A thorough inspection


A critical element to any successful investment is the skill and experience of the management team to execute the strategy and adjust to changing market conditions. While a GP will have made an assessment of the portfolio company’s management, it is critical for those managing an institution’s co-investment programme to also do so. It is advisable to have numerous interactions with the management team regarding the business, its drivers and the go-forward operating plan in order to gain insights into the team and their abilities. In addition, personal reference calls to previous employers, investors and colleagues and the employment of a specialist to make complete background checks should be considered. Anything other than a clean record should be addressed with the appropriate individual.

Finally, an institution should conduct broader on-site personnel interviews. By conducting interviews with employees, one can learn more about the qualities and capabilities of the management team and other key personnel. The institution should be able to measure whether or not the employees are well led and whether or not the company’s vision and goals have been clearly defined and communicated. Interviews with junior employees are also helpful as they are not, typically, coached to respond to investor questions. These employees can be a good source of germane information that identifies critical business or personnel issues not articulated by senior management. Site reviews also reveal issues with the assets, work environment and other areas that may require additional capital or management attention.


The next step is to assess the company’s product or service and understand its value proposition. Not having the requisite background or level of expertise in the company’s industry or sector does not mean that an investor should forego a co-investment opportunity. It does imply, however, that the investor should know what it does and does not know. In pre-revenue companies, two primary questions that the institution should be trying to answer are: whether or not the technology, product or service does what it is purported to do, and if not, why; and what will drive adoption of the product or service and in what time frame will that realistically occur? In established companies, it is important to understand the market and competitive conditions driving the company’s revenue and margin projections, and to identify risks associated with the operating plan. This may be a section of the due diligence process where an institution is more reliant on the GP, third party consultant or industry expert. However, with some guidance, an investor should be able to clarify the company’s value proposition and determine if its success is predicated on factors outside of the control of the company, such as the creation or development of another technology or market, or the establishment of an alliance with a complementary company.


Once the product/service and value of a company have been judged, those managing an institution’s co-investment programme will want to review the financial records and management projections of the portfolio company in an attempt to assess its fiscal health and the feasibility of achieving the value creation. The only certainty is that financial projections are rarely correct and often optimistic or inflated. Although GPs will typically have a company’s financial statements audited by a third party, the institution must review and understand the financial statements of the company. This review will help the institution ascertain if company management is fiscally responsible and focused on the value-creating milestones and operating plan. An investor will also want to stress test the financials of the projected operating plan. This would allow the institution to determine if the company would have the capacity to remain economically viable given an extended downside scenario and the key sensitivities driving success.

When reviewing a company’s financial statements, special atten¬tion should be paid to historical and forecasted revenues. Those managing the co-investment programme should have a good understanding of how the company’s management imparts information regarding revenue and how that translates into the overall quality of those revenues. One must also be alive to the potential and propensity for a company’s management and/or the sellers to use unrealistic revenue projections. It is prudent for a co-investment manager to discount these projections considering expected market conditions and management’s track record of meeting stated revenue targets. Customer reference calls can be helpful in verifying future revenue ranges, though even these data points must be considered in context.

Another financial issue that an institution must consider is how much capital has already been injected into the company and how much is expected to be raised. This issue is especially important when considering management’s use of capital and their ability to meet business objectives. An institution may want to avoid companies that have consumed financial resources in excess of comparable companies at similar stages of growth.

Within the realm of conducting due diligence on the financials of a proposed investment, particularly in non control co-investments, it is important for an institution to evaluate the company’s capitalisation (CAP) table and determine the company’s ownership structure on a fully-diluted basis. This will provide insight as to the investor base that has effective control over the company and its direction. In order to ensure alignment of interest, an institution should also carefully consider management, employee ownership and option pool (contained within the CAP table). The appropriateness of issued options will be dependent on several factors, including the stage and type of company, quality of management and management’s ability to achieve business objectives. A typical allocation for management and employees is 10 to 20 percent depending on the stage of the company, not including founder’s shares. In certain types of transactions, investors may also require that management invest or maintain a certain level of ownership in the company.


