Comprehensive review of major workstreams, advisers and software used in a typical private equity due diligence process
Due diligence is a process of assessing the target company for the purposes of acquiring it (M&A transaction) or investing into it (private equity / venture capital). This is a complex exercise which combines several workstreams including financial, commercial, technology, operations and legal topics. While this might seem like a daunting task, a typical investment deal team is supported by several external advisers (lawyers, accountings, consultants) who act as experts in their respective domains and also uses a variety of software tools to help with the analysis.
Below we will dive into each of the workstreams and cover the main topics of diligence as well as the software tools and advisers typically used by PE/VC funds.
Table of contents:
1. Overview of Private Equity Due Diligence workstreams
One of the first things to understand in learning how to perform due diligence on a private company is the differentiation in various DD workstreams, which can be broadly split into two categories: (i) exploratory due diligence and (ii) confirmatory due diligence. Exploratory DD addresses topics that "go to value", e.g., findings around commercial and financial aspects of the business that materially impact how the business is valued (from an EV or equity value point of view). Confirmatory due diligence addresses other important, however slightly more technical topics such as legal, regulatory compliance, insurance, etc. Confirmatory topics can also impact valuation if something is not in order, however are not the primary focus for the dealmakers.
The two most important areas for investors are typically Commercial DD (CDD) and Financial DD (FDD) as these workstreams cover the most pertinent topics, relating to the competitive differentiation of the company and its long term growth potential. As a result CDD and FDD usually receive a disproportionate amount if deal team's time and financial resources.
2. Commercial Due Diligence (CDD)
Commercial DD is a core area of any due diligence on a private company and deals with answering the question of "does this business have a sustainable commercial position and value proposition in the long term?". This workstream is typically performed by a combination of external consultants (e.g., McKinsey, Bain, BCG, Deloitte, others) and internal resources within the PE/VC fund who oversee that work. The typical questions answered in this workstream are listed below:
Market dynamics: Is the total addressable market (TAM) sufficiently large enough? How fast is it growing? How does the CAGR differ by geography or subsegment of the market?
Business model: How does the company make money? How does it serve its customers and clients? What is the company structure in terms of products or BUs?
Competitive landscape: How differentiated is the target? What is their market share? What is their Net Promoter Score (NPS)? How has the competitive landscape changed in recent years?
Supplier and customer dynamics: Is there any concentration or reliance risk either in customers or suppliers into the company
Business plan analysis: How much execution risk is in the presented business plan by management? What are the upside and downsides to it?
Other market-specific commercial questions (value chain structure, disruption risk, commoditisation, go to market stategy, etc.)
In order to answer these questions, consultants perform primary research through expert interviews (delivered by the likes of GLG, GuidePoint, AlphaSights and ThirdBridge) and market research through surveys and panels. The consultants also review and extract information form various industry reports and publications in order to form a view on the long term outlook of the market and the target company.
3. Financial Due Diligence (FDD)
While commercial DD focuses on all things business, market and product, Financial DD is focused on the domain of financial figures and accounts. Even more so than CDD, this workstream is typically delivered by external advisers, (e.g., KPMG, EY, PwC or specialist accountancies) due to the very technical nature of some of the work involved, which covers the following topics:
Historical trading: What are the biggest contributors to historical growth. Which BUs or products have growth the most. How has gross margin and EBITDA margins evolved over time
Business plan analysis: This overlaps partially with CDD, however accounts typically take a far more methodical and numerical approach to analyzing this topic. Price vs. volume, mix effect, like-for-like sales, etc. are just some of the KPIs analyzed here.
Quality of earnings: What is the underlying EBITDA in a business, i.e., when adjusted and stripped out for various one off exceptional items?
Balance sheet: What is the true net debt and net working capital figures? These are key inputs into the valuation of the business and hence "go to value".
Cash flow generation: How much free cash flow has the company generated over the past 3 years?
Working capital: What is the normalised or adjusted working capital of the business? How much seasonality is there in a given year and relative to when the transaction is looking to be completed?
Variety of other topic: tax, accounting policies, inventory schedules, etc.
4. Management Due Diligence (MDD)
Management due diligence is a key workstream when learning how to perform due diligence on a private company. This task has historically been done on qualitative basis or through in-person interactions of the deal team directly with management. However as the PE market becomes more sophisticated and more tools become available, MDD has become a separate workstream in its own right, typically performed by a senior deal team member (e.g., Partner) or a trusted advisers specialising on this area. Typical questions covered in MDD are listed below:
Quality: What is the overall quality of the management team? How experienced, senior and competent is the senior team in the company?
Gaps: Are there any gaps in the senior leadership team (SLT) that need to be filled?
Tenure: How long has the leadership team worked together? Is this a well-oiled trusted management unit? Are there any recent newcomers or individuals who have not yet proven themselves? Will some of them want to leave or retire from the company after the transaction?
Feedback / ratings: What Glassdoor ratings does the CEO have? What backchannel references can be done to understand the strength and weaknesses of the CEO and how he/she is perceived by the market?
Culture: What is the prevalent culture and way of doing business in the company?
Churn: What has been the historic churn in the senior team and company overall?
This workstream is frequently supported by head-hunters or staffers who can help with finding and appropriate Chairman, or Non-Exec Director for the business and fill other senior roles.
To lean more about automating and improving Management Due Diligence with listAlpha, see our MDD solutions page
4. Valuation & Exit
Valuation / Exit is the domain of investment bankers who can help the new owners understand how the business should be valued (e.g., EV/ EBITDA or EV/Sales multiples) and what kind of parties can be expected to want to invest in this business in 4-6 year's time. M&A advisory banks are particularly well-suited for this role as they have access to historical valuation benchmarking from prior deals and can have deep industry connections.
Public comps: What are the closes listed companies to the target? How have the industry multiples changed over the years and what does that mean for the target?
Precedent comps: What private businesses have transacted recently and at what multiples?
Exit: Which parties (strategic buyers or financial sponsors) will be interested in owning this business in 4-6 year's time? What factors need to be remedied or what story needs to be constructed for the exit? Can this business be a good IPO candidate?
5. Technology & IT
In describing how to do due diligence on a company, we cannot avoid to mention all of the workstreams related to technology and IT. Interestingly, this area has historically been a part of FDD as most of the early IT systems in businesses were developed to support financial reporting and accounting. As the modern day IT stack has evolved to take over pretty much every aspect of business operations this workstream has also grown in importance. For business that are not tech / IT in their core (e.g., manufacturing, or consulting services), Tech DD is usually confirmatory in nature and is used to identify any obvious gaps that need to be improved. For technology based businesses (e.g., e-commerce or SaaS software) this area becomes a core part of the research process and sometimes closely overlaps with CDD as it related to competitive differentiation vs. other players in the market. Similarly to CDD this is usually done by a combination of senior internal advisers (e.g., ex-CTO of a portfolio company) and external providers who specialise in this niche. Most consulting houses will offer a product in this as as well (e.g., Deloitte, Accenture, etc.)
The due diligence process for a private company is never easy, but that doesn’t mean it has to be inefficient or manual. With the proper software and tools in-place, diligence can be straightforward and productive. After all, the information that is discovered during diligence is critical to a deal’s success. Due diligence software like listAlpha, equips teams with the proper tools to be thorough, yet efficient, and to close deals faster.