It's hard these days for Fund managers to find new ways to boost asset performance, but due diligence is one area that's often overlooked.
It's a potent tool that when used cleverly can unlock greater investment value in the short and long term.
So much due diligence is a "one size fits all" approach using generic reporting templates. All too often these reports are populated with superfluous information.
A simple value test is how often does anyone refer to the reports after a transaction is completed? If the answer is seldom or not at all, the question must be "how can we get more value from the reports?".
There is an answer. Sophisticated managers get more from their due diligence spend by discarding off-the-shelf approaches and developing a bespoke strategy that keeps costs down and focuses on generating value.
It's not hard and you'll get a better result. Here are six principles you can follow:
1. Get your due diligence people working together as a team
You can minimise duplication and reduce costs by having all due diligence functions (legal, financial, technical) working together as a single team. Also include your external lawyer at this early stage.
Once the team is formed and as part of setting fee budgets, identify and agree on:
- investment objectives and strategies for the asset from acquisition to exit,
- who are your stakeholders (and what are their interests),
- materiality thresholds, reporting timeframes and assumptions.
Due diligence is meant to be solution driven. Stipulate that any risks identified must be accompanied by a suggested risk mitigation strategy.
2. Consult with your financier
Develop your due diligence strategy in consultation with the proposed financier for the venture. Perhaps the financier is happy to rely on a due diligence report prepared by the Fund's lawyers as supplemented by reports from other consultants? If so, this will avoid duplication and save time and money.
The financier is a stakeholder, so it's important to confirm what issues are important to it and ensure these are addressed in the due diligence strategy.
The Fund's lawyer can then develop a template of proposed issues which can be settled with input from the financier.
Valuations should not be viewed in isolation. Indeed if the Fund or financier is to rely on a valuation, the due diligence report should verify each of the valuer's assumptions. As a matter of course, the valuer will base its valuation on assumptions that:
- all improvements are lawful;
- the current uses are lawful and approved;
- there is compliance with fire regulations;
- the existing improvements are in good repair;
- key leases have a minimum term;
- there are no encroachments;
- there is no contamination; and
- there are no geotechnical issues.
Your due diligence should be designed to respond to these assumptions.
3. Give priority to those factors that will impact on your investment strategy
For example, if there is potential to add value to the asset in the medium to long term by virtue of a redevelopment or an extensive upgrade, your due diligence should focus on constraints and opportunities to achieve this.
Knowing which questions to ask is crucial. For instance, do the leases contain relocation or redevelopment clauses which the Fund can use to its advantage? Are there town planning restrictions which could impact on redevelopment or conversion to a different use?
In this case, the due diligence might include an analysis on the rights of tenants to extend their lease terms by options to renew or the need to consider the impact of any contractual rights of third parties which may impact on the staging of a future redevelopment.
On the other hand if an investment is simply based on securing an immediate income stream, the focus will be on understanding the potential risks to the income stream.
4. Align due diligence with ongoing management strategy
Too often lawyers produce detailed lease reports which contain information of no real value in the post acquisition phase of the investment.
The Fund's asset managers and lawyers should work together in the initial due diligence planning phase to review and refine reporting templates. These can then be used as a tool to underpin ongoing property management post acquisition.
If you can remove the need to report on issues which do not add value, the cost of due diligence will be reduced.
5. Use technology to reduce legal due diligence costs on leases
Technology can make a real difference to lease due diligence quality and costs. For example, document review software can scan and identify discrepancies in lease documents in a fraction of the time it would take a person.
6. Are you In or Out?
In the past, some have used due diligence as part of a "box ticking" exercise and a way for Fund managers to create evidence that they have discharged their fiduciary duties. However, of itself, due diligence may not add any value to the Fund at an asset management level.
Due diligence should be seen as a tool to generate real value. Done well, it will not only verify the value of the assets and issues which require immediate management focus but can also represent the first step in a value adding strategy over the life of the investment.
By developing your own, tailored strategy on an asset by asset basis, you can get a lot more bang for your due diligence bucks.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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