In larger middle market transactions we typically see senior and junior debt facilities with multiple lenders. Given tight timeframes in most LBO transactions, a delicate balance is struck between how much reliance can be placed on the confidential information memorandum (the “CIM”, also known as a bank book, etc.) and how much will be invested in separate, independent confirmatory due diligence. While it is tempting (especially by novice lenders) to rely very heavily on the table-rich, graphic-laden material supplied in the CIM to meet underwriting deadlines – I believe that is a big, big mistake. Not only is “Control+C” and “Control+V” not an intellectually interesting due diligence process, if the underwriter/lender/etc. is not explicit in the extent of sourcing of CIM material in the analyses, it is misleading to credit and investment committees and, I would argue, an ethical issue.Middle market LBOs are predominantly cash-flow deals (historically, asset-based transactions typically run +/- 14% of deal volume). It is incumbent on the debt investor to understand and believe in a compelling case for the robustness of the underlying free cash flows of the target business. Don’t get me wrong, asset coverage is lovely but free cash flow is the primary source of debt repayment. Where is the value in producing simplistic math exercises that point to asset coverage in 36 – 48 months if one doesn’t have a real handle on the fundamental drivers of the target’s free cash flow and enterprise value? These “comfy coverage” analyses typically rely on a myriad of difficult-to-predict variables where tweaking one or two inputs results in no coverage, anyway. Based on a number of years in this field, I’ll submit that these formulaic boxes are an illusion of safety. Bank credit committees and junior debt investment committees should want to know which variables have the greatest impact on free cash flow and enterprise value – and then have a sense for probability of those variables reaching problematic levels. This is where effective risk mitigation discussions can be held concentrating on the ‘vital few’ elements that matter. Even a thorough reading a CIM will not give on a complete picture of the target company.
As a non-exhaustive example, an investor should have a fact-based analysis of the strengths, weaknesses, opportunities and threats presented by the industry, the target company’s relative competitive position within its core market(s), and the expected dynamics of both over the expected investment horizon. A random slew of extracted data points to provide “thump factor” of a thick credit package is useless; there should a demand for logical articulation of the business model and insights into the relative risks and (real) mitigation strategies. We shouldn’t regurgitate “high barriers to entry” unless we know what that means – and there is a real basis to make that assertion.
On the surface, the CIM provided by Agents appears to answer many of these questions – they are designed to do so. And most Agents do a fair job of delivering materially reliable data in the CIM. But it is prudent to understand the motivation of any information provider and the potential risk of bias (e.g. for emphasizing the positives of the deal without drawing too much attention to weaknesses or headwinds). One sees why successful investors maintain robust due diligence efforts above and beyond the CIM.
As a highlight, take a closer look at an example of ‘boiler plate’ precautionary language an Agent might use for the CIMs they distribute (I still read these disclosures in the CIMs that I receive to remind myself of the potential pitfalls):
- This [CIM] has been prepared from information provided by management, and all assertions related to the Company’s services, markets, competitive position, and operating performance (unless sources specifically otherwise identified) reflect the opinions of management.
- No warranty, express or implied, or representation is made as to the completeness or accuracy of the information contained herein
- It is expected that the reader will make an independent investigation and analysis before any transaction with [the Target Company] is completed.
Here’s a thought question: Let’s say you were the sole investor in the deal and you were talking directly to management regarding the transaction. Would you, or would you not, try to verify assertions, projections, etc. independently beyond those discussions? I suspect those that answer ‘no’ are prone to cut ‘n paste CIM sections into a write up and call it a day. Those that answer ‘yes’ will welcome the information in the CIM as a starting point, but will verify the key elements through their own investigation and analysis. I would also wager that the former group has remarkably less insight into the risks of the transactions – and almost certainly has more than their fair share of deals go bad.
Experience suggests that 80 percent of the deal dynamics are driven by 20 percent of the data and assertions. An experienced LBO lender will be able to identify, prioritize, and deploy resources to effectively explore key areas of analysis. This will help not only in the up-front underwriting, but in the longer-term management of the deal – e.g. the ability to distinguish and navigate ‘speed bumps’ versus problematic deviations in underlying target company performance.
I have heard the assertion that market background, industry analysis, etc. do not need to be “re-hashed”. But I also recall in the wake of the recent cycle how fingers were pointed at “silly investors” in other asset classes who were judged to have acted on sell-side information at face value – without verification or understanding. I recall the advice I have given many lenders seeking career glory while cutting corners: If one isn’t prepared to do the “hard yards” of underwriting more complex transactions, one should stay off the field.