Despite the pandemic, more than 5,000 mergers and acquisitions (M&A) have been effected, backed by private equity. Private equity-backed M&A activity was worth an astounding USD345.4bn as of September 2020. Due diligence is an integral component of such deals. Due diligence is defined as an investigation or audit of key information, including financial resources. Conducting due diligence becomes vital when evaluating potential acquisitions. It is a risk-mitigation technique, where the entity conducting it scrutinizes everything related to the potential acquisition.
While the due diligence process remains more or less the same, its nature would change depending on the business, the type of acquisition and the type of acquirer. With private equity-backed M&A deals set to increase, it is important that standardised due diligence questionnaires (DDQs) be created to evaluate target companies holistically and reduce risks to shareholders. A DDQ should assess the following factors to evaluate the risk associated with an investment:
1. Company information:
Due diligence requires the correct information on the company under consideration. The private equity DDQ should properly assess the structure of the company and information on its memorandum of association, its operating environment, key employees and subsidiaries. This basic information would help the private equity firm determine the structure of the deal under consideration and key aspects relating to its investment.
2. Governance information:
Company governance and management in terms of factors related to the environment and society are of growing concern in the field of investment. The DDQ should, therefore, ideally include an exhaustive list of questions on these factors to ensure the target company is in line with the investment vision of both the private equity firm and its shareholders.
Offering and competitiveness
It is important to evaluate a company’s offering and its impact on the top and bottom lines. A private equity DDQ reveals how relevant a company’s offering is in the context of the current environment and how strong its competitive strengths are.
3. Customer due diligence:
Businesses exist because of customers, and it is important to evaluate a company’s customers before investing in it. Apart from identifying key customers, a private equity DDQ should also focus on other key metrics such as average revenue per user, average ticket size of the product, churn rates, credit terms being provided to customers and payment cycles. By conducting such detailed due diligence, PE firms gather crucial intelligence about the viability of the businesses they wish to invest in.
4. Management information:
It has been rightly said that a company is only as good as its leader. Prime investor concerns, therefore, relate to the quality and vision of the leader of the enterprise. The private equity firm should ensure that the management team’s vision is aligned with the firm’s goals. The leaders must be capable and have credibility. The private equity firm should also be on the lookout for frequent changes in management, as this could indicate uncertainty among the leadership team.
5. Risk management information:
Risk mitigation and management are key aspects of a business. With uncertainty now becoming a part of the business environment, a private equity DDQ should study and understand the strategies of the target company in the context of risk management, risk mitigation, and business continuity plans. This would help investors understand the maximum drawdown in the case of investment firms or the loss-absorption capacity of an organization in the case of any other business.
The due diligence process is often handled by a third party in order to ensure proper assessment of key information associated with the target enterprise and reduce the risk for the private equity firm. A DDQ would enable the private equity firm to track and tabulate the information received from the organization, allowing a proper assessment of the information to reach a decision. A DDQ facilitates a more efficient acquisition process and may well be the most important aspect of the acquisition process. Organizations would, therefore, need to have a standardized DDQ for timely and proper assessment as well as quick decision making.
