“Ignorance is bliss,” writes the English poet Thomas Gray. While such sentiments may be true in love matters, lack of knowledge in financial matters is an invitation to disaster. The need for information is especially acute in the private equity market, where millions of dollars are at risk in startup and early-stage businesses led by unproven management teams.
The Importance of Due Diligence
Due diligence is a process often under-valued in investment decisions. Yet, the exercise is typically the last opportunity for an investor to confirm or walk away from an investment. Private equity firm analysts and principals complete numerous types of due diligence before deciding to invest in a business, primarily focused on financial data, marketing plans, and company representations. Much of investment management due diligence is binary: Does a specific document or asset exist: Yes or No? Firms typically develop a proprietary checklist of requirements to ensure nothing of importance is overlooked. However, effective due diligence – the kind that reveals the information behind the curtain – is much more than ticking items on a list.
Investment Risk Management
A principal purpose of due diligence is to raise ‘red flags” about the intended investment’s management team responsible for delivering the expected returns. Are they experienced? Are they leaders or managers? Calm under pressure or quick to run and scapegoat? Does a company’s culture reflect the investor’s desired values or a case of “greenwashing” – claiming to follow desirable environmental, social, and governance practices in public while ignoring them in practice? Ignoring ESG issues can be expensive as credit-rating agencies like S&P Global regularly downgrade companies for ESG failures.
Reputational Risk Management
Companies with strong positive reputations attract better talent and have higher quality ratings of their products and services. The higher value enables them to charge a premium and deliver higher earnings, which translates into higher Pes and lower capital costs. A 2007 Harvard Business Review article detailed companies’ failure to adequately manage reputation risks, often confusing it with crisis management – closing the pen gate after the sheep have scattered.
More than a decade later, intangible assets continue to represent 70%-80% of the market value of most growth companies. This value can quickly melt and disappear at the appearance of a single negative Instance. A 2013 Deloitte Reputation Risk Study found that 88% of the global executives surveyed ranked reputation risk as a critical business challenge.
New Pressures on Private Equity Due Diligence
Multiple factors have unsettled the global private equity markets, increasing the investment risk for PE firms and their clients. According to Pitchbook, more than a quarter of VC and PE firms have lost partners or key recruits in 2021, requiring them to pay a premium to recruit and train top talent.[i] At the same time, firms are under pressure to invest enormous sums of capital in an increasingly competitive market due to
- Increase in investible funds. An unprecedented flood of capital from endowment and pension funds seeking to escape falling bond yields and a volatile stock market has pushed PE investment demand to new heights. Deloitte, a global accounting firm, predicts that global PE assets will reach $5.8 trillion by 2025, significantly above the $4.5 trillion at the end of 2019.[ii] The investment rate declined considerably during the Covid-19 pandemic, creating a mountain of uninvested, available funds. Over $500 billion at the end of the 2nd quarter of 2021).[iii] In mid-2020, the U.S. Department of Labor issued guidelines allowing 401(k) retirement plans to invest in PE under certain conditions, adding more fuel to the fire of private equity.[iv]
- Increase in Private Equity firms. The number of private equity firms raising investor funds and seeking investments has increased on average about 7% each year since 2013, with an estimated 9,000 globally in 2021.[v] The number of completed investments has been stable since 2015, while investment totals have increased. Growing competition for deals increases valuations and prices, exaggerating investment risk.
- Importance of ESG operations. PE firms and their investors are increasingly conscious of a prospective investment’s environmental, social, and governance goals. According to Elias Koronis, a partner at Hermes GPE, “The big mindset shift is that now ESG risk is as important and as central to a company as any other type of financial risk, such as leverage risk.” [vi]
Over-worked and under-trained PE firm analysts are especially adept at reviewing quantitative financial and industry data to confirm or modify prospective investments’ pro forma statements, valuations, and cap tables. However, management due diligence – evaluating the quality and skill of management – is the most difficult due to its intangible nature. Search engines index a small portion of available online information (4% to 6%), consequently omitting masses of data that could provide valuable insight about a company or its executive reputations, work histories, values, and abilities.
Financial analysts rarely have the search and database query skills and experience required to complete enhanced due diligence (for risk & compliance), investment (or management) due diligence, or specific functions, including ESG. Their lack of experience can overlook indications of questionable actions – allegations of discrimination and abusive behavior, data leaks, fraudulent behaviour, and corruption – by the potential investment candidate or its founders.
Under competitive pressures to quickly determine whether an investment is warranted, private equity analysts may be tempted to minimize reputational risk in their due diligence, especially if a cursory search confirms their subconscious biases. An open-source internet search – enhanced by machine learning and natural language processing – provides independent, unbiased information about the attitude and aptitude of individuals and firms, ensuring they comply with regulatory guidelines and identify potential conduct or financial crime risks.
The financial stakes of private equity are exceptionally high in this hyper-competitive PE period. The combination of increased client expectations and higher investment amounts forces PE firms to identify, collect, analyze, and confirm investment decisions within abbreviated due diligence periods.
Simultaneously, the global increase of social activism exposes companies to new risks – the possibility that a company’s sales and market value will fall due to public exposure of personal or corporate indiscretion or failings. While no strategy is failsafe, a thorough and complete diligence process, including reputation and management risks, may avoid the more onerous costs of negative publicity. The use of trained database and search specialists expands and supplements a PE firm’s traditional due diligence practices, often providing management team and reputational risk information commonly overlooked.
[i] Mathur, P. (2021) VC, PE firms resort to salary hikes amid historic quitting spree. Pitchbook.com (September 23, 2021) Access through https://pitchbook.com/news/articles/venture-capital-private-equity-compensation-resignation
[ii] Henry, P., Taylor, T., Fumai, F. and Patel, J. (2020) The growing private equity market. Deloitte Insights. (November 5, 2020) Access through https://www2.deloitte.com/us/en/insights/industry/financial-services/private-equity-industry-forecast.html
[iii] Geisi, S. (2021) Private-equity powerhouses are sitting on piles of uninvested cash. MarketWatch.com website. (August 25, 2021) Access through https://www.marketwatch.com/story/private-equity-powerhouses-are-sitting-on-piles-of-uninvested-cash-11629913878
[iv] Staff. (2020) U.S. DEPARTMENT OF LABOR ISSUES INFORMATION LETTER ON PRIVATE EQUITY INVESTMENTS. U.S. Department of Labor News Release No. 20-1160-NAT. (June 3, 2020) Access through https://www.dol.gov/newsroom/releases/ebsa/ebsa20200603-0
[v] Staff. (2019) Private markets come of age. McKinsey Global Private Markets Review 2019. McKinsey & Company. (2019) Access through https://www.mckinsey.com/~/media/mckinsey/industries/private%20equity%20and%20principal%20investors/our%20insights/private%20markets%20come%20of%20age/private-markets-come-of-age-mckinsey-global-private-markets-review-2019-vf.ashx
[vi] Papadopoullos, C. (2021) Why private equity has started taking ESG seriously. Capital Monitor website. (July 20, 2021) Access through https://capitalmonitor.ai/asset-class/equity/why-private-equity-is-finally-taking-esg-seriously/