Due diligence in Investing

Investing in equity markets, whether listed or unlisted, inherently involves risk. Risk arises due to elements outside of the investor’s control and the key challenge lies in identifying, assessing, and managing these risks to maximise returns and preserve capital.

This article highlights the key risks that influence equity markets and offers guidance on how to assess and mitigate these risks. Due diligence, structuring and diversification are crucial in mitigating risk and protecting an investor’s position, particularly in unlisted equity investing. However, for individual investors, these steps are often overwhelming due to resources, knowledge, and capital constraints. Assessing risks and effectively mitigating them is a complex and lengthy process that requires specialised expertise, and this is a key reason why growth equity funds serve as a practical and strategic investment opportunity.

Part I:

Key Risks in Equity Markets

Given the equity market dynamics, the breadth of the risks influencing investment opportunities are inherently difficult to define with precision. Below is a high level summary of the types of risks that an investor should consider before investing in any equity investment.

1. Market Risks – domestic and global

Market risk encompasses risks linked to financial markets and the domestic and global economy. This affects both public and private markets due to its macroeconomic nature.

Domestic macroeconomic factors, including government policies and growth expectations, are deeply interconnected and cyclical. On a global scale, market risks are further shaped by geopolitical dynamics and unpredictable one-off events. Given the breadth and complexity of these risks, they are inherently difficult to define precisely.

To provide a detailed understanding, a comprehensive summary is included in Annexure I of this article.

2. Liquidity Risk

Particularly relevant in unlisted equities, liquidity risk refers to the difficulty or inability to sell an investment position without significantly impacting its price. Investors in unlisted equity positions are generally required to wait until a liquidity event such as an IPO, trade sale, M&A activity or a (rare) sell-down opportunity presenting itself. This means that capital is generally locked up and gains cannot be realised until this time. Conversely, in listed markets, the liquidity risk is generally lower as a formal exchange with active buyers and sellers exists.

Private equity exits have continued to struggle in the last few years and as result, investor funds have continued to be illiquid. A total of 1,255 were completed in the first nine months of 2023, worth $232.4bn in aggregate value, representing 80% of the number achieved in 2022 as a whole, but only 55% by value.

Trade sales remain the dominant exit route for private equity-backed companies. A total of 681 were completed in 2023 making up 54.3% of total exits, compared with 886 in all of 2022. IPOs continued to perform poorly due to weaker public equity market conditions, in spite of a slight recovery in equity valuations over the year.

Annual number of private-equity backed exits by type

IPOs accounted for 9% of all exits by the third quarter of 2024, a historically low level akin to the 2008 credit crunch. Nevertheless, it is up from just 7% in 2023, signaling a potential bottoming out last year.

At the time of liquidating a position, whether listed or unlisted, the sale price is influenced by other risks. Although the liquidity risk is lower in listed markets, other risks discussed in this article still impact the price of liquidity.

3. Concentration Risk

Concentration risk arises where an investor’s positions are overly exposed to specific subgroups such as an asset class, sector or geography. A summary of the types of concentration risks is provided for in Annexure I. Foreshadowing the second part of his article, diversification is a key strategy to mitigate this risk, as it provides a buffer against downturns or key events that can impact a particular subset.

4. Valuation Risk

Determining the fair value of an equity investment is critical to generating a return. Valuation risk refers to the potential for a market price or intrinsic value to differ significantly from its perceived or estimated value. This mismatch can lead to overpaying for investments or realising lower-than-expected returns. While listed equities benefit from transparent pricing, valuing unlisted equities requires a more nuanced approach, such as constructing a discounted cash flow coupled with a comparable company analysis. However, valuation risk is critical in both listed and unlisted equity investments, as the methods and factors influencing valuations can vary widely.

Preqin (2024) noted that over the past two years, higher discount rates have suppressed valuations, resulting in weak exit (and deal) activity. However, the latest deal activity and expected interest rate cuts data suggests that 2025 will be a year of recovery, and we will see an upswing in exit valuations, deal activity and exits. Investor sentiment has improved and optimism is being shown.

5. Company-Specific Risks

Company-specific risks arise from internal factors directly tied to the performance, governance, or strategy of a particular company. These risks include poor management decisions, weak governance structures, or financial mismanagement. For example, a company with a history of accounting irregularities or legal disputes may pose heightened risk to investors. Operational risks, on the other hand, relate to the day-to-day functioning of a business. These include supply chain disruptions, technological failures, or operational inefficiencies that can impact profitability and growth of a business. For instance, companies reliant on global supply chains may face production delays due to geopolitical events, while outdated technology could hinder competitiveness. Such risks directly affect a company’s valuation and ability to meet investor expectations in both listed and unlisted markets.

