Due Diligence in Private Equity

Synonyms

Due diligence; Evaluation process; Investigation process

Definition/Description

In private equity (PE) financing, choosing the appropriate investee firms is crucial to minimize adverse selection and post-acquisition problems. To this end, the implementation of a thorough evaluation – known as due diligence (DD) – of potential target firms and prospective investments is essential to enhance the overall success of the entire venture (Cumming and Zambelli 2017). DD is a crucial pre-financing step to assess the potential risks, opportunities, and value of the investment. A rigorous DD is expensive and time consuming (Yung 2009). PE investors must carefully examine various aspects of their target companies, including their current and expected performance, market position, legal and regulatory compliance, intellectual property, management team, as well as market growth potential. A thorough DD helps minimize investment risks, prevent future losses, and improve decision-making. Cumming and Zambelli (2017) show that a rigorous DD is also associated with significant improvements in investee performance, as long as the majority of DD is implemented internally by PE investors and not delegated outside. PE refers to any equity investments made in high-growth potential firms, while venture capital (VC) represents a subset of PE and involves the provision of equity capital to new firms or recently established non-quoted companies, with the purpose of supporting their early stage development (e.g., Sahlman 1990; Wright and Robbie 1998; Gompers and Lerner 2006; Suchard 2009; Metrick and Yasuda 2010, 2011, 2021). VC plays a crucial role in promoting innovation among small businesses and countries (see, e.g., Kortum and Lerner 2000; Hellmann and Puri 2002a, b; Cumming et al. 2004; Bertoni et al. 2010; Lerner 2012; Cumming and Johan 2014, 2017; Devigne et al. 2018; Li et al. 2020a, b; Lerner and Nanda 2020; Quas et al. 2021; Cohn et al. 2022; Cumming et al. 2023; Burström et al. 2023; McGrath and Nerkar 2023; Rawal and Kapil 2023).

Introduction

In private equity (PE) financing the selection of the right investee firms is essential to minimize adverse selection problems and post-acquisition complications, as well as increase the chances of success of the entire venture (Cumming and Zambelli 2017). The purpose of this chapter is to provide an overview of the decision-making process implemented by PE investors (hereafter venture capitalists or VCs) when financing high-growth potential firms. To this end, a special focus will be placed on the crucial importance of implementing a thorough evaluation – known as due diligence (DD) – of potential target firms and prospective investments to enhance the overall success of the venture (Cumming and Zambelli 2017).

What is Private Equity?

In line with the broad definition of PE generally accepted within the E.U. and U.S. contexts, the term PE refers to any equity investments made in innovative companies with high-growth potential, aimed at spurring their startup, development, or expansion process by providing financial support and managerial assistance for a medium to long period of time (see, e.g., Suchard 2009; Metrick and Yasuda 2011, 2021). The financing usually occurs by acquiring equity stakes in the target companies, as well as hybrid securities such as convertible debt or convertible preferred shares (Schmidt 2003; Gompers and Lerner 2006; Cumming 2005a, b, 2006a, 2007, 2008, 2010; Tykvová 2007, 2018; Talmor and Vasvari 2011; Hellmann 2002, 2006; Cumming and Johan 2014; Zambelli 2012, 2014; Lerner and Nanda 2020; Dai 2022). PE investors not only provide long-term capital but expect to play an active role in the management and governance of their target firms for an average period of 3–7 years, after which they proceed to divest their initial equity participations (for more details on the PE investment cycle, see Gompers and Lerner 2001, 2006; Cumming and Johan 2014; Metrick and Yasuda 2021; Cumming et al. 2023).

Within the PE context, venture capital (VC) is defined as the provision of equity capital to new, or recently established, non-quoted companies to support their early or mid-stage development (Sahlman 1990; Wright and Robbie 1998; Gompers and Lerner 2006; Suchard 2009; Metrick and Yasuda 2021). From this perspective, VC financing represents a subset of PE and plays a crucial role in fostering innovation of small businesses and countries (see, e.g., Kortum and Lerner 2000; Hellmann and Puri 2002a, b; Cumming et al. 2004; Bertoni et al. 2010; Lerner 2012; Cumming and Johan 2014, 2017; Devigne et al. 2018; Li et al. 2020a, b; Lerner and Nanda 2020; Quas et al. 2021; Cohn et al. 2022; Cumming et al. 2023; Burström et al. 2023; McGrath and Nerkar 2023; Rawal and Kapil 2023).

