Third-Party Management Due Diligence: Back to Basics

Over the last two to three years, for reasons with which we are all familiar, investors and professional service providers have been “getting religion” when it comes to going back to basics with respect to due diligence, particularly management due diligence.

Thorough management due diligence in this post-bubble era is critical to not only avoid management implosions, but also otherwise increase the odds of investment success in a slow-growth business climate, where large and small companies are aggressively competing to grow revenues, gain market share, and increase return on investment.

Consequently, an increasing number of venture capital and private equity investors are turning to third parties who can combine investigative expertise, thoroughness, deal/investment experience and even competitive intelligence to objectively investigate and assess company management in a manner that provides value-added input to the deal process. Additionally, no longer are these investors restricting management due diligence to an “up-front” investigation; they are beginning to implement annual updates as part of the portfolio management process, particularly for longer deals.

Management due diligence has always been at the core of any deal, especially in middle market and smaller firms, where the success of the venture is tied to a small group of key individuals and situations in which investors are betting on the “jockeys” and not necessarily the “horses.” And even though venture capital and private equity investors are handing their wallets to jockeys for up to five or more years, management due diligence conducted “in-house” will continue to be susceptible to short-cuts for many reasons, including:

Nearly all investors feel they are a good judge of character, and most indeed are, but it takes only one bad apple to severely damage a portfolio and a reputation.

Deal Momentum
The deal quickly takes shape involving perhaps two or three investors, with the negotiating and jockeying for position as to terms and conditions quickly taking center stage in advance of thorough due diligence. “Satisfactory due diligence” becomes a condition of closing the deal, often becoming a relatively “after-the-fact” exercise.

Relying on the Lead Investor
The assumption that the lead investor has more to lose, hence that investor will “naturally” dig deeper and devote more effort to the due diligence process is dangerous as this is often not the case.

Trusting and Accepting Third-Party Vetting of Principals
Relying on a known and perhaps trusted third party who “vouches” for a principal is especially dangerous if the trusted third party is not a deal participant. Often an executive’s closest associates are unaware of potential past problems.

Due to factors such as those highlighted above, management due diligence conducted “in-house” often reflects a breakdown in investment discipline, even though quality and integrity of management are the primary factors in the investment decision. Actions are often restricted to a few phone calls (often to hand-picked references) and a quick database search, often limited to a Lexis/Nexis search for litigation records, with the feeling that most of the bases have been covered when, in fact, much of the information required for a comprehensive check is unobtainable from such a database.

While most federal courts are online, and therefore accessible through subscription-based database services, most state and local courts, where the majority of criminal and civil cases are recorded, are not. Even when state and local courts are “online”, the available records are often confined to a specific date range or are updated so infrequently as to make them unreliable for deal screening. Unfortunately, such ignorance will lead to incomplete checks. the same applies to regulatory violations and enforcement actions, e.g. SEC, FTC, FINRA, NFA, etc.

One can imagine that if such a lack of thoroughness, either intended or unintended, exists up-front, ongoing management due diligence is probably nonexistent.

In addition to ensuring that management is thoroughly investigated, a third party that possesses among its talents firsthand deal experience and competitive intelligence capabilities can supplement a deal team’s effort and add value in a number of ways at little or no additional expense (and in almost all cases the cost is passed along to the investee). Besides providing an objective presentation of factual data, a third party with deal experience can effectively highlight key information that can assist the deal team in formulating opinions concerning management’s strengths and any “gaps” that may exist. Additionally, as part of the investigative process, the “outward-looking” component of background checking (e.g. selected reference checks/interviews) performed by a deal-savvy third party with “CI” expertise can glean useful information concerning a company’s strengths, weaknesses, opportunities, and threats that can be passed along to the deal team as well.

Third party management due diligence is on a rapid upswing. Not only investors, but also professional service providers such as law firms and accounting firms, as well as investment managers, particularly hedge “fund of fund” managers, are getting back to basics and then some as investment stakes are higher today than ever before. Even limited partners have “raised the bar” on general partner background checks, and are now mandating that the general partner employ the same due diligence standards in its management due diligence for direct investments.

The cost/benefit equation that has recently swung back in favor of third parties who can objectively provide complete and accurate factual data on management is even more compelling when the third-party provider has a deal experience/competitive intelligence pedigree and can be sensitive to deal timing and other deal dynamics in addition to offering additional insight into factors effecting the company and its competitive landscape. Ongoing due diligence conducted by such a third party is more important than ever and can provide “portfolio insurance” as well as other value-added benefits over the life of the deal.