How Do Private Markets Work?

There are many times in our lives when we have to take a leap of faith. Whether it is a new job or a new relationship, sometimes you have to go with the flow and take a risk. However, when it comes to the alternative investment space, this is certainly not the case. Here, leaping before you look can be disastrous!

The process of due diligence is important for all investments. But especially so for the private markets. After all, we’re already hampered by a lack of information. Add to that the fact that these assets are quite risky and we have quite a volatile situation on our hands.

In the last chapter, we discussed how private market funds source deals. But that is just the first step. In this chapter, we’re going to find out what happens after the potential investment opportunities have been identified.

Due diligence is the rigorous process of investigating and evaluating a business opportunity before signing a contract or making an investment. This is where the private market funds do a deep-dive health check-up for companies. The objective is to reveal both strengths and potential weaknesses.

Private market funds generally have a clear estimate of how much capital they can access based on the commitments from the limited partners. But many a time, we see a situation where the LPs have committed their capital but the GPs have not called on it. This is because sometimes, the due diligence process can take a while.

The amount of dry powder in the global private equity markets reached $2.49 trillion in 2023.

Identifying investment opportunities can be quite a rush. They will stand out against the backdrop as bright spots of raw potential. But that is just the first impression. There is a lot more beneath the surface.

Fund managers evaluate everything about an investment opportunity before making a decision. From the startup’s founders and business model to the growth potential, from the industry projections to the regulations — due diligence includes the whole nine yards.

The focus and emphasis of due diligence are different for different stages of investment. Diligence on a pre-seed investment will have a different focus and emphasise different factors than diligence on a private equity LBO investment or a venture debt investment. The description of diligence which follows provides a generalised overview.

These are some of the things that fund managers consider:

Risk Mitigation

This is a two-fold approach. First, the company’s financial health needs to be assessed. For this, fund managers analyse the following:

• Revenue Streams: Understand where the company’s income comes from. Is it diversified or reliant on a single customer or product? If the majority of the startup’s revenue comes from a single source, it is very risky.
• Debt Profile: Check the company’s outstanding debts and how they’re managed. It isn’t uncommon to have some liabilities, but they should not be too high.
• Financial Statements: Fund managers review and verify balance sheets, income statements and cash flow statements to paint a clear picture of financial health.

Apart from that, the operational insights also need to be evaluated. After all, coming up with a business concept or even creating a prototype is simple. But when founders scale up and create a full-fledged operational framework, there are many things that can go wrong.

• Supply Chain Analysis: Check how strong and efficient the supply chain is. Will it hold up in times of crisis? Or will it fall apart like a house of cards?
• Technology and Infrastructure: Assessing the company’s tech infrastructure is essential to ensure they’re up-to-date and competitive.

Industry and Market Dynamics

While an in-depth analysis of the individual companies is definitely important, we cannot forget about the overall scenario. Understanding the market conditions and the potential of the sector can help fund managers pick the right companies to invest in.

In some cases, the alternative investment fund focuses exclusively on a particular industry or a group of industries. This is especially true if the fund managers take a more hands-on approach and contribute to the growth strategy of the company.

Some of the things that fund managers normally look at are:

• Market size
• Projected growth
• Market position
• Market share
• Peer comparison
• Threats
• Opportunities
• Consumer profiles

Legal Compliances

There is an in-depth legal compliance process that ensures there are no red flags. The main purpose is to provide an in-depth legal lens into the target company. It aims to unearth any potential pitfalls that could complicate the intended transaction.

The issues can be as simple as employee disputes or as complicated as contract disagreements with suppliers. Given the broad range, the private market funds set clear criteria on which legal concerns are acceptable and which ones might halt the deal.

There could be issues with intellectual property, for instance. The fund will have to ensure that any patents, trademarks, copyrights, etc., are legally owned, valid, and not infringing on others’ rights.

Apart from that, any previous agreements or contracts can also influence the growth strategies of the fund managers. For example, certain employment contracts could make layoffs costly, or supplier contracts might come with long-term commitments. All these factors can impact the profitability of the company.

There could also be industry-specific regulations and compliance requirements. A healthcare company, for instance, might face more stringent regulations compared to a restaurant chain.

Fraud Prevention

Due diligence can help uncover any fraudulent activity. It can be as innocuous as a missed background check or as significant as false financials. Private market funds often use third-party audits or forensic accounting to validate the financial health of companies.

Apart from that, fund managers also verify the operational claims to check whether they are actually feasible.

When Things Go Really Wrong:

UK-based software company Autonomy was acquired by Hewlett-Packard (HP) in 2011.
It was only after the acquisition that the true picture was revealed. HP claimed that they found serious accounting irregularities at Autonomy and that the founders had hidden these discrepancies during due diligence.

HP had to write down nearly $9 billion of Autonomy’s value a year after the acquisition!

Due diligence in private markets is particularly critical because of the unique challenges and opportunities these markets present. Here are some reasons why due diligence is so essential in private markets:

• Limited Public Information: Private companies don’t have to disclose their information. They’re not accountable to public shareholders. This means the due diligence process is the only real chance to access and verify information.
• Liquidity Constraints: Investments in private markets are typically illiquid, with longer holding periods. Holding periods can go up to a decade or maybe even longer! Once invested, LPs will only be able to retrieve their capital once the fund exits. It is very important to understand what they’re getting into.
• Potential for Higher Returns: With high returns, there is always higher risk exposure. There is always the risk of an investment failing and the capital being lost!
• Operational Involvement: GPs are more involved in the operations of the companies they invest in. They often take on an advisory role and participate in the decision-making process of the management team.
• Valuation Challenges: Valuing private companies is more challenging as there is a lack of public data and comparable benchmarks. Also, once you calculate the valuation, it will not be updated unless the startup goes for another round of funding or some other similar event.

Let’s compare the due diligence process in public markets vs. private markets with a table: