Due Diligence in Private Equity with Mark Hauser

By: Sumeet_Manhas

There are twice as many private equity firms out there today than there were a decade ago, and private market assets under management have reached an all-time high of $6.3 trillion according to McKinsey’s Private Markets Annual Review. As the market continues to grow and competition along with it, firms must determine how to quickly and effectively evaluate potential deals and identify strong investment opportunities.

According to data from Teten Advisors, the median investor in private companies reviews over 80 opportunities in order to make a single investment. To determine whether an investment is worth pursuing or if it should be passed over all investors conduct a rigorous process known as due diligence, but in the case of private equity a number of unique challenges are presented. Target companies are typically not public, meaning that information typically available in more traditional investments such as SEC filings are not accessible. Additionally, the focus of a private equity company on profits for the fund requires a different perspective from other alternative investments.

While each private equity investor will hone a due diligence strategy that best meets their individual needs, there is a standard formula and practice that is generally followed by the over 4,000 private equity firms in the United States today. Mark Hauser, founder and co-managing partner of Hauser Private Equity, provides insights below on these due diligence practices. Hauser Private Equity currently manages five private equity funds which in total have invested over $350 million in capital in privately-owned businesses on a national level. Hauser himself has over three decades of experience in investing and operating companies, and in that time has led the completion of over 500 investments, in addition to seeing over 150 of them realized.

Branches of due diligence

According to Hauser, due diligence within private equity is generally divided into two stages: exploratory due diligence and confirmatory due diligence.

Exploratory due diligence involves exploring the commercial and financial aspects of the business and assessing how it stands up to the firm’s investment thesis – its idea for how it will make the business more valuable within the next few years. During this phase, the investment team is operating under the assumption that the information provided to them is accurate, and is instead looking to confirm the viability of the thesis before moving forward.

If everything appears sound in the exploratory stage, private equity investors will then move into the confirmatory due diligence stage. This involves utilizing third parties such as outside lawyers and consultants to rigorously assess the information the target company provided, seeking to confirm its accuracy. While this stage introduces a new aspect of legal analysis seeking to identify any potential liabilities, it can also involve reevaluating commercial and financial aspects such as hiring a third party to perform a customer survey or specialized finance audits. Because it often requires bringing in outside specialists, the confirmatory due diligence stage is much more costly than the exploratory stage.

Within these two stages there are a number of types of due diligence that can be explored, but the following three are the most common and applicable to practically every target company.

Commercial due diligence

Commercial due diligence involves analyzing factors such as consumer perception, industry growth potential, and financial performance. Mark Hauser said this type of due diligence involves looking at the target company’s past and trying to utilize the information found to predict its future and potential as an investment. For example, Hauser Private Equity targets companies in a diverse number of verticals such as consumer goods, healthcare, and industrials.

A deal team should have a strong knowledge of the industries their target companies are in, allowing them to have a context for the commercial activity and operations of the company. If not, outside advice is often necessary to answer questions about growth trends, recent transactions, market size, and key ratios amongst others.

In addition to observing the business in the context of its industry, an analysis must be done on the operations of the business itself, looking at things such as its business model, how it stands when compared to its competitors, its customer base and how it achieves value creation for them, supplier base, sales volume, and the differentiators for its product or service. Remember, private equity transactions are typically more financially-focused rather than strategic, so all commercial due diligence is conducted with the end goal of a profitable sale of the company in mind.

Financial

During the commercial due diligence process a deal team will look at the financial performance of the target company and consider it in the context of its operations and the market as a whole. However, should these findings indicate favorably there must be a deeper dive in which a scientific approach is taken to evaluating the company’s financials. Hauser said that simply put, financial due diligence is confirming the numbers add up.

In addition to identifying whether the target company will prove to be a sound investment, financial due diligence is imperative to determining the appropriate valuation of the business. Hauser Private Equity also makes it a point to seek information beyond what has been provided to them by the target company itself, evaluating everything from customer acquisition costs to material contracts and intellectual property.

During the financial due diligence process there is a focus on “quality of earnings”, an intensive report that concludes the growth of the company, its greatest risks that may inhibit its growth, and the likelihood of its future growth potential. Hypothetical scenarios are often played out within these reports to identify the overall strength of the business, such as what would happen if the company lost one of its biggest suppliers or customers.

Legal

Finally, a target company must be evaluated from a legal standpoint. This includes not only verifying that the business is compliant with all laws and regulations, but also identifying potential legal implications the private equity firm may encounter as a result of the acquisition. This is most often the last step in the due diligence process, as it requires a significant spend in resources.

Legal due diligence is almost entirely confirmatory, as the deal team and the lawyers it employs pour over the target company’s business structure through its articles of incorporation, annual reports, contracts with customers, suppliers and vendors, historical compliance with state and federal laws, and shareholders and percentages owned amongst others. Hauser said this part of the process can feel the most draining and monotonous, but is crucial to the completion of the deal.

Other factors considered
While these three due diligence components are the most common they are certainly not the only factors that are taken into consideration. ESG investing is an investment strategy experiencing rapid growth, but even those who don’t employ the method have taken note in recent years on the importance of including an analysis of governance in the due diligence process. Management problems aren’t always going to result in a cessation of the deal, but becoming aware of them earlier rather than later can help the private equity firm achieve results quicker and potentially get a better deal in the meantime.

Additionally, while previously only a factor to be considered when the target company is the industry itself, technology and IT are increasingly becoming an important part of the due diligence process. This can include evaluating a company’s current technological capabilities and intellectual properties related to its business. As cyberattacks and malware become a more prevalent threat, understanding a company’s cybersecurity policies, training programs, and disaster recovery plan is an important part of the due diligence process.

Due diligence is a rigorous and often tedious process, but one that is imperative to the overall private equity investment strategy. According to Hauser, firms that are able to develop a due diligence process that is both efficient and effective are the ones who will be able to see a portfolio of realized transactions.

By Sumeet Manhas

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