Tag Archives: Due Diligence Outsourcing

Introduction

Before committing funds to private markets, due diligence for private equity outlines a potential investor’s procedure for evaluating an investment fund’s appeal, value, financial sustainability, and prospects. It is often performed by analysts and such specialists and includes gathering and processing information about a fund’s historical investment record, finances, and other aspects. A limited partnership’s decision to contribute capital to a fund is based on the findings of the due diligence process. Institutional investors often use sophisticated due diligence methods for all their public or private transactions, but due diligence in the private market presents different obstacles.

Challenges faced in Due Diligence for Private Equity

Although all due diligence processes have basic features, due diligence for private equity processes has obstacles which are explained below:

Challenges faced in Due Diligence for Private Equity

Challenges faced in Due Diligence for Private Equity

Private Data

Because the target firm is not publicly traded, there is little information about it available than otherwise, such as through its SEC filings. The businesses that fund managers usually prefer to invest in are not publicly traded, making it difficult to get all the information a transaction team wants to feel confident.

Third-party data scrapers

Third-party providers providing private market data have now been considered to help with Due diligence for private equity funds. On the other hand, some data sources are more dependable and valuable than others. Some companies offer financial performance statistics scraped from publicly available information, often confined to a summary. Furthermore, some data sets could be too tiny for investors to trust their accuracy. Investors should seek primary-sourced data from a third-party private equity data provider rather than from pitch books or elsewhere online when evaluating a third-party data provider.

A lengthy process

It is frequently both a manual and time-consuming procedure. Investors are increasingly turning to technology to speed up and streamline their due diligence procedures, ensuring that the best decision is made.

Different Strategy

As many private transactions seem to be financial instead of strategic — i.e., the private equity firm’s sole motivation is to profit from the transaction – the unique perspective. In this case, a private equity deal team may devote more time to the financial components of the transaction than to the managerial or commercial parts, requiring far more information about the company’s financial status.

Confidential Information Memorandum (CIM)

The company’s confidential information memorandum (CIM), a vast document that includes financial data, a description of the management team, and commercial specifics such as insights into the customer base, products, and competitors, is often used to drive due diligence for private equity. On the other hand, Smart private equity firms do not rely only on the CIM and double-check the data.

The Steps involved in the Process of Due Diligence for Private Equity

Various steps are included in the process of due diligence, these include the following:

Steps involved in the Process of Due Diligence for Private Equity

Steps involved in the Process of Due Diligence for Private Equity

Industry Due Diligence for Private Equity

The first aspect of due diligence for private equity is a detailed investigation of the target company’s sector. Understanding an industry takes time and based on how in-depth the private equity purchaser wants to go, the process may involve accounting, tax, and legal advisers analyzing the nuances of the business. During their sector investigation, private equity buyers may discover other intriguing target companies or decide that a related industry is better suited to their investment criteria.

Due diligence in the target company’s industry is a transaction-specific exercise tailored to the private equity investor’s requirements. Knowing the industry in which the target company operates, its competitors, and market trends are all part of the exercise. In such an exercise, the investor considers if the specific target industry is growing and how profitable an investment in that sector will be.

Quality of Earnings Assessment 

Although the financial portion of due diligence for private equity examines the same papers as any other due diligence procedure, it emphasizes the ‘quality of earnings.’ Separating extraordinary revenues and expenses from past income statements examines what the target company can earn on an ongoing basis.

By removing these remarkable factors from the financial figures, the private equity client should get a more realistic picture of how the company is expanding and how it is expected to continue. The ‘quality of earnings’ analysis can be as in-depth as the private equity buyer requires. It could, for example, include a worst-case scenario in which several of the target firm’s top clients cancel ongoing contracts and analyze the impact on the target company.

Legal Due Diligence for Private Equity

The deal team must be confident about proceeding before the firm invests time and money in legal due diligence for private equity.

Legal due diligence examines the legal ramifications of the transaction, in part to confirm the firm’s assumptions, validate that the firm is not exposed to unanticipated liabilities, and ensure that the firm is in compliance with all laws and regulations.

Legal due diligence for private equity deals should focus on the following areas:

  • The legal ramifications of a change of power at the target firm.
  • Regulatory constraints of the target company.
  • Agreements for exclusive supply or purchase.
  • Contractual agreements with current vendors, suppliers, and customers and how the transaction affects them.

