Private equity due diligence interviews
An overview of the different types of due diligence cases, the key framework and a full walkthrough of an example case.
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Types of cases | Framework | Full case example
Mergers and acquisitions (M&A) topics are one category that comes up routinely in consulting case interviews – often couched in the format of serving a private equity (PE) fund that is conducting due diligence on a new platform investment. (Other common archetypes of case interview questions are discussed elsewhere on the RocketBlocks blog – including pricing case interviews and market sizing case interviews.)
As quick background, private equity is a segment of investment firms that typically makes control investments in companies, frequently leveraging a significant amount of debt. In practice, these engagements most commonly involve a market-focused scope (e.g., determining market size and growth), but the PE case interview may also involve company-level analysis (e.g., evaluating operational excellence).
Interviewers are fond of these question formats because they provide insight into a candidate’s ability to juggle multiple – and sometimes contradictory – data sources to ultimately distill the “so what” from the information, and ultimately drive the interview to a specific go / no-go decision on the acquisition.
Don’t be thrown off if an M&A question is structured in a non-PE format – for example, if the client is a corporation looking to acquire a new subsidiary. Evaluating any acquisition involves the same basic approach.
Types of cases (Top)
Due diligence interview questions can come in a variety of shapes:
EXAMPLE A: "A buyout firm is evaluating an investment in a direct mail company. The target specializes in customized print jobs that vary highly by geography – e.g., mail ballots for local elections, sent only to registered voters – and has been able to successfully increase prices year-on-year. Despite this, revenues are down for the third year in a row. Should the firm invest?"
Be prepared for a question such as this one – which seems to involve a good company caught in a bad market . Investing is messy, and prospective deals rarely look universally good or bad – weighing these inconsistent indicators against one another in a compelling fashion is how you really shine in the interview.
EXAMPLE B: “A large Northwest anesthesiology practice is conducting due diligence on a potential add-on. The practice knows from experience that market volume growth is steady and that most insurers will accept 3-4% rate increases annually. Like the market, the target has successfully been growing revenues, but is seeing days in A/R grow and cash collections drop. How should the practice proceed?”
In contrast to the previous example, this question seems to involve a bad company fumbling through a good market. The investment decision here may hinge on why the target is seeing receivables extend, and whether the buyer believes they can bring the target’s operations up to the parent company’s standards.
EXAMPLE C: “Your client is a growth equity fund analyzing a potential investment in a fast-growing toy manufacturer, which brings to market high-quality “old-fashioned” toys like wooden blocks and music boxes. The client has asked for your help coming to an investment decision, including a point of view on valuation.”
Note that this question is specifically asking you to value the company – i.e., determine how much the fund should pay for it. We’ll discuss valuation further – and return to this example – below.
Framework (Top)
No case interview can be solved with a plug-and-play framework, and that’s especially true for – you guessed it – due diligence problems. That said, the high-level framework below can provide you with solid scaffolding for structuring many M&A cases.
As always, don't forget to customize this framework to the speicifics of the question at hands.
There are two major theoretical steps involved in making an acquisition:
- Evaluate the fundamentals: Think of this step as deciding whether you would want to own the business at any price – that is to say, would you pay for it at all or only take it if it were free? Do this before embarking on Step 2: Valuation analysis, since there’s no need to figure out how much the company is worth if it fails the fundamentals.
- Analyze the market: As mentioned earlier, market analysis is the meat and potatoes of many real-life diligence studies, with much of the work focusing on calculating market size and growth rates.
Understanding the size of the market is key to understanding whether there is sufficient white space for the target to play. Can the target conceivably achieve its growth ambitions, given the size of the market? Is the market dominated by a few players or is the market fragmented?
Understanding market growth is, of course, key to evaluating company growth – it’s far easier to grow revenues when buoyed by market tailwinds. With few exceptions (e.g., perhaps the direct mail example above), a market must generally be growing to justify investment in it. - Analyze the company: Which aspect of the company the interviewer may ask you to analyze – if any – is hard to predict. Follow the interviewer’s prompts and ask probing questions.
A natural area of investigation is the company’s financials. Are revenues growing? Is the company profitable? Are profits growing?
Another high-stakes area to investigate is differentiation. A company which is highly differentiated from competitors has natural “moats” or barriers defending its market share. Valuation analysis:
If you're proceeding to Step 2, you’ve decided that some combination of the market and / or company fundamentals merits investing in the company. This step is about figuring how much to pay.In reality, valuation is the core function of a private equity fund, and so the whole job would not be handed off to a consultant. However, there are many ways consulting work feeds into valuation, and, in some cases, an interviewer will ask you to come up with a purchase price outright.
