Private equity due diligence: process and checklist

Before a private equity fund buys a company it checks what it is buying. That check is due diligence. This page follows it in order: the funnel that narrows many opportunities to a few purchases, the work streams run on the survivors, who does the work and who signs off.

It sits in the deals section and picks up where the investment approach page leaves off.

Key takeaways

• Due diligence is a detailed investigation of financials, operations, markets and risks before investment³.
• Most opportunities never reach it. The survey average is fewer than 24 of every 100 reaching deep due diligence¹.
• The work is done by internal staff and external consultants or advisers², and an investment committee decides².
• Findings feed price and terms: issues found can be used to negotiate better terms or a lower purchase price⁸.
• It reduces risk and does not remove it¹¹.

What due diligence is for

In private equity, due diligence is the detailed investigation of a target company’s financials, operations, markets and risks before investment³. Its goal is to validate the assumptions behind the deal and uncover issues that could affect returns³. Before a deal completes, the work will customarily have been done by internal staff and by external consultants or advisers, as the IOSCO report on private equity conflicts records².

The work has two jobs. It screens out companies that would fail, and it turns what it finds into a price: information gathered during due diligence is a tool in negotiations, because uncovered issues or risks can be used to negotiate better terms or a lower purchase price⁸.

It does not guarantee anything. Risk management and due diligence processes seek to mitigate, but cannot eliminate, risk¹¹.

The deal funnel: 100 opportunities, 6 closings

Most of the time spent on diligence produces no deal. A survey of 79 private equity investors with combined assets under management of over $750B¹ reports the average funnel in its Table 19, the percentage of opportunities considered that reach each stage¹. For every hundred opportunities considered, the average investor deeply investigates fewer than 24, signs an agreement with fewer than 14 and closes on only 6¹. The survey authors read this as evidence that investors devote considerable resources to evaluating transactions even though they will ultimately invest in only a very few¹.

The sharpest drop is between limited and deep due diligence, from 49.1% to 23.7%¹. Larger and older firms pass a greater fraction of their deals through to the next stage¹.

Worked example (our arithmetic)

The funnel numbers convert into two ratios. The inputs are the survey means¹:

On the survey averages a firm carries out nearly four deep diligences for every company it buys, and weighs roughly sixteen opportunities for each one (our arithmetic from the averages above)¹. The numbers are the managers’ own reports from a survey, not an audit of deal files, and they vary by firm.

The process step by step

The funnel stages map to a sequence that most firms recognise, although each firm names the steps differently.

• First, screen. The first thing a deal team does is compare a potential investment against the fund’s investment criteria⁹. A company can be dismissed immediately if its financial profile, geography or industry does not fit the fund⁹.
• Second, first read. The seller’s confidential information memorandum, a document often upwards of 50 pages⁹, starts the work. Good deal teams do not rely solely on it: they use it as a starting point for further due diligence⁹.
• Third, committee. Once a firm has identified a potential investment it typically makes a proposal to an investment committee formed from senior staff, which determines whether to pursue it and sets parameters for bidding².
• Fourth, management and limited work. Management meetings and a limited round of checks come next¹.
• Fifth, letter of intent. The firm submits a non-binding letter of intent that outlines the proposed purchase price or valuation range, key terms and conditions, and an exclusivity period for further due diligence⁸.
• Sixth, deep work. Comprehensive due diligence is a deep dive into all aspects of the target, including financial, legal, operational, commercial, IT and cybersecurity, and ESG due diligence⁸.
• Seventh, final price and structure. Based on the findings, the firm refines its valuation model and structures the deal⁸.
• Eighth, approval and signing. The committee decides on the basis of a wide range of factors, particularly compatibility with the fund’s investment strategy and the potential for growth within the remaining life span of the fund².

The checks, work stream by work stream

A checklist is a set of questions grouped by who can answer them. One guide counts nine areas: finance, tax, legal, HR, assets, IT, competitive position, total addressable market and capital requirements⁹. The sections below take the four that most checklists open with.

Financial

Financial due diligence examines balance sheets, income statements and cash flow statements, typically for at least the past 3 to 5 years¹⁰. Quality of earnings analysis is an important part of it: it aims to verify the accuracy of a target company’s reported earnings⁸. It looks at adjustments such as one-time or non-recurring items and owner-related expenses in privately held companies⁸. Working capital matters because management of working capital shows the company’s short-term financial health⁸.

