How Private Equity Firms Investigate the Companies They Buy
When a private equity firm is considering investing in a privately owned company, it always does a deep dive into its history and current state to judge whether it has good future prospects. This due diligence is crucial to whether a PE firm decides to go through with a deal.
- PE firms conduct due diligence before investing to try and ensure that their capital is allocated to financially sound and strategically viable businesses.
Before a private equity (PE) firm buys a company, it carries out a due diligence process to decide whether it makes sense to proceed.
The process typically involves investigating different areas of the company, such as its operations, management team, and financial robustness. Ultimately, the PE firm wants to see if the deal aligns with its strategic and financial objectives and the extent to which the investment could yield positive alpha for its investors.
Two phases of due diligence
In the PE world, due diligence checks are usually carried out in two phases: the first is known as exploratory, and the second is confirmatory.
During the exploratory phase, the PE firm searches for evidence that investing in the company matches its wider investment strategy and that plans to improve operational efficiencies and revenue growth make sense.
Once the green light is given, the PE company will move on to confirmatory due diligence – checking that the information the company has provided is correct and confirming there are no hidden known risks that have not been disclosed by management
For both phases the PE firm will usually use an internal team of specialists, supported by third-party professionals including lawyers, accountants and consultants.
Spotlight on the financials
The key areas of due diligence are often commercial, financial, legal, and management and operations.
Commercial checks analyze a target’s peer group to understand how competitive each firm is. The deal team will look at each business model to divine their strengths and weaknesses and identify opportunities for growth.
Guillermo Garcia-Barrero, managing director, Infrastructure at EQT, explains: “Commercial due diligence is about understanding the market very well and the company’s competitive position, and the business plan associated with it. This includes not only the top line, how much you can grow, how fast, but also the costs associated with that growth.”
Financial checks , on the other hand, analyze the accuracy of the performance data the company has given, so the PE firm can come up with a fair valuation.
“Financial due diligence is looking particularly at the historical performance of the business so that we can take comfort in the projections going forward,” says Garcia-Barrero. “It also includes tax analysis to seek assurances there are no hidden tax liabilities, and the tax considerations are adequately reflected in our evaluation.”
Key documents required for financial due diligence are income and cash flow statements, a detailed balance sheet, and bank statements. Financial projections (to judge the expected future health of the company), inventory details, profit margin data and a schedule of bad debt and write-offs are also required. Other desirable information is the value of the company’s customers and turnover rates.
Verifying disclosures
To verify the accuracy of financial statements, PE firms will often compare current financial reports with historical data or industry benchmarks to detect anomalies, and verify by reconciling financial data across different sources like bank statements, contracts and invoices.
Francesco Malvezzi, managing director of the Infrastructure team at EQT and part of the team that acquired the cold storage operator Constellation Cold Logistics, says there is no obligation for private companies to disclose their position fully, and that they can choose how much information to share. But, he adds, it is to the private company’s advantage to be honest if they want to secure a deal in order to “convince” the buyers.
Even so, there are additional protections in place in case companies do deliberately mislead potential investors. “There’s always a contract when you sell a business. It covers the price, but also statements around the truthfulness of certain facts, and clauses that protect against fraud,” says EQT Managing Director Vincenz Borrmann.
“Willfully putting wrong information into due diligence information, essentially, is also illegal, and you could then, as a buyer, go back and claim against that.”
The ‘grey zone’
Private companies aren’t supposed to make up details during the due diligence phase, but they can flatter the truth. Borrmann calls this the ‘grey zone’.
“The grey zone is interesting. The sellers want to present the company as well as possible, and they will not put in anything incorrect. But statements about the future are always based on expectations. So it's about the glass being half full or half empty.
“As a buyer, you need to calibrate and find your own story and find your balance in that and come up with your own assumptions,” he says.
Evaluating these expectations is key. Malvezzi says he looks at the contracts currently in place with the company, how long they have been in place, and what the churn of customers has been.
“Commercial due diligence is about understanding the market very well and the company’s competitive position, and the business plan associated with it.”
Next step, legals
Once a PE firm has carried out commercial and financial audits, legal due diligence comes into play. This considers the legal consequences of the investment and explores the company's compliance with necessary laws and regulations so no costly liabilities arise after a deal is done.
“Legal due diligence is similar to tax, you want to ensure that there's no legal risks that are underestimated by the current management,” says Garcia-Barrero.
Legal documentation reviewed includes annual reports, shareholder lists and compliance reports.
The legal team will also typically check if there are any outstanding claims of wrongdoing against the company and other potential liabilities. Lawyers will also look for whether the target firm has contracts in place with other companies the PE firm invests in.
Evaluating management
As the checks proceed, the PE firm will eventually need to evaluate the target company’s management team and operations. This is a crucial part of the due diligence process .
“Either during the due diligence or shortly thereafter, when you actually acquire the company, we will do a very systematic assessment of its management,” says Borrmann.
This analysis is “a very important tool for us to see if any changes are required” he adds, “whether we have the best people for the different functions, but also how are people performing together as a team? What is the culture?”
“EQT very much likes to partner with management teams”, says Borrmann, so the personal aspect, and being able to trust in the people that drive the value creation plan, “is very, very critical, and it's a key part of getting the investment right and making it successful”.
Due diligence on the management team is typically done by interviewing the leadership team of the company in question, by a senior person from the deal team of the PE firm, though increasingly, digital tools are incorporated into this process to help streamline it.
This process seeks to analyze the experience, competency and stability of the senior leadership team, and identify any gaps in expertise…
Other management factors considered include internal and external feedback on how the company is run and how this reflects on the chief executive officer, the culture, and what staff turnover rates might indicate.
When a problem is uncovered
If red flags are found, the PE firm may want to renegotiate the price, add extra conditions to the deal, or walk away.
If the issue is considered serious – known as ‘material’ – the PE firm may stipulate it will only invest in tranches, where an amount is held back for an agreed period of time and is paid out (or not) depending on whether specific issues are resolved.
“There's always findings,” says Garcia-Barrero, “what you want to avoid is material negative findings. When there are, you often try to protect yourself contractually and reflect them in valuation by lowering the price.”
Not all issues are material. For example, management showing signs of struggling is not typically a deal breaker. PE firms will invest in a company where the management team needs support, and then support to implement strategic change to, either by adding value with coaching or new hires.
Deal or no deal
Ultimately, due diligence is not just about validating a company’s numbers — it is about assessing whether the investment aligns with the PE firm’s strategic goals and risk appetite. If red flags emerge, firms may renegotiate, impose protective conditions, or bail on the deal. However, when due diligence confirms a strong business with growth potential, PE firms can move forward with confidence, knowing they have a clear understanding of the risks and opportunities ahead.
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