Due diligence is the comprehensive investigation undertaken on an investment opportunity that helps an investor assess risk and return. Within the impact investing space, this process encompasses both financial and impact analyses to generate a holistic view of an investment’s merits. Performing due diligence on a deal-by-deal basis can be both time consuming and cost prohibitive for investors with limited resources and/or financial or industry expertise. Investing through a fund can provide diversification without the ongoing burden of doing due diligence on each deal. However, the risks that are mitigated through fund investing are replaced, at least in part, by new considerations. These risks include long lockups (for private equity funds, these often average around ten years), a lack of direct representation with underlying portfolio companies and minimal decision-making authority over investment decisions or liquidity events. In light of these unique considerations, the fund due diligence process differs from that of direct investing but is equally as important.
The due diligence process can be broken down into four stages: pre-screening, desktop due diligence, onsite due diligence and finally, synthesizing all the information collected during this process to make a confident and well-informed investment decision.
During the pre-screening stage, an investor should seek out necessary documentation to form an initial understanding of the potential investment. These documents may include fund track record details, offering documents and preliminary terms. A high-level review of each of these documents will allow the investor to determine whether the investment meets their minimum criteria and how the investment fits into their overall portfolio. Minimum investment criteria will vary by investor, but some important considerations include asset class, time horizon, impact measurement and reporting capabilities, and targeted financial and impact return. The investor should note any questions or concerns that arise during the pre-screening phase for further investigation during the next phase: desktop due diligence.
Desktop Due Diligence
During desktop due diligence, an investor gathers and reviews an exhaustive list of documents and materials on both the fund and the market in which its portfolio companies operate. This stage encompasses the initial data request, market analysis, information review and preliminary reference interviews.
Data Request and Review
The first step of desktop due diligence is to gather and review the necessary legal, financial and fund documents. An established fund will likely have relevant documents available on their website or be able to provide access to a secure online data room. If that is not the case, or if the website or data room does not contain everything necessary to complete desktop due diligence, it is acceptable to send an exhaustive diligence request to the potential investee, listing only those items unable to be sourced independently.
The diligence request should include specific documents on the fund’s organizational structure, management and operations. Some of the most important documents to review during this phase pertain to the fund’s existing portfolio, if the fund has begun investing, or the fund manager’s track record across previous funds. The investor should pay close attention to the overall performance of past funds compared to their appropriate benchmarks. The Cambridge Associates’ quarterly Private Equity & Venture Capital Impact Investing Index and Benchmark Statistics report is a highly useful tool in comparing PE or VC impact fund performance to peer funds within the same vintage range. Digging deeper, the investor should look to see that each of the individual portfolio investments are performing and that no one investment accounted for an outsized positive (or negative) return. The goal is to ensure that past overall fund performance is reflective of the fund manager’s investment acumen, rather than the fund manager’s luck or lack thereof.
It is also useful to view examples of quarterly and annual reporting provided to investors. In conducting due diligence on an impact fund, an investor should request a copy of the firm’s latest impact report to verify the sophistication of the fund’s impact measurement and reporting capabilities, which, unlike financial reporting, can vary widely across impact funds. The investor should review these documents with a fine-tooth comb looking for any anomalies in the financials or projections or any other red flags, especially any qualified opinions by an auditor. Red flags do not necessarily preclude investing. The purpose of this review is to identify all red flags in order to prepare follow-up questions with the potential investee.
An investor should also look to gain a deeper understanding of the structure of the organization and key people involved. Questions may include the pedigree and experience of the management team and staff and how long key team members have been working together. It is also important to assess the fundamental operating and governance systems of the organization. How often does the Board of Directors meet? Is there a conflict of interest policy in place? If the fund manager has previous funds that are still active, it is important to know the fund’s policy regarding cross-fund investments.
On the operations and legal side, an investor should investigate the third-party associations a potential investee has, including service providers and industry affiliations, and any legal issues they may be facing. Among the service providers that an investor should investigate include the fund administrator, auditor, bank, and law firm used by the fund. The investor should have clarity as to the roles and responsibilities of each party and note any red flags, such as a change in auditor.
Market analysis is critical to developing an independent strategic view of the fund’s targeted sector(s), its situation within the broader market (e.g. how correlated/non-correlated is the market relative to the overall economy) and the size of the total addressable market opportunity. Investors should seek out seek out market reports, association annual assessments and any industry research available. While the fund manager may provide market research as part of its data room materials, investors should independently cross-check and verify this information knowing that the fund manager is motivated to paint the most optimistic picture possible.
The final stage of desktop due diligence is to interview third-party references. Investors, independent board members and portfolio companies are all able to provide valuable insights into the quality and professionalism of the management team.
On-site Due Diligence
Following successful desktop due diligence, it is advisable to perform on-site due diligence if an investor’s budget and time constraints allow. During on-site due diligence, the goal is to ensure, to the greatest degree possible, that the information learned throughout the due diligence process up to this point is accurate. These in-person meetings are a prospective investor’s opportunity to observe the ins and outs of how the fund is run and how well its processes are followed. A well-prepared investor will come with a list of questions for the fund manager that arose during desktop due diligence. An investor should note any discrepancies between what was learned during desktop diligence and what is observed during “in the field” visits.
While what the fund manager says is important, how they say it can be equally enlightening. An investor should take note of body language during the meeting, how the team interacts as a group and whether the fund manager grants requested interviews with autonomy (to assess his level of trust in the underlying team). Depending on the geographic location of the fund manager relative to its portfolio companies, it may also be possible to visit a company in the fund’s portfolio or pipeline.
Scorecards can help synthesize the wide array of factors that play into the final investment decision and help an investor evaluate the mountain of data gathered during the course of due diligence. The structure should seek to capture the risk and reward profile, in terms of both financial and impact, and weight them according to the investor’s unique investment goals.
Combining the scored results with the overall impression gleaned during the extensive due diligence process will help inform a clear final investment decision.
While consulting other investors is wise and could provide important insights, nothing compares to the knowledge gained from doing the research and hard work oneself. Using the provided framework, tailored to suit the investment at hand, an investor can ultimately make a clear and confident investment decision.