The rise of vendor due diligence in private equity

Private equity transactions have seen an increase in vendor due diligence (VDD) in recent years, and it appears that this trend is only going to continue. Typically, it is the buyer's responsibility to carry out its own due diligence exercise to identify potential issues with the target company, including those that go to value. In comparison, VDD gives control back to sellers, as they commission an independent report on the target company before welcoming potential buyers or investors.

VDD as an alternative to traditional buyer side due diligence

In our experience, VDD is a popular choice for several reasons.

Instead of dealing with previously unknown issues as they arise during buyer due diligence, VDD identifies problem areas before bidders are heavily involved. This gives management the opportunity and time to either remedy the issues or prepare a narrative for potential buyers offering comfort as to why such issues are low risk. This means that seller side teams have significantly more control over the VDD process, as well as visibility over what information the bidders will see when they begin their investigations.

VDD can also lead to more accurate bids that are reflective of the true value of the target company. As VDD gives the same level of transparency to all potential bidders from the outset, including specific risk areas, it reduces the need for price chips and compromises later on in the deal process. As all parties are in receipt of the same information, bids tend to be more competitive and are often placed with limited conditionality.

Without a VDD process, the first time a buyer will learn of any issues is when it receives its independent advisor’s due diligence report. At this stage, the buyer may be the only acquirer left in the process, making it harder for sellers to negotiate or walk away, particularly given the time and costs already incurred. In the recovering UK market, we are seeing more sellers opt to prepare VDD reports to keep bidders in the process long enough to provide accurate and competitive bids.

VDD can also be helpful for investors looking for an exit strategy, as it not only helps to identify a target’s risks, but can also highlight the business’ strengths and identify who would be the ideal buyer in a specific sector.

VDD gives sellers the power to choose how to present their business, ultimately controlling the narrative of certain issues and providing detail on mitigating factors. In a VDD report, sellers can also include explanations as to why certain decisions were made on day-to-day business matters. This avoids bidders raising multiple rounds of enquiries to clarify specific risk areas, creating a more efficient deal process.

In addition, buyer due diligence often overlaps with negotiation of core transaction documents. Management sellers may therefore struggle to prioritise due diligence enquiries across multiple areas alongside other key elements of the transaction, which may lead to delays. The deal process can be streamlined if VDD enquiries and replies are dealt with at the outset, freeing up management to focus on other elements of the deal as it progresses. This in turn allows bidders to remain in the auction process with minimal upfront advisor spend, strengthening their interest in the overall transaction and potentially attracting more bidders.

Despite VDD frontloading a majority of the work, it is important to give bidders the opportunity to ask questions about the target business. Compared to a buyer side diligence process, these enquiries are likely to be more focussed in nature, lower in volume and will ultimately provide reassurance that VDD has been thorough.

Using VDD helps to minimise the impact of diligence as a driving factor in the deal timetable. Whilst parties aim to kick off buyer led due diligence as early as possible in the acquisition process, it can take a while to start properly whilst management gather all requested information. In comparison, during a competitive process, the information memorandum can be released quickly after the VDD process is near final, meaning there should be no surprises for bidders when considering the deal terms.

In addition, by preparing a VDD report in advance, core transaction documents can be drafted from the outset reflecting diligence findings. This will result in an expedited process, with less negotiation and more cost saving.

Further, providing the bulk of diligence information up front also saves management from having to address a multitude of bidder queries, as can be common in traditional auction sales. Using VDD as an aid to execute transactions more quickly reduces business disruption for the target company and means that buyers can take ownership sooner.

However, caution should be taken to ensure that commercially sensitive data is only be shared with preferred bidders. In addition, a balance should be struck to ensure that VDD is undertaken as close as possible to the deal so that the report includes current information, whilst giving management sufficient time to both consider any material issues flagged in VDD and, if possible, rectify them.

Market insight

Despite a decline in the number of deals in 2023, PE activity increased by 36% in value in 2024. Expectations of increased deal volume seem to be encouraging optimism that the market will continue to strengthen. As the PE sector continues to build, VDD can be an attractive option to both sellers and buyers in a competitive market. It is anticipated that the rise in VDD will continue in 2025 by driving momentum in sales processes – which will be a vital tool for competitive tenders in the improving economy.

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