Deal or no deal: The importance of private equity due diligence

Every private equity deal looks good on paper until it doesn’t. Private equity due diligence helps uncover underlying issues and serves as a key safeguard against bad deals.

In this article, we’ll discuss how due diligence in private equity works, including the different types. We’ll also zero in on legal due diligence and how it is done. For further questions, consult a lawyer.

What is due diligence in private equity?

Due diligence is used not only in private equity deals, but also for mergers and acquisitions (M&As). It involves investigating various aspects of the other party to decide whether to proceed with a deal.

In private equity, due diligence helps the private equity firm determine if the investment in or acquisition of a company is a sound financial decision. This thorough investigation before the deal closes assesses the following:

• if the target company is profitable
• what risks come with acquiring the company
• if the investment is justified, given the company’s true financial and legal position

Due diligence is important because it can identify hidden issues early, when they’re still easier and less costly to address. On the other hand, weak due diligence may leave investors exposed to unexpected problems after significant funds have been committed.

Watch this video to know what to look at when doing a due diligence in private equity:

To learn more about conducting private equity due diligence, reach out to the best private equity lawyers in Canada as ranked by Lexpert.

What are the types of due diligence in private equity?

In both private equity and M&As, there are several types, also referred to as aspects, of due diligence, including:

• industry
• financial
• operations
• legal

We’ll discuss these types or aspects below.

Industry due diligence

While the other aspects of due diligence look at specific matters, industry due diligence examines the world surrounding the target company. To support its decision, private equity funds or firms must understand the market forces that shape the business and whether they work for or against the company’s growth.

At this stage of due diligence, firms will ask if:

• the industry is expanding or shrinking
• the competition in the industry is too much
• customer demand is disappearing due to several factors

The answers to these questions help determine whether to proceed with the investment, even before reviewing the target company’s financials.

Financial due diligence

The goal of financial due diligence is to check if the target company’s financial position supports the asking price. Here, firms look at three important factors:

• money flows
• past performance
• profitability

The company’s claims about its financial position will be put to the test using hard numbers and data. Aside from looking at the company’s balance sheets, cash flow statements, and income statements, firms can look at audits to verify historical accuracy.

Operations due diligence

Operations due diligence examines how the target company runs its business, including its processes, systems, and personnel.

Productivity and efficiency are key factors in operations due diligence. Firms may review:

• supply chain structure
• inventory management
• cost structure
• production processes

Legal due diligence

“Legal due diligence is a legal background check on the company or business a private equity investor wants to invest in or acquire,” says Tatjana Obradović, a partner at Mogan Daniels Slager LLP. “The purpose is to ‘look under the hood’ of the target company to confirm that the value the private equity investor thinks they’re getting is actually there.”

Obradović adds that in legal due diligence, the private equity investor is looking to verify that the target company, among others:

• is legally registered and permitted to operate
• owns its assets free of claims
• complies with applicable laws
• is not tied up in material litigation

“If something is off, the private equity investor can renegotiate the deal (e.g. adjust the price, reallocate risk), require that legal issues be resolved prior to closing, or walk away entirely,” she says.

Obradović adds that understanding and resolving legal issues upfront helps to avoid post-closing disputes between the deal parties. “This is particularly important in private equity deals where the private equity investor often partners up with existing senior management in operating the business after closing.”

Here’s a video showing the other aspects of due diligence in private equity:

Looking for law firms that conduct private equity due diligence? Check out our directory of the Lexpert-ranked best private equity law firms in Canada.

What are the steps in conducting legal due diligence in private equity?

This section focuses on the steps in legal due diligence, which can help private equity firms and target companies understand what is required for investment deals.

According to Obradović, these are the typical steps in conducting legal due diligence in private equity:

• Firm’s questions: Typically, the private equity investor’s legal team sends a detailed list of legal questions to the target company’s legal team
• Company’s response: The target company provides written responses to the private equity investor’s detailed questions and uploads requested documents and other supporting materials to the deal data room
• Reviewing the response: The private equity investor’s deal team reviews the information provided, asks follow-up questions, and sometimes arranges interviews with key personnel to fill gaps or clarify issues
• Further investigation: Concurrently with this process, the private equity investor’s legal team:
  • conducts its own public searches on the target company and its owners
  • compares that against the information provided by the target company
  • asks for more details and documentation where needed

Rather than a one-time review, private equity due diligence usually follows a staged approach. The length of the review and which issues matter most depend on the:

• size of the investment deal
• investor’s risk tolerance
• industry where the target company operates

There’s no standard formula that works for every acquisition or investment deal. To guide both firms and target companies, we’ll be discussing some considerations below:

Reviewing legal documents and contracts

When doing legal private equity due diligence, some of the target company’s basic legal documents that firms must look at are the following:

• articles of incorporation and bylaws: show the structure of the company and how it operates
• listing of shareholders and ownership percentages: reveal the true owners of the company
• annual reports (both internal and external): display the company’s performance, including its weaknesses
• contracts and covenants: to identify how changes in ownership may affect the company under existing contract terms

Looking at regulatory compliance

Firms must also review if the company has been compliant with Canadian laws, including:

• labour and employment laws
• industry-specific licenses and permits
• antitrust and competition laws

This ensures that the firm’s investment will comply with regulatory approvals whenever necessary.

Conducting public record searches

Aside from checking if the company is lawfully compliant, part of legal due diligence is checking for other legal issues that the company is facing. Some examples are:

• registered or unregistered encumbrances of company properties
• ongoing litigation and out-of-court settlement proceedings
• insolvency history and bankruptcy filings

How can lawyers help clients in conducting legal due diligence in private equity?

Private equity firms usually rely on external counsel and specialists to conduct due diligence work for them. While lawyers can examine legal documents and contracts, financial experts are tasked with reviewing cash flows and balance sheets. Other professionals are also involved, including operational consultants and environmental specialists.

“When it comes to uncovering legal risks, lawyers know where to look and what to look for, says Obradović. “They can interpret and help private equity clients weigh the risks of what they find. Involving lawyers early brings focus and efficiency to the diligence process, ensuring the deal remains on track and closes on time.”

Private equity due diligence: Closing a deal with legal clarity

Private equity due diligence gives firms a clear picture of whether the target company makes money and can grow. But numbers and market positions don’t account for the legal risks buried in contracts, employment agreements, and regulatory obligations. This is why investigation shifts from spreadsheets to legal documents. This is when most private equity deals either get stronger or start falling apart.

To assist firms in the process, lawyers are there to provide private equity due diligence expertise and catch issues that internal teams miss before deciding if it’s a deal or no deal.

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