Due diligence

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Due diligence meaning and process

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What iS due diligence?

Due diligence is used to investigate and evaluate a business opportunity.

Due diligence serves to confirm all material facts in regards to a sale.

refers to the care a reasonable person should take before entering into an agreement or a transaction with another party

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Due diligence is a process of thorough and objective examination that is undertaken before corporate entities enter into major transactions such as mergers and acquisitions, issuing new stock or other securities, project finance, securitization, etc.

One of the key objectives of due diligence is to minimize, to the maximum extent practicable, the possibility of there being unknown liabilities or risks.

The exercise is multidimensional and involves investigation into the business, tax, financial, accounting and legal aspects of an issuer.

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The process starts with the sourcing of the fund opportunity.

an investor will either be approached directly or indirectly (through a placement agent) by the fund manager

If the investor is satisfied that the fund meets its preliminary criteria, full due diligence begins.

Investors examine the type and positioning of the fund, evaluate the historic track record, make an initial assessment of the team and the organization and ensure that there are no obvious dealbreakers.

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Due diligence processevaluate a basket of both quantitative and qualitative factors

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people
Assessment of the managers team, organization, individuals experience, remuneration structure Multiple face-to-face meetings, including visits to all the managers offices, Interviews with investment professionals, alone, and in groups, formally and informally and at various levels in the organization Detailed reference checks with portfolio company management, other private equity professionals, bankers, accountants, lawyers, investors, and previous colleagues, including leavers from the firm Ownership and remuneration analysis, including fee income and breakdown of carried interest

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process
Assessment of the managers deal sourcing, due diligence, monitoring and exit process Complete portfolio review, including a Responsible Investment (RI) review of portfolio companies Assessment of the managers previous due diligence work, including checks on portfolio company files and monitoring systems. Assessment of the managers compliance and risk management processes, including back office audit and an understanding of how the manager has integrated RI into its investment and reporting
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Philosophy and investment strategy

Assessment of the consistency and suitability of the managers strategy, and its execution

Understanding of the market within which the fund manager operates. Comparison of strategy and positioning with private equity managers targeting the same or similar markets (whether or not they are currently in the market with a new fund). Analysis of trends in previous portfolios of the fund manager)

Evaluation of the managers ability to carry out the funds stated strategy in the future.

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performance
Assessment of the managers track record, areas of valueadd and repeatability Slice and Dice analysis: evaluation, verification and attribution analysis of the managers track record, including performance breakdown by deal executive, geography. Understanding of the managers valuation policy and reasonableness thereof;

Comparison of exit values against the last stated value of a portfolio company, again to test for reasonableness of the managers valuation process
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Portfolio fit and legal review

Assessment of the funds terms and conditions and strategic fit within the fund portfolio

Suitability and fit within the investors overall portfolio.

Legal document review and comparison with best practice Reporting provisions, quality of information flow to investors, membership of the Advisory Board, and accessibility to the manager

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Once the investor has completed the due diligence stage, negotiation of the terms of the fund can proceed.

Many investors try to enter a fund at its first closing, so that they can have a greater say in setting the terms of the fund.

work is involved for both the investor (in assessing a fund) and the manager (in working through the investors due diligence process) that investors and managers try to build long term relationships

After the closing takes place, the investor needs to set up a monitoring process to conduct ongoing evaluation of the manager and the performance of the fund
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Due diligence checklist

A comprehensive business information request list sent from a private equity firm to a seller to assist the buyer in conducting a thorough business review. Due diligence checklists are typically prepared and forwarded once a buyer is in exclusivity with the seller. most information requests are somewhat predictable regardless of the buyer, much of the information requested may already have been provided in the deal data room.

