A Guide to Conducting Private Equity Due Diligence

Private equity due diligence is a process that private equity and institutional investors use to evaluate investment opportunities. Although public companies are required to disclose a wide array of information to investors and regulatory entities, private companies may have less publicly available information for investors to analyze. During the due diligence process, investors will take a closer look at financial and operational figures and other metrics to assess whether the investment has enough potential to generate a beneficial return.

Investors can leverage many types of private equity due diligence to ensure they’re making sound investment decisions. This can include:

• Industry due diligence, which evaluates the industry that a private company operates in.
• Financial due diligence, which calculates what the company can expect to earn moving forward.
• Legal due diligence, which assesses legal implications of investment or regulatory restrictions.
• Operational due diligence, which identifies opportunities for operational improvements.
• Technology/IT due diligence, which reviews a company’s technological capabilities and challenges.

Together, the different types of private equity give institutional investors the full picture of an investment opportunity. That way, investors can make a well-informed decision by fully analyzing both the investment challenges and opportunities. With different types of due diligence being utilized to evaluate different aspects of an investment, let’s dive into how each process can guide investment decisions.

Industry Due Diligence

Often, private equity firms are financial, not strategic, buyers. This means that they don’t necessarily specialize in one industry. Therefore, many firms will begin the due diligence process with industry due diligence. This type of due diligence is focused on researching the industry that the target company is in so that potential investors can have a better understanding of its landscape before entering any potential deals.

During this process, investment firms will seek to gain key information on the target company’s competitive position within their industry. Important information to consider includes key industry players, competitive dynamics, growth prospects within the industry, recent transactions and financial metrics of the industry.

To obtain this information, companies may leverage specialized industry reports that provide a detailed analysis of the industry and provide projections on the industry’s growth. Some private equity firms have retained industry experts to provide additional guidance and fill in any missing information. These experts ensure that the firm has a detailed understanding of the industry it plans to invest in. For investment firms that are more specialized in a particular industry, they may already have internal experts or industry knowledge to pinpoint opportunities for the target company.

Financial Due Diligence

One of the first things that investors look at is the financial health of a target company to see if it aligns with their risk tolerance and goals. Financial due diligence is an important part of the due diligence process, with the quality of earnings being a major focus when making investment decisions.

A quality of earnings (“Q of E”) assessment evaluates what a company can reasonably expect to earn while subtracting extraordinary income and expenses from historical earnings. These factors are removed in order to inform investors as to what the actual financial state of the target company is.

To ensure that this assessment provides the most comprehensive view of the company’s financial performance, it should include an analysis of one-time and recurring expenses, fixed and variable costs and historical revenue trends. That way, the quality of earnings assessment provides an accurate picture of the organization’s current financial state as well as its trajectory for the future. The analysis should also include interviews with management to confirm that the information and trends are accurate.

The quality of earnings analysis can be customized to provide specific information that investors may request. For example, a quality of earnings analysis can look at what would happen to the target company’s revenue if its largest customers were to cancel their contracts.

Legal Due Diligence

Legal due diligence is another key aspect of the due diligence process for private equity firms. Before proceeding with a transaction, it is important to understand the legal implications of the transaction or if there are any preexisting legal disputes or issues that pose a substantial risk. So, a firm’s counsel or external law firm should work to develop a framework that enables the company to identify what risks are acceptable and which would be deal-breakers.

In addition, legal due diligence should include the potential legal implications of future decisions. For example, a private equity firm may seek to decrease expenses by reducing headcount or terminating contracts with current suppliers. However, existing legal agreements may make these changes difficult or impossible without facing penalties, fines or other drawbacks. Similarly, the legal due diligence process should seek to verify whether there are any disputes around intellectual property or issues with regulatory restrictions.

Any of these factors can complicate the transaction and business operations of the target company. This isn’t to say that a company should have an immaculate legal history, just that any existing risks should be manageable for the private equity firm.

Operational Due Diligence

Because the goal of a private equity investment is to increase operational performance and increase the target company’s value before an eventual exit, the due diligence process needs to review the company’s operations. In alignment with both financial and legal advisors, institutional investors will seek to identify all possible opportunities to increase value and operational performance. Operational due diligence helps confirm a company’s business plan as well, ensuring that the plan is strong enough to model cash flow into the future.

Typically, opportunities to improve operations may involve:

• Cutting non-profitable lines of business and diverting their resources to generate sales in high-performing areas
• Reducing the geographical footprint in areas where business is underperforming
• Adding new sales and marketing channels
• Upgrading technology
• Opening contracts with other companies in the private equity firm’s portfolio

This process also ensures to verify how closely a company’s operations align with the customer’s journey, which plays an important role in the sales process and revenue growth.

While many companies stand to benefit from operational improvements, conducting thorough operational due diligence can help institutional investors identify whether the value of the investment outweighs the potential risks or challenges.

