Pre-investment due diligence, often an overlooked aspect, can be the line between a successful deal and a disastrous one. As investment deals grow more complex, even seasoned investors can overlook details that might spell doom for a promising deal. This piece covers what pre-investment due diligence actually includes, where it most often gets compressed, and what it costs to find out afterward instead.
Let's face it, the complexities of investment deals have risen to an all-time high, and it's surprisingly easy for even the sharpest investors to overlook critical details. These are the details that can, in one fell swoop, sour an investment deal or lead to severe consequences. When it comes to pre-investment due diligence, it's all about the devil in the details.
Deal teams meet the same tension on every transaction: a dealbreaker is cheapest to find early, and early is exactly when nobody wants to spend money looking for it. These four dimensions are about settling that tension deliberately rather than by default.
The deal team today stands on a challenging precipice. There's the essential task of identifying the dealbreakers before considerable resources of time and effort are invested into what may end up as a doomed deal. Yet, no one is thrilled about shelling out for a comprehensive pre-investment due diligence without some assurance that a deal is within reach. So, what should guide a deal team's decision to collaborate with an external expert?
Ponder upon these questions: Are there any hidden liabilities? What do technology and cybersecurity present in terms of risks and opportunities? Has any member of the management been involved in illegal activities? What's the company's reputation among its stakeholders? Has the company's governance structure been put to the test?
1. Motivations to conduct a pre-investment due diligence
Four reasons should motivate any serious investor toward comprehensive pre-investment due diligence:
- Valuation: Is the price tag justified? Are you basing your decision on the full, true picture? Numerous factors influence the valuation, and the last thing you want is to discover that you were operating at a disadvantage from the start.
- Transaction Structure: Delving deeper often brings out issues that might change your preferred course of action in structuring the deal. This could include putting funds in escrow, deciding on incentives structure, warranties, and more.
- Liability: As an investor, there's a tangible personal liability at stake. If a deal fails, and it's demonstrated that you could have known about certain flaws, you could be in hot water.
- Reputation: Don't underestimate the damage a single bad deal can do to your reputation. It can overshadow the success of countless good deals, leave a bitter taste, and potentially hamper future fund-raising endeavors or even your continued presence in the industry.
The pre-investment due diligence process can surface a wide range of issues, even those missed in preliminary examinations. These include undisclosed business interests, conflicts of interest, work history gaps, surprising political ties, problematic business associations, hidden shareholdings, and material misstatements or omissions. To uncover these, the expertise of a professional investigator is almost always essential.
Timing decides what a finding is worth. The same fact discovered a week before closing costs far more to act on than one discovered before terms are set, which is why effective deal teams start this work earlier than feels necessary.
2. Getting the timing right
Timing is everything in due diligence. Too often, investors leave it till the last minute, only to be blindsided by critical findings as they are getting ready to close the deal. The most effective deal teams approach this task early in the game.
3. Choosing the right level of pre-investment due diligence
One key point is that there's no unified definition of the levels of pre-investment due diligence. Therefore, having a detailed discussion about the desired outcome is crucial. Also, share any anecdotal evidence or observations with investigators.
Basic due diligence involves verifying publicly available information, education claims, past positions, and unearthing issues like bankruptcies and criminal records. In-depth investigations provide a more comprehensive understanding of the target's management, internal culture, and governance.
4. Working with a professional partner during pre-investment due diligence
Teaming up with a professional partner for pre-investment due diligence isn't a luxury—it's a necessity. A seasoned professional can provide you with the right intelligence, transforming it into actionable information that will safeguard you and your investors. When your funds and reputation hang in the balance, only the best will do.
Falcone International
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