Legal

Legal due diligence analyses regulatory compliance, contractual obligations and intellectual property rights⁸. The reviewer reads contracts, intellectual property rights, pending or potential litigation and regulatory compliance¹⁰. One question matters for any buyer: whether any contracts contain change of control provisions that could be triggered by the acquisition⁸.

Human resources and management

The people check is partly formal, such as whether processes exist to attract, develop and retain key talent⁸, and partly informal. A weak management team is a problem a buyer may expect to fix, and that fact can only be uncovered by a deal team that meets with managers, visits suppliers and interviews customers⁹. The survey ranks the management team as an important selection factor, covered below¹.

Information technology

IT due diligence assesses the target’s technological foundation, including its infrastructure, data security and overall IT strategy⁸. The same list puts IT and cybersecurity beside financial, legal, operational, commercial and ESG work in the comprehensive phase⁸.

Commercial, tax, ESG and the rest

Commercial work tests the market the company sells into and its place in it. Tax and asset reviews sit in the nine-area list⁹. ESG work is increasingly standard: the comprehensive phase includes environmental, social and governance due diligence⁸.

What decides a deal

Diligence produces facts, and the investment committee ranks them. In the survey, investors ranked the factors they consider in choosing an investment. The most important was the business model and competitive position of the company¹. The management team, the investor’s ability to add value and the valuation were the three next most important and were roughly of equal importance¹. The industry or market and the fit with the investor’s fund were of least importance¹.

Table 21 of the paper ranks the factors on a scale where higher numbers are more important¹.

Who does the work, and who decides

Deal teams do not work alone. Beyond the firm’s own staff and outside consultants², almost 66% of the surveyed investors have an advisory board or use senior advisors¹. The investors describe these advisers as helping with deal flow and assisting with investment due diligence, among other tasks¹. Almost 32% hire strategy consultants to help with operating plans¹.

The decision sits with an investment committee. In Hong Kong the composition of that committee has a licensing consequence under the SFC’s circular to private equity firms. Members of an investment committee who, individually or jointly, play a dominant role in making investment decisions for the funds are required to be licensed as representatives and, where appropriate, approved as responsible officers⁷. Members with no vote or veto, whose role is to give legal, compliance or internal control input, would generally not need to be licensed⁷. The Type 9 licence page covers the rest of the licensing test.

Where deals come from changes the diligence

How a deal reaches the firm affects how much room there is to look. In the survey, almost 36% of closed deals were proactively self-generated, 7.4% were provided by management and 8.6% came from the firm’s executive network¹. In contrast, 33% were investment banking generated, 8.6% came from deal brokers and 4.3% came from other private equity firms¹. The authors regard the first group as having the potential to be proprietary and the second as unlikely to be¹. The survey reports where deals come from, not how deep the work went on each.

Due diligence on the manager

Investors diligence the manager too, on a separate track. The Institutional Limited Partners Association publishes a standard questionnaire. Its latest update is intended to standardise the key areas of inquiry posed by investors during their diligence of managers⁴. The update added sections on co-investments, GP-led secondaries, credit facilities and data security⁴, after the first release in 2013⁴. The environmental, social and governance section adopts in full the Principles for Responsible Investment’s questionnaire for limited partners⁴.

ILPA’s ESG Assessment Framework helps limited partners benchmark general partners’ responses to due diligence efforts⁵. It sorts activities into four buckets: Not Present, Developing, Intermediate and Advanced⁵. Co-investing alongside a fund moves the work back to the investor’s desk: it requires more due diligence and different skills than fund investing³.

Who pays for the work

Diligence costs money, and the fund documents decide who bears it. The ILPA Principles say broken deal expenses should be charged to the fund⁶. They also say that expenses incurred through preliminary due diligence and sourcing should not be considered broken deal expenses⁶. So the cost of early sourcing and preliminary work stays outside the broken-deal charge to the fund⁶. The fees and carry page covers how fees and expenses are set.

Limits of this page

The funnel and the factor ranking are one survey of firms describing their own practice¹. The work stream lists come from vendor guides, which are context and not a standard⁸. The checklists here are not a regulatory standard. Education only: nothing on this page is an offer or advice.