Private Equity Due Diligence Checklist: From Thesis to IC Memo

What a Private Equity Due Diligence Checklist Is

A private equity due diligence checklist is the deal team's plan for testing an investment thesis before the investment committee votes. It covers the same workstreams as any buyer's list, which the due diligence checklist maps one by one, and adds the lines a fund's model depends on.

Three things set a fund's checklist apart from a corporate buyer's:

• The thesis carries a modeled return. Every assumption in the model, from the price paid to the exit, needs a line that tests it.
• Debt sits on the earnings. The financing is sized on the company's earnings and serviced from its cash, so a weak adjustment to earnings flows straight into the capital structure.
• The plan has an end. The fund expects to sell the company after a hold period, to a buyer who will run diligence of their own on the same records.

The fund's deal team owns the checklist. Accountants, counsel, tax advisers and insurers own the depth in their fields, and every line names who will judge its evidence and what that evidence is.

Start From the Thesis and the Value Creation Plan

A fund's thesis usually takes one of a few shapes: a platform to build on with add-on acquisitions, an operating improvement the new owner believes it can make, growth the company cannot fund alone, or a business carved out of a larger group. Each shape puts its weight on different lines. A buy-and-build thesis leans on whether the company can absorb acquisitions. An operating thesis leans on whether the levers in the plan exist in the company's records. A carve-out leans on everything that has to separate from the seller.

Write the value creation plan's levers down before the checklist, and give each lever a line that tests it against the company's own history: price changes in the billing records, purchasing terms in supplier contracts, sales capacity in the pipeline and the hiring plan. In a survey of private equity investors by Gompers, Kaplan and Mukharlyamov, the investors anticipated adding value to portfolio companies with a greater focus on increasing growth than on reducing costs. Growth levers tend to carry the most weight in the model and the least evidence in the data room, so they deserve the closest lines.

Then write down how the fund expects to exit, and to whom. The next buyer will test the same records, and the questions they will ask belong on this list now.

Earnings, Cash and the Debt They Carry

In a leveraged buyout the earnings figure is also the financing figure. The U.S. banking agencies' guidance on leveraged lending measures leverage against EBITDA, and asks lenders to make sure a borrower can repay its debt when due and has a capital structure it can sustain through economic cycles. Quality of earnings work therefore matters twice: once for the price, and again for the debt.

• Adjustments. Each adjustment to earnings needs support, and a one-time item that appears every year is not one. Run-rate adjustments should rest on actions already taken, not on plans.
• Cash conversion. Earnings that do not turn into cash cannot service debt. Reconcile EBITDA to operating cash flow month by month, from the ledger and the bank.
• Working capital. Measure it monthly across the whole period, so the peg in the purchase agreement reflects the business's normal level rather than a month the seller chose.
• Net debt and debt-like items. Deferred revenue, unpaid bonuses, accrued taxes, earn-outs owed on past acquisitions and leases all reduce what the equity is worth.
• Covenant headroom. Test the lenders' own definitions against the monthly numbers, because the covenants will be measured on them from the first quarter after close.

The accountants own the depth, in financial due diligence and the quality of earnings review. The deal team owns the question of whether the model's numbers survive it.

Management, Key People and Incentives

A fund backs a management team to deliver a specific plan, and often asks its leaders to roll some of their own proceeds into the deal. The checklist tests whether this team can run this plan, which is a different question from whether it ran the company well so far.

• Capacity for the plan. Leading a company through a doubling, or through a run of acquisitions, asks for different things than building it did. Test this in interviews with each leader and with the people on their teams, held separately.
• Who the company depends on. Key-person dependence shows in who approvals, customers and systems actually route through, which the organization chart rarely shows. Key person risk covers how to find it.
• What the deal pays out. Change-of-control bonuses, accelerated vesting and severance can be large. For a U.S. corporation, section 280G of the Internal Revenue Code denies the deduction for excess parachute payments: payments to certain executives and shareholders that are contingent on a change in ownership or control and pass its threshold. Counsel and the tax advisers size this before signing.
• The incentive plan. Rollover terms and the management equity plan decide whether the people the plan depends on stay through the hold.

