What is Due Diligence?
Due diligence is a collection of actions that function as an audit of an investment situation. This includes a series of items that allow managers to conduct an analysis in a methodological manner. The basic components of due diligence include macro analysis of the external conditions for the investment as well as a micro analysis of the conditions inside of the company. For example, when the investment is the purchase of a company, the due diligence checklist will reflect the internal analysis of company records and the balance sheet. However, it will also examine the company’s relationship to external forces including regulators, financing institutions and customer accounts.
Ensure Integrity of Investments, Executive Hiring
Corporate Resolutions points out that challenges to executing are useful because they provide a glimpse into the way the concept of private equity due diligence plays out in real world situations. For example, purchasing a company requires in-depth and accurate knowledge of how the company is organized and operating. This includes everything that can affect the profit margin. Examples include internal controls or the ratios produced by concentration of customer activity. If half of all sales are generated by only a few customers, this ratio is low, for example. Another example of due diligence is a line-by-line analysis of the expenses listed on the income statement. Due diligence must be applied to each situation where an investment occurs.
Another example of due diligence involves the investment in hiring practices for executive positions. Hiring a new executive to lead the organization requires absolute confidence in the new leader’s ability to recognize the importance of performing due diligence internally. This means that any audits should be evaluated in terms of the interests behind the auditors. For example, the returns for private equity funds correlate closely to the relationship of the auditor. Audits can be done internally, or they can be outsourced to a third party. Internal audits tend to produce stronger returns for private equity funds than investments made when outsourcing due diligence activities, according to Douglas Cumming and Simona Zambelli.
Due diligence formulas exist in order to simplify the process as much as possible. They contain items like examination of organizational bylaws, stock documents, contracts, intellectual property documents. It can also include a complete audit of the income statement, balance sheet and cash flows. This information is used to make critical decisions, so due diligence is the process of generating accurate data. However, when a private equity fund is conducting due diligence, the activities that produce actionable data must be relevant to the context. Buying a company is an activity that requires a different set of tasks to qualify than the activities required for hiring a new CEO, for example. The checklist is just a shorthand tool designed to assist in producing the kind of analysis that leads to informed decision-making.