“When written in Chinese, the word crisis is composed of two characters. One represents danger and the other represents opportunity.” It is a famous quote attributed to John F. Kennedy, and while not true, it’s a great conversation opener. Undeniably, a crisis presents opportunities; we now have seen for months one unfolding across the global economic landscape with Covid-19. Between factories reimagining global supply chains and tech companies — from fintech to health tech — re-evaluating growth strategies and business models, all conventional ways to work have been put through the grinder; we’re seeing the emergence of a new normal.
The pandemic has affected the financial sector as well. Fund managers are finding it hard to raise money for a first or final close; those who have dry powder face the challenge of allocating it wisely, and investors in funds have to decide if they will look into new teams or go with the ones known pre-Covid-19.
As any investor will testify, due diligence is a critical component of an investment process. Investors, whether venture capital (VC) or private equity (PE) fund managers, family offices or institutional ones, go through elaborate due diligence (DD) processes before investing in a fund or company. DD has multiple facets — investment strategy, target markets, financial, legal, business, and more. Pre-Covid-19, the process involved exhaustive on-premise and in-person engagements, which would go on for weeks, if not months. For example, an investment in a manufacturing company involved physical meetings at the production facility. In sustainable agricultural technology (or AgTech) investments it was standard DD to meet the different value chains and local producers to see them using the technology in real time. These meetings were followed by interviews and more meetings with the staff and other investors, checking internal systems, processes and technologies. Why? The findings and impressions gained during the DD stage can make or break a deal, and can be the difference between investors making money or losing everything.
The new approach, the virtual due diligence
Covid-19 changed all rules for due diligence. Many forward-looking investors and fund managers are seeing an opportunity in revitalizing investment due-diligence processes and infusing technology to weed out the inefficiencies. Communication tools such as Zoom, Microsoft Teams, Google Meet, and others are already par for the course; they were here before the pandemic and certainly will outlast the pandemic. Teams are relying more on platforms such as Dropbox, instead of tracking documents on emails. These collaborative tools also help create easily accessed cloud content, collaborate remotely and share heavy files. This way, the due diligence team can gather information and insights easily and more efficiently.
The good news is, following improvements in data management, records digitization and videoconferencing technology, one can carry out effective due diligence reviews virtually.
With virtual DD in place, physical engagement can be kept to a minimum or eliminated entirely and undertaken only if absolutely required. This has worked well for VC funds who have seen increased interest from institutional investors, and who want to show that they can continue to invest capital in promising companies in a pandemic world. A study by Omers Ventures of 150 VCs across the US, Canada, the UK and the rest of Europe shows that just 4 percent of VCs are opposed to undertaking remote deals. Among the 96 percent of VCs open to it, 42 percent said they are willing to make changes to their processes to enable this. Interestingly, 40 percent of the VCs surveyed said they had already done a fully remote deal, while 60 percent are yet to do so.
A new normal for remote due diligence
There is no well-accepted practice or standard in which to take this forward. Consequently, we’re seeing VC funds address virtual DD in multiple ways as they focus on closing their pipeline of deals. In some cases, relationships have been established with founders through meetings and conversations that have been going on for months, much before Covid-19 struck, and term sheets have already been signed. Closure of these deals has been relatively easy, as evidenced by the continued global flow of VC capital in Q2. With others, initial conversations have been fruitful, but final DD and signatures are pending. VCs are leveraging partners in the areas where these potential investees operate to drive some level of due diligence. Backchannels and talking to third parties were always an important driver for insights; this has now increased.
Connecting with previous investors or funds who have already entered in the investment is also useful and helps the DD process. Some VCs and other investment firms have, during the pandemic, done approximately 30 percent of their due diligence remotely. Virtual tours have helped provide facility tours. The quantum of discussions with founders has increased both at the individual level and in groups. Founders are also being encouraged more to connect across the network — with funds, entrepreneurs, and accelerators — in their local region. Remote DD has shown the critical role technology plays now when making an investment decision. References and testimonials apart, technology is the main driver of remote due diligence processes today. And from the looks of it, will continue to be so going forward.
But Zoom meetings are not enough to conduct due diligence in its entirety when mobility is hampered. Potential investees are working hard to help potential investors find ways to visit their factories, offices or warehouses and see first-hand what’s happening, how employees are engaged, how much stock they have and gather other information that will help the deal move forward.
Reliance on co-investors too has increased. Founders are under even more pressure to come with strong references. The increased emphasis on client checks is encouraging portfolio firms to try out the products or services of the companies under due diligence.
Don’t bet on the wrong horse
The current situation may lure investors to make mistakes. Lack of performance can be disguised under the pandemic, and going just for the supposedly “winner” sectors during Covid-19 may result in an expensive and simplistic approach, where you bet on the wrong horse. The fact that you’re conducting a remote due diligence should not relax the depth of the analyses. If anything, there are now new scenarios to play with, new indicators to look at, to see if we’re in front of attractive investments or not. The good news? It all can be done remotely.
The end goal is business continuity
In the current situation, where travel is significantly restricted, if not impossible, not institutionalizing remote due diligence will limit business progress. Of course, having a large, well-dispersed team with deep industry relationships can be an invaluable advantage in the current environment. Nimbler investors who can harness the power of technology and couple that with a well-tentacled network may be at a significant advantage as they will draw on local capabilities to maintain due diligence processes and capture new opportunities. Investors unable to draw on such resources will need to outsource parts of their process to trusted third-party specialists. The pandemic and the challenge that it imposes on due diligence should therefore not be an excuse to let the baton slip. It should be the catalyst that enhances scrutiny by utilizing technology to further augment existing processes.
Undoubtedly, the process now takes longer; it involves far more scrutiny. A simple thing that spoke volumes during normal times, which VCs now miss, is picking up on nonverbal cues when interacting with people or teams in person. Zoom calls cannot compensate for this. A few investors will, nevertheless, prefer waiting it out till the pandemic is over. That may just turn out to be a long wait. And there are too many challenges in the world waiting to be solved through companies using innovative technology. The investing world cannot grind to a halt.