Although there are common themes running through all due diligence processes, private equity due diligence processes tend to bring specific challenges.
First, as the target company is usually not publicly listed, there is less information available on the company that there would otherwise be - for example, through the company’s filings with the SEC.
Second, as many private transactions are financial rather than strategic in nature - that is, the private equity firm’s motive is to acquire the company purely for the profit that it makes on the investment - the perspective taken is different.
The first way in which this can be seen is in the industry due diligence conducted by the private equity buyer.
Industry due diligence
A private equity firm’s focus on the financial rather than the strategic elements of a deal, usually means that they will lack the industry knowledge and know-how that a company already operational in that industry possesses.
Thus, the first piece of due diligence required in a private equity transaction is thorough research of the industry (or industries) that the target company operates in.
Gaining an understanding of an industry can be a time-consuming affair, and depending on how in-depth the private equity buyer wants to go, the process can involve accounting, tax, and legal advisors to analyze the specifics of the industry in question.
It is not unusual for private equity buyers to identify other attractive target companies in the industry during their industry analysis, or even to realize that a related industry is more suited to its investment criteria.
Among the points to consider in this analysis include:
- Gaining insight from independent industry research reports.
- Understanding the target company’s positioning in its industry.
- Understanding the industry’s competitive dynamics, technology, etc.
- Understanding key industry ratios - working capital cycle, debt/equity ratio, etc.
- Conducting a Monte Carlo simulation for the industry and its growth prospects.
- Viewing recent industry transactions and their multiples.
Quality of Earnings (“Q of E”) assessment
While the financial due diligence component of private equity due diligence looks at all of the same documents as any other due diligence process, there is a particular focus on ‘quality of earnings’.
This looks at what the target company can reasonably be expected to earn on an ongoing basis by extracting extraordinary revenues and expenses from the historical income statements.
The extraction of these extraordinary items from the financial results will allow the private equity buyer to gain a more realistic picture of how the company is growing, and how that is likely to continue into the future.
The ‘quality of earnings’ report can be as rigorous as the private equity buyer demands: for example, it could also look at a worse case scenario where some of its biggest clients canceled ongoing contracts and assess how that would impact the target company.
Legal due diligence
The business plan for a private equity transaction usually includes cuts to the workforce, selling off of assets, closing business units, or terminating contracts.
Although the aim here with any of these operations is to generate extra cash flow for the business, undertaking them usually has the unintended consequence of generating legal issues.
This calls for a different form of legal due diligence than non-private equity transactions.
In particular, the legal due diligence for a private equity deal should look at:
- The legal consequences of a change in control at the target company.
- The regulatory restrictions around the target company.
- Exclusive supply or purchase agreements.
- Contractual agreements with existing vendors, suppliers, and customers, and how these are affected by the transaction.
Operational due diligence
The aim of any private equity transaction is to drive operational improvements at the target company and increase its value before exiting the investment after an agreed period of time.
Therefore, in tandem with financial and legal advisors (see previous sections), the team in charge of the deal will seek to identify all of the opportunities that exist at the target company to make value generating operational improvements. This is where operational due diligence stats.
The operational improvements could include:
- Cutting non-profitable product lines and using the extra capacity to generate extra sales in more popular project lines.
- Closing underperforming stores and/or two or more stores within close proximity.
- Adding new sales and marketing channels, such as an ecommerce channel.
- Replacing old capital with improved technology.
- Open contracts with existing portfolio companies belonging to the private equity firm.
Private equity due diligence checklist
We at DealRoom built a complete PE due diligence template that can help you start the diligence process right away.
Check out the template using the link below:
Developing an exit strategy
The ultimate aim of any private equity transaction is an attractive exit multiple.
Undertaking the aforementioned steps are a step in the right direction to achieving this, but even a company that has streamlined its operations and improved its sales significantly is only as valuable as the available market of buyers.
For this reason, the final step of private equity due diligence is to establish the universe of potential buyers for the target company.
These buyers usually involve a combination of strategic buyers (i.e. other companies in the target company’s industry or parallel industries) or financial buyers (usually another private equity firm or similar type of fund).
A final option - although usually far less common - is through an IPO. A general rule is that the more successful a company has been in generating free cash flows, the easier it will be to find a market for it.
The principles of due diligence for private equity are the same as anywhere else: Undertaking extensive analysis of the target company and its environment to reduce risks for the buyer.
However, due to the financial motive, there are specifics to private equity due diligence, which this article has outlined.
DealRoom has worked with hundreds of private equity firms, specifically in their due diligence process. If your private equity company is considering a transaction in the near future, talk to us about how we can help with your due diligence process.