6. Regulatory Risks

Regulatory risks arise from changes in laws, policies, or compliance requirements that may adversely affect a business or the industry in which it operates in. Regulatory changes can impact both listed and unlisted companies, however, as public companies have greater regulatory compliance obligations than private companies, this risk is generally greater in public markets. Generally speaking, public companies are focused on compliance with stringent disclosure and reporting obligations whereas private companies are more focused on industry specific legislation changes. For example, stricter environmental policies could increase costs for energy-intensive industries, while changes to tax laws might reduce profitability for all corporations. Conversely, unlisted companies, which often operate in niche or emerging sectors, may face heightened scrutiny due to evolving regulations tailored to their industries. Regulatory risks can also arise from international trade policies, data privacy laws, or changes in industry-specific licensing requirements. As Cthe regulatory framework is constantly evolving, companies that fail to adapt to regulatory changes risk fines, legal action, or reputational damage, all of which can negatively affect investor returns.

Part II: Assessing and Mitigating Risk Factors

Assessing risk in both unlisted and listed equity markets is a complex task for any investor. This is due to the limitless factors an investor must evaluate, and the fact that there is no hard and fast rule for the investment process. Growth equity funds, such as the iPartners Emerging Equity Fund, offer an efficient and professional solution to address these challenges while optimising investor returns.

In the listed equity markets, mandatory reporting and disclosure requirements offer investors access to business information on a timely basis. The availability of business reporting coupled with public pricing data provides transparency and helps investors assess company and industry performance. This information is used to assess risks, track record and performance for listed investments as well as comparable data for unlisted investment opportunities.

As the CAIA Association (2020) noted, data on private equity investments is “sparse, highly confidential, and difficult to obtain for research purposes” and this is because there is no public market nor the same disclosure requirements that apply to listed equities. As such, when assessing any unlisted equity investment, due diligence and financial analysis are mandatory processes that must be undertaken to evaluate and price the risk.

Due Diligence

Due diligence is a comprehensive and systematic process undertaken to evaluate a business before committing to an investment. The objective is to verify the company’s financial health, operational efficiency, management quality, market position, and compliance with regulations. This process is essential as it uncovers potential risks, validates financial and operational assumptions, and ensures that the investment aligns with the investor's goals. Additionally, as the due diligence process progresses, naturally, the funnel narrows and any skeletons uncovered throughout the process may form bargaining chips for negotiating structure and pricing – or become dealbreakers.

Annexure I provides an overview of the key areas that are assessed during due diligence. This also highlights the overlap between the risks discussed above and the due diligence process.

More specifically, due diligence involves the sharing and evaluating of information, management and stakeholder meetings, and financial modelling to ensure that no stone is left unturned. However, as there is no due diligence rule book, the process is highly dependent upon many factors such as resourcing, time, personal approach, business type and skillset. It should be noted that it is widely debated whether quantitative or qualitative data is more important in due diligence, yet the optimal approach is to in fact amalgamate the two dataset types as this forms both a wholistic and in-depth view of the business. Professional funds are designed to provide comprehensive risk mitigation strategies that are inaccessible to most individual investors. Investor demand for equity funds, especially growth equity funds, continues to increase, as shown below growth equity funds constitute 30.4% of the total equity fund market.

An advantage of investing in a growth equity fund is access to institutional-grade due diligence. Individual investors often lack the time, expertise, or resources to thoroughly assess a company’s financial health, operational capabilities, and market position. Funds like the iPartners Emerging Equity Fund conduct extensive research and analysis, leveraging expert networks to uncover hidden risks and opportunities. This meticulous approach ensures that investment decisions are informed, reducing the likelihood of unexpected losses.

Deal Structuring

In terms of mitigation strategies, effective due diligence stands at the forefront as the core strategy in assessing and managing risksrisks, however, it is far from the only one. Financial due diligence feeds into deal structuring and the negotiation of ing investment terms and valuation, which are important strategies an investor needshould adopt to protect themselves from downside risks and to determine a suitable entry price for the investment. Deal structuring is perceived as more of an art versus science, and although it involves financial analysis to determine a valuation, smart structuring involves identifying risks and determining deal terms that mitigate, or ideally eliminate, these risks. For individual investors, this is difficult to do, given the lack of leverage and expertisehowever. However, for a lead institutional investor, such as a fund, this is customary practice.

Funds also offer sophisticated deal structuring, a critical tool for risk management. Professional fund managers negotiate terms that protect investor interests, such as securing preferred equity positions, integrating protective covenants, or structuring investments in stages to minimise exposure. These measures provide a layer of security that individual investors cannot typically achieve when investing directly in a single company.

Diversification

An additional strategy, which forms the ethos of the iPartners Funds Management business, is diversification. Diversification is a fundamental investment strategy that involves spreading investment exposure across various assets, industries, geographies, or asset classes to reduce specific risks to one subset. The rationale for this strategy is by investing across multiple companies, industries, and regions, funds reduce the vulnerability associated with concentration in a single asset or sector. By adopting a diversified approachapproach, the overall portfolio risk is reduced, as losses in one area may be offset by gains in another. A diversified portfolio of investments reduces concentration risk, balances a portfolio’s volatility and mitigates both systematic and unsystematic risks. While it may not eliminate all risks, diversification provides a robust framework for achieving more stable and predictable long-term returns.

