Fintech: how vendor due diligence helps PE investment

Transaction Services Associate Director Stephen Moorcroft says fintech companies might want to take the initiative on due diligence before talking to private equity.

Financial technology (fintech) is booming. The fintech sector, from Insurtech to Blockchain, has a forecast compound annual growth rate of almost 14% up to 2028, from a value of around £4.8 trillion in 2021. And as of the end of August 2022, the sector boasted 321 ‘unicorns’—privately held startups valued at more than $1bn (£860m at today’s rates)—with a total market capitalisation of £1.4 trillion.

Unsurprisingly, private equity (PE) is keen to back companies in this market, and the UK is seen as the global capital for fintech investing, with particularly strong activity in London and Manchester. But that does not mean investment-ready fintech firms will have PE houses beating down their doors. The current economic outlook could potentially lead to caution among investors.

Introducing vendor due diligence

Furthermore, it is usually the case that a company seeking PE investment wants to get the right partner to help deliver management’s growth strategy. To do this, fintech leadership teams should consider the simple step of engaging vendor due diligence providers before approaching investors.

Vendor due diligence involves the seller commissioning an independent report on their business before starting the deal process. Obviously, such a report only has any value if it is clearly independent and impartial. Vendor due diligence is not a marketing exercise, but rather a way of saying,
 

We are a serious business and we do not mind being exposed to scrutiny.

The benefits to vendors

Of course, there is always a chance that vendor due diligence could expose issues the management team would rather not face up to. So why run the risk? Overall, vendor due diligence is beneficial to the seller because it allows them to control the narrative around key issues, maintain power and generally drop good news into the process if the issues are already on the table.

This ideally maintains momentum and competitive tension with bidders. In addition:

• It allows the vendors to position their view around underlying profit, quality of profit, growth trajectory, tax liabilities, net debt items and net working capital.
• It helps the vendor detect addressable problems that an investor’s due diligence would have thrown up anyway, giving management time to resolve or control the narrative around key issues such as tax risks and disputes.
• It saves the management team the time and effort of having to address the deluge of investor queries that could come through if PE houses do not have a vendor due diligence report for initial information.
• It can create an impression of seriousness and professionalism which may improve reputation of the business in the process.
• It reduces distraction on the business and often speeds up the deal process.

How it works

Above all, vendor due diligence can help fintech management teams maintain the initiative in negotiations with PE investors, which can potentially secure better deal outcomes. So, how does it work? To all intents and purposes, a vendor due diligence exercise is essentially the kind of investigation you will get from an investor. The due diligence team will analyse your company’s historical and forecast numbers and question your underlying profitability as well as assumptions for growth.

When it comes to technology and fintech, private equity houses are typically data hungry and aim to understand the underlying trends from each revenue stream and key performance indicator in depth. Management teams that are investing in data warehouses and analytics in advance of a transaction, allowing the analysis of revenue and margin trends, are putting themselves in a stronger position to demonstrate the credibility of run-rate calculations and forecast assumptions.

Things to consider

Another consideration is the timing of the exercise. It needs to be undertaken close enough to the deal for the analysis to be relevant, but also with enough time for management to make sure any red flags are understood and, if possible, addressed. In practice, this usually means engaging vendor due diligence providers around four to six weeks before releasing an information memorandum.
 

Fast-growing fintech businesses should consider if they can demonstrate up-to-date trends to help bidders to gain comfort over any run-rate and forecast assumptions.