Private equity due diligence: A CFO’s framework

What is private equity due diligence?

Private equity due diligence is a comprehensive investigation that fund managers at private equity (PE) firms conduct on a potential investment, known as a target company. The primary goal of PE due diligence is to uncover potential liabilities, validate the investment thesis, and confirm that the information provided by the target company is accurate and reliable, as a successful deal will become a key part of the fund's track record.

The process is the foundational analysis for making a sound investment decision. From the perspective of a fund’s chief financial officer (CFO), this process is a vital risk-management function that informs capital allocation. While deal teams and external consultants thoroughly examine the business to identify red flags, the fund CFO leverages this data to procure debt, arrange bridge financing, and structure the leverage required to facilitate the close.

Ultimately, due diligence protects the firm and its investors from unforeseen problems that could jeopardize an investment’s success, especially after a rapid run-up in interest rates shook PE to its core and ended a decade of cheap leverage. For instance, just over 19% of all new rounds on Carta in Q1 2025 were down rounds (consistent with the typical frequency since early 2023). This starkly contrasts with the previous year, when just 5% of deals saw a reduced valuation, highlighting the tangible financial risk of overvaluation that thorough diligence seeks to mitigate.

Why due diligence is different in private equity

Public companies are required to file regular, detailed financial reports that are available to anyone, but companies in private markets are not.

This challenge is magnified because many private equity transactions, such as a leveraged buyout (LBO), use a significant amount of debt to finance the purchase—a particular concern when syndicated loan yields recently approached 10-year highs, causing banks to retreat and new loan issuance to plunge.

After the deal closes, the acquired company becomes responsible for repaying that debt. This financial structure places immense pressure on the target company’s ability to generate stable and predictable cash flows, making a rigorous due diligence process essential for the fund’s CFO and the general partner (GP) managing the investment.

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The private equity due diligence process

To manage the complexity and cost of this investigation, private equity firms typically break the due diligence process into two main phases: exploratory diligence and confirmatory diligence. This structured approach allows a firm to manage its resources effectively. You commit more time and expense only after an initial review confirms the investment is promising.

Phase 1: Exploratory diligence

The first phase is exploratory diligence, which acts as a high-level screening process. As part of the firm's deal flow process, the deal team reviews the confidential information memorandum (CIM)—a document prepared by the seller that provides an overview of the business—and other readily available data. The goal is to identify any immediate deal-breakers or major inconsistencies that would make the investment opportunity unviable.

From a CFO’s viewpoint, initial discussions may focus on financial feasibility: “Do the target’s headline numbers and business model align with our fund’s specific investment strategies and financing capabilities?” If the answer is yes, the firm proceeds to the next, more intensive phase.

Phase 2: Confirmatory diligence

Confirmatory diligence is the in-depth investigation, often formalized in an investment memo, that begins after the PE firm and the target company sign a letter of intent (LOI). An LOI is a non-binding document that outlines the basic terms of the proposed deal and signals serious intent from both parties.

Once the LOI is signed, the target company typically grants the PE firm access to its confidential information. At this stage, the firm engages external advisors (including accountants, lawyers, and consultants) to conduct investigations of every aspect of the business. The deal team consolidates this influx of information to validate the investment thesis.

The focus shifts from “Is this a good investment?” to “What are all the risks, and how do we price them into the deal?”—a vital question in a volatile market where exit value plummeted nearly 70% from its recent peak before bouncing back. This phase is about building the detailed understanding needed to negotiate the final purchase agreement or merger terms, which is the legally binding contract that finalizes the acquisition and informs the subsequent purchase price allocation (PPA).

A CFO’s framework for due diligence

A fund CFO’s role in due diligence is to review the findings of the deal team and consultants to ensure the financial and operational integrity of the potential investment. The CFO relies on a structured framework that covers the key areas of risk and opportunity.

Financial integrity and quality of earnings

The cornerstone of financial due diligence is the quality of earnings (QoE) report. A QoE report is a detailed analysis that adjusts a company’s financial statements and reported earnings to reflect its true, sustainable profitability—a critical exercise in an environment where interest coverage ratios for buyout-backed companies have fallen to their lowest levels since 2007. It does this by removing non-recurring or unusual items that might inflate or hide the company’s actual financial performance.

A QoE analysis scrutinizes several key areas:

• Revenue recognition: Consultants will verify that the company is recording revenue correctly. The CFO reviews this to ensure it is not pulling sales forward from future periods to make growth appear stronger than it is.

• Expense normalization: The analysis identifies items on the income statement and adjusts for one-time costs, personal expenses paid by the owner through the business, or below-market salaries. These items can distort the company’s true operating costs.

• Working capital: This is an analysis of trends in accounts receivable, accounts payable, and inventory, which are often the same assets used to secure asset-based lending.

Just as important as the QoE is a verified cap table, which is the official record of who owns what in the company. An accurate cap table is essential for modeling the exit strategy, including the distribution waterfall, and understanding the full ownership structure.

