Investment Due Diligence: Best Practices for Success

5 Min Read

It’s no secret that private equity due diligence is a complicated matter, and as competition continues to increase in the private equity (PE) space, qualified targets are becoming harder to find. To compete, investors need to be smarter about the nuances of the seller’s company and industry and be able to read the tea leaves for investment due diligence success.

Engaging high-level experts who are adept at deep dives and intelligent appraisals during the diligence phase is no longer simply an accepted practice—it’s now expected during transactions. To win, it’s imperative that you arm yourself with advisors who fit your specific need, industry, and stage of the process. For example, what you need in early stage due diligence (Indication of interest (IOI) or Pre-Letter of Intent (LOI)) is vastly different from what you need in late stage.

To be clear, failing to organize your approach could cost you more than just losing the deal. It could cost you significant time, capital, and business standing. So we’ve broken down the key PE due diligence best practices to illustrate how to guard against common pitfalls and position your firm to win.

Early-stage Investment Due Diligence Best Practices  

Start at the macro level before working your way through the details. Your early diligence first step should be to conduct one or two conversations with high-level industry players to get a lay of the land. This should give you enough insight into whether to pursue a deal. Along the way, make sure you also:

Align yourself with relevant advisors and consultants

The sooner you can gain an insider’s expert perspective, the better. A third-party consultant can help you identify red flags and decide whether to go after an investment. Find seasoned professionals who will confirm (or reject) your industry thesis and become an ongoing partner in the space. Your advisor should help you navigate the current deal and cultivate opportunities with potential sellers on your behalf.

Prepare a customized investment due diligence checklist

While you’ll need to address thousands of investment due diligence angles before the process is finished, start with a simple list. Ask questions like these in the beginning:

• What is the market landscape? Knowing the big players, identifying expected headwinds and tailwinds, differentiators, and disruptors in the industry will help lead you to conversations and decisions.
• What are the industry trends? By digging into recent news and trends in a market, you will have a better understanding of the path you’re starting down.
• What general trends could impact the industry? By researching economic, political, tech, or other relevant trends you will begin to see potential risks and gains more clearly.
• Is the industry or market fragmented, consolidated or regionalized? As you research, you need to watch for whether the time is right to strike. For example, a fragmented market may offer lots of opportunity, but it may be too early in the industry or there may be too many players, to achieve your goals.

Choose wisely

How well does this investment align with your overall strategy and operations? The deal might be enticing to you, but make sure it fits with your business model, especially if you specialize in an industry. Choose quality over quantity—considering fewer deals will give you more focus and resources to pursue the best deals, ultimately creating a greater chance at success.

Beware of early stage pitfalls

At this stage, your advisors should be board-level candidates who you can nurture for one to two years—about the time it often takes to move the deal to LOI. Take the time to build a foundation of trust.

To ensure success, make sure you’ve covered the following when working with a private equity advisor:

• Cultivate executive buy-in. Getting sign-off from higher ups before you get too far in the process will save you time and money.
• When appropriate, consider socializing your advisor with the seller’s management team to help establish industry credibility and ensure they see them as an advisory asset, not a threat.The more your expert knows the seller and the company in question, the better he or she can provide helpful insight.
• Establish a strong advisor rapport. Develop trust with your high-level experts—they ultimately guide your strategic direction throughout the process.

Try to ensure a solid mix of junior and senior staff are on the calls so the team can build rapport and develop a long-term relationship with the industry experts.

Late-stage Investment Due Diligence Best Practices

Once your firm has secured its position as a preferred buyer—i.e., you have appealed to the seller’s vision—it’s time to focus on any remaining deep-dive questions.

Examine every angle

Be sure to interview all key stakeholders, including customers, competitors, and suppliers. Make one call per industry facet.

Categorize diligence efforts

At this stage, generic checklists aren’t enough. To understand every aspect of the business, speak to a subject matter expert who can provide a thorough evaluation of that particular angle of investment due diligence (e.g., tax or culture). Develop a comprehensive list of questions that will help you maximize time during your discussion.

To create a list of relevant questions, follow these guidelines:

• Use historical data. Past experiences and conversations will help you develop strong investment hypotheses.
• Read industry reports and talk to specialists. Immerse yourself in the seller’s industry and speak with relevant professionals at all levels.
• Imagine yourself in a company management role—think about daily problems you’d need to manage.

Treat your advisors differently

Keep in mind that there’s a difference between a subject matter expert (SME) and an industry advisor (we often refer to them as river guides). An SME might only require a one-hour phone call, but you should treat experts with deep industry ties differently—especially if the industry is attractive for future investments.

Even if your current deal falls through, your advisor can still provide you with future insights and deal leads. Think outside the due diligence bubble—how else could this person benefit your firm?

Watch out for late-stage pitfalls

As you speak with private equity advisors, keep in mind that one consultant cannot be expected to know everything. Do your best to match appropriate experts with your specific questions. Vet advisors and review their experience relative to the investment opportunity at hand.

Whatever you do, try not to get too lost in the daily grind of diligence. Don’t let your view get too myopic—think big picture and remember that the advisors you engage with today will be useful to your firm in many ways down the road. As long as you remember to be creative about how you utilize advisors,  they’ll add value to your firm for years to come.