Due diligence for Private Equity
This post covers the diligence process that private equity firms go through when evaluating an acquisition. Private equity due diligence differs from investment banking ‘buy side’ diligence in a number of important ways. Not least, it is often less arduous, as a private equity firm is either acquiring a private company, or looking to take a public company private. The reporting and management burden on private companies is significantly less than for public companies, and consequently investors have greater flexibility in how they conduct diligence.
Any private equity deal will include a thorough due diligence designed to mitigate potential risks inherent in acquiring a target company. This will include the standard types of due diligence:
- Legal due diligence
- Financial due diligence
- Commercial/operational due diligence
PE firms will need to be satisfied with the legal, commercial and financial position of the target company, be confident they can make operational improvements, avoid hidden risks and ultimately execute their exit strategy.
With that in mind, we’ll look at a typical private equity due diligence process and the path a target company must tread to be successfully acquired.
The PE due diligence process
The process a private equity firm goes through when looking to make an acquisition can be broadly laid out as follows:
- Formation of the investment hypothesis and raising of the fund
- Deal origination
- Due diligence
- Final negotiation and acquisition
Private equity (including venture capital) fund managers go through a complicated and lengthy process before making any investments. The process of formulating an investment thesis, raising a fund, and deploying the capital from that fund generally takes many years.
For a single acquisition, the time between sourcing the deal and making the final investment rarely takes less than a few months, and can often take up to a year or more for some investments.
Formation of the investment hypothesis and raising of the fund
This process generally takes place before any deal sourcing happens – though inevitably an investment hypothesis will be further refined throughout the process of deploying funds, as early winners become clear and investors learn more about companies that meet their target criteria. By the end of the deployment period, investors have significant data and feedback from their existing portfolio companies. They also have the advantage of having assessed a large number of potential investments.
This has certainly been our experience working with private equity firms both early and late in their investment cycle. The diligence checklist we receive from firms later in the private equity investment process is generally incredibly granular and proscriptive. Whereas, in the early days, our clients are often looking to us to add more in the way of opinion on top of our research so that they can test their hypotheses adversarially against ‘unbiased’ views (in the sense of not being closely involved with internal conversations).
Once the hypothesis for the fund is in place, investors will go out and look for businesses in private markets that match their investment strategy. Investment teams may do this directly themselves through industry analysis and personal outreach or by leveraging their networks. They may also work with brokers like investment banks who represent companies that would like to sell.
Deal origination is very much a ‘frog kissing’ exercise. Investors have to quickly sort through a lot of different companies to find their potential princes. Most of the initial calls and conversations will go nowhere. Private equity firms are looking for a very specific set of circumstances in order to invest. Given that the due diligence process is time consuming and costly, it is important that investors are effective at quickly filtering deals.
Once a potential deal has been found, investors will have a due diligence checklist in mind – a set of criteria they are looking to satisfy when evaluating potential investment opportunities. The diligence process is undertaken at the investor’s expense. The target company’s own lawyers and accountants may have to furnish documents that support the legal or financial due diligence process, leading to costs being incurred by the target company, however the bulk of the costs will be born by private equity firms in any due diligence process.
During this process, private equity investors will look at financial statements, independent industry research reports, industry trends, the management team, recent industry transactions, the target company’s positioning, intellectual property and many other criteria to assess the potential acquisition. Fundamentally, institutional investors are about value creation. Without it, they are unlikely to be able to create a successful exit strategy.
Final negotiation and acquisition
Once potential investors are comfortable with the target company’s industry, the industry’s competitive dynamics, and how the company operates they look to make their investment decisions. The private equity firm must be satisfied that a suitable opportunity exists to add significant value to the to the target company and that they can exit themselves in 3-5 years to strategic buyers, before it can then become a portfolio company.
As mentioned, a private equity transaction is often a lengthy process, with no guarantee of investment. However, if the target company passes the due diligence process, then it’s likely that they will receive term sheets from the private equity firm. These describe the headline terms of the deal, such as the level of investment, the pre- and post-money valuation of the company, and restrictions on the management team. The amount of negotiation and wrangling that goes on at this stage will depend on the relative strength of each party to the negotiation.
If the round is not heavily subscribed, then investors are in a much stronger position to dictate terms. Equally if the investment is an earlier stage venture capital investment then founders often lack sufficient leverage to push back on certain terms that may be quite onerous or favourable to the investors, such as vesting schedules or share forfeiture.
Over the course of the PE due diligence process, private equity firms will assess the operational processes, financial performance, cash flow statements and legal position – including any intellectual property – of the target company. They will assess the market position of the potential acquisition, their marketing channels, secondary opportunities for existing and new product lines, financial data and any number of other bits of information to reach a conclusion on whether they are able to make operational improvements to the prospective portfolio company.
Private equity investment is usually a lengthy process – any private equity transaction is likely to take a minimum of a few months, and can often take up to a year. Consequently, PE due diligence is also a substantial exercise. How in depth a due diligence goes will vary from deal to deal – though it will always be thorough.
For more detailed analysis of the commercial due diligence process, check out our deep dive into the subject here.
What is included in private equity due diligence
Generally any private equity firm will have the following on their due diligence checklist: this will be commercial due diligence, legal due diligence, and financial due diligence.
What financial information is included in financial due diligence
This depends slightly on the stage of the company being acquired. However, it is likely to include financial data like cash flow forecasts, audited accounts, and whatever other financial information the investor’s accounting firm require.
What is the point of legal due diligence
Legal due diligence protects the buyer from legal consequences in the future, if they go ahead with the transaction. It flags any potential regulatory restrictions, satisfies investors that any intellectual property is sufficiently protected, and generally provides confidence that the investor won’t be on the receiving end of any nasty surprises like litigation based on the past actions of the management team.
What are confirmatory due diligence and exploratory due diligence
These are terms that describe the stage of private equity due diligence rather than being separate categories themselves. Investors will generally perform light tough legal, financial and commercial due diligence at early stages of a deal, getting deeper and deeper as things progress. For example, they may ask to see a cash flow as a first step, before engaging an accounting firm to audit the past 5 years of a company’s financial history.
What are diligence checklists
A due diligence checklist is just the list of things an investor wants to have confirmed before making an offer to buy or invest in a company. A due diligence checklist may be long or short, depending on the stage of the company and the complexity of the deal.