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Due diligence key to private equity outperformance, says Bain

A superior due diligence process followed by a quick transition to active owner involvement will be key to generating exceptional returns from private equity funds, according to a report by business consulting firm Bain.

The research finds that new buyout funds formed and new investments made over the next three-to-five years will likely generate gross returns in the low to mid-teens on average, several percentage points below their historic levels.

Bain’s analysis of private equity fund performance finds that the quality of the buy drives top returns. The best-performing buyout funds have fewer deals that end up as zeroes—just eight per cent versus 14 per cent for the average fund. They also hit a lot more home runs – defined in the analysis as five times the return on equity investment) – 23 per cent of deals versus seven per cent for average performers.

The head start they give themselves with enhanced due diligence enables leading private equity firms to deliver on what has become their most important differentiating capability—their talent for creating value in their portfolio companies post-acquisition.

In an analysis of its clients’ performance on deals closed and exited between 1993 and 2009, Bain finds that deal returns were 3.6 times the original investment, on average, in situations where early post-acquisition work was undertaken—well above the industry average of 1.4 times.

“As important as it is for a private equity firm to be masters at adding value post-acquisition, that counts for little if it does not close the right deals, at the right price, in the first place,” says Hugh MacArthur, global head of Bain’s private equity practice and author of the market study. “Then, even before the ink is dry on a deal, top private equity firms pivot from deal-making to active engagement, accelerating performance in their new portfolio company to quickly achieve aggressive goals for post-deal value creation.”

The report finds that enhanced due diligence is becoming increasingly important as private equity firms focus their sights on smaller companies—often private ones or carve-outs of larger companies—where information is often less transparent.

The analysis goes on to explain that with less accommodating debt terms, it is becoming harder for private equity firms to compete against the abilities of trade buyers to generate synergies. With valuations remaining at lofty levels, it takes strong due diligence to avoid losers and develop the proprietary insights required to stretch for winners.

While most, if not all, of private equity firms have established due diligence processes, this capability is emerging as essential coming out of the downturn for firms to outperform their competitors in the days of modest returns ahead.

“The best private equity firms not only have more horsepower in the due diligence engine room, but they also bring better processes to bear in the investment committee board room,” says MacArthur.

As the report states, they formulate clear investment strategies and criteria that govern their decisions and are consistent with their investment focus. They follow a structured evaluation process, whereby each successive round focuses on different decision criteria that give them an effective 360-degree look at a potential deal. Finally, they zero in on key analytics that facilitate discussions that add value.

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