Operational Due Diligence for Private Equity

Any private equity transaction aims to improve the target company’s operations and rise in value before leaving the investment after a set period. As a result, the deal team will work with financial and legal experts to identify all the prospects for value-generating operational changes at the target firm. Due diligence is learning about a manager’s internal processes to safeguard investors from losses caused by operational errors or, in the worst-case situation, fraud. With limited money and time, this can be not easy. On the other hand, Minor infractions might fuel larger ones and build a culture in which practices or norms are increasingly considered toothless guidelines. Investors can choose fund managers measured based on and clear idea of the necessary operational risks, improving the quality of their portfolios and avoiding potential reputational risk and economic loss.

Future of Due Diligence for Private Equity

Asset competition has been intense, and it is expected to continue. More investors are vying for a smaller pool of assets, and potential targets’ management teams are less capable or willing to devote time and resources to responding to diligence demands. As a result, due diligence for private equity companies is growing more complex as they increasingly analyze more data and look for ways to make purchases more efficient.

-Due to market conditions, private equity firms have had to reconcile risk mitigation and wealth development.

-More technology and analytics will be used, and more sell-side investigation.

Firms can do the following to fulfill the intention of making the diligence process much more efficient and digital:

-Utilize data and analytics technologies to generate quicker, more actionable insights by embracing digital diligence.

-Integrate sell-side diligence into their procedures the proper way.

-To the degree that it can underwrite investments, focus on value generation.

-Improve ESG diligence by collecting and analyzing data more consistently.

Magistral’s Services on Due Diligence for Private Equity

Magistral Consulting’s due diligence for private equity services ensures that an asset generates healthy returns. The services include:

Industry Research

With the acquisition target in mind, the target industry is examined for potential headwinds and tailwinds and short- and medium-term security and returns.

Due Diligence

A detailed corporate profile is created utilizing primary and secondary research to detect any risks.

Due Diligence Questionnaire

This service involves the preparation of due diligence questionnaire leading to further analysis with targets and investors.

Primary Research

Exploratory interviews with all stakeholders at the Target Company, including management, employees, ex-employees, vendors, and investors, are done to uncover any future liabilities.

About Magistral consulting

Magistral Consulting has helped multiple funds and companies in outsourcing operations activities. It has service offerings for Private Equity, Venture Capital, Family Offices, Investment Banks, Asset Managers, Hedge Funds, Financial Consultants, Real Estate, REITs, RE funds, Corporates and Portfolio companies. Its functional expertise is in Deal origination, Deal Execution, Due Diligence, Financial Modeling, Portfolio Management and Equity Research.

For setting up an appointment with a Magistral representative visit www.magistralconsulting.com/contact

About the Author

The article is Authored by Marketing Department of Magistral Consulting. For any business inquiries, you could reach out to prabhash.choudhary@magistralconsulting.com

What is Due Diligence?

Due Diligence Definition: It is an exercise done to check the quality of an investment before committing funds to it. There are lots of claims that are made by an asset manager, a company founder, a real estate developer, or anyone else who is interested in selling the asset or a stake of it thereof. These claims need to be satisfactorily validated before the funds are committed to buying the asset or a part of it.

 

Due Diligence in Finance

Due diligence is a general term of analyzing the investment before committing the funds. Financial due diligence concerns with the assets that generate returns and are financial in nature like private or public companies, start-ups, hedge funds, real estate, and real estate funds.

 

What does due diligence consist of?

Due diligence for financial aspects validates the claims of the seller through a detailed study of the documentation supporting the sellers’ claims. The Due Diligence period depends on the size and the nature of the asset on which it is being performed. The speed at which the data is made available also impacts the Due Diligence period. A start-up which is a small set-up could be checked in say a few weeks’ time, whereas bigger corporates may take months before the exercise for the whole company is performed.

