Expert Perspectives: Executing Diligence in a Competitive and Selective Environment
Due diligence is a systematic process that involves investigating and verifying the accuracy and completeness of information about a company or investment opportunity before making a decision. This process is typically conducted by potential buyers, investors, or lenders to assess the financial, legal, and operational aspects of the target company or investment.
The concept of thoroughly investigating a business or investment opportunity is not a new one – it’s a practice that humans have engaged in since the earliest emergence of commerce. Over time, as regulations and business practices have evolved, the act of evaluating a potential opportunity has also evolved and become more sophisticated, with various specialized forms and methods emerging to address the unique risks and opportunities in different industries and investment types.
In today’s complex and rapidly changing business landscape, executing diligence can be challenging if you do not have the right tools in place. In this post, I’ll walk you through the playbook I use to successfully execute diligence in numerous scenarios.
The importance of due diligence
Economic and regulatory environments are constantly changing, making it difficult for private equity firms and corporations to identify and evaluate the potential risks and opportunities associated with investing in or acquiring target opportunities. Because of this and the increasingly competitive and complex nature of the industry, due diligence is more critical than ever.
Why is it so important, what’s the risk? PE firms typically invest large amounts of capital in companies, and the success or failure of these investments can have a significant impact on their returns. The risk is just as high on the corporate side – poor decisions made in acquiring a company can result in financial and reputational damage, missed opportunities for cost savings or market expansion, operational disruption, and more. Diligence helps to mitigate these risks by providing a thorough understanding of the target company or investment, including its financial, legal, and operational aspects.
As an example, I work with Tide Solar Technologies, and our commitment is to the implementation and adoption of safer, cleaner and more efficient green energy solutions for our global customers. We invest in green energy photovoltaic (PV) solutions around the world. These solutions help reduce dependency on scarce resources and help to lower greenhouse gas emissions. Often, these projects are complex, and the regulatory environment can vary greatly depending on the location of the project. Prior to commencing any project, we conduct in-depth due diligence to identify any potential risks, liabilities, or opportunities associated with the project and to ensure that the information provided by the target company or investment is accurate and complete. This has always been a guiding principle prior to any project investment we make.
Challenges to conducting due diligence
In recent years, several changes have emerged in the way firms conduct diligence. There is increasing emphasis on environmental, social, and governance (ESG) issues, technological advancements, remote work, regulatory changes, and growing importance of cybersecurity.
External or independent consulting support can be very beneficial for PE and corporate diligence today, as consulting firms often have specialized knowledge and expertise in specific industries or areas of business. They’re on top of trends and have the most up-to-date information on how these challenges may impact targets you’re investigating. They can also provide an objective assessment of the target company or investment and have access to specialized tools and resources that can help to streamline the diligence process.
A playbook for executing effective due diligence
Through my years executing diligence across numerous businesses, industries, and geographies, I’ve developed a set of principles I follow that results in successful outcomes, especially in complex or uncertain environments. Key steps to consider include:
- Conducting a comprehensive risk assessment
- Leveraging technology and data analytics
- Engaging external experts
- Being flexible and adaptable
- Communicating effectively
Conducting a comprehensive risk assessment
A risk assessment involves systematically identifying, evaluating, and prioritizing potential risks that PE firms and corporations might encounter during an investment. This process helps to understand the investment’s viability and to develop strategies for risk mitigation. We’re assessing financial, operational, legal, regulatory, and reputational risks.
Through the risk assessment process, I’ve found it essential to identify both deal-breakers and deal-amenders.
- Deal-breakers are issues that make the transaction too risky to proceed with and may include financial, legal, or cultural misalignment problems.
- Deal-amenders, on the other hand, are issues that can be resolved through changes in the structure, terms, or price of the transaction.
Identifying both deal-breakers and deal-amenders can help the deal team negotiate better terms and increase the chances of a successful transaction. These issues should be evaluated in the context of the overall investment thesis and communicated effectively between the diligence team and investment team to ensure proper consideration.
As I mentioned earlier, in the solar panel business, one mistake can be costly. We have had incidents whereby whole containers were taken by customs simply because we had exported in a zone we were not certified and permitted to operate in, observing fair trade policies. Going through this experience helped us develop a more fail-safe process by carefully considering all potential risks in a scenario.
