Quantifying Due Diligence

Research by consultants, law firms, etc. adds no value in private equity, a study finds.

Due diligence can be a source of alpha for investors, two academics have found—but only if consultants and other third parties are kept away.

“Our findings suggest the existence of apparent agency costs underlying the due diligence delegated to external agents.”Douglas Cumming, of York University’s Schulich School of Business in Ontario, and Simona Zambelli, of the University of Bologna, studied hundreds of private equity buyouts and exits made by Italian investors between 1999 and 2012.

A thorough due diligence process is “associated with improved firm performance” and a better selection of investee companies, the researchers found. It also has “a crucial role and a high economic value in the context of private equity.”

“Our data show that the due diligence carried out internally by fund managers has a more pronounced impact on performance,” Cumming and Zambelli wrote. “No significant impact emerges with reference to the due diligence performed by external agents,” including accounting firms, law firms, and consultants.

The amount of time private equity fund managers spent on research and due diligence linked directly to investments’ subsequent performance. Returns on assets and profitability-to-sales (EBITDA) ratios outperformed for thoroughly investigated deals, according to the data, which researchers sourced from general partners and third parties.

“Ultimately, our findings suggest the existence of apparent agency costs underlying the due diligence delegated to external agents,” Cumming and Zambelli wrote. The pair called for more research to confirm their findings, particularly on the return implications of outsourcing such processes.

“The opportunity cost of time is enormous [in private equity] and investors may be tempted to rush the evaluation process underlying the due diligence or to delegate it outside in order to allocate more attention to managing and adding value to their existing portfolio firms,” the authors wrote.

Separate research from data firm Preqin, published earlier this year, has shown that private equity investors generally have higher return expectations than for other asset classes. Their 14% to 15% median target return well outstripped hedge fund investors’ 8% to 9% expectation.

Read Cumming and Zambelli’s full study, “Due Diligence and Investee Performance.”

Related: Why Due Diligence Is Broken, and How 18 CIOs Would Fix It