How do Private Equity Firms perform Due Diligence?
How does private equity perform due diligence?
You must do due diligence! You can never trust a company’s numbers when that company is trying to sell.
Yes, you have their “actuals” (historical financial statements), but you have to see their projections! Let me tell you a little story. In 2012, I was looking to buy this company. It was a good company with a stable EBITDA for the last 10 years and solid cash flows. When I looked at the seller’s projections for 2013 EBITDA for 2013, I was shocked to see a triple in EBITDA! There wasn’t a big CapEx spend. There were no big acquisitions. The seller justified this triple in EBITDA by saying that the company’s existing customers were going to buy more, and that the company will get a lot of new customers using existing strategies. The company was trying to convince us that his projection of a triple in EBITDA warranted triple the price.
Needless to say, we didn’t buy that company…..and neither did anybody else. One year later, when we re-visited the company, as per our expectation, the 2013 EBITDA was very similar to the company’s 2012 EBITDA.
When buying a company, you need to understand everything about that company. In regards to sales, you need to know the customer concentration. Do half of the sales come from one customer? Or does the biggest customer account for three percent of sales?
You need to understand every single line of the income statement. You need to double and triple check the numbers for the actuals in the past. You need to understand the industry to come up with your own forecasts.
You need to question people. You may want to interview consultants or industry professionals. While maintaining the confidentiality of the company, interview as many people as possible – including customers.
I recently met two of the world’s top private equity professors: Drs. Douglas Cumming from the Schulich School of Business in Toronto and Simona Zambelli from the University of Bologna in Italy. They collaborated on a paper that concluded that by doing internal due diligence, portfolio companies and other private equity funds have performed better than when the funds hired third-party consultants to conduct due diligence.