Due diligence is an essential part of the private equity investment process. In this phase, potential investors “check under the hood” by collecting information to explore and confirm management’s financial and operational figures when evaluating a potential investment.
The goal is to uncover and mitigate potential risks to make the correct investment decision. During this stage, private equity investors and their teams (consultants, accountants, lawyers, etc.) evaluate and uncover significant red flags such as financial liabilities, operational, legal, cybersecurity, and other risks.
Historically, PE due diligence has focused on financial, commercial, and legal due diligence. Still, there are different areas, such as IT, management, and HR due diligence that potential acquirers should also assess.
In the private equity world, due diligence must overcome unique challenges. For example, most private equity funds focus on acquiring private companies with limited public information, lacking SEC filings and other public records.
Additionally, PE firms tend to be financial rather than strategic buyers, meaning the main reason to acquire a company is to achieve a positive return on investment (ROI) and provide a return to the limited partners (usually institutional investors) in a relatively short period.
This type of transaction differs from a traditional M&A transaction, where acquirers are enterprises looking for synergies, value creation or specific know-how, geographic reach, or to expand their business portfolio.
In this guide, we’ll provide an overview of the due diligence process that every PE fund can use as a starting point when evaluating potential investment opportunities.
When to Start The Due Diligence Process
Most private equity transactions follow a lifecycle similar to venture capital firms—they source deals, conduct the due diligence process, come up with a valuation, negotiate final terms, invest, support the business, and eventually execute their exit strategy.
However, private equity firms prefer to acquire a controlling interest in well-established companies they believe will achieve a certain level of financial performance.
These potential investments usually have proven business models, established management teams, customer relationships, and more financial information than early-stage companies. As a result, their due diligence process tends to be longer and more complex.
The private equity due diligence process typically involves the following steps:
- General Industry Research
- Financial Due Diligence
- Commercial and Operational Due Diligence
- Technology and IT Due Diligence
- Legal Due Diligence
The length of this process varies depending on multiple factors, including how in-depth the buyer wants to go, the nature of the deal and the number of experts and service providers consulted.
On average, the process can take between 3 weeks and up to 3-4 months for larger, more complicated transactions. But, as the adage goes, “time kills deals, even the good ones,” so firms with a solid track record in dealmaking try to get their due diligence done in less than 90 days.
For example, a private equity firm may be looking to roll up a smaller company into an existing portfolio company, meaning they’re already familiar with the industry. Or, on the other hand, they may be looking at a deal in a nascent sector with few comparables that would require involving outside industry experts or professional service firms.
Most private equity firms are financial buyers, meaning they don’t necessarily focus on specific industries. At the same time, private equity firms tend to purchase well-established companies, where industry trends and future outlook significantly impact any alpha. Therefore, the private equity due diligence process typically begins with in-depth industry research.
Some industry factors to consider include:
- The target company’s positioning within its industry.
- Recent industry transactions and their multiples.
- The industry’s competitive dynamics and key players.
- Working capital cycle, debt/equity ratios, and other financial metrics.
- Understanding the industry growth prospects by conducting Monte Carlo simulations.
Most of these data points are available in independent industry research reports. For example, IBISWorld is one of the largest publishers of industry research that goes into everything from raw material price trends to the industry’s lifecycle. In addition, private equity firms may retain industry experts or consultants to provide guidance and fill in knowledge gaps.
Finding the right industry expert can be time-consuming, so having a relationship intelligence platform that identifies the right expert from your networks in minutes is crucial when conducting due diligence.
Quality of Earnings (QoE) Analysis
Private equity firms typically use leverage in the form of a Leveraged Buyout (LBO) to make acquisitions and achieve a large Internal Rate of Return (IRR), meaning cash flow plays a critical role. If a target company’s cash flow dries up, the private equity firm loses cash each month servicing its debt.
This potential risk translates to a heavy focus on the quality of earnings or how much the target company will earn on an ongoing basis, also known as the true earnings potential. The goal of the quality of earnings report is to adjust the reported EBITDA to calculate an EBITDA that best reflects the actual financial state of the organization.
During their analysis, private equity firms will remove extraordinary items from the target company’s financial results and estimate the impact of potential adverse events, such as losing a significant customer. As a result, investors can better assess the potential earnings derived from increased sales or lowering costs by having this information.