Due Diligence Process

The process sometimes may take long periods and may require expertise. An external consultant can be hired for a Due diligence fee to make the process more objective

Here are the steps that are required for a detailed Due Diligence exercise:

Establishing the purpose of the investment

The investor needs to identify the purpose of the investment to do due diligence on the relevant aspects of the financial assets. For example, an investor wants to invest in a start-up with an aim of explosive growth in the next few years, so that he could exit the investment with massive gains. Or another investor wants to invest in a Real Estate fund specializing in infrastructure to generate a regular flow of income. Establishing the purpose clarifies the areas where the due diligence should be focused on. This leads to the development of the Due Diligence framework

Identifying the focus areas for Due Diligence

Once the purpose is established, investors should identify their focus areas for due diligence accordingly. In the above example say for the start-up the future growth is very important. What are the factors on which the future growth would depend? These are the market in which the start-up operates, its competition, its product, the capability of the team, etc. Similarly, for the Real Estate investment, the quality of underlying assets is important so that the investor could be assured of regular returns. This leads to doing due diligence on the type and quality of investments done by the RE fund, contracts signed, leases, rent rolls, tenants, users, market conditions, and everything else that may have an impact on the RE yield, where the fund operates

Preparing Due Diligence Questionnaires

A questionnaire needs to be prepared for each focus area. The way it works is that one starts with a broad question and set of other supporting questions. The questionnaire is followed by the collection of all the relevant data and documents. The seller provides the due diligence documents through data rooms, that could be physical or virtual. Investors or their representatives go through the details of all the data and documents and ask for clarifications if that is so required. A Due diligence checklist is also prepared to find out all the relevant supporting documents. A Due Diligence Analyst keeps track of the documents in the data room and the actions completed.

Preparing Due Diligence Report

Once the study of all the data and documents is complete, the service provider prepares a due diligence report for the investors. It carries all the details about the investments, outcomes that could reasonably be expected from the investments, and red flags that the investor should be concerned about. Some reports clearly suggest if the investor should go ahead with the investment at all

Magistral Consulting has experience in conducting due diligence for start-ups, private companies, public companies, and funds. It covers all aspects of due diligence done by Private Equity, Venture Capital, Investment Banks, Family Offices, and Fund of Funds. Here are the broad types of Due Diligence

Types of Financial Due Diligence

Various types of Due Diligence performed by Investment Banks, Private Equity, Venture Capital and Family Office firms

Due Diligence of a Company

Due diligence for companies is typically done before investing in or Mergers and Acquisitions of companies. This is also done before buying a business. The areas covered in the process largely depend on the size of the company and the purpose of the investment. While doing due diligence for companies, the following are the areas that should be looked into

Financial Performance-Past and Forecast

This is very critical for bigger companies. As usually the investments are done for returns from stocks, which is directly related to the expected financial performance of the company. It also impacts company valuation and stock price. Past financial performance is pulled out and compared with regulatory filings. Also studied are the market, trends, cyclicity, inventory, and other financial aspects. P&L and balance sheets are dived into to find any outliers. This is compared with peers in the same industry to look for anything that may raise suspicion. Forecast assumptions are checked for validity. Departmental budgets are scrutinized for authenticity and to find improvement potential. Previous audit reports are seen for regularly repeated observations. Usually, for start-ups, this is not a critical factor, as they are still in process of streamlining the revenue sources. Still, for start-ups that are looking to raise funds beyond seed or Series A, it’s imperative to get into the details of financials.

Strategy

Another aspect of companies that need closer careful evaluation is their strategy. The growth rates of the markets, and product categories, it plans to expand into is closely studied. It is checked if the current portfolio of its products and services is the most favorable from cost and growth perspectives. Risks are also evaluated along with the competition of the company. In the case of Start-ups and smaller companies, growth rates, competition and trends are looked into closely to verify the assumptions made while valuing the company

Operations

various other functions of the company are also studied under this like Manufacturing, Procurement, Human Resources, Technology, etc. It is evaluated with a lens of efficiency and cost. This is to evaluate the scope of operational efficiency in case the ownership of the company changes hands. Again this is not so important for smaller or start-up companies.

