A Value Creator for Private Equity?

For many investors, the quality and likely success of a Private Equity fund can be directly linked to the quality of their due diligence processes - as Boston Consulting Group says “due diligence can make the difference between stellar and poor performance in a private equity portfolio”. 

PE funds have been locked in a battle for talent for years, seeing huge value in having the brightest and best in their investment teams in order to increase the quality of due diligence and, therefore, the likelihood of making successful investments. Without downplaying the significance that decisions made during the life of an investment have, many deals are hamstrung before the ink is dry on an acquisition agreement due to missing key details during the due diligence phase.

Investment data platform DealRoom.net estimates that funds spend between 2%-10% of a deal’s value on financial and commercial due diligence. With PitchBook predicting that PE deal activity in Europe could reach €500bn for 2021, the level of investment in due diligence is clearly significant. How much of that is put towards understanding Diversity and Inclusion (“D&I”) in a target company is difficult to pinpoint, however the (albeit anecdotal) evidence we have collected suggests it is immaterial when compared to the broader due diligence a fund will conduct. Data from Pitchbook’s 2021 Sustainable Investment Survey supports this, with only 25% of investors satisfied with their approach in utilising ESG risk factors when making investment decisions. When considering why this is, we should first explore the benefits.

The link between diversity and business success is substantial: numerous studies have shown that a business ranked in the top quartile for D&I in their industry will materially outperform the bottom quartile in both growth and profitability metrics. A 2020 survey by sustainability consultancy ERM found that 93% of PE firms agreed that focusing on ESG helps generate good investment opportunities (with D&I being a key component of the ‘S’ in ESG). In a paper earlier this year, McKinsey suggests that “building D&I criteria into due diligence of targets and investment-committee reviews can help not only to assess risk but also to understand the value-creation opportunity inherent from improving D&I.” 

Identifying risks with proper D&I due diligence could also help reduce the potential for expensive legal proceedings that can emerge from, say, sexist or racist behaviour that may be hidden in an otherwise positive business culture. At the high end of the scale, missing potential red flags that could lead to a legal issue making the papers (for example, Pinterest’s $20m pay out to settle a gender discrimination lawsuit last year) will have huge financial and reputational costs that might transform an otherwise successful investment into a failure. Less sensationally, but as important, getting an accurate understanding of where business is on its D&I journey can help identify opportunities where investment in D&I could create value.

Moreover, investing more time and resource into D&I due diligence brings greater alignment between General Partner and Limited Partner interests. Private Equity International’s 2020 LP survey found that 80% of LPs now factor in ‘Evidence of diversity and inclusion at the GP level’ into their own fund investment due diligence process. If GPs are able to demonstrate the efforts they are making to understand D&I risks and opportunities during acquisition processes, there is little doubt that this will be positively received by LPs. 

The benefits of properly assessing D&I in a target company are compelling and, potentially, undeniable (and that is before even considering the broader positive social impact that investing in creating more diverse and inclusive business cultures can bring). So, when compared to other areas of due diligence, why is D&I seemingly not as important in an acquisition process? The simple answer is that it is a complex topic which can be difficult to quantify. Investment teams generally are strong at understanding financial and commercial risk, and therefore prefer easily quantifiable information to base their decisions on. D&I as a broader topic (beyond, say, gender pay metrics) is difficult to measure and therefore some investors may choose to ignore or, at best, pay lip service to the topic and focus their resources on areas where they are confident of accurately assessing value. Additionally, many due diligence processes are conducted on privately owned businesses, where D&I information is less available than businesses that are publicly listed. Often D&I is only properly assessed in the months after a deal has closed, when the investment team have spent time ‘in the business’ and working with the Board, which may well be too late.

The PE industry has been investing in D&I for some time, but many of the strides it has made are limited to improvements at the fund level (for example, a better gender balance in investment teams). It seems that, moving forward, there is more scope to improve D&I in portfolio companies, and that starts during the due diligence process. As a relatively undeveloped area, those PE funds that make even small investments in better understanding D&I before pulling the trigger on an investment will likely gain a competitive advantage over those that do not.