed investing

Once you’ve identified a distressed investment opportunity, developed a strategy and approached the company to express your interest, the time has come to perform your due diligence. At this stage, you take a deeper dive into the distressed business to understand performance and profitability, as well as evaluate options to turn the business around.

Navigate complexity with the right insights

Performing due diligence on a distressed business brings a unique set of challenges.

Comparability: Analysis of historical results must be comparable to the go-forward business plan. Since the business will be turned around, historical information is only relevant to the extent that it informs post-deal projections. To understand how the business could look post-deal, buyers often need to look further back in the company’s history. Buyers also need to be granular in their due diligence to allow for meaningful sensitivity analysis when modelling the impact of closing a division or restructuring existing contracts.
Timing: Perform due diligence quickly to preserve the value of the company and win transaction processes. This means focusing only on significant value drivers and using technology like data-analytics-driven due diligence tools.
Access to management: Plan interactions with management carefully and focus on key issues. The distressed company’s management team may be more focused on figuring out how to meet payroll than responding to your requests for data. It’s also important that you and your advisers are assessing management by asking who might need to be replaced, who is worth keeping and who is critical to the investment thesis, if anyone at all.

The right questions for distressed investing due diligence focus on understanding where the business has been to get an informed view of where it can go. As an investor, ask the following:

How did the business get here? Superficial answers about how the business got into this situation, such as the slow economy or low commodity prices, aren’t enough. Closer examination may reveal a combination of factors, which could go deeper than what is on the surface. It could be a failing product line that’s bringing down successful lines or mismanagement that’s spun the company off course.
What can I change? Distress creates new optionality for a potential buyer and the opportunity to “get it right” as the business emerges from distress. Through a deep understanding of how the business got here, you will be able to identify what can be changed and what is outside your control. Actions could include right-sizing a company’s workforce, changing the capital structure, negotiating historical liabilities or dropping leases for unprofitable locations.
What needs to go right to make this profitable—and what could go wrong? How will your approach differ from the previous owner’s, and what does success depend on? That could mean an injection of capital or being able to make the most of complementary businesses you own. Likewise, for a new business plan, it’s critical to understand what could go wrong, particularly factors beyond your control such as a dip in market prices, change in currency exchange rates or new government policy.

The tools you need to succeed

Many buyers are succeeding in distressed situations by using data analytics-driven due diligence tools and approaches. Instead of starting with high-level financial statements and drilling deeper, they start with detailed transactional or product-level data and build their analysis up. Modern data analytics tools can effectively handle data sets of essentially any size and allow for weekly or even daily updates as due diligence progresses. By getting a complete data set up front, buyers can focus management’s time on responding to hypothesis-driven questions instead of simply pulling data.

An independent third party can help accelerate due diligence getting it done faster, and in some cases more accurately, as distressed companies can be more open to sharing data with a trusted outsider. In a distressed situation, speed and confidence are critical. Talk to a professional who has been through these transactions, and knows what works and what doesn’t to help you get the most insight into your target. What you learn during the due diligence process will validate your overall deal hypothesis and help determine how likely it is your strategy will be successful.

Once your due diligence is complete, it’s time to structure the deal—which we’ll cover in our next post.