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Private Equity Due Diligence: One Size Does Not Fit All

man looking at maze

  |  By Christopher Orr, SDIP

The rise of equity crowdfunding means that the world of private equity is becoming a bit less private as more investors are being given the opportunity to participate in deals they might never have been given access to in the past.

But it’s important for investors to understand what they are getting in to if they decide to invest in private equity -- whether it’s through crowdfunding or not – because the potential returns that come with these investments also entail taking on risk.

At PENSCO, where we custody alternative assets for our clients’ retirement accounts, we believe it is crucial that investors conduct due diligence before making a private equity investment. One way to get a good sense for how to perform due diligence is by looking at how groups that have been investing in private equity for decades – like institutional investors or angel investors – conduct their fund research.

Seven elements that an investor should review to conduct due diligence  before making an investment:

A recent article in Private Wealth looked at private equity investing from the point of view of institutional investors, which includes pension plans, university endowments and insurance companies. The article lists seven elements that an investor should review to conduct due diligence on a fund manager before making an investment:

  1. Value Creation: The article states that one of the most crucial factors in evaluating a PE opportunity is understanding how a manager has created value in past investments.
  2. Track Record: Investors should understand how a manager has achieved their results, and whether the necessary elements are present or likely to be replicated in the next fund.
  3. Unrealized Portfolio: Private Wealth says investors should understand whether a manager’s unrealized deals are on track to generate returns that compare favorably to the realized portfolio. 
  4. Benchmarking: While a manager’s track record may be attractive on an absolute basis, the article says it is crucial to compare the firm’s historical performance to that of its peers.
  5. Investment Strategy: Investors should assess a manager’s strategy and how it fits with the expected market environment over the investment period of the fund.
  6. Investment Team: Private Wealth says prospective investors should investigate the backgrounds and experience of the firm’s investment professionals, and their continuity and experience working effectively together.
  7. Deal Sourcing: The article says it is critical that a manager has a structured process for identifying which companies are best positioned for future growth or the best candidates for a turnaround strategy.

 3 tips when it comes to conducting due diligence:

Having spent years helping clients hold private equity investments in their self-directed IRAs, I’ve also watched how institutions and angel investors perform due diligence. Here are 3 tips I’d pass along when it comes to conducting due diligence.

  1. Take your time: Investors who vet deals for a living can take months to conduct due diligence. Don’t underestimate how much time can be involved in the process.
  2. Join a club: Many angel investors work in groups to conduct due diligence, review deals or bounce ideas off one another. Getting a second, third or even fourth opinion from an investing club can be very helpful before making a commitment.
  3. Ask lots of questions: A fund looking to raise money will have its pitch in place. But don’t be afraid to listen to your gut and ask questions that go above and beyond what the fund manager discloses in a prospectus or a pitch.

For investors interested in crowdfunding opportunities, I recent wrote a blog compiling due diligence tips from crowdfunding sites that participated in the PENSCO 2015 Crowdfunding Report. I’ve also blogged about how to conduct due diligence not just on crowdfunding investments, but also on crowdfunding platforms.

While all of these articles, blogs, lists and tips are very helpful, prospective investors need to understand that they are not exhaustive and due diligence is not a one-size-fits all undertaking. As lessons from institutional investors show, due diligence is an extensive process that will vary based on the investment being considered, an investor’s goals and risk tolerance. While all of these resources are helpful, investors should look at them as a starting point for conducting due diligence and be sure to work with an advisor if necessary before particiapting in an offering.

This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.

PENSCO Trust Company performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. Other than the Opus Affiliates, PENSCO is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.