In these cases, the interviewer will almost certainly give you some numbers and guidance about which direction to head. For example, the interviewer might give you comparable company valuations (e.g., trading multiples) and ask you to calculate a reasonable valuation range based on the target’s earnings. Or, the interviewer might give you an exit value as well as the fund’s “hurdle rate” – or minimum acceptable return – and ask you to back into the maximum price you could pay for the company and still clear the company hurdle rate.
- Fundamentals:
- Market: From the information we’ve already been given, we know the company is growing quickly, but we don’t know whether that’s due to market forces or company outperformance.
You should start by asking questions. How large is the market? Is it growing?
You’re told that the US market is in excess of $25bn – seems plenty large. You’re also told the market is growing ~5% p.a. That’s pretty good, you reason – it seems to be outstripping GDP growth of 2-3% – but maybe doesn’t quite amount to “fast-growing.”
Thus, it looks like the company must be doing something more than simply riding market growth. You might turn to segmentation next.
Upon investigating, you’re told that the market is highly concentrated among three major players: Hasbro, Mattel and LEGO. You’re slightly concerned about the market concentration, but note that the company is still growing at above-market rates despite this competition. - Company: Turning to the company, you might ask about revenue trends. At this stage, you are given three years of financials. Doing some quick math on the revenue figures provided, you confirm that company revenues have, in fact, been growing 10%+ p.a.
Time to figure out why: You start probing on differentiation. Let’s say the interviewer offers you some data on the market growth of different product segments. Scanning the data, you see under-market growth in Action Figures & Accessories and Youth Electronics. You also see above-market growth in Building Sets and Games / Puzzles.
Recalling the information from the beginning of the case, you offer a hypothesis: The target has successfully identified “old-fashioned” toys like puzzles and board games as resurgent high growth areas, and has been focusing on them, while the Big Three competitors have been more focused on slower-growth licensing-driven segments like X Men action figures. Valuation analysis:
Faced with a growing market and an even faster-growing company, you’re likely to want to move forward to valuation.You should probe for direction from the interviewer (channel your inner finesse). You might ask if management has shared projections, or if the fund has a view on exit value on the eventual sale of the company.
Let’s say you’re told that earnings (possibly identified by the funny acronym EBITDA) are $100m today and expected to be $150m in four years. The fund expects they can both buy and sell the company at a 10x multiple of earnings.
Next, you’re asked: Will this investment clear the fund’s unlevered hurdle rate of 10%?
At last, we’ve arrived at the part you’ve been yearning for: mental math. $100m current earnings * 10x multiple = $1bn current enterprise value. $150m future earnings * 10x multiple = $1.5bn future enterprise value. Thus, the increase to enterprise value is $1.5bn - $1.0bn = $500m. Dividing the $500m evenly over four years (using a simplifying heuristic) gives you a $125m annual return.
To calculate the rate of return, you divide the $125m annual return / $1bn initial investment = 12.5%, which exceeds the fund’s hurdle rate. (In practice, valuation math gets rather more complex with the use of leverage and the timing of cash flows – but such analysis runs beyond the scope of a case interview.)
Break the fundamentals into two parts – the quality of the market and the quality of the company:
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Full case example (Top)
Let’s work through the case we introduced earlier step-by-step, using the two-part framework above.
“Your client is a growth equity fund analyzing a potential investment in a fast-growing toy manufacturer, which brings to market high-quality “old-fashioned” toys like wooden blocks and music boxes. The client has asked for your help coming to an investment decision, including a point of view on valuation.”
First: breathe. Second: structure, structure, structure. You should note down the key information as you are given it, and you might diagram out this framework on your page.
Don’t forget to synthesize your findings and provide an unambiguous go / no-go decision. Rather than simply stating that 12.5% is greater than 10% and walking out of the room, you want to tell the story of why the fund should invest.
You might reiterate the expansive size of the market, explaining that it provides a long runway for expansion, and emphasize that the industry as a whole experiences GDP+ growth. You might argue that the company’s strategic alignment with high-growth sectors points to high-caliber management and provides defensibility via early-mover advantages, even if the competition were to pivot in the future. Finally, you might tie it all together by hypothesizing that with best-in-class execution and the benefit of leverage, a 15-20% levered return might be within reach, well above and beyond the 12.5% unlevered rate.
Conclusion
While it can take some acrobatics to get through a private equity due diligence case interview, and this framework may be better suited to some questions than others, this broad structure should help you cover the key problem-solving buckets.
Don’t forget – practice makes perfect. The more you apply this and other frameworks on sample cases, the more agile you will be when an interviewer throws you a curve ball.
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