Due Diligence and Investee Performance

AuthorSimona Zambelli,Douglas Cumming
Date01 March 2017
Published date01 March 2017
Due Diligence and Investee
Douglas Cumming
Professor and Ontario Research Chair, York University, Schulich School of Business, 4700 Keele
Street, Toronto, Ontario M3J 1P3, Canada
E-mail: Douglas.Cumming@gmail.com
Simona Zambelli
Associate Professor, University of Bologna, School of Economics, Management and Statistics, Piazzale
della Vittoria, 15, 47100, Forl
ı, Italy
E-mail: simona.zambelli@unibo.it
We estimate the economic value of due diligence (DD) in the context of private
equity by investigating the relationship between DD and investee performance,
while controlling for endogeneity. With the adoption of a novel dataset, we f‌ind
evidence highly consistent with the view that a thorough DD is associated with
improved investee performance. We also distinguish the role of different types of
DD and show that the DD performed by fund managers has a more pronounced
impact on performance. Instead, the DD mainly performed by external agents, i.e.,
consultants, lawyers and accountants, gives rise to puzzling results and imperfect
Keywords: due diligence, governance, performance, private equity
JEL classification: G23, G24, G28
The authors would like to thank the Editor, John Doukas, three anonymous referees, and
the participants at York University seminar series (March 2013, Toronto, Canada), the 2013
IFABS Conference (June 2013, Nottingham, UK), the 2014 EFMA Conference (June 2014,
Rome, Italy), Paris Financial Management Conference (December 2015, Paris), 4
European Business Research Conference (April 2015, London), Annual Paris Economics,
Finance and Business Conference (April 2016), as well as Pierpaolo Pattitoni, Jeffrey
James Austin, Steven Balaban, Mohammad Hoque, Ali Mohammadi, Feng Zhan, Silvia
Pazzi and Matteo Lippi Bruni for comments and suggestions. Simona Zambelli owes
special thanks to the Fondazione Cariplo (Milan) for financial support, as well as to Rocco
Corigliano and Roberto Tasca for support and suggestions. Douglas Cumming owes thanks
to the Social Sciences and Humanities Research Council of Canada for financial support.
European Financial Management, Vol. 23, No. 2, 2017, 211253
doi: 10.1111/eufm.12100
© 2016 John Wiley & Sons, Ltd.
What we hope ever to do with ease, we must learn f‌irst to do with diligence.
Samuel Johnson (Boswell, 1994. Life of Johnson, Volume 1, 17091765)
1. Introduction
This study aims at empirically investigating the determinants and economic value of due
diligence (DD) in the context of private equity (PE) f‌inancing, as well as the impact of
different types of DD (e.g., internal vs. external) on f‌irm performance. Despite the
emphasis placed on the importance of DD by various industry guides and venture capital
associations (e.g., the European Venture Capital Association, the National Venture
Capital Association, and the Canadian Venture Capital Association), very few academic
studies have investigated its eff‌icacy and economic value.
Research in entrepreneuri al f‌inance has stressed the importan ce of DD, but
primarily from a theoretic al perspective (Yung, 2009). W hile empirical studies to dat e
have emphasised the import ance of investor character istics, reputation and cu ltural
differences among venture ca pital (VC) and private equity (PE) intermediaries
(Casamatta and Haritchaba let, 2007; Caselli et al., 2013; Das et al., 2010; Masulis and
Nahata, 2009, Nahata, 2008; Nahata et al., 2014; Sevilir, 2010), no empirical studies
have formally examined the e conomic value and impact of D D. Related research in
corporate f‌inance (Li and Prabhala, 2006) and entrepreneurial f‌inance (Bengtsson and
Hsu, 2012; Sorensen, 2007; Yung, 2009) has focused on selection mod els. However,
there have been no empirical st udies examining the f‌inancial i mportance of selection
and matching investors and investees in a PE setting. Also, little evidence exists on
how such screening takes pla ce and who exactly carries out DD. In this paper, we
provide some of the f‌irst evidence on screening by empirically investigating the
determinants and the eco nomic value of the DD in the co ntext of private equity (P E)
f‌inancing. Moreover, we provi de a novel look at the impact of d ifferent types of DD
(e.g., internal vs. exter nal) on f‌irm performance. We comp are the role of lawyers,
accountants and consulta nts carrying out DD to assess whether there are agency costs
associated with delegating DD.
As highlighted by Brown et al. (2008, 2009, 2012), DD is crucial for hedge fund and
other types of alternative investments, including but not limited to PE f‌inancing.
