The Depth of Due Diligence in Large-Cap Private Equity (and how to get comfortable with public market diligence) - Long Post
As your classic PE associate who wants to jump to the public side one day, I have been doing more reflections on the level of diligence in my current role vs what a public seat would imply and want to share a few thoughts covering:
1) Private Equity Due Diligence
2) Private Equity Information Availability
3) Reflections on how to underwrite investments with (much) less information
4) Why the level of Due Diligence should technically be the same across public and private markets
Let’s get into it
Firms helping PE shops make a deal
1) Private Equity Due Diligence
The amount of (i) human capital, (ii) time, and (iii) dollars that go into the due diligence process of a deal in Large-Cap PE is hard to comprehend. Let me give you an idea of the classic lineup that a PE firm will hire to put in a bid in a deal:
a) consultants: pick your MBB private equity team that will help you “dissect” the market, understand long-term growth assumptions, trends shaping the industry, factors to consider, etc. (i.e. validate our long-term assumptions so that IC is confident these are valid assumptions)
b) financial due diligence: Big 4 team to validate the financials of the company
c) tax due diligence: another Big 4 team or similar to make sure the company is not committing tax fraud and everything looks good
d) legal due diligence: a big law team that helps you review contracts and understand where major liabilities could emerge from
e) technical due diligence (not always): specialized consultants that help us non-technical people understand complex businesses and make assumptions (the calls with them are some of the driest things I have ever witnessed)
f) M&A bank (not always): buy-side M&A team helping you (especially by coordinating with the sell-side bank)
g) expert networks / calls (not always): this is the deal team spending $500+/hour to interview “experts” in the industry to learn how the business / industry / ecosystem works
While not every deal will see 6 external teams help you in your due diligence, a combination with multiple of these parties is very common. You can easily see how a working list of 20+ people becomes very common when putting in a bid.
Compare this to your Single-Manager analyst who has to underwrite an investment basically by himself, and you can easily see that the workforce/time available to analyze an investment is immensely different.
A natural question would be: “What are all these people in private markets working on”?
As part of a private equity process, the amount of information available to analyze is very large.
2) Private Equity Due Diligence Information Availability
Let’s introduce the data room: a shared folder with any possible information you could ever think you would need to value and invest in a company.
Financials, contracts, customer-level information (as granular as you can guess), tax filings, permits, articles of incorporation, voting agreements, M&A agreements, etc. The list could go on forever.
The moment the data room is opened, you can waive bye to your social life for a few days straight, you will start running data cuts to validate the key thesis points.
The legal team will handle the contracts, the financial team will handle the financials, etc.
For weeks, the PE firm will pay an army of people to digest all the information included and answer every question that will make the deal team comfortable to present this to the Investment Committee (read the below tweet on intellectual honesty for more on this) so that IC is comfortable to put in a final offer.
On the other hand, a public market investor will get virtually no other information from the company besides the public filings, and a big part of the job is being creative and finding new pieces of information that can help create a thesis.
3) Reflections on how to get comfortable with (much) less information
As I look to the future and picture myself in a public seat where I will need to underwrite a company without all the above resources, I sometimes struggle to understand how I will get comfortable (and this tweet does not serve as an answer in any way!).
The amount of insights you can get from getting access to customer-level information is incredible:
- company broken down into as many segments as you would like
- every detail information by segment (avg. spend, churn, LTV, CAC)
- historical trends by segment by any metric
- etc. etc. etc.
While I would love to get more insights from someone on the public side explaining how to get information besides public filings, alt-data, and expert networks, I think **three considerations** can help bridge this apparently huge gap in the amount of resources dedicated to underwriting an investment.
(i) Public markets revolve around having a differentiated view of the earnings power of the company, virtually all of the PE due diligence above does not serve this goal.
For example, many of the due diligence steps highlighted in Tweet 1 are check-the-box types of due diligence vs. trying to gain a hedge
Therefore, these steps can be eliminated, and 99% of the time there would be no consequence in the public market for a specific reason —>
(ii) Private markets generally look at much smaller companies than public market investors. You do not need to do legal due diligence on Apple.
This is my rough math:
A large PE fund is $20B these day
Let’s assume it stays concentrated and invests in 12 companies (vs. 15+)
That’s an implied $1.6B equity check (before co-invest) per deal.
Let’s assume $1B of co-invest which is large but not abnormal, this brings us to ~$2.5B Equity check
Let’s assume the PE firm really pushes the leverage to 66% LTV (high for such check), that’s a total TEV of $7.5B using pretty bullish assumptions across the board (easy lever to pull is that you can raise more co-invest if LPs like the deal)
Therefore, even for Mega-Funds, investing in $10Bn+ enterprises is very very rare which means PE investors look at companies that would generally be considered small-to-mid caps and that generally require more diligence to make sure all things are ok (people just assume these things are good with mega-caps).
(iii) Public markets are a game of imperfect information and high velocity, private markets are a game of perfect information and low velocity
If a stock picker is right 60% of the times, he / she will have an outstanding career.
If a PE investor is right 60% of the times, he will have a poor career.
The idea that a public investor will see its capital being impaired is part of the job, while the same cannot be said about private equity firms which should never really lose money (as even funds who bought a lot of companies during periods of high valuations are expected to generate ~10%+ IRRs).
The concept that every deal has to generate profits creates a higher bar in the due diligence process that implies turning every stone to make sure no information is missed.
4) Why the Due Diligence should technically be the same
If you are going to make the argument that the level of due diligence is expected to be higher in private markets as you are doing a full buyout vs buying a 1% stake, we are going to disagree.
This paragraph will be redundant for anyone working in investing, but there is no difference in terms of putting $500MM in equity in a stock vs in the equity of a private company. Sure, the private company will be more illiquid and it will be harder to get out if things go south, but the capital impairment possibility is equal across both. Just because you are buying a larger or smaller percentage of the enterprise, this should not entitle you to do less due diligence.