Dealmaking in private equity nearly ground to a halt last year. Year-over-year, deal counts plummeted,1 with a decline of up to 65% in 2022, followed by another 40% drop in 2023. By Q4/23, the private capital industry was sitting on an unprecedented $4 trillion in ‘dry powder,’2 or capital waiting to be deployed.
However, 2024 brought renewed momentum as inflation has cooled and supply chain disruptions have eased. In Q2/24, 134 deals were announced,3 amounting to $195 million — nearly double the $97 million in Q1/24 — making it the most active period of capital deployment since the downturn began in late 2022.
The floodgates have opened: deals that seemed unlikely less than a year ago are back on the table. Start-ups, particularly in the AI sector, are emerging to capitalize on this enthusiastic spending spree, with many aiming for quick exits. AI alone accounted for 50% of all deal value in Q2/24.4 Additionally, many small, family-run businesses with aging owners and difficulty in succession planning are eager to sell. Under the hood, however, many of these companies may have more issues than they’re letting on.
As competition for acquisitions grows and demand outpaces rational deal valuations, reputational due diligence comes to the fore with new urgency. Without thorough scrutiny, a private equity firm risks damaging its hard-earned successes by acquiring a company with hidden legal liabilities, unresolved debts or a questionable ethical history.
Traditionally, reputational due diligence has been seen as a box-ticking exercise: reviewing financials, contracts, client lists and scanning public perception. However, this surface-level approach is outdated in today’s more complex, technological and competitive acquisition landscape.
Private Markets Face Increased Regulatory Scrutiny
A recent wave of regulations has further heightened the need for new dimensions of due diligence. Lawmakers are making it clear: private markets will now face the same scrutiny as their public counterparts.
The Foreign Investment Risk Review Modernization Act (FIRRMA) of 2018 expanded the reach of the Committee on Foreign Investment in the United States (CFIUS), requiring private equity transactions that cross borders or involve foreign investors to undergo detailed disclosure and national security assessments. Similarly, the European Union’s General Data Protection Regulation (GDPR) imposes stringent data protection and privacy requirements, creating significant compliance hurdles for companies operating in the global marketplace.
We’re in an age when companies are in a race to collect customer data to refine their algorithms. However, this excessive accumulation of data, combined with increasingly strict privacy regulations and the SEC’s 2023 cyber disclosure rules, has created a ticking time bomb within many organizations. These rules require companies to promptly disclose material cybersecurity incidents and outline their risk management strategies. As data collection increases, so does the risk of non-compliance and cybersecurity breaches, which could result in significant fines and irreversible reputational damage.
Geopolitical Tension Rises
In recent years, geopolitical tension has also escalated, with conflicts in Eastern Europe, the Middle East and increasingly strained relations with China. As a result, private equity firms must navigate a complex web of sanctions and trade-offs during dealmaking. For instance, acquiring a company led by someone outspoken on sensitive issues, such as the Hong Kong protests, could alienate the Chinese market.
Additionally, due diligence teams must investigate potential ties to sanctioned individuals or organizations, including past employment with Russian companies or hidden foreign bank accounts.
New Technology Brings New Risks
Reputational due diligence has evolved significantly over the past few decades, shaped by each modern wave of corporate fraud, from the dot-com bubble to the Enron scandal and the 2008 financial crisis. The collapse of FTX last year, though driven by poor governance, is another example of how emerging technologies bring new risks. Investigators must now look in unexpected places, as cryptocurrency introduces new avenues for fraud, money laundering and tax evasion.
With this competitive dealmaking landscape, heightened regulatory scrutiny, geopolitical tension and an entirely new shadow banking system that can be used for illicit activities, it’s becoming a daunting task for investigators — akin to inspecting every relationship in the value chain from supplier of raw materials to the finished garment on the shelf of a luxury retailer.
Public Databases Can Uncover Critical Details
In light of these challenges, what tools do investigators have to navigate this increasingly complex landscape? It may seem very basic that many reputational red flags can be uncovered using information readily available to the public. A crucial initial step involves verifying details such as an individual’s birth, education, professional credentials and licensing — facts that dealmakers often blindly assume to be true. There have been cases in which it’s discovered that a high-profile executive claiming otherwise hadn’t completed their undergraduate studies, let alone an advanced degree — a revealing oversight indeed.
Beyond verifying background information, investigators examine publicly available legal records of both individuals and the companies they’ve been involved with, including checking for any involvement in serious litigation or issues with regulatory bodies. However, this process is not always straightforward; in industries like oil and gas, multiple regulatory bodies beyond the Federal Energy Regulatory Commission must be considered. Social media accounts are also scrutinized, though this avenue has recently become less fruitful as executives grow more cautious about sharing personal information online, with some avoiding social media altogether to prevent career-damaging slip-ups.
Don’t Lean Too Heavily on Automation
Only after exhausting public records do investigators turn to private databases. Even these cannot provide a complete picture, however. A thorough examination requires the person conducting reputational due diligence to act like an investigative journalist, digging deeper than automated systems generally enable. Many organizations mistakenly reduce due diligence to digital box-checking, overlooking the fact that red flags often require the expertise and intuition of a skilled investigator to uncover.
In-person interviews are particularly effective at uncovering gray area situations — and they carry more weight today, especially in the wake of the #MeToo movement. An individual may not have broken any laws, but their behavior could be perceived as hostile, discriminatory or sexually predatory within the workplace. On paper, someone might seem like a high performer, but a conversation with a former employer or coworker could reveal issues that are better addressed now, rather than in court later.
Identifying Both the Weak Link and its Consequences
Modern due diligence requires not only assessing the risks associated with an individual or company, but also evaluating the potential fallout if those risks materialize. The supply chain crisis of 2021 to 2023 was a wake-up call for many organizations, revealing how reliance on a single supplier could cripple operations. Now, businesses are diversifying their suppliers and planning for alternatives. Similarly, in private equity, when investigators uncover an executive, client or partner with a questionable track record, the focus shifts to whether the company can survive their departure or if they pose a larger risk that could sink the entire firm.
With every new wave of technology comes an accompanying surge in fraud. As artificial intelligence becomes ubiquitous across organizations, private equity firms must anticipate these shifts by moving from reactive to proactive due diligence. The rise of AI opens new avenues for fraud, money laundering and data manipulation, making it crucial for firms to stay ahead of the curve and identify potential risks before they become costly mistakes. •
- Conway, Edwin, et al., “2024 Private Markets Outlook,” BlackRock.
- “The private capital industry’s ‘dry powder’ has hit $4tn,” Financial Times. Dec. 12, 2023.
- Whitte, Pete, “Private Equity Pulse: key takeaways from Q3 2024,” EY, Oct. 24, 2024.
- US VC Valuations Report,” PitchBook, Aug. 7, 2024.
Sam Taylor is head of corporate intelligence for the Americas at S-RM, a global corporate intelligence and cybersecurity consultancy. He can be reached at [email protected]
