A crucial part of the investment process is the due diligence performed on the company. Think of it like an investigation process for a potential investment: PE firms will perform very detailed due diligence to ensure that they are making a sound investment. This process is crucial to the success of the investment, and the financial sponsor must look at all critical aspects of the target company:
commercial, financial, and legal. Much of the time is spent on commercial due diligence while the financial and legal areas are more confirmatory. PE firms rely on consultants for their expertise and advice for portions of the due diligence process, but ultimately the investment decision is the firm’s responsibility.
Commercial due diligence includes understanding the company’s value proposition, market position, historical performance, and industry trends to assess the target’s ability to achieve its forecasted projections.
Sample due diligence questions include:
Competitive Landscape and Market Position: It is important to understand how sustainable the target’s business model is and where it is positioned relative to its competitors.
What is your competitive advantage (e.g. product offering, technology, price, premium brand, distribution capabilities, geographic presence, fully integrated solution, etc.)? Is this a disruptive business model (i.e., one that changes the landscape of how business is done in this space in some way)?
What are the barriers to entry into the business? What are the costs of switching to a competitor’s product?
Where does the company fit in the industry value chain? How has the industry changed over the last 5 years? How do you expect that to change over the next 5 years?
Who are your main competitors? From whom have you been gaining/losing market share? What firm is the biggest threat to your company? What is the biggest share gain opportunity?
What is the market landscape (e.g. oligopoly, fragmented market, first-mover, etc.)? How saturated is the market?
Industry Growth/Addressable Market: When evaluating the industry, it is crucial to understand the market environment and the external factors affecting the business.
What is the historical growth of the market? What is the projected growth of the market over the next 5 years? How mature is the industry?
What is the total addressable market? What segments of the industry are growing faster than others?
Describe the key macroeconomic drivers of the business. What are the trends?
Have there been any significant changes to the industry landscape (e.g. disruptive new entrants, consolidation, vertical/horizontal integration, demand/supply imbalance, etc.)?
What are the regulatory concerns and how can they adversely affect the business?
Customer Base/Suppliers: This entails understanding the “stickiness” of customers and the company’s reliance on suppliers.
How many customers do you have? What is the concentration of your top 50 customers?
What is the typical contract length of a customer relationship? What is a typical renewal rate? What percentage of customers have multiple products?
Who are the key decision-makers for the customers? What are the buying dynamics? How long is the entire sales process?
How many suppliers do you have? What is the concentration of your top suppliers? How large of a customer are you to them? What is the average length of the relationship? How often are your supply contracts renegotiated?
Capital Requirements of the Business: A good understanding of the total capital needed to run the operations of a business is needed, especially during difficult times.
How capital intensive is the business? What percentage of capital expenditures is growth capital vs. replacement/maintenance capital? How has that trended over the last 5 years? What kind of lead-time is needed (i.e. time from purchase order to delivery) when making a purchase order? How large of a deposit is customary for new purchases?
How cyclical is the business? Are there any severe seasonal changes in demand? What are the factors? How much visibility do you have in expected sales?
What percentage of the COGS cost structure is fixed vs. variable? What is the breakdown of operating expenses?
What is the normal working level of cash to run the business for a year?
At what manufacturing capacity is the company running right now? How quickly and to what extent can it be reduced if demand falls?
What would be your biggest concern in a downside scenario?
Financial Performance (Historical & Projected): This analysis provides a deeper look into the company’s historical performance to understand how realistic the company’s forecasted projections are.
Provide a comparison of the historical performance to the management budgets for the last 5 years. Describe the methodology behind the budget and the reasons for beating/missing the budget.
What are the key performance indicators (KPIs) the management uses to monitor the business? Describe the trends in these indicators.
Break out your organic growth over the last 5 years (not including the impact from acquisitions).
Provide your 5-year financial model and describe the key drivers in your projections.
Growth: Please describe the key assumptions. How does it compare to expected market growth? Where will it come from (increase in price, increase in volume, increase in market share, new products, acquisitions, etc.)?
Margins: Please describe the key assumptions. Why (for example) do you expect margins to increase so significantly compared to historical performance? Where will it come from (operating leverage, cost efficiencies, higher margins on products, revenue/cost mix, etc.)?
KPIs: Describe key assumptions. How do they compare to the industry average and/or your main competitors?
What are the primary risks to this forecast (new product introduction, successful expansion into a new geography, customer concentration, sufficient hiring of employees, R&D resources, etc.)?
Financial due diligence confirms that all the financial information provided is accurate and helps PE firms understand some of the unique dynamics of the company from a financial reporting perspective. The firms typically hire accountants and/or auditors to review the financials, operations, customers, markets, and tax issues in detail. This is usually referred to as “transaction advisory services.”
Corporate filings: This component of the legal due diligence process is to confirm that all corporate filings have been filed correctly (corporate organization and documents) and to understand the legal organization of the company, such as whether there are any strange corporate structures.
Material contracts: Prior to acquiring a company, it is important to look at past and current material contracts. This includes the debt structure, acquisitions and other liabilities, and it may include key customer, partner or supplier agreements.
Property, plant and equipment: It is important to consider the company’s property, plant and equipment to study its assets and liabilities. One example of this is a detailed review of key operating or capital leases.
Human resources: HR due diligence is another important area in legal due diligence, and it refers to the target company’s management team and employees. Any HR risks need to be captured in the valuation model. The firm will look at employment terms/agreements, individual contracts, collectively bargained agreements and retention/severance agreements. In conjunction, a review of the management and employees are necessary. The compensation structure is crucial to understanding the organizational and operational structure of the company. This includes compensation for executives, and the possible severance required if they are to be terminated during the deal. This also includes other salary and stock option plans for key employees.
Health and welfare plans: The target company will have various benefit plans set up, which must be evaluated as the acquisition is taking place. The firm reviews the health benefit plans, retiree health plans, and retirement plans to understand any regulations or legal issues surrounding the benefits.
Information technology: Reviewing the company’s IT structure during legal due diligence is very important. Assessing the company’s information technology and related agreements can provide further insight into the company’s weaknesses and strengths. The review includes looking at software or hardware agreements with external parties, contractually obligated product features or service level agreements, license agreements, and other technology agreements
Lawsuits/litigation/patents: A look at the company’s lawsuits/litigation provides a summary of any pending litigation, history of past litigations, and what may arise in the company, such as environmental, employment, customer or worker compensation issues. Similarly, a careful review of the in