Before entering into an agreement or contract with another party, a company usually conducts due diligence. Due diligence for any transaction minimizes risks and maximizes value for the shareholders and stakeholders involved. According to Thomson Reuters Westlaw, the specific due diligence plan for a private equity transaction is driven by the private equity (PE) fund’s underlying strategy for building value.
Enhanced due diligence (EDD) refers to a deeper level of scrutiny of entities with whom a company seeks to do business. The goal of EDD is to uncover risks that cannot be detected through regular due diligence, namely identity verification. EDD helps prevent the flow of “dirty” money—obtained from money laundering, terrorism, or fraudulent activities—from ending up in the PE fund’s ecosystem and possibly being channeled into a portfolio company.
Due diligence regarding private equity can involve two distinct scenarios:
- Due diligence on the part of the PE fund in evaluating a company in which it seeks to make an investment.
- Due diligence on the part of investors or consultants when screening PE funds in which they plan to make an investment or make a recommendation to clients to make an investment.
Let’s have a look at the process for each of these two scenarios.
For Private Equity Investment
Due diligence is expected for PE firms interested in making an investment in a company. The PE fund, often referred to as the financial buyer, or simply buyer, must gather information about the company seeking funding, or about the seller. Information about the business and its assets enable the PE firm to formulate the purchase price for the acquisition and a comprehensive business plan for the target company.
Although the seller occasionally conducts due diligence on the buyer, especially when the issuing of shares is involved and valuation is key, the due diligence process is usually more significant for — and driven by — the buyer.
Using due diligence, the buyer can measure and verify the target company’s business to determine what profit opportunities exist currently or in the near term.
Such areas to explore include the company’s
- Business plan
- Operational capacity
- Technology and IP
- Employee capabilities and skills
- Product or service lines
- Existing customers
These can all be quantified as assets, which the buyer currently may feel are not adequately being exploited. Of course, the buyer also needs to identify any risks and liabilities, as these can also severely impact valuation.
Aside from spreadsheets, many other types of documents demonstrating the target company’s assets and liabilities are involved. Some might be in hard copy form only and need to be digitized for sharing with the PE fund; others might already be in digital format but need to be reformatted and shared via a cloud access system.
Smaller, private companies may not be used to the due diligence process, creating a challenge. All proper documentation needs to be collected and consolidated in such a way that the due diligence process can proceed smoothly as planned. Any obstacles to accessing documents can delay a decision by the PE fund, impacting the disbursement of funds to the target company.
For Investors Seeking to Invest in a Fund
Considerable challenges abound for institutional investors involved in screening and selecting a PE fund in which to invest. Such investors also need to conduct their due diligence on the PE fund. Aside from investors, there are also placement agents, investment consultants and other professionals who conduct due diligence on behalf of their institutional investor clients. Of course, such professionals need to access information that provides the best indications of that PE fund’s likely future success.
Because investments in PE funds are by nature long-term and illiquid, due diligence can be challenging. As such, the process and tasks around it should be well-defined, executed, tracked and documented.
Creating a PE due diligence questionnaire, or a checklist related to the asset class-specific issues, is one of the fundamental steps toward successful due diligence on a PE fund.
Aside from the general topics that should be covered relating to the market opportunity, strategy, the organization, the team and (of course) the PE fund’s track record, there are some additional important aspects specific to PE fund due diligence that investors should consider.
Some of these might include:
- Source of the PE fund manager’s deal flow
- The fund’s reliance on non-public information in selecting companies in which to invest
- The fund’s participation in joint ventures vs. owning the entire portfolio company
- Whether the fund usually acts as the lead investor
- Length of time of holding an investment in a company
- How the PE fund adds value to a company
- What portion of the investments are sold through IPOs, auctions or acquisitions
A proper due diligence questionnaire provided by the PE fund for investors is key, though investors need to access multiple, additional documents to answer any questions they may have.
How to Best Manage Documents in a Sensitive Financial Transaction
As thousands of pages of highly-sensitive documents are handled by dozens or hundreds of people in a PE transaction, security and tracking are needed to ensure that the right access has been granted and has not been compromised.
Organizations should consider an enterprise document security solution, such as Caplinked, that has these needs in mind. Digital rights management capabilities provide encryption and complete control over how a document is used, edited, copied or even printed. Caplinked’s FileProtect feature lets companies share documents while retaining the ability to deny access to anything, even after a file is downloaded.
In today’s anytime anywhere environment, documents are most likely accessed via multiple cloud platforms. Caplinked provides cloud integrations with such platforms as Salesforce, Dropbox, Box, Google Drive and OneDrive. Ready to learn how Caplinked can make your enhanced due diligence process seamless? Start your free trial today.
Jake Wengroff writes about technology and financial services. A former technology reporter for CBS Radio, Jake covers such topics as security, mobility, e-commerce, and IoT.