The superficiality of most due diligence
I read a memorable quote in the Harvard Business Review recently:
all too often [due diligence] becomes an exercise in verifying the target’s financial statements rather than conducting a fair analysis of the deal’s strategic logic and the acquirer’s ability to realize value from it
Unfortunately, this is supremely true; due diligence is often just a triviality. If you don’t believe me, ask a private equiteer how many times they’ve binned a deal due to new discoveries regarding the fundamentals of the business. And you can’t really blame them; they’re incentivized by carry, and carry is just as easily created from financial engineering as it is from long-term value creation. Therefore, it often becomes more about closing deals than closing quality deals.
But, it doesn’t have to be this way, and it shouldn’t. The same Harvard Business Review article suggests asking yourself four questions:
- What are we really buying?
- What is the target’s stand-alone value?
- Where are the synergies—and the skeletons?
- What’s our walk-away price [and what findings would see us walk away]?
I believe you need to define the hypotheses for investing early in the process. Then, decide what findings would lead to pulling out of the deal. Finally, conduct the analysis to test the hypotheses and determine whether the deal should continue. The DD process should be methodical and purposeful if long-term value creation is the goal. If it’s not, then ignore this post and keep closing those deals.
Then again, who am I to edify the private equity community on long-term value creation. I suppose I’m directing this sermon more at those looking to become uniquely differentiated private equiteers. And trust me when I say, you will be unique if you conduct purposeful due diligence. Like a straight cop in a corrupt precinct, try not to let the financial engineers in this industry deprave you.
[...] create a bias towards making the deal a success. I spoke indirectly about this in my recent post, the superficiality of most due diligence. In my opinion, this is the single biggest threat to the objective appraisal of a potential deal; [...]
Human behaviour and its affect on private equity | The Private Equiteer
20 Jun 09 at 23:55
Regarding Due Diligence, a few thoughts to ponder:
1) If the relationship between Equiteer and Investee/Founder/Mgt will be anything less than “brotherly” post-close…from our observation…due diligence may well be the last opportunity to identify the critical deficiencies that the Equiteer really wants to get done (without stonewalling) and can get those items on the short-term to-do list post-close. Reviewing operations post-close to identify IT and business process matters just takes on a whole new and different dimension from identifying the same and agreeing upon specific action pre-close.
2) You do not mention IT due diligence as a key diligence item. We live in the Information Age where information is often the secret sauce to success, differentiation and a higher valuation downstream when executing the exit strategy. Burying IT due diligence within other diligence agendas typically misses the whole IT/future valuation relationship.
Reply to the email if these cause you to ponder and you want to consider further.
David Jung
7 Aug 09 at 16:37
Greetings David; thanks for the note. Also, great points that I should have noted. I suspect the most valuable outcome of DD is the to-do list for the short-term. By having a look at a business from the outside, you often find areas for cheap and quick improvements. People working within the business can miss these opportunities. On your second point, I have to admit that I agree, but am also guilty of lumping IT DD with things like environmental DD. Both matter, but many people fail to see their direct relevance to earnings.
The Private Equiteer
11 Aug 09 at 06:04