Pre-Investment Due Diligence

Leveraging the benefits of pre-investment due diligence has never been easier

As complexities of deals continue to increase, it's easy for even the most experienced and astute investors to miss an important detail that can sour a deal or mean detrimental consequences in their pre-investment due diligence.

Modern deal teams face a dichotomy. The most critical part is getting to know about the showstoppers before weeks and months have been invested into making a deal that will fall apart in the eleventh hour due to dealbreakers that have been discovered in the pre-investment due diligence.

Yet, nobody wants to spend money on a proper pre-investment due diligence before they know that there is a deal on the table. So what should drive a deal team's decision to work with an external expert?

Four main motivations for pre-investment due diligence

1. Valuation: Is the price you are about to pay really justified and based on the true and accurate information? The valuation is influenced by so many factors, and you don't want to find out that the deck was stacked against you from the get go.
2. Transaction Structure: When you get into the weeds, issues come out that alter the preferred course of action when structuring the deal (i.e., put funds in escrow, incentives structure, warranties, etc.)
3. Liability: As an investor or investment professional, your head is on the line if the deal does not pan out. A real personal liability exists if it can be shown that you could have known about defects.
4. Reputation: You will look foolish if you get it wrong. One bad deal can offset the work of dozens of good deals and will leave a lasting aftertaste. In some cases, it can make it exponentially more difficult to raise another fund or work in the industry altogether.

Issues that can be discovered in the process

Before diving into the pre-investment due diligence with the help of an external expert, most investors will have done a preliminary search or examination. However, getting the highest quality information, will almost always only be obtained with the help of a seasoned, professional investigator.

Previously, clients have been surprised by the following findings despite their own extensive research:

• Undisclosed business interests
• Conflicts of interest
• Personal histories of problematic behaviors
• Work history gaps
• Surprising political connections
• Problematic business associations
• Hidden shareholdings or work with stakeholders
• Material misstatements or omissions

What is good timing of effective pre-investment due diligence?

Time again and again, investors leave the pre-investment due diligence for late in the deal process. While nearly all experts advocate for doing it as early as possible, many investors try to wait until the last moment to 'tick the box' and are surprised by important findings in the eleventh hour.

Effective deal teams approach this the other way around.

What are the different levels of background due diligence?

One of the most important points to note is that there is no unified definition really exists to describe the levels of pre-investment due diligence. Thus, it is critical to have a detailed brief and conversation about the desired outcome, as well as to provide valuable context. If there is a founding team, for example, how have they come together? Do they know each other? Have you worked with them before ?

As the deal team has worked on this for weeks or months, and have spent time with the management team, there might be anecdotal evidence or observations that should be shared at this stage with the investigators.

Basic pre-investment due diligence will verify publicly available information and verify education claims, positions that have been reposted on their CV and biographies. It will unearth issues like bankruptcies, judgements, adverse regulators filings, ligation, and criminal records. It will also verify industry-specific sources and databases, depending on the sector the investment target operates in.

More in-depth investigations will contextualize findings and develop a clearer picture regarding the target's management previous performance and impact on businesses they have led. It can also include confidential interviews with former employees, business partners, colleagues, who can provide additional context. Examining the target company in more depth, it can also lend insight into the internal culture and governance. This allows the investment team to develop strategic intelligence regarding issues with key person risks, government relations, supplier relationships, customers, and other business partners.

Why work with a professional partner on pre-investment due diligence?

With some much on the line, not working with a truly professional organization on pre-investment due diligence is not a good idea. Using an expert is not unduly costly and will always pay off in the short and the long term.

A seasoned professional knows what to look for as well as know what should be there. They know what questions to ask and probe for what should and should not be there. Equally, they are familiar with their jurisdiction and are culturally sensitive enough to contextualize findings.

It will provide you with intelligence in the form of actionable information that will protect you and your investors. Using anything but the best is just not an option with funds and reputation on the line.