Private Equity Due Diligence Process: Driving Value Creation

5 Min Read

It’s no secret that the private equity due diligence process is complex, and as competition increases in the private equity (PE) space, qualified target companies are becoming harder to find. To compete, investors must sharpen their understanding of the seller’s business and industry while navigating private equity due diligence for successful deals.

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. For example, what you need in early-stage due diligence (Indication of Interest or Pre-LOI) is vastly different from late-stage acquisition due diligence, where cash flow sustainability and value creation levers take center stage.

To be clear, failing to organize your approach could cost you more than just losing the deal. It’s a liability that could cost you significant time, capital, and business standing. So we’ve broken down the private equity due diligence process and key PE due diligence best practices to illustrate how to guard against common pitfalls and position your PE 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 includes preliminary reviews of both financial due diligence (e.g., revenue trends) and legal due diligence (e.g., regulatory compliance) to flag major risks early. This should give your private equity firm enough insight to identify opportunities and decide whether to pursue a PE deal. Along the way, make sure you also:

Align your private equity firm with relevant advisors and due diligence consultants

The sooner you can gain an insider’s expert perspective, the better. A third-party due diligence consultant can help you identify red flags and decide whether to proceed with an investment decision. Find seasoned professionals with a proven track record who will validate your investment thesis and become ongoing partners. Your advisor should help you navigate the current deal and cultivate opportunities with potential sellers on your behalf.

Prepare a customized private equity due diligence checklist

While you’ll need to address thousands of investment due diligence angles before the process is finished, start with a simple PE due diligence checklist. 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.
• How does this acquisition fit into your portfolio strategy? Assessing strategic fit with your existing investments and long-term value creation goals will determine if this aligns with your firm’s investment strategy.

Choose PE deals 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 in the private equity due diligence process

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 deal 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. This is also the point in the private equity investment process to validate the target’s financial statements, especially the income statement, to ensure earnings quality aligns with your investment thesis.

Examine every angle

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

Categorize private equity due 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 private equity advisors differently

Keep in mind that there’s a difference between a subject matter expert (SME) and an industry advisor (At Apex Leaders, we often refer to them as “River Guides”). An SME might only require a one-hour phone call to conduct due diligence on specific technical questions, 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 investor network and help your PE firm?

Watch out for late-stage PE deal pitfalls

As you speak with private equity advisors, keep in mind that one consultant cannot be expected to know everything for a private equity transaction. Do your best to match appropriate experts with your specific due diligence questions. Have your PE deal team vet advisors and review their experience relative to the investor opportunity at hand.

Whatever you do, try not to get too lost in the daily grind of standard due 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.