The human capital due diligence workstream owns the depth.

Operations, Systems and What the Fund Will Ask For

After close, the fund will ask the company for monthly numbers, board materials and covenant calculations, often on a timetable the company has never kept. Check now whether its systems can produce them, and whether the operations behind the plan hold up.

• The close. How long the monthly close takes, and whether it has slipped, shows in the close calendar and the timestamps in the ledger.
• The metrics. Trace one month of the metrics the fund will track back to the systems that produce them. Numbers someone assembles by hand each month are a finding in their own right.
• The operating core. The path from order to cash, the suppliers the business cannot run without, and where work waits. The operational due diligence checklist goes line by line.
• Technology. Who owns the code, what went wrong in the period, and which systems would need replacing to carry the plan. The technology due diligence checklist names where each answer lives.

The Legal, Regulatory and Tax Lines a Fund Adds

Counsel and the tax advisers own these lines and the judgment on them. The deal team's job is to make sure each one is asked early enough to change the price, the structure or the timetable.

• The merger filing. Under the Hart-Scott-Rodino Act, the parties to certain transactions must notify the Federal Trade Commission and the Justice Department, and may not close until the waiting period has passed or the government grants early termination. Whether a filing is needed sets the timetable.
• Competing businesses. When the company competes with the platform it will join, or with another business the fund owns, the FTC's guidance applies: competitively sensitive information, such as current and future prices, strategic plans and costs, should pass through clean teams and other safeguards, and clean teams should not include anyone responsible for competitive planning, pricing or strategy.
• Tax attributes. Losses the model counts on may be limited. After an ownership change, section 382 of the Internal Revenue Code caps how much taxable income the pre-change losses can offset each year.
• Corruption and sanctions exposure. Government customers, agents and intermediaries, and the countries the company sells into, are screened before signing, because exposure found after signing is much harder to price or protect.
• The insurance behind the agreement. Where the deal uses representations and warranties insurance, the buyer usually cannot recover for liabilities it knew about when the policy was bound. A finding from diligence therefore has to be priced, or dealt with in the purchase agreement itself.

What the Data Room Cannot Tell the Committee

The data room holds what the seller prepared. The management presentation is the seller's argument, and the questionnaire returns the seller's answers. A deal team needs all three, and all three share limits that no amount of careful reading removes:

• They describe policy, not practice. A documented approval policy answers the question. Whether decisions follow it shows only in the records of who approved what, and when.
• They describe a moment. A close that slips a little each quarter, attrition that climbs in one team, a customer whose activity falls before renewal: each shows only across the whole period, never in a single answer.
• They speak for the top of the company. Management answers for the business, but the people who run its processes, approve its exceptions and hold its customer relationships are rarely in the room.
• They are bounded by the questions asked. A questionnaire covers what its author thought to ask. The company's own records were written before anyone knew there would be a sale, and they hold answers to questions nobody thought to ask.

None of this argues for a shorter checklist. It argues for naming, on every line, what will confirm it. A document proves that something exists. A record in the company's own systems shows what happened. An interview carries the judgment. The checklist below tags every line with one of the three, so the committee can see which lines rest on the record and which rest on someone's word.

From the Checklist to the Memo and the First Hundred Days

A private equity checklist ends in two documents: the investment committee memo and the hundred-day plan. Before the committee meets, every line should be in one of four places:

• Confirmed, with its evidence and the date it was seen.
• Priced, in the valuation or the working capital peg.
• Protected, in the purchase agreement, by counsel.
• Carried, into the hundred-day plan, with an owner.

A line that fits none of the four is an open question, and the memo should say so plainly. Write the thesis into the memo as claims, each citing the lines that tested it, and mark the claims that rest on management's word alone. The carried lines become the first entries in the 100-day integration plan, so the work diligence started does not stop at close.