In the high-stakes world of private equity, due diligence is not just a procedural step—it’s a strategic imperative. For managers and operators in private equity, mastering due diligence best practices can mean the difference between a transformative investment and a costly mistake. This guide details comprehensive approaches to due diligence, ensuring that every investment decision is rooted in careful analysis and risk mitigation.
Introduction
Private equity managers operate in a dynamic and competitive environment where investment choices carry significant financial implications. Due diligence best practices in private equity involve thorough assessments of a target company’s financial, operational, legal, and commercial aspects. By conducting comprehensive due diligence, firms can identify red flags, mitigate risks, and maximize investment returns. In today’s market, staying informed and adaptable is key to maintaining a competitive edge.
Common Risks and Red Flags
During the due diligence process, it’s crucial to identify potential risks and red flags that could affect the investment. Some common risks include:
- Funding risk: The risk that the private equity firm may not be able to secure the necessary funding to complete the acquisition or support the target company’s growth.
- Liquidity risk: The risk that the private equity firm may not be able to exit the investment at a desirable time or valuation.
- Capital risk: The risk of losing the invested capital due to poor performance or unforeseen circumstances. This can occur through the failure of underlying companies within the PE portfolio and suppressed equity prices, which make exits less possible.
- Market risk: The risk of adverse changes in market conditions that could negatively impact the target company’s value.
- Regulatory risk: The risk of changes in regulations or legal requirements that could affect the target company’s operations or profitability.
- Cybersecurity risk: The risk of data breaches, cyberattacks, or other cybersecurity incidents that could harm the target company’s reputation or financial performance.
A report by KPMG identifies industry-specific reasons why private equity firms face inherent risks, including involvement in complex transactions, lean operating structures, intense competition for portfolio company investments, extensive involvement with third-party intermediaries, lack of transparency, and a rising trend of investor activism. Overlooking critical issues during due diligence can result in significant financial losses, operational hurdles, and reputational damage.
Key Areas of Due Diligence
Due diligence in private equity typically covers the following key areas:
- Commercial Due Diligence: This involves assessing the target company’s market position, competitive landscape, customer base, and growth potential. It includes analyzing market size, industry trends, competitive dynamics, and the target company’s competitive advantages. Before evaluating an individual company, one should take a look at the overall industry it operates in, including its market, competitors, and unique opportunities and challenges.
- Financial Due Diligence: This focuses on understanding the company’s financial health and growth potential. It involves examining financial statements, analyzing trends in revenue, profit margins, and cash flows, and verifying the accuracy of financial forecasts.
- Legal Due Diligence: This ensures the company complies with all legal obligations and regulations. It includes verifying adherence to industry standards, reviewing contracts for risks or liabilities, and confirming the ownership and validity of intellectual property assets.
- Operational Due Diligence: This reviews the company’s internal processes, supply chain, and scalability. It includes assessing the efficiency of operations, identifying potential bottlenecks, and evaluating the company’s ability to meet future demands. This also includes analyzing how effectively the target company converts inputs into outputs and if it has any competitive advantage owing to its operations.
- Management and Operations: This assesses the management team’s quality, experience, and ability to execute the company’s strategy. It also involves evaluating the company’s organizational structure, key personnel, and human resources practices.
- IT Due Diligence: This evaluates the company’s technology infrastructure, cybersecurity measures, and data management practices. It includes assessing the company’s IT systems, data security, and compliance with relevant regulations.