Team

Due diligence on the team is very important for start-up companies. Their experience, skills, qualifications, and past achievements are looked into to have a comprehensive view of their capabilities and future potential. This factor is not that important in the case of large companies where this exercise is being done for M&A

Product

This is very important for SaaS-based tech start-ups. The product needs to be checked as to where is it in the development stage. If it is fully developed, whether its UI, features, etc. are working properly. If not how much time and effort will go into developing the product. Is there even a chance of whether the team will ever be able to develop the product? For bigger companies, the entire portfolio of the product is studied to find out winners

Customers

In the case of B2B health of the biggest clients is checked out to suggest the sustainability of the market for the company. In the case of the B2C demographic profile and its future changes are analyzed to understand any revenue impact in the future. For SaaS-based tech companies, the nature of customers is understood whether they are free, freemium, or paid and the average ticket price to understand the sustainability of the business in the long run

Due Diligence of Funds

Due diligence of funds is usually done by Fund of Funds, Family Offices, and other investors who are interested in investing in the fund. The process, in this case, is different from the  process followed in case of companies

Activities of Due Diligence

Major differences between due diligence of companies and funds

Here are the items that are looked at while performing due diligence for the funds

Fund Performance

This is true for both Real Estate and Hedge Funds. All the technical parameters related to the fund performance are looked at while making a decision.  This evaluates not only the returns that the fund has generated in the past but also the volatility and the risk taken to produce those returns. Funds’ performance is benchmarked with the indices that carry no investment risks

 

Team

Here the profile of Fund Managers is looked into. Their experience qualification and past performance are looked into while evaluating the team. This is again true for both Hedge Funds and Real Estate funds

 

Investment Focus

The investment focus of the fund is analyzed to see if it is in line with the expectations of the investor. If it is a hedge fund that its markets, stocks, and geography are considered whereas if it is a Real Estate fund then the Real Estate Class and geography are considered for the exercise.

 

Underlying Portfolio

This is slightly more important in the case of Due Diligence of Real Estate funds as compared to Hedge funds as the Hedge Fund portfolio churns more often, whereas the Real Estate portfolio is more or less permanent. The quality of the underlying portfolio is looked at for the potential of generating regular returns. If there are any red flags in any of the properties, the same is highlighted. Real Estate properties and assets are analyzed for price trends, forecasts, rent, value increase, neighborhoods, and future potential of the asset.

Markets

This is more relevant for niche Real Estate funds that are dealing in specialist RE categories like handicap hostels or Self-storage. The potential in the underlying theme is objectively evaluated to find out the potential of returns that could be generated in the future

 

Magistral has experience and capabilities in providing Due Diligence Services to global clients in the space of Private Equity, Venture Capital, Investment Banking, and Family Offices

About Magistral

Magistral Consulting has helped multiple funds and companies in outsourcing operations activities. It has service offerings for Private Equity, Venture Capital, Family Offices, Investment Banks, Asset Managers, Hedge Funds, Financial Consultants, Real Estate, REITs, RE funds, Corporates and Portfolio companies. Its functional expertise is around Deal origination, Deal Execution, Due Diligence, Financial Modeling, Portfolio Management and Equity Research

For setting up an appointment with a Magistral representative visit www.magistralconsulting.com/contact

About the Author

The Author, Prabhash Choudhary is the CEO of Magistral Consulting and can be reached at Prabhash.choudhary@magistralconsutling.com for any queries or business inquiries.

 

Why Private Investments are more important than they ever were?

Wealth creation has moved from ‘Post-IPO’ in public markets to ‘Pre-IPO’ in private markets. All indicators related to private investments are at an all-time high. Gone are the days, when institutional investors would invest in primary and secondary markets to stay in the security for the long term, for continued wealth creation and regular flow of dividends. Increasingly, experienced investment managers are investing in private markets, scaling the company, merge it with others, and take the bigger entity public to create wealth for themselves, while limiting the returns upside for retail and other institutional investors in the secondary market. Robust Due diligence exercise is imperative.

At least in the near future, it can be said that IPO will not be the source of funds for the companies also. It is going to be the private investors in the form of Angel, Private Equity, and Venture Capital firms. Companies are increasingly postponing their IPOs in favor of private investors due to less regulatory requirements, the savvy nature of investors to back maverick ideas, less number of stakeholders to manage, and industry-specific knowledge of investors that can be used for further scaling companies. But private investments from investors’ point of view are very different from investing in equities where all the data is available upfront. Due diligence of private target companies is a painstaking process. As part of due diligence, the following are the items that need to be checked before a private investment is signed and closed:

Founders and the Founding Team: We hear this often that a VC backs a ‘team’ and not a company. So when we talk about due diligence of early-stage investment, the team acquires the center-stage, in terms of investment decision making. There are a host of questions that need answering before backing a founding team. For example, whether one of the founders was sacked in the last job due to charges of sexual harassment against him? How founders behave with their teams when investors are not around? Are the educational and experience credentials claimed by founders correct and verifiable? Has someone spoken to the references provided? And so many more!!

