private equity due diligence

Conducting Due Diligence on Private Equity Funds

private equity due diligence

There’s significant due diligence that needs to be performed by investors when evaluating a private equity fund opportunity. This diligence typically includes a top-down macro analysis as well as a bottom-up manager analysis. A top-down approach focuses on the general economic environment that relates to the fund’s investment thesis. This includes the analysis of a fund’s investment criteria in terms of industry segment, geography, and typical investment size. A bottom-up manager analysis includes a thorough review of the fund’s track record, management credentials, third party service providers, and risk mitigation tools.


Top-Down Macro Analysis:

This macro analysis is based on the investors’ particular worldview as it relates to the market. Is the investor attracted to the economic environment in China? This would necessitate an understanding of Chinese business dynamics. So, an investor should be confident in the expertise of the private equity firm engaged with Chinese companies. Is an investor attracted to biotechnology companies coming out of top California universities? The investment thesis has to be backed up by a macro analysis of why the particular opportunity presents such a strong possibility for enhanced returns. Is the investment strategy clearly laid out and communicated? For example, one strategy can be the investment in growth-stage mobile companies in Singapore. Investment strategies also include investment dollar ranges and sample equity targets. For example, a firm will invest with a $5M-10M target allocation in companies with over $100M EBITDA, for a target equity ownership or complete buyout. These variables also determine the risk/return profile of the investment, which will have an important bearing on whether or not an investor finds the opportunity attractive.

Investors should have a clear return perspective and confidence that the manager will perform and stand out compared to peers. This requires an understanding of what returns have historically looked like within that asset segment. Additional considerations have to be given to understand where the investment fits in the overall portfolio of the investor. While the opportunity may appear great on its own, it may not provide diversifying or alpha-generating qualities when added to the portfolio. Furthermore, the investment could be too similar to an already committed investment. Would an investor invest in two private equity funds focusing on growth stage mobile companies in Singapore? Probably not. An investor has to understand the risk perspective of the investment, which is the confidence that the manager has all the right tools and skills in place to mitigate potential business and investment risk. For example, does the fund have quality service providers providing legal, compliance, tax, and accounting support?


Bottom-up Manager Specific Analysis:

The analysis of the historic and projected financials of the internal firm and its external investments is a good first step to understand how the manager allocates resources. Does the firm have sound business and operational processes? Are the fund investment projections reasonable considering the segment, sector, and geography? Do the projections reasonably match historic returns of a previous fund, or peer-group funds that have similar strategies?

Are the fund investment projections reasonable considering the segment, sector, and geography? Do the projections reasonably match historic returns of a previous fund, or peer-group funds that have similar strategies?

The other important criterion is the analysis of the legal and tax structure of the business. This requires the understanding of the intricacies of private equity structures. For example, can the fund accept foreign investments if it’s domiciled in China? Depending on where the fund is domiciled, how will the investments be taxed? This all requires close familiarity of private equity investing and will oftentimes require the guidance from legal and tax professionals.


Due Diligence Challenges

This is typically a difficult process due to the relative newness of the industry, the difficulties of obtaining quality and verifiable information, and challenges inherent in comparing the returns of one private equity fund to another. According to The Wall Street Journal, the seeds of private equity were planted in 1946 with the founding of two venture capital firms, American Research and Development Corporation and JH Whitney & Company. This is remarkably young compared to evidence of public stocks being traded by Venetian bankers in the 13th century, and the founding of the Dutch East India Company in 1602 as the first joint-stock company. This newness results in difficulties in analyzing historic returns in an accurate manner.

Also, as technology develops at breakneck speeds, it’s very hard to gauge returns looking back at historic results.  Certain fundamentals remain constant, but there’s still an element of unknown with such a young industry. Private equity returns and firms don’t have to be audited by a third party, and historic and projected returns don’t have to be conveyed in any sort of standardized way. This further necessitates a professional expert experienced in private equity to review the financials and projections. As these returns are not standardized it is difficult to compare and contrast the results of one firm to another. The investor is primarily putting confidence in the management team and deal sourcing capabilities, with supplemental evidence of track record, return potential, bullishness on the investment thesis, and confidence in the operational soundness and efficiency supplied by due diligence documentation.


Having a Process

A quality due diligence process should be structured and have standard processes. Generally, family offices and institutions like pension funds have a standard diligence process. This will include a first screening process addressing fit with portfolio as evidenced by track record, strategy, and analysis of management team. Upon this initial review, if the fund qualifies and passes the screening process, funds will typically go through a qualification phase. This phase requires the review of internal financials and projections, the review of operational structures and governance, the calling of references, and due diligence on the legal and tax side. If the fund passes this stage it will be passed to the final investment decision stage in which the investment committee reviews and votes on the investment allocation. When the vote passes this formalized approval mechanism, documents are signed and money is transferred. After the investment is made, the investor will have to actively monitor progress and require transparency as it relates to fund activity and any material events.


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