Preliminary Evaluation and Screening Process

To minimize adverse selection problems while ensuring higher probabilities of venture success, VCs must carry out a thorough evaluation process of potential target firms (see, e.g., Yung 2009; Cumming and Zambelli 2017; Gompers et al. 2020). The PE evaluation process refers to the sequence of steps VCs undertake to identify and fund their target firms (as shown in Fig. 1). The empirical literature highlights that VCs are in search of high-growth potential firms (e.g., Sahlman 1990; Gompers and Lerner 2006; Cumming and Johan 2014; Gompers et al. 2020), but how do they choose the right target companies to invest in? Among the various investment proposals received, do VCs cherry-pick the most performing targets or the most promising ones? Bertoni et al. (2016) show that the investee firms that are chosen by VCs are not necessarily the top performers at the time of selection. Rather, they are those perceived to have the greatest potential for growth and for being transformed into winners. Their study suggests that VCs most commonly engage in a “frog-kissing” process when selecting firms. This metaphor indicates that VCs actively seek out the most promising companies, with significant transformation potential (i.e., “Frogs”) to be turned into successful ventures (i.e., “Princesses”), rather than just cherry-picking the already best-performing ones (for more details, see the theoretical model of Bertoni et al. 2016).

Fig. 1

Private equity evaluation process. Source: Own elaboration from Tyebjee and Bruno (1984); Fried and Hisrich (1994); Cumming (2006a); Kaplan et al. (2009); Cumming and Dai (2011); Block et al. (2019); Gompers et al. (2020); Esen et al. (2023)

Investment Screening

The main objectives of the VC evaluation process are the following: (a) selecting the most promising investment proposals, (b) suggesting optimal methods for project implementation, and (c) determining the required capital and choosing the most appropriate financial instruments, such as equity, convertible bonds, or debt instruments (see, e.g., Cumming 2005b, 2006a, 2007; Cornelli and Yosha 2003; Kaplan and Strömberg 2003, 2004; Cestone 2014; Correia and Meneses 2021). Given the inability to use traditional valuation models to properly value innovative target firms (Köhn 2018; Gornall and Strebulaev 2020), various studies (mainly based on survey data) have attempted to generalize the PE decision-making process through the analysis of the selection criteria employed by VCs (see, e.g., Gompers et al. 2016, 2020; Esen et al. 2023).

As summarized in Fig. 1 and described by the recent PE literature (e.g., Gompers et al. 2016, 2020; Kaplan et al. 2009; Block et al. 2019), the evaluation process implemented by VCs is quite complex but can be simplified into a number of sequential phases (for more details, see Tyebjee and Bruno 1984):

• 1. Collection of potential deals, which involves gathering investment proposals (deal–flow, or deal origination).

• 2. Preliminary selection, which involves two steps of screening of the investment proposals and business plans (BPs) received by VCs (first- and second-step screening).

• 3. Due diligence (DD), which includes a thorough assessment of the target company, the management team, and the investment opportunity (formal due diligence).

• 4. Risk/return analysis and decision.

• 5. Valuation and negotiation, which is aimed at quantifying the value of the target company, the investment amount, the equity stake, and its purchase price. This step also includes the decision on the security design and control rights that minimize moral hazard problems (deal structuring and closure).

Investment proposals can originate from various sources, such as previously funded companies, other venture capitalists seeking to participate in different VC funds, and active deal searches conducted by the VCs themselves. As VCs receive numerous investment proposals per year, they need to properly screen them. A first-step screening involves a preliminary qualitative overview of the received business plans (BPs). The proposals that successfully pass the pre-selection phase proceed to a second-step screening, which focuses on various general factors such as the industry, development stage, and location of the target firm, as well as investment policies regarding the size of the investment (Cumming 2006b). Historically, VCs used to prefer target firms belonging to specific high-tech industries such as innovative technologies and industrial goods, due to the high-growth potential inherent in these sectors. However, the need to implement a higher portfolio diversification has expanded the range of industries considered by VCs, moving beyond these traditional favorite sectors (for more details, see Tyebjee and Bruno 1984).

