Sitting on the patio, you’re enjoying the sun at a backyard barbeque. Your neighbor tells you about a stock opportunity you should consider. You’re interested, but how do you go about special situations investing? And what is the due diligence process in investment?
What is the Due Diligence Process in Investment?
The investment due diligence process is an organized, methodical investigative analysis of an investment opportunity or subject company. This systematic process is essential for buyers and sellers to verify information and assess the risk/reward dynamic to arrive at a thoroughly researched decision.
This comprehensive analysis involves investment viability assessment and evaluating the potential return on invested capital. Let’s review the key steps of due diligence to add structure to answer to, what is the due diligence process in investment?
Prepare to conduct due diligence by utilizing a thoroughly planned and organized approach. Here are the steps to assist you with effective investor due diligence.
Key Steps of Due Diligence
The key steps in due diligence are specific quantitative and qualitative investment areas that are analyzed for viability, risk, and potential capital gains. The steps can vary depending on industry, regulatory and legal requirements, and transaction type and circumstances. Here are key investigative areas:
Financial Due Diligence – Financial statements analysis should include revenue, operating expenses, free and levered free cash flows, total debt, and a review of dividends and share buyback history.
Legal Due Diligence – Investigate and examine legal commitments and contingencies, intellectual properties, and legal compliance.
Operational Due Diligence – Acquire a deep understanding of the firm’s ERP (enterprise resource planning) technology, scalability, and operation processes.
Market, Sector, and Industry Research – Analyze market movements relative to economic climate. Sector and industry competition and projected growth should be researched.
Strategic Due Diligence – Strategic due diligence evaluates the investment thesis rationale and objectives, coupled with examining the strategic portfolio fit and the investment’s profit potential.
Tax Implications – What is the due diligence process in investments? Tax consideration is paramount. Taxes affect an investment’s gross capital gains and total shareholder return (TSR). The prudent investor must understand the different capital gains tax treatment based on the type of income and length of the holding period. Establishing a tax contra-account is smart money.
Management Evaluation – Investigate and determine management’s return on invested capital and their shareholder goals alignment. Assess if management returns value to shareholders in the form of sustainable dividends and frequent share buybacks.
Risk Assessment – Identify and investigate systematic and idiosyncratic risks of the market, company and conservatively extrapolate the execution and closure of the transaction. Risks must be identifiable, manageable and if all goes wrong, they must be survivable.
Environmental and Social Due Diligence – Make an environmental and social impact assessment of the responsibilities and the governance track record of the firm.
What is the due diligence process in investment? It is a deliberate, investigative approach tailor-made to the specific company, investment, and industry. The due diligence process is designed to minimize surprises, mitigate downside risk, increase the potential upside, and enhance profit probability.