Likewise, we would expect that DD is particularly important in PE f‌inancing
where value-added fund managers are actively involved in the governance and
management of their portfolio companies (Casamatta, 2003; Gompers and Lerner, 1999;
For the purpose of this paper, we adopt the term private equityto refer to the later stage
f‌inancing of existing f‌irms, in line with the def‌inition provided by the Italian Venture Capital
Association (AIFI), Capizzi (2004), and Heed (2010), among others. This def‌inition, which
differs from the one typically adopted in USA (see, e.g., Gompers and Lerner, 1999),
excludes the funding of start-up and early stage f‌irms (venture capital investments) and
includes: a) development or expansion f‌inancing, b) leveraged buyout (LBO) deals, and c)
replacement and turnaround f‌inancing (see, e.g., Zambelli, 2010; 2014). Historically, the PE
sector has dominated the Italian alternative f‌inancing industry, while early stage investments
have always represented a minority (see AIFI Statistics Reports from 1999 onwards, Caselli
et al., 2013).
© 2016 John Wiley & Sons, Ltd.
212 Douglas Cumming and Simona Zambelli
Gorman and Sahlman, 1989; Inderst and Muller, 2004; Ivanov and Xie, 2010;
Yung, 2009). Also, private equity funds are generally not well diversif‌ied and, as such,
fund managers take extra care to mitigate idiosyncratic risks (Altintig et al., 2013;
Kanniainen and Keuschnigg, 2003, 2004; Knill, 2009; Nahata, 2008; Nahata et al., 2014;
Nielsen, 2008, 2010; Wang and Wang, 2011, 2012).
In the context of our analysis, due diligence refers to the investigation process of a
prospective investment in a particular target f‌irm by PE investors (hereafter venture
capitalists, or VCs). Due diligence involves a thorough assessment of a number of
factors, e.g., management skills, target industry and competitors, project opportunity,
f‌inancial forecasts and strategic f‌it with the fund portfolio companies (Camp, 2002), as
well as operational and f‌inancial risk (Brown et al., 2008). This evaluation process may
be performed mainly internally by PE fund managers themselves (internal DD)or
mainly externally by strategic and f‌inancial consultants, or law and accountancy f‌irms
(external DD).
A rigorous DD is costly and takes time. Expenses for DD include direct costs of paying
for information pertaining to the investee, legal costs for background checks, and the
value of time spent on the DD. Indirect costs of DD include the potential lost opportunity
in terms of the investee walking away from the deal or getting f‌inancing elsewhere.
Indirect costs likewise include opportunity costs on time not spent considering other
potential projects, or time not spent on adding value to other f‌irms in a funds portfolio.
Considering the costs, time and effort involved, important research questions are: a) How
worth it is the time spent on implementing it? b) Would it be better to save time and
delegate this investigation process to external agents (e.g., strategic consultants, law
f‌irms or accountants)? As highlighted by Camp (2002), the main reason underlying such
deep investigation of prospective investments in target companies is that, by doing so,
VCs hope to make better investment decisions, and thereby enhance the returns on their
overall portfolios. However, considering the direct and indirect costs involved, PE
investors may be tempted to rush the DD process or to delegate it to external agents and it
is not exactly clear as to whether or not additional DD is worth it in terms of performance
Despite the existence of a vast literature on selection criteria (for a recent review see,
e.g., Alemany and Villanueva, 2014), no prior study has empirically investigated the
economic value of DD and its eff‌icacy with reference to how much the investment in DD
pays in terms of obtaining better future performance from the investee. The importance
and the costs of DD for PE funds have been examined solely from a theoretical
perspective by Yung (2009), who argues that DD facilitates matching and mitigates
adverse selection problems. To the best of our knowledge no prior study has empirically
examined the relationship between PE due diligence and investment performance.
Partial exceptions are Wangerin (2015), who analyzes the DD in the context of M&A
transactions, Brown et al. (2008), who investigated the role of DD solely for hedge funds,
For the purpose of this study, when we use the terms internalor externalDD we refer to
the agents (internal or external) who performed the majority of the DD process (not the entire
process). These activities are not mutually exclusive and may act as complements. For
example, an internalDD refers to a situation in which the majority of the DD is performed
by the PE investor internally and it is possible that a small part of this activity (e.g., the legal
DD) is delegated externally (see Table 1 for more details).
© 2016 John Wiley & Sons, Ltd.
Due Diligence and Investee Performance 213

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