Technology and IT Due Diligence

As more companies rely on technology for various business processes, understanding a target company’s technology and IT infrastructure is an important part of the due diligence process. Across organizations, variations in technologies and sophistication can make it challenging for private equity firms to apply standardized processes across their portfolio of companies.

With technology and IT due diligence, private equity firms will assess the target company’s current capabilities, ability to scale and security risks. To get the most accurate picture, institutional investors should try to understand the target company’s current enterprise technologies (such as ERP, CRM and supply chain management), all hardware and software, IT staff, security and any backup or recovery measures in place.

The due diligence process needs to capture the complete digital landscape for the target company to accurately assess any potential risks, especially because companies can have an extensive number of technologies they use on a day-to-day basis. Investors should also aim to understand what training practices the target company employs to ensure both IT staff and end users are well-versed in cybersecurity best practices.

Understanding how target companies approach technology within their organization can provide potential investors with greater insight into any challenges they may face or risks that need to be mitigated.

Private Equity Due Diligence Checklist

A private equity due diligence checklist is a valuable tool that private equity teams can use for assessing and evaluating potential deals to ensure that they align with their investment criteria and objectives. Most due diligence checklists are lengthy because the more comprehensive they are, the less likely it is that investors will be surprised down the road if any unforeseen circumstances arise. This checklist should evaluate all aspects of a target company, from industry and financial to legal and technology. Let’s dive into what a comprehensive checklist should include.

General Company Information

As a starting point, institutional investors should collect general company information such as general records, articles of formation and business plans. Even when it comes to this general information, there are many documents and materials that need to be reviewed. Private equity investors should also collect data on past board meetings, shareholder voting agreements, corporate bylaws, restructuring or reincorporating documents and any other related materials. With this information in hand, investors can begin to build an accurate image of the target company.

Financial Information

After the background is established, private equity firms can begin turning to financial information to assess the target company’s financial position. This evaluation should include historical financial data, current and future expenses and future projections to understand where the company is today and where it’s heading. To ensure financial due diligence is comprehensive, institutional investors should review balance sheets, sales reports, outstanding contracts, bad debt or write-offs, additional funding sources and other financial documents. Financial information should also include details related to shareholders, including those who have controlling stakes, and rights that shareholders are awarded.

Independent Industry Reports

Taking the time to review detailed and objective industry reports allows private equity investors to assess where the target falls within the market. These reports are a neutral, impartial source of data that can tell investors whether the industry is poised for growth, what kind of competition is in the market and any other factors companies within a particular industry will need to contend with to be successful.

Tax Situation

For investors, it is important to understand what tax situation is facing the target company. To get a clear picture, investors should look at the organization’s tax structure, recent state, local and federal tax returns, communications with tax authorities and any tax examinations or audits over the past several years. Reviewing data ensures that the target company is operating by the book. Private equity firms may also be able to identify new opportunities to maximize profits and reduce tax liabilities.

Legal and Regulatory

When it comes to conducting due diligence, institutional investors need to take a close look at the legal aspects of the target company. During this aspect of the checklist, private equity firms should pay close attention to ensure the target company has all necessary permits or licenses, complies with state and federal regulations and maintains corporate filings. Also, it’s important to determine whether the company has any ongoing litigation, experienced regulatory issues and how it approaches environmental issues. Because intellectual property also falls under legal, private equity investors will want to check if the target company maintains all necessary copyrights, holds any patents or has commercially valuable trade secrets. Additionally, all existing contracts should be reviewed, whether it’s with contractors, vendors, suppliers or employees to identify whether these agreements provide value or create risk.

Human Resources

During the due diligence process, closely evaluating a company’s workforce can help investors uncover any potential issues or risks. First, start by observing the organization’s structure and management teams to gain insight into how the organization and its people are guided. For the management team, potential investors should look to evaluate their performance, strengths and weaknesses to understand leadership effectiveness. From here, human capital can be evaluated by collecting employee resumes, analyzing salary schedules and benefits plans, reviewing employment agreements and future hiring initiatives. This assessment should also include any external contractors that provide services to the organization.

Technology

Before making an investment decision, private equity investors should analyze the technologies a target company utilizes and any security risks these technologies or related practices may pose. As a step in the due diligence process, collect a complete list of all software and hardware used by the company. The list should include details of the complete IT system, including data management, security practices and documentation of any disaster recovery plan.

Competitive Position

Evaluating a company’s competitive position provides investors with valuable information about revenue streams and market position. Start by assessing all current, planned and discontinued products and services. Then, assess sales volume by product or service to identify potential opportunities for growth or identify risks with certain offerings.

After collecting this information, investors should determine what the target company’s market share is, how its project will grow and who its competitors are. These types of insights can help investors envision what types of change they can make to achieve growth or identify if the market is too volatile or saturated.

Assets

Lastly, an important part of any investment decision is understanding what assets the company has that can provide liquidity. Therefore, there should be a complete accounting of real estate, equipment and inventory. Assets such as trade secrets, patents and copyrights should also be accounted for. Both tangible and intangible assets have a value that can increase the overall value of a company.