Most likely prepared in parallel to the assessment of a company’s value proposition and revenue projections, the managers of the co-investment programme should conduct a study of the industry and market in which the company operates. An institution should not rely on third party market analysis or industry consultant reports alone. In pre-revenue companies, an institution must validate the company’s potential customers and gauge their willingness and ability to purchase the offered product or services. Investing in a “better mouse trap” or buying into the premise of “if they build it, someone will buy it” only leads to the funding of someone else’s research and development project. In addition, one will want to identify the key drivers of a potential customer’s purchasing decision and determine if existing purchasing habits will need to be changed. In established companies the markets are typically more defined and historical trends and market information, together with an analysis of the likely market changes, can be used to verify the operating plan projections and assumptions.

The review of market conditions and forces can be accomplished, for example, by preparing a SWOT (strengths, weaknesses, opportunities and threats) analysis of the company, as well as recognising the market dynamics affecting a company by completing an analysis based on Michael Porter’s five forces model. Input into these models and support for the conclusions drawn from them can be achieved by making reference calls to current board members, key management, current and potential customers, competitors or industry insiders, as well as former employees and investors. Another helpful exercise is an analysis of the value chain and where value is migrating during the investment period.


While making reference calls to assess the market environment, an institution should also evaluate the quality and status of the company’s key relationships. These relationships include customers, vendors, possible joint venture partners, influential industry participants, current investors and board members. Where applicable, it is important to understand the make-up and group dynamics of the investor syndicate and company board. An ineffective board can paralyse a company. Therefore, strong personalities, lack of experience with leading companies or the inability to provide sound, strategic advice should be addressed and resolved immediately.


Visiting the offices of companies provides an institution the opportunity to review the physical condition of the premises, information systems, and manufacturing assets and operations of a potential co-investment opportunity. In addition, it will provide an opportunity to meet many more employees and evaluate the strengths, motivations and key challenges of the employee base. The institution may also conduct an informal audit of the company’s record-keeping policies and procedures, and review any environmental and workplace issues.


Due diligence must include a review of the material contracts (supplier, employment, contractor/consulting and sales) and how they impact the business. As due diligence progresses and investor terms and conditions are negotiated, an overabundance of legal documents will be created. Given the complexities of corporate law, it is recommended that an institution utilise the services of a lawyer experienced in the intricacies of investing in private transactions. Typical documents include stock purchase agreements, articles of incorporation, investor rights, schedule of exceptions, prior funding documents, key contracts and strategic agreements. Any past or present litigation or regulatory documents and/or proceedings should also be carefully investi¬gated. In addition, an institution should ask its lawyers to review a company’s intellectual property and patents to ensure freedom to operate and to avoid potential infringement opinions.


Co-investing alongside trusted, top-tier private equity GPs can provide benefits to a private equity portfolio through the placement of capital into this asset class free of the management fees and carried interest associated with a commitment to a fund. Assuming a well diversified portfolio is created, this can lead to a significant value contribution, both financial and, if desired, strategic. However, an institution must approach co-investing with the requisite pre-determined strategy, the appropriate perspective and with caution. The institution must be aware of the drivers of successful co-investment, such as responsiveness, a long-term approach, the ability to add value and understanding the alignment of interests. In addition to generating high quality deal flow, executing a thorough due diligence process is a key part of successful co-investing. Leveraging the GP’s due diligence and experience can be helpful and efficient; however, the activity does require an investment in people and capital to effectively develop relationships and deal flow, conduct inde¬pendent due diligence, manage the transaction process and monitor the portfolio post investment. ?

Kenneth J. Van Heel is global director of alternative investments for portfolio investments at The Dow Chemical Company. He oversees a team of investment professionals managing global investment strategy and execution of private equity fund and direct investments, real estate and real assets and infrastructure for pension plan and insurance assets at Dow.