Operational and systems readiness

Operational due diligence assesses how the business actually runs. This involves evaluating the leadership team, supply chain, processes, and technology that support the company’s day-to-day functions. A CFO needs to know if the target’s back-office and IT infrastructure, such as its accounting systems and customer relationship management (CRM) software, can scale with future growth. Teams must also assess potential risks related to cybersecurity and data privacy.

If these systems are outdated or inefficient, they may require a costly and time-consuming overhaul after the acquisition. Understanding these operational realities factors into the overall private company valuation and the post-acquisition integration plan. This review also extends to the management team’s capabilities, their current equity incentives, and any dependencies on key employees.

Legal and regulatory compliance

Legal due diligence involves a thorough review of all of the target company’s organizational documents, capitalization, intellectual property, litigation, and other legal or regulatory obligations. This includes examining material contracts for change of control clauses that could be triggered by the acquisition. It also means understanding the terms of existing debt, such as senior or subordinated debt, and assessing any pending or potential litigation.

As Arnie Frielandler, partner at Weil, explained during Carta’s Lifecycle of a Private Equity Deal webinar: “Companies are messy, businesses are messy…disclosure schedules should be fulsome and should put on the page how the business works and all the texture of it.”

A growing area of focus is investor and borrower compliance, as regulators introduce amendments designed to facilitate compliance and assist examination staff. Firms are also increasingly scrutinizing ESG (environmental, social, and governance) factors and sustainability practices to ensure long-term viability.

Commercial viability

Commercial due diligence evaluates the target’s business plan and position in the market. This includes analyzing the competitive landscape, the stability of its customer base, and the overall strength of its industry. This part of the process, which can inform future portfolio stress testing, helps you understand the external factors that could impact the company’s future success.

While the deal team typically leads this analysis, the CFO relies on its findings to stress-test the financial projections and validate recurring revenue assumptions. For example, if commercial diligence reveals that a large portion of the target’s revenue comes from a single customer, this represents a significant financial risk. This customer concentration must be factored into the company’s valuation and the post-acquisition strategy, as it will impact future portfolio valuation for the fund.

Building an institutional-grade diligence process

For modern PE firms, due diligence is a capability enabled by PE software. The old way of conducting diligence—a process often defined by scattered data rooms, endless email chains, and messy spreadsheets—creates significant inefficiencies. To streamline workflows and optimize efficiency, firms must reduce the risk of errors—a critical flaw when a recent slowdown has caused dry powder to swell to a record high, intensifying competition for quality assets.

These delays are reflected across the venture landscape: For companies raising a Series B, the median wait since Series A reached 2.8 years in Q1 2025—the longest median interval on record.

A centralized platform transforms this fragmented process. Here’s how:

• Single source of truth: An integrated platform ensures all diligence findings, documents, and communications are in one place. This creates a complete and auditable record of the transaction, which is invaluable for both the deal team and future auditors.

• Streamlined collaboration: Instead of chasing updates from various providers and advisors, the entire deal team—both internal and external—can work from a unified dashboard. This improves communication and accelerates the diligence timeline.

• Audit readiness: A clean, centralized record of the diligence process simplifies post-acquisition work.

For example, QED Investors, a global venture capital firm, leverages Carta’s platform to manage compliance and limited partner (LP) relationships. As CFO Jamie Loving notes, this integration proved valuable, as “important documents are organized to help LPs locate and access them at any time.”

This kind of streamlined access to verified information is what auditors and private equity investors expect. A tool like the Carta Auditor Portal provides secure, permissioned access that transforms the audit from a painful data-gathering exercise into an efficient review.

From due diligence to value creation: Preparing for post-close

The due diligence process is not just about getting a deal to the finish line. The insights gained during this investigation form the blueprint for strategic initiatives and the post-acquisition value creation plan, a key component of strategic portfolio management, which is the ultimate goal of any private equity investment.

This is where a technology-first approach to diligence and ongoing portfolio monitoring becomes a competitive advantage.

For example, middle-market PE firm Kayne Anderson partners with Carta to standardize operational processes across its portfolio. As managing director Andrew DeYoung explains, “We can integrate some of Carta’s technology through the use of APIs to make our operational processes more standardized... It’s accessing the key information you need in a more efficient way.”

This data integrity, established during diligence and maintained post-close, also builds trust with the fund’s LPs.

Request a demo to see how Carta’s suite of products can help you build an institutional-grade diligence process.

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Frequently asked questions about private equity due diligence

How long does private equity due diligence take?

The timeline for due diligence varies depending on the complexity of the deal. It can range from several weeks for an initial review to a few months for a full confirmatory process on a larger, more complex company.

What is the difference between due diligence in private equity and venture capital?

While both involve investigating a potential investment, the focus differs based on the maturity of the target company and the specific private equity fund structure involved.

What are common red flags in due diligence?

While red flags like inconsistent financial reporting, high customer concentration, and weak internal controls are qualitative, their impact can be quantified by observing investor behavior. When private equity investors perceive heightened risk, they often demand protective deal terms. In Q2 2024, for instance, liquidation preference multipliers over 1x appeared in 3.7% of primary rounds (down from a 6.0% peak in Q1 2023).