A well-structured due diligence process contains a top-down macro and a bottom-up manager analysis, allowing the investor to filter the most promising funds.
A consistent framework for fund and fund-manager assessment is essential. This assessment must address quantitative and qualitative aspects, and focus on the manager’s “ingredients for success”.
At first sight, fund offerings may appear attractive from a pure return perspective. It is crucial that the investment has an attractive risk–return balance.
The term “due diligence” covers a broad range of different due diligence types. These can be grouped into three major types; financial, legal/tax, and business due diligence. The goal of this article is to shed light on business due diligence for investing in private equity funds. Due diligence is commonly defined as “the process of investigation and evaluation, performed by investors, into the details of a potential investment, such as an examination of operations and management, the verification of material facts”.1 “It is a requirement for prudent investors and the basis for better investment decisions.”2 Private equity fund evaluation faces specific challenges; the private character of the industry makes it inherently difficult to obtain the relevant information; furthermore, the investment decision reflects a commitment to a fund manager to finance future investments rather than a straightforward purchase of specific assets. Therefore, common evaluation techniques used to assess public equity investments are not appropriate within the private equity asset class.
The private equity market has enjoyed extraordinary growth rates in the past, and private equity investments showed strong returns, supported by a booming economy and an expanding debt market. The current financial crisis will have a significant impact on the private equity market; a shake-out of fund managers is to be expected over the coming years. Managers who can demonstrate how they created value in the past, beyond just benefiting from favorable market developments, and who are able to make a compelling case for future value creation will continue to raise capital successfully.
Before investing in a private equity fund, an investor should have sufficient comfort regarding:
Strategy perspective: the investment strategy of the fund.
Return perspective: evidence that the manager stands out compared to his/her peer group.
Risk perspective: assurance that risk is mitigated to the level required by the investor.
The relative youth of the private equity industry, data paucity, as well as benchmarking difficulties within and across asset classes are just a few elements that indicate why the investor has to rely on qualitative aspects and judgment during the due diligence process of private equity funds.
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