When investing in a company, VCs typically expect to play an active role in its management. For this reason, the geographic proximity of the target firm is an important factor in the VC preliminary screening process. Cumming and Dai (2012) demonstrate that VCs, especially those specializing in high-technology industries or investing alone, often exhibit a strong preference for local ventures. They favor companies that are either nearby or at least within their own country to limit travel expenses and time dispersion (local bias). This local bias facilitates frequent and relatively inexpensive interactions between VCs and their target companies. Cumming and Dai (2012) further show that geographic proximity positively impacts firm performance, mainly due to enhanced VCs’ monitoring capacity. Specifically, they demonstrate that having syndicated investors geographically closer to the target company increases the venture’s success rate. However, they also note that more experienced and reputable investors are less influenced by local biases, probably due to their major expertise in managing asymmetric information problems associated with greater investment distances. Additionally, further empirical evidence provided by Cumming et al. (2022) indicates that local biases diminish in cases of syndication and with broader syndicated networks.

Due Diligence: Areas, Types, and Economic Value

Once the pre-selection phase is completed, VCs proceed with a rigorous evaluation process (known as formal due diligence, DD), by analyzing various aspects such as accounting, financial, legal, fiscal, and environmental characteristics of potential investments, as outlined by Camp (2002) and Metrick and Yasuda (2021). More specifically, this thorough investigation includes assessing management capabilities, industry position, project potential, financial projections, and alignment with the objectives of fund’s portfolio, as well as identifying operational and financial risks (Brown et al. 2008).

DD is particularly crucial for PE investors, given their active involvement in the governance and management of their target firms (Yung 2009; Scharfman 2012). Additionally, PE investors usually have less diversified portfolios and, as such, they must devote extra care to reducing the unique, idiosyncratic risks associated with their investments (Knill 2009; Cumming and Zambelli 2017). As emphasized by Cumming and Zambelli (2017), the primary purpose of DD is to help VCs make better decisions by selecting the most promising investee companies in the hope to enjoy increased future portfolio returns. This purpose is in line with the “frog-kissing” model highlighted by Bertoni et al. (2016) and discussed in the previous section.

Areas and Types of DD

The DD process involves an in-depth selection of firms based on a detailed analysis of different areas regarding the prospective investment and target company. It may also involve interviews and site visits to engage directly with management, employees, customers, and other stakeholders. During the DD the VCs examine in great detail a number of factors such as professional and personal characteristics of the entrepreneurial and managerial team; strategic fit with the current VC portfolio; characteristics of the proposed product or service (price, distribution, degree of innovativeness and competitiveness, technology used); target industry, competitors, and market expansion opportunities (Scharfman 2012; Metrick and Yasuda 2021).

The DD process is highly selective. Gompers et al. (2016) report that out of 100 investment proposals received, only 15 pass the initial screening to undergo deeper investigation, after which 8 enter the negotiation phase and are considered for the final deal structuring. Ultimately, VCs close the deal with merely four target companies (see Gompers et al. 2016; Block et al. 2019).

The DD process includes the investigation of several key areas (e.g., financial, legal, operational, context, and regulation). Financial DD involves a deep dive into the company’s financial statements, investigating (when possible) past revenues, profit margins, cash flows, debt structures, and future financial projections (Afyonoǧlu 2013). Legal DD examines potential legal risks, including contracts, intellectual property rights, litigation risks, and regulatory compliance. This is particularly relevant in cross-border investments, where regulatory compliance with diverse legal environments must be fully satisfied. Operational DD evaluates the company’s business operations, management capabilities, IT systems, and infrastructure (Porsgaard et al. 2018). Market DD focuses on understanding the market environment, the competitive landscape, and the company’s market position (Scharfman 2012; Metrick and Yasuda 2021). Additionally, Environmental, Social, and Governance (ESG) DD has become increasingly important in order to combine the assessment of financial performance with non-financial performance evaluations (Duke 2015).

