The vital role of due diligence in private equity transactions
The primary purpose of due diligence for any investment is to minimise risks while maximising value for investors. In private equity (PE), due diligence is critically important because transactions typically involve a medium-term investment in illiquid, unlisted assets or companies within a fund manager’s portfolio. That means a PE fund cannot easily exit an unprofitable transaction – so it’s crucial to get it right at the outset.
Due diligence – an investment decision process with quality control
Schroders Capital has an investment process that consists of five stages: Sourcing, Prequalification, Qualification, Subscription and Monitoring. The first stage decision is made by the program team and a full investment decision requires a two-step approval process conducted by the investment committee. Let’s look at each stage in turn for an illustrative co-investment opportunity.
Stage 1 – Sourcing
Schroders Capital actively monitors the universe of investable private equity funds across regions to identify and proactively approach fund managers for the sourcing of attractive primary, secondary and direct/co-investment opportunities.
For this purpose, Schroders Capital has created a proprietary database and a proprietary software tool which, alongside other tools, deploys artificial intelligence-based methods to monitor and highlight potentially attractive investment opportunities.
Additionally, Schroders Capital receives significant unsolicited deal flow based on its longstanding relationships, market position, brand awareness and reputation in the industry.
Stage 2 – Prequalification
Once the decision has been made to move forward with an investment opportunity, the next stage involves considering the merits of the target portfolio company’s business model using various financial metrics. This can include looking at its operating margins, recurring revenue models, end markets, and how capital-intensive the business is.
Prequalification represents the first round of in-depth due diligence and involves an intensive review of all materials that the manager can provide, including any external third-party reports and financial modelling. The findings are used to prepare the prequalification document for Schroders Capital’s investment committee and will be the preliminary version of the final approval document for the transaction.
Stage 3 – Qualification
This is the second phase of in-depth due diligence and involves meetings with the target fund manager, reference calls with various third parties and in some cases, meetings with industry experts. Given the financially sensitive nature of PE transactions, this will be the first time that representatives of Schroders Capital will meet with the management team of the target company.
It’s during this stage that Schroders Capital’s PE team completes its ‘four eye’ reviews, made up of one-on-one meetings with investment committee members. Once the investment opportunity has received investment committee approval, external tax and legal counsel are engaged to review and verify all transaction documentation.
Stage 4 – Subscription
This stage represents the execution phase for the transaction. At this time the final allocation amount of the investment opportunity is confirmed by the target fund manager, depending on the level of demand from other investors. In some cases, the PE team’s initial preferred allocation may be scaled back due to strong appetite for the investment opportunity from other co-investors.
The time taken to complete the investment process varies, but typically the shortest window can be three weeks on a co-investment or direct co-investment where there’s an existing relationship with the manager. For new fund manager relationships, the process from first meeting to close can take up to two years, when committing to a fund investment.
Stage 5 – Monitoring
Post-investment, Schroders Capital actively monitors developments at each fund manager and its underlying portfolio companies. Portfolio company progress is continuously monitored and discussed in detail with the fund manager in regular one-to-one meetings. This can include receiving quarterly reports from the manager and in some direct investment cases, obtaining board observer seats to attend monthly/quarterly board meetings.
A combination of the insights gained from the fund manager due diligence process, portfolio assessment, global benchmarking and continuous monitoring also provides a platform that can be leveraged to help evaluate other secondary-related investment opportunities.
ESG factors driving the PE investment process
ESG factors are a core consideration in the PE investment process. They are key drivers of the PE team’s investment decisions when evaluating and monitoring target fund managers, the funds they manage, and the portfolio companies in which they invest.
Schroders Capital’s commitment to ESG and responsible investment starts with its mission of ‘making investments that our investors can be proud of’. This is the guiding principle for all investments made by Schroders Capital.
The Fund seeks investments that meet return expectations through the active implementation of ESG elements (positive selection), managing downside ESG-related risks (exclusion), and actively seeking the adoption of ESG practices among its fund managers and portfolio companies (engagement).
Linked to this, the RISE framework (responsible investment, sustainability and engagement) is employed to provide an in-depth assessment of investment opportunities, integrating the latest guidance about ESG fund due diligence from the ILPA (Institutional Limited Partners Association).
Looking ahead, Schroders Capital will continuously advance its responsible investment approach, and will actively engage with fund managers to promote more sustainable business practices and monitor its investments for ongoing ESG risks and positive developments.
Case Study: Due diligence delivering returns
Schroders Capital’s detailed due diligence process proved valuable in identifying a high-quality North American technology specialist fund manager whose prior funds have consistently delivered top 5% returns within the PE buyout segment for their respective vintage years. It served to highlight the fund manager’s strong team of senior partners whose complementary mix of investment and operational expertise contributed to a very credible and impressive track record.
By assessing the fund’s existing portfolio and examining its operating and financial metrics through the due diligence process, the value of the investment opportunity was confirmed. Additionally, the ongoing relationship benefits both parties as the fund manager can leverage Schroders Capital as a sparring partner to preview new potential investments to get a different perspective and views on a certain sub-sector.
 Past performance is not a reliable indicator of future performance.
 As measured by Cambridge benchmarking data.
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