Key definitions and checklists to guide the essential due diligence process
Due diligence is an important part of every financial transaction, with risks carefully weighed against potential rewards prior to entering into agreements. The research, investigation, and analysis required to complete due diligence can be time-consuming and challenging, so private equity firms have developed tools and strategies to optimize this process as they evaluate potential acquisitions and other investments.
In this blog post, we review the definition and importance of private equity due diligence, while providing a checklist of essential considerations and activities. We also examine some practical examples that reveal how PE deal evaluation can impact long-term business success.
What is private equity due diligence?
Due diligence is a strategic and organized process PE firms utilize to identify risks, assess growth potential, and ensure cultural and strategic alignment prior to investing capital. The overall process includes a comprehensive review of financial, operational, legal, and technological facets of the business, as well as the structure and performance of the management team and other key contributors.
The due diligence process is carried out in stages, with an initial screening completed even before the letter of intent (LOI) is signed. Mid- and late-stage due diligence activities that include more in-depth analysis require direct access to sensitive business information, along with the requisite legal agreements to protect confidentiality and intellectual property (IP) rights.
Why is due diligence important?
Private equity firms are faced with a myriad of options as they build new partnerships and invest in the future growth and success of portfolio organizations. Most private equity transactions involve acquiring a majority stake in a company with little or no public information available, so this discovery process provides the first and best opportunity to uncover risk factors and evaluate growth potential.
Unlike other investment types that only require an infusion of working capital, private equity transactions mark the beginning of long-term partnerships that allow organizations to leverage the expertise of the PE firm as they chart their future course and identify opportunities for predictable growth. PE assets and resources must be deployed strategically to ensure the return on investment (ROI) is optimized.
PE due diligence checklist
Each new opportunity brings unique challenges and intangibles to light as the discovery process begins and relationships are forged. A due diligence checklist helps to ensure no key elements are overlooked during an investment risk assessment.
1. Financial health
A review of cash flow, financial statements, and key performance indicators such as gross margin stability, working capital, and EBITDA lies at the core of the due diligence process. Financial analysis PE metrics also feed directly into the company valuation, while revealing past and current spending, sales, and productivity trends that help to characterize business potential. A comprehensive review of all physical assets, real estate, and intellectual property ensures a complete understanding of the business and minimizes any potential surprises.
2. Liabilities
A review of all liabilities, including any tax issues and potential lawsuits, is an important subset of the financial due diligence process that should be emphasized to avoid potential legal risks or hidden liabilities that can undermine the growth strategy. The tax structure of each potential partner should also be evaluated to determine the most tax-efficient acquisition strategy.
3. Market position
The market position of the organization is reviewed within the context of the overall business model to determine the current market standing, along with the growth potential. A complementary review of intellectual property, including inventions that have not yet been productized, helps to define pathways for market expansion and brand enhancement.
4. Leadership
Interviews, reference checks, and peer feedback help to paint a picture of each business’s leadership talent and potential. A thorough review of management practices and personnel also helps to assess the cultural fit of the organization and avoid misalignments that can lead to philosophical differences, disputes, or post-transaction employee turnover.
5. Talent
Human capital is the most important asset for businesses of all types and sizes, so an investment risk assessment must include a top-to-bottom review of the current organizational structure, employee agreements and benefits, the overall strengths and abilities of the team, as well as any gaps in talent that might curtail future growth.
6. Strategic alignment
Assessing long-term strategic alignment requires a review of both tangible and intangible factors. For example, a business with established products and customers that can fill important gaps in the overall PE portfolio might also have ongoing projects or ambitions that overlap with existing interests, or conflict with the overall vision.
7. ESG factors
A review of environmental, social, and governance (ESG) factors is also important for determining strategic and cultural fit, with metrics and KPIs like environmental impact scores used to baseline performance. Emerging businesses should also be assessed to determine their interest level with respect to future ESG initiatives.
Due diligence examples
Blind trust and a lack of patience are among the pitfalls associated with negative outcomes in business transactions. Historical examples, including the high-profile mergers of Time Warner & AOL, or BMW & Rover, demonstrate how even established corporations can overlook important details and warning signs. Common themes include force-fitting disparate cultures and philosophies, or failing to complete thorough financial reviews.
Well-orchestrated due diligence results tell a much different story, with the process helping to avoid unwise investments altogether, or alter expectations and valuations upfront to foster a smoother path forward. Successful Valesco partnerships with companies, including Principal Lighting Group and Earthlite, were prefaced by a robust diligence process that allowed the leadership teams to hit the ground running and exceed expectations for growth and profitability.
Conclusion
Due diligence is an important business process that demonstrates the power of planning and foresight in optimizing resource allocation. PE firms take on enormous financial risk with each new partnership, so the due diligence tools and strategies are continually evolving to improve accuracy and efficiency. Looking forward, artificial intelligence and other emerging technologies will play a growing role as systems are developed to characterize both tangible and intangible business elements. Successful partnerships help validate evolving strategies and best practices for PE deal evaluation, with skillful and comprehensive due diligence a key to optimized ROI and outcomes.