Quality of earnings analysis usually includes:
– Analysis of the assumptions used in cash flow projections and scenario analysis
– Determination of recurring expenses vs. one-time expenses
– Determination of fixed vs. variable costs
– Detailed analysis of historic revenue trends
A well-executed QoE analysis will not be limited to reviewing documentation available in the data room. This analysis also requires interviewing management to confirm information or explain trends.
Evaluating Potential Returns
Private equity firms are ultimately looking to maximize their profit potential. Therefore, as with any investment, they use a variety of financial metrics and ratios to evaluate each deal. However, they may look particularly closely at balance sheets to determine how much leverage they can use to make an acquisition.
In addition to financial leverage, private equity firms typically look to make operational improvements at a target company to increase its value. So, they might look at product line profitability, underperforming locations, supply chain, marketing channels, information technology investments, and other areas to ensure that they have the ability and flexibility to add value.
Finally, private equity firms may look at public markets for an idea of exit multiples, particularly if they’re moving into different areas. For example, a private equity firm may acquire a conventional consulting firm and productize its services to transform it into a tech company. In that case, they might look at tech firm multiples for an idea of return potential.
Legal Due Diligence
The main objective of the legal due diligence (LDD) process is to gain a legal perspective on the target company and uncover any legal risks associated with completing the transaction.
Few companies have an immaculate legal history, with some having ongoing human resources-related disputes, licensing and contract issues with suppliers, partners, etc. Therefore, your firm’s general counsel or an outside law firm should develop a benchmark of what is acceptable and what would be a deal-breaker from a legal perspective.
Private equity firms typically look for ways to increase cash flow by selling off assets, finding synergies, or terminating contracts. But, of course, the viability of these strategies depends on existing legal agreements. For example, employment contracts could make layoffs more expensive, or supplier contracts may have minimum terms. These are all elements that the acquirer should evaluate during the LDD process.
Private equity firms may also need to look at intellectual property disputes and regulatory restrictions depending on the target company’s industry. This is because federal, state, or local governments could influence parts of operations, making turnaround or restructuring efforts less viable. For example, a company in the healthcare space will usually have more regulatory restrictions than a chain of fast-casual restaurants.
Due Diligence Checklist
There are multiple factors private equity firms must consider when evaluating a target company. That is why we’ve prepared a high-level due diligence checklist of the standard elements that a fund’s investment committee might want to seek out or request as part of their due diligence process. However, keep in mind that this is a starting point and doesn’t reflect a comprehensive list.
- General Company Information- includes company articles of incorporations, business plans, lists of all the entities where the organization has equity interests, etc.
- Independent Industry Reports – These reports help improve the acquirer’s understanding of a target company’s industry.
- Financial Statements – Confirm financial performance by examining: audited income statements, balance sheets, and cash flow statements. These can help assess the profitability and viability of a private equity transaction.
- Proforma & Segments – Breakdowns by retail location, product line, or business unit can help identify opportunities to generate alpha, while proformas can provide insights into expectations.
- Legal Contracts & Agreements – Collecting legal agreements helps ensure that any potential plans to unlock value are viable and uncover any possible hidden risks.
- Key Customers & Partners – Customer lists and partnerships are essential to quantify the risk of losing a large customer account or restructuring partnerships to improve outcomes.
- Human Resources Information– Understand a business’s leadership and human capital by looking at their org chart, roles and responsibilities, and HR legal and compliance areas.
- Physical Assets: Verify tangible assets held by the company, including paperwork for all real estate holdings, PP&E, inventory, etc.
The Bottom Line
Due diligence is an essential part of any investment process, but private equity firms have some unique factors at play. In particular, they require a higher level of due diligence due to their larger ownership levels and the amount of risk involved.
Nevertheless, considering the factors we discussed in this article, firms can maximize their odds of success and ultimately deliver value to their stakeholders.
To successfully execute a due diligence process, private equity investors need access to the right experts at the right time. By using a private equity relationship intelligence platform with the right functionality, investment teams can have instant access to relevant subject matter experts in a matter of minutes, saving valuable time during this often stressful period. To see this in action, click here to request a personalized demo of 4Degrees.