What is Due Diligence?
It’s an examination, investigation, or audit to confirm the details of facts and information, generally for an investment in a product, company, or team. It’s an easy process with public companies: just look up the ticker and you’ll find their 10-Ks, 10-Qs, announcements, news, and everything in between. Reporting requirements make it easy to find ample information, since it’s one of the requirements of public companies who want to be listed for trading. In-depth due diligence is usually done during mergers and acquisitions, because of the amount of money and risk in large public company transactions. But what about private investments, like alternatives?
Private investments may provide some basic information, but won’t have anywhere near the amount of information available as a public company. Small projects just don’t have the resources for extensive reporting, and are often small enough that it wouldn’t make sense for such requirements, as they would be financially unfeasible. This is where finding a good due diligence company comes into play. An outside due diligence firm can dive into the details of a potential investment, spending the time investors don’t have and using expertise in their specific areas of focus. Above all, due diligence is time-consuming and investors don’t have the resources to dig into the nitty gritty details of every investment they are interested in. So let’s take a look at why investors hire due diligence companies, and how they can add value to an investor’s portfolio.
The two main types of due diligence
Due diligence can be broadly categorized into two types: hard and soft due diligence. Hard due diligence is quantitative and based on data, numbers, and legal concerns. Examining facts, figures, and hard data can raise red flags, such as exponential returns, unrealistic financial ratios, and practices that may be in legal gray areas. Soft due diligence looks at harder to quantify, more intangible factors of a target or project. For example, is the management capable, is there a good culture, and how loyal are customers? While some of these can be quantified, they also often contribute to numbers in unusual ways, and should be examined in addition to the numbers. Interviews, research, and a wholistic view are important pieces of the qualitative side of the diligence process. It’s tempting for many investors to ignore this side, and that often leads to failure. According to Investopedia and Harvard Business Review, “When M&A deals fail, as an estimated 70%-90% of them do, it is often because the human element is ignored.” The best diligence looks at all aspects of a deal, then crafts a narrative that’s easy to understand and improves decision-making. After all, exceptional due diligence should inform your decisions and reduce risk.
We’ve taken a look at due diligence as a whole, an investigation of facts, figures, and representations of a deal. The two main types of due diligence, hard quantitative and soft qualitative, and how they fit together. Let’s take a look at why an outside due diligence firm is usually used to evaluate alternative investments.
10 reasons to engage a due diligence firm
1 Impartial – Due diligence firms are impartial by nature, as they don’t have a stake in the deal and are paid whether or not the deal moves forward. Although some firms may tell you what you want to hear, the best due diligence firms will present all the information in a cohesive picture, without bias or influence. Getting an honest view of the deal may not be as exciting, but it does make for better decision-making.
2 Validation – In the intricate landscape of investments, proving the validity of a given opportunity can be difficult. Diligence companies play a critical role in dissecting the investment’s structure, market position, and potential returns. This validation process is essential not just for the sponsor but for potential investors, offering a clear, unbiased perspective on the investment’s viability.
3 Credibility – Engaging a reputable firm can increase the credibility of a project. An independent evaluation speaks volumes about the sponsor’s commitment to transparency and excellence, traits highly valued by investors. In business, credibility is currency, and an evidence-based assessment can be exponentially valuable.
4 Risk identification – The earlier in the process risks are identified, the less risky they become. The longer risks go uncovered, the more time, money, and opportunity-cost go up. Using the right risk-assessment tools and methodologies ensure that sponsors and investors are well-informed of unseen challenges up front. Early assessments mean more time to mitigate potential risks, and more time to negotiate or even cancel a substandard deal that otherwise could have been a loss.
5 Regulatory compliance – outside opinion, etc. The complexity of regulatory environments can be daunting for investors. Due diligence companies know how to navigate projects to uncover regulatory hazards. The safeguarding of client interests are central to the services offered by exceptional due diligence firms.
6 Investor confidence – At the heart of any investment endeavor is the need to build and maintain investor confidence. Due diligence reports serve as a testament to the investment’s thorough examination and viability, significantly boosting investor trust. This confidence is critical in attracting and retaining investors, lenders, and partners for current and future deals. Your due diligence company should excel in providing detailed, accessible reports that underline their commitment to fostering investor confidence through transparency and rigorous analysis.
7 Market Analysis – Understanding the market is fundamental. Due diligence firms offer in-depth market analysis with a nuanced understanding of current trends, potential market shifts, and the broader economic environment. This analysis is essential, especially with alternative investments that may have multiple moving parts, such as hard and soft assets, cash flows, and real estate.
8 Operational Assessment – Operational efficiency directly impacts an investment’s success. Due diligence firms conduct thorough operational assessments, identifying areas of strength, weakness, and potential improvement. Operations should not be overlooked for high returns or low risk – they are essential to a smooth-running organization. The people represent the company to customers, and are an extension of the investment made in them. As James Kerr said in his Inc. article ‘Your People Are Your Most Important Asset’, “The people in your company will ultimately determine the success or failure of your business.”
9 Financial Analysis – This may seem like the most important reason for due diligence, so why is it at the bottom of this list? After all, a robust financial analysis lays the foundation for an informed investment decision. Financial analysis is here because everyone does it, yet no investment can be fully known until the returns become real, good, bad, or flat. The most important part of any due diligence process is the wholistic view of the opportunity and what the numbers really mean. Your due diligence company should excel in dissecting financial statements, assessing organizational health, and providing a realistic view of projected performance. But knowing how the numbers fit into the narrative is the key to unlocking value in every project.
10 Real Asset Feasibility – Last, but certainly not least is the reason Greenlight Companies was founded: real asset feasibility. Most due diligence assessments go over financials and background information, but leave out the real estate, location, and demographics of a deal. In the information age, you need to know about the real assets underneath the project and the value they add in the event of any outcome. Find a diligence company that can bring real expertise to the real assets of your project, not just the financials.
Conclusion
Clarity. Investors, sponsors, bankers, managers, they all seek clarity. Due diligence should create a transparent project through an in-depth investigation of every part of an opportunity and presenting it in an easy to digest way. You need an impartial party to validate your investment, identify risks, and provide a real assessment of every aspect of a project. Only with clarity can you make a sound decision with your capital.
Do you have the Greenlight? Greenlight Companies provides diligence services specializing in a comprehensive assessment of real assets, as well as financial and regulatory aspects of alternative investments. If you have any questions about the validity of your diligence, reach out and we will provide a diligence review at no charge.
Sources:
Investopedia