Due Diligence Checklists
Due diligence checklists provide a structured approach to ensure all essential aspects are covered during the evaluation process. The following tables outline the necessary due diligence checks for each area:
| Financial Due Diligence Checklist | |
| Historical financial performance | Review historical financial data to assess trends and performance. |
| Financial projections | Analyze future financial projections to evaluate growth potential. |
| Current financial statements | Examine current financial statements, including the balance sheet, income statement, and cash flow statement. |
| Sales reports | Review sales reports to understand revenue generation and customer trends. |
| Outstanding contracts | Analyze outstanding contracts for supplies, materials, and other obligations. |
| Inventory | Evaluate inventory levels and management practices. |
| Accounts payable | Assess accounts payable to understand the company’s payment obligations. |
| Schedule of bad debt and/or write-offs | Review the schedule of bad debt and write-offs to assess credit risk and potential losses. |
| Current accounting system | Evaluate the company’s accounting system and internal controls. |
| Any funding by VCs | Identify any funding received from venture capital firms. |
| Bank statements | Review bank statements to verify cash flows and transactions. |
| Audits | Examine audit reports to assess the company’s financial reporting practices. |
| Leases | Review lease agreements for equipment, property, and other assets. |
| Materials contracts | Analyze contracts for raw materials and other essential supplies. |
| Product margins | Evaluate product margins to assess profitability. |
| Customer Due Diligence Checklist | |
| Customer information | Gather information about the company’s customer base, including contracts and invoices. |
| Standard contract length | Determine the typical length of customer contracts. |
| Customer churn rate | Analyze the customer churn rate to assess customer retention. |
| Customer lifetime value | Calculate the customer lifetime value to understand long-term customer profitability. |
| Cost to acquire a customer | Determine the cost of acquiring new customers. |
| Supplier Due Diligence Checklist | |
| List of suppliers | Identify the company’s key suppliers. |
| Average relationship length | Determine the average length of supplier relationships. |
| Contract renegotiation frequency | Assess how often supplier contracts are renegotiated. |
| Supply chain issues | Identify any current or potential supply chain disruptions or risks. |
| Supplier relationships | Evaluate the strength and stability of relationships with key suppliers. |
| Supply chain resilience | Assess the company’s ability to adapt to disruptions or changes in the supply chain. |
| Legal Due Diligence Checklist | |
| Articles of incorporation | Review the company’s articles of incorporation. |
| Shareholder information | Obtain a list of all shareholders and details about their ownership. |
| Shareholder agreements | Review documentation of past and current shareholder agreements. |
| Voting agreements | Obtain copies of any voting agreements, trusts, or proxies. |
| Right of first offer/refusal | Review copies of right of first offer or refusal and preemptive rights agreements. |
| Transfer Restrictions | Examine transfer restriction agreements and registration agreements. |
| Bylaws and amendments | Review the company’s bylaws and any amendments. |
| Annual reports | Examine annual reports for financial and operational information. |
| Legal compliance | Verify compliance with state and federal laws. |
| Legal claims | Investigate any legal claims against the company. |
| Outstanding liabilities | Identify any known outstanding liabilities. |
| Supply agreements | Review exclusive supply agreements or purchase agreements. |
| Contracts with vendors and customers | Examine contracts with existing vendors, suppliers, and customers. |
| Change in control | Assess the legal ramifications of a change in control at the target company. |
| Open contracts with portfolio companies | Review open contracts with existing portfolio companies belonging to the PE firm. |
| Company headquarters location | Determine the location of the company’s headquarters. |
| Corporate filings | Review corporate filings for legal and regulatory compliance. |
| Antitrust and regulatory issues | Assess any antitrust and regulatory issues. |
| Environmental issues | Investigate any environmental concerns or liabilities. |
| Insurance coverage | Review insurance policies and coverage. |
| Licenses and permits | Verify the company’s licenses and permits. |
| Pending litigation | Identify any pending litigation or legal disputes. |
| Administrative Due Diligence Checklist | |
| Owned/leased properties | Obtain a list of all owned or leased properties and relevant details. |
| Capital equipment | Gather details on sales and purchases of major capital equipment in the last three years. |
| Equipment lease agreements | Obtain copies of all lease agreements for equipment. |
| Real estate documentation | Review copies of real estate deeds, appraisals, mortgages, leases, surveys, title policies, use permits, and other relevant documents. |
| Fixed assets schedule | Obtain a schedule of owned and leased fixed assets, including descriptions, acquisition dates, values, and locations. |
| Equipment appraisals | Review copies of any equipment appraisals. |
| Inventory listing | Obtain a copy of the inventory listing, including item descriptions, item numbers, dates, units, and costs. |
| Tax Due Diligence Checklist | |
| Tax structure | Analyze the company’s tax structure. |
| Federal tax returns | Review federal tax returns from the last three years. |
| State and local tax returns | Review state and local tax returns from the last three years. |
| Correspondence with tax authorities | Examine any correspondence with tax authorities since the company’s founding. |
