Value creation: The missing link to private equity due diligence

The traditional due diligence approach for most mid-market transactions has resembled a hectic home inspection: The private equity firm looks to rapidly pull together a team of partners to look at different risk areas of the business—one partner to look at the foundation, another to look at the plumbing and electrical, and another to look at the location of the property. 

This approach has worked historically—but there’s an emerging approach that better fits our uncertain macroeconomic environment. We recommend using the diligence period not just as a time to find leaky plumbing but primarily seeing it as an opportunity to identify and quantify development opportunities that can be leveraged during the ownership period (a new deck, installing a pool, or using the property as an Airbnb rental). 

This shift comes as private equity investors consider an uncertain economic outlook of rising prices and interest rates—to say nothing of competitive pressures—that force them to look for ways to maximize their upside as quickly as possible to achieve their desired investment thesis. 

Identifying these opportunities also allows private equity firms to be more aggressive in their bids and more competitive for assets. In our recent survey, The Future of Diligence in Private Equity, 63% of respondents told us they are prioritizing value creation in their diligence processes. But our report also uncovered a disconnect, as more than 60% of respondents also said that outputs from these processes are only incorporated in value creation plans “rarely” or “some of the time.” 

To put it simply, it’s difficult to connect top-down diligence estimates across a variety of teams to bottoms-up execution plans that can be implemented together. But it doesn’t have to be. And we’re increasingly finding that savvy investors are charting a new course forward. Here’s how they’re doing it. 

Blend technology, data, and operations to create a holistic and quantifiably backed view of the target 

We see leading private equity investors taking a more holistic view through the diligence process to combine data they’re receiving from financial, commercial, operational, and technology partners to substantiate and quantify their value creation plans. 

By taking this broader view, private equity investors can move forward knowing their specific value creation initiatives are visible in real operating metrics, rooted in technological realities, relevant to the competitive landscape they inhabit, and modeled directly to the P&L statements they're purchasing. 

For all the talk of big data, smart investors can do a lot with a little—even just a handful of operationally relevant KPIs and historical trial balances can uncover a wealth of actionable information. Through effective use of analytical tools and an understanding of how the operational KPIs flow through to the financial statements, we’ve helped leading private equity firms uncover digital value creation opportunities hiding in plain sight. We’re beginning to see a few large private equity firms invest time and money to build the required data infrastructure and tools required for automated analytics that uncover valuable revenue or cost-saving opportunities. 

We’ve seen increasing success (and interest) from leading private equity investors in this type of approach—and anticipate the need for it to grow as private equity investors look for tangible and quantitatively backed value creation plans in the face of increasing market uncertainty. 

Several common factors of success in private equity firms can effectively carry this approach from diligence through the hold period: a strong appreciation for data infrastructure and data literacy, a focus on tech-enabled operations, and a rigorous approach to translating pre-close plans into reality during the hold period. 

Focus on tech-enabled operations to drive revenue growth and decrease costs 

Private equity firms moving to this style of diligence understand that digital technology is a core differentiator that can improve operations and drive financial performance. Whereas historically investors may have seen tech as just an enabler, or something that only needed to be “good enough” or "scalable enough," the new baseline is an understanding of how technology creates or subtracts value at a specific company.  

Solely identifying risks in the technology environment or potential upgrades to key systems is no longer sufficient to provide value. Providing value through the diligence period requires connecting the use of technology to specific metrics in the business, and then modeling the upside of better leveraging technology to create recommendations and operational plans tied to the P&L.  

These recommendations can take a variety of forms—whether it’s implementing a new digital tool to capture back-office efficiencies, extending a current solution to a new stakeholder group, or leveraging new forms of analytics to better target customers and make smarter decisions. 

Whatever the recommendation, one constant must remain: a laser focus on how these technologies lead to quantifiable financial and operational outcomes that can be underwritten by investors with confidence. 

Maintain rigor about translating estimates into actions 

After the deal closes, private equity firms often struggle to translate the intelligence found during diligence to action items in value creation plans. That makes sense: Pre-close estimates are top-down and done from the outside on short timelines, while a post-close environment provides an opportunity to re-validate strategic goals and value drivers that support tactical “flight plans” to guide day-to-day execution. When it comes time to resell, those initial plans must translate into value-creation activities and then measurable results to form one, cohesive story. 

One way to address this challenge is to create new, horizontal operations teams that specialize in applying technology and using data to specific operational areas that work toward operational improvement in sales processes. For example, a revenue operations (RevOps) team might work with deal teams during the diligence process to help understand why a target company’s products are more competitive than others with certain market segments and how application of tools and processes to the broader product portfolio could result in increased wins, pricing consistency, and overall better margins. 

Finding partners that can provide guidance throughout the deal’s lifecycle, from identifying value creation opportunities to executing on them to helping prepare for an exit, provides critical continuity and accountability throughout the hold period. 

Given the vast array of potential inputs and strategic aims in play for any acquisition, it can be difficult to know where to begin. The value creation framework below can help by ensuring the right people, operating activities, and customer interactions are in place to effectively enable the business and drive financial results.  

Accelerating the transition  

Myriad factors are working together to accelerate the transition among investors from the traditional risk-based diligence approach to a more value creation focused approach: economic uncertainty, compressed hold periods, the elevation of technology within the diligence landscape, and the rapidly dawning realization that market leaders are quickly moving in this direction. 

Use the diligence process for more than simply making sure the house isn’t going to topple over—move forward with a digital value creation mindset and an operating model backed by data to help unlock revenue and profitability more effectively.