Fundamentals of Private Equity and Venture Capital - PEI Media

GETTING THE MOST OUT OF THIS MODULE
Welcome to Module 7 in the Fundamentals of private equity series. This module
focuses on the due diligence process. It is designed to work both as a stand alone
section and as part of the whole series. The module necessarily draws upon topics
reviewed in earlier modules, and seeks to avoid repetition of their content.
However, for the benefit of the stand alone reader, a comprehensive glossary has
been incorporated, which explains the background and use of private equity terminology.
All terms which may require explanation or expansion are printed in
bold, to indicate that there is a glossary entry for them.
What is due diligence?
In its simplest terms, we can define due diligence
as the process of assuring that all the assumptions
on which an investment or acquisition decision
are based do, in fact, hold true; an exercise in validation
or verification. In modern practice, however,
it goes further than this, as the results of a
thorough, detailed and focused series of reviews
into a company’s markets, processes, finances,
management, technologies, assets, intellectual
property and customers will in many cases identify
areas where improvements can be made, risks
reduced and additional gains realised.
The levels of competition in modern private equity
markets demand that investors must consistently
add value in order to outperform. As we saw in
Modules 4, 5 and 6 this added value is increasingly
generated by identifying, instigating and driving
performance enhancements, in tandem with the
investee company’s management teams. To do this
requires ever deeper understanding of markets,
companies and strategic opportunities. The due
diligence exercise can contribute to this understanding
by providing essential raw material to
inform the entire investment, growth and realisation
process, rather than being seen as a tedious
and non-productive hurdle between commercial
decision making and completion.
As with every aspect of private equity, the most
valuable due diligence exercises are those where
investors, their advisers and the management
team are fully engaged, with shared objectives
and complete openness.
Types of due diligence
Due diligence has evolved in depth, complexity
and sophistication, and in modern practice is
broken down into a series of different disciplines.
Commercial due diligence
Commercial due diligence (CDD), also referred to
as market, or strategic due diligence, is focused on:
• establishing the credibility of the revenue projections
in the investee company’s business plan;
• providing an objective, impartial assessment
of the company’s markets and its position in
them; and
• testing and evaluating the key strategic drivers
in the company’s business plan.
With the growing importance of earnings, or performance,
enhancement as the route to value
creation in the buyout market, a subset of CDD –
operational due diligence – is becoming an
increasingly prominent part of the process.
As the Clinovia case study in Module 5 demonstrates,
market due diligence need not be limited
to specific investment proposals but can also be
used as a tool for identifying attractive sectors or
investment opportunities.
Financial due diligence
Whilst the focus of CDD is primarily external,
financial due diligence (FDD) looks in detail at
the company itself, providing a review of:
• the company’s historic financial performance;
• working capital movements and cashflows;
• comparison of actual performance with forecasts
and budgets;
• the financial projections;
• financial reporting and control systems;
• tax compliance; and
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THE FUNDAMENTALS OF PRIVATE EQUITY 5