| R&D credit reports | Review research and development credit reports. |
| Tax examinations and audits | Obtain a schedule of comprehensive tax examinations and audits in the last five years. |
| Human Resources Due Diligence Checklist | |
| Organization structure | Review the company’s organization structure. |
| Key employees | Identify key employees and gather biographical information. |
| Employee agreements | Review employee agreements and contracts. |
| Employee handbook | Examine the employee handbook and company policies. |
| Employee benefits and compensation | Gather details of employee benefits and compensation packages. |
| Employee stock ownership plans (ESOPs) | Review any employee stock ownership plans. |
| Labor relations history | Assess the history of labor relations and any disputes. |
| Labor law compliance | Verify compliance with labor laws and regulations. |
| Products and Services Due Diligence Checklist | |
| Current products and services | Identify the company’s current products and services offerings. |
| Planned products and services | Review plans for new or upcoming products and services. |
| Discontinued products and services | Identify any discontinued products or services. |
| Sales volume | Analyze sales volume by product and service. |
| Profitability | Evaluate the profitability of each product and service. |
| Market share | Determine the market share for each product and service. |
| Future market share analysis | Analyze the potential future market share for products and services. |
| Regulatory documentation | Review any regulatory documentation related to products and services. |
| Competition Due Diligence Checklist | |
| Main competitors | Identify the company’s main competitors. |
| SWOT analysis | Conduct a SWOT analysis to assess the company’s strengths, weaknesses, opportunities, and threats in relation to its competitors. |
Red flags that may indicate potential problems include:
- Inconsistent financial reporting
- High employee turnover
- Pending legal actions
- Discrepancies in financial statements
- Ongoing litigation or regulatory investigations
- Investors with material negative/adverse news alerts
- Investors requesting investments inconsistent with their stated strategy or prior investments
- Investor funds coming from or going to banks in jurisdictions with no legitimate ties
- High customer churn rate, even with new clients
- Lack of advanced sales conversations or poor understanding of potential customers
Stages of Private Equity Due Diligence
Private equity due diligence typically involves several stages:
- Exploratory Due Diligence: This initial phase focuses on assessing the target company’s fit with the fund’s investment thesis and identifying any immediate red flags.
- Confirmatory Due Diligence: If the target company passes the initial screening, this phase involves a more in-depth investigation of the company’s financials, operations, legal compliance, and other relevant areas.
- Initial Due Diligence and Valuation: This stage includes reviewing financial statements, analyzing market position and competitive landscape, conducting management interviews, and performing initial valuation models.
- Letter of Intent (LOI): If the initial assessment is positive, the firm submits a non-binding LOI outlining the proposed purchase price, key terms, and an exclusivity period for further due diligence.
- Formal Due Diligence: This involves a comprehensive review of all aspects of the target company, including financial, legal, operational, and commercial due diligence.
- Negotiation and Documentation: Once due diligence is complete, the parties negotiate the final terms of the transaction and prepare the necessary legal documentation.
- Closing: This is the final stage where the transaction is completed, and ownership of the target company is transferred to the private equity firm.
Legal and Regulatory Considerations
Legal and regulatory considerations are crucial in private equity due diligence. Some key aspects include:
- Regulatory Compliance: Ensuring the target company complies with all relevant laws and regulations, including industry-specific regulations, environmental compliance, labor law compliance, and data protection laws.
- Contractual Obligations: Reviewing all existing contracts, including supplier and customer agreements, for potential liabilities or risks.
- Intellectual Property: Confirming the ownership and protection of the company’s patents, trademarks, and copyrights.
- Antitrust and Competition Laws: Assessing any potential antitrust or competition issues related to the acquisition.
- Environmental, Social, and Governance (ESG) Factors: Evaluating the target company’s ESG practices, including environmental impact, social responsibility, and corporate governance. ESG factors are increasingly important in private equity due diligence, as investors are becoming more aware of the potential risks and opportunities associated with these factors.
Case Studies
Financial Due Diligence
- Successful Due Diligence: A private equity investor and mezzanine lender invested $33.2 million in a sporting goods manufacturer with $60 million in revenue. Thorough due diligence ensured the investment’s success.
- Unsuccessful Due Diligence: A private equity investor and mezzanine lender provided a $22 million loan to a lumber distributor with $92 million in revenue. Inadequate internal controls and an undiscovered senior lien resulted in an unfavorable outcome.
Legal Due Diligence
- Unsuccessful Due Diligence: A private equity firm missed a key due diligence risk related to open-source software when considering a $100 million investment in an industrial company. The extensive use of open-source software and associated legal ambiguities led the investors to withdraw from the deal.
Use of Technology in Due Diligence
- Successful Due Diligence: A private equity firm used an AI tool to identify a red flag related to a director’s ties to a sanctioned individual, allowing them to assess the investment’s risk profile early on.