When millions are riding on the personal conduct of a group of people, no investor would want to repeat a ‘Travis Kalanick’ episode. It is thus imperative to get into all the minute details about the founding team’s business and personal conduct.

Market and Industry of the Target Company: Another oft-repeated saying of the Alternative Investment industry is that ‘it is better to invest in an average company in a rising industry rather than backing an excellent company in a declining industry’. To be on the top of the industry trends and how it is going to unfold in the near to mid-term is imperative for risk aversion of the invested capital. An industry with all its hues of multiple sub-industries with cross-germination of tech into it needs a specialist intervention in terms of market research and forecasts

Past Financial Performance: The target company usually provides data on revenue and market traction. Although dollars coming into a bank account is a fairly straight-forward end KPI, there are multiple other market traction KPIs that finally ensure dollars in the account at some point in time in the future. These traction KPIs are industry-specific like the number of paid customers, freemium customers, free to paid customer conversion rates, claimed market share, etc. It would have been fairly simple if the company would have provided these numbers accurately. Sometimes clouds are deliberately maintained on data. One sees a month-on-month increasing number of customers, but what is not known is the percentage of paid customers amongst them or worst still, maybe the whole surge has come from free membership campaigns. Devil is in the details. Talking to market and tech experts along with customers will go a long way in ensuring the right investment decision.

Future Financial Performance: Future financial performance is usually a linear or exponential extrapolation of current performance or sometimes just pulled out of the hat to sell a rosy picture of the future. Many times, the company is struggling to meet expenses currently, but future forecasts graph takes off like a rocket headed into space. All these forecasts need to be taken with a pinch of salt. It’s worthwhile to check and challenge all the assumptions that have gone into coming up with the financial model and the forecasts. It is a factor that could literally make or break for your millions going into the private investment.

Customers: Proof of the pudding is in the eating. Customers talking well of a company is a good sign for investors. Also, customers vote with their dollars. Talking to them gives an idea about the customer journey, pain points, existing alternatives to product or service and what exactly would be needed for them to shell out those dollars for the product or service. This requires a specialist Market Research agency that has expertise in ghost shopping and customer surveys.

Employees: One of the first people who bought into a vision is the ‘employees’ of the start-up. A place that has happy employees speaks louder than any other credential for the founder. At the same time, a toxic culture will be quicksand that will absorb millions of dollars in no time, without a blip on revenue numbers. Most founders are not ‘Steve Jobs’ type visionary. They are average folks, who get stressed with day to day running of the start-up machinery, which takes a toll on them. How do they behave with their employees at that point in time is a fairly good indicator of an individual’s potential as an effective stakeholder manager currently and in the future? A research agency can provide honest feedback on this indicator.

Regulations: Are there any regulatory risks in the business, that will come into play after scaling up of operations? Thorough research and liaising with government agencies can go a long way in avoiding statutory and regulatory risks that might plague your investment in the future.

Other Investors: Old boys of the industry do remark that ‘VCs and PEs hunt in packs’. It is heard often. Other investors are more of a support than a threat. If they have voted with their dollars than it might be a good company. Also in situations of B2C tech where winners take it all or a small group of winners take it all, funding dollars make the difference between the winner and the laggards. Multiple investors backing a company will take care of those dollars, which means your own investment is safer. At this point, verifying the claim of the company about other lead investors, co-investors, and conversations going on needs to be verified by a neutral agency.

Magistral Consulting helps Private Equity, Venture Capital, Family Offices, and Investment Banks in performing due diligence for private assets. All these steps are taken care of, in our proprietary research method that is designed to eliminate potential investment risks. A concise weight-based evaluation metrics with clear recommendations about future potential and risks are delivered in aggressive timelines. As our delivery centers are based out of low-cost countries, it builds in significant savings in terms of research costs as well. To know more, please get in touch with info@magistralconsulting.com

The author is CEO of Magistral Consulting and can be reached at prabhash.choudhary@magistralconsulting.com for any clarifications and queries.

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