The investment world can be a financial minefield. What looks like a sensible merger or acquisition could turn into a legal nightmare without going through a private equity due diligence process. Private equity due diligence is an audit or investigation that takes place before a business or an investor buy or merge with a potential asset. A due diligence investigation will confirm all the facts pertinent to the transaction. Financial records, internal systems and operation effectiveness, and any other material that pertain to a financial transaction are open for review and discussion.
Due diligence is the process fund managers, equity research managers, investors and brokers use to uncover issues before any money or stock changes hands. Brokers and dealers have a legal obligation to conduct due diligence before they sell a security. Individual investors don’t have to perform a due diligence exercise, but most investors voluntarily go through the process.
Performing due diligence is standard procedure and an important part of an initial public offering. Underwriters perform a careful investigation to make sure all pertinent material is on the table, so prospective investors can make rational decisions. Plus, due diligence will uncover any issues that violate federal and state laws.
In the United States, due diligence became a common term and common practice when the Securities Act of 1933 became law. Brokers and security dealers who fail to disclose pertinent information to investors can face criminal prosecution. But the lawmakers who created the Securities Act knew that demanding full disclosure could leave equity brokers and dealers vulnerable if they didn’t disclose material or facts they did not have or know about at the time of the sale. So in order to protect brokers, the 1933 Act included a legal defense that states as long as due diligence is part of the process, brokers are not liable for information that surfaces after the initial investigation.
One company that has a reputation for conducting business investigations is Corporate Resolutions Inc. Corporate Resolutions offers clients a wide range of investigative services. Their client base includes law firms, the private equity community, insurance companies, healthcare organizations, multinational corporations, and alternative asset funds. Corporate Resolutions specializes in company investigations and background checks in countries around the world. Corporate Resolution started performing due diligence investigations in 1991 after former FBI agent Ken Springer saw an opportunity that other people and companies didn’t see.
There is a process in place when a business or an investor wants to start a due diligence investigation. The first step in the process is to analyze the total value of the asset or the company. A company’s market capitalization tells a lot about the company’s stock in terms of how broad the ownership is, the volatility of the stock, and the potential size of the company’s market.
The second step in private equity due diligence is to analyze revenue, profit, and market trends. Companies like Corporate Resolutions usually go back at least two or three years so they can fully understand revenue and profit potential. Step number three in due diligence is to study the competition and the industry. Most companies have some kind of connections with their competitors, so studying major competitors can reveal issues like industry growth and where the company stands in the industry in terms of performance and reputation.
Due diligence step four gets into the nitty-gritty of price-to-earnings ratios and potential earnings growth. Basic stock growth, and the value of all the stock fall under step five. It’s always a good idea to look at several years of net earnings in order to confirm the number used to calculate price-to-earnings and price-to-sales ratios are normal. Price-to-book ratio comparison is also part of step four.
Step five in the process is an in-depth study of the management and share ownership. High-level managers who have a stake in the company tend to function more effectively than managers with no vested interest. Step six is a balance sheet examination, and step seven includes tracking the stock’s history. Step eight is all about studying stock options and dilution possibilities.
Step nine includes an examination of seller expectations as well as buyer expectations. And step ten in any comprehensive due diligence examination is studying the short and long-term risks.