What is “good diligence”?

I see this term being floated around a lot, not sure exactly what people mean. This is in reference to private equity / credit funds, stated as a strength for good funds (most recently read this in the HPS thread).

What does this actually mean? Hard to wrap my head around varying levels of diligence. Does it mean they are taking more rigorous approaches (e.g. leveraging contacts in related industries / competitors, using alternative data, connecting dots that aren't immediately evident)? Are there players in the space that have a lax approach to this? Can't say I've ever run into a sponsor on a deal who hasn't drowned us with left-field but meaningful questions during DD

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Comments (13)

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Jul 27, 2021 - 8:37am

The reason you feel drowned with left-field questions that are "on point" is that fundamentally the job of an investment bank is to sell a Company, not diligence it. Doing due-diligence is the core of what a PE fund does, so even with little to no thought, they will ask questions that are perceived as meaningful / intelligent.   

Good DD:

1. Generally knows the space, asset, prior to the sale process being on their radar

2. Has a network of executives at least a few of whom know the business directly or at least the space 

3. No cut corners and engages all third-parties (market consultants, QofE, ghSmart etc.) with sufficient time to do all their work 

4. Creates an actual, credible plan to accelerate growth in the Company 

5. Honest during investment committee about what the strengths of the business are, the weaknesses are, and what a price with a reasonable margin of safety should be 

Bad DD:

1. First learned about the industry when the CIM hit the MD's desk

2. Doesn't have any prior investment experience in the sector AND doesn't have executive relationships AND convinces themselves its a good industry after an associate does a few GLG calls

3. Start cutting corners on DD - for example, in competitive processes, using the sell-side QofE versus doing their own. Accelerated market study work vs. a typical ~2-3 week process. 

4. No actual differentiated view on what growth / opportunities there are for the business

5. "Pitches" the deal to investment committee leaving out some of the more contentions points (of which every deal has); pays nosebleed prices with little to no margin of safety in an effort to "do a deal"

In this environment when interest rates are so low, capital so abundant, processes are highly competitive. All it takes is one sponsor to decide to cut corners and they have a higher chance of walking away with the deal. Capital deployment pace is being rewarded by LPs as returns will not be evident for several more years. Perfect recipe to create a classic prisoner's dilemma situation where funds are increasingly pressured / incentivized to 'accelerate' DD. 

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Jul 27, 2021 - 10:55pm

Counterpoint - don't have to actually be that strong at the industry at first, but it requires tremendous amounts of dd to get up to speed (industry data books, paid for (multi thousand dollar reports), dozen glg calls, etc.

I think the real takeaway from good dd is that you will basically ask every question you possibly can, and understand how the business makes money. Then you have everyone on your team do the exact same thing. If you can get comfortable with the answers to all of those questions (and this could be a TON), and the people at your fund are exceptionally smart / good, then you can feel comfortable at end of day.

too many people believe the sell side stuff or simply leverage others buy side materials. Would honestly say that maybe 25% of funds encounter are "good" at dd (shoutout Odyseey, best I've ever seen), 50% are meh / do the basics, and 25% just are full money bazooka (looking at you GSO)

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Jul 28, 2021 - 11:10pm

Well when I was a banker I loved the firms that did "bad DD" haha. Much less stressful/annoying diligence questions and more smooth process overall. Also if a firm did "bad DD" and smoothly won a process, then they'd be rewarded with more deal flow and more appearances on our buyers lists. So it's a lot more complicated than just good vs bad DD. 

Additionally so much of this is luck... In the last 5-7 years, you could buy any random software company with decent growth and retention and made 10x your money. Same thing on the healthcare side by buying a platform multi site for 10-12x and rolling a bunch of smaller providers for 3-7x and then selling the whole thing for 15x to a larger fund. Not much DD required there, good or bad!

Jul 29, 2021 - 8:42am

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