Leveraging technology and data analytics
The due diligence process requires collecting, reviewing, and analyzing large amounts of data. Using advanced technology and data analytics tools helps us gain deeper insights into target companies and markets, uncover hidden risks, and identify potential opportunities.
PE deal teams and corporate development teams can use data analytics tools to analyze large volumes of financial data, customer data, or market trends to better understand the target company’s performance and competitive position. By employing machine learning algorithms, deal teams can also discover patterns in unstructured data like customer reviews, social media activity, or news articles.
Engaging external experts
External experts, such as lawyers, accountants, industry specialists, or consultants, can provide valuable insights, specialized knowledge, and independent assessments that you may not have in-house. This extends the capability of your team, and also allows you to fully vet an opportunity. The use of independent consultants is a particularly advantageous option for PE firms and corporations who are able to access networks like Catalant’s.
Identifying potential litigation risk is particularly important, especially today, as regulatory environments continue to change and become harder to navigate. Investigate any legal risks associated with the rights and obligations of the target opportunity. You don’t want to get blindsided. I recommend reviewing all customer or supplier disputes and any pending litigation.
Areas covered under the scope of an engagement typically include asset and property ownership, intellectual property, securities, existing contracts (for instance – customers, suppliers, management), insurances (including a review of any past claims).
Review any issues associated with long-term sustainability (for instance – availability of raw materials or environmental factors) that could affect the investment’s future.
An important key question the due diligence team should constantly be asking themselves is, “Are there any problems with the prospective investment that would force you to abandon the investment, even given a significant price reduction?”Matthew Madhumera
Being flexible and adaptable
Due diligence is an iterative process, and new information or risks may emerge throughout the investigation. Deal teams and corporate development teams need to be flexible and adaptable, adjusting their due diligence approach as new information comes to light. For instance, if I discover a significant regulatory risk during an initial assessment, our team may need to reevaluate the investment’s potential return or adjust the valuation of the target company.
Effective due diligence requires a team with the knowledge and expertise to identify potential risks and opportunities. This means it’s essential to appoint team members who can spot issues and opportunities that others may miss – across many dimensions.
An important but sometimes overlooked detail is the corporate culture of the target. I always recommend conducting site visits where possible.
Over the 12 years I previously worked in the cruise line industry, Carnival Corporation invested heavily in due diligence exercises for potential partners, hosts, travel agents and the various ports of calls their ships visited. An important focus was the health and security of guests and crew. This certainly involved focusing on their wellbeing, but more importantly, it meant understanding the impact of their operation on the environment. To date, most cruise lines have become a part of Cruise Line International Agency to ensure safe sustainable cruising that does not negatively impact the environment or seeks to minimize unhealthy practices.
Effective communication is essential to executing diligence in the current environment. This involves maintaining open lines of communication with the target company, external experts, and internal team members. Effective communication between the diligence team and investment team is critical to ensure that all issues are properly evaluated and considered in the context of the overall investment thesis.
Additionally, as new findings emerge during the due diligence process (as they tend to do), it’s essential to communicate these insights to the relevant parties promptly. This can help the team make informed decisions, address potential risks, and capitalize on opportunities in a timely manner.
As an example, I recently helped a firm release an AI tool whose purpose and focus was leveraging AI to enhance the recruitment process. The client’s concern was local legislation and how to govern AI usage in a regulated environment. Our first call was making sure we understood all the legal statutes governing AI usage and its impact on the client’s new technology, and clearly understanding the risks that could arise.
In summary, due diligence is a crucial process in any investment or acquisition decision. It helps to identify potential risks and opportunities associated with the target company or asset, and it ensures that the investment or acquisition aligns with the investor’s overall objectives and investment thesis. With a comprehensive due diligence process in place, investors can make informed decisions and increase the chances of a successful investment or acquisition.
Meet the Author
Matthew Madhumera is an Independent consultant at Madhumera Global Consultancy who has championed performance management functions helping execute go-to-market strategy for global expansion. He is an Expert on the Catalant platform and is reachable at email@example.com.