Due Diligence And Investee Performance
Douglas J. Cumming
York University – Schulich School of Business
Simona Zambelli
University of Bologna – Department of Management
May 30, 2016
European Financial Management, Forthcoming
Abstract:
We estimate the economic value of due diligence (DD) in the context of private equity by investigating the relationship between DD and investee performance, while controlling for endogeneity. With the adoption of a novel dataset, we find evidence highly consistent with the view that a thorough DD is associated with improved investee performance. We also distinguish the role of different types of DD and show that the DD performed by fund managers has a more pronounced impact on performance. Instead, the DD mainly performed by external agents, i.e., consultants, lawyers and accountants, gives rise to puzzling results and imperfect matching.
Due Diligence And Investee Performance – Introduction
This study aims at empirically investigating the determinants and economic value of due diligence (DD) in the context of private equity (PE) financing, as well as the impact of different types of DD (e.g., internal vs. external) on firm performance. Despite the emphasis placed on the importance of DD by various industry guides and venture capital associations (e.g., the European Venture Capital Association, the National Venture Capital Association, and the Canadian Venture Capital Association), very few academic studies have investigated its efficacy and economic value.
Research in entrepreneurial finance has stressed the importance of DD, but primarily from a theoretical perspective (Yung, 2009). While empirical studies to date have emphasized the importance of investor characteristics, reputation, and cultural differences among venture capital (VC) and private equity (PE) intermediaries (Casamatta and Haritchabalet, 2007; Caselli et al., 2013; Das et al., 2010; Masulis and Nahata, 2009, Nahata, 2008; Nahata et al., 2014; Sevilir, 2010), no empirical studies have formally examined the economic value and impact of DD. Related research in corporate finance (Li and Prabhala, 2006) and entrepreneurial finance (Sorensen, 2007; Yung, 2009; Bengtsson and Hsu, 2012) has focused on selection models. However, there have been no empirical studies examining the financial importance of selection and matching investors and investees in a PE setting. Also, little evidence exists on how such screening takes place and who exactly carries out DD. In this paper, we provide some of the first evidence on screening by empirically investigating the determinants and the economic value of the DD in the context of private equity (PE) financing. Moreover, we provide a novel look at the impact of different types of DD (e.g., internal vs. external) on firm performance. We compare the role of lawyers, accountants, and consultants carrying out DD to assess whether there are agency costs associated with delegating DD.
As highlighted by Brown et al. (2008, 2009, 2012), DD is crucial for hedge fund and other types of alternative investments, including but not limited to PE financing. Likewise, we would expect that DD is particularly important in PE financing where value-added fund managers are actively involved in the governance and management of their portfolio companies (Gorman and Sahlman, 1989; Gompers and Lerner, 1999; Casamatta, 2003; Inderst and Muller, 2004; Yung, 2009; Ivanov and Xie, 2010). Also, private equity funds are generally not well diversified and, as such, fund managers take extra care to mitigate idiosyncratic risks (Kanniainen and Keuschnigg, 2003, 2004; Nahata, 2008; Nielsen, 2008; Knill, 2009; Wang and Wang, 2011, 2012; Altintig et al., 2013; Nahata et al., 2014).
In the context of our analysis, due diligence refers to the investigation process of a prospective investment in a particular target firm by PE investors (hereafter venture capitalists, or VCs). Due diligence involves a thorough assessment of a number of factors, e.g., management skills, target industry and competitors, project opportunity, financial forecasts, and strategic fit with the fund portfolio companies (Camp, 2002), as well as operational and financial risk (Brown et al., 2008). This evaluation process may be performed mainly internally by PE fund managers themselves (“internal DD”) or mainly externally by strategic and financial consultants, or law and accountancy firms (“external DD”).
A rigorous DD is costly and takes time. Expenses for DD include direct costs of paying for information pertaining to the investee, legal costs for background checks, and the value of time spent on the DD. Indirect costs of DD include the potential lost opportunity in terms of the investee walking away from the deal or getting financing elsewhere. Indirect costs likewise include opportunity costs on time not spent considering other potential projects, or time not spent on adding value to other firms in a fund’s portfolio. Considering the costs, time and effort involved, important research questions are: a) How worth is the time spent on implementing it?; b) Would it be better to save time and delegate this investigation process to external agents (e.g., strategic consultants, law firms, or accountants)? As highlighted by Camp (2002), the main reason underlying such deep investigation of prospective investments in target companies is that, by doing so, VCs hope to make better investment decisions, and thereby enhance the returns on their overall portfolios. However, considering the direct and indirect costs involved, PE investors may be tempted to rush the DD process or to delegate it to external agents and it is not exactly clear as to whether or not additional DD is worth it in terms of performance payoffs.
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