Deal Origination and Due Diligence in Private Equity Explained

This article goes into detail on how to search for, identify and evaluate a private equity investment with a deal origination process and rigorously assess the leadership team pre-deal with leadership due diligence.

By: Leadership Dynamics team


5 mins

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The route to a completed deal in private equity is never totally linear, nor even straightforward, but there are some stages of the process that are critical to its success: deal origination and due diligence – identifying, pitching and rigorously evaluating investment opportunities before a purchase.

This article will explain what the two terms mean and how they work, helping you learn to identify opportunities and conduct the due diligence necessary to de-risk a deal.

What is deal origination?

Before you can buy a company, you need to find one. Deal origination, also called deal sourcing, is the process of identifying qualified investment opportunities that fit within a private equity fund's investment criteria.

Deal origination methods

The traditional approach to deal sourcing is conducted through a firm’s deep knowledge of a market, their reputation and their network of contacts. They will bid on opportunities as they find them.

Financial intermediaries like corporate finance houses who offer deal advisory and transaction services also do their own deal origination, and approach private equity firms with potential opportunities. Much like an estate agent feeds home buyers lists of properties they think they would like.

Then, there are online deal sourcing platforms that use data and technology to match buyers and sellers (like a Rightmove or Zillow for buying and selling businesses). These tools let buyers or intermediaries search outside of their networks, and automate time-intensive processes like deal tracking.

Some platforms can even predict which companies are likely to be ready for a transaction in the near future, based on shareholder, financial and leadership data.

The deal origination process

Any private equity firm needs a healthy flow of investment opportunities coming their way. When the volume of deals in their target market is high, they can rely on the corporate finance houses to bring opportunities to them, but during times of uncertainty, when volume is low, buyers need to be proactive.

Firms often use intermediaries to explore their target markets, and while deal origination is an art not a science, they will normally involve the following:

1. Market mapping

This is where you build your longlist of potential transactions by identifying companies that fit your criteria and could be ready for a sale.

First you need to know what the market looks like. Who are they key players? Who is likely to sell? Who might want to divest some of their brands?

As with all market research and competitor analysis, knowing the market will help you mitigate risk.

Enhancing the process with technology

It’s possible to speed up the traditional deal origination process, from weeks and months to just a few clicks. At the market mapping stage, analytics and search tools can cut out the middle man – and their fees, which can be 5-10% of the total sale – to bring private equity firms a short list of companies that both fit the bill and are most likely to go for a capital event in the near future.

At Leadership Dynamics, we call this function of our tools our “transaction propensity analysis”. Using our rich data sets, we look at the number, type and age of shareholders, as well as financial information. Most importantly we assess the behaviours of their current leadership using PACE so that buyers can understand the future sustainability of the team. 

In 2013 a private equity firm bought UK taxi business Addison Lee for £300m, only months before Uber entered Europe and completely disrupted the market.

Getting a sense of how the market will evolve can be extremely helpful when identifying potential investment opportunities and help avoid any nasty surprises.

By looking at historical deals, you can understand how consolidated the market is and whether there are other transactions currently underway. And if the market is dominated by large entities, there could be opportunities for carve-outs on which to build.

3. Talking to experts

Talking to people who have extensive experience in the market, and know the companies you are considering purchasing, can use their industry specific knowledge to help you explore your market beyond the data.

Identify senior alumni from potential investments and their competitors. These advisors can confirm what you were expecting, warn you of unseen weaknesses and even open up new opportunities.

4. Shortlist and approach

Sift through the deals that will work for your investment team and your limited partners. Once you have your shortlist, it's time to get in contact.

Pre-deal due diligence

Due diligence is the process of verifying or auditing a potential investment opportunity to confirm all information, financial or otherwise, is as it has been presented during the deal process.

During the due diligence phase, investors will conduct financial due diligence (FDD) once the books are opened up, and audit teams will ensure the finances are as expected.

At the same time, teams will conduct commercial due diligence (CDD) to assess its position within the market and forecast its competitiveness. Technical due diligence (TDD) is especially important when purchasing a software company, but should be done for all companies’ IT systems and digital platforms.

It's a way of mitigating risk to a buyer. But also could uncover previously unexpected value and increase the price in the seller's favour.

Key questions to ask during your due diligence phase include:

  • Why is the owner selling the company?

  • Have they tried to sell the company before?

  • Are the financial statements audited?

  • Are future projections reasonable?

  • What is their marketing strategy?

  • Who are the company’s top customers?

  • How will the company fit into the buyer’s organisation?

  • What does their ESG look like?

  • What digital tools do they use?

  • Do they have patented technology?

How to conduct leadership due diligence

This is often called management due diligence or MDD, but we like to call it leadership due diligence, or LDD. Leadership assessment is becoming increasingly important as a requirement from investment committees, as firms recognise that the quality of the management team is a major differentiator. And so, now more than ever, it is essential to assess management to judge the resilience of not only the business but its senior leaders in changeable market circumstances.

Our research shows that 71% of investment directors cite the calibre of leadership as the primary reason for success in a PE growth journey. 

Leadership is an asset that you can develop, whether by expanding a team, developing it with new skills or hiring new people. But if it’s not right for the business, it can also be a liability. And waiting too long to make a change can have negative impacts on the investment timeline.

Our research also shows that the best performing businesses make more change earlier in the investment cycle – most within the first 9 months and on average 4.2 times through the investment journey. Conversely, the lowest performing businesses still make leadership changes 18 months post-deal, which impacts the value creation plan and the stability of senior leaders.

So, assessing an existing leadership team pre-deal is responsible due diligence. Find out how Leadership Dynamics helps private equity firms with pre-deal leadership evaluations.

Removing emotion from the deal

Private equity investors often have to make decisions based on the quality of their relationships, and relationships can introduce bias. Firms that use data-led people analytics tools allow themselves a dispassionate assessment of an existing or potential team, which removes any personal biases and relies solely on objectivity.

Assessing with relevant data

People analytics tools work best when they use data that is relevant. Most well-known psychometric tests rely on surveys from the general population, which is too broad to have any relevance when hiring leaders.

More than 4000 executives from high-growth businesses have taken our PACE test (Pragmatism, Agility, Curiosity and Execution), which has a relevant dataset to create archetypes that suit each C-suite role. Take the test yourself and discover your behavioural profile. It will give you an idea of how detailed you can get with potential hires and current leaders in your portfolio companies, and your prospective investments.

Regular leadership assessments

As well as pre-deal, pre-exit is also a good time to evaluate your leadership, when you are making your company as attractive as possible to buyers.

If they are a new team, you need to be able to demonstrate their effectiveness. And that’s where the data can paint a clear picture of each individual and how they fit together as a whole.

If you need to hire new leaders, most firms employ executive search companies. But there are also tools to help you. For example, Leadership Dynamics' Livelist tracks private equity deals in real-time, and highlights those C-Suite executives who will soon be available post-deal, as well as the immediately available candidates in the market.

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