Tag Archives: Due Diligence Services

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.

 

Are you a Private Equity or a Venture Capital firm that has finalized the asset with a huge manufacturing base? Then read on….

Valuing a factory or a manufacturing company can be tricky. Number oriented investment bankers are more comfortable with the valuation derived from the financial models. All the assets like land, factories, machineries, inventories, vehicles etc. are taken into account with assumptions on depreciation to arrive at a value that a manufacturing-based asset deserves.

There is one thing that often gets overlooked in the financial models. That is the potential for factory to save costs or improving productivity in future. Assessing this has significant element of experience and intuition. It can have an impact on the final COGS and thus improve the bottom-line of the overall organization. An improved bottom-line that is possible in future will have a bearing on the current valuation. It also decides if the asset managers will be able to derive the value that they plan from the asset in the future.

I will detail a few tools here, that can give experienced operations personnel, a quick and dirty guide to indicate the improvements that are possible in the operations of a manufacturing company or a factory.

Productivity Improvements Studies

DILO: DILO stands for “Day in the Life Of”. It has been used for years now by productivity improvement consultants. DILO is shadowing personnel for a whole shift/day to understand nature of all activities performed by him, and whether they are value adding or not. DILO is performed over the activities of first level supervisor in the plant. It’s not done for the people at the top and it’s not done for people at the lowest rung too. First supervisory level DILO gives a firsthand idea about the cultural DNA of the organization. It also helps zeroing on the productivity improvements that is possible. A 20% productivity improvement using improved systems is not exactly unheard of.

Management Control Systems: An effective Management Control System study charts out flow of information in the organization and the actions that are being taken on the same. Production planning processes, production control processes and production reporting processes are taken into account. All KPIs/KRAs and review mechanisms are studied too. This study should be able to show gaps in the processes and improvements possible. This can be repeated for functions of Maintenance, Quality Control, Supply Chain, R&D or any other function that has an important bearing on the final output.

Pit-stop studies: A pit stop study is conducted to see if the flow of material, men and information happen as they happen during a pit-stop in F1 racing. It also records all the bottlenecks for not achieving the pit stop level efficiencies. Analysis of these bottlenecks give a fair idea about the improvements possible

Bottleneck Study: Identifying a clear line of value addition itself is a task in multiple industries, but if processes are visibility and logically connected, a bottleneck study can be done to find out the bottleneck process or a bottleneck machine. Once identified it’s clear that any improvement that is done on the bottleneck process/machine improves the productivity of the whole line. We need to study the bottleneck machines/processes in further details to find out downtimes and reasons for the same. More avoidable the reasons are, more chances of improvements. A bottleneck process improvement has been able to show 10% improvements in throughput even across process-wise mature plants.

Process Maps: A simple flow of material and information exposes the gaps in processes. Material waiting for information or material waiting for other material or machines or men, all cause delays. As per the established principles of Toyota Production System and lean methodology, wastes need to be identified. Once identified, it needs to be ascertained, if these wastes are avoidable. Again, more avoidable the reasons, more chances of improvements.

Quality Processes: Reduction in quality rejected items directly adds to the throughput. Finding out the effectiveness of quality systems can point towards improvements possible due to reduction in quality rejects.

5S and other housekeeping systems: It makes the workplace clutter free. Absence or presence of these systems point towards the current processes maturity and thus improvements possible.

Cost Optimization Studies

Material Cost: Material costs most often are the highest cost bucket for a factory. There is some raw material fed at the beginning of the production line and there is output in terms of finished product at the other end. All the material that is lost in between is the dollars lost. In process industries, this is also referred as material yield. Finding out the potential to reduce this waste is guaranteed to give future direct bottom-line benefits.

Inventory Cost: In some industry cost of inventory is huge. If inventory turns are not monitored carefully, it leads to working capital being tied up in inventory. Finding out if A, B, C classifications are there and if there are inventory standards for each classification can be a starting point. In case there are standards, a quick audit of some A class materials will show potential of releasing stuck working capital back to P&L.

Procurement Costs: A quick look at procurement processes show if there is some value that can be derived from tighter procurement standards. Few things that can be looked at include, how contracts are finalized, presence of penalty clauses in contracts, contracts negotiations process, RFQ process, low cost country sourcing potential, supply chain cost reduction possibilities, mass discounts and vendor rationalization possibilities. A tighter procurement process has known to produce 10% savings in the spends related to material.

All these studies will also need to be supported by number crunching exercises. It all depends on the extent and quality of data available in the factory.

A dipstick study can be concluded in 2-3 weeks’ time for a plant that produces around 200-1000 Crore worth of stock by a team of 3-4 people. This exercise gives an input to valuation of the plant and the company. It also acts as the road-map for the management in case the asset gets acquired.

Prabhash Choudhary, CEO, Magistral Consulting.

Magistral (www.magistralconsulting.com) is a leading consulting research and analytics firm that helps PE/VC firms globally in performing operational due diligence. The author can be reached at prabhash.choudhary@magistralconsulting.com for queries.

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