Cumming and Zambelli (2017) show that VC investors can perform the majority of DD either internally (“internal DD”) or externally, by employing specialized consultants or professionals (“external DD”), such as strategic consultants, law firms, or accountants. As these activities are not mutually exclusive, they can complement each other. For example, even if the major part of DD is performed internally, VCs can still delegate a minor part of it to external experts in order to perform specialized assessments in certain areas (e.g., the legal DD).

Selection Criteria

How do VCs ultimately select their target firms? In the literature, a number of empirical studies have attempted to investigate the complex VC decision-making process (see, e.g., Block et al. 2019) and the various selection criteria adopted by VCs once the pre-screening phase has been completed (e.g., Esen et al. 2023; Gompers et al. 2020; Scharfman 2012; Kaplan et al. 2009; Khanin et al. 2008; Cumming 2006a; Kaplan and Strömberg 2000, 2004; Zacharakis and Meyer 1995, 1998; Hall and Hofer, 1993; Gorman and Sahlman 1989; MacMillan et al. 1985, 1987; Tyebjee and Bruno 1984). A comparative analysis of these studies highlights the difficulty of finding a universally accepted selection and evaluation model employed by VCs. The specific set of selection criteria varies from study to study. Despite these differences, there is a general consensus on certain selection criteria considered most important by VCs, such as the characteristics of the entrepreneurial and managerial team, as well as business and market characteristics.

Historically, the work of Tyebjee and Bruno (1984) represents one of the first studies empirically investigating the VC screening process. With the adoption of a survey methodology based on interviews and questionnaires, the authors identified 23 selection criteria, condensed into 5 homogeneous categories, as described below:

• 1. Attractiveness of the market and its growth potential (context)

• 2. Degree of product novelty and differentiation (opportunity)

• 3. Founders and managerial skills (people)

• 4. Degree of business resilience to environmental changes and threats (risks)

• 5. Expected capital gains at the exit stage (cash-out potential)

The first selection category considered in the model of Tyebjee and Bruno (1984) is represented by the market or context attractiveness, involving the evaluation of the market size and its expected growth, the market accessibility (which is influenced by the presence of eventual barriers to entry), as well as the identification of unmet market needs.

A second key selection criterion highlighted in the model of Tyebjee and Bruno (1984) is related to product differentiation (opportunity), evaluated in terms of innovativeness, uniqueness, technical characteristics, and eventual patentability of the proposed product relative to what is offered by competitors. The greater the perceived innovation and uniqueness of the product, the higher the potential for creating entry barriers, which, in turn, increases the related expected returns for VCs.

A third important selection criterion is related to entrepreneurial and managerial skills, evaluated in terms of proven track record and reputation, as well as financial, marketing, and leadership experience. Before investing in a product, VCs invest in people; therefore, selecting the right team to lead the business and develop the project is vital (Tyebjee and Bruno 1984).

Another significant characteristic considered by VCs is the resilience of the venture against environmental threats, such as technological changes, adverse economic shifts, and increased competition. The level of threat is more pronounced when entry barriers are low (Tyebjee and Bruno 1984).

The fifth key selecting factor is represented by the expected future liquidity of the investment, estimated by its potential cash-out at the exit stage, through trade sales or Initial Public Offerings (IPOs) (for more details, see Tyebjee and Bruno 1984).

After describing the key areas involved in the DD process, an important question arises: among the various selecting criteria employed by VCs during their DD process, which are the most relevant ones? In order to answer this question, Kaplan et al. (2009) investigate the investment decision-making process carried out by VCs and further condense the selection criteria into two main groups, labeled as:

• 1. the “Jockey,” which focuses on the human capital aspects, including founders and the managerial team

• 2. the “Horse,” which refers to the business characteristics and all the business-related factors, such as the business idea, the business model, and the market potential (for more details, see Kaplan et al. 2009, and Gompers et al. 2020).

Kaplan et al. (2009) found that the quality of human capital, in terms of managerial and entrepreneurial teams (the Jockey), emerges as the most relevant selection criteria for VCs. This evidence reinforces the idea that VCs first invest in people and then in the opportunity given by the proposed project. More recent empirical studies (Gompers et al. 2020; Esen et al. 2023), have further reinforced the results of Kaplan et al. (2009), emphasizing the crucial role of the founder and managerial group.

