Due Diligence CHAPTER 14

Need for Due Diligence Areas of Due Diligence Objective of Alternative Investment Investment Process for Private Equity Alternative Investment Process for Hedge Funds Due diligence in Alternative Investments

Due Diligence Due diligence can be defined as research, examination, and analysis that an investor conducts to evaluate an investment opportunity prior to the decision making process. It essentially helps the investor take the decision whether to undertake an investment or not. It involves quantitative as well as qualitative analysis.

Due Diligence Due diligence is an indispensable tool in the hands of institutional investors to identify managers who are likely to generate alpha in the market and to discard others that are most likely to dissipate investor wealth

Areas of Due Diligence The main areas of financial due diligence includes: a. Quality of earnings, b. Debt and debt-like items, c. Tax structure, d. Human Resources

Commercial Due Diligence Commercial Due Diligence includes understanding the value proportion of the company, its market position, historical performance, and trends of the industry in order to evaluate the target company s ability to achieve its forecasted projections

Legal Due Diligence Legal Due Diligence focuses on confirming whether the target company is not subject to any current or future liabilities which may include regulatory issues, vulnerable or ongoing lawsuits, and unfamiliar or difficult contract provisions.

Alternative Investment Alternative investments are asset classes outside of publicly listed equities, fixed income products, and cash and include hedge funds, private equity funds, real estate, commodities, and infrastructure. Usefulness in asset liability management and growing public acceptance are cited in the literature as reasons for the growing popularity of alternative investments.

Objectives Traditional funds focus their investment strategies on long-term stock and bond investing, whereas non-traditional funds generally use more complex trading strategies. Non-traditional investment strategies are designed to produce investment outcomes different from those of traditional investment strategies.

Investment Process Private Equity investor must analyse several factors in order to ascertain whether any given opportunity for investment is a good one Investigation is needed in order to comprehend a company s financials, industry trends, market position, and debt financing obtainable

Investment Process Some of the fundamental methods by which PE firms can assist in creating value for the portfolio company are: a. Relationships in the industry b. Experience running companies c. Transformation of businesses d. Bolt-on acquisitions and creation of platforms e. Experienced sellers of businesses f. Financial engineering

Investment Process There are three primary methods used to increase the exit value realized by the equity holders in an LBO: a. EBITDA/Earnings Growth b. Multiple Expansion c. Free Cash Flow Generation

Exit Strategies Trade/ Strategic Sale A financial sponsor may recognize gains in the sale of a portfolio company investment to a strategic acquirer allowing for an instant liquidity event for the financial sponsor Usually the trade sale will generate the highest sale price

Exit Strategies Initial Public Offering (IPO) The primary benefit of an Initial Public Offering exit for a portfolio company is the prospective for a higher valuation, as long as that there is demand for the equity by the investor in the company as well as stable and favourable public market conditions An IPO involves high transaction costs

Exit Strategies Secondary Buyout When a financial sponsor sells a portfolio company to another financial sponsor in a leveraged buyout transaction, it is known as a secondary buyout. The name originates from the fact that the LBO is being sold to another sponsor in a separate LBO transaction.

Investment process for Hedge Funds Mill Creek Capital Advisors (MCCA) began managing hedge fund programs on behalf of its clients shortly after the firm began in 2006. Behavioural science as well as MCCA s real world experiences suggest that the risk tolerance of most investors is asymmetric.

Investment process for Hedge Funds MCCA specific biases are as follows a. Returns Dispersion b. Terms and Conditions c. Leverage d. Capacity e. Asset Size.

Due diligence in Hedge funds Hedge funds may voluntarily disclose information to existing investors or to potential investors, they are not legally required to do so. Due diligence can be a source of alpha and even a profit centre in hedge fund portfolio strategies

Due diligence in Hedge funds There are broadly two types of risks that affect hedge fund performance: a. Operational risk b. Financial risk.

Due diligence in Hedge funds The top five challenges that investor s face while conducting due diligence of hedge funds are: a. Selecting/monitoring managers b. Lack of transparency c. Investment frozen with a manager d. Redemptions e. Poor returns.

Due diligence in Private equity Private equity includes investments that are directly made into companies in private transactions or into public companies so as to take them private. The transparency and disclosure requirements required for publicly listed companies or securities do not apply to private equity partnerships

Due diligence in Private equity The transparency and disclosure requirements required for publicly listed companies or securities do not apply to private equity partnerships

Due diligence in Real estate There are certain risks specific to real estate investment. Global and economic factors affect value of real estate. Other risks inherent in real estate include the ability of mangers to select and manage properties, and changes in regulations

Diligence is the mother of good fortune. Benjamin Disraeli

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