Active Portfolio Management

Moreover, active portfolio management sets funds apart from static individual investments. Growth equity funds continuously monitor market conditions, company performance, and broader economic trends. This dynamic approach allows fund managers to adjust strategies, rebalance portfolios, and capitalize on emerging opportunities. The result is a level of adaptability that enhances returns while mitigating downside risk.

For example, the iPartners Emerging Equity Fund employs a disciplined and systematic approach to portfolio management. By combining diversification, rigorous due diligence, and advanced deal structuring, the fund delivers a robust framework for navigating the complexities of equity investing. This provides investors with confidence that their capital is being managed with a focus on long-term stability and growth.

Navigating the complexities of equity markets demands a proactive, expert and savvy approach to risk management. Through meticulous assessment and the adoption of risk mitigation strategies – anchored in due diligence, diversification, and effective deal structuring – investors can safeguard their positions and generate superior risk-adjusted returns. Ultimately, investing in a professionally managed equity fund, like the iPartners Emerging Equity Fund, offers investors with an array of benefits. Fund managers master the art of balancing risk and reward, as they zero in on risk mitigation strategies whilst also unlocking opportunities for consistent returns through strategic oversight and institutional expertise. This is why, in an increasingly volatile market, investors seeking to preserve capital and achieve growth adopt a fund investing strategy.

Annexure I – Detailed Summary of Risks Influencing Equity Markets

A. Domestic Market Risks

Economic Growth

Gross Domestic Product (GDP) measures economic health and growth potential, directly influencing investor confidence. A rising GDP indicates increased consumer and business spending, boosting business revenues and profitability. Conversely, GDP contraction dampens investor sentiment and may shift investments to foreign markets.

Monetary Policy and Interest Rates

The Reserve Bank of Australia (RBA) sets monetary policy, including the cash rate. Rising interest rates increase borrowing costs and reduce profitability, lowering appetite for equity investments. Conversely, lower rates stimulate economic activity and valuations.

Inflation

High inflation erodes purchasing power and increases business costs, narrowing profit margins, especially for sectors dependent on stable input costs such as retail and manufacturing.

Currency Fluctuations

The Australian dollar (AUD) impacts export-oriented industries like mining and agriculture. A stronger AUD reduces export competitiveness, while a weaker AUD benefits these sectors.

Sector-specific Trends

Sectoral trends fluctuate over time, influencing equity markets. For instance, a downturn in Australia’s property market impacts construction, banking, and retail sectors.

Meanwhile, technological advancements and evolving consumer behaviour can render some industries obsolete while driving growth in others. A deep dive into the industry frameworks and trends is generally undertaken during due diligence. These risks are critical to understanding the business model, operational intricacies and market dynamics.

B. Global Market Risks

Global market risks involve interconnected economic systems and financial dynamics that shape equity markets globally. These risks stem from the interplay of international trade, capital flows, and macroeconomic policies across major economies, influencing investment opportunities and valuations worldwide.

Global Economy

The health of the global economy significantly impacts equity markets, influencing capital flows, investor sentiment, and market valuations. For instance, economic slowdowns in major economies like the United States or China can create ripple effects across global markets, affecting export-reliant nations like Australia.

Geopolitical Factors

Geopolitical factors, a subset of global risks, impact markets through political, economic, and security developments:

• International Trade Agreements: Changes in trade policies and agreements affect businesses reliant on imports or exports. For instance, the Australia-United Kingdom Free Trade Agreement (A-UKFTA) eliminates tariffs on over 99% of Australian goods exported to the UK, enhancing opportunities for sectors like agriculture and technology.

  
  

• Commodity Prices: Australia’s reliance on resource exports makes its economy sensitive to global commodity price fluctuations, impacting operational expenses and profitability in sectors like manufacturing and construction.

Global Economic Events

Global economic events, such as recessions, financial crises, or significant policy shifts in major economies, have profound implications for equity markets worldwide. Events like the COVID-19 pandemic, the 2008 GFC, or shifts in US-China relations significantly affect Australian markets. For example, following the 2024 US election, the AUD weakened, impacting businesses reliant on imports and exports, while the ASX 200 index surged due to favorable US policy announcements.

The following graph shows AUD/USD exchange rate movements following the 2024 US election:

Concentration Risk

Concentration risk can arise due to overexposure in the following categories:

• Sector: Overallocation to a particular industry can lead to portfolio vulnerabilities during sector downturns. Certain investors may focus on sectors as they have experience or expertise in the industry or a belief that the industry has a high growth profile however, sector-specific events can wipe out an entire portfolio.

  
  

• Company: Excessive investment in a single company or a small group amplifies risk.

  
  

• Geography: Heavy exposure to a single region makes portfolios vulnerable to local economic, locational or political disruptions.

  
  

• Asset Class: Focusing solely on one asset class such as listed equities or unlisted shares limits diversification and increases vulnerability to systemic risks.

  
  

Key Topics Covered By Due Diligence