Economic Value of Due Diligence

A rigorous DD is quite expensive and time consuming. Reviewing all relevant financial and legal documents involves substantial direct costs, both in terms of the price paid for gathering the necessary information on the prospective investment and time spent on implementing such investigation process. Moreover, a thorough DD also involves significant indirect costs, mainly connected to the opportunity costs of time not spent on adding value to the other existing portfolio firms (Cumming and Zambelli 2017). Considering the high costs underlying a rigorous DD, VCs may be tempted to rush it or hire external advisors, such as legal, financial, and operational experts, to conduct the entire DD process or part of it. In theory, external experts are supposed to provide specialized knowledge and insights to better evaluate the investment opportunity. But, how worthwhile is the time spent on implementing the DD? To what extent do the quality and type of DD affect the future performance of investee companies? For the VCs, would it be more beneficial to save time by delegating the majority of DD to external agents?

In the finance literature, very few empirical studies have investigated the DD. For example, Brown et al. (2008) investigate the DD in the context of hedge funds by analyzing registration statements and show that DD represents a relevant source of alpha. Cumming et al. (2019) analyze the role of DD in crowdfunding. Sorensen (2007) investigates the importance of matching models in VC and finds that matching is more relevant than investor experience in explaining performance, in terms of successful exits in terms of IPOs. Yung (2009) presents a theoretical model of DD in venture finance, by examining the link between asymmetric information and costly DD. Compared to traditional financial intermediaries, such as banks, VCs are better equipped to bear the high costs of DD and manage adverse selection problems. On the other hand, potential investee companies can better distinguish themselves and attract the attention of VCs only by incurring the costs of signaling their quality. Only the firms that can better afford high-quality signals have a higher probability of receiving funding. Yung (2009) shows that in situations of high asymmetric information, costly DD is more effective in minimizing adverse selection problems than costly quality signaling faced by target companies. This is because target companies usually deal with significant cash constraints, while investors are usually more capable of absorbing DD costs, and, as such, a rigorous and costly DD is more effective in selecting high promising firms.

The study of Cumming and Zambelli (2017) is the first to specifically investigate the economic value and efficacy of DD in PE settings, by empirically analyzing the link between the duration of DD effort and investee performance. Specifically, they empirically evaluate how valuable DD is for VCs and its subsequent impact in terms of performance payoffs for the investee firm. Additionally, as the DD can be externalized to specialized agents, the authors also investigate the effects of such delegation. Cumming and Zambelli (2017) show that, on average, PE investors take 7–8 weeks to complete the DD process. In their study, they compare various sub-samples of deals in various investee companies according to the duration of DD. The time spent on DD is considered as a proxy of the importance and effort allocated to implementing such activity. The basic idea is that the amount of time spent on an activity reflects its importance to the person doing it. Further studies, such as Wangerin (2019), have reinforced this view in the context of mergers and acquisitions.

The results of Cumming and Zambelli (2017) show that the time spent on implementing the DD has substantial economic value: a longer and diligent DD is associated with improved post-acquisition performance of investee companies, 3 years after their acquisition. As shown in Fig. 2, the transactions associated with a longer DD (greater than 10 weeks) display higher performance (in terms of Return of Assets (ROA)) 3 years after the transaction. This evidence is also confirmed with reference to the Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)/Sales ratio.

Fig. 2

Impact of DD on the performance of investee companies, 3 years after their acquisition. Source: Elaboration from Cumming and Zambelli (2017)

In their multivariate analyses, Cumming and Zambelli (2017) also show that an extra week of DD is associated with significantly higher post-transaction firm performance (both in terms of ROA and in terms of EBITDA/Sales). They show that such positive effect on investee performance is particularly evident when the majority of DD is performed internally by PE investors (internal DD). Surprisingly, when the majority of the DD is delegated to external specialized agents (such as legal firms, accountants, and external strategic consultants), no significant performance improvement emerges.

This puzzling result about external DD highlights the existence of apparent agency costs associated with delegation, which calls for more empirical research investigating the costs and implications of external DD (for more details see Cumming and Zambelli 2017).

Cross-References

• Capital Structure in New Ventures

• Default Probabilities in Private Equity

• Innovation in Private Equity