Due Diligence and Company Valuation

Due Diligence in Private Equity: comprehensive analysis
Due Diligence (DD) is a systematic investigation of a company before investment, allowing confirmation of the investment thesis, identification of risks, and determination of fair value. In PE transactions, DD typically lasts 4–12 weeks and costs $1–5 million for large transactions.

Due Diligence Focus Areas

Type of DD	Focus	Performer	Typical Cost
Commercial DD	Market, competition, customers	Strategy consultants (Bain, McKinsey)	$300–800K
Financial DD	Earnings quality, working capital	Big 4, specialized firms	$200–500K
Legal DD	Contracts, litigation, IP	Law firms	$300–700K
Tax DD	Tax risks, structuring	Big 4 tax practice	$100–300K
Operational DD	Processes, IT, HR	Operations consultants	$150–400K
ESG DD	Environmental, Social, Governance	Specialized consultants	$50–150K

Commercial Due Diligence

Evaluation of market attractiveness and company’s position:

Key questions:

Market size (TAM/SAM/SOM): How large is the addressable market?
Growth rates: What drives growth—volume, price, mix?
Competitive dynamics: Concentration, barriers to entry, threat of substitution
Pricing power: Can the company raise prices?
Customer concentration: Share of top-10 clients
Retention rates: NRR, churn, customer lifetime value

Red Flags in Commercial DD:

More than 20% of revenue from a single client
Declining market share
Technological disruption in the industry
Product commoditization
Regulatory threats

Financial Due Diligence and Quality of Earnings

Quality of Earnings (QoE) — the key product of financial DD, showing the “true” EBITDA of the company:

Normalized EBITDA Adjustments

Category	Example adjustment	Direction
Non-recurring items	Legal expenses, restructuring costs	Add-back
Owner adjustments	Excess owner compensation, related party transactions	Add-back
Pro forma adjustments	Full-year effect of acquisitions	Add-back
Run-rate synergies	Realized cost savings	Add-back
Aggressive revenue recognition	Premature revenue recognition	Deduction
Understated expenses	Deferred capex, deferred maintenance	Deduction
One-time revenue	Unusual contracts, catch-up payments	Deduction

Example of QoE bridge:

Metric	Amount ($M)
Reported EBITDA	50.0
+ One-time legal settlement	2.5
+ Former CEO excess compensation	1.8
+ COVID-related costs	1.2
- Aggressive revenue recognition	(3.0)
- Below-market rent (related party)	(0.8)
- Deferred maintenance capex	(1.5)
Adjusted EBITDA	50.2

Working Capital Analysis

A critically important element of financial DD:

Metric	Formula	What is analyzed
Days Sales Outstanding (DSO)	AR / Revenue × 365	Trend, comparison with peers, aging
Days Inventory Outstanding (DIO)	Inventory / COGS × 365	Obsolescence risk, turnover
Days Payable Outstanding (DPO)	AP / COGS × 365	Sustainability, supplier terms
Cash Conversion Cycle	DSO + DIO - DPO	Efficiency, working capital needs

Net Working Capital Peg

In the SPA (Share Purchase Agreement), a target NWC is set—deviations adjust the purchase price:

NWC above target → Price increase for seller
NWC below target → Price decrease / payment to buyer
Typical mechanism: dollar-for-dollar adjustment

Company Valuation Methods

DCF (Discounted Cash Flow)

Fundamental valuation based on future cash flows:

FCF projection: 5–10 years detailed projection
Terminal Value: Gordon Growth or Exit Multiple
WACC: Weighted Average Cost of Capital
Limitations: Sensitivity to assumptions

LBO Analysis

“How much can a PE fund pay for a target IRR?”:

Determining maximum entry price at 20% IRR
Considers debt capacity and exit assumptions
Practical floor for valuation in the PE context

Comparable Companies (Trading Comps)

Valuation based on multiples of public peers:

Multiple	When to use	Typical Range
EV/Revenue	Early-stage, high growth, unprofitable	1–10x (tech: 5–20x)
EV/EBITDA	Mature companies with positive EBITDA	6–15x
EV/EBIT	Capital-intensive industries	8–18x
P/E	Financial firms, stable businesses	10–25x

Precedent Transactions

Multiples of recent M&A deals in the sector:

Advantages:

Includes control premium

Disadvantages:

Different deal terms, timing

Control premium: Usually 20–40% above trading value

Key metrics by sector

Sector	Key metric	Typical multiple
Software/SaaS	ARR, NRR, Rule of 40	8–15x ARR
Healthcare Services	EBITDA, same-store growth	10–14x EBITDA
Industrial	EBITDA, backlog	7–10x EBITDA
Consumer/Retail	EBITDA, comp sales	6–9x EBITDA
Financial Services	P/E, P/Book	10–15x P/E
Real Estate	NOI, Cap Rate	15–25x NOI

Red Flags Checklist

Area	Red Flag	Action
Financial	Significant EBITDA adjustments (>20%)	Deep sustainability analysis
Financial	Deteriorating cash conversion	Working capital deep-dive
Financial	Related party transactions	Legal review, normalization
Commercial	Customer concentration >25%	Customer reference calls
Commercial	Declining prices/margins	Competitive analysis
Legal	Pending litigation >5% EV	Legal opinion, contingency reserve
Tax	Aggressive tax positions	Tax opinion, indemnity
Management	High turnover, key person risk	Retention packages, non-competes
Operational	Deferred capex, aging equipment	Capex plan, adjustment to price
ESG	Environmental liabilities	Environmental assessment, insurance

DD Timeline and Process

Week	Activities	Deliverables
1–2	Data room review, initial analysis	Preliminary findings, request list
3–4	Management presentations, site visits	Commercial DD draft
5–6	Expert calls, customer interviews	QoE draft, Tax memo
7–8	Final analysis, issue resolution	Final DD reports
9–10	SPA negotiation, closing conditions	Investment Committee memo

Recommendations for Investors

Do not skimp on DD: The cost is 0.5–1% of deal size but protects against catastrophic mistakes
Integrate workstreams: Commercial and Financial DD should be aligned
Challenge management: Independently verify assumptions
Focus on risks: DD should identify not only upside, but also downside
Document everything: For future disputes and investment committee