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I. Financial Information
A. Annual and quarterly financial information for the past three years 1.Income statements, balance sheets, cash flows. 2. Planned versus actual results 3. Management financial reports 4. Breakdown of sales and gross profits by: a. Product Type b. Channel c. Geography
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B. Financial Projections Major growth drivers Predictability of business Risks (e.g., exchange rate fluctuation, government instability) Industry and company pricing policies Explanation of projected capital expenditures,
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 C. Capital Structure 1. List of all stockholders with shareholdings, options, warrants 2. Schedule warrants, rights. 3. Summary of all debt instruments 4. balance sheet liabilities

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II. Products
A. Description of each product 1. Major customers and applications 2. Historical and projected growth rates 3. Market share 4. Speed and nature of technological change 5. Timing of new products, product enhancements 6. Cost structure and profitability
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III. Customer Information

A. List of top 15 customers for the past two fiscal years (name, contact name, address, phone number, product(s) owned, and timing of purchase(s) B. Revenue by customer (name, contact name, phone number for any accounting for 5 percent or more of revenue) C. Brief description of any significant relationships severed within the last two years. (name, contact name, phone number) D. List of top 10 suppliers for the past two fiscal years information (name, contact name, phone number, purchase amounts, supplier agreements

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IV. Competition
A. Description of the competitiveness within each market segment including: 1. Market position and related strengths and weaknesses as perceived in the market place 2. Basis of competition (e.g., price, service, technology, distribution

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V. Marketing, Sales, and Distribution

A. Strategy and implementation B. Major Customers C. Principal avenues for generating new business D. Ability to implement marketing plan with current and projected budgets

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VI. Research and Development

A. Description of R&D organization 1. Strategy 2. Key Personnel 3. Major Activities B. New Product Pipeline 1. Status and Timing 2. Cost of Development 3. Critical Technology Necessary for Implementation 4. Risks
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 A. Organization Chart B. Summary biographies of senior management, including employment history, age, service with the Company, years in current position C. Compensation arrangements 1. Copies (or summaries) of key employment agreements 2. Benefit plans D. Discussion of incentive stock plans E. Significant employee relations problems, past or present

VII. Management and Personnel

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VIII. Legal and Related Matters

A. Pending lawsuits against the Company B. Pending lawsuits initiated by Company C. Description of environmental and employee safety issues and liabilities D. List of material patents, copyrights, licenses, and trademarks
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Challenges
Consistent application of criteria Various firms indicate that their process is outlined and documented but tends to be more institutional. Formal documentation is not fully utilized. the fundamental elements of the screening and due diligence process should create valuable time to explore the details of a potential investment opportunity
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Capturing knowledge and experience

efforts to enhance ones learning curve become critical in facilitating the capture of knowledge. Often it becomes necessary to have knowledge that is narrow and deep to intimately understand a particular market / technology space. This intimacy with a particular space leads to improved handling of the due diligence process.
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Proactive Research
Often firms are focused on their core expertise and are not able to devote sufficient time and resources to exploring new market spaces. Firms often comment that, if time allowed, they would like to devote resources to understanding new market space opportunities through extending their knowledge and core competencies. The ability to not only identify new market space, but to also identify the specific companies, could create a significant potential advantage for firms. Therefore, improving the process of due diligence should create time to devote to other endeavours.
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PRECAUTIONARY MEASURES COMPANIES TAKE BEFORE ENTERING A DUE DELIGENCE AGREEMENT

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1 Make sure a business is worth buying should verify the information you have been given about your prospective new business It should also highlight any issues or problems which might need warranting or guaranteeing.
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 There are traditionally three types of due diligence you should do.
You might need different advisors for each:

legal due diligence - as part of a sales and purchase contract, the lawyers can check that the business has legal title to sell, ownership of all the assets and that regulatory and litigation issues are fully addressed
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financial due diligence - checking the numbers and making sure there are no black holes or hidden financial issues

commercial due diligence - finding out the business' place in the marketplace, checking competitors and the regulatory environment

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2. WHEN TO BEGIN Don't start due diligence until you have agreed a price and terms with the seller.

They may agree to take the business off the market during your investigation.
This is known as an exclusivity period - and the seller will often ask for a down payment to secure it.
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3. Help Ideally you should get accountants and solicitors to help you identify risk areas but, if it is registered with Companies House, you can also obtain copies of the company accounts, the annual return and the other key documents filed by your target business using the Companies House WebCHeck service.

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Key areas to cover are: employment terms and conditions outstanding litigation major contracts and orders IT systems and other technology environmental issues commercial management including customer service, research and development, and marketing

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4. Information sources Dig as deeply as you can and use whatever documents are available. For instance, if you're looking at employee records, you could check out: payroll records staff files copies of pension and profit-sharing plans, plus financial statements, if relevant employment contracts the staff manual union contracts, if relevant You may also need information from external sources such as the landlord, tax office or bank.
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