- Unsuccessful Due Diligence: Manual due diligence failed to uncover risks that AI-powered tools could have identified, highlighting the importance of technology in modern due diligence.
Mergers and Acquisitions
- Successful Due Diligence: Dell’s acquisition of EMC Corp. for $67 billion created Dell Technologies, the largest privately controlled tech company globally. This successful merger demonstrates the importance of thorough due diligence in evaluating large-scale M&A deals.
Regulatory and Compliance
- Unsuccessful Due Diligence: HIG Capital paid nearly $20 million to settle a fraud case involving portfolio company South Bay Mental Health Center, which was accused of fraudulent billing practices. This case emphasizes the need for comprehensive due diligence to identify potential legal and regulatory risks.
Other Cases
- Rapid Tech Due Diligence: A private equity firm utilized rapid technology due diligence to assess a target company’s technology within a two-week timeframe, enabling them to make an informed investment decision with confidence.
These case studies demonstrate the importance of thorough due diligence in private equity transactions and the potential consequences of overlooking critical issues.
Best Practices for Effective Due Diligence
- Define the Scope: Clearly define the scope of due diligence based on the target company’s industry, business model, and the specific objectives of the investment.
- Assemble a Team: Engage specialists from different disciplines (finance, legal, operations, ESG) to ensure all areas of the company are evaluated by experts.
- Use a Standardized Checklist: Implement a comprehensive checklist that outlines all the major areas of due diligence to ensure consistency and thoroughness.
- Leverage Technology: Utilize advanced tools such as AI-powered analytics platforms to streamline the due diligence process and enhance efficiency. AI and machine learning are transforming the due diligence process by enabling faster and more comprehensive analysis of data from various sources. These tools can help identify red flags, assess risks, and uncover hidden opportunities more effectively than manual processes.
- Conduct Thorough Research: Gather information from various sources, including financial statements, industry reports, market data, and interviews with management, customers, and suppliers.
- Verify Information: Independently verify the information provided by the target company to ensure accuracy and completeness.
- Identify and Mitigate Risks: Proactively identify potential risks and develop mitigation strategies to minimize potential negative impacts.
- Maintain Confidentiality: Ensure the confidentiality of all information obtained during the due diligence process.
- Document Findings: Maintain detailed documentation of all due diligence activities, findings, and conclusions.
- Communicate Effectively: Communicate findings and recommendations clearly and concisely to the investment team and stakeholders.
Conclusion
Due diligence is a crucial process for private equity firms to make informed investment decisions and mitigate risks. By implementing due diligence best practices in private equity—such as utilizing comprehensive checklists and conducting thorough research—firms can significantly enhance their chances of successful investments and maximize returns.
Identifying potential risks and red flags early in the private equity due diligence process is essential. Evaluating the target company’s financial, operational, legal, and commercial aspects, along with considering legal and regulatory implications, ensures a holistic review. Due diligence is not a one-size-fits-all process; it requires a tailored approach based on the specific circumstances of each transaction.
The key areas of due diligence, including commercial, financial, legal, operational, management and operations, and IT, are interconnected and should be evaluated holistically. By adhering to these due diligence best practices in private equity, firms can navigate the complexities of the evaluation process, make sound investment decisions, and contribute to long-term success.
Private equity firms are encouraged to implement the strategies outlined to enhance their due diligence processes and achieve optimal investment outcomes.
References:
- Affinity – Private equity due diligence: how to conduct it properly
- USPEC – Best Practices for Thorough Private Equity Due Diligence
- Grata – Private Equity Due Diligence Process
- Affinity – Private equity due diligence: how to conduct it properly
- Allvue – Key Risk Management Practices in Private Equity
- Gerald Edelman – Key risks in private equity investment
- Liberty Mutual Business Insurance – 6 risks in private equity
- Lowenstein Sandler LLP – AML Best Practices for Private Funds: Red Flags and Responses for Private Funds (Anti-Money Laundering)
- Brandlin And Associates – Due Diligence Case Studies
- EverEdge Global – Private Equity Firm Misses Key Due Diligence Risk
- Xapien – Private equity due diligence in the age of AI with a case study
- CapLinked – 7 Banger Private Equity Case Studies
- Bain & Company – Rapid Tech Due Diligence Helped a PE Firm Invest with Confidence